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A number of transfer pricing cases, many with potentially significant precedent value and tax provision consequences, are either at trial or proceeding to trial. Michael Peggs and Cheryl Magat comment on two of the major cases on the Tax Court Docket, Altera and Zimmer. Those who think arm’s length means “do what others do” will be surprised.
Read MoreJudicial authorities in India are recommending that the country adopt a similar position as the United States with respect to offshore bank accounts. While investigating the “black money” held in undeclared Swiss bank accounts by 628 wealthy Indians, two of the judges recommended that tax evasion should constitute a criminal offense and not simply a civil one.
The scandal has been at the forefront of both political discussion and legal debate since there is a fine line that is being straddled between disclosing and punishing these tax evaders versus violating the confidentiality clause from the Indian-Swiss tax treaty. According to the treaty, these account names can only be revealed once charges identifying the specific individual have been filed.
In India, “black money” has always been an obstacle to tax collection. Black money constitutes undeclared income that has been “hidden,” profits from the undervaluation of exports, and earnings from fake invoices or unaccounted-for goods. Black money not only affects the national treasury, but has fueled corruption, too. According to the judges, classifying tax evasion as a criminal offense, and dealing with these lawbreakers more strictly should serve as a deterrent.
In conjunction with its audit of Microsoft’s cost-sharing transfer pricing methods for the 2004-2006 tax years, the I.R.S. has filed a petition for enforcement of an issued summons for 50 types of documents, including those relating to marketing, R&D, financial projections, revenue targets, employees, studies, and surveys.
The O.E.C.D.’s pending base erosion and profit shifting action plan is due to face a significant challenge as to how to address controlled foreign corporations. Action 3, which strengthens C.F.C. rules, is set to be released in 2015. Currently, European case law restricts the scope of E.U. members establishing C.F.C. regimes.
Stephen E. Shay of Harvard Law School says the U.S. is encouraging the expansion of the C.F.C. rules as a way to solve several of the issues the B.E.P.S. action plan is trying to address, however, these new rules run the risk of being contrary to E.U. jurisprudence. The E.U.’s ability to adopt stringent C.F.C. rules is limited by the Cadbury Schweppes (C-196/04), a 2006 ruling from the Court of Justice of the European Union. The Court held that E.U. freedom of establishment provisions preclude the U.K. C.F.C. regime unless the regime “relates only to wholly artificial arrangements intended to escape the national tax normally payable.”
Without resolving the issue among E.U. countries, Action 3 may not be effective in appropriately addressing earnings stripping. However, Shay also added that Action 2, which neutralizes the effects of hybrid mismatch arrangements, so far appears to include an approach that works without C.F.C. rules.
Department of Justice announced that charges have been laid against Peter Canale, a U.S. citizen and resident of Kentucky, for conspiring to defraud the I.R.S., evade taxes, and file a false individual income tax return. It is alleged that Canale conspired with his brother and two Swiss citizens to establish and maintain secret, undeclared bank accounts in Switzerland.
In approximately the year 2000, a relative of Canale died and left a substantial portion of assets which were held in an undeclared Swiss bank account to Canale and his brother, Michael. The brothers met with two Swiss citizens, who agreed to continue to maintain the assets in the undeclared account for the benefit of the Canales.
Israel has announced that it will adopt the Standard for Automatic Exchange of Financial Account Information: Common Reporting Standard (“C.R.S.”) issued by the O.E.C.D. in February 2013.
The C.R.S. establishes a standardized form that banks and other financial institutions would be required to use in gathering account and transaction information for submission to domestic tax authorities. The information would be provided to domestic authorities on an annual basis for automatic exchange with other participating jurisdictions. The C.R.S. will focus on accounts and transactions of residents of a specific country, regardless of nationality. The C.R.S. also contains the due diligence and reporting procedures to be followed by financial institutions based on a Model 1 F.A.T.C.A. intergovernmental agreement (“I.G.A.”).
At the conclusion of the October 28-29 O.E.C.D. Forum on Transparency and Exchange of Information for Tax Purposes, about 50 jurisdictions had signed the document. The U.S. was notably absent as a signatory to the agreement. In addition to the C.R.S., the signed agreement contains a model competent authority agreement for jurisdictions that would like to participate at a later stage.
Implementation of many of the B.E.P.S. Action Items would require amending or otherwise modifying international tax treaties. According to the O.E.C.D., the sheer number of bilateral tax treaties makes updating the current treaty network highly burdensome. Therefore, B.E.P.S. Action Item 15 recommends the development of a multilateral instrument (“M.L.I.”) to enable countries to easily implement measures developed through the B.E.P.S. initiative and to amend existing treaties. Without a mechanism for swift implementation of the Action Items, changes to model tax conventions merely widen the gap between the content of the models and the content of actual tax treaties.
Discussion of Action Item 15 has centered on the following issues:
In the spirit of these ongoing discussions concerning Action Item 15, we offer our commentary in a “point/counterpoint” format.
After an arduous path through the courts regarding the creditability of the U.K. windfall tax, the Third Circuit followed the holding of the U.S. Supreme Court and found the tax to be creditable in a case involve PPL Corp.
The U.S. and foreign countries can tax foreign-sourced income of U.S. taxpayers. To lessen the economic cost of double taxation, U.S. taxpayers are allowed to deduct or credit foreign taxes in computing income or net tax due. The amount of the U.S. income tax that can be offset by a credit cannot exceed the proportion attributable to net foreign source income. Code §901(b) specifies that a foreign credit is allowed only if the nature of the foreign tax is similar to the U.S. income tax and is imposed on net gain.
The U.S. entity PPL is a global energy company producing, selling, and delivering electricity through its subsidiaries. South Western Electricity PLC (“SWEB”), a U.K. private limited company, was an indirect subsidiary that was liable for windfall tax in the U.K. Windfall tax is a 23% tax on the gain from a company’s public offering value when the company was previously owned by the U.K. government. When SWEB paid its windfall liability, PPL claimed a Code §901 foreign tax credit. This was denied by the I.R.S. and the long and winding litigation commenced.
Initially, the Tax Court found the windfall tax to be of the same character as the U.S. income tax. The decision was reversed by the Third Circuit Court of Appeals, which held that the tax was neither an income tax, nor a war profits tax, nor an excess profits tax. It took into consideration in determining the tax base an amount greater than gross receipts. Then, the Supreme Court reversed, finding that the predominant character of the windfall tax is an excess profits tax based on net income. Therefore, it was creditable. In August, the Third Circuit followed the Supreme Court’s decision and ordered that the original decision in the Tax Court should be affirmed.
Anyone may soarrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury. There is not even a patriotic duty to increase one’s taxes.
– Judge Learned Hand
Helvering v. Gregory, 69 F.2d 809, 810-11 (2d Cir. 1934).
To invert or not to invert: That seems to be the question many U.S. corporations are deliberating today, particularly in the context of acquisitions of non-U.S. businesses. Although the level of the political and public outcry on the “evils” of inversion transactions is a recent phenomenon, inversion transactions are not new to the U.S. business community. This article provides a perspective on the issue of U.S. companies incorporating in other jurisdictions by means of inversion transactions. It will discuss the historical context, the legislative and regulatory responses, and current events including proposed legislative developments as of the date of publication. Finally, we will offer our suggestions for a reasonable approach to the inversion issue designed to balance the governmental and the private sector concerns.
What is an Inversion?
An inversion transaction is a tax-motivated corporate restructuring of a U.S.-based multinational corporation or partnership in which the U.S. parent corporation or U.S. partnership is replaced by a foreign corporation, partnership, or other entity, thereby converting the U.S. entity into a foreign-based entity. In a “self-inversion,” the U.S. entity effects an internal reorganization by re-domiciling in another jurisdiction. In an “acquisition-inversion,” a U.S. entity migrates to a foreign jurisdiction in connection with the purchase of a foreign-incorporated M&A target corporation. In this latter type of inversion, the target and the U.S. entity often can be combined under a new holding company in a lower-tax foreign jurisdiction.
On July 24, the I.R.S. selected Kenneth Wood, senior manager in the Advance Pricing and Mutual Agreement Program, to replace Samuel Maruca as acting director of Transfer Pricing Operations. The appointment took effect on August 3, 2014. We previously discussed I.R.S. departures, including those in the Transfer Pricing Operations, here.
To re-iterate, it is unclear what the previous departures signify—whether the Large Business & International Division is being re-organized, or whether there are more fundamental disagreements on how the Base Erosion and Profit Shifting (“B.E.P.S.”) initiative affects basic tenets of international tax law as defined by the I.R.S. and Treasury. Although there is still uncertainty about the latter issue, Ken Wood’s appointment seems to signify that the Transfer Pricing Operations’ function will remain intact in some way.
President Obama echoed many of the comments coming from the U.S. Congress when he recently denounced corporate inversion transactions in remarks made during an address at a Los Angeles technical college. As we know, inversions are attractive for U.S. multinationals because as a result of inverting, non-U.S. profits are not subject to U.S. Subpart F taxation. Rather, they are subject only to the foreign jurisdiction’s tax, which, these days, is usually lower than the U.S. tax. In addition, inversions position the multinational group to loan into the U.S. from the (now) foreign parent. Subject to some U.S. tax law restrictions, interest paid by the (now) U.S. subsidiary group is deductible for U.S. tax purposes with the (now) foreign parent booking interest at its home country’s lower tax rate.
“Inverted companies” have been severely criticized by the media and politicians as tax cheats that use cross-border mergers to escape U.S. taxes while still benefiting economically from their U.S. business presence. This has been seen as nothing more than an unfair increase of the tax burden of middle-income families.
Recently, the First Circuit held that Code §936 does not require a credit cap decrease for the U.S. seller of business lines in Puerto Rico if the buyer is a foreign entity that does not pay U.S. corporate income tax. In OMJ Pharmaceuticals, Inc. v. U.S., a U.S. corporation based in Puerto Rico transferred a significant portion of its assets to an Irish subsidiary; the corporation was not required to decrease its base period income for the purposes of computing the cap on its Section 936 possessions tax credit. As a result, the corporation’s credit was not capped at the lower amount that was asserted by the I.R.S., thus allowing the corporate taxpayer a refund of close to $53 million.
From 1976 to 1996, Code §936 provided to U.S. corporations a credit that fully offset the federal tax owed on income earned in the operation of any trade or business in Puerto Rico. Under the Small Business Job Protection Act of 1996 (P.L. 104-188), the credit was repealed and phased out over a ten-year period. During this transition period, the credit remained available only to those taxpayers who had claimed it in previous years. Furthermore, during the last eight years of the transition period the taxable income that an eligible taxpayer could take into account in computing its credit was capped at an amount roughly equal to the average of the amounts it had claimed in previous years. Although the cap was generally fixed, it could be adjusted up and down to account for the taxpayer’s purchases and sales of lines of business that had generated credit-eligible income.
When a U.S. company acquires foreign targets, the use of a holding company structure abroad may provide certain global tax benefits. The emphasis is on “global” because standard U.S. benefits such as deferral of income while funds remain offshore may not be available without further planning once a holding company derives dividends and capital gains. This article will discuss issues that should be considered when setting up a company overseas, particularly a foreign holding company, in order to maximize foreign tax credits despite the limitations under the U.S. tax rules, and to reduce the overall U.S. taxes paid. These issues include challenges to the substance of a holding company, recent trends in inversion transactions, the net investment income tax on investment income of U.S. individuals, and the significance of the O.E.C.D. Base Erosion and Profit Shifting report on tax planning structures.
If we assume the income of each foreign target consists of manufacturing and sales activities that take place in a single foreign country, no U.S. tax will be imposed until the profits of the target are distributed in the form of a dividend or the shares of the target are sold. This is known as “deferral” of tax. Once dividends are distributed, U.S. tax may be due whether the profits are distributed directly to the U.S. parent company or to a holding company located in another foreign jurisdiction. Without advance planning to take advantage of the entity characterization rules known as “check-the-box,” the dividends paid by the manufacturing company will be taxable in the U.S. whether paid directly to the parent or paid to a holding company located in a third country. In the latter case, and assuming the holding company is a controlled foreign corporation (“C.F.C.”) for U.S. income tax purposes, the dividend income in the hands of the holding company will be viewed to be an item of Foreign Personal Holding Company Income, which generally will be taxed to the U.S. parent company, or any other person that is treated as a “U.S. Shareholder” under Subpart F of the Internal Revenue Code.
The Stop Corporate Inversions Act was introduced in the Senate on May 20 by Senator Carl Levin. The bill represents an attempt to tighten U.S. tax rules preventing so-called “inversion” transactions, defined generally as those involving mergers with an offshore counterpart. Under current law, a U.S. company can move its headquarters abroad (even though management and operations remain in the U.S.) and take advantage of lower taxes, as long as at least 20% of its shares are held by the foreign company's shareholders after the merger. Under the bill, the foreign stock ownership for a non-taxable entity would increase to 50% foreignowned stock. Furthermore, the new corporation would continue to be considered a domestic company for U.S. tax purposes if the management and control remains in the U.S. and at least 25% of its employees, sales, or assets are located in the U.S. The Senate bill would apply to inversions for a two year period commencing on May 8, 2014. A companion bill (H.R. 4679) was introduced in the House which would make the changes permanent. However, the bills face opposition on the Hill with lawmakers indicating that the issue could be better solved as part of a broader tax overhaul. House Republicans favored pushing corporate tax rates lower as opposed to tightening inversion requirements, believing that the lower rates would give corporations an incentive to stay in the U.S. and invest, rather than go overseas for a better corporate tax rate. Senate Finance Committee Chairman Ron Wyden (D-Ore.) stated that he would consider the issue at a later time during a hearing on overhauling the international tax laws but would not introduce anti-inversion legislation nor would he sign onto the Levin bill. We agree that any changes to the inversion rules should not be made in isolation but as part of an overall rationalization of the U.S. international tax system.
After more than two weeks of speculation, 49 on June 18, 2014, the I.R.S. announced major changes to its current offshore voluntary disclosure programs earlier today. The programs affected are the 2012 Streamlined Filing Compliance Procedures for Non-Resident, Non-Filer U.S. Taxpayers (the “Streamlined Procedures”) and the 2012 O.V.D.P.
In general, as will be discussed in more detail below, the changes to the programs relax the rules for non-willful filers and at the same time potentially increase penalties for willful non-compliance.
The changes to the O.V.D.P., as announced today, include the following:
In 2014-8 I.R.B., the I.R.S. proposed amendments to regulations issued under Code §707 relating to disguised sales of property to or by a partnership and under Code §752 regarding the treatment of partnership liabilities. The proposed regulations address certain deficiencies and technical ambiguities in the existing regulations and certain issues in determining partners’ shares of liabilities under Code §752. The proposals are designed to limit taxpayers’ ability to structure a sale of a partnership interest as a contribution of property by one partner and the receipt of a distribution by a second partner in a way that is not taxable in the year of the transaction. For a foreign investor, the proposed regulation regarding the interplay of partnership liabilities and investor basis in the partnership add another unwelcome level of complexity that must be accounted for in tax planning for an investment. The reason is that a partner’s ability to deduct losses of a partnership or L.L.C. is capped at the basis maintained in the partnership interest held. Partners have basis for liabilities of the partnership. The issue is the allocation of losses among the partners or members. The proposed regulations limit ways to increase basis through planning mechanisms that have been accepted for a long period of time.
Background
A partnership is said to be created when persons join together their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business and when there is community of interest in the profits and losses.
On December 5, 2013, proposed and final Treasury Regulations were published, relating to U.S. source dividend equivalent payments made to nonresident individuals and foreign corporations. On February 24, 2014, a correction to the proposed regulations was published, which tackles errors contained in the 2013 proposed regulations. The corrections mainly clarify the 2013 proposed regulations and prevent any potential misleading caused by their formulation. In addition, on March 4, 2014, the I.R.S. released Notice 2014-14, which states that it will amend forthcoming regulations to provide that specified equity-linked instruments (“E.L.I.’s”) will be limited to those issued on or after 90 days following publication of the final regulations. This will allow additional time for financial markets to implement necessary changes.
On March 25, 2014, H.K. and U.S. governments signed a Tax Information Exchange Agreement (“T.I.E.A.”) confirming their commitment to enter into an I.G.A., subject to ongoing discussions. The T.I.E.A. will apply to profits tax, salaries tax, and property tax in H.K. and will cover federal taxes on income, estate and gift taxes, and excise taxes in the U.S.
On January 13, 2014, the District Court for the District of Columbia dismissed the Florida Bankers Association and the Texas Bankers Association (collectively, the “Plaintiffs”) lawsuit that challenged the 2012 regulations requiring U.S. banks (including U.S. offices of non-U.S. financial institutions) to report to the I.R.S. the amount of interest paid to certain non-residents.
Pursuant to the United States’ relentless fight against offshore tax evasion, the I.R.S. finalized regulations requiring U.S. banks to report certain information on non-U.S. account holders. These regulations are necessary, in part, for countries that request reciprocal information on their resident account holders who have U.S. financial accounts as a precondition to signing an I.G.A. with the U.S. In particular, the regulations require reporting of deposit interest aggregating $10 or more paid to N.R.A.s on Form 1042-S (Foreign Person’s U.S. Source Income Subject to Withholding) for the calendar year in which interest is paid. Interest is reportable even if there is no withholding requirement. The regulations apply to all payments of interest made after January 1, 2013, and the first Form 1042-S must be filed with the I.R.S. by March 15, 2014. The reporting will be made with respect to an N.R.A. who is a resident of a country that is identified as a country with which the U.S. has in effect an income tax agreement relating to the exchange of tax information.
