The Hewlett-Packard Debt v. Equity Case – Reply Brief Filed

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INTRODUCTION

The focus of a debt-versus-equity inquiry generally narrows to whether there was intent to create a debt with a reasonable expectation of repayment and, if so, whether that intent comports with the economic reality of creating a debtor-creditor relationship. This determination has led various courts of appeals to identify and consider a multi-factor test for resolving such inquires.

In the typical debt-versus-equity case, the I.R.S. will argue for equity characterization whereas the taxpayer will endeavor to secure debt characterization to obtain an interest deduction. In some cases, the roles are reversed, but this does not require that courts apply different legal principles. Some courts consider 10 factors, while others consider as many as 16 factors. No matter how many factors are considered, the multi-factor test is the established, standard analysis used in such disputes.

P.L.R. 201446025 – A Change of I.R.S. Direction?

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INTRODUCTION

U.S. charities are required to obtain I.R.S. approval in order to be exempt from federal income tax under §501(a) of the Internal Revenue Code (the “Code”). Under Code §508(a), new organizations must notify the Secretary of the Treasury that they are applying for recognition of Code §501(c)(3) status. In order to establish such exemption, Treasurey Regulation §1.1501(a)-1(a)(2) requires that an organization must file an appropriate application form with the district director for the internal revenue district in which the principal place of business of the organization is located. Furthermore, any rulings or determination letters holding the organization exempt are effective so long as there are no material changes in the organization’s character, purposes, or methods of operation. To be tax-exempt under §501(c)(3), an organization must be organized and operated exclusively for exempt purposes and none of its earnings may inure to any private shareholder or individual.

This begs the following question: If a charity changes its organizational structure or state of incorporation, will a new application be required?

Ten Year Throwback

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Two years ago, a U.S. Senate investigation accused Ireland of granting Apple Inc. special tax treatment. This accusation sparked a seemingly never-ending investigation into the state aid granted by certain European countries to specific multinational companies. More recently, Apple, Starbucks, Fiat, and various other companies exposed in the “Luxembourg Leaks” scandal were accused of having paid substandard taxes as a result of agreements between those companies and the Netherlands, Luxembourg, and Ireland, which constituted illegal state aid.

Now, the European Commission (the “Commission”) is looking into the penalties that should be levied upon the income earned through these agreements. The Commission’s investigations into these advance rulings and advance pricing agreements (“A.P.A.’s”) between E.U. member-states and major U.S. multinationals could lead to tax adjustments dating as far back as ten years.

STATE AID

State aid is defined as “an advantage in any form whatsoever conferred on a selective basis to undertakings by national public authorities.” This does not include subsidies or tax breaks available to all entities. A measure of state aid constitutes an intervention by a state, or through state resources, that gives specific companies or industry sectors an advantage on a selective basis, thereby distorting competition and affecting trade between E.U. member states.

Competitiveness of the U.S. Tax System

volume 2 no 4   /   Read article

By Stanley C. Ruchelman, Andrew P. Mitchel, and Sheryl Shah

This month, our team delves into the Joint Committee Report addressing international tax reform in a series of articles. The report compares the U.S. tax system with the systems of other countries. Stanley C. Ruchelman, Andrew P. Mitchel, and Sheryl Shah explain what the J.C.T. staff believes. It is not pretty.  See more →

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Repatriation of Foreign Earnings v. Related Party Indebtedness

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On March 13, 2015, the United States Court of Appeals for the Fifth Circuit (the “Appeals Court”) reversed a decision of the United States Tax Court regarding the rules relating to the repatriation of earnings under Code §965.

Code §965 was a temporary statute permitting an 85% dividends received deduction in connection with the repatriation of earnings from a foreign subsidiary as long as the proper tests were satisfied. One test related to intercompany loans to foreign subsidiaries allowing them to pay the low-tax dividends. Even though the statute is not currently in effect, the reasoning of the Appeals Court suggests that substance will at times prevail, even if it works against the I.R.S.

BMC Software, Inc. (“BMC”) was a software developer that generated income from licensing operations. It had in effect a qualified joint cost-sharing agreement with a subsidiary. In 2002, the agreement was terminated and BMC began to pay royalties to the subsidiary in return for the transfer of rights back to BMC. In an I.R.S. examination, the arm’s length nature of the royalty amount was challenged and ultimately was resolved through two closing agreements entered into in 2007. The first determined that the amount of an arm’s length royalty was less than the amount paid. The second permitted BMC to treat the excess payment as a loan to the foreign subsidiary. This treatment, which has a long history in practice, was permitted under Rev. Proc. 99-32. As a result, the cash flow between BMC and its subsidiary was not changed but made to conform to the agreed amount of an arm’s length royalty, and the return of the cash would be tax-free but for some deemed interest.

Using a §897(i) Non-Discrimination Election to Avoid F.I.R.P.T.A.

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Mistakes happen. Often nonresident alien individuals buy U.S. real property, often personal use property, in their individual names. This can be a costly mistake. With certain exceptions, if such an individual were to die while owning the property, a U.S. estate tax of approximately 40% of the value of the property could be imposed.

There is one method to restructure this investment in the case of a foreign individual, or an entity owned by a foreign individual, if such a person is eligible to claim the benefit of an income tax treaty with the United States and the treaty contains a so-called “Nondiscrimination Clause.” These clauses provide that a resident of a treaty state will not be treated any less favorably than a U.S. resident carrying on the same activities. This article will look at how a Nondiscrimination Clause can be used to avoid onerous F.I.R.P.T.A. provisions when a foreign person invests in U.S. real property.

The technique described in this article essentially permits a nonresident alien individual to transfer U.S. real property on a tax-free basis to a foreign entity, which will be treated as a domestic entity for income tax purposes and as a foreign (non-taxable) entity for U.S. estate tax purposes.

Tax 101: Understanding U.S. Taxation of Foreign Investment in Real Property – Part III

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INTRODUCTION

This is the final article in a three-part series that explains U.S. taxation under the Foreign Investment in Real Property Tax Act of 1980 (“F.I.R.P.T.A.”). This article looks at certain planning options available to taxpayers and the tax consequences of each.

These planning structures aim to mitigate taxation by addressing several different taxable areas of the transaction. They work to avoid gift and estate taxes, and double taxation of cross-border events and corporate earnings, while simultaneously striving for preferential treatment (e.g., long-term capital gains treatment), as well as limiting over-withholding, contact with the U.S. tax system, and liability. Often, such structures are helpful in facilitating inter-family transfers and preserving the confidentiality of the persons involved.

PRE-PLANNING

As with everything else, planning can go a long way when it comes to maximizing U.S. real estate investments. Here are a few questions to ask:

Investor Background

1. Where is the investor located?
2. Where is the investment located?
3. What kind of business is the investor engaged in?

U.S. Residency Certification: Pitfalls & Considerations

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INTRODUCTION

Income from sources within one country paid to residents of other countries often is subject to withholding tax in the source country at a rate that is set by the source country’s internal law. The withholding tax rate can be reduced or eliminated if (1) an income tax treaty exists between the source country and the residence country and (2) the taxpayer is a resident of that second country for purposes of the treaty. This article explains how a U.S. resident taxpayer demonstrates that residence classification in order to claim benefits under an income tax treaty.

FORM 6166

For U.S. residents with non-U.S. source income, proving residency in order to obtain an income tax treaty is accomplished by obtaining a Residency Certificate from the I.R.S. This document certifies that the taxpayer is a resident of the U.S. for Federal income tax purposes. The certification is provided on Form 6166, which certifies to the withholding agent that for a specific year, the taxpayer was a resident of the U.S. for U.S. tax purposes. In the case of a fiscally transparent entity, Form 6166 will certify that the entity, when required, filed an information return and its partners, members, owners, or beneficiaries filed income tax returns as residents of the U.S. As partnerships (including L.L.C.’s treated as partnerships) and disregarded entities are not considered U.S. residents within the meaning of the residence article of most U.S. income tax treaties. As a result, the Form 6166 that is issued by the I.R.S. to will include a list of U.S. resident partners, members or owners. Each person’s ownership percentage does not accompany the names on the list, as with limited exception, the I.R.S. does not have that information.

Insights Vol. 2 No. 1: Updates & Other Tidbits

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TAX EVASION INDIAN STYLE: CRIMINAL OR CIVIL OFFENSE?

Judicial 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.

HAND IT OVER, MICROSOFT?

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.

B.E.P.S. Action 14: Make Dispute Resolution Mechanisms More Effective

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INTRODUCTION

The O.E.C.D. has continued to publish discussion drafts under its 15-part action plan (the “B.E.P.S. Action Plan”) for combatting base erosion and profit shifting (“B.E.P.S.”), with Action 14 being the most unique.

Action 14, entitled “Make Dispute Resolution Mechanisms More Effective,” provides as follows:

Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

While most components of the B.E.P.S. Action Plan address the problems caused by base erosion and profit shifting, the recently proposed discussion draft for Action 14 (“Discussion Draft” or “Draft”) addresses the mutual agreement procedures (“M.A.P.”) used to resolve treaty-related disputes. Action 14 addresses the current obstacles faced by taxpayers seeking M.A.P. relief to avoid economic double taxation and provides suggestions as to how to revise provisions in order to improve the integration of M.A.P. dispute resolution mechanisms. The O.E.C.D. describes it as a unique opportunity to overcome traditional obstacles and to provide effective relief through M.A.P. The Discussion Draft proposes complementary solutions that are intended to have a practical and measurable impact, rather than merely providing additional guidance which may not be followed.

B.E.P.S. Action 4: Limit Base Erosion Via Interest Payments and Other Financial Payments

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Action 4 of the B.E.P.S. Action Plan focuses on best practices in the design of rules to prevent base erosion and profit shifting using interest and other financial payments economically equivalent to interest. Its stated goal is described in the following Action:

Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related-party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments. The work will evaluate the effectiveness of different types of limitations. In connection with and in support of the foregoing work, transfer pricing guidance will also be developed regarding the pricing of related party financial transactions, including financial and performance guarantees, derivatives (including internal derivatives used in intra-bank dealings), and captive and other insurance arrangements. The work will be coordinated with the work on hybrids and CFC rules.

On December 18, 2014, the O.E.C.D. issued a discussion draft regarding Action 4 (the “Discussion Draft”). The Discussion Draft stresses the need to address base erosion and profit shifting using deductible payments such as interest that can give rise to double non-taxation in both inbound and outbound investment scenarios. It examines existing approaches to tackling these issues and sets out different options for approaches that may be included in a best practice recommendation. The identified options do not represent the consensus view of the Committee on Fiscal Affairs, but are intended to provide stakeholders with substantive options for analysis and comment. This article discusses the Discussion Draft for Action 4 of the B.E.P.S. Action Plan.