Substance Matters

Concerned about high blood pressure? Don’t read the tax press.

In a move sure to raise systolic and diastolic numbers everywhere, Caroline Silberzstein, head of the Transfer Pricing Unit in the OECD Centre for Tax Policy and Administration, went on the record last week at the OECD transfer pricing and treaties conference in Paris supporting the proposition that there was no need to define “intangible” for treaty purposes.

Huh? We’re confused.

In other words, if we don’t have a standard definition of an intangible asset what is to prevent different jurisdictions from asserting their own definition and wreaking havoc on transfer pricing? Nothing. That’s what. Without a definition, tax authorities could argue that a given piece of intellectual property is or is not an asset and therefore (based on the more favorable treatment for the tax authority) deny or force an arm’s length payment. Sounds like open season on taxpayers with significant cross-border transactions involving intangibles.

For example, U.S. law defines “intangible” for purposes of Section 482 – the transfer pricing statute – as “an asset that has substantial value independent of the services of any individual if it derives its value not from its physical attributes but from its intellectual content or other intangible properties.” (Treas. Reg. § 1.482-4(b)).

Other countries differ as to the definition of “intangible.” Case in point, India believes that an “intangible” asset should have human intelligence and uniqueness to be recognized. Given this construct, query then to what extent “distribution rights” would be valued in the U.S. versus India? Clearly the U.S. definition of intangible would include a distribution right as an intangible, as the right has value from its “other intangible properties,” notwithstanding that there may be no employees as yet. India, apparently, would reach an inapposite conclusion in the absence of employees. Apparently the ability to distribute vis-à-vis current employees is paramount from an Indian point of view. Given the dichotomy of views as to what constitutes an “intangible” for transfer pricing purposes, it will be difficult at best for tax authorities to agree on what an arm’s length result should be in the absence of a definitional framework as to what constitutes an “intangible” asset for treaty purposes.

This should be a clarion call for the OECD and its member states to put forth a common definition of “intangible” for treaty purposes or if not a definition, at least agree on the indicia of an “intangible” so that taxpayers and tax authorities alike will have a framework to foster negotiation. Moreover, in light of convergence of financial reporting standards there will likely be differences between what is reported for financial accounting purposes, statutory accounting purposes (the starting point for the tax return) and tax reporting in the U.S. versus non-U.S. jurisdictions. Thus leading to a further mudding of the waters as to intangibles that may or may not be reported for financial accounting purposes, but may nevertheless exist for tax purposes.

Absent a definition or at least an agreement as to the indicia of intangible asset(s) for treaty purposes, we will be left with the so-called Pornography Standard: You’ll know it when you see it. The OECD can and should do better.

Cyberspace has been atwitter since the IRS pushed back the date (to October 15) for eligible taxpayers with previously unfiled foreign bank account reporting (FBAR) forms to take advantage of the IRS’ amnesty program. While it is a good thing for those who may have been in a quandary over what to do, for those who decide to roll the dice it is likely going to be catastrophic.

IRS, Treasury and Department of Justice officials have made a coordinated effort to get the word out to tax practitioners and their clients, through public speaking engagements, the tax press, and mainstream media that taxpayers who fail to file unfiled FBARs during the amnesty period will result in affected taxpayer’s having a very unpleasant experience with the IRS. In this case unpleasant means being subject to criminal prosecution and paying usurious fines, in some cases in excess of the account balance.

So, if you or your clients are still on the fence as to what to do, ask yourself this simple question: Do you look good in orange?

This extension doesn’t sound like generosity on the Government’s part to us. It sounds like the perfect way to preempt “reasonable cause” and the “uncertainty defense.” It will be a tough road, at best, to claim “extenuating circumstances.” The Government comes out looking magnanimous for giving the wayward additional time to file while it gets ready to pounce on the noncompliant.

Treasury published final regulations (T.D. 9456) regarding the treatment of controlled services transactions under §482 of the Internal Revenue Code on August 4, 2009. This post is our second in a series discussing key points of interest in the final regulations.

Reviewing the final regulations, two key areas of clarification jumped out at us.

Services Cost Method clarification. The application of Services Cost Method (SCM) has been clarified and the regulations revised to provide that the tests for SCM are conjunctive rather than disjunctive, as some had perhaps hoped. That is, all four of the requirements must be satisfied to apply the SCM:

1. The service must be a “covered service;”
2. The service must not be an “excluded activity;”
3. The service cannot be precluded from being a “covered service” by operation of the business judgment rule; and
4. Adequate books and records must be maintained with respect to the service.

As a result, it seems likely that the scope of services to which the exception would apply will be somewhat diminished. To what extent remains to be seen. However, most taxpayer-favorable exceptions tend to be narrowly construed. We doubt this will be an exception.

Business Judgment Rule clarification. The Preamble reiterates that the Business Judgment Rule (BJR) should be determined on a controlled group basis and the final regulations clarify this by noting that, “it is determined by reference to a trade or business of the controlled group.” In applying the BJR, the Preamble to the final regulations contains a helpful clarification with regard to evidencing the BJR. The final regulations answer the question of whether an executive’s representation must be preferred to the tax director’s, by clarifying that the BJR is applied on a case-by-case basis and takes into account the taxpayer’s facts and circumstances. Therefore the rank of the representative making the representation is a secondary consideration to the basis for that representation. It appears that IRS and Treasury carefully considered the comments received from the tax community in finalizing the services regulations. Only time will tell how the regulations will apply in the real world.

The final services regulations are effective for tax years beginning on or after July 31, 2009.

Part of our ongoing focus on Latin American tax and transfer pricing issues.

With Brazil adopting IFRS there are now some serious questions facing Brazilian companies with non-Brazilian subsidiaries, i.e., controlled foreign legal entities. Under the Brazilian accounting rules, results of controlled foreign investees can be recorded two ways: 1) Equity method; or 2) Direct consolidation of foreign legal entities’ results in the Brazilian parents’ results.  In the latter instance, the Brazilian parent will effectively have to consolidate the foreign legal entities’ results into its own results effectively treating the controlled foreign legal entity as if it were a branch of the Brazilian parent.

Which method is used depends on the degree of independence between the Brazilian parent company and the foreign affiliate. i.e., Does the controlled foreign legal entity have sufficient autonomy and functionality to operate independently from its Brazilian parent?

Factors that need to be considered in assessing independence:

1. Organizational structure and autonomy;
2. Power to effectuate transactions in the name of the foreign legal entity, including financial transactions, e.g., borrowings;
3. Engaging in transactions that are distinct from its parent company’s activities;
4. Having relatively few intercompany transactions with the Brazilian parent company, compared to total transactions with other parties; and
5. Ability for the subsidiary to generate sufficient cash flow from its own activities to cover its working capital requirements without need of contributions from the Brazilian parent company.

Now is the time for Brazilian companies to review their cross-border investments to determine whether their controlled foreign legal entities have sufficient economic purpose and an organizational structure compatible with their activities to use the equity method of accounting. Otherwise, the Brazilian parent company will be required to pick-up the controlled foreign legal entities’ assets, liabilities, and profit and loss in its results and pay tax on a current basis in Brazil.

Treasury published final regulations (T.D. 9456) regarding the treatment of controlled services transactions under §482 of the Internal Revenue Code on August 4, 2009. This post is one in a series discussing key points of interest in the final regulations.

While the preamble to the final regulations is chock-full of helpful information, it does not really address one of the most controversial aspects of the new regulations: Shareholder Activities.

Instead of the kinder, gentler stewardship concept, taxpayers must now contend with Treas. Reg. § 1.482-9(l)(3)(iv) which provides that an activity is a Shareholder Activity if “the sole effect of that activity is either (i) to protect the render’s capital investment in the recipient or in other members of the controlled group, or (ii) to facilitate compliance by the renderer with reporting, legal, or regulatory requirements applicable specifically to the renderer or both.” (Emphasis added.)

Not surprisingly, IRS and Treasury received numerous comments on the “sole effect” language from a variety of commentators, apparently to no avail. In keeping with tradition, the eight examples provided in the final regulations with respect to Shareholder Activities are simple, straightforward and benign – rendering them useless to evaluate the subtleties and nuances of the real world. Taxpayers and practitioners are left to wonder how narrowly the Service will interpret the new language. At least as far as tax law is concerned, examples do not create rules of law.

What may be especially difficult is distinguishing between day-to-day activities related to operations undertaken by the senior management team (not Shareholder Activities) and oversight and regulatory, legal and/or reporting requirements (could be treated as Shareholder Activities). This area merits extra attention particularly since stock based compensation is expressly included in the cost base for purposes of intragroup allocations.

- EAS & RBJ

By now you’ve probably heard about the U.S. Government’s high profile victory in overcoming Swiss bank secrecy laws — at least partially — to obtain account information for wealthy Americans with offshore bank accounts that were presumptively used to evade U.S. tax. While the IRS and DOJ personnel should be lauded for their dogged determination and perseverance in this matter, many important questions remain unanswered. Chief among these questions is whether this case will be an aberration or whether it will usher in a new degree of cooperation among governments aimed at thwarting unscrupulous banking practices, tax evasion, and other narishkeit.

While the jury is still out on this matter (sorry, just couldn’t help myself), anecdotal evidence seems to suggest that if the IRS has its way the trend will be toward greater information sharing among the G20 tax authorities. So what, you ask? Well, think about this: IRS Commissioner Schulman is working diligently with the Leeds Castle Group to promote coordinated examinations of multinationals. If the IRS is successful in its bid to promote cooperation among the tax authorities of major U.S. trading partners, one of the likely outcomes will be increased scrutiny of cross-border planning and transactions, especially transfer pricing. Consequently, documentation of cross-border planning will need to be consistent among jurisdictions and will need to align more closely with business operations. Otherwise, there will be significant enterprise risk. While it remains to be seen if the IRS will be successful in its endeavors, early indications show that they likely have the momentum to succeed. If the global economy continues to contract, it seems probable that cooperation will increase among tax authorities if for no other reason than resource constraints. However, it’s not likely to take them long to conclude that, working collaboratively, taxpayer information can be leveraged across multiple jurisdictions to reduce the amount of time and effort required to audit a multinational enterprise. Only time will tell whether the cooperation seen in the UBS Case is an aberration or a paradigm shift.

- RBJ

Recently I was having a conversation with a teenager and the subject of irony came up. And it got me thinking about the recent disclosures about the ranking member of the House Ways and Means Committee — the very committee tasked with overseeing and promulgating U.S. federal tax law — who had undisclosed assets and tax related oversights. I wondered whether I am in the minority in my outrage over the fact that the ranking member neglected to report income from renting a vacation home in the Dominican Republic and failed to file the Foreign Bank Account Reporting (FBAR) to disclose the existence of an offshore financial account with more than $10,000 on deposit and most recently neglected to disclose assets of $500,000 on Congressional filings.

As the old adage goes, “where there’s smoke, there’s fire.” So, why shouldn’t the American taxpayer be outraged over the apparent double standard being applied by elected members of Congress? If we are going to pick-up the tab to bailout the financial service and automobile industries, it seems that our elected officials, especially those tasked with legislating our tax laws, should be expected to comply with the very legislation that they put into place. We’re living on George Orwell’s Animal Farm — apparently Congressional animals are more equal than the rest of us.

At what point do we demand the resignation and prosecution? Seeing as this particular individual has a law degree, I just don’t see “ignorance of the law” holding up as a defense. Will this state of affairs go down in history as a humorous anecdote or a tragedy?

-RBJ