Substance Matters

The IRS has decided to play Yente.

At the recent LMSB Financial Services industry seminar in New York City, Kathy Robbins, LMSB field operations director (financial services industry) and Stuart Mann, Program Director for Withholding Taxes, noted that cross-border payments and compliance related to those payments will continue to be an area of emphasis and may well become a national program.

A subgroup of IRS personnel is working to develop a matching program for Form 5471 filings and annual Form 1042 filings to cross-reference this information to ensure that proper reporting with respect to Form 1042 has occurred. It also appears that the Form 5471 information will continue to be relevant in other areas as well, such as with respect to transfer pricing documentation. LMSB examiners have often found “gaps” in the information reported on Form 5471 and the taxpayer’s transfer pricing documentation under Section 6662. Thus, taxpayers and their advisors are well advised to review the content of their Forms 5471 filings with their Form 1042 filing and their transfer pricing documentation to ensure that there is consistency in this information.

Bear in mind that there are legitimate reasons for inconsistencies between amounts reported on Forms 5471 and Form 1042 and what is included in the taxpayer’s transfer pricing documentation. For example, transfer pricing documentation includes all intra-group transactions, not just U.S. sourced-fixed, determinable, annual or periodic income (“FDAP”) paid to non-U.S. persons – what is reported on Form 1042.

Given the IRS’ recent success with its withholding efforts and the fact that withholding is now a tier-I LMSB initiative, taxpayers and their advisors would be well advised to consider reconciling the information on Forms 5471/5472 with the information contained in their transfer pricing documentation, as unaccounted for items on Forms 5471/5472 may give rise to penalty exposure in the event of an adjustment on examination.

Apparently Congress is taking tips on how to fix the economy from my dog. Don’t get me wrong, Macallan is a very smart pup, but he’s not exactly about to turn the recession around – unless you consider his eating my shoes as an attempt to stimulate consumer spending. Macallan is a puppy and he has a puppy attention span. He tears his stuffed toy apart one moment and wants to cuddle on the couch the next. He is full of energy and enthusiasm but has no understanding of how to channel it.

Macallan's approach to tax reform

Congress seems to have the same issue. With respect to the economy, the focus appears to be on short-term quick fixes and the “flavor of the week” (e.g., job credits) more so than on addressing the fundamental, systemic problems that have resulted in our current predicament.

U.S. tax policy plays a key role in the health of our economy and current policy is hindering our ability to be competitive in the global economy. Among the many reasons:

1. The U.S. has the highest corporate tax rate (second only to Japan) among developed countries in the world.
2. The U.S. is the only OECD member country without a consumption-based system of taxation.
3. The U.S only provides a temporary incentive for Research and Development (“R&D”) related activities resulting in businesses wondering whether the R&D credit will be around long-term and if it’s worth investing in U.S. R&D if there is not going to be an incentive to do so.

Businesses make investment decisions based in large part on taxes – the higher the corporate tax rate, the lower the after-tax-return from those investments.

By cutting the corporate tax rate by 10% or more over time, including a permanent extension of the R&D credit, eliminating the domestic manufacturing exemption, and imposing a value-added or consumption-based tax the U.S. can bring its tax policy into the 21^st Century and provide incentives for companies to take advantage of the vast resources in the U.S.

Ireland exemplifies the benefits of this approach. Less than twenty years ago, Ireland was the poorest country in the European Union; today it is one of the wealthiest. The country’s turnaround has been credited to a highly-educated English speaking workforce, targeted incentives for knowledge-based businesses that have since morphed into a 12.5% corporate tax rate, and an effective government-private sector partnership aimed at reducing bureaucratic friction and other impediments to inward investment. The Irish understood that Foreign Direct Investment (“FDI”) creates inward investment in infrastructure that creates jobs for its citizens. There is absolutely no reason that the U.S. cannot replicate the success of the Irish.

Canada has also been very successful by cutting corporate tax rates and implementing a consumption-based system of taxation. And, like the U.S., they have states that have their own systems of taxation. We need a permanent R&D credit because it will eliminate the “brain-drain” in the U.S. and act as an incentive to locate knowledge-based personnel in the U.S. which will help spawn new industries and create additional jobs. To pay for the corporate tax rate reduction, a consumption-based tax should be implemented at the federal level with some type of harmonization with the states overtime so that consumer consumption is taxed. These steps will improve the long-term savings rate in the U.S. significantly improving the quality of life in this country and strengthening the embattled Dollar.

Given the dearth of interesting material in the financial press this week, I thought I would devote some blog-space to one of my other passions: Bikram Yoga.

For the uninitiated, Bikram Yoga is a series of twenty-six postures (called asanas) developed by Yogiraj Bikram Choudhury performed in a room heated to about 105 degrees Fahrenheit. While Al-Qaeda members get sent to “Gitmo” to be put into stress positions in extreme heat for free, I pay for the privilege. But, I digress…

How did Bikram Yoga teach me about finance, tax and transfer pricing risk management?

Focus

The single most important aspect of yoga is focusing on breathing. By setting your objective at the outset, focusing on yourself in the mirror and centering your energy and attention on a single point, you are able to accomplish a tremendous amount of very hard work in 90 minutes. As a consultant, I work with companies who have many, many strengths, but often lack the ability to focus clearly on a single point or aspect of their business or strategy. Why? Because of the frenetic pace of business activity and the daily crises that are a way of life for every multinational enterprise. Consequently, the state in which most in-house finance, transfer pricing, tax and legal professionals operate is somewhat ad hoc in nature; akin to fire-fighting. As in yoga, the ability to successfully filter the surrounding chaos in order to identity the underlying matter/challenge-at-hand and at the same time hold-in-check everything else that is going on, is the only way to succeed individually or organizationally. It is thus a great balancing act that requires constant stretching and adjustment to remain in balance.

When practicing yoga, the focus is on maintaining the breath. If you hold your breath you cannot sustain the postures. If you panic and start to breathe erratically the “fight or flight” instinct kicks in and you lose your ability to concentrate and maintain your postures. In finance, transfer pricing, legal, and tax matters, the focus has to be on designing, developing, implementing, maintaining and sustaining the strategy that supports the business objectives of the organization; which are dynamic. Focus is the single most important tool of the corporate or consulting professional. You cannot manage enterprise risk if you are constantly distracted from the purpose. We have a saying in East Texas: “When you’re up to your neck in alligators, it’s tough to remember that the objective was to drain the swamp.”

Balance

My favorite pose in the Bikram series is Dandayamana-Dhanurasana (try saying that five times fast…). Standing Bow Pulling Pose is possible because you are kicking your foot back and at the same time stretching forward – it is a balancing act. The same is true for finance, tax, legal, operations, and transfer pricing-risk management. No matter how well-run the business or excellent the planning and implementation, the company will have risk. How that risk is allocated, managed and aligned operationally around the world impacts the organizations’ success. No Board of Directors or Senior Officer wants to hear that an organization has significant unmitigated risk. However, risk is an inherent part of what we deal with as professionals. In finance, transfer pricing, legal, operations and tax, balancing risk means understanding the full benefits and challenges of the enterprises’ operations and keeping those pros and cons in tension – pulling in some places and stretching in others. Balance is critical for enterprise risk management.

Everything Working Together

In the series of standing postures, yogis work up to a master pose – Trikanasana, the Triangle Pose. Triangle is a challenging asana that involves every muscle, tendon and ligament in the body working together. Finance, legal, transfer pricing, and tax are fundamentally issues of facts and circumstances. For a corporate finance or consulting professional to add value, he or she must understand how the organization works both in terms of individual product or service lines and collectively as a business. Finance, tax, legal and transfer pricing cannot exist in a vacuum where decisions are made without a foundation in the business substance and strategic objectives of the enterprise. In many ways, transfer pricing is the “master pose” of a multinational enterprise: It involves understanding the operations and inner-workings of an enterprise from its most basic and fundamental levels up to its global corporate objectives and then translating that understanding into a structure with accompanying processes and procedures that support the objectives while being as financially efficient as possible and at the same time minimizing enterprise-related risk. It is the multinational enterprise equivalent of the Triangle Pose.

Ultimately, yoga has taught me to breathe in difficult and challenging situations, to not lose sight of the vision and objective (no matter how distinctly unpleasant the circumstances), to keep balance between stretching forward and pulling back, and to bring many components together to achieve a singular objective while respecting the individual parts. All of these skills and abilities help me to be a better consultant, advocate and advisor for my clients and colleagues.

-          EAS

Check out our article on LexisNexis: The Tax Implications of Proposed Health Care Act.

In a move that recalls the “ready, fire, aim” approach of past Congresses, newly-introduced Section 453 of H.R. 3200, the America’s Affordable Health Choices Act of 2009, would increase the penalty on understatements attributable to transactions lacking economic substance. Instead of the “substantial authority” standard or reasonable basis plus disclosure test of current law, transactions would be subject to a “more likely than not” (“MLTN”) test. It would seem, if this proposed legislation is passed in its current form, that companies may have to accrue for additional penalties under FIN 48 for positions taken on a tax return where the position did not meet MLTN under the proposed legislation.

Congress has a seemingly myopic focus on Economic Substance likely increasing the uncertainty associated with tax-related planning, particularly for multinational enterprises – and an apparent bent on “tweaking” the tax laws related to penalties in the U.S. While the public policy considerations may well warrant some of this “tweaking,” the breakneck pace at which it is being introduced is making a morass out of U.S. tax law and making it difficult for taxpayers and their advisors to keep abreast of all of the changes associated with both taxpayers’ disclosure standards and practitioners’ standards. The likelihood of some type of economic substance provision being incorporated explicitly into U.S. federal tax law is high, particularly as Congress comes to grips with a historic budget deficit and the vagaries of having to pay for bailouts and wars. It seems likely that we will continue to see the policymakers focus on Economic Substance as a means of thwarting cross-border tax planning.

Despite much debate in Washington, the hundreds of gallons of ink spilled and pounds of paper consumed – not to mention the billions of 1s and 0s expended in cyberspace – nowhere does the Obama administration’s Green Book or other tax-legislative proposals provide for a national sales tax. The focus is entirely on increasing the federal wage tax base.

Kenneth Baer, a spokesman for White House Budget Director Peter Orszag, told the Washington Post in May that “while we do not want to rule any credible idea in or out as we discuss the way forward with Congress, the VAT tax, in particular, is popular with academics but highly controversial with policymakers.”

It would seem that at some point in the not-too-distant future employees will be faced with an increasing burden on their wages with little hope of receiving the benefit such taxes promise. Social Security is on shaky ground at best. With some form of nationalized healthcare in the offing (increasing the burden on employees and their employers) Congress should be considering a national sales tax or consumption-based tax.

NOTE: We could devote an entire series of blogs to the differences between and benefits and drawbacks of a true sales tax verses a value-added (or goods and services) tax. We’re not going to do that. Mostly because it would be pretty dull for all but the most hardcore tax wonks. Suffice it to say that if you really, desperately want to read more about it. Go here, here or here.

Consider that the U.S. is the only OECD member state that does not have some form of nationalized healthcare or a consumption tax at the federal level. Other OECD member states that have enacted nationalized healthcare have resorted to consumption-based tax systems to pay for those benefits.

Such systems are tax-neutral for businesses for the most part and are borne by the consumer. They also have the added benefit of allowing exemptions and /or reduced rates of taxation for certain classes of products, e.g., ethical pharmaceuticals, children’s clothing, etc., thereby constraining the regressive nature of the tax with regard to social causes. Individual states in the U.S. have managed to provide a sales-tax base that is fair for the most part. Why not at the federal level too?

From the perspective of preserving the dwindling corporate tax base, a consumption tax should allow the U.S. to reduce the corporate tax rate – currently the second highest amongst the OECD member states.

U.S.-based multinational enterprises are increasingly moving their operations out of the U.S. to lower-tax jurisdictions. High corporate tax rates affect Foreign Direct Investment (“FDI”) into the U.S.; which provides jobs and other opportunities for American workers.

Examples abound. Currently the Japanese have the world’s highest corporate tax rate and have suffered economically for almost two decades. By contrast, Ireland suffered significant unemployment and declining FDI in the early ‘80s. By reducing the corporate tax rate (now at 12.5%), the country generated a significant increase in FDI leading to historic employment levels and economic growth. Closer to home, Canadian corporate taxes have been steadily reduced and are expected to be around 25% in 2012. The Canadian economy has grown.

It’s time for the US Congress to bring U.S. tax law into the 21^st century. Apparently it is more politically expedient to tax the working class with an outmoded payroll tax without any regard to the longer-term implications of having the second highest corporate tax burden in the OECD.