Substance Matters

In the preliminary edition of its Economic Outlook No. 86 released November 19, the Organization for Economic Cooperation and Development, emphasized that raising corporate income taxes is not only the wrong answer for cash-strapped governments in the current economic environment but that approach will inherently impede a recovery.

From the report:

“Most taxes have adverse effects on economic performance by distorting incentives to work, save and invest. Raising taxes therefore could be costly. Indeed, GDP could fall by 1 to 1.5% if the overall tax/income ratio were increased to provide revenue equal to 2% of GDP (OECD, 2003). A rise in the tax ratio would be particularly harmful if it was concentrated on corporate or labour income taxes; increasing indirect taxes and taxes on immovable property would be much less costly. In particular, the estimates in Arnold (2008) suggest that the economic cost of raising government revenue by increasing taxes on labour income could be up to five times higher than that from raising the same amount of revenue from higher indirect taxes.”

Raising a corporate tax rate that is already the second highest among the G20 will push more companies – and therefore jobs – out of the U.S. At the very time that unemployment is reaching new highs in America, the tax policy put forth by Congress to pay for health care reform is forcing jobs overseas. Cutting the corporate tax rate will create jobs and expand the dwindling individual tax base. The issue is not figuring out how to divide the proverbial pie, but rather how to expand it.

Buried deep in the Affordable Health Care for America Act (H.R. 3962) passed late last Saturday night by the U.S. House of Representatives are three pieces of tax legislation that have the potential to do for multinational enterprises what Sauron’s little gold ring did for Middle Earth: create tumult and uncertainty. Every tax professional needs to be aware of this legislation. While the likelihood of the health care bill passing in its current incarnation may be low, these tax proposals aren’t going away. Someway, somehow they will be passed and so tax pros must be prepared to address them.

Section 561: Limitation on Treaty Benefits for Certain Deductible Payments

• What it says: “In the case of any deductible (U.S. source item of fixed, determinable, annual, or periodic (“FDAP”) income ) related-party payment, directly or indirectly, any withholding tax imposed under chapter 3 (and any tax imposed under subpart A or B of this part) with respect to such payment may not be reduced under any treaty of the United States unless any such withholding tax would be reduced under a treaty of the United States if such payment were made directly to the foreign parent corporation.” [Emphasis added]
• What it means: 1) The stock ownership threshold for what it means to be a controlled party under IRC section 1563(a)(1) is reduced from “at least 80 percent” to “more than 50 percent”, 2) Withholding taxes cannot be reduced under a U.S.-treaty, unless a direct-payment to the foreign parent corporation would also qualify for such reduced rate of withholding tax. Clearly, the aim is to shut-down inverted companies with inbound financing structures. Given the broad nature of the proposal, however, the collateral consequences may not have been fully considered, as it appears to be a “super-limitation-on-benefits” provision to redress real or perceived abuses in cross-border financing structures. It will likely be more of a clarion call for U.S. trading partners to cry foul, akin to the FIRPTA provisions on the 1980s with respect to treaty benefits. At a time when multinational enterprises are seeking certainty in their cross-border affairs it will likely throw a monkey-wrench in planning and (as currently drafted) have unintended consequences.

Section 562: Codification of Economic Substance Doctrine, Penalties

• What it says: “In the case of any transaction to which the economic substance doctrine is relevant, such transaction shall be treated as having economic substance only if – (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.”
• What it means: The Economic Substance Doctrine, heretofore an amorphous standard molded by the judiciary, would now be on the books as law. Essentially, the government would have a weapon to combat perceived tax shelters even if the taxpayer was technically compliant with relevant law and historical precedent. The language is highly subjective and ambiguous. Given that taxpayers already have the burden of proof, codification of the Economic Substance Doctrine raises the bar even higher, requiring justification not only of the transaction from a legal standpoint, but also from a business and economic position as well both qualitatively and qualitatively and leaves the door open to questions in the event the non-tax aspects of the transaction are unrealized or realized to a lesser degree than anticipated. In addition, the “Reasonable Cause and Good Faith” exceptions under IRC section 6664, would be amended to exclude transactions for which “Economic Substance” was lacking and for tax-shelters. In addition, IRC section 6662 would be amended to increase the 20 percent penalty, to 40 percent for non-disclosed non-economic substance transactions.

Section 563: Certain Large or Publicly Traded Persons Made Subject to a More Likely Than Not Standard for Avoiding Penalties on Underpayments

• What it says: “In the case of any specified person, paragraph (1) shall apply to the portion of an underpayment which is attributable to any item only if such person has a reasonable belief that the tax treatment of such item by such person is more likely than not the proper tax treatment of such item.”
• What it means: 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. If this proposed legislation is made law in its current form, 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. It effectively raises the bar on affected taxpayers with respect to the current penalty regime under section 6662 by amending the “Reasonable Cause” provisions of section 6664. As currently drafted, the proposed change would pick up privately held corporations with $100 million or more of gross receipts and publicly traded persons.

At a recent presentation in Texas, Stephen E. Shay, Deputy Assistant Secretary for International Tax Affairs in the U.S. Treasury Department, was asked about the likelihood of the U.S. adopting a Federal consumption tax.

In response, Mr. Shay avoided the question completely stating that the policy must be carefully evaluated in context. His point: The U.S. relies more heavily on corporate tax receipts as compared with the other G20 nations; thus, it is unlikely the U.S. would adopt a consumption-based system at the Federal level. In other words, since we are already so good at pillaging corporate taxpayers, why do we need to branch out and further pillage individuals?

If only it were so simple.

The Congressional Budget Office forecasts a continued decline in U.S. corporate tax receipts – due to, among other things, the U.S. having the second-highest corporate tax rate in the developed world, lack of available capital and general economic malaise.

So, if 1) corporate tax receipts are declining and 2) a Federal consumption tax is not on the menu, what’s left? Perhaps Mr. Shay’s position presages the Administration’s likely next move – despite statements to the contrary – to seek repeal of deferral of non-U.S. earnings, so that there would be current taxation and a likely residual U.S. tax, since many of those earnings are subject to rates of taxation below the U.S.’ current confiscatory 35% rate?

In the immortal words of Han Solo, “I’ve got a bad feeling about this.”

The U.S. government is inefficient and overrun with bureaucracy. The current direction of U.S. tax policy – a confiscatory corporate tax-rate – will continue to stifle job growth and constrain Foreign Direct Investment. The U.S. needs to follow the lead of Canada, Ireland, the UK, and other trading partners who have reduced corporate taxes as a means of stimulating employment and GDP growth. Every 1% point drop in the corporate tax rate translates into a 0.1% increase in GDP.

Given the wealth of empirical and anecdotal evidence, and despite Mr. Shay’s statement to the contrary, we believe the Federal consumption tax option must remain in play.

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.

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.

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