Substance Matters

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.

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.

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.

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.

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