1. Global increase in transfer pricing audits – In 2009 the IRS hired scores of additional agents, particularly international examiners and economists, with the intention of expanding audits of large and mid-size corporate taxpayers – particularly those in the middle-market. The U.S. was not alone. Around the world, tax authorities increased their numbers of cross-border examiners in 2009 and beyond. Of the countries with the most aggressive additions of audit related personnel, key U.S.-trading partners Brazil, Mexico and China have signaled an increase in transfer pricing audits in the coming year. Multinational enterprises must anticipate that IRS initial documentation requests will include a request for transfer pricing documentation and be prepared to respond to such requests within 30 days of the request. Other countries will have similar, if not, shorter response times. Moreover, failing to respond in many cases is tantamount to being non-responsive. The days of “just-in-time” transfer pricing documentation are over.
2. Intellectual property and cost-sharing – On December 31, 2008, the U.S. Treasury released the new temporary cost-sharing regulations under Treas. Reg. §1.482-7T. The Temporary Treasury Regulations are hardly taxpayer-friendly and represent the increased scrutiny U.S. multinationals will face with respect to arrangements to share costs and the global structuring and alignment of intellectual property portfolios going-forward. In order to “grandfather” cost-sharing arrangements in place prior to the January 5, 2009 effective date, taxpayers had until July 6, 2009 to conform their existing cost-sharing arrangements to the requirements contained in the new temporary regulations with certain adaptations. The key for U.S. multinationals in 2010 is to remain vigilant with respect to existing cost-sharing arrangements and events that may trigger an arrangement – particularly important as M&A deal flow likely increases during the coming year in response to a (hopefully) reviving economy.
3. Codification of Economic Substance – The proposed bill codifying the Economic Substance Doctrine is still alive in the House and will likely find its way into law sometime in 2010 – either in the form of the ultimately enacted healthcare bill or in another piece of legislation. U.S. taxpayers must critically examine the transaction structuring and planning which has provided tax benefits and be prepared to produce documentation and other evidence showing the non-tax business purpose justifying the underlying transaction and attendant structuring.

The stakes are rising for multinational enterprises as the world is getting smaller and tax authorities are sharing information at unprecedented levels. Thus, the best defense is a well-crafted offense that is integrated contemporaneously with acquisitions, divestitures and/or restructurings. The days of operational autonomy for multinational enterprises are over.

As we noted last week, meaningful financial statement reform cannot be the result of knee-jerk legislation and/or influence-peddling by a Congress that – at best – has only a modicum of understanding of the challenges facing U.S.-based businesses. Similarly, standard-setting bodies divorced from in-the-trenches corporate accounting, tax and legal professionals and their advisors are also not capable of championing meaningful financial statement reform.

With the U.S. converging with IASB and IFRS, the point may seem moot. It’s not. FASB has adopted an aggressive timetable for convergence. However, it has also indicated that convergence does not mean agreement. Thus, differences between U.S. GAAP and IFRS will continue to exist. If the U.S. seeks convergence with IFRS it is crucial for FASB to demonstrate an understanding of the impact of both in-place and proposed standards on the day-to-day legal and tax-related considerations of U.S. companies. Case in point: FIN 48.

It is interesting that accounting for tax-benefits and related contingencies has one set of standards and yet other contingencies – which are very often more relevant to financial statement end-users – are left to be accounted for under SFAS 5, the old “probable and estimable” standard that rarely, if ever, gets triggered. Pending litigation, environmental contingencies, FCPA investigations, employment disputes and a whole host of other uncertainties are in all likelihood far more relevant to potential investors than uncertain tax positions relating to R&D credits and potential NOLs. However, these items are generally not contained in the financial statements or, at best, are mentioned in vague terms.

Adoption of IFRS in the U.S. may or may not resolve the foregoing dichotomy. There is no IAS equivalent of FIN 48. The closest standard is provided by IAS 37 (Provisions, Contingent Liabilities and Contingent Assets) which employs a one-step approach to recognizing a provision when: 1) An enterprise has a present obligation as a result of a past event, 2) It is probable that an outflow of resources embodying economic benefits will be required to settle the obligation, and 3) A reliable estimate can be made of the amount of the obligation. The term “probable” is defined in IAS 37 as “more likely than not.” If these conditions are not met, no provision is recognized. This standard provides no greater clarity and, if anything, would lead to less disclosure as opposed to greater transparency.

FASB must be focused on the needs of the end user – the analyst community and accredited investors – and taking steps to increase accessibility and readability by lay people, not creating additional standards with no teeth and promulgating divergent standards for different types of liabilities (e.g., income taxes versus other contingencies). If, as FASB has contended for some time now, the balance sheet is the Holy Grail of financial reporting, it seems wrong-headed to have inapposite standards for recording liabilities.

Moreover, the fact that end users have increasingly relied on non-GAAP measures, (e.g., EBITDA, EBIT, ROCE) in analyzing financial statements suggests that the information set forth in financial statements is not sufficient on a standalone basis to facilitate analysts’ review and/or to make investment decisions.  This is important as it is the foundation of U.S. financial reporting and raises many questions, chiefly: Why have end-users – especially the investment community – been left out of the standard-setting process? Relying on academics and bureaucrats for financial statement reform is a terrible idea.

The Financial Accounting Foundation and the FASB need to implement some aggressive change management practices and listen to their constituents – not just the U.S. Congress—with respect to financial statement reform.

IFRS is not a panacea. A return to principles-based reporting is a step backwards at a time when the U.S. needs to march forward. Balance and common sense must return. The amount of time and resources corporations must devote to reporting must enter into the equation, lest there be more people accounting for a transaction than transacting businesses on behalf of an issuer. When it takes more lawyers and accountants to report the business than there are resources transacting business the train has come off the tracks.

Given that we are in the middle of the most devastating financial crisis since the Great Depression when there has been a clarion call of epic proportions for greater transparency and more usable financial statement information, why FASB is embracing IFRS – a principles-based set of standards, as opposed to continuing to evolve the U.S. GAAP rules-based system – is beyond belief. Those of us who have been practicing for more than two decades remember the principles-based approach under U.S. GAAP that, with pressure from Congress, the SEC and investors, became rules-based over the past two decades.

Based on the teachings from recent CPE seminars I have attended in the last two weeks, it seems that the accounting standard-setting bodies have run amok. Consider the proposal on lease accounting. Under IFRS and revised U.S. GAAP, the expectation is that operating leases will be eliminated. As a result, lessees will have to capitalize the asset and amortize or depreciate that asset; details to follow later. Conceptually this seems odd as in many instances the lessor clearly retains title to the property and, in the case of commercial real estate, has no intention of conveying same to the lessee. Put differently, the lessor is not necessarily providing financing to the lessee.

Alternatively, consider commercial real estate leases – typically operating leases – where the lessee has a right to occupy the premises owned by the landlord. Now, consider the implications of capitalizing these leases and treating the lessee as having an ownership interest in the property – which in theory implies that the transaction is a form of financing. In point of fact, nothing could be further from the truth. The economic reality, accounting notwithstanding, is that the lessee has an occupancy right to the premises provided payments and lease terms are satisfied. So, how could this be a capitalized asset?

Add on the tax implications of such arrangements, as it is unlikely there will be a basis for arguing that the lessee has a depreciable asset, aside from leasehold improvements. Thus, it seems likely that there will be even more book/tax differences to account for – which adds increased complexity to an already overly complex set of provisions. How does this change help users of the financial statements? It seems that there will be more people required to account for transactions than there are generating revenue and transacting business.

Meaningful financial statement reform must be based on the needs of the end user. The capital markets won’t recover until investors are confident in the information they are receiving. Until balance and incremental change return to the standard-setting process the capital markets will likely remain tepid at best. Unlike the Pirate Code, accounting standards in the U.S. cannot be “more guidelines than actual rules.” FASB needs to rethink the wisdom of moving the U.S. to a principles-based set of standards given the current economic climate and the needs of U.S. businesses and their investors particularly in view of the fact that we have already been down this road.

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.

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.

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.

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.

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.

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