Substance Matters

Welcome to 2010. This year promises to bring interesting developments on the U.S. legislative agenda, particularly with respect to international “tax reform.” Case in point, two bills – one each in the House and Senate – could have serious implications for companies with a U.S. taxable presence. Here are three issues which we believe will be significant in the next calendar year and strategies for addressing them proactively.

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.

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.

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.