Last week the IRS published the following Private Letter Rulings and Chief Counsel Advice relating to international taxation.
PLR 201251003: Shares of a domestic corporation were transferred to foreign corporation in order to deconsolidate the domestic corporation. Code §1502.
PLR 201251005: A real estate investment trust’s (REIT’s) deemed inclusions as Subpart F Income under Code §951 and passive foreign investment company (“PFIC”) inclusions under Code §1293 are considered qualifying income under Code §856(c)(2). In addition, currency gain or loss under Code §986(c) is also considered qualifying income under Code §856(c)(2).
CCA 201251012: “DOM,” a U.S. citizen who resides in the U.S. and operates a sporting event bookmaking business, contracts with a foreign corporation (“FOR”) to maintain betting information about DOM’s bettors. FOR’s participation in the arrangement is limited to data maintenance. DOM is accepting wagers and is liable for the Code §4401 excise tax on wagers.
CCA 201251015: Brief email indicating that a taxpayer would be eligible under Article 19 of a treaty for the $5,000 annual exclusion for a period of no more than 5 years.
The de-consolidation effected in PLR 201251003 can be graphically represented as (for a PDF click here):
In international tax planning, one of the issues that frequently comes up is whether certain income that is not technically received by a taxpayer is nonetheless taxable to them because they “turned their back” on receiving the income. The rule that makes such income currently taxable to the taxpayer is known as the “constructive receipt doctrine.”
The constructive receipt doctrine is defined in Treas. Reg. §1.451-2(a) as the following:
General rule. Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account or set apart for him so that he may draw upon it at any time. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. Thus, if a corporation credits its employees with bonus stock, but the stock is not available to such employees until some future date, the mere crediting on the books of the corporation does not constitute receipt.
Many cases have dealt with the constructive receipt doctrine or doctrines of a similar nature. For example, in Lucas v. Earl,(FN 1) it was held that the taxpayer was liable for income tax upon the whole of his salary and attorney’s fees even though he had made a valid prior assignment of one half of those amounts to his wife, and the Supreme Court, speaking through Mr. Justice Holmes, said:
[T]he tax could not be escaped by anticipatory arrangements and contracts however skillfully devised to prevent the salary when paid from vesting even for a second in the man who earned it. * * * [N]o distinction can be taken according to the motives leading to the arrangement by which the fruits are attributed to a different tree from that on which they grew.(FN 2)
In Corliss v. Bowers,(FN 3) the Supreme Court, considering a revocable trust created by a husband in favor of his wife, established the principle that the power to revoke the trust and regain control of the income producing property makes the holder of that power liable for taxes on the income from that source. Mr. Justice Holmes, again speaking for the Court, said:
But taxation is not so much concerned with the refinements of title as it is with actual command over the property taxed--the actual benefit for which the tax is paid. * * * The income that is subject to a man’s unfettered command and that he is free to enjoy at his own option may be taxed to him as his income, whether he sees fit to enjoy it or not.(FN 4)
These principles were applied in Helvering v. Horst.(FN 5) In that case the owner of certain coupon bonds detached certain coupons which fell due during the year and gave them to his son. In due course the coupons were paid to the son but it was held that the donor realized income in the year equal to the face amount of the coupons. The Supreme Court explained its reasoning:
The power to dispose of income is the equivalent of ownership of it. The exercise of that power to procure the payment of income to another is the enjoyment, and hence the realization, of the income by him who exercises it.(FN 6)
The constructive receipt doctrine is an important principle to keep in mind when doing any type of tax planning.
1 281 U. S. 111 (1930).
2 281 U. S. at 115.
3 281 U. S. 376 (1930).
4 281 U. S. at 378.
5 311 U. S. 112 (1940).
6 311 U. S. at 118.
Below is a diagram showing the broad categories of U.S. international taxation segregated into "inbound" topics, "outbound" topics, and overlapping topics.As indicated in the diagram, "inbound" generally means foreign persons (e.g., foreign corporations, nonresident aliens, etc.) with U.S. income, and "outbound" generally means U.S. persons (e.g., domestic corporations, U.S. citizens and residents, etc.) with foreign income. Click on image to enlarge.
For related blog post see inbound-outbound.
Several weeks ago the IRS published the following Private Letter Rulings and Chief Counsel Advice relating to international taxation.
PLR 201238005 - Late Canadian registered retirement savings plan ("RRSP") deferral election. Form 8891. Rev. Proc. 2002-23.
PLR 201239003 - Code §368(a) reorganizations involving foreign subsidiaries.
PLR 201239005 - Late Canadian registered retirement savings plan ("RRSP") deferral election. Form 8891. Rev. Proc. 2002-23.
PLR 201240017 - Code §355 spin-offs involving foreign corporations with foreign parent company.
CCA 201240019 - Code §§114 and 951, the extraterritorial income ("ETI") exclusion for purposes of computing Subpart F income is zero (i.e., ETI cannot be excluded from Subpart F income).
Several weeks ago the IRS published the following Private Letter Rulings and Chief Counsel Advice relating to international taxation for the 28th week of 2012. There were no international related Private Letter Rulings for the 27th week of 2012.
PLR 201228013 - Taxpayer is a resident alien and will become a nonresident alien, and then again a resident alien. Taxpayer’s unused net operating losses that were generated while he was taxed as a U.S. resident, and that would have been allocated and apportioned, in accordance with the rules in Treas. Reg. § 1.861-8(e)(8), to the gross income of the U.S. business had he been taxed on such income as a nonresident alien for such years, may be used to the extent provided in Treas. Reg. § 1.861-8 to offset gross income effectively connected with the conduct of the U.S. business while he is a nonresident alien. Taxpayer may carry over any unused net operating losses from the U.S. business allocated and apportioned to income effectively connected with the conduct of the U.S. business while he is taxed as a nonresident alien, and may apply such losses against gross income from the U.S. business after he reacquires U.S. resident status. Taxpayer may carry over any unused net operating losses from the U.S. business generated while he was taxed as a U.S. resident, if still available, against his gross income after he reacquires U.S. resident status.
PLR 201228020 - Gain from the disposition of carbon credits allocated to a controlled foreign corporation were not foreign personal holding company income.
PLR 201228021 - Late/retroactive passive foreign investment company ("PFIC") qualified electing fund ("QEF") election. Form 8621. Treas. Reg. §1.1295-3(f).
PLR 201228030 - Spin-off and reorganizations of controlled foreign corporations.
PLR 201228031 - Late entity classification election for foreign entity to be treated as a disregarded entity. Form 8832. Treas. Reg. §301.7701-3(c).
PLR 201228032 - Late entity classification election for foreign entity to be treated as a disregarded entity. Form 8832. Treas. Reg. §301.7701-3(c).
PLR 201228033 - Multi-tiered spin-offs, including spin-off by a controlled foreign corporation.
CCA 201228035 - Code §267(a)(3) applies to the patronage dividends paid by a cooperative to its related foreign patrons, so the cooperative will not be able to deduct the patronage dividends under Code §1382 until the amounts are includible in the foreign patrons’ gross income, subject to the exceptions and special rules set forth in § 267(a)(3)(B) and Treas. Reg. §1.267(a)-3(c).
Last week the IRS published the following Private Letter Rulings relating to international taxation.
PLR 201223001: Taxpayer was permitted to change to the tax book value method of asset valuation for interest expense allocation. Temp. Treas. Reg. §§1.861-8T(c)(2) and 1.861-9T(g)(1)(ii).
PLR 201223006: Grandfather rule for “existing 80/20 company” continues to apply. Expansion of the taxpayer’s mineral business did not constitute “an addition of a substantial line of business” within the meaning of Code §871(l)(1)(A)(iii).
PLR 201223009: Late entity classification elections for 10 foreign entities to be treated as partnerships. Form 8832. Treas. Reg. §301.7701-3(c).
PLR 201223010: Late entity classification elections for 10 foreign entities to be treated as disregarded entities. Form 8832. Treas. Reg. §301.7701-3(c).
The IRS published the following Private Letter Rulings relating to international taxation for the 22nd week of 2012
PLR 201222002: Taxpayer was permitted to change to the tax book value method of asset valuation for interest expense allocation. Temp. Treas. Reg. §§1.861-8T(c)(2) and 1.861-9T(g)(1)(ii).
PLR 201222019: Late Canadian registered retirement savings plan ("RRSP") deferral election. Form 8891. Rev. Proc. 2002-23.
PLR 201222021: Late Canadian registered retirement savings plan ("RRSP") deferral election. Form 8891. Rev. Proc. 2002-23.
PLR 201222026: Late entity classification election for foreign entity to be treated as disregarded entity. Form 8832. Treas. Reg. §301.7701-3(c).
Last week the IRS published the following Chief Counsel Advice relating to international taxation.
CCA 201212008: Taxation of Green Card Holders at the Italian Embassy under the 1878 U.S.-Italy consular convention, the 1984 U.S.-Italy income tax treaty, and section 893.
CCA 201212020: Personal liability of the executor of an estate (fiduciary is liable only if it had notice of the claim of the United States before making the distribution). The only asset in the estate was a foreign trust.
U.S. citizens that live and work outside the U.S. often participate in foreign retirement plans. Similarly, non-U.S. citizens that move to the U.S. and become U.S. tax residents, after working outside the U.S., have often participated in foreign retirement plans.
A question that sometimes arises is whether the income accruing annually in the foreign retirement plans must be included on the individual's U.S. tax return. The rule for this situation was concisely stated in Rev. Proc 2002-23:
Under the domestic law of the United States, an individual who is a citizen or resident of the United States and a beneficiary of a [foreign] retirement plan will be subject to current United States income taxation on income accrued in the [foreign retirement] plan even though the income is not currently distributed to the beneficiary, unless the plan is an employees’ trust within the meaning of section 402(b) of the Internal Revenue Code and the individual is not a highly compensated employee subject to the rule of section 402(b)(4)(A).
Thus, as long as the foreign retirement plan is an employees’ trust and the individual is not a highly compensated employee, then no inclusion is required. On the other hand, if the foreign retirement plan is not an employees’ trust or if the individual is a highly compensated employee, then the annual increase in value of the foreign retirement plan is required to be included on the U.S. individual’s U.S. tax return.
There are often special rules in U.S. tax treaties that modify the taxation of pensions or retirement plans. Consequently, the applicable treaty should always be reviewed to determine whether U.S. domestic law is overridden by treaty.
Forms 3520 and 3520-A are generally not required to be filed by a U.S. individual who is the beneficiary of a foreign retirement that is an employees’ trust. However, U.S. individuals who are beneficiaries of other types of foreign retirement plans that are characterized as trusts for U.S. tax purposes may need to file Forms 3520 and 3520-A.
In addition, it is important to note that an FBAR and a Form 8938 may be required with respect to an interest in a foreign retirement plan.
Large U.S. based multinationals have been lobbying for a repatriation holiday where offshore profits are brought back to the U.S. and only taxed at a rate of 5.25%, similar to the 2004-2005 repatriation holiday. Many argue that the repatriation of the offshore profits will stimulate the U.S. economy.
I propose a comparable benefit for individuals --- let’s call it the “Repatriation IRA.” Under the Repatriation IRA, individuals can contribute up to 75% of their taxable income each year into an IRA so that their taxable income is reduced by 75%. As a result, they are only subject to current income tax on 25% of their income, and the earnings in the Repatriation IRA are not taxed until distributed.
At the end of each seven year period, the individuals are given the option of withdrawing the funds from the Repatriation IRA at a tax rate of 5.25%. Individuals who do not elect to withdraw from their Repatriation IRA can continue to defer tax.
One of the major benefits of the Repatriation IRA is the massive stimulation to the U.S. economy in year seven, when many of the individuals withdraw from their Repatriation IRAs and have lots of cash to spend.
I have received a number of inquiries recently regarding the taxation of gains associated with the disposition of Iraqi dinars. Some of the inquiries have related to the formation of an offshore structure (such as an offshore trust, foundation, corporation, etc.) to hold the Iraqi dinars.
If you are a U.S. citizen or a U.S. resident, the short answer to the question of whether you should set up such a structure is “no.” The long answer is the same - “No, you should not set up an offshore structure to hold your Iraqi dinars.”
Make sure that you speak with a qualified U.S. tax advisor before setting up or being associated with any non-U.S. entity, corporation, partnership, structure, trust, foundation, etc. The penalties for simply failing to disclose to the I.R.S. various offshore transactions can be huge.
The amount of U.S. tax imposed on the sale of an asset can increase when held through an offshore structure. A qualified U.S. tax advisor can help you understand what disclosure rules and potential penalties may apply, as well as the risks, costs, and benefits of setting up an offshore structure.
The follow are excerpts from various tax cases discussing a taxpayer’s attempts to “clothe” a transaction to disguise its true form.
Lynch v. Commr, 31 T.C. 990 (1959):
A commonly encountered problem, however, is that a taxpayer, seeking to avoid taxation, will clothe a transaction and make it appear to be something which in reality it is not.
Federal Oil Company v. Commr, 25 TCM 996 (1966):
It is true that the Court is not bound by the form in which parties to an agreement clothe their transaction but is charged with the duty of determining the realities of the transaction after having considered all the pertinent facts.
Copperhead Coal Company, Inc. v. Commr, 17 TCM 30 (1958):
It is well established that the form in which a taxpayer chooses to clothe its transactions does not bind the Government for tax purposes.
Skinner v. Commr, 27 TCM 680 (1968):
[T]he form chosen by the parties to clothe that slice of reality cannot dictate the application of the statute.
Commr v. Kohn, 158 F.2d 32 (4th Cir. 1946):
The circumstances are merely external garments that clothe the transactions, outward trappings at best. In no way do they condition the essential verities.
Cairo Developers, Inc. v. U.S., 381 F.Supp. 431 (1974):
[T]he taxpayers attached the “sale” label to the transfers of land and tried to clothe the transactions with appropriate documents and other indicia of a bona fide sale and debtor-creditor relationship.
Glazer v. Commr, 44 T.C. 541 (1965):
We think that on the facts before us there was in substance no real sale of partnership interests in this case, notwithstanding the efforts of petitioners and their attorney to clothe the transaction in that form.
Anagnoston v. Commr, 68 TCM 146 (1994):
[P]etitioners have gone to great lengths to clothe in “sales” garb transactions that are not sales . . . .
Earp v. Commr, 131 F.2d 292 (10th Cir. 1942):
All he did was to clothe himself in the cloak of a partnership, but when the cloak was removed, there stood the same individual, doing business in substantially the same way . . . .
Blair v. Commr, 300 U. S. 5 (1937):
. . . attempting to clothe the transaction in the guise of a transfer of trust property rather than the transfer of income where that is its obvious purpose and effect.
Collins v. Commr, 54 T.C. 1656 (1970):
[S]uch reporting . . . was to be part of the transparent pretension that was designed to clothe the payment with the garb of interest.
American Realty Trust v. U.S., 498 F.2d 1194 (1974):
[C]lothe a loan in the superficial garb of a sale-and-lease-back.
Culligan Water Conditioning v. U.S., 567 F.2d 867 (9th Cir. 1975):
[W]e should remain free to examine all the facts in order to determine whether there exists a plan or agreement to dispose of control regardless of the formalities with which the parties may choose to clothe their intentions.
First National Corporation of Portland v. Commr, 2 T.C. 549 (1943):
The form in which [the parties] chose to clothe the transaction invites this argument. Nevertheless we think the contention is unsound.
I have recently been typing the word “goodwill,” and I wondered whether it was grammatically preferable for the word to be one or two words. My dictionary says it can be either one. I decided I wanted to use the same convention as used in the U.S. tax arena. Therefore, I looked in the statute of the section in which I was dealing (section 882) and saw that it was listed as two words. I thought this settled the matter.
However, today I was looking in another Code section (section 865) and I saw that goodwill was listed as one word. Intrigued, I thought that perhaps one of the sections was an outlier and that most Code sections would be consistent, one way or the other.
To my surprise, after searching the Code (in CCH, at least), I realized that there was no consistency. Seven Code sections used goodwill as one word (Code sections 167, 197, 338, 865, 901, 1060, and 2036) and nine Code sections used good will as two words (Code sections 401, 736, 871, 861, 862, 881, 882, 927, 993).
Hmmm. What to do?
In 2001, the I.R.S. and Treasury Department published proposed regulations which would have provided that U.S. bank deposit interest paid to nonresident alien individuals ("NRAs") would be reported annually to the I.R.S. In 2002, the proposed regulations were withdrawn and narrower proposed regulations were published that would require reporting only interest payments to NRAs of certain designated countries. The 2002 proposed regulations were never finalized.
In January 2011, the I.R.S. and Treasury Department withdrew the 2002 proposed regulations and published new proposed regulations which would again require the information reporting of interest paid to NRAs of any foreign country.
The rationale for the rule appears to be that the I.R.S. would like to receive information with respect to interest paid by foreign banks to U.S. citizens and U.S. residents from other countries. As a quid pro quo, the tax authorities of other countries would like to receive similar information from the U.S. However, the I.R.S. cannot provide this information to other countries if it doesn’t even collect the information. Thus, the new proposed regulations would require the collection of this information.
NPR’s Fresh Air program yesterday (March 17, 2011) interviewed Jesse Drucker, a Bloomberg News reporter, about the Google "Double Irish" structure. The interview was titled “How Offshore Tax Havens Save Companies Billions.”
The interview is about 20 minutes long and is quite good.
Last year I blogged about “hybrid entities” and “reverse hybrid entities.” Unfortunately, these terms are not intuitive. A hybrid entity is an entity that is “fiscally transparent” for U.S. tax purposes but not fiscally transparent for foreign tax purposes, and a reverse hybrid entity is the “reverse” of a hybrid entity in that the entity is fiscally transparent for foreign tax purposes but not fiscally transparent for U.S. tax purposes.
The I.R.S. recently published Notice 2010-62, which deals with Pre-2011 “splitter arrangements” under the new foreign tax credit splitter rules of Code § 909. Splitter arrangements can occur with reverse hybrid entity structures as well as with hybrid instruments.
New Hybrid Instrument Terminology
Interestingly, the Notice creates a new (to me, at least) terminology for hybrid instruments. The Notice refers to an instrument that is treated as equity for U.S. tax purposes and as debt for foreign tax purposes as a “US Equity Hybrid Instrument” (or a “US Equity HI”). Further, the Notice refers to an instrument that is treated as debt for U.S. tax purposes and as equity for foreign tax purposes as a “US Debt Hybrid Instrument” (or a “US Debt HI”).
I really like this new terminology. It is very intuitive. It is easy to remember that a US Debt HI is debt for U.S. tax purposes. If it is a hybrid, therefore, it must be treated as equity for foreign tax purposes. I commend the I.R.S. for this simple but helpful innovation.
Application to Entities
This terminology can also be applied to hybrid entities. For instance, a hybrid entity could be called a “US Fiscally Transparent Hybrid Entity” or “US FT HE” for short. Intuitively, if the entity is fiscally transparent for U.S. tax purposes, then it must be non-fiscally transparent for foreign tax purposes.
Similarly, a reverse hybrid entity could be called a “US Non-Fiscally Transparent Hybrid Entity” or “US NFT HE” for short. The Notice does discuss reverse hybrid entities, but unfortunately, the author of the Notice didn’t suggest the new terminology for entities.
For my charts, I use the triangle pointing upwards to represent a US FT HE and a triangle pointing downwards to represent a US NFT HE. I do not use ovals, as many tax practitioners do, to represent disregarded entities. My reason for avoiding ovals is that it is often unclear whether a nominee shareholder of a foreign entity should be treated as a separate owner, creating a partnership, or whether the nominee should be disregarded under substance principles, resulting in a disregarded entity (see e.g., Rev. Proc. 2010-32).
Google recently made available a cool new tool called “Google Books Ngram Viewer.” Using data derived from their Google Books project, when you enter phrases into the Google Books Ngram Viewer, it displays a graph showing how those phrases have occurred in a body of books over the selected years.
For instance, if you plug in the word “tax” for the years 1800 to 2010, you get the following graph:
Presumably the I.R.S. was formed at some time during the 1860s.
The term “foreign tax credit" for the period 1920 until 2008 provides:
The graph for “value added tax” from 1945 to 2008 is:
The graphs above have used the books in the “English” category. The same value added tax graph for American English is:
I don’t get as frustrated as I used to when I get calls from victims that are involved in international financial scams and I can’t convince them that they are involved in a scam. The scammers have brain washed their victims into believing that the money is at their fingertips.
The call usually comes to me when the millions of dollars were supposed to have already been transferred, but the money had to be held up due to an unforeseen tax. Therefore, the money never got transferred. The victim then calls me to see if they can somehow reduce this tax.
As indicated on the U.S. Department of State website, “scams evolve constantly, and we cannot include all scam variations here.” The scammers are very creative in coming up with ways to extract money out of their victims. Usually the victim will start using legal terminology that they have been taught by the scammers as being very important. This is just a smoke screen.
Often the fees that the victims pay have something to do with the Patriot Act, money laundering, or other “new” rules put in place since 9/11. One of the latest fees that I have heard about is an “insurance bond,” supposedly to make sure no one else transfers your money out of your account. I am sure that the victim feels that the $1,000 [or whatever] fee is well worth the peace of mind that their “millions of dollars” are being protected.
As stated on the U.S. Department of State website:
If you feel you have been a victim of an Internet scam, please consult the publications below for help and send all reports of Internet fraud directly to the Internet Crime Complaint Center. If the scam originated through a particular website, notify also the administrators of that website. When it becomes apparent you are the victim of a scam, it is best to end all communications with the scam artist, rather than attempt resolution. It is extremely rare for victims to recover lost money. If you feel threatened in any way, you should report your situation to the local police.
For our prior coverage of international tax scams, see here.
Paul Caron’s TaxProf Blog today highlights an article by Bloomberg that discusses Google’s use of a Double Irish structure to reduce the tax rate on its overseas profits to 2.4%. The article includes a helpful graphic as to how the reduced tax rate is achieved.
See here for our earlier coverage of the Double Irish Structure.
Under U.S. generally accepted accounting principles (“GAAP”), publicly traded U.S. multinationals do not record U.S. tax expense on undistributed earnings of non-U.S. subsidiaries where the earnings are considered to be permanently reinvested outside the U.S.
For example, if a U.S. multinational earns $100 in a foreign jurisdiction that has no local income tax (i.e., a tax haven), the full $100 is included in the earnings reported to the public. Ultimately, the foreign earnings will be subject to U.S. federal and state income taxes. However, no U.S. tax expense is currently recorded if the earnings are designated as being permanently invested outside the U.S. These earnings will ultimately be subject to U.S. taxes. Even though it makes sense to accrue U.S. taxes as these earnings are generated, the accounting rules do not require such accrual.
Publicly traded U.S. multinationals primarily focus on earnings reported to shareholders. Because GAAP rules do not require the booking of U.S. tax expense on undistributed earnings of non-U.S. subsidiaries, U.S. multinationals can increase their earnings per share by simply moving their profits out of the U.S. to a low tax foreign jurisdiction.
If Congress were to force a change in the GAAP rules so that U.S. multinationals had to record U.S. federal and state income taxes on all worldwide earnings (net of applicable foreign tax credits), regardless if the foreign earnings were undistributed, it would significantly reduce the incentive to shift profits (and jobs) abroad.
Interestingly, this would not be a tax increase at all. It would merely be an improvement in the calculation of earnings reported to shareholders. The earnings would reflect a tax that will ultimately be paid. The U.S. multinationals would continue to pay the same amount of U.S. tax as prior to the change. The companies would merely be booking an expense and a liability that will ultimately come due, and the change would substantially reduce the incentive to shift profits and jobs overseas.
Jesse Drucker of Bloomberg recently published an article discussing a cross-border tax strategy known as the “Double Irish.” Under this structure, large U.S.-based multinational corporations set up manufacturing operations in Ireland, but record most of their profits in Bermuda.
According to the article, the profits of the Irish/Bermuda subsidiary are subject to an effective tax rate of 2.4%. The Irish subsidiary profits are often attributable to products sold in the U.S. With U.S. federal and state corporate income tax rates in the range of 40%, these multinationals substantially reduce their effective tax rates by shifting profits (and often jobs) outside the U.S.
With such a tax rate differential, multinationals put forth significant efforts into substantiating why their Irish/Bermuda operations should be so profitable. The profits are shifted to Ireland in related party transactions. The multinationals must apply the “arms-length” standard for transactions between related parties.
The arm’s length standard requires a hypothetical analysis --- “How would the related parties have acted if they were not related?” Of course, the parties are related. Therefore, they will structure their operations in a way that provides them the most benefit when the hypothetical analysis is performed. The hypothetical analysis is very fact intensive and the multinationals have the best access to the facts and they can even manipulate the facts to their best advantage.
Typically, an arm’s length “range” is determined and as long as the related party transactions are within that range, the transactions are respected. The I.R.S. often determines that the related party transactions are not within the proper range, but the multinationals seem to have the upper hand. Some penalties already exist in this area. However, they do not seem to be effective.
Congress recently enacted penalties in the tax shelter area where taxpayers are found to lack economic substance. An interesting aspect of these new penalties is that there is no “reasonable cause” exception. If there is no economic substance, the penalty applies. Commentators have noted that this new “strict liability” penalty will likely deter aggressive tax shelter planning.
Should a new strict liability penalty be created for related party transactions? Perhaps the penalty would apply only if the transactions are "materially" outside of the arm’s length range or if the profits were outside the range and were ultimately shifted to a low tax jurisdiction. Such a penalty might deter aggressive tax planning for multinational related party transactions. In fact, it might even discourage (rather than encourage) the transfer of jobs overseas.
Code § 7805(e)(2) provides: “Any temporary regulation shall expire within 3 years after the date of issuance of such regulation.” This rule was enacted in 1988.
I can’t locate any materials as to why this rule was put in place. I have always assumed that Congress must have felt that the Treasury Department had abused its authority to issue “temporary” regulations and then left them in place indefinitely, thereby effectively making the regulations permanent.
On March 20, 2007 the I.R.S. and the Treasury Department published temporary regulations § 1.368-1T(e)(2) dealing with the continuity of interest test applicable to Code § 368(a) reorganizations. Under Code § 7805(e)(2), the temporary regulations were set to expire today.
Yesterday the I.R.S. published Notice 2010-25. The Notice provides that:
The Service and the Treasury intend to issue final regulations, but do not expect to issue such regulations prior to the expiration of the temporary regulations. The purpose of this notice is to provide taxpayers with interim guidance applicable to the period between the expiration of the temporary regulations and the issuance of new regulations.
The temporary regulations were generally taxpayer friendly. Thus, it is commendable that the I.R.S. and the Treasury Department are extending the more liberal continuity of interest rules.
However, I wonder how long the Notice will be in place before final regulations are issued. I am aware of some notices that have been outstanding for more than 20 years without regulations being issued (e.g., Notice 88-22). To me, it seems like the I.R.S. and the Treasury Department may be circumventing the spirit of the law in Code § 7805(e)(2) by issuing notices that in many ways simply extend the temporary regulations.
Happy Birthday to the 16th Amendment to the U.S. Constitution. The 16th Amendment was ratified on February 3, 1913. The Amendment provides:
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
Only three more years until the 100th year anniversary.
Many tax preparers these days are in the process of amending their clients' tax returns under the recent voluntary disclosure program for offshore financial accounts. If their clients have invested in offshore bearer bonds, it is important to understand certain special rules that apply to these bearer bonds.
Under Code § 165(j), no deduction is allowed for losses sustained on bearer bonds. For instance, if a bearer bond is purchased and later resold at a loss, no deduction would be allowed for U.S. tax purposes. This is quite an unusual rule and many tax preparers may not be aware of it.
In addition, Code § 1287 denies capital gain treatment for gains on bearer bonds. For instance, if a bearer bond is purchased and later resold at a gain, the gain would be taxed as ordinary income.
If your clients have been investing in bonds through their foreign financial accounts, it is important to determine whether the bonds were bearer bonds.
The IRS recently stated in an internal memorandum that Liechtenstein Anstalts, in most cases, are properly classified as business entities for U.S. tax purposes under Treas. Reg. § 301.7701-2(a). The memorandum stated that Liechtenstein Anstalts generally are not treated as trusts under Treas. Reg. § 301.7701-4(a) because in most situations their primary purpose is to actively carry on business activities.
In the same memorandum, the IRS stated that Liechtenstein Stiftungs will generally be classified as trusts, unless under the facts and circumstances, the entity was created primarily for commercial purposes.
The proper U.S. tax classification of foreign entities is critical for proper tax planning. Different substantive tax rules and different U.S. tax reporting requirements apply to business entities versus trusts.
As indicated in the IRS memorandum, the business entity classification for Anstalts is "in most cases," and the trust classification for Stiftungs is "generally." The specific facts and circumstances of each case must be analyzed to determine the proper U.S. tax classification of foreign entities.
In our last blog posting, we discussed that it is useful to conceptually divide cross-border taxation into the categories of “inbound” and “outbound.” Inbound refers to non-U.S. persons with U.S. income and/or U.S. activities, and outbound refers to U.S. persons with non-U.S. income and/or non-U.S. activities.
Another useful classification for dealing with cross-border transactions is that of widely held companies and that of closely held companies. These categories are useful for both inbound and outbound transactions. Thus, inbound and outbound can be sub-divided as follows:
Widely Held Companies
Widely held companies have certain advantages and certain disadvantages in both the inbound and outbound contexts. In the inbound context, if the widely held company is publicly traded, then one of its advantages is that it may more easily qualify for the limitation on benefits provisions included in most U.S. income tax treaties. This qualification may allow it to be subject to lower tax rates on U.S. withholding taxes or, in some circumstances, to avoid U.S. taxation entirely. One of the disadvantages of a widely held company in the inbound context is that it is more difficult to avoid branch profits taxes and/or dividend withholding taxes.
In the outbound context, a disadvantage is that widely held companies (typically “C” corporations) are subject to two levels of taxation - one tax at the corporate level as profits are earned and another tax at the shareholder level when profits are distributed. Several other countries have “integrated” tax systems that allow shareholders to claim credits against their own income tax liabilities for taxes paid at the corporate level. The U.S. does not have such an integrated tax system. Consequently, profits earned by widely held corporations in the U.S. are generally subject to two levels of taxation.
An advantage of a widely held company in the outbound context is that foreign income taxes paid by foreign subsidiaries of the U.S. parent can generally be claimed as foreign tax credits in the U.S. when the foreign profits are distributed (or deemed distributed) to the U.S. parent. These foreign tax credits are sometimes called “indirect” or “deemed paid” foreign tax credits. If widely held U.S. parent companies were not allowed to claim deemed paid credits, profits earned by foreign corporate subsidiaries would ultimately be subjected to three levels of taxation: foreign corporate taxation, U.S. corporate taxation, and U.S. shareholder taxation.
Closely Held Companies
As with widely held companies, closely held companies have certain advantages and disadvantages in both the inbound and outbound contexts.
In the inbound context, an advantage of a closely held company is that it may be able to structure its U.S. operations to avoid branch profits taxes and dividend withholding taxes. A disadvantage of a closely held company is that, depending on the structure, there may be U.S. estate taxation risks.
A brief discussion of the taxation of U.S. closely held companies is helpful to understand the advantages and disadvantages in the outbound context. U.S. closely held companies are often structured to avoid entity level taxation. This is typically achieved with the use of “S” corporations or partnerships. Without an entity level tax, only the shareholders/partners are subject to U.S. income tax.
NB: Limited liability companies (“LLCs”) formed in the U.S. are often treated as partnerships for U.S. tax purposes. However, LLCs can also be treated as S corporations, C corporations, or disregarded entities.
In the outbound context, a disadvantage is that a closely held U.S. parent company which is not structured as a “C” corporation does not qualify for deemed paid foreign tax credits. Consequently, profits of foreign subsidiaries of closely held U.S. parent companies may be subject to two levels of taxation (foreign entity level tax and U.S. shareholder level tax). However, an advantage of a closely held company is that it may be able to structure the operations of its foreign subsidiaries to be subject to only one level of worldwide taxation.
Complex U.S. Tax Rules for Both
Both widely held and closely held companies are subject to some of the same complex U.S. tax rules. For instance, in the inbound context, some of the rules that apply to both types of companies include:
In the outbound context, some of the rules that apply to both types of companies include:
This blog posting touches on many issues and is not intended to cover any of the issues in depth. Each of the sub-categories of cross-border taxation has many intricate rules that should be analyzed in detail with respect to each specific taxpayer.
Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.
Update: For related blog post see inbound-outbound graphic.
Cross-border taxation can be subdivided into various categories based on the type of transaction being analyzed. At the highest level, the categories include “inbound” and “outbound.” These categories are useful because significantly different U.S. tax rules can apply to the different types of transactions.
When viewed from the United States, “inbound” refers to non-U.S. persons (“persons” meaning both individuals as well as entities) with U.S. income and/or U.S. activities. A typical inbound circumstance exists where a foreign corporation has income and/or activities in the U.S. For instance, Toyota is a Japanese headquartered company. However, Toyota sells its products in the United States. Thus, Toyota is selling “into” the U.S., and Toyota would generally be considered in the inbound category.
In order for a transaction to be considered inbound, however, it is not necessary for product to be imported into the U.S. Continuing the example above, Toyota may decide it is better to manufacture product in the U.S. Consequently, Toyota may form a U.S. subsidiary and have the subsidiary manufacture and sell the product in the U.S. In this circumstance, there has been no product imported into the U.S. However, it is still an inbound transaction because the parent company is from outside the United States and its subsidiary has activities in the United States.
Typical cross-border tax issues related to inbound transactions can include: U.S. withholding taxes, transfer pricing, branch profits taxes, branch interest taxes, earnings stripping, income tax treaties, etc.
“Outbound” refers to U.S. persons with NON-U.S. income and/or NON-U.S. activities. A typical outbound circumstance exists where a U.S. headquartered corporation has income and/or activities in other countries. For instance, Wal-Mart is an American publicly traded company. However, Wal-Mart purchases many of its products from suppliers located outside the United States. Further, Wal-Mart sells many of its products outside the United States (either through foreign subsidiaries or otherwise). Thus, Wal-Mart is a U.S. headquartered company with activities “outside” the U.S., and Wal-Mart would generally be considered in the outbound category.
Typical cross-border tax issues related to outbound transactions can include: foreign withholding taxes, transfer pricing, foreign tax credits and foreign tax credit limitations, subpart F income, Code § 956 inclusions (a.k.a. investments in U.S. property), income tax treaties, etc.
Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.
The Obama administration has proposed to defer deductions for certain expenses incurred by U.S. multinationals with deferred foreign income. This blog posting first discusses two other U.S. tax matching principles and then discusses the proposed Obama matching principle.
Exempt Income / Expense – Matching Principle
Expenses are often incurred in the process of generating taxable income. These expenses are generally deductible for tax purposes, so that only the net profit is subject to income tax.
Certain types of income are exempt from income taxes. Examples include municipal bond interest income and certain foreign earned income. As would be expected, expenses related to the exempt income are generally not deductible for tax purposes.
The disallowance of expenses related to tax exempt income can be thought of as a matching principle: if the income is not taxable, the related expense should not be tax deductible.
Timing of Income / Expense – Matching Principle
Certain types of expenditures create assets or other long term benefits. U.S. tax law generally requires that the cost of creating or purchasing assets, and expenditures that create long term benefits, be deducted for tax purposes over the useful life of the asset, or over the term of the benefit.
This deferral of deductions is based on an accounting matching principle which attempts to match the timing of expense deductions with the timing of income recognition.
Deferral of Foreign Income / Expense – Obama Proposed Matching Principle
U.S. based businesses with foreign subsidiaries are often able to defer U.S. taxation of foreign profits, sometimes for extended or even indefinite periods.
Expenses related to the foreign operations, however, are often incurred and deducted by the U.S. parent company on a current basis. Thus, there is a mismatch with the timing of income recognition and the timing of deductions – income is deferred but expenses are not deferred.
The Obama administration has proposed to create a matching principle: foreign related expenses cannot be deducted until the foreign related income is subject to U.S. tax. There are large dollar amounts at stake.
Example of Interest Expense
Interest expense is an example of the mismatch of income and expenses. Say a U.S. parent company typically earns $100 of profit before income taxes on its U.S. operations. Say also that the U.S. parent is considering expanding its operations by borrowing and investing $1,000. The expanded operations can be located either in the U.S. or overseas. Say also that labor and material costs are identical in the U.S. and in the proposed foreign country. As long as the tax rate in the foreign country is lower than the tax rate in the U.S., the U.S. parent can reduce its current worldwide tax cost by expanding its operations outside the U.S. rather than inside the U.S.
This can be demonstrated as follows: Assume the U.S. parent borrows $1,000 at 10% interest per annum in the U.S. The U.S. parent invests the $1,000 as equity into a foreign subsidiary in a lower tax country with an active foreign business. Assume also that the foreign subsidiary earns $150 per year and reinvests its earnings in the foreign business.
Under today’s tax rules, the U.S. parent can generally deduct the $100 of interest expense in the U.S. on a current basis. This interest expense wipes out the U.S. parent’s U.S. taxable income ($100 pre-interest profit minus $100 interest expense). The foreign income of $150, however, is not currently taxed in the U.S.
Incentive to Invest Overseas
The current deduction for the U.S. interest expense combined with the deferral of the foreign income creates an incentive for the U.S. parent to invest in new businesses overseas rather than to invest in the U.S. The proposed matching principle would eliminate this incentive by deferring the $100 of interest expense until the $150 of foreign earnings were subject to U.S. tax.
Under U.S. tax rules, qualified business units (QBUs) are important for purposes of calculating certain transactions denominated in currencies other than the U.S. dollar. This posting discusses what a QBU is. However, this posting does not discuss the specific U.S. tax rules on how to report non-U.S. dollar denominated transactions for a QBU or a non-QBU.
In general, a QBU is any separate and clearly identified unit of a trade or business of a taxpayer, provided that separate books and records are maintained.
Certain entities can constitute QBUs. For instance, a corporation is a QBU. Further, a partnership, trust, or estate is a QBU of a partner or beneficiary.
Certain activities can also qualify as a QBU. In order for activities to create a QBU:
The definition of a “trade or business” for this purpose is broader than most definitions of “trade or business.” A trade or business for purposes of defining a QBU is:
[A] unified group of activities that constitutes (or could constitute) an independent economic enterprise carried on for profit, the expenses related to which are deductible under section 162 or 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).
Deductions for typical trade or business expenses are generally found in Section 162. However, section 212 generally allows deductions for the production or collection of income, regardless of whether an actual trade or business exists. Expenses typically fitting within section 212 include rental property deductions and investment-related expenses.
Thus, investment activities can create a QBU as long as they are a separate and clearly identified unit and separate books and records are maintained. This principle is illustrated in Treas. Reg. § 1.989(a)-1(e), Example 6, which provides:
Taxpayer A, an individual resident of the United States, is engaged in a trade or business wholly unrelated to any type of investment activity. A also maintains a portfolio of foreign currency-denominated investments through a foreign broker. The broker is responsible for all activities necessary to the management of A’s investments and maintains books and records as described in paragraph (d) of this section, with respect to all investment activities of A. A’s investment activities qualify as a QBU under paragraph (b)(2)(ii) of this section to the extent the activities engaged in by A generate expenses that are deductible under section 212 (other than that part of section 212 dealing with expenses incurred in connection with taxes).
In certain circumstances, the existence of a QBU can allow for the deferral of recognition of currency gains and losses.
Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.
There are many forms of asset protection. There is no silver bullet and often multiple techniques are used.
One of the best types of asset protection is purchasing insurance. If your home burns to the ground, insurance protects you. If you get in a car accident and injure someone, insurance protects you. Insurance, however, has limitations on coverage - both on the amount that will be covered and on the type of activity covered. Therefore, insurance is not always sufficient to protect your assets.
Limited Liability Companies
Another type of asset protection is operating your business activities through a company with limited liability - such as a corporation or a limited liability company. If formalities are complied with and if business and personal assets are not commingled, a company with limited liability can be an effective means of asset protection for the shareholders of the company. If the company is sued, the shareholders generally cannot be held liable for the debts of the company.
Divesting of Assets
If one member of a family is more likely to be sued than another, it may be helpful to have family assets held by other members of the family. For instance, if one spouse engages in a high risk profession, it may be prudent to have the family home and other assets held by the other spouse. It is important to note, however, that this approach merely shifts risk from one spouse to another. If the low risk spouse is held liable for an action, the assets can still be lost.
Domestic asset protection trusts (“DAPT”) and offshore asset protection trusts (“OAPT”) are also included in this category. Trusts can be created for the benefit of family members and property can be transferred to the trusts so that the property is beyond the reach of creditors. In several U.S. states it is now even possible to create “self-settled” trusts, where the trust benefits the creator of the trust and may protect the property from creditors.
Obfuscation (Hiding Assets)
Making it difficult for creditors to find assets and/or to gain control of those assets is another technique of asset protection. There are an unlimited number of techniques that can be used to hide assets. This rationale is often one of the major selling points of offshore asset protection advisors.
One approach to hiding assets is to set up bank or other accounts in countries with bank secrecy laws. Another approach is to set up foreign corporations, foreign trusts, foreign foundations, or other types of foreign entities where the owners or beneficiaries of those entities are kept secret. This secrecy might be achieved by having the title to the shares held by one person, but the shares beneficially owned by another. Sometimes, instead of keeping the owners or beneficiaries secret, the beneficiaries or owners are simply not yet determined (shares not officially issued for corporations, contingent beneficiaries for trusts, etc.).
U.S. Tax Issues With Obfuscation
The problem with obfuscation is that Congress has created numerous U.S. tax reporting requirements for offshore activities. The penalties for failing to comply with the U.S. tax reporting requirements can be enormous. For instance, if a U.S. citizen transfers $100,000 to a foreign trust and simply fails to tell the I.R.S. about the transfer, the penalty starts at 35% ($35,000) and goes up from there. Code § 6677(a). The comparable penalty for failing to disclose transfers to foreign corporations is 10%. Code § 6038B(c).
To learn more about U.S. tax reporting requirements (and the penalties) for offshore activities, speak with a qualified U.S. tax professional.
Obfuscation Increases U.S. Tax Advisor Fees
Even without obfuscation, it can cost thousands of dollars to hire a tax professional to help you prepare the necessary U.S. tax forms related to the offshore activities. Many tax professionals don’t regularly deal with offshore tax reporting, and the ones that do may be hesitant to prepare the tax returns due to the potential for penalties.
Where there has been obfuscation, it can cost even more. In the typical case, the U.S. citizen that has created the offshore asset protection structure may initially be tight-lipped about the details. The conversation might go as:
Client: "I don’t own the shares of the foreign corporation (to which I transferred assets)."
U.S. Tax Advisor: "Who owns the shares?"
Client: "My foreign attorney’s secretary holds title to the shares."
U.S. Tax Advisor: "Can you have the shares transferred into your name at any time?"
Client: "Well . . . "
U.S. tax law looks to the substance of the transaction. If shares or assets are nominally owned by one person, but beneficially owned by another, U.S. tax law would treat the beneficial owner as the true owner. Therefore, the beneficial owner would be required to report the ownership of the shares or assets.
Obfuscation techniques intentionally make transactions overly complex and unclear. To meet the U.S. tax filing requirements, the complexity and uncertainty must be sorted through to determine the proper filings. The time it takes the U.S. tax advisor to sort through the “mess” costs the client in additional fees.
U.S. Tax Reporting Undercuts Obfuscation
A properly prepared U.S. tax return will be a road map to where the assets went and to who controls the assets. It is not recommended that the U.S. tax filings have any misleading information. On the contrary, it is important that the U.S. tax filings be as complete and as accurate as possible. The I.R.S. often has discretion in determining whether they will assert penalties. If an I.R.S. agent perceives that the information provided is not complete or accurate, they may be more likely to impose penalties.
In essence, the obfuscation must be unwound for purposes of preparing the U.S. tax return. Therefore, the complexity and uncertainty intended for asset protection purposes may not serve its purpose.
In summary, it is important for U.S. citizens and U.S. residents to understand all of the U.S. tax implications of setting up offshore asset protection structures, preferably prior to entering into such a structure. However, if such a structure has already been set up and the U.S. tax reporting requirements for earlier years have not been complied with, it is important to get up to date with those filings. While the I.R.S. generally waives penalties for reasonable cause, they are much less likely to find reasonable cause when they are the ones who discover the existence of the offshore structure.
Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.
There are many reasons to like Ireland. It is a beautiful place to visit and to live. It has an educated, English-speaking population and many other valuable attributes. From a tax perspective, many companies in Ireland enjoy a local income tax rate of no more than 12.5%. This contrasts with combined U.S. federal and state corporate income tax rates of as much as 40% or more.
A low foreign income tax rate is especially attractive for publicly traded companies that can indefinitely keep their earnings outside the U.S. For earnings per share (“EPS”) purposes, companies in these circumstances calculate tax expense on their foreign earnings based only on the foreign tax imposed.
For instance, if $100 of pre-tax earnings is earned in the U.S., the federal and state tax expense could be $40 or more. Thus, only $60 of earnings would be reported to shareholders for EPS purposes. If it is possible to shift that $100 of pre-tax earnings to Ireland (and to indefinitely keep the earnings out of the U.S.), the tax expense for that income for EPS purposes declines to $12.5. In this case, $87.5 of earnings would be reported to shareholders for EPS purposes. By merely shifting the location of the income from the U.S. to Ireland, EPS for that item of income has increased by 46%.
The more profit that can be shifted to Ireland, the bigger the benefit. Even better, some companies are able to shift profits to zero tax jurisdictions. In these circumstances, the outsourcing of U.S. jobs provides a 67% increase in earnings per share for the profits outsourced.
Theoretically, the foreign earnings will be subject to U.S. tax (for book purposes and for tax purposes) when repatriated to the U.S. However, there can be all sorts of ways to utilize the cash earned outside the U.S. Foreign acquisitions is one example. In fact, foreign acquisitions may be “cheaper” than U.S. acquisitions because U.S. acquisitions require the cash to be repatriated to the U.S., thereby triggering a tax cost.
Even with foreign acquisitions and other strategies to utilize the foreign cash, some companies build up large amounts of cash outside the U.S. In 2004, however, Congress came to the rescue with the enactment of Code § 965. Under this new provision, these companies were allowed to repatriate cash to the U.S. during a window period where they could deduct 85% of the dividends received. During this window period, approximately $312 billion was repatriated to the U.S.
Undoubtedly, many of the same companies have again built up foreign cash and are yearning for another gift from Congress.
The Irish times recently published an article indicating their concern about the fate of the Irish economy if Obama were elected. The article stated that:
[T]he [Bush] administration's attitude towards international tax incentives that reduce investment, jobs and tax revenue within the US . . . has been laissez-faire, if not benevolent.
The article continued:
. . . Irish agencies charged with attracting foreign investment to Ireland have always been more wary of Democratic administrations than Republican ones.
The concern of the article was that if the U.S. stops shifting investment, jobs, and tax revenue outside its borders, the Irish economy will suffer.
Does the Treasury Department have the authority to create law with no statutory basis? I am no expert at the tax rules regarding limitations on losses after ownership changes under Code § 382. However, it would appear to me that this is exactly what the Treasury Department may be doing with the issuance of Notice 2008-83.
Notice 2008-83 is very short (and sweet if you are an acquiring bank). It provides in part:
The Internal Revenue Service and Treasury Department are studying the proper treatment under section 382(h) . . . of certain items of deduction or loss allowed after an ownership change to a corporation that is a bank . . . .
For purposes of section 382(h), any deduction properly allowed after an ownership change . . . to a bank with respect to losses on loans or bad debts . . . shall not be treated as a built-in loss or a deduction that is attributable to periods before the change date.
[Banks] may rely on the treatment set forth in this notice . . . .
I am looking forward to reading the Treasury Department’s statutory analysis to support the issuance of Notice 2008-83. It would seem that the determination of whether a loan had a built-in loss on the date of the ownership change would be a factual matter to be determined in court.
This notice is very likely worth billions of dollars in tax savings to banks that are taken over. The benefits, of course, will accrue to the acquiring bank because it will be able to shelter its future income with the losses of the taken over bank. Ordinarily, the acquiring company would be severely limited in its usage of a target company’s losses after an ownership change.
Is this another example of the executive branch of the federal government by-passing the legislative and judicial branches of government?
This morning I noticed a quirk in the drafting of the CFC statutes. The following language is used in defining “United States Shareholder” in Code § 951(b):
. . . the total combined voting power of all classes of stock entitled to vote of such corporation. (Emphasis added)
In contrast, the following language is used in defining “Controlled Foreign Corporation” in Code § 957(a)(1):
. . . the total combined voting power of all classes of stock of such corporation entitled to vote . . . . (Emphasis added)
Notice the different position of the red text. In the first definition, “entitled to vote” accurately modifies the noun “stock.” This makes sense because you can have voting stock or non-voting stock. The language “entitled to vote” specifies that this definition is only discussing voting stock.
In the second definition, “entitled to vote” appears to be modifying the noun “corporation.” However, this would make no sense. Corporations are not entitled to vote. There is no such animal as a “voting corporation” or a “non-voting corporation.” Thus, the only sensible reading of the statute is that “entitled to vote” modifies the noun “stock.” The regulations under Code § 957 are consistent with this reading of the statute. See Treas. Reg. § 1.957-1(b)(1).
It is just surprising that two related provisions that were enacted at the same time and use very similar language in defining two related provisions would use different language.
On May 30, 2008, the Treasury Inspector General For Tax Administration published a report recommending that the I.R.S. better focus its resources on international transactions of small businesses. The Treasury Department found that tax returns of small businesses were far less likely to be examined by the I.R.S., even when significant dollars were involved in the transactions.
The report noted that the compliance risk associated with international transactions continues to grow as companies expand operations across international boundaries, and that a significant number of high-risk international tax issues that should be scrutinized for examination are missed.
In response, the I.R.S. stated that plans are underway to improve the way in which small business tax returns with international features are identified and selected for examination. The I.R.S. is developing plans to use international examination specialists in the screening process and to ensure that specialists are involved in determining the scope and depth of examinations with international features.
The U.S. Treasury Department recently issued temporary and proposed regulations under Code § 367(b) to close a loophole used by multinationals to repatriate cash from their foreign subsidiaries to the U.S. without paying tax on the repatriated earnings.
On September 22, 2006, the IRS and Treasury Department issued Notice 2006- 85 (charted here), which announced that regulations would be issued under Code § 367(b) to address certain triangular reorganizations under section 368(a) involving one or more foreign corporations. On May 31, 2007, the IRS and Treasury Department issued Notice 2007-48 (charted here), which amplified Notice 2006-85 and announced that additional regulations would be issued under Code § 367(b).
Notice 2006-85 describes triangular reorganizations in which a subsidiary (S) purchases stock of its parent corporation (P) from P in exchange for property, and then exchanges the P stock for the stock or assets of a target corporation (T), but only if P or S (or both) is foreign. Notice 2006-85 announced that regulations to be issued under Code § 367(b) would make adjustments that would have the effect of a distribution of property from S to P under Code § 301 (deemed distribution).
Notice 2007-48 describes a transaction very similar to the transaction in Notice 2006-85, except that S purchases the P stock from a person other than P (such as from public shareholders on the open market).
The New Regulations
The new temporary and proposed regulations (Treas. Reg. § 1.367(b)-14T) apply to triangular reorganizations where P or S (or both) is foreign and, in connection with the reorganization, S acquires, in exchange for property, all or a portion of the P stock that is used to acquire the stock or assets of T. In a triangular reorganization subject to the temporary regulations, adjustments shall be made that have the effect of a distribution of property from S to P under Code § 301. The amount of the deemed distribution shall equal the amount of money plus the fair market value of other property that S used to acquire P stock.
In Notice 2006-85 and Notice 2007-48, the transactions were structured as triangular B reorganizations (sometimes referred to as “killer B” reorganizations). The regulations include an example (Treas. Reg. § 1.367(b)-14T(b)(4)) of another type of triangular reorganization (forward triangular merger -- Code §§ 368(a)(1)(A) and (a)(2)(D)) that could be used (if not for the new rules) to repatriate cash tax free (say, a "killer forward triangular merger"). We expect to create a chart of the example soon.
Most states in the United States define “residency” based on a person’s “domicile.” Domicile, in general, is the place which an individual intends to be his or her permanent home and to which such individual intends to return whenever absent.
An individual can only have one domicile at a time. Once a person acquires a domicile, he/she retains that domicile until another is acquired. A change of domicile requires: 1) abandonment of a prior domicile, 2) physically moving to and residing in the new locality, and 3) intent to remain in the new locality permanently or indefinitely. If a person moves to a new location but intends to stay there only a limited time (no matter how long), their domicile does not change.
Domicile is not dependent on citizenship. However, a United States citizen shall not ordinarily be deemed to have changed domicile by going to a foreign country unless it is clearly shown that such individual intends to remain there permanently.
Factors to Determine Intent
As indicated above, the location of a person’s domicile is dependent on a person’s intentions. Intent is a state of mind. A state of mind is difficult to prove. As a result, taxing authorities (and courts) look to a person's actions to determine their intent. Some of the factors that courts and taxing authorities look to include:
A classic situation where an individual has moved, but has not changed their domicile, is where an employee of a multinational corporation has been transferred to an overseas location for a specified period of time (e.g., 2 years, 5 years, etc.). By definition, the temporary nature of the assignment precludes a change of domicile. Even if the assignment is extended, say for another 5 years, there has been no change in domicile unless the individual intends to remain in the new locality permanently or indefinitely.
How the States Catch You
States do not typically track in detail the activities of each taxpayer. If a taxpayer leaves a state, has no further income sourced in that state, and ceases to file tax returns in that state, then the tax authorities of that state do not typically inquire where the taxpayer moved to or whether they changed their domicile. The domicile/residency issue usually arises in two different circumstances. In the first circumstance, the taxpayer continues to have income sourced from that state, but the taxpayer begins filing as a nonresident.
The second circumstance is when a person, who has been filing as a resident of the state, ceases all filings in that state, and then at some point in the future again files as a resident of the state. This second circumstance often applies to individuals that move overseas for a period of time and then return to the same state. When the state tax authorities receive a tax return, they check to see if that individual filed a tax return in prior years. If prior year resident tax returns have been filed, but there is a gap in filings (of perhaps several years), the state tax authorities begin to wonder why no tax returns were filed during the intervening years.
If the state tax authorities identify a person with a gap in tax filings, and they believe that that person retained their domicile in that state, then they will require the filing of state income tax returns for the intervening years. Statutes of limitations for tax returns generally begin to run on the date a tax return is filed. If no tax returns have been filed for the intervening years, then the statute of limitations for those years remains open indefinitely.
Substantial Taxes May be Due
States do not typically allow foreign taxes paid as credits against state income taxes. Further, states may or may not conform to the federal rules which allow certain foreign earned income to be excluded from taxable income. As a result, persons temporarily residing overseas will often owe significant state income taxes, even though they may not be present in the state at all during the year.
Some states provide exceptions to individuals being treated as residents, even if the individuals retain their domicile in that state. For instance, California allows (with certain exceptions) individuals that are domiciled in California to be treated as nonresidents of California if they are located outside California under an employment-related contract that lasts for at least 546 days.
Connecticut, on the other hand, has two alternative tests that allow Connecticut domiciled individuals to be treated as nonresidents. To meet the requirements of the first test, an individual must:
To meet the requirements of the second test, an individual must:
As can be seen from the California and Connecticut rules, the state exceptions to residency for domiciled individuals are not consistent. Thus, it is important to review the rules for the state in which the person is domiciled.
Attorney Andrew Mitchel is an international tax attorney that advises individuals and businesses with cross-border activities.
I recently read an article dealing with Canadian taxation of cross-border transactions. Part of the article discussed the Canadian approach to outbound taxation. In many ways, the Canadian rules for taxing outbound investments are very similar to the U.S. rules.
The U.S. generally allows for deferral -- Canada generally allows for deferral.
The U.S. has certain anti-deferral regimes (subpart F income and passive foreign investment companies) -- Canada has certain anti-deferral regimes (foreign accrual property income, or "FAPI," and foreign investment entities).
The U.S. allows foreign tax credits to offset U.S. tax when foreign profits are repatriated -- Canda allows foreign tax credits to offset Canadian tax when foreign profits are repatriated.
One major difference, however, is that the U.S. generally does not allow foreign profits to be exempt from U.S. taxation when the profits are repatriated. In contrast, Canada exempts from Canadian corporate income tax certain foreign profits of active businesses in countries that have income tax treaties or tax information exchange agreements ("TIEAs") with Canada.
Based solely on information provided in the article, we have created a rudimentary flowchart showing the Canadian taxation of outbound transactions. The flowchart is shown below: (for a larger version of this chart, click here)
In many countries, real estate is commonly owned through entities with limited liability, such as corporations and limited companies. If a U.S. person inherits the stock of a foreign corporation from a non-U.S. person, or from another U.S. person, the U.S. tax costs related to the disposition of the underlying real estate can be much greater than most taxpayers and tax professionals would expect.
As a preliminary matter, it is important to file the appropriate U.S. tax forms to disclose the receipt of an inheritance from a non-U.S. person. Form 3520, Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts, must be filed by U.S. persons that receive foreign inheritances of $100,000 or more. Failure to file Form 3520 to report the inheritance can result in a penalty of 5% of the amount of the inheritance for each month that the failure to report continues (not to exceed a total of 25%). See Code § 6039F(c).
The following example demonstrates the U.S. tax ramifications of a U.S. person inheriting stock in a foreign corporation that owns foreign real estate. Assume the following facts:
Individual A is a U.S. resident or U.S. citizen. Individual A’s father (“Father”) is not, and has never been, a U.S. resident or U.S. citizen. Prior to his demise, Father’s only asset is stock in a foreign corporation (“FC”). FC was formed years ago when Father had contributed $100,000 into FC in exchange for FC stock. FC used the cash to purchase undeveloped real estate in a foreign country.
Father dies and leaves his sole asset (stock in FC) to his only child, Individual A. The real estate owned by FC has substantially appreciated since FC purchased it years before. The fair market value of the real estate held by FC at the time of Father’s death is $1,000,000 and the fair market value of the stock of FC is also $1,000,000.
Three months after Individual A inherits the stock of FC, FC sells the foreign real estate for $1,000,000 and distributes the cash of $1,000,000 to Individual A in liquidation of FC. For simplicity, this example assumes that there are no transaction-related costs on the sale and that there are no foreign income taxes imposed on the sale.
For U.S. tax purposes, Individual A will receive a tax basis in the stock of FC equal to the fair market value of the stock at the date of Father’s death ($1,000,000). Code § 1014(a). This is often referred to as a “stepped up” tax basis. FC’s tax basis in the foreign real estate, however, remains equal to FC’s original cost of the real estate ($100,000). When FC sells the foreign real estate, for U.S. tax purposes, a gain of $900,000 will be recognized by FC.
When Individual A inherits 100% of the stock of FC, FC will become a controlled foreign corporation (“CFC”). Code § 957(a). As a U.S. shareholder of a CFC, Individual A will be required to file Form 5471, Information Return of U.S. Person With Respect to Certain Foreign Corporations, for FC. See Code §§ 6038 and 6046.
Certain income of CFCs is treated as an inclusion in income of the CFC’s U.S. shareholders (similar to a “deemed” dividend), even if no cash or other property is actually distributed out of the CFC. Such income is known as “subpart F income.” The $900,000 gain recognized by FC on its sale of the undeveloped foreign real estate would be considered subpart F income. Code § 954(c)(1)(B)(iii). Thus, Individual A will have an inclusion in income of $900,000. This inclusion will be treated as ordinary income and will not qualify for the maximum 15% rate on dividend income, even if FC is located in a country that has a comprehensive income tax treaty with the U.S. See Notice 2004-70.
Thus, even though the fair market value of the FC stock was $1,000,000 and Individual A’s tax basis in the stock of FC was $1,000,000, Individual A will recognize ordinary income of $900,000. Under Code § 961(a), Individual A will receive an increase in his/her tax basis in the stock of FC as a result of the recognition of the subpart F income. This increase in basis is generally intended to prevent double taxation of the same income. Thus, Individual A will increase his/her tax basis in the stock of FC from $1,000,000 to $1,900,000.
The liquidation of FC will be treated as a sale or exchange of the stock of FC by Individual A in exchange for the $1,000,000 received. Code § 331(a). Individual A’s proceeds will equal $1,000,000 and his/her basis in the stock will be $1,900,000. Thus, Individual A will recognize a loss on the liquidation equal to $900,000. Although Individual A and FC are treated as related parties, and losses on sales or exchanges between related parties are generally disallowed, an exception applies for distributions in corporate liquidations. Treas. Reg. § 1.267(a)-1.
If the subpart F income and the loss on the liquidation were both treated as ordinary income/loss, or both treated as capital gain/loss, then the income of $900,000 would be offset by the loss of $900,000. However, because the subpart F income is ordinary income and the loss on the liquidation is a capital loss, the two cannot be directly offset. Instead, the subpart F income will be included in income in its entirety but, the capital loss will be subject to restrictions on the amount that can be deducted. If Individual A has no capital gains during the year, then he/she will only be able to deduct $3,000 of the $900,000 capital loss.
The net result of these transactions is that Individual A will recognize ordinary taxable income during the year of $897,000 and will have a capital loss carryforward of $897,000 that can be used in future years (subject to the annual limitation of $3,000, plus capital gains). This result typically comes as a huge surprise to taxpayers and tax practitioners alike.
There are certain tax planning strategies that can be implemented to avoid this unexpected and uneconomic result. However, some strategies require that steps be taken soon after the stock is inherited. Other strategies can be implemented at a later date, but almost certainly require that steps be taken before the property is sold. Thus, if a U.S. person inherits foreign real estate in a foreign corporation, it is important to contact an international tax advisor as soon as possible.
The Tax Foundation recently published a report that compares the U.S. corporate income tax rate with corporate income tax rates of various developed countries. The report, titled "U.S. States Lead the World in High Corporate Taxes," indicates that the U.S. average combined federal and state corporate income tax rate is over 39%. By comparison, Sweden, Norway, and Finland have corporate income tax rates of 28%, 28%, and 26%, respectively. These rates are much lower than the U.S. rate. The results of this report might lead one to believe that the U.S. has one of the highest overall tax rates in the world.
Can this be true? Is the U.S. really so UNcompetitive from a tax perspective?
In short, no. Corporate income taxes are only one type of tax imposed. Various other types of taxes exist. For instance, many other countries impose a value added tax ("VAT"). The U.S. does not impose a VAT. If the U.S. federal government were to impose a VAT, it is likely that it could raise sufficient revenue to significantly reduce (or possibly even eliminate) the federal corporate income tax rate. This is not to say that the U.S. should impose a VAT. Instead, it is merely stating that comparing solely corporate income tax rates among countries can be an "apples to oranges" comparison.
A better measure, perhaps, to consider tax competitiveness would be total taxes raised as a percentage of gross domestic product ("GDP"). In 2003, the U.S. raised total tax revenue of 25% of GDP. In contrast, the countries of Sweden, Norway, and Finland raised total tax revenue as a percent of GDP of 51%, 44%, and 45%, respectively. See OECD Report. This statistic would imply that the U.S. is in fact a very competitive jurisdiction from a tax perspective.
The Third Circuit Court of Appeals recently reversed the Tax Court’s decision in Swallows Holdings Ltd v. Commissioner, 126 T.C. 96 (2006). The Tax Court had held that Treas. Reg. § 1.882-4(a)(3)(i) was invalid.
Treas. Reg. § 1.882-4(a)(3)(i) requires that a foreign corporation file a return within eighteen months of the filing deadline set in Code § 6072 in order for the corporation to be able to claim deductions. In Swallows, the taxpayer filed the tax returns in question well after the expiration of the eighteen-month filing period.
The Third Circuit held that the Tax Court erred in applying the six factors provided in National Muffler Dealers Association v. United States, 440 U.S. 472, 477 (1979), to the extent that the National Muffler factors are inconsistent with the standard established in Chevron U.S.A., Inc. v. Natural Resources Defense Counsel, Inc., 467 U.S. 837 (1984).
The Third Circuit stated that:
The Secretary will, under the current regulation, allow a foreign company to file eighteen months after the filing was originally due. Moreover, because I.R.C. § 6072(c) already provides for a five and one-half month filing period, foreign companies have, in practice, twenty-three and one-half months to submit a “timely” return. It is not unreasonable for the Secretary to impose such a deadline.
Thus, Treas. Reg. § 1.882-4(a)(3)(i) continues to be a valid regulation.
In a recent tax bulletin board posting, a tax preparer revealed that they had been designated as a resident agent for a foreign corporation. After alerting the foreign corporation of the U.S. tax filing requirements, the foreign corporation terminated the relationship. However, the tax preparer was never removed as the resident agent of the foreign corporation. The Florida tax authorities then issued a summons to the resident agent, since the foreign corporation did not pay its taxes. The taxes due were listed in the millions of dollars.
This is but one example of how getting involved in cross-border activities can be costly to tax preparers. More typically, tax preparers that have not dealt with international operations often are unware of the various U.S. tax filing requirements related to cross-border activities. The potential penalties for simply failing to report the existence of cross-border transactions can be amazingly large.
Tax practitioners should make certain they are prepared to delve into international waters prior to making the plunge. The tax bulletin board link can be found at cross-border dangers.
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