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International Tax Law • La Trobe • February, 2010 Contact Details +1 646 479 6663 Jonathan.email@example.com 0801-0898732 1 La Trobe – February 2010 Tax Structure World Bank Institute study for 123 countries finds: Consumption taxes account for 40% of tax revenues (40% from VAT) Personal Income Tax contributes another 40% PIT more revenue productive than Corporate Income Tax Remaining revenues collected from trade taxes Trade taxes more important for island states & low income countries 0801-0898732 2 La Trobe – February 2010 VAT VAT is a transactional tax and thus an integral element in the accounting process, requiring its own procedures and controls For Sales, VAT covers: – Routine day to day sales, including inter-company transactions – Balance Sheet transactions – sale of assets – Marketing/Promotional activities – samples, gifts – Self-supplies For Purchases, VAT covers: – Domestic Purchases – Foreign Purchases requiring self-assessment – Importations 0801-0898732 3 La Trobe – February 2010 VAT – Its Impact VAT Quantum** A USA Inc Revenue: $16,000m 16000 COGS: $4,400m 14000 12000 SGA/R&D: $7500m 10000 Net Income: $2100m US$ 8000 EBITDA: $3000m 6000 4000 Tax: $310m 2000 VAT*: $2200m 0 Revenue COGS SGA/R&D Net EBITDA Tax VAT Non-US Income Rev. *excludes US Sales Taxes and CN GST **Actual + Notional VAT EPS: $1.54 1% VAT adj: $22,000,000 Significant for s404? VAT Quantum: $1.62 1% VAT adj/share: $0.02 0801-0898732 4 La Trobe – February 2010 VAT: How it Works for “Fully Taxable” Persons Importation Phone mfg Telecom Final of Raw Carrier Consumers Material Phones Services 50,000 + 100,000 + 250,000 + 10,000 VAT 20,000 VAT 50,000 VAT 10,000 20,000 50,000 - (10,000) (20,000) 10,000 10,000 30,000 TAX REVENUE VAT Rate: 20% 50,000 0801-0898732 5 La Trobe – February 2010 VAT: How it Works for the Financial Sector Cross-border Services 10,000 + 2,000 Importation Computer Computer Bank self-assessed of Goods distributor VAT 50,000 + 100,000 + Loan 250,000 10,000 VAT 20,000 VAT Exempt 10,000 20,000 2,000 – (10,000) – 10,000 10,000 2,000 Note: outsourcing will increase the VAT cost by adding irrecoverable VAT to prior payroll costs TAX REVENUE 22,000 VAT Rate: 20% Cost to Bank: 22,000 0801-0898732 6 La Trobe – February 2010 Corporate Tax Classical Corporate Tax – The ―problem‖ of double taxation – Solutions Integration systems Consolidation systems – Application to ―Foreign‖ Income Permanent Establishment ―Worldwide‖ tax systems (the ―outbound‖ concern) 0801-0898732 7 La Trobe – February 2010 Permanent Establishment A ―taxable presence‖ that allows a country to tax the local operations of a company, branch, individual, or, under some treaties, a partnership, in that country. The ―presence‖ can be physical, or it can be the activities of individuals. Domestic law vs. Income Tax Treaty 0801-0898732 8 La Trobe – February 2010 What Is It…Creation Generally a PE is created when an entity: – has a fixed place of business in the relevant country through which the business is wholly or partly carried on. It will generally include, inter alia, a place of management, a branch or an office; or – has a person acting on its behalf in the relevant country (other than an agent of independent status) who: – has, and habitually exercises, an authority to conclude contracts in the name of the home country entity. in some countries, a PE is also created when services are provided through employees or other personnel in that other country which exceed a set period of time. Patterns of travel, especially to the same customer, can create PE argument for host tax authorities The Key Question: Is the home entity doing anything in the host location that has the potential to generate revenue? 0801-0898732 9 La Trobe – February 2010 “Business is Carried on”: When is That so? “… persons who, in one way or another, are dependent on the enterprise (personnel) conduct the business of the enterprise in the State in which the fixed place is situated.‖ ―The business...is carried on...by the entrepreneur or persons who are in a paid-employment relationship with the enterprise (personnel). This personnel includes…other persons receiving instructions from the enterprise (e.g. dependent agents).‖ (Commentary to OECD Model Article 5) 0801-0898732 10 La Trobe – February 2010 PE – Specific Inclusions U.S. Model, Art. 5(2,3)) PE specifically includes: – Place of management, branch, office, factory, or workshop – Place where natural resources are extracted (e.g., mine, oil or gas well, quarry) – Construction or installation project that lasts longer than 12 months – Drilling rig or ship used to explore for natural resources, but only if activity lasts longer than 12 months 0801-0898732 11 La Trobe – February 2010 PE – Specific Exclusions (U.S. Model, Art. 5(4)) PE specifically does NOT include: – Use of facilities solely to store, display or deliver goods belonging to enterprise – Maintain stock of goods solely for purpose of storage, display or delivery, or processing by another enterprise – Maintain fixed place of business (e.g., office) solely to purchase goods, collect information, or other activity of a "preparatory or auxiliary" nature (e.g., advertising) 0801-0898732 12 La Trobe – February 2010 Preparatory or Auxiliary Does not Create a PE (OECD MC) The term ―permanent establishment‖ does not include: – The use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise – The maintenance of stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or delivery – The maintenance of stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise – The maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character. 0801-0898732 13 La Trobe – February 2010 What Is It…Generally Exempt Actions ―Pure‖ training in the host location Market analysis and planning ―Merely‖ meeting potential customers, government officials and others Providing information about products to potential customers Relaying information between customers and affiliated companies Monitoring products and services Planning for office needs of all affiliated organizations in-country Participating in the selection of distributors and facilitating the negotiation of distribution agreements Providing technical assistance to affiliated marketing personnel Assisting local affiliated entities and joint ventures in the establishment of objectives with regard to orders, revenues, inventories and receivables, planning, and meeting capital budgets and expense budgets Assisting affiliates in providing products or services in-country by providing information regarding financing, transportation and insurance 0801-0898732 14 La Trobe – February 2010 Relation of PE to Statutory Threshold for Taxing the U.S. Business Profits of a Foreign Person Existence of a ―trade or business within the United States‖ (§§ 871, 882) – Code and regs do not define ―trade or business‖ – Case law indicates that to be engaged in a trade or business, ―the taxpayer must be involved in the activity with continuity and regularity‖ Groetzinger (480 U.S. 23, 1987) PE is generally a higher threshold – PE requires the conduct of business in the U.S. through a ―fixed place of business‖ situated in U.S. 0801-0898732 15 La Trobe – February 2010 What do You Think? Do the following situations represent a PE? Assume the Foreign Company….. – is the ―importer of record‖ of products it sells locally? – has a storage facility at the airport? – has a 12-month contract to built an oil rig? – sends repair personnel to your country on an as needed basis (a few days a month usually)? – uploads software on the internet which can be downloaded locally by its customers? – sells books over the internet and ships directly to the customers in your country, it outsources the shipping and customs clearing to UPS? 0801-0898732 16 La Trobe – February 2010 Agency Arrangements – Common Law The principal is directly bound. P A TP 0801-0898732 17 La Trobe – February 2010 PE by Imputation From an Agent (U.S. Model, Art. 5(5,6)) Independent agents – Doing business in U.S. through independent agent (e.g., broker) does not create a PE, provided agent is acting in ordinary course of its business as an independent agent Person other than an independent agent – Presence of dependent agent can create a PE if agent habitually exercises an authority to conclude contracts that are binding on taxpayer – An exception applies if contracts relate only to preparatory or auxiliary activities (e.g., advertising or displaying goods) 0801-0898732 18 La Trobe – February 2010 Agency Arrangements – Civil Law “...where a person – other than an agent of an independent status, is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise…..‖ Article 5, para 5 OECD MC 0801-0898732 19 La Trobe – February 2010 Agency Arrangements – Civil Law Direct representation: contract concluded in the name of the principal. P A TP Indirect representation: contract established between the intermediary (commissionaire) and the third party. Principal not legally involved. P C TP 0801-0898732 20 La Trobe – February 2010 Profit Attribution… How much of a PE should be taxed? 0801-0898732 21 La Trobe – February 2010 Business Profits (OECD) ... there shall in each Contributing State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities, under the same and similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.‖ Article 7, para 2 OECD MC 0801-0898732 22 La Trobe – February 2010 Business Profits (U.S.) Statutory threshold for taxing foreign person‘s business profits – Engaged in "trade or business within the United States" (IRC §§ 871 and 882) U.S. Model, Art. 7 – ―The business profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein.‖ 0801-0898732 23 La Trobe – February 2010 Resisting the Force of Attraction Principle Enterprise Residence State Source State Agent PE 0801-0898732 24 La Trobe – February 2010 PE by Imputation From an Agent (U.S. Model, Art. 5(5,6)) (continued) Subsidiaries (U.S. Model, Art. 5(7)) – Mere control of a domestic subsidiary does not create a PE for the foreign parent corporation – Activities of a subsidiary could create PE for parent, however, if subsidiary: Is a dependent agent, and Habitually exercises an authority to conclude contracts that are binding on the parent (OECD Commentary, Art. 5(41)) Partnerships – PE of partnership is imputed to partners (Rev. Rul. 90-80; Unger, 936 F2d 1316, DC Cir., 1991). 0801-0898732 25 La Trobe – February 2010 What Is It…Revenue Attribution Includes revenue from activities of the PE – Sales – Distribution activities Also, revenue attributed to the following activities – An employee of the home country entity participates in the day-to-day management of a host country entity (whether wholly-owned or a joint venture) – The employee serves as a director of a host country entity while continuing in the employment of the home country entity – The employee provides "overall account management" directly to local customers in the name of, or on behalf of, an affiliate (in contrast to providing general information in a liaison capacity) – The employee has authority to negotiate and conclude contracts on behalf of the home country employer, and regularly exercises that authority – The employee of the home country entity draws, accepts or endorses any negotiable instrument on behalf of the host country entity – The employee of the home country entity pledges the credit of the host country entity – With no subcontract, an employee performs any contract or fills any order on behalf of a different entity other than the specific entity s/he is assigned to 0801-0898732 26 La Trobe – February 2010 Worldwide Tax System Resident taxed on all income regardless of source of income - in or outside the country Non-resident taxed only on income sourced in the country – China, Japan, Korea, Thailand, UK – US extends rule to US citizens who are not tax residents 0801-0898732 27 La Trobe – February 2010 Double Tax Relief Three main methods providing relief from international double taxation: – Exemption method Residents exempted from tax on foreign income – Credit method Residents taxed on foreign income (gross of foreign tax) at domestic tax rate subject to a credit for foreign taxes paid – Deduction method Residents allowed a deduction for foreign taxes paid 0801-0898732 28 La Trobe – February 2010 Controlled Foreign Companies (CFC) Undistributed CFC income included in parent company‘s taxable income calculation Active business exception: – US Subpart F rules – Japan Anti-tax haven rules 0801-0898732 29 La Trobe – February 2010 Territorial Tax System Only income sourced in the country is taxed in the country – Pure territorial Hong Kong: only applicable to companies carrying on business in Hong Kong – Extended territorial/―hybrid‖ Malaysia: worldwide tax system applies to resident companies engaged in banking, insurance, shipping or air transport Singapore: extends rule to income received in the country but sourced outside Singapore 0801-0898732 30 La Trobe – February 2010 Overview of Tax Regimes United States Netherlands Hong Kong Philippines Singapore Sri Lanka Malaysia Australia Thailand Vietnam Taiwan Japan Korea China CN HK JP KR MY PH SG SR TW TH VN AU NL US Tax System Worldwide Territorial “Hybrid” * * CFC Regime Double Tax Relief System Credit (FTC) Exemption Deduction 0801-0898732 31 La Trobe – February 2010 US International Tax Regime US corporation subject to tax on: – Worldwide income – Subpart F income of CFC Strict credit system 0801-0898732 32 La Trobe – February 2010 Dutch International Tax Regime Dutch corporation subject to tax on worldwide income Generous participation exemption system – Exempt income from qualifying shareholdings Attractive holding company location 0801-0898732 33 La Trobe – February 2010 Australian International Tax Regime Australian corporation subject to tax on: – Worldwide income – Attributable CFC income Foreign income exemption system – Exempt non-portfolio dividends from foreign subsidiaries – Exempt foreign branch profits – Participation exemption for capital gains on sale of foreign subsidiaries 0801-0898732 34 La Trobe – February 2010 Introduction to CFCs Parent company (high tax) Apportion Foreign subsidiary (low tax) 0801-0898732 35 La Trobe – February 2010 Why do We Care About CFCs? If profits in a group are subject to a low tax rate it reduces the group‘s ETR and cash tax outflow CFC rules prevent this so drive up group ETR In practice likely to see CFCs where – Planning can be undertaken to avoid CFC rules, e.g. US ‗check the box‘ planning – ‗Accidental‘ CFCs, e.g. following an acquisition Where companies are owned by a group in a territory with CFC rules, the impact of those rules must always be considered, even on purely domestic transactions in that territory (e.g. merger) 0801-0898732 36 La Trobe – February 2010 CFC Countries Australia Mexico Canada New Zealand Denmark Norway Finland Portugal France South Africa Germany South Korea Hungary Spain Indonesia Sweden Italy UK Japan US 0801-0898732 37 La Trobe – February 2010 Typical CFC Exemptions ‗White list‘ of specific exempt jurisdictions Active trading companies and certain holding companies Motive exemptions Companies engaged wholly or mainly in transactions with persons resident in the same jurisdiction, e.g. same country exception for US More recently, e.g. in Spain, Italy and France exemptions for EU territories 0801-0898732 38 La Trobe – February 2010 CFC Legislation vs. Tax Treaties Treaty can expressly permit CFC legislation (German/Swiss treaty) Treaty law as superior international law supersedes CFC law according to domestic law (France) CFC law overrides treaty (USA) Conflict between CFC legislation and treaty is denied (Germany) 0801-0898732 39 La Trobe – February 2010 CFC Rules and DTTs Apportionment treated as business French profits parent France/Belgium France/Lux. treaty applies treaty applies Belgian Luxembourg coordination captive centre PE in PE in Belgium Luxembourg 0801-0898732 40 La Trobe – February 2010 CFC Rules and DTTs Apportionment treated as fully taxable dividend German income parent Treaty application is excluded in the German CFC rules Low- taxed foreign subsidiary 0801-0898732 41 La Trobe – February 2010 CFC Rules and DTTs Tax credit No tax credit available Foreign company 0801-0898732 42 La Trobe – February 2010 Hybrid – Definitions Hybrid entity: Entity with features of both a corporation (i.e. in principle non-transparent) and a partnership (i.e. in principle transparent) – Consequence: the entity is treated as transparent in one jurisdiction and as non- transparent in the other jurisdiction Hybrid instrument: Instrument with features of both equity and debt – Consequence: the instrument is treated as equity in one jurisdiction and as debt in the other 0801-0898732 43 La Trobe – February 2010 What Can Hybrids Achieve? Tax deferral through mismatch of hybrid classification Double deduction of finance costs, start-up losses and royalty expenses Step-up in asset basis due to transfer of assets through hybrids Withholding tax benefits Matching company law/accounting flexibilities with attractive tax regimes 0801-0898732 44 La Trobe – February 2010 „Natural‟ Hybrids Dual resident companies – Holding companies – CFC planning – Loss planning – Step up in basis of assets Branches – Double dip losses – Creation of de facto cross-border branch loss relief Partnerships – Implementation of holding structure – CFC planning – Double dip losses 0801-0898732 45 La Trobe – February 2010 Financing With “Natural” Hybrids: Examples 1. DRC 2. Branch 3. Partnership US Spanish LUX Branch Australian Ltd. Ptr. 0801-0898732 46 La Trobe – February 2010 Elective Systems U.S. – ‗Check the box‘ – Domestic hybrid regulations France – May elect for corporate treatment for certain entities (SNC, SEP, etc) 0801-0898732 47 La Trobe – February 2010 Use of Hybrid Entities: Factors to Consider Local treatment of foreign entities Possibility of ―looking-though‖ an entity to its partners or members Possibility of fiscal consolidation Availability of tax treaties Domestic partnerships or flow-through entities Legal personality 0801-0898732 48 La Trobe – February 2010 Summary of Final Regs Predetermined list of per se corporations Simple election for classifying all other entities If fail to elect, ‗‗default ‘‘ classification based on extent of liability under foreign law Election made on Form 8832 – Copy filed with tax return 0801-0898732 49 La Trobe – February 2010 Listed „„Per Se‟‟ Corporations Entity organized under federal or state statute and referred to as a corporation State organized joint-stock company or joint-stock association Insurance company State-chartered bank if deposits FDIC insured State-owned entity Entity taxed as corporation under other Code section, e.g., publicly traded partnership Certain enumerated foreign business entities – Simplifies classification 0801-0898732 50 La Trobe – February 2010 “Per Se” Foreign Corporations 80 foreign limited liability business entities, including: – Germany, Austria & Swiss Aktiengesellschaft (―AG‖) – France & Luxembourg Societe Anonyme (―SA‖) – Spain & most Latin American countries Sociedad Anonima (―SA‖) – Australian, Indian, Singapore, Hong Kong & UK Public Limited Company (―PLC‖) – Korea Chusik Hoesa – Japan Kabushiki Kaisha – Philippines Stock Corporation – Taiwan Company Limited by Shares 0801-0898732 51 La Trobe – February 2010 Legend PE Permanent establishment Branches treated as a corporation for target country purposes and transparent for investor country purposes Companies treated as a corporation for target country purposes and as transparent for investor country purposes Partnerships treated as transparent for target country purposes and as a corporation for investor country purposes 0801-0898732 52 La Trobe – February 2010 US Check-the-Box Election and CFCs U.S. Parent U.S. Parent ETVE loan loan GmbH BV GmbH BV interest interest BV’s interest income is Subpart F Interest is viewed as an intra- company payment within the ETVE. GmbH’s deduction is offset by BV’s income. No Subpart F taxation. 0801-0898732 53 La Trobe – February 2010 US Check-the-Box Election and CFCs (continued) UKP is a partnership and therefore not subject to UK tax US Parent US makes a check-the-box election to treat UKP as a company and therefore not subject to US tax US do not apportion profits under US US Sub CFC rules as the interest income is from a UK entity for US purposes and therefore satisfies same country UK Co UKP exception loan 0801-0898732 54 La Trobe – February 2010 US CTB Planning in Asia Countries where checkable entity is the more common business entity form: – Malaysia – China – Indonesia – Thailand – Singapore – Hong Kong Philippines – Only corporate entity available is a per se entity – Consider using a pure branch or a partnership Taiwan – Per se entity is by far more common – Legal restrictions on ability to convert to non per se entity form 0801-0898732 55 La Trobe – February 2010 US CTB Planning in Asia (continued) Korea and Japan – CTB conversion possible with minimal tax cost – Corporate law formalities – Japan: KK to YK (Note the recent corporate law reforms) – Korea: CH to YH Issues to consider – Number of shareholders (e.g., 7 in Thailand!) – Corporate law restrictions on public debt issuances 0801-0898732 56 La Trobe – February 2010 Planning Ideas Italian-Dutch Finance Structure Sweden-Financing via Two Dutch BV‘s and Swedish AB Japanese Goshi Kaisha/Gomei Kaisha Finance Structure Dutch-Spanish General Partnership/Debt Push Down 0801-0898732 57 La Trobe – February 2010 Objectives of Treaties Elimination of double taxation Prevention of fiscal evasion Enable co-operation between fiscal authorities Allocation of tax revenues between states Provide certainty for investors Eliminate discriminatory taxation Other Political/Business Reasons 0801-0898732 58 La Trobe – February 2010 Types of Treaties Limited, e.g., air or shipping Comprehensive Capital and Estate Tax Treaty – Comprehensive Capital treaties are not entered into by the United States Comprehensive Income Tax Treaty More Limited Exchange of Information Agreement 0801-0898732 59 La Trobe – February 2010 Model Treaties U.S. Model Treaty (1996) OECD Model Treaty (1995) Commentaries 0801-0898732 60 La Trobe – February 2010 Comparison US and OCED Articles 1- 4 – Scope – Taxes Covered – General definitions – Residence Territorial Extension Limitation of Benefits 0801-0898732 61 La Trobe – February 2010 ARTICLE 1: General Scope U.S. Model OECD Model – Residents – Residents – Citizens – Benefits/relief, not restrictions – Disputes re: scope 0801-0898732 62 La Trobe – February 2010 ARTICLE 2: Taxes Covered U.S. Model OECD Model – Federal income taxes – Income – Federal excise taxes re: private – Capital foundations – Subsequent substantially similar – Not social security taxes taxes – Subsequent substantially similar taxes 0801-0898732 63 La Trobe – February 2010 ARTICLE 3: General Definitions (1) U.S. Model OECD Model – ―Person‖-individual, estate, trust, – Same as U.S. Model, except partnership, company, any other ―Person‖ definition does not specifically list body of persons estates, trusts or partnerships ―Enterprise of a Contracting State‖ makes no – ―Company‖ – corporate reference to fiscally transparent entities – ―Enterprise of a Contracting State Enterprise carried on by a resident of a Contracting State Includes enterprises carried on through a fiscally transparent entity 0801-0898732 64 La Trobe – February 2010 ARTICLE 3: General Definitions (2) U.S. Model OECD Model – ―Competent Authority‖ – Same as U.S. Model, except no definition of ―qualified governmental – ―International traffic‖ entity‖ – ―National‖ – ―Qualified governmental entity‖ – Domestic law definitions 0801-0898732 65 La Trobe – February 2010 ARTICLE 4: Residence U.S. Model OECD Model – Individual – Same as U.S. Model, except no reference to: – Corporation Citizenship – Partnership Place of incorporation Exempt organizations – Tie breaker Qualified governmental entity Fiscally transparent entities – Dual residence – Residence of persons other than individuals determined by reference to place of effective management 0801-0898732 66 La Trobe – February 2010 Territorial Extension U.S. Model OECD Model – N/A – (Article 28) – Permits extension of Convention to other states/territories and to territories of the Contracting States originally excluded from the Convention – Termination of Convention also terminates its application to the other states/territories 0801-0898732 67 La Trobe – February 2010 Treaty Shopping Treaty shopping may exist if: – A person acts through a legal entity created in a country with the main or sole purpose of obtaining treaty benefits which would not be available directly to that person 0801-0898732 68 La Trobe – February 2010 Forms of Treaty Shopping Use of income conduit Use of entity conduit Other, such as: – Triangular transactions – Dividend stripping 0801-0898732 69 La Trobe – February 2010 Treaty Shopping: Income Conduit US A interest interest C A B loan loan Two or more payments are made that constitute one stream of income Entity in country A is interposed to enjoy the benefits of the treaty between A and B which would otherwise not be available Income stream is ultimately collected in a tax haven (country C) 0801-0898732 70 La Trobe – February 2010 Treaty Shopping: Entity Conduit Conduit is set up in State B by persons of a third State (A) who wish to use the conduit to receive income that would A otherwise be attributable to them, to avail itself of the treaty between countries B and C B dividend C 0801-0898732 71 La Trobe – February 2010 Treaty Shopping: Triangular Cases Person in country B pays interest to a low taxed branch in country C while A availing itself of the benefits of the treaty between A and B A B interest loan Low taxed branch 0801-0898732 72 La Trobe – February 2010 Treaty Shopping Dividend stripping (in its simplest form): Sale of shares ―cum dividend‖ to a shareholder who can claim treaty benefits Distribution of dividends to such shareholder Repurchase of shares ―ex dividend‖ to original shareholder Purchase/repurchase price takes into consideration the reduced withholding tax rate 0801-0898732 73 La Trobe – February 2010 Efforts to Combat Treaty Shopping Application of treaty is determined by: Attribution of income to a person Residence of such person Efforts to combat treaty shopping typically focus therefore on attribution of income, residency or both 0801-0898732 74 La Trobe – February 2010 Efforts to Combat Treaty Shopping/Treaty Beneficial ownership (art. 10, 11, 12 OECD Model Convention) – Beneficial owner: ―The creditor of the income, or if the creditor is acting as an agent or nominee, the principal for the account of whom the agent or nominee is acting‖ Commentary to OECD Model 2003 – Excludes from beneficial ownership persons who have very narrow powers over the income 0801-0898732 75 La Trobe – February 2010 Efforts to Combat Treaty Shopping – U.S. Approach Aiken Industries case—early guidance setting the conduit principle Northern Indiana Power—more recent case, favorable to taxpayer Internal Revenue Code Section 894(c) – Payments through hybrid entities – Overrides treaties Regulations under IRC Sec. 1441/1442 – Responsibility of withholding agents Limitation on Benefits articles in newer treaties, renegotiations Expanded residency articles of newer treaties – Treatment of hybrids/transparent entities – Renegotiations 0801-0898732 76 La Trobe – February 2010 Efforts to Combat Treaty Shopping/Treaty “Qualified Resident‖: LOB provisions Aimed at establishing connection of the conduit to its claimed residence state: Publicly traded company test Ownership test Derivative benefits test Active trade or business test Headquarters test 0801-0898732 77 La Trobe – February 2010 Efforts to Combat Treaty Shopping Example: Germany Bermuda US German Federal Finance Court (2005): A company benefits from a treaty or directive of the EU if there are business reasons for its interposition, Bermuda Ltd. e.g.: – Another group entity carries out Dutch active business in the same NV country Dutch Dutch Dutch – The company is not a single OpCo BV1 BV2 purpose entity. Dutch BV2 is entitled to claim the 0% withholding tax rate under the EU European subsidiaries German GmbH Parent- Subsidiary-Directive. Dividend 0801-0898732 78 La Trobe – February 2010 Efforts to Combat Treaty Shopping: Triangular Case Provisions A interest B C branch Treaty benefits denied if taxation of interest in B and A combined is less than X% of company taxation in A (see art. 12, 8 US-NL tax treaty) 0801-0898732 79 La Trobe – February 2010 2006 Korean Tax Revisions Reinforced anti-treaty shopping measure in the International Tax Coordination Law – ―Substance over Form‖ principle – WH tax applies to ultimate beneficial owner In line with commentary on Article 1 of OECD Model Treaty Followed by the USA, Switzerland, Germany and Canada Supreme court case in Korea- denied the application of Korea-Netherlands tax treaty for a Dutch paper company 0801-0898732 80 La Trobe – February 2010 2006 Korean Tax Revisions (continued) Imposition of 27.5% WH tax on investment income paid to funds in designated tax haven jurisdictions – WH tax may be refunded later upon substantiation of beneficial owner within 3 years – Exemption is available with a pre-approval from NTS – MOFE is to designate specific tax haven jurisdictions: likely to follow OECD guidelines – Current status of the Blacklist 0801-0898732 81 La Trobe – February 2010 Holding Companies 0801-0898732 82 La Trobe – February 2010 Why Use a Holding Company? – Capital Gain Scenario: A Swedish investor in China sells its wholly owned Chinese trading sub. This would expose the investor to capital gains in China. How can the investor use holding companies to avoid paying capital gain tax? 0801-0898732 83 La Trobe – February 2010 Why Use a Holding Company? – Capital Gain Can sell Swedish HoldCo without Chinese capital gain HoldCo 0801-0898732 84 La Trobe – February 2010 Why Use a Holding Company? – Capital Gain No capital gains tax in China when the Swiss company sells the shares in the Chinese trading subsidiary European headquarters 0801-0898732 85 La Trobe – February 2010 Why Use a Holding Company? – Withholding Tax Dutch group holds Japanese investment 5% dividend withholding tax on dividends distributions from Japan to the Netherlands, provided some 5% conditions are met Would the tax treatment be different if the shares were held by the Dutch group‘s subsidiary in the US? 0801-0898732 86 La Trobe – February 2010 Why Use a Holding Company? – Withholding Tax Should be 0% withholding on dividends out of Japan Should be 0% withholding on dividends from US to Netherlands, provided certain conditions are met 0% 0% 0801-0898732 87 La Trobe – February 2010 Why Use a Holding Company? – Tax Groupings Scenario: – US parent carries on 2 separate Parent businesses, both in Italy – Italy 1 makes profits – Italy 2 makes huge losses – How can US parent use holding companies to reduce tax paid by Italy 1? Italy 1 Italy 2 0801-0898732 88 La Trobe – February 2010 Why Use a Holding Company? – Tax Groupings Losses of Italy 2 used to offset profits of Italy 1 Parent Italy HoldCo Italy 1 Italy 2 0801-0898732 89 La Trobe – February 2010 Why Use a Holding Company? – Leveraging Acquisitions Ireland Co is a trading company resident in IE and pays tax at 12.5% Wants to acquire a German Company DE Co, which has an ETR of 38% 12.5% What can IE Co do to reduce the group‘s effective tax rate? 38% 0801-0898732 90 La Trobe – February 2010 Why Use a Holding Company? – Leveraging Acquisitions Interest deductible against profits of German group at 38% Income taxable in Ireland at 12.5% As a result, tax arbitrage of 25.5% on interest Debt Organschaft 0801-0898732 91 La Trobe – February 2010 Why Use a Holding Company? – Blender or Mixer Companies Parent Lux Holdco DIVIDENDS DIVIDENDS Sub 1 Sub 2 Sub 3 0801-0898732 92 La Trobe – February 2010 Why Use a Holding Company? Tax motivations – Capital gains/losses – planning – Withholding tax planning – Consolidation of earnings/losses – Repatriation of earnings – Acquisition by indebtedness – Blending/mixer companies for parents in tax credit regimes 0801-0898732 93 La Trobe – February 2010 Why Use a Holding Company? (continued) Non-tax considerations – Align legal structure and organizational structure – Easy to acquire and to disinvest subsidiaries – Publication – disclosure requirements/anonymity – Attract investors/minority shareholders/flotation – Control mechanism 0801-0898732 94 La Trobe – February 2010 Tax Parameters in Selecting a Holding Company Location Holding company – No tax on dividend received – No tax on capital gains – No/reduced withholding tax on dividends paid – Good and extensive tax treaty network – Deductibility of liquidation losses/provisions against loss in value – No capital tax – Other activities allowed 0801-0898732 95 La Trobe – February 2010 Tax Parameters in Selecting a Holding Company Location (continued) Holding company – Deductibility of finance expenses – No, or lenient, thin-capitalization rules – Easy access to the holding company‘s regime – Absence of anti-avoidance provisions such as CFC – Stable legislation/ruling – Substance requirements/management and control 0801-0898732 96 La Trobe – February 2010 Other Tax Parameters to Consider Costs of entry into the structure Exit from the structure Parent company CFC position 0801-0898732 97 La Trobe – February 2010 Non-tax Parameters in Selecting a Holding Company Location Infrastructure (airport, banks, telephone, service providers) Language Time-zone Third parties, shareholders Administration costs Mix of permitted activities Accounting standards meet desired accounting result Regulatory authorities Location of subsidiaries 0801-0898732 98 La Trobe – February 2010 Non-tax Parameters in Selecting a Holding Company Location (continued) Company law requirements – Flexibility of return of capital/ability to pay dividends – Currency of capital denomination – Flexibility to structure rights attaching to share classes – Supervisory board, board of directors, advisory board, local directors Number – nationality – remuneration – Workers – representation Publication of financial statements 0801-0898732 99 La Trobe – February 2010 Asia Pacific Holding Company Structure US BRANCH CHECK-THE-BOX ENTITY JAPAN Philippines REVERSE HYBRID SHC EU Holdco LA Holdco MAURITIUS/ SINGAPORE NETHERLANDS BARBADOS CHINA AUSTRALIA MALAYSIA VIETNAM THAILAND INDIA TAIWAN 2 KOREA HONG TAIWAN 1 KONG INDONESIA 0801-0898732 100 La Trobe – February 2010 Asia Pacific Holding/HQ Structures Regional HQ incentives – Singapore, Malaysia, Thailand, Philippines, China Pan-Asian holding company candidates – Netherlands (most extensive treaty network with Asian countries) – Singapore (HQ incentives, participation exemption) – Use of investor country entity as the direct HoldCo Pure SPV holding companies – Mauritius – Labuan 0801-0898732 101 La Trobe – February 2010 Tax Preferred HoldCo Survey China: Mauritius, Barbados India: Mauritius, Singapore Indonesia: NL Japan: US (!), NL Korea: Hungary, Malta Philippines: NL, Labuan Taiwan: NL, UK Malaysia, Singapore Thailand, Vietnam: Any Country 0801-0898732 102 La Trobe – February 2010 Pan-Asian Holding Companies Structures There is no one single Pan-Asian holding company. Instead, the following are commonly used for various countries: – Mauritius/Barbados/Switzerland – China – Singapore – Australia/Malaysia/Taiwan branch/Vietnam/Hong Kong/Thailand/India/China – USA – Japan/Philippines – Netherlands – Taiwan, Korea, Indonesia Proposed Australian tax changes will make Australia an attractive holding company location – Australia can hold Singapore, Hong Kong, India, Taiwan branch, Vietnam 0801-0898732 103 La Trobe – February 2010 Singapore Holding Company Reduced withholding tax rate on dividend payments – Taiwan: 0% (if operates as a Branch) – Vietnam: 0% (DWHT repeal from 1/1/04) U.S. – Hong Kong: 0% – Malaysia: 0% – Philippines: 15% (if ≥ 15%) SINGAPORE Tax exemption on qualifying FS dividends/branch remittances – Subsidiary/branch should be subject to 15% headline tax rate – Subject-to-tax test (actual tax payment test) TAIWAN 1 VIETNAM MALAYSIA SUB’S Guidance extending exemption coverage to tax holiday subs – Resolves tax payment requirement for tax exemption in Singapore on dividends from tax holiday subs (e.g., China, Thailand) Regional/Int‘l HQ incentives available in Singapore 0801-0898732 104 La Trobe – February 2010 Netherlands Holding Company Other Opco candidates: – Thailand (10% DWHT) EC – HK, Malaysia and Singapore (0% DWHT) – Philippines (10% DWHT) NETHERLANDS – India (14% DDT/capital gains exempt) Netherlands – Country Overview – 100% dividend/capital gains exemption KOREA TAIWAN 2 INDONESIA – No holding period – Exit at 0% via Malta/Cyprus/Other EU – Good treaty network with Asia-Pac – New US-NL treaty protocol: 0% DWHT 0801-0898732 105 La Trobe – February 2010 Other Holding Company Location Candidates Luxembourg UK Spanish ETVE Sweden Labuan Malaysian Satay Philippines ROHQ, Thailand RHQ 0801-0898732 106 La Trobe – February 2010 What is a Dividend? The term "dividends" means income from shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident. OECD model treaty 0801-0898732 107 La Trobe – February 2010 Dividends Key tax factors to consider – Exemption systems – Rules for exemption – Credit systems – Withholding taxes – Parent subsidiary directive and double tax treaties 0801-0898732 108 La Trobe – February 2010 Credit Systems: UK Source by source On-shore mixing Complex rules for – Intermediate Holding Companies – CFC dividends 0801-0898732 109 La Trobe – February 2010 Credit Systems: U.S. Basket system Interest allocation Excess credit v Excess limitation Passive income 10/50 basket More than 50% – General limitation – Passive basket 0801-0898732 110 La Trobe – February 2010 Repatriation – Local Country Considerations Local Tax Considerations – Dividend withholding taxes – Tax-exempt transfer of stock/assets – Transfer taxes/capital duties Local Legal Considerations – Existence of distributable reserves – Possibility of interim dividends – Possibility of capital reduction and repurchase or redemption of shares – Possibilities of conversion – Consequences of liquidation – Valuation requirements in the event of asset/share transfers Transactions that generate reserves Alternatives to dividend distributions 0801-0898732 111 La Trobe – February 2010 Dividends: Planning – Minimizing Withholding Taxes Use of conduit jurisdictions – Treaties/directives Substance requirements Navigating U.S. limitation on benefits (―LOB‖) provisions 0801-0898732 112 La Trobe – February 2010 Dividends: Planning – Maximizing Underlying Tax Exemption countries – Use of third countries to ―reclassify‖ dividends – No mixing issues Credit countries – Mixing (U.S.) – ―Hyping‖ (UK) – Decontrolled foreign sub-group 0801-0898732 113 La Trobe – February 2010 Dividends: Planning – Other Methods Parent Company Shares – Sub invests in Parent Co shares – Cash transferred – No Parent Co income inclusion – Local company law important (U.S. compared to UK) – CFC issues to consider? 0801-0898732 114 La Trobe – February 2010 Dividends: Planning – Other Methods (continued) Redeeming Capital – Aim to convert income to capital – Relevant where Recipient has a credit system, and Recipient exempts gain/return of capital – Effective for UK/Netherlands UK/Luxembourg – Usually creates reserves – U.S. cannot return capital until earnings exhausted 0801-0898732 115 La Trobe – February 2010 Dividends: Planning – Other Methods (continued) Acquiring Assets Intra-Group – Purchase property rather than make dividend payment – Avoid income tax inclusion – Effect on distributable reserves Local company law 0801-0898732 116 La Trobe – February 2010 Other Methods Capital reductions Loans from subsidiary to parent/affiliate Loans into subsidiary country Headquarter charges Liquidation or partial liquidation Use of branch or PE Leverage intermediate holding 0801-0898732 117 La Trobe – February 2010 Repatriation Through Subscription for Shares in a UK Co + Upstream Loan(s) Description – Cash repatriation to UK – May also effectively allow repatriation UK Plc from company which may otherwise not be able to pay dividends due to (say) lack of earnings. Loan(s) Consolidation Benefits – No additional taxation in the UK Sub Co – Loan eliminated on consolidation UK tax issues Subscription for shares in – Loan at an arm‘s length, but no UK tax UK2 for cash issues arise due to availability of group UK2 consideration relief (tax consolidation) – No re-characterisation of loan as dividends – No withholding tax 0801-0898732 118 La Trobe – February 2010 What Do You Think…. Would it be wise to finance a company with 100% debt? Why/Why not? How do you determine the optimal mix of financing? What factors should you consider? 0801-0898732 119 La Trobe – February 2010 Debt Financing: How Much is too Much? Limitations of debt finance Economic – Debt policy: trade-off between tax advantages and risk of borrowing – Risk of borrowing: financial distress: R assets < R debt R assets: companies with stable R assets can borrow more R debt: depends on capital markets and risk rating of firm – Repatriation objectives Easier to pay down debt than equity? – Return on debt and equity Above/below ―the line‖ 0801-0898732 120 La Trobe – February 2010 Debt Financing: How Much is too Much? (continued) Limitations of debt finance Tax law – Thin capitalization rules (debt to equity requirements) – Taxation of interest at recipient level Local vs investor tax rate – Withholding tax on interest – Deductibility rules (i.e., accrual and actual, NOLs carry-forward rules) – Availability of funds – Debt/Equity -> repatriation objectives 0801-0898732 121 La Trobe – February 2010 Debt Financing: How Much is too Much? (continued) Limitations of debt finance Legal – Exchange controls – Solvency requirements – Limits on interest rates 0801-0898732 122 La Trobe – February 2010 Debt/Equity: General Tax Differences Different treatment of interest and dividend – Deductibility of remuneration Interest rate Inflation Exchange gains/losses – Rate differences Corporate rate Withholding tax – Timing differences (accruals/payments) – Taxation to investor/lender – tax relief differences Exchange gains/losses Capital gains 0801-0898732 123 La Trobe – February 2010 Debt/Equity: General Tax Differences (continued) Different treatment of interest and dividend – Capital duty – Registration/stamp duty – Different requirements for treaty relief? 0801-0898732 124 La Trobe – February 2010 Debt/equity: In a Domestic Context General rule for the paying company: – Dividend distributions are not tax deductible – Interest payments are tax deductible General rule for the receiving company: – Dividends may be totally or partially exempt (exemption method or imputation system); – Interest income is generally taxable 0801-0898732 125 La Trobe – February 2010 Debt/Equity: In an International Context In the country of source: – Both interest and dividend payments are generally/often subjected to a withholding tax (reduced or eliminated under treaties and/or EU Directives) 0801-0898732 126 La Trobe – February 2010 Debt/Equity: In an International Context (continued) In the country of the recipient: – Interest is generally recognized on an accrual basis even if not paid – The foreign tax credit in relation to interest is generally limited to the w/h tax charged on the interest (some treaties contain tax sparing clauses that allow a ftc higher than the tax charged on the interest) – Foreign tax credit or participation exemption– direct/indirect (dividends) Include tax sparing? Aimed at mitigating or eliminating economic double taxation Tax credits (UK/US) Exemption (total/partial) (mainland Europe) 0801-0898732 127 La Trobe – February 2010 Strategies to Minimize Withholding Tax Registering debt Using qualifying financial institutions Back to back loans Export financing Treaties Discount notes Leasing Deferral – Balloon loans Others... 0801-0898732 128 La Trobe – February 2010 Thin Capitalization What is thin cap? How does it impact a company‘s ability to finance? How does it impact international tax planning? What limits may apply within thin cap rules? 0801-0898732 129 La Trobe – February 2010 Thin Capitalization Rules Limitations on interest deductibility – Debt-to-equity ratio – Definitions of debt and equity – Interest rate higher than arm‘s length rate – General anti-abuse approach – Treatment of non-deductible interest (reclassified as dividends, carried forward?) – Treaty aspects 0801-0898732 130 La Trobe – February 2010 Debt: Tax Deductibility of Interest Other issues: – Reclassification of financing Rules classifying debt into equity and/or interest into dividends – Borrowing to pay dividends/return capital Is such interest deductible in local countries? – Borrowing to insert new holding company – Inflation accounting rules – Registration requirements 0801-0898732 131 La Trobe – February 2010 Summary Significant tax benefits available through debt funding BUT Lots of issues to deal with to optimize international tax benefits Economic, legal and tax restrictions to consider 0801-0898732 132 La Trobe – February 2010 Losses Why are losses a valuable asset in tax planning? 0801-0898732 133 La Trobe – February 2010 Losses Why are losses a valuable asset in tax planning? May reduce ETR and cash tax by sheltering taxable income – Other key points to consider Effective loss planning influenced by accounting Stranded losses can drive up a group‘s ETR You need to know key characteristics of the loss regime in the loss country… 0801-0898732 134 La Trobe – February 2010 What do You Think? Tax losses only arise in a group as a result of poor trading conditions (i.e. the business is losing money)? True/False? 0801-0898732 135 La Trobe – February 2010 Generating Tax Losses False! – You can generate losses for tax purposes, in the following ways… Intragroup disposals – Transferring assets in group to realise loss in value – Liquidating companies to realise historic basis Loss purchasing – Grouping with other companies to access their losses Double dip financing Other ways that you are aware of? 0801-0898732 136 La Trobe – February 2010 Using Losses in a Cross-border Context Creating deductible expenses with income in loss jurisdictions Generate relief for same loss/expense in 2 countries – Branches, Dual residency Generate relief for expense in country A but income not taxed in country B – Move assets (eg, IP, customer lists) to country that can amortise – Hybrid debt – Put finance receivables in low/nil tax countries; or countries with losses Move profits between countries – Transfer pricing, TESCM Other? 0801-0898732 137 La Trobe – February 2010 Using Losses in a Cross-border Context (continued) Cross border tax consolidation Two basic tax systems: – worldwide tax system (which allows losses of foreign businesses to be offset against the local parent‘s profits) – territorial system, which does not In the worldwide system, generally the countries do not allow the offset of the losses of a foreign subsidiary, but will allow the deduction of the losses of a foreign branch or PE Marks & Spencer ECJ case 0801-0898732 138 La Trobe – February 2010 Consider This… Example: A Dutch company wants to set up a trading operation in Italy. It anticipates that the Italian trade will make losses and would like to deduct those losses against its Dutch profits. How could the Dutch company do this? 0801-0898732 139 La Trobe – February 2010 Branch: “Start-up” NL starts up new operations in Italy – NL offsets Italian branch expenses against profits. – Italy carries forward NOLs When Italy become profitable Start-up Italian – Transfer branch to Italian company Branch – Claw-back of losses in NL 0801-0898732 140 La Trobe – February 2010 Branch: Acquisition Scenario: Both UK and Spain are profitable but have created a loss for tax purposes. How can they generate the loss? Achieves Debt Spanish • Interest deduction in UK as branch results Branch consolidated • Interest deduction in Spanish consolidated tax return Restriction • Countries that allow a branch to hold a group of companies • Treaties that allow double relief of loss • Dual consolidated loss provisions (e.g USA) 0801-0898732 141 La Trobe – February 2010 Simple Arbitrage Scenario Equity – NL currently lends to Italy – Interest deduction in Italy – Interest income in NL – France has losses Idea – Drop debt into France by equity Debt – Use French losses to shelter finance income 0801-0898732 142 La Trobe – February 2010 Simple Hybrid Scenario – Spain currently lends to Italy – Interest deduction in Italy – Interest income in Spain Idea Hybrid – Replace debt with hybrid debt – Interest deduction in Italy – No interest pick up in Spain – treated as equity 0801-0898732 143 La Trobe – February 2010 Loss Refreshing As discussed, losses are a valuable tax asset However, in a number of jurisdictions, they can expire after a certain period Techniques therefore exist to ―refresh‖ losses and extend their life where they are likely to expire. Common strategies include: – Sale and leaseback of assets – Conditional debt waivers – Are you aware of others? 0801-0898732 144 La Trobe – February 2010 Creating Interest Expense… A foreign group wants to buy shares of trading company in your jurisdiction and would like to finance that acquisition w/ debt. How would you structure the transaction to ensure the interest expense can be deducted from the target’s trading profits? 0801-0898732 145 La Trobe – February 2010 Scenario 1 – Acquisition and Tax Consolidation Acquisition debt Holding entity finance expense Target operating Profits company Consolidation/Group/ Fiscal Unity 0801-0898732 146 La Trobe – February 2010 Scenario 2 Acquisition and no Tax Consolidation Acquisition Local holding debt company Merger Target company 0801-0898732 147 La Trobe – February 2010 Summary Take advantage of different tax systems to optimize use of tax losses Think about different methods to generate losses if none exist (e.g. selling assets within the group) Find ways to leverage an acquisition efficiently Beware of jeopardizing existing tax losses and think about refreshing expiring losses Use cross-border planning techniques to optimize use of tax losses 0801-0898732 148 La Trobe – February 2010 Definition of Hybrid Instrument A form of financing that is treated differently by the tax system of the country receiving the finance and that of the country providing 0801-0898732 149 La Trobe – February 2010 List of Financial Instruments Intensivity of equity character Common stock: no assurance of fixed return Preferred shares Non voting shares Profit sharing bond Convertible bond/Payment in shares Payment in shares Participation in profits (profits participating debt obligations) Subordinated long-term debt Deferral of payment (zéro coupon debt obligation) Common bond Intensivity of debt character 0801-0898732 150 La Trobe – February 2010 Why use Hybrid Instruments? Create mismatch between two or more tax jurisdictions Create mismatch between accounting standards and tax rules Increase credit/solvency ratings Improve capital structure for bidding on contracts (eg, government) Mitigate capital duty 0801-0898732 151 La Trobe – February 2010 Classifying HD as Equity: Characteristics Equity rights (e.g. conversion right, voting rights) Participation in profits Subordination Long or indefinite term 0801-0898732 152 La Trobe – February 2010 Hybrid Debt: International Accounting Standards (IAS) Equity instrument: any contract that evidences a residual interest in the assets of an enterprise after deducting all of its liabilities Financial liability: any liability that is a contractual obligation to deliver cash or another financial asset Substance over form approach 0801-0898732 153 La Trobe – February 2010 Hybrid Debt: Tax Majority of countries apply domestic classification principles and pay little or no attention to tax treatment of the instrument in any other country 0801-0898732 154 La Trobe – February 2010 Hybrid Debt: Cross-border Tax Planning: Summary Mismatch in character of financial instruments to combine tax advantages of equity (income eligible for tax credits or exemption) and debt (interest tax deductible) Withholding tax considerations Different rules for determining the timing and amount of deduction in source country and income in country of receipt 0801-0898732 155 La Trobe – February 2010 Hybrid Debt: Summary Timing differences – Accruals basis deduction of costs/expenses vs. receipts basis taxation of income – Withholding taxation on redemption basis vs. granting tax credits on accruals basis Permanent differences – Tax deductible interest vs. dividend income eligible for tax relief (credit/exemption) – Tax deductible deemed interest vs. no deemed interest income recognition 0801-0898732 156 La Trobe – February 2010 Hybrid Debt: Example Deep Discount Bond – Tax Rate Italian company receives 95% of Saving and Timing Benefit dividends tax free from Irish company. Italian company claims tax relief at 33% for the funding costs associated Italy with the investment. Irish company taxed on discount (rate shares/capital contribution is 25%) only on maturity or sale of Ireland bond. Luxembourg borrower tax relief at zero coupon bond 29.63% for annual discount expense on an accruals basis. Luxembourg 0801-0898732 157 La Trobe – February 2010 Definition of “Transfer Prices” Economic Views – Transfer Prices represent the remuneration for the intercompany transactions – Amount stated for transactions between divisions of an enterprise or between entities of one group of enterprises 0801-0898732 158 La Trobe – February 2010 Transfer Pricing – Why Important? Performance Profit contribution evaluation analysis for financial reporting purposes Tax appropriate Coordination Functions of income and control Transfer Prices allocation Company-/ Tax optimization Investment within the group planning 0801-0898732 159 La Trobe – February 2010 Impact of Transfer Pricing on the Effective Tax Rate Thailand Thai Ltd. Manufacturer Big Apple Unrelated 3rd parties USA Distributor Customer Sale of 100 million product units Sales price per unit US$ 7.60 to customer Production costs per unit US$ 2.50 0801-0898732 160 La Trobe – February 2010 Impact of Transfer Pricing on the Effective Tax Rate Thai Ltd Big Apple Group a) Transfer price US$ 4 US$ m US$m US$m Sales (100 m units) 400 760 760 Cost of goods sold (250) (400) (250) Operating expenses (50) (250) (300) Taxable income 100 110 210 Tax rate 12.5% 40.0% 26.9% Tax liability 12.5 44 56.5 b) Transfer price US$5 Sales (100 m units) 500 760 760 Cost of goods sold (250) (500) (250) Operating expenses (50) (250) (300) Taxable income 200 10 210 Tax rate 12.5% 40.0% 13.8% Tax liability 25 4 29 0801-0898732 161 La Trobe – February 2010 Impact of Transfer Pricing on the Effective Tax Rate Adjustment of Transfer Price to U.S. $4 in U.S. (without corresponding adjustment in Thailand) ThaiLtd Big Apple Group US$m US$m US$m Sales (100 m units) 500 760 760 Cost of goods sold (250) (500) (250) Operating expenses (50) (250) (300) Income adjustment 100 100 Taxable income 200 110 310 Tax rate 12.5% 40.0% 32.9% Tax liability 25 44 69 Additional tax due to double taxation 40 0801-0898732 162 La Trobe – February 2010 Need For a Regulatory Framework Globalisation International expansion Increased cross border transactions within the same MNE Manipulation of transfer prices in order to minimise the MNE‘s global tax burden Tax authorities forced to regulate transfer price setting in order to protect their revenue base; Internationally coordinated approach (common sense) required in order to avoid conceptional conflicts across countries 0801-0898732 163 La Trobe – February 2010 Transfer Pricing – Why Important? Controversy Highlights Transfer Pricing still the most important international tax issue for MNEs (86%) 60% audit rate for MNEs with annual revenue of US $500 million or more, 76% of MNEs expect a TP audit within next two years – E.g., in France, of total of 260 requests for Mutual Agreement Procedure, 110 covered transfer pricing issues (as of 11/03) Tax authorities are substantially increasing efforts to boost number of TP audit specialists and TP training to conduct more audits 0801-0898732 164 La Trobe – February 2010 Transfer Pricing – Why Important? Planning Highlights Majority of MNEs still have not explored the full potential of TP planning opportunities – Only 40% of parent MNEs and 36% of subsidiaries believe TP is more than just compliance – Planning process can build on compliance process – At minimum, documentation process can be used as a ―health check‖ Apparent disconnect between business and tax aspects of TP – About 50% of MNEs report that TP is only used to satisfy tax requirements – Tax authorities may exploit by asserting lack of business substance in tax planning 0801-0898732 165 La Trobe – February 2010 Transfer Pricing – Why Important? Documentation Highlights Motivation > risk reduction and consistency – Two-thirds of parents and 60% of subs see documentation as more important than two years ago – 50% have undertaken a risk assessment of their transfer pricing policy Only 30% MNEs taking a globally coordinated approach Only 40% MNEs have a clear management process for maintenance of documentation Experiences from audits > improve the quality of documentation 0801-0898732 166 La Trobe – February 2010 Types of Intercompany Transactions Tangible Property Services – Finished Goods – Research and Development – Inputs (Raw Materials/Work-in- – Headquarter/Management Process) – Sourcing Use of Intangible Property – Treasury Management – Technology Cost Sharing – Marketing (e.g., Trademarks, Loans/Leases Brands) – Know-How 0801-0898732 167 La Trobe – February 2010 Definition of Transfer Prices The OECD Transfer Pricing Guidelines Transfer prices are the prices at which an enterprise transfers physical goods and intangible property or provides services to associated enterprises Two enterprises are deemed associated if one of them participates directly or indirectly in the management, control, or capital of the other, or if both enterprises are under common control The 1995 Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (The Guidelines) – International consensus= compromise – Guidance – To avoid double taxation – Not legally binding Local country laws may extend or modify scope of provisions – however the Guidelines would still be relevant 0801-0898732 168 La Trobe – February 2010 The Principle: Working «At Arm‟s Length» In general, transfer prices are accepted by the tax authorities if they are «at arm‘s length» Standard is met if …«Results of the (controlled) transaction are consistent with the results that would have been realized if uncontrolled tax payers had engaged in the same transaction under the same circumstances» 0801-0898732 169 La Trobe – February 2010 Applying the Arm‟s Length Principle Arm‘s length principle is based on comparing all the conditions of the intercompany vs. third parties transactions (economically relevant characteristics must be sufficiently comparable and accurate adjustments to remove some differences) 0801-0898732 170 La Trobe – February 2010 Key Value Drivers and Risks Value Drivers/Intangibles Risks – Sources of competitive advantage – Marketing Market risks – Marketing intangibles Credit risks Know-how Trademarks/Tradenames – Product Customer relationships Warranty Liability – Manufacturing intangibles Know-how – Manufacturing/Operations Processes Availability/cost of raw materials and energy Over/under capacity – Technology intangibles Inventory Patents Technology 0801-0898732 171 La Trobe – February 2010 Profitability Factors Intangibles Developed/ Risks Undertaken/ Profitability Functions Performed/ 0 20 40 60 80 100 120 Profits = [Intangibles] + [Functions] + [Risks] The effect is material on the determination of taxable income in related companies operating in different countries 0801-0898732 172 La Trobe – February 2010 Comparability Factors Guidelines provide for five comparability factors to ensure that economically relevant characteristics are sufficiently comparable and accurate adjustments are made to remove some differences: – Characteristics of Property or Services Tangibles ( physical features, quality, volume involved) Services ( nature and extent) Intangibles ( underlying agreement, type, duration, protection, anticipated benefits) – Functional Analysis Focus on group structure and organization Identification and comparison of all the economically relevant activities undertaken Identification of functions performed (design, manufacturing, assembling, R&D, servicing, transportation, distribution, marketing, financing, management) Identification of assets used such as tangible, intangible ( including management effectiveness), type of intangibles (plant, equipment, nature, age, market value, location, property rights) Identification of risk assumed (market (price fluctuations), investments, financial, currency, credit) • allocation of risks must be consistent with the economic substance of the transaction • determination of to what extent in reality each party bears risks 0801-0898732 173 La Trobe – February 2010 Comparability Factors (continued) Guidelines provide for five comparability factors to ensure that economically relevant characteristics are sufficiently comparable and accurate adjustments are made to remove some differences (continued): – Contractual Terms Written contracts, communications and simple conduct Define how responsibilities, risks and benefits are split by parties – Economic Circumstances Identification of the relevant market(s) considering available substitute goods or service Geographic location, size, competitive position, supply and demand level, consumer‘s power, cost of production, transport costs, retail/wholesale – Business Strategies Innovation, new product development, degree of diversification, risk aversion, political changes, Strategies devised such as market penetration policies 0801-0898732 174 La Trobe – February 2010 Practical Issues Recognition of actual transaction undertaken – Groups retain the freedom to apply methods not provided by the Guidelines, provided that arm‘s length principle is met No obligation to use more than one method – The arm‘s length principle does not require the application of more than one method – Local laws may nonetheless require analysis of more than one method Ideally a transaction-by-transaction approach applies – Continuous or closely linked transactions may require an aggregate evaluation – Depending on circumstances, package deals may be evaluated as a whole or by segregating different elements 0801-0898732 175 La Trobe – February 2010 Practical Issues (continued) Use of multiple year data – Data from both the year under examination and prior years allows a broad understanding of business circumstances – Particularly useful for transactional profit method – May not be appropriate in all OECD countries Losses – Need to show business strategy involved (market penetration) Use of custom valuation – Customs information could be relevant also for TP purposes – Co-operation between income tax and customs authorities is becoming more common 0801-0898732 176 La Trobe – February 2010 Countries With Effective Documentation Rules 1994-1997 1998-2001 2002-2003 2004-2005 Documentation Rules Expected Soon USA USA USA USA Chile Australia Australia Australia Australia China France France France France Finland Mexico Mexico Mexico Mexico Ireland Brazil Brazil Brazil Brazil Israel New Zealand New Zealand New Zealand New Zealand Russia Canada Canada Canada Sweden South Korea South Korea South Korea Argentina Argentina Argentina United Kingdom United Kingdom United Kingdom Denmark Denmark Denmark Venezuela Venezuela Venezuela South Africa South Africa South Africa Germany Germany Germany Belgium Belgium Belgium Japan Japan Japan Poland Poland Poland Kazakhstan Kazakhstan Kazakhstan India India India Portugal Portugal Portugal Argentina Argentina Columbia Columbia Netherlands Netherlands Thailand Thailand Malaysia Malaysia Indonesia Norway Spain Peru Taiwan Hungary Ecuador 0801-0898732 177 La Trobe – February 2010 Documentation Even in countries where the burden of proof regarding the appropriateness of the transfer prices is at the tax administration, taxpayers may still be obliged to produce documentation Documentation requirements vary from country to country In international practice, appropriate documentation should include: – A business outline – Structure of the organization, ownership linkages within the MNE – Information about the market conditions under which the enterprise operates 0801-0898732 178 La Trobe – February 2010 Documentation (continued) Appropriate documentation should also include: – Information about the taxpayer‗s transactions with foreign associated enterprises – Nature and terms of the relevant transactions – Selection process of adopted transfer pricing methodology – Information about comparable uncontrolled transactions and their pricing – Information about price determination process – Contracts, invoices, etc., substantiating the implementation 0801-0898732 179 La Trobe – February 2010 Manufacturing Structures – Hierarchy Consignment manufacturing Contract manufacturing Full-fledged manufacturing 0801-0898732 180 La Trobe – February 2010 Sales Structures – Hierarchy Agent Commissionaire Limited risk distributor Full-fledged buy/sell distributor 0801-0898732 181 La Trobe – February 2010 Basic Design – Example TP1 TP2 cost plus resale minus ProdCo CenterCo SalesCo Cost Center Investment Center Revenue Center Efficiency Entire business Sales Cost competitiveness responsibility Volumes Quality of Integrated economic profit Customer relations manufacturing Category management (national accounts) Delivery Product development Operational cost of Brand management SalesCo Supply flow management Pan-European integration After sales co-ordination 0801-0898732 182 La Trobe – February 2010 BPA – Example Example description of added-value processes Corporate Strategic Corporate …% Corporate Strategy Public Brand Management ….. Management Relations Corporate Support …% Finance IT Human Resources Tax & Legal Management Research & Product Research & Basic …% Development Development Strategy Research Develop- ment ….. Supply Chain …% Management Purchase Production Marketing Sales 0801-0898732 183 La Trobe – February 2010 BPA – Example Finished Semi-finished products I-SpA Sales PL- products Unrelated D-GmbH Sp.z.oo 3rd parties NL-B.V. Transaction Characterization Method Semi-finished products CC -> PC Cost Plus PL-Sp.z.oo (production) -> D-GmbH (principal) Finished products PC -> CC Resale Minus D-GmbH (principal) -> I-SpA (distribution) Agency Services CC -> PC Cost Plus NL-B.V. (agent) -> D-GmbH (principal) Marketing Services CC -> PC Cost Plus I-Spa (distribution) -> D-GmbH (principal) 0801-0898732 184 La Trobe – February 2010 Economic Analysis – The “Gap” Full Risk Distributor Profit Level 6% Gap = The “Gap” PV (CS- FS) Current State 2.5% Limited Risk Distributor Future State Profit Level Terms of Agreement/Relative Time Frame 0801-0898732 185 La Trobe – February 2010 IP Definition No one all encompassing definition of what constitues IP. Possible definition: IP is any non-physical identifiable asset that enables a company to generate a profit above the level achievable with currently available physical assets. Examples of IP: – Research and Development (e.g., Patents) – Procedures, Formulations, Models – Know-how, Concepts, Experience – Design, Symbols, Logos – Brands and other trademark rights 0801-0898732 186 La Trobe – February 2010 IP Classification Common classification OECD classification – Product related IP – Marketing Intangibles, e.g., Trademarks – Manufacturing related IP Trade names Brands (local, regional, global) – Marketing and sales related IP – Trade Intangibles, (all commercial – Other intangibles other than marketing intangibles) Patents (formulas, production processes) Economic phenomena that typically do not Know-how qualify as intangible asset but may Literary and artistic rights influence the value of such asset, e.g., : – Market share – Market potential – Barriers to entry.... 0801-0898732 187 La Trobe – February 2010 IP Planning Considerations General Tax rate differential – Structure: Ownership, Exploitation, – Foreign tax credits (e.g., withholding Management, Development taxes, low taxed royalty income) – Situation: Acquisition or non-acquisition – CFC-considerations – Many questions to explore – R&D credits and other benefits – Tax rate/tax capacity in territory – Cash-flow considerations – Location of developed and future IP – Availability and nature (i.e., capital/revenue) of deductions for R&D – Timing of deductions, benefits expenditure – Amortization deductions for IP/interest deductibility (and effect on other tax issues, e.g., thin-cap) – Changes to income classification (e.g., parent receives tax free dividend instead of taxable royalty) 0801-0898732 188 La Trobe – February 2010 IP Planning Considerations (continued) No change to existing IP : Future profit potential moved to low tax jurisdiction through contract R&D; R&D centres in high tax jurisdictions? Change to existing IP : New-IP ownership offshore and also moving old-IP ownership and income offshore? Additional questions to above: – Buy-in Costs – Lump Sum/Declining Royalty – Exit charges – Cost sharing, declining royalty as relocation tool – Opportunities for double deductions for IP expenditures Non-tax considerations 0801-0898732 189 La Trobe – February 2010 IP Planning: Transfer Vs. Licensing Transfer License – Sale or contribution – Subject of license – Transfer of legal and/or economic – Type of license ownership Quota license (produced/sold units) Sales license Profit license – Scaling: fix, degressive, progresive, etc – Transfer of neither legal nor economic ownership Consider implications of differences for tax planning purposes. 0801-0898732 190 La Trobe – February 2010 Principles of Licensing Royalty agreements – Right to use intangible property for payment or in exchange for other value – Agreement of its own kind, rental and leasing elements – Clear and unambiguous agreement in advance – Global licenses (for baskets of IP) Types of royalty payments – Running royalty (e.g., based on sales, quantity) – Lump-sum – Declining vs. Progressive vs. Flat etc. ―Embedded IP‖ vs. separately charged IP 0801-0898732 191 La Trobe – February 2010 IP – Questions to Ask For the whole enterprise – What is the IP? – Where is the IP? How is IP created? – Life of IP? – Value of IP? – Royalty structure currently in place? Who pays to whom? – Current versus future IP – Consider split of IP between countries – Role of IP taking into account group`s strategy 0801-0898732 192 La Trobe – February 2010 Tax Authorities and IP Tax authorities are becoming increasingly aware of IP related matters in case of group reorganizations although the local emphasis can differ Examples: – Netherlands: Focus strongly on place of management – and consistency between location of functions and location of IP – Germany: Focus on substance, exit cost which could require payments for ―deemed‖ transfers (e.g., customer base). – US: Requires royalties commensurate with income and outbound transfers of IP are subject to tax; new service regs dealing with embedded IP Tax authorities increasingly focus on IP transfers since it creates an obvious taxable event upon conversion (“tax revenue”) 0801-0898732 193 La Trobe – February 2010