A Forecast of Taxation Developments

01 March 2007

Michael O’Connor, chief tax officer, Alcan Inc, Montreal 

Fortunately, years go by quickly and this will be replaced before anybody has a chance (or hopefully the time) to check any of the envisioned outcomes. I was invited to prepare this introduction to provide a buyer’s insight into the tax issues facing multinationals and presumably to provide some degree of hope to all and sundry that 2007 will be a banner year for tax lawyers, particularly those listed in these pages.

As we start a new year, all of those contained in this mighty volume are wondering where this year’s available (and even unavailable) hours will be spent – or more realistically, on whom tax clients will spend their available funds?

Most of you are already run off your feet with all of the tax consequences of the transactions undertaken in 2006, a record year for M&A activity, a year that saw what must be the largest single transfer pricing tax settlement ever, and a year that marked a continuation of ECJ madness for those lucky few who played the powerful Treaty of Rome card in years past and surprisingly continue to reap the benefits through the European Court of Justice’s benevolence. But the year will linger in tax terms for several more to come, so whether you are playing in the forward-looking space of the tax planner or the historical space of dispute resolution and litigation, there is likely to be more tax work than ever before falling from the tables of 2006 corporate events and activity, with yet more to come in 2007.

There are a number of significant developments in 2006 that should propel tax lawyers into new and profitable frontiers in the coming year. In my mind, the single biggest thing affecting the tax world in 2007 is the Financial Accounting Standards Board’s (FASB) recently pronounced requirements for increased transparency and disclosure around uncertain tax positions. But transfer pricing developments continue to attract attention and people should not lose sight of the considerable hidden value that can emerge in post-acquisition integration.

FASB Interpretation 48, or FIN 48 as it is known to thousands of SEC-registered public company tax directors who will have to deal with its effects, is an interpretation of another FASB brainchild, FAS 109: the statement of accounting practice governing the accounting for income taxes. But why would a seemingly arcane set of accounting rules be of interest to a Who’s Who of legal taxation practitioners? Simply put, while everything we do in life is governed by some law (natural or otherwise), everything also needs to be accounted for, for any number of reasons ranging from financial reporting to performance measurement to taxation. Since the tax lawyer’s best friend is the securities lawyer, it will pay to be aware of this new standard which becomes effective for SEC registrants on 1 January and will likely find its way into the practices of other jurisdictions, even within the EU.

FAS 109 was an attempt to establish accounting rules for companies to follow with regard to the income taxation effects of transactions or events occurring in particular financial reporting periods. It was actually the third attempt to do so in my lifetime and the fact that the legal tax community is not well versed in these rules does not seem to have affected the ability of tax lawyers to earn a reasonable living issuing tax opinions to, or executing transactions for, reporting issuers. FAS 109 is a broad document, which one can easily get lost in as one attempts to estimate (and I stress estimate – in the context of tax accounting effects in this day and age – where we face massive restatement risk) the tax provision of a multinational SEC registrant. But despite its breadth, FAS 109 appears to contain at least one shortcoming that made it worthy of an ‘Interpretation’ by the FASB; that is, it does not prescribe a recognition threshold or measurement attribute for tax positions taken in a tax return.

This is a ghastly hole, you will admit and no doubt you also wonder how the accountants ever got themselves into this mess in the first place. How on earth, without a rule, nay without a law, could companies ever go about deciding when to recognise, in their financial results, a tax benefit? And how might the investing public ever be capable of understanding the workings of FAS 109 when so much uncertainty exists in the tax filings of these companies? Clearly this awkward state of affairs demanded FASB attention. After all, the auditing business was reborn with the regulated audit mandated by the 2002 Sarbanes-Oxley Act; why not place some regulatory scrutiny, through the guise of financial reporting purity?

So we have FIN 48, a simple but effective rule that will govern the tax world and the tax opinion business for some years to come, unless and until the FASB develops a better way to measure and account for the tax effects of transactions or events. This will be a boon to the legal community in two ways. First it should bolster the tax opinion business and secondly, the increased transparency will likely lead to increased tax disputes and litigation.

There are two parts to the FIN 48 rule that will have a profound effect on the taxation legal community: one is recognition and the other measurement. Basically, when you are involved in advising on any sort of tax issue, any financial benefits of the positive outcome for that issue cannot be recognised in the financial accounts of the company, unless the tax position to be taken when filing the tax return is more likely than not capable of being sustained based on its technical merits. This means more than 50 per cent assurance that the position will be accepted. This will end once and for all the annoying debate around whether tax opinion likelihoods should be qualified with “will” or “should” or something equally vague, such as “the better view”.

Opinion qualifiers will evolve a common standard, ‘more likely than not’ that in time will define itself beyond the mere mathematics through market forces. Clearly the stakes of being wrong on this point are significant and undoubtedly the legal firms will be inundated with requests for comfort letters on old tax positions. Once it has been determined that a positive outcome of a tax position taken meets the ‘more likely than not’ threshold for recognition, it will then be necessary to measure the extent to which recognition of some or all of the tax benefit is appropriate.

The new rule is effective essentially from 1 January 2007 and companies are expected to report the effects of transitioning to the new model and apply the new measurement model for the first quarter of the year. Consequently, most companies are working at putting in place the systems and documentation to support the analysis for significant uncertainties. The year will culminate with broad-based disclosures in the year-end accounts, designed to show the movement in the amount of uncertain tax positions – including the benefits that are realised from settlements with tax authorities or lapses of statute of limitations. Further disclosures are required to illustrate the anticipated effects of significant changes in the forthcoming 12-month period, with the 12-month disclosure being required on a quarterly basis with an item-by-item description.

These disclosures will undoubtedly arouse the interest of tax authorities; and companies will have to get used to managing tax issues with an increased level of transparency. As a result, FIN 48 should open a vast well of frothy work for the legally endowed tax mind.

Next up for 2007 in my mind is the increasing burden of transfer pricing documentation. I think that by now most multinationals have moved towards practices that comply with the OECD transfer pricing guidelines. But despite all the efforts by multinationals to transact at arm’s length standards, transfer pricing still appears to be a game played between two governments with multinationals as the ball. The $3.8 billion Glaxo transfer pricing settlement harkens to a day when the field was far more wide open and so perhaps does not reflect today’s practices, but demonstrates that the length of time required to bring about transfer pricing or competent authority settlements makes for an extremely long game.

During 2006, Canada and the US marked the first full year of working under their new memorandum or understanding on applying the mutual agreement procedures under the Canada-US treaty. This was a welcome anniversary to a long-overdue development (much like many of the transfer pricing dispute files under their collective watch). While it is too early to determine whether the memorandum will have the desired effect of resolving the backlog of old files, I will say that some of our oldest transfer pricing files have been brought to resolution in the past year. Co-incidence? You decide.

I think that the future in this area will, as a consequence of the greater levels of transparency, take us closer toward advance pricing agreements, provided the cycle time can be dramatically improved. The recent news that China has entered this venue in a land-mark APA with Wal-Mart suggests to me that APAs will become faster and cheaper in the years to come. However with any old technology, the evolution of new rules will likely thwart the efforts to simplify this area. Late in 2006, the OECD released their 179- page report on the Attribution of Profits to Permanent Establishments, which will take some time to digest and raise more issues than it resolves.

I look forward to contrasting comments in this report with a recent New Jersey Corporation Business Tax (CBT) case, Lanco Inc v Director, Division of Taxation, which rejected a physical presence requirement for the imposition of the CBT. Lanco was a Delaware company, with no office, no employees and no property in New Jersey, but merely licensed its intangible property to its retailing affiliate, Lane Bryant Inc, for use in New Jersey. The New Jersey Supreme Court accepted the lower New Jersey court’s analysis that physical presence was not a requirement for imposition of a taxing nexus. How far this case can be taken in a digital world remains to be seen, but it is speculated that similar non-physical property could be subject to the New Jersey CBT and if other jurisdictions start down this path with similarly soft income targets there is no telling what kind of transfer pricing or nexus disputes will arise. So I think transfer pricing will clearly continue to be an area where care and caution will have to be exercised and I advocate working closely with your legal advisers and government stakeholders to take early action to avert long-lasting disputes. With so many players in the transfer pricing game now, it can only end in an eventual stalemate and a new game will emerge.

Finally, the area that I think has been most overlooked for tax opportunities is just the plain old backyard. With all of the acquisitions that have taken place, and the stacks of companies on top of companies that exist today in most multinationals, understanding the multinational’s global fact base becomes a real challenge. I expect that many tax directors will spend 2007 untangling cross-border subsidiary structures and while they do, don’t forget the basics. Wherever the jurisdiction you or your client are headquartered, valuable tax attributes that exist today throughout a multinational’s group can likely be identified from simply educating the client’s global tax staff and the tax advisers on the patterns to watch for. Once identified, plans can be developed to maximise the value of such attributes and typically none of this work depends on unpredictable judicial outcomes or fancy technical analysis.

So I think that the legal world will be well treated in 2007 with the continuing plethora of tax opportunity that exists in all parts of the planet. How you get your share of that work remains a mystery to me – I don’t think that deploying armies of contentfree sales people will be enough. I have often said that the firms don’t need people who can sell, but rather clients who can buy; what I have been able to learn over the years is that there are three requirements for success as a tax adviser: a mastery of the rules, a mastery of the client fact base and access to clients who can buy. If all of these things emerge at the same time you will be blessed with enough work to keep you in the highest tax bracket wherever you live. On that note, I wish you all good luck in the year to come.

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