Current Tax Issues in the US

01 June 2006

Jim Fuller, Fenwick & West LLP

First, the APA programme, for all of its strong points, takes a long time. It can be a matter of years before the taxpayer obtains its APA. Recently, the IRS APA programme administrators modified the APA procedures in an effort to reduce the time to complete an APA. The programme administrators also announced an intention to increase staffing. Hopefully, this ‘time-to-completion’ matter will be resolved, and improved. 

Second, cost sharing remains an issue, and the APA programme does not seem to be able to help here. The treasury and the IRS have taken taxpayers to court with respect to research and development costsharing arrangements. These taxpayers have included Xilinx, Adaptec and, most recently, Symantec. Others have had the issue arise, and eventually resolved, at the administrative level. The issue in these cases typically concerns the buy-in, which is the upfront cost at the beginning of a cost sharing arrangement, as well as certain other matters. The only case decided to date is Xilinx, in which the taxpayer was successful. The IRS also proposed new cost sharing regulations, which are quite unrealistic and onerous, and will make buy-ins much more expensive for taxpayers. An uncertainty about the proposed regulations lingers: they are based on an enforced hypothetical comparable. Xilinx held that section 482 is based on arm’s length principles, and that the IRS is required to use these arm’s length principles, as are taxpayers. The future of the proposed regulation, and its hypothetical comparable, will need to be resolved. Xilinx was decided only a few weeks after the proposed regulation was issued. 

The third area of concern is the widely followed ‘Glaxo’ case: the US and the UK could not agree in competent authority discussions, and Glaxo was left with no other recourse but to litigate its transfer pricing issue in the US tax court. The amounts concerned are phenomenal. If foreign countries cannot agree through the competent authority process, what are taxpayers to do? The taxpayer stands to suffer double taxation. This clearly is not the way the world’s economic system should operate from a tax perspective. 

Other Issues of International Interest 

Congress enacted section 7874 in 2004. It was intended to prevent US companies from expatriating – ie, from forming a Bermuda parent company to own the US company – with the public shareholders becoming shareholders of the Bermuda company. Some taxpayers had inverted in this manner. The difficulty is that section 7874 is extremely broad and can present serious issues in international restructurings, joint ventures and acquisitions. The IRS issued regulations intended to ameliorate some of the problems under this new statutory provision, but a wholesale legislative rewrite would seem more appropriate. The provision can arise in unexpected circumstances. For example, must the acquiror of a foreign company, which owns assets formerly owned by a US company, require a representation that section 7874 did not apply to the previous restructuring transaction? One of the consequences under section 7874 is that a foreign company is treated as a US corporation for US tax purposes. 

Other issues of significance to US corporate taxpayers concern the dual consolidated loss regulations. The IRS did a complete rewrite of the previous DCL regulations, which are designed to prevent a foreign loss from being used in a foreign country by a different taxpayer and at the same time claiming a deduction in the US. 

There has also been a lot of recent attention given to the US foreign tax credit regime, where foreign taxes may be treated as paid, for US tax purposes, by an entity different from the one that earned the foreign income. The IRS has discussed issuing new regulations, and has also unsuccessfully proposed having congress modify the statute to provide the IRS with special regulatory authority in this regard. The government unsuccessfully litigated the issue in a recent case: Guardian Industries. 

Finally, section 987 regulations need to be written. These regulations will deal with the important issue where a foreign branch, for example, a check-the-box branch, has a functional currency different from its owner’s functional currency. These rules will also apply where a partnership has a functional currency different from the partner’s functional currency. Exchange gain or loss, possibly in large amounts, can become taxable or deductible when the entity remits to its owners. 

Treaties 

The US has a growing number of treaties that provide for a zero rate of withholding when dividends are paid to a direct corporate shareholder. This is an important development internationally, as it assists substantially in the cross-border flow of funds. Although the US treasury states that zero withholding will not be a general policy applicable to all treaties, the most notable exception is Canada. The US and Canada, geographically joined at the hip, ought to have such a provision, as well. At present, this treaty is being renegotiated, but, some fear, with little hope for zero withholding. 

Another significant development in US tax treaties concerns look-through entities. The US check-the-box regime has resulted in many more flow-through entities than previously existed in international structuring. Historically, treaties were often remiss in how they dealt with flow-through entities, such as partnerships. The checkthe- box regime has created the all-toocommon additional flow-through entity: the disregarded entity. An entity may be a corporate, non-flow-through entity in one country, and yet constitute a flow-through entity in the other country. Addressing this through competent authority agreements and treaty modifications has been helpful. 

As treaties have been modified in recent years, the US, of course, has insisted on the limitation of benefits provisions in the treaties. The US is intent on eliminating treaty shopping to the greatest extent possible. The difficulty for the taxpayer and the tax adviser is that these limitationon- benefits provisions vary from treaty to treaty. Some are many pages in length. The few remaining US tax treaties that do not contain LOB provisions are presently under renegotiation (Hungary and Iceland). 

Tax Reform 

Last autumn, a presidential commission recommended major changes to the US tax law. Internationally, a US parent company would be subject to tax under an exemption system where foreign business income would not be subject to tax in the US. The US parent company’s expenses, however, would have to be allocated and apportioned to that exempt income, and could not be claimed as deductions to that extent. Passive income earned by foreign subsidiaries would remain subject to subpart F, and would be taxable in the US. This would dramatically change the approach to financing foreign subsidiaries as interest income would be taxable in the US, whereas a dividend would not. Royalties received from foreign subsidiaries would also be taxable in the US. The joint committee scored this proposal as a major revenue raiser, ie, a major source of new tax revenue for the US government. 

The proposed changes would also adopt a ‘managed and controlled’ concept in determining corporate residence. If a corporation is incorporated in the US, it would be treated as a US taxpayer, which is the rule today. If a foreign corporation is managed and controlled in the US, it, too, would be treated and taxed as a US taxpayer. The US tax rules today do not contain a managed and controlled concept. 

Finally, the proposal recommends a VAT-style consumption tax. The report says the tax is different from a value added tax, but it walks like a VAT, talks like a VAT and looks like a VAT. Imports would be subject to the tax whereas exports would not be subject to the tax, as in a VAT system. 

Most tax-knowledgeable people in the US believe that chances for implementing these major changes are quite slim. At this time, it seems unlikely that these major changes will ever be implemented by congress. 

Taxpayer Advisers 

The US now has important new disclosure rules with respect to tax shelters, putting a substantial damper on their marketing and promotion. This is good. It has substantially curtailed the promotion of tax shelters. The government also has pursued a number of former KPMG partners in criminal proceedings with respect to the promotion and marketing of tax shelters. This, in my view, is overzealous prosecution. The tax shelter problem has already been resolved by the disclosure rules. Moreover, KPMG was certainly not the only promoter and marketer of tax shelters. 

There also are new ‘circular 230’ rules. Circular 230 contains, in part, standards of conduct for US tax advisers. The revised circular 230 rules provide that writings by tax advisers must state that the recipient cannot rely on any tax advice continued therein for purposes of avoiding a penalty. Although well-intended when the IRS wrote the rule, that is, promoters of tax shelters should not be permitted to write sometimes quite weak, or even specious, opinions as a penalty-protection device, the rules are clearly overbroad. Virtually all e-mails and correspondence by US tax advisers today contain a legend stating that any tax advice contained therein cannot be relied upon for purposes of avoiding a penalty. In some cases, the advice may even concern penalty issues, with the absurd contradiction that while the substance of the correspondence addresses a penalty matter, the correspondence states that advice cannot be relied upon for purposes of avoiding the penalty. Since all correspondence by US tax advisers contains this legend, it obviously is a self-defeating rule. It needs further refinement.

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