US Tax Trends and Developments
01 January 2008
FIN 48, so well known that nobody would cite it as Financial Accounting Standards Board Interpretation 48, and FAS 109, FASB Statement 109: Accounting For Income Taxes, have resulted in a substantial change in the amount of publicly available information with respect to a publicly held corporation’s taxes and tax reserves.
The significance of this new information was underscored by a series of developments during 2007. The IRS developed a new training course “Use of Financial Accounting Information – A New Perspective.” Its purpose is to teach IRS examining agents how to use information available in a corporation’s SEC filings to learn more about the company’s uncertain tax positions. In December 2007, the IRS started issuing IDRs requesting information about corporate taxpayers’ FIN 48 disclosures. The IDRs request information about reserves related domestic and foreign jurisdictions, penalty exposure and other areas.A congressional committee also wrote letters to a number of companies in August 2007 requesting information about their FIN 48 disclosures. The letter also requested information about the percentage of the companies’ worldwide revenues: what percentage of those revenues was generated in the US? The letter also sought information about the percentage of the companies’ worldwide payroll expenses for the period: what percentage was attributable to employees in the US? The letter then moved on to a number of questions concerning FIN 48. The Senate letter was the subject of a Wall Street Journal story on 11 September 2007.
The IRS published a chief counsel advice in June 2007 that concluded that FAS 109 effective tax rate reconciliation workpapers are neither tax accrual workpapers nor audit workpapers under the IRS’s longstanding policy of not asking for that information in the absence of the taxpayer’s having engaged in certain listed transactions. Even the IRS has experienced some uncertainty in these areas: on 31 December 2007, the IRS issued another chief counsel advice cancelling the June 2007 advice without comment or further direction.
Combined with Sarbanes-Oxley, which has caused corporate accounting firm auditors to apply a new rigidity and inflexibility, the amount of this public, audited information is likely to have a lasting effect on US tax practice. Accounting firm auditors, for example, also now routinely ask for memoranda prepared by law firms, which raises issues concerning attorney– client privilege and work product protection.
TRANSFER PRICING
Transfer pricing continues to play a leading role for multinational corporate taxpayers. Transfer pricing documentation has become almost a cottage industry for corporate taxpayers, whether done in-house or externally. One large corporate taxpayer estimated that commencing in 2008 it would have to prepare 1,000 transfer pricing reports per year given that it does business in so many different countries. An executive of that corporate taxpayer stated that transfer pricing documentation must be prepared for 37 countries, in addition to the United States. The taxpayer has a number of different divisions and each business has its own economics, thus necessitating different transfer pricing reports for those divisions. While some companies prepare specific documentation for each jurisdiction, other companies use a master documentation model and customise it to meet the particular requirements for each jurisdiction.
Clearly the volume of transfer pricing documentation that must be prepared is on the increase. Moreover, in one recent case, the IRS argued that the taxpayer may not reasonably have concluded that its selection and application of a particular transfer pricing method provided the most reliable measure of an arm’s length result. Thus, the IRS argued that the taxpayer could be subject to a transfer pricing penalty despite the taxpayer’s having prepared contemporaneous transfer pricing documentation.
Transfer pricing also has a new issue beyond documentation. Under the new financial statement disclosure rules, discussed above, many large corporate taxpayers have been reporting uncertainties with respect to how various tax authorities will view their transfer pricing. It is uncertain how this will play out over time. Combined with the need to coordinate transfer pricing in many jurisdictions, this has given rise to the increasing likelihood that more taxpayers will seek advance pricing agreements. Of course, this too presents issues. The congressional committee FIN 48 letter referred to above asks whether on receipt of an APA any adjustments to the company’s tax reserves were made as a consequence of the APA.
HYBRIDS
The US check-the-box rules have over the past 10 years given rise to substantially more hybrid entities. This certainly is not news. A hybrid entity could be an entity that is treated in its local country as a corporation but which for US tax purposes is treated as a flow-through entity, that is, as a partnership or a “disregarded entity”. However, this has caused increasing attention in many countries to fund flows through potentially hybrid entities, whether in the form of dividends, interest or royalties.
The US has had to modify many of its treaties to more properly reflect hybrid entity characterisations. For example, the recent US–Canada treaty protocol has as one of its more significant changes the treatment of hybrid entities. Heretofore, Canada did not respect the flow-through nature of a US limited liability company that was disregarded or a partnership for US tax purposes. Similar issues arose under other treaties, such as the US–Japan treaty, until those treaties were modified.
In modifying the US-Canada treaty, hybrids were generally accorded their proper treatment. The person who is taxed is the person who must qualify under the treaty. However, the protocol also contains anti-hybrid rules that apply in certain situations. When a US company uses a Canadian unlimited liability company, payments by that ULC to its US owners cannot qualify for treaty benefits. This was an unfortunate surprise to virtually all non-government tax advisers. It is still unclear why this was done. In addition, under the protocol, payments by a Canadian payor to a Canadian partnership with US partners that is characterised as a corporation for US tax purposes also cannot qualify for treaty benefits.
This multilateral attention to hybrid entities has made working with them substantially more tricky.
Hybrid instruments have also come under increased scrutiny. The LMSB (large and mid-size business) division of the IRS designated hybrid instruments as a “tier one” issue in 2007. A “tier one” issue, something new in the US starting in 2007, gets substantially increased scrutiny. A national IRS coordination team is also involved. A hybrid instrument might be a loan-type instrument pursuant to which a US parent company has advanced funds to its foreign subsidiary. It might also be a promissory note combined with a forward purchase agreement. For US tax purposes the US parent’s interest in the instrument might be classified as equity; for local country purposes the instrument might be classified as debt.
Further, to the surprise of virtually everyone outside the government, the IRS’s recently issued dual consolidated loss regulations, which heretofore seemed to have nothing to do with hybrid instruments, addressed them in a potentially material manner. If a hybrid entity foreign branch has debt and interest expense on that debt is used to shelter income from tax in the foreign country, perhaps by having the branch invest in another entity by using a hybrid instrument, the interest expense cannot be deducted in the US (assuming the offset income is not taxable in the US). “Double dip” financing arrangements also are knocked out under the new DCL regulations in other, but not all, fact patterns.
Hybrid structures came under further attack in the US in the context of newly proposed foreign tax credit regulations, which are styled “foreign tax credit generator transactions”. These regulations attack structures where the US and an applicable foreign country treat an arrangement differently under their respective tax systems. In such an arrangement, the US investor obtains a foreign tax credit. An unrelated foreign investor also obtains benefits as a result of the foreign tax payment. The IRS’s concern is that these deals are structured to pay tax that otherwise would not be due. Both parties, but not their governments, benefit. Under the proposed regulations, the US party cannot claim a foreign tax credit for taxes paid in the structured transaction.
TAX RETURN PREPARER PENALTIES
The US Tax Code has had a provision providing for a penalty on tax return preparers who take aggressive positions on their clients’ tax returns. In a surprising development in May 2007, a change in these rules slipped by almost unnoticed in a bill that seemed to have nothing to do with tax: US Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Accountability Appropriations Act of 2007. The changes in the statutory tax return preparer language caught virtually all tax advisers by surprise. Even the IRS seemed surprised by these statutory changes. Bar associations submitted comments as to the scope of these rules as did organisations whose members are corporate tax executives.
The penalty could be 50 per cent of the income earned by the tax return preparer with respect to the return or refund claim. Certain rules need to be followed to avoid suffering the penalty. One concern under the new rules is whether, for example, an attorney providing an opinion in a large corporate acquisition could become a “nonsigning” tax return preparer and possibly subject to a penalty even though he or she never saw the corporate tax return. A bar associate report used the example of an attorney who provides an opinion on the creditability of a large foreign income tax for foreign tax credit purposes. Could he or she become a tax return preparer under these rules if that’s all he or she does for that client? Corporate tax organisations also have been concerned: they do not want a corporation’s in-house tax staff to become tax return preparers under these rules.
The IRS issued interim guidance under these rules on 31 December 2007. A person who for compensation prepares all or a substantial portion of a tax return or a claim for refund is a tax return preparer. A “substantial portion” and “substantial preparation” require a “facts and circumstances” analysis. Certain rules may have to be followed by non-signing tax return preparers, for example, such as possibly advising the client to disclose the transaction on a penalty form.
One helpful example describes an attorney in a law firm who advises a large corporate taxpayer on specific issues of law regarding a proposed corporate transaction. Based on this advice, the corporate taxpayer enters into the transaction. Once the transaction is completed, the corporate taxpayer does not receive any additional advice from the attorney or the attorney’s firm. Someone else prepares the corporate tax return. The example concludes that the attorney has not prepared a substantial portion of the corporation’s tax return and is not considered a tax return preparer under these rules.
The IRS Notice states that the IRS is still looking at these issues. The 31 December 2007 guidance is intended to serve only as interim guidance.
STRAWS IN THE WIND
Congressman Charles Rangel, who is chairman of the House Ways and Means Committee, introduced a potentially important bill in November 2007. It would significantly change the US tax laws, and internationally move the US to or in the direction of a territorial tax system. A US Treasury Department Report on Global Competitiveness dated 20 December 2007 also considers substantial changes in the US tax system, including the possibility of moving to a VAT-like system and, internationally, a territorial tax system. Time will tell what happens. There soon will be a new president. Things might change. But then again, they might not.