tax notes international - Tuck School of Business - Dartmouth College
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<strong>tax</strong> <strong>notes</strong> <strong>international</strong><br />
Volume 53, Number 5 February 2, 2009<br />
Minding the Book-Tax Gap<br />
U.S. Widens Swiss Bank Probe<br />
Indian Supreme Court Denies Vodafone Appeal<br />
U.S. Companies Facing Chinese Compliance Burdens<br />
Treatment <strong>of</strong> Intangibles in Spain<br />
Attributing Pr<strong>of</strong>its to Agency PEs<br />
Multinationals Accumulate to Repatriate<br />
<strong>tax</strong>analysts ®<br />
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
369<br />
371<br />
376<br />
380<br />
381<br />
383<br />
IN THIS ISSUE<br />
by Cathy Phillips<br />
HIGHLIGHTS<br />
Minding the Book-Tax Gap<br />
by Joann M. Weiner<br />
Multinationals Accumulate to<br />
Repatriate<br />
by Lee A. Sheppard and Martin A. Sullivan<br />
U.S. Widens Investigation <strong>of</strong> Swiss Bank<br />
by Randall Jackson<br />
Indian Supreme Court Denies Vodafone<br />
Appeal<br />
by Kristen A. Parillo<br />
AP Photo/Martin Meissner<br />
Canadian Budget Delivers Outbound<br />
Tax Relief<br />
by Steve Suarez<br />
387 COUNTRY DIGEST<br />
FEATURED PERSPECTIVES<br />
411 Buddy, Can You Spare a Dime?<br />
by Trevor Johnson<br />
415<br />
BOOK REVIEW<br />
The Global Tax Revolution: The Rise <strong>of</strong><br />
Tax Competition and the Battle to<br />
Defend It<br />
417<br />
419<br />
421<br />
447<br />
PRACTITIONERS’ CORNER<br />
New Rules for Valuing Intangible<br />
Assets In Spain<br />
by Sonia Velasco and Ana Colldefors<br />
Deduction <strong>of</strong> <strong>School</strong> Fees Under<br />
German Law<br />
by Marko Wohlfahrt and Katrin Köhler<br />
SPECIAL REPORTS<br />
Different Methods <strong>of</strong> Attributing Pr<strong>of</strong>its<br />
To Agency PEs<br />
by Carlos Eduardo Costa M.A. Toro<br />
U.S. Tax Review<br />
by James P. Fuller<br />
475 CALENDAR<br />
ON THE COVER<br />
Minding the Book-Tax Gap. . . . . . . . . . . . . . .371<br />
U.S. Widens Swiss Bank Probe . . . . . . . . . . . .380<br />
Indian Supreme Court Denies Vodafone Appeal . . . 381<br />
U.S. Companies Facing Chinese Compliance<br />
Burdens. . . . . . . . . . . . . . . . . . . . . . . .389<br />
Treatment <strong>of</strong> Intangibles in Spain. . . . . . . . . . .417<br />
Attributing Pr<strong>of</strong>its to Agency PEs. . . . . . . . . . .421<br />
Multinationals Accumulate to Repatriate . . . . . . .376<br />
Cover photo: Newscom<br />
TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 367<br />
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
ARGENTINA<br />
387 Buenos Aires’ New Stamp Tax<br />
Triggered by Two Core Events<br />
BANGLADESH<br />
388 Government Revokes Import Tax on<br />
Renewable Energy Imports<br />
CAMBODIA<br />
388 Tax Breaks Targeted to Critical<br />
Garment Industry<br />
CHILE<br />
389 Stimulus Package Wins Unanimous<br />
Approval<br />
CHINA (P.R.C.)<br />
389 U.S. Companies Facing Compliance<br />
Burdens in China<br />
ECUADOR<br />
390 Congress Approves Tax Package<br />
EUROPEAN UNION<br />
391 Austrian Leasing Rules Incompatible<br />
With EC Treaty, ECJ Says<br />
GERMANY<br />
393 Former Deutsche Post CEO Convicted<br />
Of Tax Evasion<br />
HAITI<br />
394 Mobile Phone Service Providers<br />
Oppose Tax Hike<br />
HUNGARY<br />
394 Employer Tax Cut, VAT Increase Under<br />
Consideration<br />
INDIA<br />
395 Indian PE Not Responsible for<br />
Withholding, Tax Tribunal Says<br />
396 Subsidiaries in India Do Not Constitute<br />
A PE, Tribunal Rules<br />
NEWS AT<br />
A GLANCE<br />
INDONESIA<br />
397 Exit Tax Rules Revised<br />
398 Regulation Amends CFC Rules, Clarifies<br />
Export Duty<br />
JAMAICA<br />
399 World Bank Backs Jamaican Tax<br />
Reform Effort<br />
JAPAN<br />
399 Consumption Tax Measure Advances<br />
MULTINATIONAL<br />
400 IASB Rejects Proposal to Allow<br />
Discounting <strong>of</strong> Current Tax in IAS 12<br />
NORWAY<br />
401 Government Proposes Carryback Rule<br />
For Losses<br />
OECD<br />
402 OECD Group Addresses CIVs,<br />
Cross-Border Investors<br />
PORTUGAL<br />
405 Government Submits Budget<br />
Supplement<br />
RUSSIA<br />
406 Court Dismisses Claim for Back Taxes<br />
Against Ernst & Young<br />
SPAIN<br />
407 Directors’ Remuneration Not<br />
Deductible, Supreme Court Says<br />
SWEDEN<br />
408 Government Proposes to Defer<br />
Employee Tax Payments<br />
UNITED STATES<br />
408 Drafters <strong>of</strong> Temporary Branch Regs<br />
Defend Rules’ Complexity<br />
368 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL<br />
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
y Cathy Phillips<br />
The news that Sarah Palin’s shoes recently sold for<br />
more than $2,000 on eBay shouldn’t fool anyone<br />
into thinking the economic crisis is over. If you believe<br />
the pundits, the worst is yet to come as the global<br />
economy continues its precipitous slide. Recovering<br />
will be an agonizingly slow process.<br />
But how did we get here? Contributing editor Joann<br />
Weiner has some ideas, and <strong>tax</strong> policymakers should<br />
take heed. As Weiner explains, financial transactions<br />
are at the root <strong>of</strong> the crisis. But for too long, she says,<br />
policymakers have failed to see the impact <strong>of</strong> financial<br />
transactions on the economy at large. Both the accounting<br />
community and <strong>tax</strong> policymakers should focus<br />
on financial accounting. Together they might see<br />
how differences in book and <strong>tax</strong> accounting have allowed<br />
companies to skew their financial statements<br />
and <strong>tax</strong> filings — and engage in the kind <strong>of</strong> shenanigans<br />
that got us in trouble in the first place (p. 371).<br />
Squandering Stimulus?<br />
Big pharmaceuticals, s<strong>of</strong>tware companies, and financial<br />
intermediaries are holding vast amounts <strong>of</strong> pr<strong>of</strong>its<br />
<strong>of</strong>fshore in anticipation <strong>of</strong> another repatriation <strong>tax</strong><br />
holiday. As you can imagine, battle lines are forming<br />
over whether these companies deserve another chance<br />
to bring back the dough. Contributing editors Lee<br />
Sheppard and Martin Sullivan make no bones about<br />
their opposition to the idea, arguing that a second repatriation<br />
‘‘would constitute frittering <strong>of</strong> stimulus <strong>of</strong> a<br />
high order’’ (p. 376).<br />
In the News<br />
U.S. prosecutors have increased their scrutiny <strong>of</strong><br />
Swiss bank UBS, and now believe that the bank helped<br />
far greater numbers <strong>of</strong> U.S. clients hide income in <strong>of</strong>fshore<br />
accounts than originally thought (p. 380). U.K.<br />
telecom giant Vodafone hit another roadblock in its<br />
ongoing challenge <strong>of</strong> a $2 billion capital gains <strong>tax</strong><br />
claim. India’s Supreme Court refused to hear<br />
Vodafone’s appeal in the case, which stemmed from<br />
Vodafone’s 2007 merger with Indian telecom Hutchison<br />
Essar (p. 381). Canada has managed to escape the<br />
worst <strong>of</strong> the global economic downturn, but its 2009<br />
budget nevertheless contains substantial stimulus measures.<br />
The budget also features improvements to Canada’s<br />
outbound regime, as well as corporate and individual<br />
income <strong>tax</strong> relief measures (p. 383).<br />
Commentary<br />
Our first report, by Carlos Eduardo Costa M.A.<br />
Toro, deconstructs article 7 <strong>of</strong> the OECD model convention,<br />
which deals with business pr<strong>of</strong>its, in an attempt<br />
to clear up uncertainties on the <strong>tax</strong> consequences<br />
<strong>of</strong> setting up a business involving an agency PE (p.<br />
421). Jim Fuller’s U.S. <strong>tax</strong> review returns this week<br />
with his expert analyses <strong>of</strong> the final contract manufacturing<br />
regs, the temporary branch rules, and the revised<br />
cost-sharing regs. He also discusses recent U.S. treaty<br />
developments and <strong>of</strong>fers an alternative to reinstating<br />
section 965 (p. 447).<br />
Do banks matter in an age <strong>of</strong> government takeovers?<br />
Trevor Johnson contends that U.K. business<br />
owners needing a loan to pay the <strong>tax</strong> bill might as well<br />
go directly to the government for the money, rather<br />
than ask a bank for a loan that likely won’t be approved<br />
(p. 411).<br />
A practice article by Sonia Velasco and Ana Colldefors<br />
discusses Spain’s advantageous new <strong>tax</strong> rules on<br />
valuing intangible assets (p. 417). Another practice article,<br />
by Marko Wohlfahrt and Katrin Köhler, reviews<br />
German law on the deductibility <strong>of</strong> school fees (p.<br />
419).<br />
Chris Edwards and Daniel J. Mitchell <strong>of</strong> the Cato<br />
Institute have written a book on <strong>tax</strong> competition that<br />
even a liberal could love. So says Gary Clyde Hufbauer<br />
in his review <strong>of</strong> The Global Tax Revolution: The Rise <strong>of</strong><br />
Tax Competition and the Battle to Defend It. Hufbauer characterizes<br />
the book as ‘‘entertaining’’ and a good resource<br />
for policy wonks (p. 415).<br />
♦ Cathy Phillips is editor <strong>of</strong> Tax Notes<br />
International.<br />
TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 369<br />
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NEWS ANALYSIS<br />
Minding the Book-Tax Gap<br />
by Joann M. Weiner<br />
For too long, <strong>tax</strong> policy experts have acted as if<br />
financial transactions have no impact on the real<br />
economy. If the current economic crisis, which financial<br />
transactions largely spawned, hasn’t clearly established<br />
that connection, then it’s time for <strong>tax</strong> policymakers<br />
to go back to business school.<br />
Experts in financial accounting and <strong>tax</strong> policy made<br />
that point loud and clear at the 12th annual UNC Tax<br />
Symposium held January 23 and 24 at the Kenan-<br />
Flagler <strong>Business</strong> <strong>School</strong> at the University <strong>of</strong> North<br />
Carolina in Chapel Hill. 1<br />
‘‘We want to take a big-tent approach and broaden<br />
our audience to scholars outside the accounting community,’’<br />
said Douglas A. Shackelford, the Meade H.<br />
Willis Distinguished Pr<strong>of</strong>essor <strong>of</strong> Taxation at UNC.<br />
‘‘Accountants know the difference between reported <strong>tax</strong><br />
expenses and actual <strong>tax</strong>es paid. It is time for others to<br />
understand the implication <strong>of</strong> this difference.’’<br />
The importance <strong>of</strong> this outreach should not be underestimated<br />
as accounting rule makers and <strong>tax</strong> policymakers<br />
begin to focus on issues such as how differences<br />
in book and <strong>tax</strong> accounting may lead firms to<br />
manipulate their financial statements, <strong>tax</strong> filings, or<br />
both, Shackelford added.<br />
Pr<strong>of</strong>. Joel Slemrod <strong>of</strong> the University <strong>of</strong> Michigan<br />
warned that economists might be missing the policy<br />
impact because they ignore the financial accounting<br />
issues. ‘‘This could be a really, really big issue. If financial<br />
decisions are correlated across firms with respect<br />
to <strong>tax</strong> policy, the errors we make might be compounded,’’<br />
Slemrod said.<br />
Accounting for Income Taxes<br />
Public corporations expend much effort properly<br />
accounting for their income <strong>tax</strong>es, yet practitioners rou-<br />
1 The UNC Tax Symposium papers are available at http://<br />
areas.kenan-flagler.unc.edu/Accounting/<strong>tax</strong>sym09/Pages/<br />
AcceptedPapers.aspx.<br />
tinely condemn the poor quality <strong>of</strong> the information,<br />
implying that it is relatively useless. However, researchers<br />
disagree, as they use these data to analyze<br />
many issues concerning the <strong>tax</strong> position <strong>of</strong> public corporations.<br />
The <strong>tax</strong> information reported in financial accounts<br />
is critically important to researchers for one simple reason:<br />
The <strong>tax</strong> information reported on corporate <strong>tax</strong><br />
returns is confidential. Thus, financial statements are<br />
generally the only source <strong>of</strong> public information about a<br />
corporation’s <strong>tax</strong> situation.<br />
The reliability <strong>of</strong> financial information is important<br />
not only in the academic world, but also in the real<br />
world. Policymakers regularly rely on financial statement<br />
<strong>tax</strong> information, and studies based on that information,<br />
to guide their <strong>tax</strong> policies. Thus, understanding<br />
the real implications <strong>of</strong> how firms account for their<br />
income <strong>tax</strong>es is one <strong>of</strong> the most critical issues <strong>tax</strong><br />
policy analysts face today.<br />
Along with coauthors John Graham <strong>of</strong> Duke University<br />
and Jana Smith Raedy <strong>of</strong> UNC, Shackelford<br />
presented the report, ‘‘Research in Accounting for Income<br />
Taxes,’’ highlighting the importance <strong>of</strong> understanding<br />
how the financial accounting treatment <strong>of</strong> income<br />
<strong>tax</strong>es has a real effect on <strong>tax</strong> policy.<br />
For example, the authors note that when <strong>tax</strong> law<br />
and financial accounting treat transactions in the same<br />
manner, the accounting for income <strong>tax</strong>es is ‘‘straightforward,<br />
intuitive, and relatively simple.’’ But when<br />
book and <strong>tax</strong> treatment differ, the <strong>tax</strong> accounts can<br />
materially affect both the income statements and balance<br />
sheets, the authors cautioned.<br />
Those book-<strong>tax</strong> differences are not trivial. The most<br />
recent IRS data from 2005 show that corporations reported<br />
about $32 billion less in <strong>tax</strong>able income than in<br />
book income, which reduced their 35 percent statutory<br />
<strong>tax</strong> rate to an effective <strong>tax</strong> rate <strong>of</strong> about 23.5 percent.<br />
The authors evaluate how well the <strong>tax</strong> information<br />
in financial statements does in approximating actual<br />
<strong>tax</strong> return information and for assessing a firm’s <strong>tax</strong><br />
strategy. In a word, the answer is ‘‘poorly.’’ This poor<br />
performance is not the fault <strong>of</strong> the accounting statements,<br />
which are designed to provide information<br />
about the firm’s financial condition and not its <strong>tax</strong> status.<br />
But more worrisome to the authors is that ‘‘attempts<br />
to extract confidential <strong>tax</strong> return information<br />
TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 371<br />
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
HIGHLIGHTS<br />
from the <strong>tax</strong> accounts in the financial statements can<br />
lead to erroneous and misleading inferences.’’<br />
The confidentiality <strong>of</strong> corporate <strong>tax</strong> returns, however,<br />
places researchers in an unenviable position.<br />
Either they apply to the IRS for permission to use confidential<br />
data, as many researchers have done, or they<br />
develop ways to tease <strong>tax</strong> information out <strong>of</strong> the financial<br />
reports. Shackelford and his coauthors chose the<br />
latter path and suggest ways to use this imperfect public<br />
information to better approximate information in<br />
the confidential <strong>tax</strong> return.<br />
Book-Tax Differences<br />
As Shackelford noted, accountants and the IRS frequently<br />
take different views <strong>of</strong> what constitutes income.<br />
For a given accounting definition, the differences<br />
in book and <strong>tax</strong> treatment largely arise from <strong>tax</strong> legislation<br />
designed to encourage a specific behavior, such as<br />
additional investment spending or simplification.<br />
These differences may be permanent or only temporary.<br />
For example, the <strong>tax</strong> law exempts municipal bond<br />
income from <strong>tax</strong>, while accounting rules include the<br />
income in book income. This creates a permanent difference<br />
between book and <strong>tax</strong> income and will drive<br />
down the reported effective <strong>tax</strong> rate (the income <strong>tax</strong><br />
expense divided by net income before <strong>tax</strong>es) in the financial<br />
statements. The income <strong>tax</strong> expense is the<br />
product <strong>of</strong> the statutory <strong>tax</strong> rate and book income adjusted<br />
for permanent differences.<br />
Temporary differences in book and <strong>tax</strong> income generally<br />
do not cause effective and statutory <strong>tax</strong> rates to<br />
differ. However, because permanent differences in book<br />
and <strong>tax</strong> income reduce the effective <strong>tax</strong> rate, corporate<br />
managers likely value transactions that reduce permanent<br />
income more highly than those that reflect only<br />
temporary differences in <strong>tax</strong> payments.<br />
Those differences have drawn the attention <strong>of</strong> many<br />
researchers. David Weisbach 2 and George Plesko 3 have<br />
argued that firms seek to enter <strong>tax</strong> shelters precisely<br />
because they permanently reduce income reported to<br />
the government while having no impact on financial<br />
statement earnings. Mihir Desai 4 suggests that the unexplained<br />
growth in book-<strong>tax</strong> differences may largely<br />
be explained by the growth in <strong>tax</strong> shelters. Jeri<br />
2 David Weisbach, ‘‘Ten Truths About Tax Shelters,’’ 55 Tax<br />
Law Review, 215-253 (2002).<br />
3<br />
George Plesko, ‘‘Corporate Tax Avoidance and the Properties<br />
<strong>of</strong> Corporate Earnings,’’ LVIII National Tax Journal, 729-737<br />
(2004).<br />
4<br />
Mihir Desai, ‘‘The Divergence Between Book Income and<br />
Tax Income,’’ Tax Policy and the Economy 17, edited by James M.<br />
Poterba, National Bureau <strong>of</strong> Economic Research and MIT Press<br />
(Cambridge, Mass.), 169-206 (2003).<br />
Seidman5 examined data from 1995 to 2004 and found<br />
that after narrowing during the 2001 economic downturn,<br />
the book-<strong>tax</strong> gap significantly widened in 2003<br />
partly because <strong>of</strong> earnings management.<br />
These book-<strong>tax</strong> differences are not inconsequential.<br />
As the Senate Homeland Security and Governmental<br />
Affairs Permanent Subcommittee on Investigations6 noted when investigating the collapse <strong>of</strong> Enron, the<br />
firm regularly showed positive financial earnings while<br />
reporting losses for <strong>tax</strong> purposes. The committee’s report<br />
concluded that:<br />
some U.S. financial institutions have been designing,<br />
participating in, and pr<strong>of</strong>iting from complex<br />
financial transactions explicitly intended to help<br />
U.S. public companies engage in deceptive accounting<br />
or <strong>tax</strong> strategies. This evidence also<br />
shows that some U.S. financial institutions and<br />
public companies have been misusing structured<br />
finance vehicles, originally designed to lower financing<br />
costs and spread investment risk, to carry<br />
out sham transactions that have no legitimate<br />
business purpose and mislead investors, analysts,<br />
and regulators about companies’ activities, <strong>tax</strong><br />
obligations, and true financial condition.<br />
While no one has yet accused any <strong>of</strong> the companies<br />
involved in the current financial crisis <strong>of</strong> engaging in<br />
Enron-style abuses, I believe something seems wrong<br />
when a company can regularly report high, positive<br />
earnings to the financial community while reporting<br />
low or no <strong>tax</strong>able income to the <strong>tax</strong> authorities.<br />
The Treasury Department had already placed book<strong>tax</strong><br />
differences under suspicion in its 1999 <strong>tax</strong> shelter<br />
study. (See Doc 1999-22641 or 1999 WTD 128-43 and Doc<br />
1999-22867 or 1999 WTD 128-44.) Whether <strong>tax</strong> shelters<br />
or other, innocuous <strong>tax</strong> planning explains today’s book<strong>tax</strong><br />
differences has yet to be determined. I believe the<br />
IRS is years away from providing the data necessary to<br />
determine the extent to which a favorable interaction<br />
between financial and <strong>tax</strong> reporting contributed to the<br />
current financial crisis.<br />
Shining a Spotlight on the Accounts<br />
Because corporate <strong>tax</strong> returns are not public, it is<br />
difficult to determine whether book-<strong>tax</strong> differences indicate<br />
that the firm is participating in a <strong>tax</strong> shelter or<br />
whether it has legitimate <strong>tax</strong> deductions. Researchers<br />
without access to <strong>tax</strong> data have had to look elsewhere.<br />
5<br />
Jeri Seidman, ‘‘Interpreting Fluctuations in the Book-Tax<br />
Income Gap as Tax Sheltering: Alternative Explanations,’’ working<br />
paper, University <strong>of</strong> Texas (2008).<br />
6<br />
U.S. Congress, Senate Committee on Governmental Affairs,<br />
‘‘Report on Fishtail, Bacchus, Sundance, and Slapshot: Four Enron<br />
Transactions Funded and Facilitated by U.S. Financial Institutions,’’<br />
Permanent Subcommittee on Investigations, Jan. 2,<br />
2003. For a reference to the study, see Doc 2003-511 or 2003 TNT<br />
2-22.<br />
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A few years ago, Lillian Mills, Kaye Newberry, and<br />
William Trautman7 turned the spotlight on areas where<br />
the <strong>tax</strong> community may wish to start looking. First,<br />
financial firms and multinational corporations report<br />
the largest gap between book and <strong>tax</strong>able income, and<br />
the gap is concentrated among the largest firms. Second,<br />
<strong>of</strong>f-balance-sheet structured transactions or special<br />
purpose entities accounted for part <strong>of</strong> the differences.<br />
These researchers may be on to something big. Offbalance-sheet<br />
structured transactions and special purpose<br />
entities have been identified as culprits behind the<br />
economic crisis. And financial institutions are the primary<br />
players in this game.<br />
As much as he might have liked to use that evidence<br />
to conclude that firms exploit book-<strong>tax</strong> differences,<br />
Shackelford could not reassure users <strong>of</strong> financial statements<br />
that their data were up to the task. As the study<br />
<strong>notes</strong>, because we do not know whether using the best<br />
publicly available firm-level <strong>tax</strong> data ‘‘leads to minor<br />
mismeasurement or substantial errors in scholarship,<br />
practice, and policy,’’ we should ‘‘interpret scholarly<br />
findings with caution.’’<br />
Firms’ ability to increase their book income without<br />
increasing their <strong>tax</strong> liability has led many to call for<br />
conformity between the two measures. However, there<br />
is no agreement on the wisdom <strong>of</strong> that move. John<br />
McClelland <strong>of</strong> the Treasury Department and Lillian<br />
Mills <strong>of</strong> the University <strong>of</strong> Texas8 summarized the pros<br />
and cons <strong>of</strong> conformity and came out in favor <strong>of</strong> continuing<br />
nonconformity. Shackelford also reports that a<br />
study by Danqing Young and David A. Guenther9 <strong>of</strong><br />
book and <strong>tax</strong> conformity in 13 countries reveals that<br />
countries with a high degree <strong>of</strong> conformity exhibit reduced<br />
<strong>international</strong> capital mobility. From his survey<br />
<strong>of</strong> the issue, Shackelford concludes that ‘‘the empirical<br />
evidence suggests that conformity would adversely affect<br />
the information that financial reports provide the<br />
capital markets.’’ Shackelford calls for more research<br />
rather than for continued nonconformity.<br />
International Financial Reporting Standards<br />
Some conference participants mentioned that because<br />
they require more disclosure than U.S. generally<br />
accepted accounting principles, the move to <strong>international</strong><br />
financial reporting standards might help address<br />
the issues that arise under book-<strong>tax</strong> nonconformity. In<br />
7 Lillian Mills, Kaye Newberry, and William Trautman,<br />
‘‘Trends in Book-Tax Income and Balance Sheet Differences,’’<br />
Tax Notes, Aug. 19, 2002, p. 1109, Doc 2002-19155, or2002 TNT<br />
161-49.<br />
8 John McClelland and Lillian Mills, ‘‘Weighing Benefits and<br />
Risks <strong>of</strong> Taxing Book Income,’’ Tax Notes, Feb. 19, 2007, p. 779,<br />
Doc 2007-1810, or2007 TNT 35-61.<br />
9 Danqing Young and David A. Guenther, ‘‘Financial Reporting<br />
Environments and International Capital Mobility,’’ 41 Journal<br />
<strong>of</strong> Accounting Research, 553-579 (2003).<br />
HIGHLIGHTS<br />
August 2008 the Securities and Exchange Commission<br />
issued for comment a proposal to start allowing voluntary<br />
adopting <strong>of</strong> IFRS, and eventual mandatory adoption<br />
beginning in fiscal 2014. A more general move to<br />
adapt U.S. rules to IFRS may be postponed. The Global<br />
Oversight Committee <strong>of</strong> the Financial Executives<br />
Institute recently removed the Accounting Principles<br />
Board (APB) Opinion No. 23, ‘‘Accounting for Income<br />
Taxes — Special Areas,’’ exception for the treatment <strong>of</strong><br />
permanently reinvested earnings (PRE) from the convergence<br />
project.<br />
Other conference participants warned that although<br />
the accounting pr<strong>of</strong>ession is moving toward <strong>international</strong><br />
rules, the U.S. Congress might be unwilling to<br />
cede its ability to provide <strong>tax</strong> incentives to an <strong>international</strong><br />
forum.<br />
Earnings Management<br />
The General Rule<br />
With Congress considering reintroducing a temporary<br />
dividend repatriation <strong>tax</strong> holiday, the way that<br />
corporations account for their foreign earnings may<br />
greatly influence whether a corporation repatriates dividends.<br />
That only a fraction <strong>of</strong> the firms that could<br />
have participated in the 2004 dividend repatriation <strong>tax</strong><br />
holiday took advantage <strong>of</strong> it suggests that the repatriation<br />
decision may be more complicated than initially<br />
understood.<br />
In general, a U.S. multinational pays U.S. <strong>tax</strong> on<br />
foreign earnings only when it receives the dividend<br />
from its foreign subsidiary. However, the accounting<br />
and the <strong>tax</strong> rules differ in how they treat the <strong>tax</strong> liability<br />
associated with those foreign earnings. And it is<br />
that difference that can lead firms to alter their financial<br />
decisions to benefit from the <strong>tax</strong> provisions.<br />
Under GAAP, firms immediately recognize both<br />
their foreign earnings and the expected <strong>tax</strong> associated<br />
with those foreign earnings, although they pay the <strong>tax</strong><br />
only when the earnings are repatriated to the United<br />
States. Thus, for accounting purposes, the firm takes a<br />
hit on its financial earnings, but it benefits by avoiding<br />
an earnings reduction when it later repatriates the<br />
earnings.<br />
That companies may continually reinvest their foreign<br />
earnings complicates the decision. Because many<br />
firms never expect to return their foreign earnings to<br />
the U.S., the accounting rules under APB 23 have,<br />
since 1972, provided an exception to that general rule<br />
that allows the firm to disclose its potential U.S. <strong>tax</strong><br />
liability only in a footnote to its financial statements.<br />
This treatment creates a permanent difference between<br />
book and <strong>tax</strong>able income. The firm immediately benefits<br />
when it declares that it is permanently reinvesting<br />
its foreign earnings, because it recognizes those earnings<br />
without recognizing a related <strong>tax</strong> expense for the<br />
residual U.S. <strong>tax</strong> on those earnings.<br />
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HIGHLIGHTS<br />
However, if the firm reconsiders and later decides to<br />
repatriate those earnings, it faces a disadvantage because<br />
it must recognize an income <strong>tax</strong> expense on<br />
those earnings but cannot recognize any earnings because<br />
it has already recognized the income in an earlier<br />
accounting period. So firms that decide to repatriate<br />
PRE face a dilemma: Should they take advantage<br />
<strong>of</strong> the <strong>tax</strong> holiday and repatriate the earnings despite<br />
the reduction in earnings, or should they continue to<br />
reinvest the earnings abroad and skip the <strong>tax</strong> holiday?<br />
As demonstrated by the surge in dividend repatriations,<br />
many firms decided the <strong>tax</strong> benefit outweighed the adverse<br />
impact on earnings.<br />
The bottom line is that firms can increase their financial<br />
earnings without increasing their <strong>tax</strong> liability<br />
by increasing the amount <strong>of</strong> foreign pr<strong>of</strong>its designated<br />
as PRE. This incentive to manipulate earnings is one<br />
<strong>of</strong> many possibly unintended consequences that the<br />
differences between book and <strong>tax</strong> accounting may have<br />
on real behavior — the repatriation <strong>of</strong> foreign earnings.<br />
International Effects <strong>of</strong> the PRE<br />
Multinational firms benefit from their PRE in many<br />
ways. Empirical evidence suggests that they take advantage<br />
<strong>of</strong> the discretion allowed under GAAP to designate<br />
at least some portion <strong>of</strong> their foreign earnings as<br />
permanently reinvested abroad so that they have the<br />
flexibility to manage their earnings as needed to meet<br />
market expectations. Shackelford and his coauthors<br />
discussed research showing that the amount firms report<br />
as PRE depends on the difference between analysts’<br />
forecasts and their premanaged earnings.<br />
This discretion in the treatment <strong>of</strong> foreign earnings<br />
may have unintended consequences. Linda Krull10 <strong>of</strong><br />
the University <strong>of</strong> Oregon examined the disclosures in<br />
the financial statements <strong>of</strong> 267 multinational firms<br />
from the 1990s and found that firms took advantage <strong>of</strong><br />
the discretion allowed under the accounting rules to<br />
actively manage their PRE. Her research revealed that<br />
when the firms increased their PRE, their earnings rose<br />
by an amount sufficient to meet analyst expectations.<br />
Krull also noted that given the minimal information<br />
that firms report about their foreign operations, it is<br />
difficult for analysts to understand the source <strong>of</strong> these<br />
additional earnings. As one conference participant<br />
noted, stock analysts sometimes lack the expertise or<br />
experience to understand these variations in earnings<br />
reporting.<br />
So it isn’t surprising that multinational firms have<br />
accumulated more than $600 billion in permanent reinvestment<br />
foreign earnings since the dividend repatria-<br />
10 Linda Krull, ‘‘Permanently Reinvested Foreign Earnings,<br />
Taxes, and Earnings Management,’’ 79 The Accounting Review<br />
745-767 (2004).<br />
tion <strong>tax</strong> holiday expired. The discretion allowed under<br />
the accounting rules makes this behavior an acceptable<br />
way to manage earnings. However, as Krull noted in<br />
her paper, firms that report large fluctuations in PRE<br />
as the <strong>tax</strong> treatment <strong>of</strong> dividend repatriations changes<br />
might deserve greater scrutiny regarding how long the<br />
firms actually intend to reinvest the earnings abroad.<br />
More on the Lock-In Effect<br />
Krull and Leslie Robinson, in a paper titled ‘‘Is U.S.<br />
Multinational Intra-Firm Dividend Policy Influenced<br />
by Capital Market Incentives?,’’ revisited the issue <strong>of</strong><br />
the lock-in effect <strong>of</strong> the dividend repatriation <strong>tax</strong>. The<br />
paper identifies two major disincentives public firms<br />
face — an actual cash <strong>tax</strong> liability and a reduction in<br />
their reported pre<strong>tax</strong> earnings — when deciding<br />
whether to repatriate their foreign earnings to the<br />
United States.<br />
That research shows that financial accounting rules<br />
can and do have large impacts on the real economy.<br />
For example, because the accounting rules do not require<br />
firms to report a <strong>tax</strong> expense on PRE, firms<br />
(such as those operating in low-<strong>tax</strong> countries that did<br />
not have foreign <strong>tax</strong> credits from high-<strong>tax</strong> countries<br />
that would shield their repatriations) may have been<br />
encouraged to accumulate their earnings abroad rather<br />
than repatriate them to the United States.<br />
Prior research on the impact <strong>of</strong> the American Jobs<br />
Creation Act <strong>of</strong> 2004 largely ignored the financial accounting<br />
cost <strong>of</strong> repatriation. Krull and Robinson’s<br />
study shows that capital market pressures to report<br />
high earnings deter firms from repatriating their foreign<br />
earnings and that those pressures are consistent with<br />
both the buildup in undistributed foreign earnings and<br />
the surge in dividend repatriations under the Jobs Act.<br />
This example demonstrates that financial rules had a<br />
clear impact on real <strong>tax</strong> decisions.<br />
Firms have many avenues to minimize the repatriation<br />
<strong>tax</strong> cost, whether through borrowing funds abroad,<br />
corporate reorganizations, or by routing income<br />
through low-<strong>tax</strong> locations and expenses through high<strong>tax</strong><br />
locations. As Krull noted, however, ‘‘These effects<br />
are not costless.’’ Firms incur many costs — whether<br />
in the form <strong>of</strong> actual <strong>tax</strong> expenses or in compliance<br />
and <strong>tax</strong> planning costs — to minimize the <strong>tax</strong> on returning<br />
their earnings to the United States. To the list<br />
<strong>of</strong> well-known <strong>tax</strong> costs to repatriation, Krull and Robinson<br />
add financial reporting costs.<br />
The <strong>tax</strong> and accounting rules converge in one area.<br />
Because firms can defer their U.S. <strong>tax</strong> liability on foreign<br />
earnings until they are repatriated, the <strong>tax</strong> code<br />
creates a lock-in effect to keep earnings <strong>of</strong>fshore, and<br />
the accounting rules reinforce that effect. As Krull and<br />
Robinson noted, ‘‘The results <strong>of</strong> this study provide evidence<br />
that APB 23 creates incentives to leave earnings<br />
<strong>of</strong>fshore.’’ Conference participants added another cost<br />
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(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
to the dividend repatriation <strong>tax</strong> — a cost to the competitiveness<br />
<strong>of</strong> U.S. companies. Two <strong>of</strong> the United<br />
States’ major trading partners, Japan and the United<br />
Kingdom, are moving away from <strong>tax</strong>ing dividend repatriations,<br />
while a third major partner, the Netherlands,<br />
has few restrictions on income repatriations.<br />
The evidence is overwhelming that the U.S. <strong>international</strong><br />
<strong>tax</strong> system badly needs reform. I believe it is<br />
time for Congress to add the financial reporting and<br />
the competitiveness costs when it considers changing<br />
the <strong>tax</strong> treatment <strong>of</strong> the foreign pr<strong>of</strong>its <strong>of</strong> U.S. multinational<br />
corporations.<br />
Cross-Country Differences in Tax Systems<br />
Slemrod, along with coauthor Leslie Robinson <strong>of</strong><br />
the <strong>Tuck</strong> <strong>School</strong> <strong>of</strong> <strong>Business</strong> at <strong>Dartmouth</strong> <strong>College</strong>,<br />
took a global view <strong>of</strong> <strong>tax</strong> systems. They took advantage<br />
<strong>of</strong> new OECD information to analyze how variations<br />
in <strong>tax</strong> systems beyond the <strong>tax</strong> rate and the <strong>tax</strong><br />
base affect real economic behavior. Their study, ‘‘Measuring<br />
the Impact <strong>of</strong> Tax Systems on Economic Behavior<br />
Using New Cross-Country Data,’’ examined how<br />
variations in <strong>tax</strong> administration, enforcement, withholding,<br />
and corruption, for example, help explain<br />
variations in economic behavior across countries.<br />
‘‘Tax systems are multidimensional,’’ Robinson explained.<br />
‘‘Ignoring these differences may skew our view<br />
<strong>of</strong> how <strong>tax</strong> rates affect economic behavior. Leaving out<br />
important aspects <strong>of</strong> <strong>tax</strong> systems may bias estimated<br />
partial effects <strong>of</strong> <strong>tax</strong> rates, and/or miss entirely the effects<br />
<strong>of</strong> other <strong>tax</strong> system features.’’ For example, while<br />
prior research has shown that countries with high <strong>tax</strong><br />
rates tend to have a smaller informal sector, Robinson<br />
noted that the <strong>tax</strong> rate impact largely disappears once<br />
<strong>tax</strong> administration is taken into account. Somewhat<br />
counterintuitively, she found that although countries<br />
with high penalty rates have a smaller informal<br />
economy, countries that use extensive withholding systems<br />
have larger informal sectors.<br />
The reason, she suggests, is that withholding systems<br />
make it less attractive to work in the formal sector,<br />
because withholding makes it difficult to avoid paying<br />
<strong>tax</strong>es. Given that more corrupt countries exhibit<br />
greater use <strong>of</strong> withholding, that may partially explain<br />
why prior research has found a strong positive association<br />
between corruption and the informal sector.<br />
One main benefit <strong>of</strong> Slemrod and Robinson’s paper<br />
is that it references a 2006 OECD report 11 that provides<br />
<strong>international</strong>ly comparable data on the aspects <strong>of</strong><br />
<strong>tax</strong> systems in 30 OECD countries and 14 non-OECD<br />
countries.<br />
11 For the report Tax Administration in OECD and Selected Non-<br />
OECD Countries: Comparative Information Series, see Doc 2006-22140<br />
or 2006 WTD 210-10; for related coverage, see Tax Notes Int’l,<br />
Sept. 25, 2006, p. 1046, Doc 2006-19457, or2006 WTD 180-2.<br />
HIGHLIGHTS<br />
It’s no surprise that <strong>tax</strong> systems vary significantly<br />
across countries — some countries have effective <strong>tax</strong><br />
administrations, while others have weak administrations;<br />
some countries tend to rely on withholding,<br />
while others rely on self-assessment; some countries<br />
have strong debt collection powers, while others have<br />
low ratios <strong>of</strong> <strong>tax</strong> administrators per worker.<br />
Until the OECD published its data, researchers had<br />
no comparable cross-country information on how <strong>tax</strong><br />
systems varied, other than in their rates and their<br />
bases, and so could not examine the factors that explained<br />
why <strong>tax</strong> systems varied across countries. Slemrod<br />
and Robinson used the OECD data to show that<br />
<strong>tax</strong> system differences affect real economic behavior,<br />
because they affect how the <strong>tax</strong>payer perceives the expected<br />
<strong>tax</strong> burden triggered by its actions.<br />
The authors also explore a well-known <strong>tax</strong> fact:<br />
Rich countries levy more <strong>tax</strong>es per capita than poor<br />
countries. The OECD data confirm that, but also show<br />
that <strong>tax</strong> systems in high-income countries tend to share<br />
some characteristics and that there may be underlying<br />
factors about those countries that explain the <strong>tax</strong> burden.<br />
Relative to low-income countries, high-income countries<br />
impose withholding and reporting on fewer types<br />
<strong>of</strong> income, have fewer powers to facilitate debt collection,<br />
impose lower penalties, are less likely to use selfassessment<br />
principles, and hire more <strong>tax</strong> administrators,<br />
but they do not spend significantly more on<br />
administrative costs as a share <strong>of</strong> income.<br />
For example, Luxembourg, Iceland, and the Netherlands<br />
are in the top per capita income quartile but tend<br />
to fall in the lowest quartiles for penalty rates, withholding<br />
<strong>tax</strong>es, and information reporting. Chile, China,<br />
and South Africa fall in the lowest income bracket but<br />
tend to fall in the highest brackets for imposing penalties,<br />
levying withholding <strong>tax</strong>es, and relying on information<br />
reporting.<br />
Those correlations suggest that high-income countries<br />
tend to design their <strong>tax</strong> systems in ways that explain<br />
why those countries have a relatively high <strong>tax</strong><br />
burden. As Robinson noted, an analysis that considers<br />
only <strong>tax</strong> rates will miss the effect <strong>of</strong> other factors that<br />
may affect the size <strong>of</strong> the informal economy and may<br />
bias the estimates <strong>of</strong> how <strong>tax</strong> rates affect <strong>tax</strong> burdens.<br />
Robinson said it might be a variation in <strong>tax</strong> system<br />
design that is correlated with national income, rather<br />
than national income itself, that affects a country’s <strong>tax</strong><br />
burden.<br />
In conclusion, Slemrod emphasized: ‘‘Leaving out<br />
consideration <strong>of</strong> administrative issues can lead to severely<br />
biased measures <strong>of</strong> the role <strong>of</strong> <strong>tax</strong> rates in the<br />
economy.’’<br />
♦ Joann M. Weiner is a contributing editor to Tax<br />
Analysts. E-mail: jweiner@<strong>tax</strong>.org<br />
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HIGHLIGHTS<br />
NEWS ANALYSIS<br />
Multinationals Accumulate to<br />
Repatriate<br />
by Lee A. Sheppard and Martin A. Sullivan<br />
Printing lots <strong>of</strong> unsecured money is bad enough. Frittering<br />
it away on courtiers is worse.<br />
That was historian Paul Kennedy writing in The<br />
Wall Street Journal about the coming stimulus bill and<br />
the dismal prospects for gargantuan U.S. budget deficits<br />
stretching into the future (The Wall Street Journal, Jan.<br />
14, 2008, p. A13).<br />
Elsewhere in his piece, Kennedy compared the U.S.<br />
budget to that <strong>of</strong> ‘‘Iceland or some poorly run Third<br />
World economy.’’ He could have mentioned Italy,<br />
which routinely incurs government debt equal to GDP,<br />
but has the luxury <strong>of</strong> selling its debt to its own citizens.<br />
The United States does not have that luxury, and<br />
Kennedy predicts that the Chinese purchasers <strong>of</strong> U.S.<br />
government debt will demand higher interest.<br />
Our subject today, however, is the courtiers asking<br />
that money be frittered away on them in the stimulus<br />
bill. Big pharma, s<strong>of</strong>tware companies, and financial<br />
intermediaries have accumulated vast amounts <strong>of</strong> foreign<br />
pr<strong>of</strong>its that some <strong>of</strong> them are lobbying to repatri-<br />
Billions<br />
$800<br />
$700<br />
$600<br />
$500<br />
$400<br />
$300<br />
$200<br />
$100<br />
$0<br />
ate at very low <strong>tax</strong> rates. Since 2005, they have accumulated<br />
foreign pr<strong>of</strong>its at a greater rate than<br />
historically.<br />
Well, so what, don’t they just have very pr<strong>of</strong>itable<br />
foreign operations? Data examined in this article<br />
strongly suggest that section 965 may have encouraged<br />
more shifting <strong>of</strong> pr<strong>of</strong>its <strong>of</strong>fshore than usual in preparation<br />
for another repatriation <strong>tax</strong> holiday. Of course,<br />
multinationals have always had ample incentives to<br />
shift pr<strong>of</strong>its <strong>of</strong>fshore. Section 965 enlarged their incentives<br />
to do so. This phenomenon argues that repatriation<br />
<strong>tax</strong> holidays have the effect <strong>of</strong> encouraging the<br />
very behaviors they were intended to reverse. In short,<br />
another repatriation <strong>tax</strong> holiday would constitute frittering<br />
<strong>of</strong> stimulus <strong>of</strong> a high order.<br />
After their last repatriation <strong>tax</strong> holiday, U.S. multinationals<br />
went back to work building up earnings in<br />
foreign jurisdictions. Here we show the increase in undistributed<br />
foreign earnings <strong>of</strong> 40 <strong>of</strong> the largest U.S.<br />
corporations since the American Jobs Creation Act <strong>of</strong><br />
2004 allowed them ‘‘one-time’’ dividend relief. Although<br />
these 40 multinationals account for less than 5<br />
percent <strong>of</strong> the 832 multinationals that repatriated earnings<br />
under the Jobs Act provision, they received 44<br />
percent <strong>of</strong> the total $362 billion <strong>of</strong> repatriated earnings,<br />
as reported by the IRS. (Melissa Redmiles, ‘‘The<br />
One-Time Received Dividend Deduction,’’ IRS Statistics<br />
<strong>of</strong> Income Bulletin, spring 2008.)<br />
Figure 1. Accumulated Foreign Earnings <strong>of</strong> 40 U.S. Multinationals, 2002-2007<br />
$261.7<br />
$321.8<br />
$389.4<br />
$484.4<br />
$300.3<br />
$580.7<br />
$395.9<br />
2002 2003 2004 2005 2006 2007<br />
Fiscal Years<br />
Source: Company annual reports as shown in table.<br />
Simulated Assuming No Jobs Act<br />
Actual Accumulated Foreign Earnings<br />
376 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL<br />
$702.8<br />
$518.0<br />
(C) Tax Analysts 2009. All rights reserved. Tax Analysts does not claim copyright in any public domain or third party content.
Figure 2. Annual Flow <strong>of</strong> Tax-Advantaged Foreign Earnings <strong>of</strong> 40 U.S. Multinationals, 2003-2007<br />
Billions<br />
$140<br />
$120<br />
$100<br />
$80<br />
$60<br />
$40<br />
$20<br />
$0<br />
$60.1<br />
$67.6<br />
For this group <strong>of</strong> 40, the accumulated stock <strong>of</strong> unrepatriated<br />
foreign earnings hit a temporary low in<br />
2005 <strong>of</strong> $300.3 billion. Under the Jobs Act provisions,<br />
these companies repatriated a total <strong>of</strong> $184.8 billion <strong>of</strong><br />
foreign earnings — about 90 percent in that year. By<br />
the end <strong>of</strong> fiscal 2007 these multinationals had replenished<br />
their stash <strong>of</strong> unrepatriated earnings to $518 billion<br />
— a 72 percent increase in two years. These totals<br />
are shown in a solid line in Figure 1. Company-bycompany<br />
figures are presented in the table at the end<br />
<strong>of</strong> the article.<br />
Another view is provided in Figure 2. It shows<br />
growth in the stock <strong>of</strong> unrepatriated foreign earnings<br />
plus earnings repatriated under the Jobs Act. In other<br />
words, it shows the annual change in accumulated foreign<br />
earnings that would have occurred each year without<br />
the Jobs Act. This is a measure <strong>of</strong> how much<br />
pr<strong>of</strong>it multinationals are keeping <strong>of</strong>fshore to maximize<br />
<strong>tax</strong> advantages. From 2003 to 2007 the annual increase<br />
approximately doubled — from $60 billion to $122 billion.<br />
The two figures show multinationals are loading up<br />
on unrepatriated earnings at a far greater rate than before<br />
the <strong>tax</strong> holiday legislated in 2004. This is a result<br />
<strong>of</strong> higher worldwide pr<strong>of</strong>itability since the prior recession<br />
and an increasingly larger share <strong>of</strong> business activity<br />
taking place abroad. But as documented previously<br />
in these pages, it is also a result <strong>of</strong> greater pr<strong>of</strong>it shifting<br />
by multinationals out <strong>of</strong> the United States and into<br />
$95.0 $96.4<br />
$122.1<br />
2003 2004 2005<br />
Fiscal Years<br />
2006 2007<br />
Source: Dotted line in Figure 1.<br />
foreign jurisdictions. (For that discussion, see Tax Notes<br />
Int’l, Mar. 17, 2008, p. 910, Doc 2008-4725, or2008<br />
WTD 49-5.)<br />
What’s Next?<br />
HIGHLIGHTS<br />
These data suggest that the pressure for another repatriation<br />
holiday may be greater than ever. Despite<br />
this, it looks like the growing opposition could thwart<br />
any repeat.<br />
First <strong>of</strong> all, there is widespread skepticism that these<br />
repatriations work as advertised. For most lawmakers,<br />
the debate about the need for a repeat <strong>of</strong> the ‘‘onetime’’<br />
<strong>tax</strong> relief for repatriated dividends centers on the<br />
economy and job creation. Did those lucky multinationals<br />
increase jobs as they told Congress they would<br />
and as they outlined in their legally required dividend<br />
repatriation investment plans? The evidence is in, and<br />
the answer clearly is no. (Dharmapala, Foley, and<br />
Forbes, ‘‘The Unintended Consequences <strong>of</strong> the Homeland<br />
Investment Act: Implications for Financial Constraints,<br />
Governance, and International Tax Policy,’’<br />
2008.)<br />
Besides job creation, there is the additional issue <strong>of</strong><br />
how temporary repatriation relief affects the web <strong>of</strong><br />
global <strong>tax</strong> checks and balances. Repeated ‘‘one-time’’<br />
relief would send a signal to multinationals that they<br />
no longer need to consider pr<strong>of</strong>its shifted <strong>of</strong>fshore as<br />
trapped. This increases the benefit <strong>of</strong> aggressive transfer<br />
pricing practices that would otherwise be held in<br />
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HIGHLIGHTS<br />
check by full <strong>tax</strong> on any unlocking <strong>of</strong> <strong>of</strong>fshore cash.<br />
And this in turn reduces U.S. <strong>tax</strong> revenue as well as<br />
provides an added incentive for multinationals to locate<br />
facilities abroad.<br />
President Barack Obama campaigned on reducing<br />
the incentives for <strong>of</strong>fshore job creation that U.S. <strong>tax</strong><br />
law provides by deferring <strong>tax</strong> on unrepatriated foreign<br />
earnings. Temporary repatriation relief is a pro-deferral<br />
provision.<br />
In early 2008, Senate Finance Committee member<br />
John Ensign, R-Nev., tried to include an amendment<br />
that would provide another round <strong>of</strong> foreign dividend<br />
relief in the Finance Committee markup <strong>of</strong> the first<br />
stimulus bill. His efforts failed then, and any repeated<br />
effort would likely run into even tougher opposition.<br />
And according to a January report by Ryan J. Donmoyer<br />
<strong>of</strong> Bloomberg News, there is little support in the<br />
House for another round <strong>of</strong> repatriation relief.<br />
<strong>Business</strong> lobbyists know all this, so now there is talk<br />
<strong>of</strong> a substitute for section 965 for multinationals whose<br />
foreign earnings are available in cash. Some policy-<br />
makers see expansion <strong>of</strong> section 956, which treats a<br />
controlled foreign corporation’s investment in U.S.<br />
property as gross income to its U.S. shareholder, as an<br />
acceptable alternative to a revival <strong>of</strong> section 965.<br />
As also reported in the Donmoyer article, Morgan<br />
Stanley, United Technologies, General Electric, and<br />
unnamed other multinationals are promoting a plan to<br />
Congress that would waive U.S. <strong>tax</strong> under subpart F<br />
on businesses that borrow from their <strong>of</strong>fshore units.<br />
This would be a statutory expansion <strong>of</strong> the section 956<br />
relief the Treasury provided in October to the general<br />
rule that loans from foreign subsidiaries should be<br />
treated as gross income. In Notice 2008-91, 2008-43<br />
IRB 1001, Doc 2008-22166, 2008 WTD 202-27, the IRS<br />
lengthened the permissible period <strong>of</strong> short-term loans<br />
from CFCs.<br />
♦ Lee A. Sheppard is a contributing editor to Tax<br />
Analysts. E-mail: lees@<strong>tax</strong>.org<br />
Martin A. Sullivan is a contributing editor to Tax<br />
Analysts. E-mail: martysullivan@comcast.net<br />
378 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL<br />
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HIGHLIGHTS<br />
Reported Accumulated Foreign Pr<strong>of</strong>its and Jobs Act Repatriations <strong>of</strong> 40 U.S. Multinational Corporations,<br />
1996-2008 (millions <strong>of</strong> dollars)<br />
Jobs Act<br />
Repatria-<br />
Company Company Fiscal Year<br />
tion<br />
Amount<br />
2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996<br />
1,200 General Electric - 62,000 47,000 36,000 29,000 21,000 15,000 * * * * * *<br />
37,000 Pfizer - 60,000 41,000 27,000 51,600 38,000 29,000 18,000 14,000 8,200 6,500 4,500 3,900<br />
- Exxon Mobil - 56,000 47,000 41,000 25,000 22,000 17,000 17,000 14,000 11,100 8,400 6,600 6,200<br />
- American<br />
International<br />
Group<br />
- 21,200 17,600 13,800 7,000 6,500 5,100 4,500 3,500 3,100 3,300 2,900 3,100<br />
3,200 Citigroup - 21,100 14,700 10,600 10,000 5,800 3,200 2,000 1,500 1,300 1,300 1,300 *<br />
- ChevronTexaco - 20,557 21,035 14,317 10,000 10,541 10,108 9,003 8,544 8,002 7,958 7,900 7,420<br />
9,500 IBM - 18,800 14,200 10,100 19,644 18,120 16,631 16,851 15,472 14,900 13,165 12,511 12,111<br />
15,900 Merck - 17,200 12,500 8,300 20,100 18,000 15,000 12,400 9,700 7,500 5,800 6,600 5,400<br />
7,200 Procter &<br />
Gamble<br />
21,000 17,000 16,000 10,300 16,750 14,021 10,698 9,231 8,828 7,764 6,739 6,108 5,078<br />
1,200 Cisco Systems 21,900 16,300 11,100 6,800 4,300 2,500 1,200 707 411 133 * * *<br />
7,500 PepsiCo - 14,700 10,800 7,500 11,900 8,800 7,500 * * * * * 4,000<br />
9,000 Bristol-Myers-<br />
Squibb<br />
- 14,100 11,300 8,400 16,900 12,600 9,000 8,800 6,000 4,400 3,200 2,600 2,506<br />
1,800 Merrill Lynch - 13,000 9,800 7,700 8,100 5,900 4,300 4,800 3,700 3,300 2,230 1,645 1,206<br />
4,300 Abbott<br />
Laboratories<br />
- 12,330 7,320 5,800 7,900 5,194 4,304 4,681 2,432 1,980 1,818 1,549 1,312<br />
2,700 Wyeth - 12,060 9,420 7,480 8,790 6,435 6,000 * * * * * *<br />
6,100 Coca-Cola - 11,900 7,700 5,100 9,800 8,200 6,100 5,900 3,700 3,400 3,600 1,917 542<br />
5,500 Altria Group - 11,000 11,000 9,300 11,800 8,600 7,100 5,600 4,700 5,800 3,400 3,000 4,200<br />
9,100 DuPont - 9,644 7,866 7,031 13,865 13,464 10,320 9,106 8,865 6,666 5,996 7,007 5,928<br />
8,000 Eli Lilly - 8,790 5,700 4,100 2,800 9,500 8,000 6,400 5,200 2,610 1,010 115 1,833<br />
- Alcoa - 8,753 8,470 7,562 7,248 6,154 5,893 4,399 3,861 1,838 1,528 1,389 1,115<br />
- Walmart Stores 10,700 8,700 6,800 5,300 4,000 2,141 1,000 722 * * * * *<br />
4,100 Dell 10,800 7,900 5,700 2,900 5,100 4,100 711 492 541 263 127 97 70<br />
14,500 Hewlett-Packard 12,900 7,700 3,100 1,200 15,000 14,400 14,500 13,200 11,500 9,000 7,100 5,200 3,800<br />
- Xerox - 7,500 7,000 3,900 6,000 5,000 5,000 3,400 5,000 4,900 4,700 4,500 3,900<br />
6,200 Intel - 6,300 4,900 3,700 7,900 7,000 6,300 5,500 4,200 2,200 2,200 1,505 992<br />
780 Micros<strong>of</strong>t 7,500 6,100 n.a. 4,100 2,300 1,640 780 * * * * * *<br />
9,400 Schering-Plough - 5,800 4,200 3,100 2,200 11,100 9,400 7,600 6,400 5,020 3,475 2,850 2,119<br />
4,000 Morgan Stanley - 5,800 4,400 3,900 5,800 4,900 4,000 4,700 4,300 3,100 2,600 2,200 *<br />
- Goldman Sachs<br />
Group<br />
- 4,970 2,900 2,400 1,650 1,100 209 * * * * * *<br />
- American<br />
Express<br />
- 4,900 3,900 3,200 2,700 2,900 2,400 2,100 1,900 1,600 1,200 873 677<br />
- Conoco Phillips - 4,381 3,597 2,773 2,091 2,046 2,171 1,687 1,661 Merger<br />
2,700 Honeywell<br />
International<br />
- 4,100 2,900 2,100 3,900 3,300 2,200 2,000 2,100 1,600 552 355 326<br />
4,600 Motorola - 4,100 4,000 2,800 5,600 6,100 7,600 7,100 7,900 * * * *<br />
2,100 International<br />
Paper<br />
- 3,700 2,700 2,400 2,700 3,300 2,500 1,800 1,800 1,200 1,100 555 361<br />
1,900 J.P. Morgan<br />
Chase Co.<br />
- 3,400 1,900 1,500 2,600 2,300 1,900 1,667 1,404 1,054 764 *<br />
755 Apple 3,800 2,400 823 1,200 972 822 755 755 755 520 437 395 395<br />
1,290 Texas<br />
Instruments<br />
- 1,620 1,290 1,010 2,034 1,604 1,293 * * * 620 870 760<br />
- Viacom - 939 457 351 155 2,000 1,900 1,600 1,600 1,400 1,500 1,500 1,300<br />
2,200 Verizon - 900 3,000 3,000 5,100 3,400 4,500 4,000 3,600 Merger<br />
1,100 Weyerhaeuser - 357 828 1,300 1,700 1,300 1,100 972 1,259 993 789 827 792<br />
Note: * indicates information not available.<br />
Source: Company annual reports.<br />
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HIGHLIGHTS<br />
U.S. Widens Investigation <strong>of</strong><br />
Swiss Bank<br />
by Randall Jackson<br />
U.S. prosecutors reportedly are expanding their investigation<br />
<strong>of</strong> the actions <strong>of</strong> UBS AG, the Swiss banking<br />
giant that has been accused <strong>of</strong> helping its U.S. clients<br />
conceal <strong>tax</strong>able assets.<br />
Officials are looking into the possibility that the<br />
bank helped tens <strong>of</strong> thousands <strong>of</strong> U.S. <strong>tax</strong>payers hide<br />
income in <strong>of</strong>fshore accounts. New evidence reportedly<br />
has led investigators to believe that the original estimate<br />
that UBS helped about 17,000 U.S. residents<br />
evade <strong>tax</strong>es may be too low and that thousands <strong>of</strong> previously<br />
unknown accounts may exist.<br />
Investigators now are looking into whether previously<br />
unidentified investment vehicles may have been<br />
used and whether divisions <strong>of</strong> the bank in addition to<br />
the previously targeted wealth management section<br />
may have been involved, according to a January 26<br />
Wall Street Journal report.<br />
The talk <strong>of</strong> additional illegal activity comes close on<br />
the heels <strong>of</strong> a January 13 order declaring former UBS<br />
<strong>of</strong>ficial Raoul Weil a fugitive. Weil failed to surrender<br />
to U.S. authorities after the November 12, 2008, unsealing<br />
<strong>of</strong> an indictment charging him with conspiring<br />
to defraud the U.S. government. (For prior coverage,<br />
see Tax Notes Int’l, Jan. 26, 2009, p. 307, Doc 2009-856,<br />
or 2009 WTD 10-1.)<br />
Weil was head <strong>of</strong> the <strong>international</strong> portion <strong>of</strong> UBS’s<br />
wealth management division from 2002 to 2007 and<br />
was appointed chair and CEO <strong>of</strong> the bank’s global<br />
wealth management and business banking division on<br />
July 6, 2007.<br />
Peter Kurer, who was appointed chair <strong>of</strong> UBS on<br />
April 23, 2008, told investors in a January 15 presentation<br />
that the bank’s key goals for 2009 include reaching<br />
a settlement with the U.S. Justice Department and ensuring<br />
the ‘‘recovery <strong>of</strong> UBS’s reputation,’’ according<br />
to the Wall Street Journal report.<br />
UBS is at the center <strong>of</strong> both criminal and civil investigations<br />
in the United States and reportedly is hoping<br />
to avoid felony indictments through ongoing talks with<br />
the Justice Department. Unnamed sources close to the<br />
discussions say UBS <strong>of</strong>ficials have <strong>of</strong>fered to confess to<br />
criminal activity and pay a fine in the neighborhood <strong>of</strong><br />
$1.2 billion as part <strong>of</strong> a deal.<br />
In the civil case, the Justice Department and the<br />
IRS reportedly are contemplating an additional, perhaps<br />
more comprehensive, summons aimed at forcing<br />
UBS to turn over the names <strong>of</strong> American account<br />
holders. On July 1, 2008, a federal judge in Miami issued<br />
a John Doe summons requiring the bank to disclose<br />
the U.S. account holders’ names. However, UBS<br />
has thus far failed to comply.<br />
Unnamed individuals involved in the case say UBS’s<br />
best hope appears to be a resolution <strong>of</strong> the criminal<br />
case while the civil case continues. Furthermore, any<br />
deal is likely to be between the U.S. government and<br />
UBS, and will not include the American <strong>tax</strong>payers allegedly<br />
involved.<br />
‘‘It’s my impression that whatever the settlement is<br />
between the bank and the U.S. government, this will<br />
not legally impact the <strong>tax</strong>ability or non-<strong>tax</strong>ability <strong>of</strong><br />
the bank’s customers,’’ William M. Sharp Sr., a Tampa<br />
<strong>tax</strong> attorney with UBS clients, said in the Journal report.<br />
The criminal case has proven particularly damaging<br />
to UBS as it tries to cope with the global financial crisis.<br />
In October 2008 the bank reportedly required a $60<br />
billion bailout from the Swiss government to stay<br />
afloat.<br />
♦ Randall Jackson is a legal reporter with Tax Notes<br />
International. E-mail: rjackson@<strong>tax</strong>.org<br />
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Indian Supreme Court Denies<br />
Vodafone Appeal<br />
by Kristen A. Parillo<br />
India’s Supreme Court on January 23 declined to<br />
hear an appeal by U.K. telecom giant Vodafone in the<br />
company’s challenge <strong>of</strong> a $2 billion capital gains <strong>tax</strong><br />
claim stemming from its 2007 merger with Indian telecom<br />
company Hutchison Essar. (For prior coverage,<br />
see Tax Notes Int’l, Dec. 15, 2008, p. 854, Doc 2008-<br />
25691, or2008 WTD 236-3.)<br />
The Court’s decision means Vodafone now will have<br />
to reply to a show-cause notice issued in September<br />
2007 by the Indian Income Tax Department demanding<br />
that the company explain why it should not be<br />
treated as an ‘‘assessee in default’’ for failure to withhold<br />
<strong>tax</strong> when it acquired the controlling stake in<br />
Hutchison Essar. The <strong>tax</strong> department will then take a<br />
HIGHLIGHTS<br />
‘‘final view’’ on the issue <strong>of</strong> Vodafone’s <strong>tax</strong> liability,<br />
said Sishir Jha, a spokesman for India’s Central Board<br />
<strong>of</strong> Direct Taxes.<br />
In February 2007 Vodafone (through its Dutch unit,<br />
International Holdings BV) paid Hong Kong-based<br />
Hutchison Telecom International Ltd. (HTIL) $11.2<br />
billion for the entire share capital <strong>of</strong> CGP Investments<br />
(Holdings), a Cayman Islands entity. CGP Investments,<br />
through a chain <strong>of</strong> intermediary entities (including<br />
Mauritius entities), indirectly held a 67 percent stake in<br />
Hutchison Essar, which at the time was India’s fourthlargest<br />
mobile phone company.<br />
India’s <strong>tax</strong> authorities claim that Vodafone should<br />
have withheld approximately $2 billion in CGT at source<br />
when it paid HTIL. The authorities maintain that because<br />
most <strong>of</strong> the assets were in India, the deal was subject<br />
to Indian CGT, and that under Indian law the buyer<br />
AP Photo/Martin Meissner<br />
Vodafone hit another dead-end as it continues to challenge Indian <strong>tax</strong> authorities' claim that the telecom giant failed to<br />
withhold $2 billion in capital gains <strong>tax</strong>.<br />
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HIGHLIGHTS<br />
is required to withhold CGT and pay it to the government.<br />
In September 2007 the authorities issued showcause<br />
notices to Vodafone and Vodafone Essar. (The notice<br />
to the latter demanded that the company explain<br />
why it should not be treated as an agent, or representative<br />
assessee, <strong>of</strong> Vodafone under Indian <strong>tax</strong> law.)<br />
Vodafone and Vodafone Essar challenged the showcause<br />
notices in writ petitions filed with the Bombay<br />
High Court in October 2007. Vodafone argued that it<br />
had no Indian <strong>tax</strong> liability on the transaction because<br />
the transfer <strong>of</strong> shares took place outside <strong>of</strong> India and<br />
that any <strong>tax</strong> liability lies with the seller <strong>of</strong> the shares<br />
— that is, HTIL — and not the buyer.<br />
The company submitted an amended writ petition in<br />
June 2008 challenging the constitutionality <strong>of</strong> a retroactive<br />
amendment to India’s <strong>tax</strong> laws in May 2008 that<br />
widened the scope <strong>of</strong> the term ‘‘assessee in default’’ for<br />
withholding <strong>tax</strong> purposes, thereby enabling Indian <strong>tax</strong><br />
authorities to take action against companies that do<br />
not withhold <strong>tax</strong>es when making a transaction.<br />
The High Court dismissed Vodafone’s petition on<br />
December 3, 2008. (Vodafone Essar’s petition is still<br />
pending.) Vodafone later filed an appeal with the Indian<br />
Supreme Court.<br />
Appeal Dismissed<br />
At a January 23 hearing on the matter, the Supreme<br />
Court declined to intervene and directed the Income<br />
Tax Department to decide whether it has jurisdiction<br />
to <strong>tax</strong> the transaction, saying that ‘‘the substantial<br />
question <strong>of</strong> law raised in the petition is left open.’’ The<br />
Court said that if the authorities decide against<br />
Vodafone on the jurisdictional issue, the company can<br />
challenge the decision in the High Court.<br />
The Supreme Court seemed to suggest that<br />
Vodafone’s petition was filed prematurely. ‘‘It’s only a<br />
show-cause notice,’’ Justice S.B. Sinha reportedly told<br />
Vodafone’s counsel. The Court further questioned why<br />
Vodafone had refused to file with the Bombay High<br />
Court the agreements relating to the transaction. ‘‘Why<br />
were the details not disclosed to the High Court? It has<br />
not even been shown to us,’’ Sinha said.<br />
The government’s counsel, Additional Solicitor General<br />
Mohan Parasaran, noted that Vodafone had finally<br />
submitted the agreements.<br />
‘‘The ball is now in the court <strong>of</strong> the income <strong>tax</strong> authority,’’<br />
Parasaran told the media after the hearing. ‘‘It<br />
will look into all the relevant material to arrive at the<br />
conclusion. However, we are now in possession <strong>of</strong> all<br />
relevant documents <strong>of</strong> agreement between Vodafone<br />
and HTIL.’’ He added that the <strong>tax</strong> department will<br />
now issue a revised notice to Vodafone for a hearing<br />
on its <strong>tax</strong> liability.<br />
In a January 23 statement, Vodafone said, ‘‘Given<br />
the fact that the petition filed by Vodafone involves<br />
important questions <strong>of</strong> jurisdiction, the Honorable Su-<br />
preme Court <strong>of</strong> India has asked the <strong>tax</strong> authorities to<br />
decide, as a preliminary issue only, whether it has jurisdiction<br />
to proceed against Vodafone (and no other issues).’’<br />
The company added, ‘‘Should Vodafone be aggrieved<br />
by the order <strong>of</strong> the <strong>tax</strong> authorities’ preliminary<br />
adjudication on jurisdiction, Vodafone has been permitted<br />
to again directly approach the High Court.’’<br />
♦ Kristen A. Parillo is a legal reporter with Tax Notes<br />
International. E-mail: kparillo@<strong>tax</strong>.org<br />
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Canadian Budget Delivers<br />
Outbound Tax Relief<br />
by Steve Suarez<br />
Canadian Finance Minister Jim Flaherty on January<br />
27 delivered to the House <strong>of</strong> Commons the 2009 federal<br />
budget, which includes improvements to Canada’s<br />
outbound <strong>tax</strong>ation system as well as corporate and individual<br />
income <strong>tax</strong> relief measures. (For prior coverage,<br />
see Doc 2009-1706 or 2009 WTD 16-1.)<br />
The budget is the minority Conservative government’s<br />
first item <strong>of</strong> business since proroguing Parliament<br />
near the end <strong>of</strong> 2008 to avoid being defeated in<br />
the House by the three opposition parties. As TNI<br />
went to press, newly installed Liberal leader Michael<br />
Ignatieff signaled he would support the budget contingent<br />
on the government agreeing to provide quarterly<br />
progress reports starting in March. The other two opposition<br />
parties (the New Democratic Party and the<br />
Bloc Québécois) have already declared their intention<br />
to vote against the budget. Hence, it is likely but not<br />
certain that the budget has the support necessary to<br />
pass the House <strong>of</strong> Commons. 1<br />
Canada has enjoyed exceptional economic performance<br />
over the past several years, running a series <strong>of</strong><br />
budget surpluses and reducing Canada’s debt-to-GDP<br />
ratio to the lowest level in the G-7. However, Canada<br />
is not immune to the dramatic economic downturn<br />
that has swept across the globe over the past year; Flaherty<br />
announced that he anticipates Canada’s real<br />
GDP will contract by 0.8 percent over the next year.<br />
As a result, the budget contains more spending than<br />
<strong>tax</strong>ing, and the government has clearly adopted the<br />
same posture as other G-7 countries (particularly the<br />
U.S.) by embarking on a very substantial spending program<br />
in an effort to stimulate the economy. The budget<br />
contains a wide variety <strong>of</strong> stimulus measures amounting<br />
to about 1.9 percent <strong>of</strong> Canada’s GDP (near the<br />
IMF’s suggested target <strong>of</strong> 2 percent). The measures are<br />
forecast to lead to budgetary deficits totaling over C<br />
$60 billion during the next two years. The budget optimistically<br />
projects a return to budgetary surpluses by<br />
2013 to 2014.<br />
The budget announces some very important changes<br />
to Canada’s outbound <strong>tax</strong>ation system, which would<br />
be improved by withdrawing (or potentially withdrawing)<br />
existing proposed amendments.<br />
1 Current standings in the House <strong>of</strong> Commons are: Conservative,<br />
143; Liberal, 77; Bloc Québécois, 49; New Democratic<br />
Party, 37; Independent, 2. See http://www/parl.gc.ca.<br />
HIGHLIGHTS<br />
Outbound Taxation: A Brief History<br />
Canada’s manner <strong>of</strong> <strong>tax</strong>ing Canadian <strong>tax</strong>payers’<br />
foreign-source income and the entities they invest in<br />
has been in a state <strong>of</strong> flux for almost a decade. First,<br />
very far-reaching and complex rules (the foreign investment<br />
enterprise and nonresident trust (NRT) rules)<br />
were announced in 1999 and released as draft legislation<br />
in June 2000 that dealt with the <strong>tax</strong>ation <strong>of</strong> passive<br />
(or what is supposed to be passive) foreign-source<br />
income <strong>of</strong> Canadians. These rules, which have been<br />
criticized for their extreme complexity (even by <strong>tax</strong><br />
standards) and overly broad scope, have gone through<br />
a number <strong>of</strong> variations and amendments and have still<br />
not been enacted into law (in their most recent form,<br />
they are proposed to be effective retroactively). (For<br />
prior coverage <strong>of</strong> the FIE/NRT rules, see Doc 2005-<br />
16307 or 2005 WTD 148-2.)<br />
In 2004 a number <strong>of</strong> proposed changes were announced<br />
relating to Canada’s foreign affiliate regime,<br />
which governs the <strong>tax</strong>ation <strong>of</strong> investments in foreign<br />
entities that meet a certain ownership threshold so as<br />
to make the foreign entity a foreign affiliate (or in<br />
some cases a controlled foreign affiliate) <strong>of</strong> the Canadian<br />
<strong>tax</strong>payer. These changes were also very complex<br />
and far-reaching and in many cases, seem to produce<br />
unintended effects. Among the proposed amendments<br />
(much <strong>of</strong> which has not yet been enacted into law)<br />
were the expansion <strong>of</strong> the controlled foreign affiliate<br />
definition (with the effect <strong>of</strong> increasing the likelihood<br />
that foreign-source passive income would be imputed<br />
to the Canadian <strong>tax</strong>payer and <strong>tax</strong>ed on an accrual basis)<br />
and so-called surplus suspension rules designed to<br />
prevent perceived abuses on the recognition <strong>of</strong> income<br />
on intragroup transactions. These provisions have created<br />
a great deal <strong>of</strong> uncertainty and made it difficult<br />
for Canadian <strong>tax</strong>payers with foreign affiliates to plan<br />
their affairs on an ongoing basis (many <strong>of</strong> these rules<br />
are also to be effective retroactively). (For prior coverage<br />
<strong>of</strong> the 2004 package, see Doc 2004-6779 or 2004<br />
WTD 60-2.)<br />
Finally, the 2007 federal budget included an initiative<br />
directed at foreign affiliates and the manner in<br />
which they are financed. The original proposal effectively<br />
eliminated the ability <strong>of</strong> Canadian <strong>tax</strong>payers to<br />
deduct interest expense on money borrowed to invest<br />
in a foreign affiliate earning exempt surplus (active<br />
business income earned in a country with which<br />
Canada has a <strong>tax</strong> treaty). The basis for this proposal<br />
was that because exempt surplus is not <strong>tax</strong>able in<br />
Canada when repatriated, allowing interest deductibility<br />
on borrowed money used to earn such income<br />
amounted to an undue subsidy <strong>of</strong> foreign business operations.<br />
Widely condemned by the business community as<br />
putting Canadian multinationals at a severe disadvantage<br />
relative to their foreign competitors, these rules<br />
were ultimately scaled back to a more limited objective<br />
<strong>of</strong> denying interest deductibility on money borrowed<br />
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HIGHLIGHTS<br />
by a Canadian <strong>tax</strong>payer and used to finance a foreign<br />
affiliate that in turn made some kinds <strong>of</strong> intragroup<br />
loans that generated deductible interest in another jurisdiction<br />
(double dipping). These more modest provisions<br />
were ultimately enacted in the form <strong>of</strong> section<br />
18.2 <strong>of</strong> the Income Tax Act (Canada), effective after<br />
2011, and remain controversial because <strong>of</strong> both their<br />
underlying rationale and the uncertainty <strong>of</strong> their application<br />
in a variety <strong>of</strong> circumstances. (For prior coverage,<br />
see Doc 2007-7732 or 2007 WTD 60-1; see also Doc<br />
2007-11796 or 2007 WTD 94-1.)<br />
The Advisory Committee’s Report<br />
An <strong>of</strong>fshoot <strong>of</strong> the 2007 budget was the minister <strong>of</strong><br />
finance’s establishment <strong>of</strong> an advisory committee to<br />
review Canada’s <strong>international</strong> <strong>tax</strong>ation system and<br />
make recommendations. The advisory committee delivered<br />
its report to the minister in December 2008, making<br />
a number <strong>of</strong> detailed recommendations concerning<br />
both inbound and outbound <strong>tax</strong>ation. (For prior coverage,<br />
see Tax Notes Int’l, Jan. 26, 2009, p. 345, Doc 2009-<br />
84, or2009 WTD 15-11.)<br />
Among the report’s recommendations were:<br />
• Canada should move to a broader exemption system<br />
for <strong>tax</strong>ing foreign-source active business income<br />
earned through foreign affiliates;<br />
• the Department <strong>of</strong> Finance should reconsider the<br />
need for the FIE/NRT rules, in particular with a<br />
view to reducing complexity and overlap in Canada’s<br />
antideferral regimes (while ensuring that passive<br />
foreign-source income earned by Canadian<br />
<strong>tax</strong>payers is <strong>tax</strong>ed on a current basis); and<br />
• ITA section 18.2 should be repealed, and no new<br />
interest deductibility restrictions should be imposed<br />
on borrowing to finance foreign affiliates <strong>of</strong><br />
Canadian <strong>tax</strong>payers. 2<br />
The Budget<br />
The budget’s most important business <strong>tax</strong> measure<br />
is the announcement that ITA section 18.2 would be<br />
repealed as recommended by the advisory panel. The<br />
government cited the negative effect that this provision<br />
could have had on foreign investment by Canadian<br />
multinationals. This development should please that<br />
segment <strong>of</strong> the <strong>tax</strong> community. In the current economic<br />
environment more than ever, Canadian businesses<br />
must be competitive <strong>international</strong>ly in order to<br />
survive, and a disadvantageous <strong>tax</strong> system is an illogical,<br />
unnecessary cost. The government should be commended<br />
for assembling a very knowledgeable panel <strong>of</strong><br />
experts and then acting on their advice. The repeal <strong>of</strong><br />
2 Measures against a specific practice referred to as debt<br />
dumping were advocated.<br />
section 18.2 is a very important and welcome development<br />
for Canadian business.<br />
The budget also indicates that the government has<br />
carefully considered the advisory panel’s views on<br />
other elements <strong>of</strong> the outbound <strong>tax</strong>ation regime. The<br />
budget states that the government will: review the existing<br />
FIE/NRT rules in light <strong>of</strong> the advisory panel’s<br />
comments and the many submissions it has received<br />
about them; and consider the advisory panel’s comments<br />
on the foreign affiliate system before proceeding<br />
to enact the outstanding measures contained in the<br />
2004 foreign affiliate amendments (a number <strong>of</strong> which<br />
would be unnecessary under a full exemption regime).<br />
Although statements about reconsidering legislative<br />
initiatives that have been so heavily criticized do not<br />
constitute an outright abandonment <strong>of</strong> those proposals,<br />
they are a positive development for the many <strong>tax</strong>payers<br />
who are overwhelmed by the complexity <strong>of</strong> the <strong>tax</strong><br />
system — and these provisions in particular — and<br />
who would welcome simpler, more narrowly targeted<br />
rules that do a better job <strong>of</strong> focusing on the real areas<br />
<strong>of</strong> potential abuse. Many <strong>of</strong> the current proposals are<br />
simply not working satisfactorily, and it would not be<br />
surprising if these statements are the first step toward a<br />
larger redesign <strong>of</strong> the outbound <strong>tax</strong>ation system. The<br />
government should again be commended for listening<br />
to the business community. Making the entire outbound<br />
<strong>tax</strong>ation system simpler, more efficient, and<br />
more <strong>international</strong>ly competitive would significantly<br />
boost the Canadian economy.<br />
Other <strong>Business</strong> Tax Measures<br />
Accelerated Capital Cost Allowance<br />
Capital cost allowance (CCA) is the Canadian <strong>tax</strong><br />
version <strong>of</strong> the accounting concept <strong>of</strong> depreciation. Under<br />
the CCA system, the cost <strong>of</strong> capital property is<br />
deducted from income over a period <strong>of</strong> years on a declining<br />
balance basis, 3 matching (to some degree) the<br />
expenditure on the property to the business income it<br />
produces.<br />
The 2007 budget provided a temporary incentive to<br />
invest in capital equipment by accelerating the rate at<br />
which CCA could be claimed (thereby allowing a<br />
larger deduction from income sooner for <strong>tax</strong> purposes)<br />
on eligible machinery and equipment used in manufacturing<br />
and processing. Instead <strong>of</strong> the usual 30 percent<br />
declining balance CCA rate generally applicable, the<br />
3 Declining balance means that the depreciation rate is applied<br />
in each year against the remaining portion <strong>of</strong> the property’s cost,<br />
such that each year’s deduction is smaller than the preceding<br />
year’s. For example, a C $100 property depreciated at 50 percent<br />
on a declining balance yields a C $50 deduction in year 1 (C<br />
$100 x 50 percent), a C $25 deduction in year 2 (50 percent x (C<br />
$100 - C $50)), and so forth.<br />
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2007 budget allowed most such property acquired before<br />
2009 to be written <strong>of</strong>f entirely over three years<br />
under a special 50 percent straight-line CCA rate (subject<br />
to the usual half-year rule limiting the first year’s<br />
deduction). The 2008 budget then extended this deduction<br />
for an additional three years by proposing that:<br />
• for eligible property acquired in 2009, the same<br />
CCA rate announced in the 2007 budget would<br />
apply; and<br />
• for eligible property acquired in 2010 and 2011,<br />
less generous CCA rates would apply. 4<br />
The 2009 budget would extend to eligible property<br />
acquired in 2010 or 2011 the more generous 50 percent<br />
straight-line CCA rate applicable to eligible property<br />
acquired in 2009 (the half-year rule would still apply).<br />
Another budget proposal would <strong>of</strong>fer faster CCA on<br />
eligible computers and s<strong>of</strong>tware acquired after January<br />
27, 2009, and before February 2011. Instead <strong>of</strong> the 55<br />
percent declining balance rate currently applicable, the<br />
CCA rate would be 100 percent and the half-year rule<br />
would not apply, meaning that the cost <strong>of</strong> the property<br />
would be written <strong>of</strong>f entirely in the year it is acquired<br />
by the business. The property eligible for this faster<br />
write-<strong>of</strong>f would be most general purpose electronic<br />
data processing equipment (and related systems s<strong>of</strong>tware)<br />
that:<br />
• is located in Canada;<br />
• is acquired by the <strong>tax</strong>payer for use in a Canadian<br />
business or to earn income from property located<br />
in Canada (or to lease to someone so using it);<br />
and<br />
• was not previously used (or acquired for use) before<br />
being acquired by the <strong>tax</strong>payer for use in<br />
Canada.<br />
Canadian-Controlled Private Corporations<br />
A corporation that is a Canadian-controlled private<br />
corporation (CCPC) enjoys a number <strong>of</strong> advantages<br />
within the Canadian <strong>tax</strong> system. In particular, a CCPC<br />
may benefit from a low 11 percent <strong>tax</strong> rate on the first<br />
C $400,000 <strong>of</strong> qualifying active business income that it<br />
earns via a mechanism called the small-business deduction.<br />
5 The budget would increase the maximum in-<br />
4<br />
In both cases the deduction in the first year was limited by<br />
the half-year rule.<br />
5<br />
When two or more corporations are associated, they must<br />
share the limit. To limit this <strong>tax</strong> preference to smaller businesses,<br />
the deduction begins to phase out when the CCPC has <strong>tax</strong>able<br />
capital employed in Canada <strong>of</strong> C $10 million, and is eliminated<br />
completely when the CCPC has C $15 million <strong>of</strong> <strong>tax</strong>able capital<br />
employed in Canada.<br />
HIGHLIGHTS<br />
come eligible for the deduction from C $400,000 to C<br />
$500,000 effective January 1, 2009. 6<br />
CCPCs are also eligible to earn investment <strong>tax</strong><br />
credits at an enhanced 35 percent rate on up to C $3<br />
million <strong>of</strong> qualifying scientific research and experimental<br />
development. The C $3 million threshold is reduced<br />
once the CCPC’s <strong>tax</strong>able income for the previous year<br />
reaches C $400,000 and eliminated entirely once<br />
previous-year <strong>tax</strong>able income reaches C $700,000. The<br />
budget would increase the C $400,000 and C $700,000<br />
amounts to C $500,000 and C $800,000, respectively,<br />
expanding the availability <strong>of</strong> the enhanced ITCs.<br />
Finally, the budget would correct a technical problem<br />
arising from a court decision in 2006, which affects<br />
the precise time at which control <strong>of</strong> a CCPC is<br />
acquired on the relevant day. The ruling had created<br />
anomalous results arising from determining exactly<br />
when control <strong>of</strong> the corporation had been acquired,<br />
and the CCPC had thereby lost its status as a CCPC.<br />
Administrative Matters<br />
The budget proposes to require that some <strong>tax</strong>payers<br />
file their <strong>tax</strong> returns electronically, effective for <strong>tax</strong><br />
years ending after 2009. Corporations with annual<br />
gross revenue over C $1 million would be required to<br />
file electronically except in situations (to be announced<br />
later) when the Canada Revenue Agency believes electronic<br />
filing would be inefficient. 7 Some minor amendments<br />
to related penalty provisions have also been proposed.<br />
The budget also proposes that in 2010 and<br />
thereafter a <strong>tax</strong>payer that files 50 or more <strong>of</strong> any particular<br />
type <strong>of</strong> information return would be required to<br />
do so electronically. This would occur most frequently<br />
in the case <strong>of</strong> T4 reporting returns for employment<br />
income.<br />
Previously Announced Measures<br />
When Parliament was prorogued in December 2008,<br />
a number <strong>of</strong> <strong>tax</strong> measures had not yet been enacted<br />
into law and were automatically terminated. The budget<br />
confirms the government’s intention to reintroduce<br />
many <strong>of</strong> these previously announced proposals, including:<br />
• changes to the <strong>tax</strong>ation <strong>of</strong> financial institutions to<br />
better align income <strong>tax</strong> laws with accounting<br />
rules; and<br />
• draft amendments relating to the rules allowing<br />
some <strong>tax</strong>payers to report their Canadian income<br />
<strong>tax</strong> in a foreign (‘‘functional’’) currency.<br />
6<br />
This increase in the small-business limit would also: result in<br />
some CCPCs earning between C $400,000 and C $500,000 in<br />
<strong>tax</strong>able income having an additional month to pay any balance<br />
<strong>of</strong> <strong>tax</strong> owed; and entitle some CCPCs to be eligible to pay their<br />
<strong>tax</strong>es in quarterly installments rather than monthly.<br />
7<br />
Examples provided <strong>of</strong> such exceptions include nonresidents<br />
and insurance companies.<br />
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HIGHLIGHTS<br />
Personal Tax Measures<br />
The budget also contains a number <strong>of</strong> relatively minor<br />
personal income <strong>tax</strong> amendments, largely directed<br />
at low- and middle-income earners. These include:<br />
• the basic personal amount (the amount <strong>of</strong> income<br />
that can be earned before any <strong>tax</strong> is payable)<br />
would increase from C $9,600 for 2009 to C<br />
$10,320 for 2010 and would thereafter be indexed<br />
to inflation;<br />
• the upper limit <strong>of</strong> the two lowest <strong>tax</strong> brackets<br />
would be increased for 2009, with the 15 percent<br />
<strong>tax</strong> bracket ending at C $40,726 instead <strong>of</strong> C<br />
$37,885 and the 22 percent <strong>tax</strong> bracket ending at<br />
C $81,452 instead <strong>of</strong> C $75,769 — both brackets<br />
would be indexed to inflation thereafter; and<br />
• the <strong>tax</strong> credit for persons 65 and older would increase<br />
by C $1,000 to C $6,408.<br />
A new home renovation <strong>tax</strong> credit <strong>of</strong> up to C<br />
$1,350 would be introduced for qualifying home renovation<br />
expenditures (excluding routine repairs and furniture)<br />
<strong>of</strong> up to C $10,000 incurred between January<br />
28, 2009, and February 1, 2010. This <strong>tax</strong> credit may<br />
not cost the government much in forgone <strong>tax</strong> revenue<br />
because much home renovation activity occurs under<br />
the table as part <strong>of</strong> the underground economy. That<br />
activity would have to come into the <strong>tax</strong> system for the<br />
credit to be claimed. The budget would also introduce<br />
a small first-time home buyer’s <strong>tax</strong> credit on qualifying<br />
homes acquired after January 27, 2009. Also, the<br />
amount <strong>of</strong> money that a first-time home buyer could<br />
withdraw from his registered retirement savings plan<br />
(RRSP, a <strong>tax</strong>-sheltered individual retirement fund<br />
analogous to a U.S. 401(k)) would increase from C<br />
$20,000 to C $25,000. The budget also proposes relief<br />
provisions to compensate for the decrease in the value<br />
<strong>of</strong> investments in an RRSP (or some similar<br />
retirement-related vehicles) following the death <strong>of</strong> the<br />
annuitant to prevent undue hardship when investments<br />
decline in value postmortem before the deceased’s<br />
property is distributed.<br />
Finally, the 15 percent mineral exploration <strong>tax</strong> credit<br />
available to individuals who invest in flow-through<br />
shares <strong>of</strong> mining exploration companies would be extended<br />
another year for flow-through share agreements<br />
entered into by March 31, 2010.<br />
♦ Steve Suarez is a partner with Osler, Hoskin &<br />
Harcourt LLP in Toronto.<br />
Full Text Citations<br />
• Finance Minister Jim Flaherty describes Canada’s 2009<br />
budget economic action plan. Doc 2009-1816; 2009 WTD<br />
17-9<br />
• Summary <strong>of</strong> 2009 budget <strong>tax</strong> relief measures. Doc 2009-<br />
1817; 2009 WTD 17-10<br />
• Prime Minister Stephen Harper <strong>notes</strong> home renovation<br />
<strong>tax</strong> credit. Doc 2009-1819; 2009 WTD 17-11<br />
• Flaherty’s budget speech. Doc 2009-1823; 2009 WTD<br />
17-12<br />
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Argentina<br />
Buenos Aires’ New Stamp Tax<br />
Triggered by Two Core Events<br />
Buenos Aires’ <strong>of</strong>ficial gazette on January 19 published<br />
Resolution 10/09, the first set <strong>of</strong> implementing<br />
rules for the city’s stamp <strong>tax</strong>, which was reenacted on<br />
January 9 by Law 2997. (For prior coverage, see Tax<br />
Notes Int’l, Jan. 26, 2009, p. 294, Doc 2009-822, or2009<br />
WTD 9-2.)<br />
The stamp <strong>tax</strong>, which was limited to real estate<br />
transactions until December 2008, was absent from<br />
Buenos Aires for more than five years. The stamp <strong>tax</strong><br />
is a local levy, so each jurisdiction provides its own<br />
legislation. Accordingly, the <strong>tax</strong>able events, exemptions,<br />
<strong>tax</strong>able amounts, <strong>tax</strong> rates, terms for payment, penalties,<br />
and interest vary by jurisdiction. However, the<br />
general aspects <strong>of</strong> the stamp <strong>tax</strong> are shared by most<br />
jurisdictions.<br />
Buenos Aires’ stamp <strong>tax</strong> can be triggered by two<br />
core events resulting in the assessment <strong>of</strong> an instrumentality<br />
<strong>tax</strong> or a financial transaction stamp <strong>tax</strong>.<br />
Instrumentality Tax<br />
This <strong>tax</strong> is triggered by written legal contracts either<br />
executed or having effects within the city <strong>of</strong> Buenos<br />
Aires. In general, the term ‘‘effects’’ refers to the execution<br />
<strong>of</strong> the contractual obligations. The fact that the<br />
contract is executed outside Argentina does not relieve<br />
the parties thereto from their obligation to satisfy the<br />
stamp <strong>tax</strong> because the agreement — though executed<br />
abroad — could still have effects in Buenos Aires.<br />
The <strong>tax</strong>able amount is equal to the contractual value<br />
during its whole term. However, there are specific rules<br />
for contracts subject to automatic renewal or extension<br />
terms beyond five years. The new rules provide that in<br />
the absence <strong>of</strong> a fixed <strong>tax</strong>able amount set forth in the<br />
contract, it should be reasonably estimated — with the<br />
evidence and data available to the <strong>tax</strong>payer when the<br />
<strong>tax</strong>able event is triggered — using, for example, any <strong>of</strong><br />
the following guidelines: similar past agreements; the<br />
forecasted revenue in the relevant jurisdiction; or the<br />
COUNTRY<br />
DIGEST<br />
figures <strong>of</strong> the developing business. If the local <strong>tax</strong> authority<br />
challenges the <strong>tax</strong>able amount assessed and<br />
proves that the estimation procedure was wrong, fines<br />
and interest will be applied.<br />
The new legislation provides rules aimed at avoiding<br />
double <strong>tax</strong>ation within Argentina. If a contract is executed<br />
in one jurisdiction and the assets are located in<br />
a different one, <strong>tax</strong>ing powers are granted with priority<br />
to the jurisdiction where the assets are located.<br />
Tax rates vary depending on the <strong>tax</strong>able events. The<br />
standard <strong>tax</strong> rate is 0.8 percent, while a higher rate up<br />
to 2.5 percent applies to real estate transactions. A reduced<br />
rate <strong>of</strong> 0.5 percent applies to leasing agreements,<br />
and a higher rate <strong>of</strong> 1 percent applies to set contracts<br />
involving trading <strong>of</strong> rights <strong>of</strong> soccer players. All parties<br />
to the agreement are jointly and severally liable before<br />
the State Revenue Service for the payment <strong>of</strong> the full<br />
amount <strong>of</strong> the stamp <strong>tax</strong> triggered by a given agreement.<br />
Like the stamp <strong>tax</strong> in most provinces, the Buenos<br />
Aires stamp <strong>tax</strong> is governed by the ‘‘instrumentality<br />
principle,’’ according to which the <strong>tax</strong>able event is only<br />
triggered when a contract or document is prepared in<br />
writing by the parties or the party to the agreement;<br />
and such written document sufficiently prove the rights<br />
and obligations <strong>of</strong> the parties — namely when it reproduces<br />
the main elements <strong>of</strong> the contract, disregarding<br />
the facts and actions taken by the <strong>tax</strong>payers. This instrumentality<br />
principle is also stated in the federal coparticipation<br />
<strong>of</strong> <strong>tax</strong>es law, a law passed by the National<br />
Congress that provides for the allocation <strong>of</strong> <strong>tax</strong> revenues<br />
between the federal government and the provinces.<br />
This law imposes a restriction on the <strong>tax</strong>ing<br />
powers <strong>of</strong> the provinces.<br />
Some <strong>tax</strong> planning devices have been used countrywide<br />
to avoid payment <strong>of</strong> the stamp <strong>tax</strong>. They have<br />
mainly consisted <strong>of</strong> agreements implemented in such a<br />
manner that they do not fit within the instrumentality<br />
principle. These options are available under the new<br />
Buenos Aires legislation, but <strong>tax</strong>payers must carefully<br />
implement them to ensure that the Supreme Court precedents<br />
governing these matters can be reasonably relied<br />
upon.<br />
There are a number <strong>of</strong> exemptions available, which<br />
should be scrutinized on a case-by-case basis. Some <strong>of</strong><br />
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ARGENTINA<br />
the most significant exemptions relate to contracts for<br />
the incorporation <strong>of</strong> companies in Buenos Aires, as<br />
well as their capital increases and liquidations; all contracts<br />
aimed at papering public listing <strong>of</strong> securities; and<br />
guarantee agreements that secure other <strong>tax</strong>able instruments,<br />
life insurance agreements, labor agreements,<br />
export related agreements, and so on.<br />
Financial Transaction Stamp Tax<br />
This <strong>tax</strong> is triggered on all loans or credits that a<br />
financial institution is party to that imply a delivery or<br />
receipt <strong>of</strong> principal (or funds in general) that triggers<br />
interest over time and that are registered and recorded<br />
by such financial entities. The <strong>tax</strong>able amount is<br />
deemed to be the figures used to calculate the interest<br />
times the <strong>tax</strong> rate, which is the standard one <strong>of</strong> 0.8<br />
percent per year. So the <strong>tax</strong> burden is proportional to<br />
the term the <strong>tax</strong>able transaction remains in place: The<br />
larger the term, the higher the <strong>tax</strong> burden.<br />
The persons contracting with the financial entities<br />
are deemed to be the <strong>tax</strong>payers and such entities are<br />
deemed to be the collecting agents. Accordingly, they<br />
are subject to joint and several liability.<br />
Specific exemptions apply to this <strong>tax</strong>able event, the<br />
most significant being that related to transactions subject<br />
to the instrumentality <strong>tax</strong>: To the extent such burden<br />
is triggered, even in a different jurisdiction, there<br />
will be no financial transaction <strong>tax</strong> on the same transaction.<br />
Also, bank deposits in savings accounts, time<br />
deposits, and checking accounts are exempt, as well as<br />
mortgage deeds and other security agreements used to<br />
secure <strong>tax</strong>able transactions.<br />
As <strong>of</strong> the enactment <strong>of</strong> Law 2997, <strong>tax</strong>payers are<br />
required to monitor the stamp <strong>tax</strong> legislation in the city<br />
<strong>of</strong> Buenos Aires in conjunction with the one applicable<br />
in other provinces to ensure they take advantage <strong>of</strong> <strong>tax</strong><br />
planning options or at least avoid double <strong>tax</strong>ation<br />
when transactions that are executed in one location<br />
have effects in a different one.<br />
Bangladesh<br />
♦ Cristian Rosso Alba, Rosso Alba,<br />
Francia & Ruiz Moreno, Buenos Aires<br />
Government Revokes Import Tax on<br />
Renewable Energy Imports<br />
Bangladeshi Prime Minister Sheikh Hasina Wajed<br />
on January 15 announced that all <strong>tax</strong>es and duties assessed<br />
on imports <strong>of</strong> solar power generating equipment<br />
have been revoked to encourage the use <strong>of</strong> renewable<br />
energy as the country continues to struggle with power<br />
shortages.<br />
Previously, imports <strong>of</strong> renewable energy equipment<br />
were subject to a 3 percent import duty and a 15 percent<br />
VAT.<br />
The withdrawal <strong>of</strong> the import <strong>tax</strong>es is part <strong>of</strong> the<br />
country’s new renewable energy policy, which was approved<br />
in December 2008. The policy also provides for<br />
a five-year corporate <strong>tax</strong> holiday for income from renewable<br />
energy projects. The government’s goal is for<br />
the country to derive 5 percent <strong>of</strong> its electricity from<br />
renewable sources by 2015 and 10 percent <strong>of</strong> its overall<br />
electric supply by 2020.<br />
In addition to commercial-scale solar energy plants,<br />
the government also seeks to promote the use <strong>of</strong> microlevel<br />
solar energy for domestic use. More than 300,000<br />
households are using solar energy equivalent to 15<br />
megawatts, accounting for less than 1 percent <strong>of</strong> the<br />
country’s total electricity generation <strong>of</strong> around 3,500<br />
megawatts.<br />
Hasina also heads the Ministry <strong>of</strong> Electricity, Oil,<br />
and Mineral Resources.<br />
♦ Aziz Nishtar, Nishtar & Zafar Advocates, Karachi<br />
Cambodia<br />
Tax Breaks Targeted to Critical<br />
Garment Industry<br />
The Cambodian government has announced that it<br />
will <strong>of</strong>fer <strong>tax</strong> breaks targeted to the clothing industry<br />
(accounting for 320,000 jobs in a country <strong>of</strong> 14.2 million)<br />
as a way to address the global financial crisis’s<br />
impact on Cambodia, according to media reports.<br />
Because the Phnom Penh government lacks cash, it<br />
reportedly cannot undertake the kind <strong>of</strong> stimulus packages<br />
seen in neighboring countries like Thailand, Malaysia,<br />
and Singapore.<br />
In addition to the <strong>tax</strong> breaks, the government plans<br />
to invest in infrastructure such as power plants, rural<br />
roads, irrigation systems, and telecommunications in an<br />
attempt to establish the kinds <strong>of</strong> structures the country<br />
will need when growth returns. According to the Economic<br />
Institute <strong>of</strong> Cambodia (a Phnom Penh think<br />
tank), up to 66 percent <strong>of</strong> the workforce works in the<br />
rural sector at some point during the year.<br />
The projects are to be funded through donor contributions,<br />
according to a January 26 article on<br />
Bloomberg.com. Contributor countries in December<br />
2008 pledged $950 million in aid for fiscal 2009, a 40<br />
percent increase over fiscal 2008. The money will go<br />
toward Cambodia’s $1.8 billion 2009 budget, which<br />
includes the infrastructure expenditures. Cambodia’s<br />
fiscal year runs January 1 to December 31.<br />
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‘‘We cannot distribute cash to the people. What we<br />
can do is give targeted <strong>tax</strong> cuts to garment factories<br />
and spend more on infrastructure so we can prepare<br />
for economic developments in the future,’’ Hang<br />
Chuon Naron, secretary-general <strong>of</strong> the Ministry <strong>of</strong><br />
Economy and Finance, said in a January 23 interview<br />
with Bloomberg.com.<br />
Despite its problems, Cambodia has experienced<br />
four straight years <strong>of</strong> growth above 10 percent. This<br />
growth has stemmed largely from special deals for foreign<br />
firms, such as <strong>tax</strong> holidays and greatly reduced<br />
import tariffs.<br />
Furthermore, 60 percent <strong>of</strong> that growth has arisen<br />
from just three sectors: tourism, construction, and garment<br />
manufacturing, with the latter accounting for 12<br />
percent <strong>of</strong> GDP in 2007. However, weakening demand<br />
in crucial retail markets like the United States, which<br />
receives 70 percent <strong>of</strong> Cambodia’s textile exports, has<br />
forced Cambodia to close 10 percent <strong>of</strong> its garment<br />
factories, triggering the loss <strong>of</strong> 20,000 jobs, according<br />
to Roger Tan <strong>of</strong> the Garment Manufacturer’s Association<br />
<strong>of</strong> Cambodia.<br />
Hang Chuon Naron anticipates a drop in garment<br />
exports <strong>of</strong> 2 percent. He also foresees a 20 percent<br />
drop in the number <strong>of</strong> tourists visiting Cambodia and<br />
the virtual collapse <strong>of</strong> the construction sector. He<br />
hopes the <strong>tax</strong> breaks will keep businesses afloat<br />
through the difficult times.<br />
The IMF has predicted that Cambodia will grow at<br />
a rate <strong>of</strong> 4.75 percent in 2009, the slowest pace since<br />
1998.<br />
Chile<br />
♦ Randall Jackson, Tax Analysts.<br />
E-mail: rjackson@<strong>tax</strong>.org<br />
Stimulus Package Wins Unanimous<br />
Approval<br />
The Chilean Senate on January 14 unanimously approved<br />
a $4 billion economic stimulus plan presented<br />
by President Michelle Bachelet on January 5. (For<br />
prior coverage, see Tax Notes Int’l, Jan. 19, 2009, p. 212,<br />
Doc 2009-349, or2009 WTD 5-3.)<br />
The plan, which was unanimously approved by the<br />
Chamber <strong>of</strong> Deputies on January 8, still must be<br />
signed by Bachelet, a formality that Finance Minister<br />
Andrés Velasco said would soon be addressed.<br />
Tax measures in the plan include the temporary<br />
elimination <strong>of</strong> the stamp <strong>tax</strong>, a reduction in the<br />
monthly advance <strong>tax</strong> payments made by businesses<br />
(expected to take effect as early as this month), and<br />
provisions to accelerate income <strong>tax</strong> refunds for the<br />
2010 <strong>tax</strong> year and to accelerate the <strong>tax</strong> credit available<br />
for some training costs.<br />
Velasco called the package ‘‘important and urgent’’<br />
and expressed gratitude for the political consensus that<br />
led to the approval <strong>of</strong> the package in a unanimous and<br />
expedited manner.<br />
China (P.R.C.)<br />
CHINA (P.R.C.)<br />
♦ Lisa M. Nadal, Tax Analysts.<br />
E-mail: lnadal@<strong>tax</strong>.org<br />
U.S. Companies Facing Compliance<br />
Burdens in China<br />
U.S. companies with operations in the People’s Republic<br />
<strong>of</strong> China now face much more significant <strong>tax</strong><br />
compliance obligations, according to panelists on a<br />
January 15 PricewaterhouseCoopers International Tax<br />
Services webcast.<br />
The P.R.C. government last year introduced a new<br />
annual enterprise income <strong>tax</strong> return package, new<br />
related-party transaction (RPT) forms, and new contemporaneous<br />
transfer pricing documentation requirements.<br />
The new EIT return package and the new transfer<br />
pricing disclosure rules are very complex, PwC <strong>tax</strong><br />
partner Todd Landau said. ‘‘It is always a common<br />
experience with respect to China that there’s only some<br />
<strong>of</strong> what we need to know that is known today, with<br />
additional information that will clearly need to be<br />
known as time progresses throughout the period prior<br />
to deadlines’’ for the filing <strong>of</strong> returns and the submission<br />
<strong>of</strong> contemporaneous transfer pricing documentation,<br />
he said.<br />
For example, the State Administration <strong>of</strong> Taxation<br />
(SAT) released guidance on the EIT return, plus 45<br />
pages <strong>of</strong> explanatory <strong>notes</strong>, late in 2008, PwC <strong>tax</strong> partner<br />
Michael Ho said. But those <strong>notes</strong> are no longer<br />
valid because a new set <strong>of</strong> <strong>notes</strong> (Guo Shui Han [2008]<br />
No. 1081) released on January 7 has superseded them.<br />
This has left many companies struggling to keep up.<br />
Background<br />
The SAT on October 30, 2008, issued a new annual<br />
EIT return package (Guo Shui Fa [2008] No. 101) for<br />
use by <strong>tax</strong>payers that must file returns under the EIT<br />
law that took effect on January 1, 2008. The return<br />
package includes a main return and 15 schedules, all <strong>of</strong><br />
which must be filed by May 31. (For prior coverage,<br />
see Tax Notes Int’l, Dec. 22, 2008, p. 945, Doc 2008-<br />
24993, or2008 WTD 247-14.)<br />
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CHINA (P.R.C.)<br />
On December 16, 2008, the SAT released nine RPT<br />
disclosure forms (Guo Shui Fa [2008] No. 114) to replace<br />
forms required under China’s previous annual<br />
income <strong>tax</strong> return filing system for foreign investment<br />
enterprises. The new RPT forms ask companies to disclose<br />
whether they have prepared contemporaneous<br />
transfer pricing documentation when filing the annual<br />
CIT return. (For prior coverage, see Doc 2008-26922 or<br />
2008 WTD 247-18.) The RPT forms must be filed together<br />
with the annual EIT return package.<br />
The SAT on January 9 published the Implementation<br />
Regulations for Special Tax Adjustments (Guo<br />
Shui Fa [2009] No. 2, or Circular 2), which define the<br />
scope <strong>of</strong> China’s transfer pricing rules and set out the<br />
contemporaneous transfer pricing documentation rules<br />
that both foreign and domestic enterprises must follow<br />
under China’s new EIT law. (For prior coverage, see<br />
Tax Notes Int’l, Jan. 19, 2009, p. 205, Doc 2009-521, or<br />
2009 WTD 7-1.)<br />
Circular 2 provides for some exemptions from the<br />
contemporaneous documentation rules. For example,<br />
companies may be exempt if the value <strong>of</strong> their intercompany<br />
tangible goods transactions is below CNY<br />
200 million (about $30 million) and if the value <strong>of</strong><br />
their intercompany nontangible goods transactions is<br />
below CNY 40 million (about $6 million), not counting<br />
sales and purchases that are covered by cost-sharing<br />
agreements or advance pricing agreements.<br />
An exemption is also available if the foreign shareholding<br />
in the enterprise is less than 50 percent and the<br />
enterprise traded only with domestic related parties.<br />
Finally, an exemption is available for transactions covered<br />
by an APA.<br />
Details<br />
Ho outlined the company filing requirements for<br />
calendar year 2008, saying companies must file the<br />
new annual EIT return package and the new RPT<br />
forms by May 31, and prepare the contemporaneous<br />
transfer pricing documentation by December 31, which<br />
is an extended deadline for calendar year 2008. Normally,<br />
the due date for contemporaneous documentation<br />
will be May 31 <strong>of</strong> the year following the <strong>tax</strong> year,<br />
he said.<br />
The new EIT return asks for information <strong>tax</strong>payers<br />
previously did not have to provide. For example, Ho<br />
said, the new return now has lines for:<br />
• a <strong>tax</strong> adjustment <strong>of</strong> assets measured at fair value;<br />
• an analysis <strong>of</strong> income or loss from long-term investments;<br />
• a <strong>tax</strong> adjustment <strong>of</strong> advertising and promotion<br />
expenses;<br />
• a <strong>tax</strong> adjustment <strong>of</strong> depreciation or amortization;<br />
and<br />
• a <strong>tax</strong> incentive statement for both grandfathered<br />
and new <strong>tax</strong> incentives.<br />
Ho also urged <strong>tax</strong>payers to act swiftly to complete<br />
the nine new RPT forms by May 31 for <strong>tax</strong> year 2008<br />
— even though they only came out in December 2008.<br />
‘‘While it seems like we still have a few more months<br />
to go, given the uncertainty and the difficulties in handling<br />
some <strong>of</strong> the <strong>tax</strong>ation treatment, there may not be<br />
a lot <strong>of</strong> time in preparing the returns for filing,’’ Ho<br />
said. He said the new RPT forms are much more complex<br />
than the old filing regime that was in place for<br />
calendar year 2007.<br />
After the webcast, Ho told Tax Analysts that the<br />
new EIT return forms contain many items and adjustments<br />
that will be subject to subsequent regulations<br />
and further SAT guidance. ‘‘As a result, there will be<br />
many cases <strong>of</strong> uncertain <strong>tax</strong> treatment, which will<br />
likely increase <strong>tax</strong>payer compliance burdens,’’ he said.<br />
The obligation to provide more detailed information<br />
on intercompany transactions and other new filing<br />
rules ‘‘may be too great a responsibility to delegate entirely<br />
to the <strong>tax</strong> and accounting staff <strong>of</strong> the Chinese<br />
subsidiaries’’ <strong>of</strong> U.S. parents, Ho said. ‘‘Therefore, a<br />
much more coordinated effort to work with the local<br />
Chinese entity will likely be necessary to satisfy the<br />
greater Chinese compliance responsibilities.’’<br />
Landau predicted the expanded information available<br />
to Chinese <strong>tax</strong> examiners could make future <strong>tax</strong><br />
examinations ‘‘a very bumpy ride.’’ He said U.S. companies<br />
with Chinese operations may need to undertake<br />
‘‘new information gathering processes and protocols’’<br />
to meet the new compliance requirements.<br />
Finally, the panelists cautioned that companies must<br />
correlate the EIT return package, RPT forms, and any<br />
contemporaneous transfer pricing documentation. Even<br />
though the forms and filings are all separate, <strong>tax</strong>payers<br />
must ensure a consistent position for all <strong>of</strong> them, according<br />
to PwC.<br />
Ecuador<br />
♦ Charles Gnaedinger, Tax Analysts.<br />
E-mail: cgnaedin@<strong>tax</strong>.org<br />
Congress Approves Tax Package<br />
Ecuador’s recently inaugurated National Congress<br />
has approved a new <strong>tax</strong> package designed to combat<br />
the effects <strong>of</strong> the global financial crisis, including<br />
amendments to the income and capital flight <strong>tax</strong>es and<br />
a new <strong>tax</strong> on deposits held abroad. The amendments<br />
entered into full force and effect on January 1.<br />
The amendments, published in Official Gazette 497<br />
on December 30, 2008, are in response to a package <strong>of</strong><br />
measures prepared by President Rafael Correa Delgado.<br />
Ecuador’s economy is largely dependent on oil<br />
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exports, and the recent drop in oil prices has created a<br />
difficult economic scenario that will affect government<br />
funding and the cash flow <strong>of</strong> private enterprises. (For<br />
prior coverage <strong>of</strong> the Tax Fairness Bill, see Doc 2008-<br />
472 or 2008 WTD 7-5.)<br />
The new law extends a 10 percentage point reduction<br />
in the 25 percent corporate income <strong>tax</strong> rate to financial<br />
entities and cooperatives that reinvest their<br />
pr<strong>of</strong>its by increasing their capital and purchasing assets<br />
that would help their operations.<br />
The amendments provide for the reduction or dismissal<br />
<strong>of</strong> the advance income <strong>tax</strong> payment when there<br />
are economic effects for a given industry or economic<br />
sector. To be approved by the president, the Ministry <strong>of</strong><br />
Economy and Finance and the <strong>tax</strong> administration must<br />
issue technical reports <strong>of</strong> an income reduction in the<br />
industry or economic sector. The reduction or dismissal<br />
<strong>of</strong> the payment must be evaluated on a yearly basis.<br />
The new law establishes 2009 as a transition year<br />
regarding withholding <strong>tax</strong> on interest paid on foreign<br />
credits. The normal 25 percent withholding rate over<br />
interest, which does not exceed the Ecuadorian Central<br />
Bank’s rate, has been reduced to 5 percent until December<br />
31, 2009. Payments made by financial entities<br />
are free from withholding during the entire year.<br />
The capital flight <strong>tax</strong> rate has been increased from<br />
0.5 percent to 1 percent, and all but one exclusion have<br />
been eliminated. Therefore, all payments (including<br />
those made for imports) are charged with the 1 percent<br />
capital flight <strong>tax</strong>. Individuals can leave the country<br />
with up to US $8,570 in cash free <strong>of</strong> <strong>tax</strong>.<br />
All imports whose payment is made with funds located<br />
abroad are deemed to be made with local money<br />
and therefore will be <strong>tax</strong>ed.<br />
To encourage financial entities and those entities<br />
participating in the stock market to bring billions <strong>of</strong><br />
Ecuador dollars <strong>of</strong> their clients’ deposits into the country,<br />
the National Congress has created a new <strong>tax</strong>. This<br />
<strong>tax</strong> will be charged on all deposits held abroad by the<br />
above-mentioned companies at a monthly rate <strong>of</strong> 0.084<br />
percent <strong>of</strong> the amount <strong>of</strong> their assets held abroad.<br />
♦ Roberto M. Silva Legarda, pr<strong>of</strong>essor <strong>of</strong> <strong>tax</strong> law,<br />
Pontificia Universidad Católica del Ecuador, Quito, and<br />
partner, Tributum Consultans<br />
European Union<br />
EUROPEAN UNION<br />
Austrian Leasing Rules Incompatible<br />
With EC Treaty, ECJ Says<br />
Austrian rules that denied an investment-premium<br />
<strong>tax</strong> advantage to lessors <strong>of</strong> goods used by lessees in<br />
other EU member states violated article 49 <strong>of</strong> the EC<br />
Treaty (the freedom to provide services), the European<br />
Court <strong>of</strong> Justice said in its December 4, 2008, judgment<br />
in Jobra Vermögensverwaltungs-Gesellschaft mbH v.<br />
Finanzamt Amstetten Melk Scheibbs (C-330/07). (For the<br />
judgment, see Doc 2008-25509 or 2008 WTD 235-10.)<br />
Background<br />
Jobra was an Austrian company with a wholly<br />
owned subsidiary, Braunsh<strong>of</strong>er, also an Austrian resident<br />
company. Jobra purchased some trucks and leased<br />
them to Braunsh<strong>of</strong>er, which used the trucks in EU<br />
member states other than Austria. Consequently, Jobra<br />
was denied an investment-premium <strong>tax</strong> advantage because<br />
the leased assets were used ‘‘primarily abroad’’<br />
and not in Austria.<br />
The Austrian <strong>tax</strong> rules at issue made the <strong>tax</strong> advantage<br />
available only if the assets had been used at an<br />
Austrian place <strong>of</strong> business for at least half the time<br />
they had been in use. Jobra argued that the rules were<br />
incompatible with its rights under EC Treaty articles<br />
43 (freedom <strong>of</strong> establishment) and 49 (freedom to provide<br />
services).<br />
Considerations<br />
The ECJ noted that the leasing <strong>of</strong> vehicles is a service<br />
under article 50 <strong>of</strong> the EC Treaty.<br />
The Court went on to determine that the Austrian<br />
<strong>tax</strong> regime at issue — ‘‘which applies a less favourable<br />
<strong>tax</strong> regime to investments in assets which, once they<br />
have been hired out for remuneration, are used in other<br />
Member States, than to investments in such assets that<br />
are used domestically — is likely to discourage undertakings<br />
that would be eligible for that <strong>tax</strong> advantage<br />
from providing rental services to economic operators<br />
that carry out their activities in other Member States.’’<br />
Justifications<br />
The ECJ examined and rejected three possible justifications:<br />
the need to ensure balance in the allocation<br />
<strong>of</strong> <strong>tax</strong>ing rights, the need to safeguard the coherence <strong>of</strong><br />
the national <strong>tax</strong> system, and the need to prevent abuse.<br />
Allocation <strong>of</strong> Taxing Rights<br />
The Austrian and German governments argued that<br />
the investment-premium rules at issue were consistent<br />
with the allocation <strong>of</strong> <strong>tax</strong>ing rights between the member<br />
states. They pointed out that the conditional granting<br />
<strong>of</strong> the investment-premium <strong>tax</strong> advantage ‘‘aims to<br />
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EUROPEAN UNION<br />
ensure that there is a connection between, on the one<br />
hand, the granting <strong>of</strong> that <strong>tax</strong> advantage and, on the<br />
other hand, the <strong>tax</strong>ation <strong>of</strong> pr<strong>of</strong>its generated through<br />
the use <strong>of</strong> those assets.’’<br />
The ECJ replied that the rental income at issue is<br />
<strong>tax</strong>able in Austria; therefore, Austria’s right ‘‘to exercise<br />
its <strong>tax</strong>ing powers in relation to activities carried on<br />
in its territory’’ was not jeopardized.<br />
Coherence <strong>of</strong> the Tax System<br />
In response to arguments about the need to safeguard<br />
the coherence <strong>of</strong> the <strong>tax</strong> system, the ECJ noted<br />
that there was no direct link between the investmentpremium<br />
<strong>tax</strong> advantage granted to the lessor and the<br />
subsequent <strong>tax</strong>ation <strong>of</strong> the lessee’s income generated<br />
through the use <strong>of</strong> the leased assets.<br />
Need to Prevent Abuse<br />
The Austrian government argued that the <strong>tax</strong> rules<br />
at issue were aimed at preventing ‘‘wholly artificial arrangements<br />
involving transfers for remuneration.’’ One<br />
concern mentioned by the government was that ‘‘the<br />
lessor could hand over all or part <strong>of</strong> the premium to<br />
the lessee which, for its part, could use that asset to<br />
generate pr<strong>of</strong>its in other Member States. Thus, it would<br />
be possible to circumvent the fact that the advantage is<br />
limited to Austria.’’ Without the <strong>tax</strong> rules at issue, ‘‘it<br />
would be possible, merely by setting up the leasing<br />
company for a corporate group in Austria, to claim the<br />
investment premium for all the acquisitions made by<br />
that group, irrespective <strong>of</strong> where those assets are<br />
used,’’ it said.<br />
The ECJ agreed that the member states can have<br />
national <strong>tax</strong> rules that restrict the freedom to provide<br />
services, provided that those rules specifically target<br />
‘‘wholly artificial arrangements which do not reflect<br />
economic reality and whose only purpose is to obtain a<br />
<strong>tax</strong> advantage.’’ However, it said the leasing <strong>of</strong> assets<br />
to another undertaking for use in other member states<br />
‘‘cannot be the basis <strong>of</strong> a general presumption <strong>of</strong> abusive<br />
practice and justify a measure which compromises<br />
the exercise <strong>of</strong> a fundamental freedom guaranteed by<br />
the Treaty.’’<br />
The ECJ observed that the Austrian <strong>tax</strong> rules affected<br />
every lessor eligible for the investment-premium<br />
<strong>tax</strong> advantage that hired out assets for remuneration to<br />
undertakings operating cross-border activities, ‘‘and<br />
does so even where nothing points towards the existence<br />
<strong>of</strong> such an artificial arrangement. Furthermore,<br />
the legislation does not allow lessors to adduce evidence<br />
that no abuse is taking place.’’<br />
The Judgment<br />
Accordingly, the ECJ held that because the Austrian<br />
<strong>tax</strong> rules did not make it possible to limit the denial <strong>of</strong><br />
the investment-premium <strong>tax</strong> advantage to cases involving<br />
wholly artificial arrangements, the rules could not<br />
be justified by overriding reasons <strong>of</strong> public interest and,<br />
consequently, were precluded by article 49 <strong>of</strong> the EC<br />
Treaty.<br />
The ECJ further stated that there was no need to<br />
examine whether the EC Treaty provisions on freedom<br />
<strong>of</strong> establishment might also preclude the rules.<br />
Analysis<br />
This case is particularly interesting because <strong>of</strong> the<br />
ECJ’s comments on justifications — particularly the<br />
need to prevent <strong>tax</strong> abuse. The judgment appears to<br />
take the ECJ’s previous reasoning in this context one<br />
step further. The judgment also represents the latest in<br />
a line <strong>of</strong> cases concerning the <strong>tax</strong>ation <strong>of</strong> leasing services<br />
and how the <strong>tax</strong> rules interact with the fundamental<br />
freedoms.<br />
Balancing the Allocation <strong>of</strong> Taxing Rights<br />
In Jobra, that justification <strong>of</strong> the Austrian rules was<br />
unsuccessful because Austria failed to take into account<br />
the rental income received by Jobra from its subsidiary<br />
in relation to the leased assets. That income remained<br />
<strong>tax</strong>able in Austria. Thus, even though the leased assets<br />
might be used outside Austria, the income received<br />
from the leased assets remained within Austria’s <strong>tax</strong><br />
jurisdiction. Consequently, the argument that there was<br />
an impact on the allocation <strong>of</strong> <strong>tax</strong>ing rights was rejected,<br />
because although Austria granted an<br />
investment-premium <strong>tax</strong> advantage for the leased assets,<br />
which in this case were not used mainly in Austria,<br />
that did not impinge on Austria’s right to <strong>tax</strong> the<br />
income from those assets.<br />
Preventing Tax Abuse<br />
The ECJ acknowledged that the member states retain<br />
the right to prevent abuse in situations when the<br />
national rules specifically target ‘‘wholly artificial arrangements<br />
which do not reflect economic reality and<br />
whose only purpose is to obtain a <strong>tax</strong> advantage.’’ This<br />
was, in many respects, a repeat <strong>of</strong> its mantra from earlier<br />
cases such as Marks & Spencer (C-446/03), in which<br />
the ECJ noted that the member states were ‘‘free to<br />
adopt or to maintain in force rules having the specific<br />
purpose <strong>of</strong> precluding from a <strong>tax</strong> benefit wholly artificial<br />
arrangements whose purpose is to circumvent or<br />
escape national <strong>tax</strong> law.’’ 1 (For the ECJ judgment in<br />
Marks & Spencer, see Doc 2005-25015 or 2005 WTD 239-<br />
16.)<br />
The word ‘‘specific’’ should be emphasized because,<br />
as the ECJ explained once again in Jobra, problems<br />
1 This harks back to the much earlier ECJ judgment in ICI v.<br />
Colmer (C-264/96), in which the ECJ held that the U.K. rules<br />
were precluded by the freedom <strong>of</strong> establishment because they<br />
applied generally to all situations in which most <strong>of</strong> the group’s<br />
subsidiaries were established for whatever reason outside the<br />
United Kingdom.<br />
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occur when the national antiabuse rules are general in<br />
nature. The ECJ stated that it could not be claimed<br />
that there was such abuse when an undertaking hired<br />
assets out for remuneration to another undertaking that<br />
used them primarily in other member states, highlighting,<br />
in particular, that that hiring out ‘‘cannot be the<br />
basis <strong>of</strong> a general presumption <strong>of</strong> abusive practice and<br />
justify a measure which compromises the exercise <strong>of</strong> a<br />
fundamental freedom guaranteed by the Treaty.’’ This<br />
key flaw in the design <strong>of</strong> many member states’ <strong>tax</strong><br />
antiabuse rules is apparent from the ECJ’s jurisprudence,<br />
including the Austrian rules in this case.<br />
Burden <strong>of</strong> Pro<strong>of</strong><br />
Clearly, the burden <strong>of</strong> pro<strong>of</strong> in the area <strong>of</strong> <strong>tax</strong> abuse<br />
should remain on the <strong>tax</strong> authorities, at least until they<br />
make a prima facie case that the abuse exists. However,<br />
this is rarely the case when the antiabuse rules are<br />
drafted in a general way to include situations like those<br />
seen in Jobra, where no apparent abuse was happening.<br />
The ECJ dealt with this issue for the first time in Jobra<br />
when it commented that ‘‘the legislation at issue affects<br />
every lessor eligible for the investment premium which<br />
hires out assets for remuneration to undertakings carrying<br />
out cross-border activities, and does so even where<br />
nothing points towards the existence <strong>of</strong> such an artificial<br />
arrangement.’’<br />
The requirement that some evidence pointing toward<br />
the existence <strong>of</strong> wholly artificial arrangements or<br />
abuse should exist may be helpful to <strong>tax</strong>payers facing<br />
antiabuse rules in the future as, clearly, they can advance<br />
the argument to the <strong>tax</strong> authorities that the<br />
ECJ’s ruling in Jobra specifically mentioned that there<br />
is an onus on the <strong>tax</strong> authorities to at least demonstrate<br />
that something abusive is occurring. This is an<br />
additional part <strong>of</strong> the <strong>tax</strong> authorities’ burden <strong>of</strong> pro<strong>of</strong><br />
before the burden gets transferred over to the <strong>tax</strong>payer<br />
to show that no abuse is taking or has taken place.<br />
The ECJ, following the reasoning <strong>of</strong> its earlier <strong>tax</strong><br />
avoidance case law, goes on to make it clear that in the<br />
circumstances <strong>of</strong> this case, the Austrian rules do not<br />
allow lessors ‘‘to adduce evidence that no abuse is taking<br />
place.’’ The consequences <strong>of</strong> this are significant<br />
because the <strong>tax</strong>payer is never given the opportunity to<br />
rebut the allegation <strong>of</strong> abuse. Perhaps more importantly,<br />
as a result, the ECJ found that the Austrian <strong>tax</strong><br />
rules at issue do not make it possible to limit the refusal<br />
to grant the investment-premium <strong>tax</strong> advantage to<br />
cases involving wholly artificial arrangements, which<br />
indicates that the rules go too far and are a disproportionate<br />
restriction on the fundamental freedom to provide<br />
services.<br />
Protective Nature <strong>of</strong> the Austrian Rules<br />
Finally, it is useful to highlight the protective nature<br />
<strong>of</strong> the Austrian <strong>tax</strong> rules at issue in Jobra. Article 49 <strong>of</strong><br />
the EC Treaty precludes such rules because their aim<br />
was to provide <strong>tax</strong> advantages mainly for Austrian residents<br />
who leased assets to other Austrian residents<br />
who used the leased assets mainly in Austria. In an<br />
internal market, it is clear that such rules seriously<br />
hamper cross-border trade and economic activity, and<br />
the provision <strong>of</strong> leasing services in particular, because<br />
the <strong>tax</strong> advantage is limited to Austrian lessors and<br />
lessees who lease assets for mainly Austrian domestic<br />
use purposes.<br />
With many leasing companies providing services<br />
cross-border, Jobra may be one <strong>of</strong> the ECJ’s most significant<br />
preliminary rulings in the area <strong>of</strong> cross-border<br />
leasing, on a par with its earlier judgment in Eurowings<br />
(C-294/97), in which German <strong>tax</strong> rules that penalized<br />
a German company for obtaining its leasing services<br />
from an Irish company came under scrutiny and were<br />
found to be incompatible with the freedom to provide<br />
(and to receive) services as set forth in EC Treaty article<br />
49.<br />
In the eyes <strong>of</strong> the ECJ, protectionist rules <strong>of</strong> this<br />
nature have no place in an ‘‘area without internal frontiers.’’<br />
Although direct <strong>tax</strong>ation remains within the<br />
competence <strong>of</strong> the member states, the exercise <strong>of</strong> that<br />
competence when the member states design their <strong>tax</strong><br />
systems must take place in full compliance with EU<br />
law. In this case, the protectionist Austrian <strong>tax</strong> rules<br />
will have to be either amended (to ensure compliance)<br />
or repealed.<br />
♦ Tom O’Shea, Queen Mary University <strong>of</strong> London, Centre<br />
for Commercial Law Studies<br />
Germany<br />
GERMANY<br />
Former Deutsche Post CEO Convicted<br />
Of Tax Evasion<br />
A German court on January 26 convicted Klaus<br />
Zumwinkel, former CEO <strong>of</strong> Deutsche Post and the<br />
most prominent German <strong>tax</strong>payer to be caught up in<br />
the Liechtenstein <strong>tax</strong> scandal, <strong>of</strong> <strong>tax</strong> evasion, according<br />
to media reports.<br />
The Bochum court reportedly handed down a twoyear<br />
suspended sentence and fined Zumwinkel €1 million<br />
(about $1.3 million).<br />
The fine and two-year suspended sentence was what<br />
prosecutor Gerrit Gabriel called for in his closing remarks,<br />
according to a January 26 Associated Press report.<br />
‘‘He knew exactly what he was doing,’’ Gabriel<br />
was quoted as saying.<br />
Gabriel requested a relatively light sentence (conviction<br />
<strong>of</strong> <strong>tax</strong> evasion can lead to up to 10 years in prison<br />
under German law) given that Zumwinkel has paid<br />
€3.9 million (about $5.1 million) in back <strong>tax</strong>es and<br />
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GERMANY<br />
confessed to his wrongdoing on January 22 at the start<br />
<strong>of</strong> his trial. (For prior coverage, see Doc 2009-1382 or<br />
2009 WTD 13-3.)<br />
Since news <strong>of</strong> the Liechtenstein scandal broke in<br />
February 2008, German prosecutors have reportedly<br />
recovered over €150 million from German <strong>tax</strong>payers<br />
seeking to avoid a trial. German authorities claim that<br />
up to €4 billion was hidden in Liechtenstein.<br />
Haiti<br />
♦ Randall Jackson, Tax Analysts.<br />
E-mail: rjackson@<strong>tax</strong>.org<br />
Mobile Phone Service Providers<br />
Oppose Tax Hike<br />
Mobile phone service providers in Haiti are protesting<br />
a 2008-2009 budget measure that would increase<br />
the <strong>tax</strong> on mobile phone users.<br />
Radio Kiskeya, a Port-au-Prince news radio station<br />
reported on January 16 that the new proposal would<br />
amend the <strong>tax</strong>ation component <strong>of</strong> the Telecommunications<br />
Act <strong>of</strong> 2002.<br />
Mobile service providers have joined together to oppose<br />
the <strong>tax</strong> increase, claiming it would hurt the<br />
economy. Digicel, Voila, and Haitel insist that raising<br />
the <strong>tax</strong> on cell phone use would actually reduce <strong>tax</strong><br />
revenue by discouraging cell phone use and in turn<br />
reducing general business activity.<br />
The three companies say they have invested more<br />
than $600 million in the nation’s networks and services<br />
over the past 10 years, and that they directly employ<br />
more than 2,000 Haitians. They claim that as many as<br />
55,000 jobs indirectly rely on the smooth functioning<br />
<strong>of</strong> the telecommunications sector.<br />
Haiti’s General Tax Directorate acknowledged that<br />
the telecom sector has been the greatest source <strong>of</strong> government<br />
<strong>tax</strong> income since 1999, producing 28 percent<br />
<strong>of</strong> Haitian revenues in fiscal 2007-2008, which ended<br />
September 30, 2008.<br />
The proposed changes reportedly include a new<br />
charge <strong>of</strong> HTG 3.60 per minute (about $0.09) for local<br />
calls and HTG 4 per minute for <strong>international</strong> calls. The<br />
new charges would come on top <strong>of</strong> the current charge<br />
<strong>of</strong> HTG 4.70 per minute that subscribers must pay; the<br />
current charge includes a 10 percent revenue <strong>tax</strong>.<br />
♦ Randall Jackson, Tax Analysts.<br />
E-mail: rjackson@<strong>tax</strong>.org<br />
Hungary<br />
Employer Tax Cut, VAT Increase<br />
Under Consideration<br />
The Hungarian government has proposed cutting<br />
the payroll <strong>tax</strong> employers must contribute to the nation’s<br />
social security system by 5 percentage points to<br />
augment employment as Hungarian businesses struggle<br />
with liquidity and credit issues arising from the world<br />
financial crisis.<br />
In announcing the proposed payroll <strong>tax</strong> cut, Prime<br />
Minister Ferenc Gyurcsany was careful to emphasize<br />
that overall government revenue cannot be allowed to<br />
plummet as a result <strong>of</strong> <strong>tax</strong> breaks, according to media<br />
reports. He therefore also proposed increasing the VAT<br />
rate by 2 to 3 percentage points — to 22 percent or 23<br />
percent — to <strong>of</strong>fset the revenue loss from the payroll<br />
<strong>tax</strong> reduction.<br />
The government estimates that the proposed payroll<br />
<strong>tax</strong> reduction would cost an estimated HUF 300 billion<br />
(about $1.4 billion).<br />
The <strong>tax</strong> proposals follow a January 25 meeting at<br />
which Gyurcsany told economists that a reduction in<br />
Hungary’s <strong>tax</strong> and contribution rates is necessary to<br />
maintain the nation’s competitiveness.<br />
The economists suggested that Budapest put in place<br />
an overall economic and social reform plan that would<br />
cover the next three to four years, extending beyond<br />
the next parliamentary elections in 2010.<br />
Hungarian industrialists <strong>of</strong>fered their own suggestion<br />
at the January 25 gathering. Peter Furo, head <strong>of</strong> the<br />
Confederation <strong>of</strong> Hungarian Employers and Industrialists,<br />
told the Hungarian press that his organization suggested<br />
that Budapest suspend the capital gains <strong>tax</strong> for a<br />
year or two to spur savings and the purchase <strong>of</strong> government<br />
securities.<br />
While Gyurcsany was receptive to the economists’<br />
suggestion, he remained noncommittal toward the<br />
CGT proposal.<br />
The government expects the economy to contract by<br />
2 percent to 3 percent in 2009, forcing an adjustment<br />
in the budget that was approved in December 2008.<br />
But while Gyurcsany pointed to the need to lessen the<br />
<strong>tax</strong> burden on businesses, he also spoke <strong>of</strong> the need to<br />
maintain the budget’s deficit target <strong>of</strong> less than 3 percent<br />
<strong>of</strong> GDP, as required by the European Union.<br />
The government therefore hopes it can redistribute<br />
the <strong>tax</strong> burden, freeing up corporate money while preserving<br />
the income needed to hold down borrowing<br />
and the potential <strong>of</strong> an inflated deficit.<br />
Unnamed government sources were quoted as saying<br />
that Budapest wants to rearrange about HUF 1 trillion<br />
<strong>of</strong> spending and revenue items in the 2009 budget,<br />
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ut will insist on <strong>of</strong>fsetting <strong>tax</strong> cuts in one area with<br />
increases in another, such as with the VAT increase to<br />
<strong>of</strong>fset the payroll <strong>tax</strong> reduction.<br />
Peter Szijjarto, spokesman for the right-wing opposition<br />
Hungarian Civic Union, labeled Gyurcsany’s<br />
January 25 meeting a failure, according to a January<br />
26 report in The Budapest Times.<br />
The Alliance <strong>of</strong> Free Democrats, a fellow left-wing<br />
party to Gyurcsany’s Hungarian Socialist Party, said in<br />
a statement that while it applauds Gyurcsany’s desire<br />
to reduce <strong>tax</strong>es and contributions, it questions his earnestness<br />
in light <strong>of</strong> a December 2008 statement in<br />
which he said that <strong>tax</strong> cuts in 2009 or 2010 would be<br />
impossible. The Alliance <strong>of</strong> Free Democrats called<br />
Gyurcsany’s inconsistency ‘‘harmful’’ to the Hungarian<br />
economy.<br />
The parties were scheduled to meet in an extraordinary<br />
session <strong>of</strong> parliament on January 29 to discuss<br />
the worsening economy and the government’s proposed<br />
legislation. The government plans to submit the<br />
most pressing bills to the parliament by mid-March to<br />
facilitate an effective date <strong>of</strong> July 1, Gyurcsany said in<br />
a statement.<br />
India<br />
♦ Randall Jackson, Tax Analysts.<br />
E-mail: rjackson@<strong>tax</strong>.org<br />
Indian PE Not Responsible for<br />
Withholding, Tax Tribunal Says<br />
The Mumbai Income Tax Appellate Tribunal on<br />
December 5 issued its ruling in DCIT v. Stock Engineer<br />
and Contractors BV, clarifying the withholding <strong>tax</strong> obligation<br />
on payments made to nonresidents by an Indian<br />
permanent establishment <strong>of</strong> a Dutch company, as well<br />
as the deductibility <strong>of</strong> some expenses for such a PE.<br />
In the case at issue, which related to assessment<br />
year 2000-2001, Stock Engineer and Contractors (the<br />
assessee), a company incorporated in and resident <strong>of</strong><br />
the Netherlands, was engaged in the design and construction<br />
<strong>of</strong> oil, gas, and petrochemical plants. It<br />
signed a contract with an Indian oil company for the<br />
engineering, procurement, and construction <strong>of</strong> a facility<br />
in India on a turnkey basis. For that purpose, the<br />
assessee set up project and site <strong>of</strong>fices in India (an Indian<br />
PE) after obtaining the due regulatory approval.<br />
The assessee in turn subcontracted a part <strong>of</strong> the work<br />
to its Malaysian subsidiary.<br />
Under that agreement, the Malaysian subsidiary was<br />
to supply personnel to the assessee for the purpose <strong>of</strong><br />
INDIA<br />
executing the Indian project. Those personnel stayed in<br />
India for a period <strong>of</strong> more than six months during the<br />
year under consideration.<br />
Separately, the assessee also engaged a U.K. company<br />
to deploy employees for supervision <strong>of</strong> the Indian<br />
project, and another Dutch company to provide engineering<br />
services. Both <strong>of</strong> those companies were unrelated<br />
to the assessee.<br />
The personnel <strong>of</strong> the U.K. company were deployed<br />
in India for 135 days. The assessee did not withhold<br />
any Indian income <strong>tax</strong> when paying the Malaysian,<br />
U.K., and Dutch suppliers. (The assessee also had<br />
some employees at its head <strong>of</strong>fice who dedicated part<br />
<strong>of</strong> their time providing technical support to the Indian<br />
PE; however, none <strong>of</strong> those employees visited India for<br />
the project work.)<br />
During the 2000-2001 assessment year, the assessee<br />
deducted the payments it made to the Malaysian subsidiary<br />
and the unrelated U.K. and Dutch companies<br />
in computing the Indian PE’s <strong>tax</strong>able income. The assessee<br />
also deducted part <strong>of</strong> the salary cost incurred by<br />
the head <strong>of</strong>fice for its employees based on the number<br />
<strong>of</strong> hours the employees spent on the Indian project.<br />
In the course <strong>of</strong> assessment proceedings, the <strong>tax</strong><br />
<strong>of</strong>ficer concluded that the assessee was subject to a<br />
withholding <strong>tax</strong> obligation on the payments it made to<br />
the various service suppliers. Because no <strong>tax</strong> was withheld,<br />
those payments were not deductible in computing<br />
the <strong>tax</strong>able pr<strong>of</strong>its <strong>of</strong> the Indian PE, 1 the <strong>tax</strong> <strong>of</strong>ficer<br />
said.<br />
In particular, the <strong>tax</strong> <strong>of</strong>ficer took the position that<br />
the Malaysian subsidiary had a PE in India under article<br />
5(4)(a) <strong>of</strong> the India-Malaysia income <strong>tax</strong> treaty,<br />
which states that a PE is created if supervisory activities<br />
are carried out in India for more than six months<br />
in connection with a construction, installation, or assembly<br />
project in India.<br />
The <strong>tax</strong> <strong>of</strong>ficer also held that the U.K. company had<br />
a PE in India under article 5(2)(k) <strong>of</strong> the India-U.K.<br />
income <strong>tax</strong> treaty, which states that a services PE is<br />
created if the aggregate stay <strong>of</strong> the personnel in India<br />
exceeds 90 days.<br />
Regarding the payment to the Dutch company, the<br />
<strong>tax</strong> <strong>of</strong>ficer held that it constituted a payment for technical<br />
services, which is subject to <strong>tax</strong> under the India-<br />
Netherlands income <strong>tax</strong> treaty.<br />
1 Failure to meet the withholding <strong>tax</strong> obligation leads to,<br />
among other things, the denial <strong>of</strong> a <strong>tax</strong> deduction for the payment<br />
in question (ITA section 40(a)(i)). The withholding <strong>tax</strong> obligation<br />
in the case <strong>of</strong> payment to a nonresident is triggered under<br />
ITA section 195 if the payment is subject to Indian income<br />
<strong>tax</strong> in the hands <strong>of</strong> the recipient.<br />
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INDIA<br />
Addressing the assessee’s deduction <strong>of</strong> the salary<br />
costs <strong>of</strong> some employees in its head <strong>of</strong>fice, the <strong>tax</strong> <strong>of</strong>ficer<br />
said those costs were in the nature <strong>of</strong> head <strong>of</strong>fice<br />
expenses, which are subject to a deductibility cap under<br />
section 44C <strong>of</strong> the Indian Income Tax Act. 2 Subjecting<br />
it to that limit, the <strong>tax</strong> <strong>of</strong>ficer denied the deduction.<br />
The assessee successfully argued its case before the<br />
commissioner <strong>of</strong> income <strong>tax</strong> (appeals). The Revenue<br />
Department then appealed to the tribunal.<br />
Tribunal’s Ruling<br />
The tribunal held that the Malaysian company did<br />
not have a PE in India under article 5(4)(a) <strong>of</strong> the<br />
India-Malaysia <strong>tax</strong> treaty. It noted that the personnel<br />
supplied by the Malaysian company were under the<br />
direct control <strong>of</strong> the assessee, that the Malaysian company<br />
had no further role after the personnel were supplied<br />
to the assessee, and that the Malaysian company<br />
did not carry out any direct supervisory activities in<br />
India.<br />
Also, the tribunal noted that there is no article in<br />
the India-Malaysia <strong>tax</strong> treaty that deals specifically<br />
with fees for technical services. Consequently, there<br />
was no obligation on the assessee to withhold Indian<br />
<strong>tax</strong> from the payments it made to the Malaysian company<br />
and the payments were therefore <strong>tax</strong> deductible.<br />
The tribunal also noted that article 5(2)(j) <strong>of</strong> its <strong>tax</strong><br />
treaties, which provides for a threshold <strong>of</strong> six months<br />
in India, specifically refers to a building site, installation,<br />
or assembly project, or supervisory activities in<br />
connection therewith.<br />
Turning to the assessee’s payments to the U.K. company,<br />
the tribunal noted that, in contrast to article<br />
5(2)(j), a PE is triggered under article 5(2)(k) when services,<br />
including managerial services, are performed in<br />
India for an unrelated party for a period <strong>of</strong> more than<br />
90 days in any 12-month period.<br />
The tribunal therefore applied the settled legal principle<br />
that if two provisions are equally applicable to a<br />
situation, the one that is most beneficial to the <strong>tax</strong>payer<br />
should be adopted. Because the personnel <strong>of</strong> the<br />
U.K. company were deployed in India for no more<br />
than 135 days, there was no PE for the U.K. company<br />
under article 5(2)(j) <strong>of</strong> the India-U.K. <strong>tax</strong> treaty. Consequently,<br />
the assessee was not required to withhold any<br />
Indian <strong>tax</strong> from its payments to the U.K. company and<br />
the payments were therefore <strong>tax</strong> deductible.<br />
Regarding the services supplied by the Dutch company,<br />
the tribunal held that those services, while tech-<br />
2 ITA section 44C limits the deduction for head <strong>of</strong>fice expenses<br />
to 5 percent <strong>of</strong> <strong>tax</strong>able income, computed as specified.<br />
Head <strong>of</strong>fice expenses have been defined to mean executive and<br />
general administrative expenditures incurred by the assessee outside<br />
<strong>of</strong> India, including salaries, rent, travel expenses, and so on.<br />
nical, did not make any technical knowledge or experience<br />
available to the assessee. As such, the assessee’s<br />
payments to the Dutch company could not be classified<br />
as fees for technical services within the meaning <strong>of</strong><br />
article 12 <strong>of</strong> the India-Netherlands <strong>tax</strong> treaty, the tribunal<br />
said. The assessee therefore was not required to<br />
withhold any Indian <strong>tax</strong> from the payments, and the<br />
payments were <strong>tax</strong> deductible, the tribunal ruled.<br />
On the final question, the tribunal held that the deductibility<br />
cap on head <strong>of</strong>fice expenses is limited to<br />
executive and general administrative expenses incurred<br />
by the head <strong>of</strong>fice for a common purpose — for example,<br />
for purposes <strong>of</strong> managing the head <strong>of</strong>fice as<br />
well as all branches and PEs in general. In the case at<br />
issue, the payment was made to employees who<br />
worked in the head <strong>of</strong>fice and did not work exclusively<br />
on the Indian project (that is, they also worked for the<br />
head <strong>of</strong>fice, as shown by the allocation <strong>of</strong> part <strong>of</strong> the<br />
salary costs based on the hours spent on the Indian<br />
project). Therefore, there was a common purpose for<br />
those expenses as envisaged in ITA section 44C, the<br />
tribunal said.<br />
However, because the employees were providing specific<br />
technical services to the Indian project, their costs<br />
could not be classified as executive and general administrative<br />
expenditures, which refer to managerial and<br />
administrative services alone and do not include technical<br />
services, the tribunal said. Therefore, those costs<br />
were not subject to the deductibility cap imposed by<br />
ITA section 44C and were fully deductible in computing<br />
the <strong>tax</strong>able pr<strong>of</strong>its <strong>of</strong> the Indian PE.<br />
For nonresidents with a PE in India, this ruling may<br />
make it easier to fully claim a deduction for costs relating<br />
to services other than managerial and administrative<br />
services, subject <strong>of</strong> course to the arm’s-length principle<br />
under the transfer pricing code.<br />
♦ Shrikant S. Kamath, <strong>tax</strong> consultant, Hong Kong<br />
Subsidiaries in India Do Not<br />
Constitute a PE, Tribunal Rules<br />
A German company’s Indian subsidiaries do not<br />
constitute a permanent establishment in India; therefore,<br />
the company is not subject to <strong>tax</strong>ation in India,<br />
according to the Pune Income Tax Appellate Tribunal.<br />
The tribunal’s ruling in ACIT v. Epcos AG — issued<br />
on June 30, 2008, and made public on January 21 —<br />
involves the 2003-2004 assessment year and deals with<br />
issues relating to the Germany-India income <strong>tax</strong> treaty<br />
and the Indian Income Tax Act, 1961. (For the ruling,<br />
see Doc 2009-1333 or 2009 WTD 14-21.)<br />
Background<br />
Epcos AG is a multinational company that designs,<br />
manufactures, and markets electronic components. It<br />
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has operations in Germany and subsidiaries across the<br />
world, including two in India. During the year under<br />
consideration, the German arm <strong>of</strong> Epcos AG supplied<br />
services such as marketing, sales support, and technology<br />
support to the Indian subsidiaries in return for royalty<br />
payments.<br />
In its Indian <strong>tax</strong> return, the German arm <strong>of</strong> Epcos<br />
AG classified the payments it received from the Indian<br />
subsidiaries as royalties and fees for technical services,<br />
which were subject to Indian income <strong>tax</strong> at a rate <strong>of</strong><br />
10 percent under article 12 <strong>of</strong> the Germany-India income<br />
<strong>tax</strong> treaty.<br />
The Indian <strong>tax</strong> <strong>of</strong>ficer requested details about the<br />
services supplied to the Indian subsidiaries by the assessee,<br />
and the company submitted that sales are<br />
handled by Epcos AG’s regional sales <strong>of</strong>fices, whereas<br />
marketing efforts are centralized at the German headquarters<br />
in Munich.<br />
The company said it is organized by product divisions,<br />
and each division has a central marketing team<br />
that works for all the manufacturing subsidiaries in that<br />
division. Epcos AG charges an arm’s-length fee for the<br />
services that the central marketing team renders for the<br />
benefit <strong>of</strong> the various manufacturing subsidiaries.<br />
The transfer pricing <strong>of</strong>ficer (TPO) agreed that the<br />
services provided by the assessee were supplied to the<br />
Indian subsidiaries on an arm’s-length basis, as required<br />
by the transfer pricing provisions <strong>of</strong> the ITA.<br />
The <strong>tax</strong> <strong>of</strong>ficer, however, thought that the assessee<br />
had a PE in India in the form <strong>of</strong> the two subsidiaries<br />
because the assessee was conducting its business in India<br />
through those subsidiaries and more specifically,<br />
through the employees <strong>of</strong> the subsidiaries. He classified<br />
the payments at issue as business pr<strong>of</strong>its under article 7<br />
<strong>of</strong> the Germany-India <strong>tax</strong> treaty and assessed <strong>tax</strong> on a<br />
gross basis at the 20 percent rate provided under the<br />
ITA. (For the year in question, the ITA did not allow a<br />
deduction for any expenses related to royalties and fees<br />
for technical services earned by a foreign company.)<br />
The commissioner <strong>of</strong> income <strong>tax</strong> (appeals) subsequently<br />
overturned the assessment, holding that the<br />
services supplied by Epcos AG were routine in nature<br />
and were provided to enable the Indian subsidiaries to<br />
carry on their own business activities, and not the business<br />
<strong>of</strong> the assessee. The Revenue Department then<br />
appealed to the tribunal.<br />
The Tribunal’s Decision<br />
In the tribunal’s own words, the commissioner <strong>of</strong><br />
income <strong>tax</strong> (appeals) properly rejected the <strong>tax</strong> <strong>of</strong>ficer’s<br />
‘‘overzealous approach.’’<br />
The tribunal held that a <strong>tax</strong> treaty generally provides<br />
for an alternate <strong>tax</strong> regime and not an exemption regime.<br />
Therefore, the burden is first on the Revenue Department<br />
to show that the assessee has <strong>tax</strong>able income<br />
under the treaty, and then the burden is on the assessee<br />
to show that its income is exempt under the treaty. Unless<br />
a <strong>tax</strong> jurisdiction has a right to <strong>tax</strong> an income, it is<br />
irrelevant whether, under the domestic <strong>tax</strong> legislation<br />
<strong>of</strong> that <strong>tax</strong> jurisdiction, the income in question is <strong>tax</strong>able.<br />
In a situation in which India has no right to <strong>tax</strong> a<br />
particular income in the hands <strong>of</strong> the nonresident covered<br />
by a <strong>tax</strong> treaty, the provisions <strong>of</strong> ITA do not<br />
come into play at all.<br />
The tribunal confirmed that when an economic activity<br />
is carried out in a fixed place <strong>of</strong> business available<br />
to a foreign enterprise, that place will be a PE <strong>of</strong><br />
the foreign enterprise regardless <strong>of</strong> whether the activities<br />
at issue are core activities or peripheral activities.<br />
However, if the PE carries on an activity that does not<br />
serve the overall purpose <strong>of</strong> the foreign enterprise or<br />
does not contribute to the pr<strong>of</strong>its <strong>of</strong> the foreign enterprise,<br />
the existence <strong>of</strong> such a PE is wholly academic<br />
and does not have any <strong>tax</strong> implications in the source<br />
jurisdiction (in this case, India).<br />
While Epcos AG’s business is to supply certain<br />
types <strong>of</strong> services to its Indian subsidiaries, the business<br />
<strong>of</strong> the Indian subsidiaries is to manufacture and sell<br />
their own products, the tribunal said. The fact that the<br />
employees <strong>of</strong> the Indian subsidiaries were also engaged<br />
in marketing and information technology support activities<br />
does not mean that those employees were doing<br />
the business <strong>of</strong> the assessee, it said.<br />
Further, the TPO had agreed that the payments<br />
made by the Indian subsidiaries to Epcos AG were at<br />
arm’s length, and the assessee had not reimbursed the<br />
subsidiaries for any costs incurred in connection with<br />
their employees in India, and as such, there could not<br />
be any payment for, or in connection with, the services<br />
rendered by those employees.<br />
The tribunal therefore held that the Indian subsidiaries<br />
did not constitute a PE <strong>of</strong> Epcos AG in India, and<br />
that the assesssee was not subject to <strong>tax</strong>ation in India<br />
on royalties or technical service fees paid by the Indian<br />
subsidiaries.<br />
♦ Shrikant S. Kamath, <strong>tax</strong> consultant, Hong Kong<br />
Indonesia<br />
Exit Tax Rules Revised<br />
INDONESIA<br />
Indonesia’s Directorate General <strong>of</strong> Taxation on December<br />
21, 2008, issued Regulation PER-53/PJ/2008<br />
(later amended by PER-1/PJ/2009 <strong>of</strong> January 9,<br />
2009), regarding the procedures for payment, exemption,<br />
and administration <strong>of</strong> the fiscal (exit) <strong>tax</strong> for resident<br />
individuals traveling overseas.<br />
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INDONESIA<br />
As <strong>of</strong> January 1 and continuing through December<br />
31, 2010, the new rates for the fiscal <strong>tax</strong> are IDR 2.5<br />
million for travel by air and IDR 1 million for travel by<br />
sea.<br />
Indonesian <strong>tax</strong> residents who are 21 years and older<br />
and who have not registered and received a <strong>tax</strong> identification<br />
number (NPWP) are required to pay the fiscal<br />
<strong>tax</strong>, which is creditable against the individual’s income<br />
<strong>tax</strong> payable at the end <strong>of</strong> the year (once the <strong>tax</strong>payer<br />
has obtained an NPWP). The new regulation does not<br />
address the mechanism for crediting fiscal <strong>tax</strong> against<br />
an employer’s income <strong>tax</strong> payable at year-end.<br />
In contrast, <strong>tax</strong>payers who have registered and received<br />
an NPWP are no longer required to pay the fiscal<br />
<strong>tax</strong>. The <strong>tax</strong>payer’s spouse and dependent family<br />
members also will be exempt from the <strong>tax</strong>, provided<br />
that they are listed on the family card (Kartu Keluarga)<br />
<strong>of</strong> the NPWP holder. For families <strong>of</strong> foreign citizens<br />
with an NPWP, the <strong>tax</strong>payer must attach a photocopy<br />
<strong>of</strong> a Certificate <strong>of</strong> Expatriate’s Family Structure or<br />
other <strong>of</strong>ficial document equivalent to the certificate,<br />
indicating the family relationship status.<br />
Exemptions from the fiscal <strong>tax</strong> are granted to foreign<br />
<strong>tax</strong>payers who do not reside in Indonesia or who<br />
stay in Indonesia for no more than 183 days in a 12month<br />
period. Diplomats and representatives <strong>of</strong> <strong>international</strong><br />
organizations and their families, Indonesian<br />
citizens permanently residing abroad, hajj pilgrims, individuals<br />
crossing land borders, Indonesian students<br />
studying abroad, Indonesian workers with migrant<br />
worker cards, and individual <strong>tax</strong> residents with annual<br />
income below the non<strong>tax</strong>able income threshold also<br />
are exempt from the fiscal <strong>tax</strong>.<br />
♦ Firdaus Asikin and Connie Chu,<br />
Deloitte Touche Tohmatsu, Jakarta. Copyright © 2009<br />
Deloitte Touche Tohmatsu. All rights reserved.<br />
Regulation Amends CFC Rules,<br />
Clarifies Export Duty<br />
Indonesia’s Ministry <strong>of</strong> Finance recently issued<br />
Regulation 256/PMK.03/2008 (dated December 31,<br />
2008) revising the previous controlled foreign corporation<br />
rules under Ministry <strong>of</strong> Finance Decree 650/<br />
KMK.04/1994.<br />
The new rules, which entered into force on January<br />
1, no longer contain blacklisted countries; thus, Indonesia<br />
no longer distinguishes between the jurisdictions <strong>of</strong><br />
foreign subsidiaries. Any undistributed pr<strong>of</strong>its <strong>of</strong> unlisted<br />
companies with Indonesian control <strong>of</strong> 50 percent<br />
or more that are incorporated in foreign countries will<br />
be deemed to be distributed if they are not distributed<br />
within four months <strong>of</strong> the most recent submission <strong>of</strong><br />
an annual <strong>tax</strong> return in that foreign country.<br />
If there is no obligation to file an annual <strong>tax</strong> return<br />
in that foreign country, the undistributed pr<strong>of</strong>its will be<br />
deemed distributed if they are not distributed within<br />
seven months after the <strong>tax</strong> year ends.<br />
Distributed dividends received from foreign subsidiaries<br />
are <strong>tax</strong>ed in the normal manner. The ordinary<br />
foreign <strong>tax</strong> credit with a per-country limitation does<br />
not extend to the underlying corporate <strong>tax</strong>.<br />
Like the old CFC regulations, the new rules apply<br />
only to foreign subsidiaries that are directly held by<br />
Indonesian <strong>tax</strong> residents and do not have grandfathering<br />
provisions that extend to foreign subsidiaries indirectly<br />
owned by Indonesian <strong>tax</strong> residents through their<br />
direct foreign subsidiaries acting as mixer companies.<br />
It is unclear whether the CFC rules are still applicable<br />
if the Indonesian shareholder does not have<br />
rights to receive dividends under the relevant laws in<br />
the jurisdiction <strong>of</strong> the foreign subsidiary.<br />
Export Duty<br />
The Ministry <strong>of</strong> Finance also issued Regulation<br />
214/PMK.04/2008 (dated December 16, 2008), which<br />
clarifies Export Duty Regulation 214. Regulation 214,<br />
which entered into force on January 1, implemented<br />
Customs Law 17 <strong>of</strong> 2006 and articles 2(5), 14, and 18<br />
<strong>of</strong> Regulation 55 <strong>of</strong> 2008 concerning the application <strong>of</strong><br />
export duty.<br />
Generally, exported goods are subject to export duty,<br />
with the exception <strong>of</strong>:<br />
• goods owned by foreign missions or their <strong>of</strong>ficials<br />
who are posted in Indonesia, based on the principle<br />
<strong>of</strong> reciprocity;<br />
• goods that are owned and used by museums,<br />
zoos, and similar public places, as well as goods<br />
used for nature conservation;<br />
• goods used in scientific research and development;<br />
• goods that are used as samples and are not for<br />
commercial use;<br />
• belongings <strong>of</strong> individual passengers and carrier<br />
crew members traveling cross-border, and shipments<br />
up to a certain value <strong>of</strong> export duty or in<br />
specified amounts;<br />
• goods that were imported and reexported; and<br />
• exported goods that will later be imported.<br />
To be eligible for the export <strong>tax</strong> exemption, an exporter<br />
must file a written declaration with the head <strong>of</strong><br />
the customs <strong>of</strong>fice reporting goods that fall into the<br />
first four categories mentioned above, and must file an<br />
application with the head <strong>of</strong> the customs <strong>of</strong>fice for the<br />
last two categories <strong>of</strong> goods mentioned above.<br />
The export duty rate is based on a percentage <strong>of</strong> the<br />
export value (ad valorum) or the specific amount <strong>of</strong><br />
the export value. The rate is based on the export value<br />
stipulated on the date the export declaration is filed<br />
with the customs <strong>of</strong>fice.<br />
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The exporter or its customs proxy generally must<br />
pay the export duty by the time the export declaration<br />
is filed with the customs <strong>of</strong>fice. For some exports, the<br />
deadline is 60 days after the departure <strong>of</strong> the carrier <strong>of</strong><br />
those goods.<br />
As with other customs and <strong>tax</strong> disputes, any dispute<br />
over export duty shall begin with the filing <strong>of</strong> an objection<br />
application to the Directorate General <strong>of</strong> Customs<br />
and Excise. If the directorate’s decision is not satisfactory,<br />
the exporter may appeal to the <strong>tax</strong> court.<br />
Jamaica<br />
♦ Freddy Karyadi, senior lecturer,<br />
Trisakti University, Jakarta<br />
World Bank Backs Jamaican Tax<br />
Reform Effort<br />
The World Bank has issued a $100 million development<br />
policy loan to Jamaica that is intended to assist<br />
the Caribbean nation as it seeks to improve its finances<br />
and reform its <strong>tax</strong> system.<br />
The World Bank on January 15 announced it had<br />
approved the fiscal and debt sustainability development<br />
policy loan to aid Jamaica in containing public spending,<br />
improving financial management and budgeting<br />
processes, and ‘‘enhancing the efficiency and fairness<br />
<strong>of</strong> the <strong>tax</strong> system.’’ The loan will have a 30-year term<br />
and will defer payments for the first five years.<br />
The Jamaican government laid out its proposal to<br />
reform both <strong>tax</strong> policy and <strong>tax</strong> administration in its<br />
December 2008 loan request. The proposal calls for<br />
reporting the costs <strong>of</strong> <strong>tax</strong> exemptions and special rates<br />
to lawmakers, eliminating general consumption <strong>tax</strong> exemptions<br />
for nonfood categories and certain purchaser<br />
categories, taking steps to ensure that corporate pr<strong>of</strong>its<br />
are <strong>tax</strong>ed at either the corporate or individual level,<br />
and increasing the income <strong>tax</strong> threshold.<br />
To improve <strong>tax</strong> system administration, the proposal<br />
calls for reducing filing requirements through payroll<br />
<strong>tax</strong> consolidation, increasing enforcement efforts, and<br />
improving the <strong>tax</strong> authorities’ ability to collect and use<br />
information to detect fraud and evasion.<br />
In his April 2008 budget speech, Prime Minister<br />
Bruce Golding had outlined the challenges faced by the<br />
government as it seeks to reform <strong>tax</strong>ation. Golding<br />
called the current system ‘‘inequitable, inefficient and<br />
leaky.’’ According to Golding, the government is collecting<br />
only 20 percent <strong>of</strong> applicable corporate <strong>tax</strong>es<br />
and only half <strong>of</strong> applicable property <strong>tax</strong>es. He also<br />
said that outside the country’s pay as you earn (PAYE)<br />
system, only 4,000 individuals pay income <strong>tax</strong>. Gold-<br />
ing estimated that 250,000 self-employed individuals<br />
who are liable to pay income <strong>tax</strong> are not doing so.<br />
‘‘We could significantly reduce <strong>tax</strong>es and collect significantly<br />
more <strong>tax</strong>es, if everybody paid and this will<br />
be the aim <strong>of</strong> the comprehensive <strong>tax</strong> reform program,<br />
which we intend to introduce next year,’’ Golding said.<br />
The Jamaica Confederation <strong>of</strong> Trade Unions<br />
(JCTU) has criticized the current income <strong>tax</strong> system as<br />
creating an ‘‘unfair and unjust <strong>tax</strong> burden’’ on PAYE<br />
workers. In a January 4 opinion article published in<br />
The Gleaner, JCTU General Secretary Lloyd Goodleigh<br />
called on Parliament to ‘‘implement a <strong>tax</strong> reform package<br />
that is efficient and equitable.’’<br />
‘‘Parliament can correct an economic inefficiency<br />
and transform the society by putting in place an<br />
efficient/equitable <strong>tax</strong> system and seeking to secure<br />
national consensus on a social covenant between the<br />
government <strong>of</strong> Jamaica and its citizens,’’ Goodleigh<br />
wrote.<br />
On January 17 the Jamaican government announced<br />
the Domestic Tax Administration Project, which targets<br />
the same <strong>tax</strong> administration goals included in the<br />
World Bank proposal. Under the plan, the government<br />
will consolidate three collection departments to fall<br />
within the authority <strong>of</strong> the commissioner general.<br />
‘‘The new regime is expected to achieve increased<br />
revenue through significant improvements in the efficiency<br />
and effectiveness <strong>of</strong> the organization <strong>of</strong> domestic<br />
<strong>tax</strong>; contribute directly to macroeconomic stability,<br />
stimulate greater voluntary compliance and collect<br />
more <strong>of</strong> the revenues due; reduce dependence on borrowing<br />
by making additional financial resources available<br />
on a sustainable basis to finance budgetary needs<br />
and be able to reduce <strong>tax</strong> rates through widening <strong>of</strong><br />
the <strong>tax</strong> base,’’ the government said in a January 17 release.<br />
Japan<br />
JAPAN<br />
♦ David D. Stewart, Tax Analysts.<br />
E-mail: dstewart@<strong>tax</strong>.org<br />
Consumption Tax Measure Advances<br />
Japanese Prime Minister Taro Aso’s Cabinet on<br />
January 23 approved a supplementary clause in the<br />
implementation legislation for the proposed 2009<br />
budget proposal that paves the way for an increase in<br />
the current 5 percent consumption <strong>tax</strong> rate in or after<br />
fiscal 2011. (For related coverage, see Doc 2008-26445 or<br />
2008 WTD 243-2.)<br />
The final wording <strong>of</strong> the supplementary clause reflects<br />
a compromise between members <strong>of</strong> the ruling<br />
Liberal Democratic Party (LDP) who opposed Aso’s<br />
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JAPAN<br />
insistence that the bill include a hard and fast commitment<br />
to raise the consumption <strong>tax</strong> in fiscal 2011, and<br />
those who supported Aso’s position. The clause also<br />
stresses the need for Tokyo to promote administrative<br />
reform and to deal with wasteful expenditures — important<br />
points for many LDP members who opposed<br />
the initial 2011-specific wording. With an election<br />
looming later this year, Aso reportedly wants to avoid<br />
creating tension within his party.<br />
The LDP needs to receive a two-thirds majority in<br />
the powerful lower house <strong>of</strong> the Diet to have any<br />
hopes <strong>of</strong> passing budget-related bills that may be rejected<br />
by the opposition Democratic Party <strong>of</strong> Japan<br />
(DPJ), the majority party in the upper house.<br />
The revised clause states that the actual date for increasing<br />
the <strong>tax</strong> rate will be specified in a separate bill,<br />
but that all necessary legal preparations will be put in<br />
place by fiscal 2011, which would enable the government<br />
to implement the <strong>tax</strong> increase and other related<br />
<strong>tax</strong> reforms as soon as a date is agreed upon.<br />
By revising the supplementary clause the Cabinet<br />
has aligned itself with the LDP’s Treasury and Finance<br />
Division and its Policy Deliberation Committee, both<br />
<strong>of</strong> which reportedly gave their approval a day earlier.<br />
The party’s General Council also signaled its backing<br />
<strong>of</strong> the implementation legislation, including the supplementary<br />
clause, on January 23. The 2009 budget proposal<br />
was presented to the Diet on January 19.<br />
Some LDP lawmakers continue to harbor concerns.<br />
‘‘The wording is still ambiguous. Prime Minister Aso<br />
has a responsibility to give a full account <strong>of</strong> the plan,’’<br />
said Kenichi Mizuno, an LDP member <strong>of</strong> the House<br />
<strong>of</strong> Representatives (lower house), according to a January<br />
22 Kyodo News report.<br />
‘‘I find it acceptable if the government would<br />
specify the rate increase and the specific date in separate<br />
legislation,’’ added Ichita Yamamoto, an LDP<br />
member <strong>of</strong> the House <strong>of</strong> Councillors (upper house)<br />
who had previously opposed the clause. However,<br />
Yamamoto told reporters that ‘‘it is impossible to raise<br />
the consumption <strong>tax</strong> in fiscal 2011.’’ The Japanese fiscal<br />
year runs April 1 to March 30.<br />
Not surprisingly, the opposition DPJ was quick to<br />
condemn the consumption <strong>tax</strong> clause. At a January 23<br />
press conference in Tokyo, DPJ acting President Naoto<br />
Kan said the clause ‘‘has highlighted Prime Minister<br />
Aso’s flip-flop on another important issue.’’ Kan apparently<br />
was alluding to Aso’s indecision about whether<br />
high-income individuals should accept cash payments<br />
from Tokyo as part <strong>of</strong> the government’s overall stimulus<br />
plan. Aso initially suggested that high-income individuals<br />
should not accept any <strong>of</strong> the ¥2 trillion (about<br />
$22.5 billion) dispersal, but he reportedly changed his<br />
mind, later saying that everyone should use the money<br />
to stimulate the economy.<br />
LDP supporters defended Aso at various Tokyo<br />
press conferences on January 23. In one conference,<br />
Chief Cabinet Secretary Takeo Kawamura downplayed<br />
the possibility that LDP members will still oppose the<br />
bill when it comes up for vote in the Diet and denied<br />
that the wording indicates a retreat from Aso’s original<br />
position. ‘‘The policy presented remains the same,’’ he<br />
told reporters.<br />
Aso now hopes to build support among the Japanese<br />
public for an eventual consumption <strong>tax</strong> increase.<br />
He reportedly has assigned Akira Amati, state minister<br />
in charge <strong>of</strong> administrative reform, to draw up a plan<br />
that will address needed administrative reforms, spotlight<br />
wasteful spending, and suggest ways to make the<br />
public servant system more efficient. All <strong>of</strong> those steps<br />
are reflected in the supplementary clause as steps to be<br />
taken before resorting to a consumption <strong>tax</strong> increase.<br />
Aso’s approval rating has plummeted recently to<br />
below 20 percent, partly as a result <strong>of</strong> rising unemployment<br />
and falling wages. His decreasing popularity<br />
raises the threat <strong>of</strong> an LDP defeat in the general elections,<br />
which are to be held by September.<br />
Multinational<br />
♦ Randall Jackson, Tax Analysts.<br />
E-mail: rjackson@<strong>tax</strong>.org<br />
IASB Rejects Proposal to Allow<br />
Discounting <strong>of</strong> Current Tax in IAS 12<br />
The International Accounting Standards Board<br />
January 23 voted against a proposal included in a ballot<br />
draft <strong>of</strong> an exposure document <strong>of</strong> amendments to<br />
International Accounting Standard No. 12, ‘‘Income<br />
Taxes,’’ that would broadly allow for the discounting <strong>of</strong><br />
a company’s current <strong>tax</strong> assets and liabilities.<br />
At its board meeting in London, the IASB also decided<br />
to ‘‘stay silent’’ and not include any discussion<br />
on the discounting <strong>of</strong> current <strong>tax</strong> in the forthcoming<br />
exposure draft. The board members agreed there is no<br />
need to mention a specific requirement in IAS 12 because<br />
a company can use existing accounting literature<br />
during rare circumstances when a discount could apply<br />
because <strong>of</strong> a government agreement.<br />
IASB member James Leisenring objected to the ballot<br />
draft’s proposal, but noted that discounting <strong>of</strong> current<br />
<strong>tax</strong> can depend on circumstances, such as when<br />
there are <strong>tax</strong>es that are owed but for which a settlement<br />
can be reached with a revenue service. He added<br />
that he had no problem with a company discounting<br />
that <strong>tax</strong> amount.<br />
IASB member Robert Garnett added that in practice<br />
large accounting firms discount current <strong>tax</strong>es when<br />
there has been an agreement with a government that<br />
falls outside the normal <strong>tax</strong> code for deferred payment.<br />
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He added that he doesn’t believe firms routinely discount<br />
current <strong>tax</strong>es across the board.<br />
Leisenring also said the proposal created a ‘‘fundamental<br />
difference’’ from U.S. generally accepted accounting<br />
principles during the ongoing convergence<br />
project with the U.S. Financial Accounting Standards<br />
Board.<br />
An agenda paper prepared for the meeting <strong>notes</strong><br />
that FASB’s Financial Accounting Standard No. 109,<br />
‘‘Accounting for Income Taxes,’’ does not include a<br />
specific requirement or prohibition regarding the discounting<br />
<strong>of</strong> current <strong>tax</strong>.<br />
Leisenring took issue with the proposal’s also failing<br />
to note the differences between U.S. GAAP and what<br />
the IASB was considering. ‘‘It’s just so frustrating to<br />
work on convergence projects and have these lastminute<br />
180s come up, and it’s no wonder we don’t get<br />
things done,’’ he said.<br />
‘‘I do not think this is worth it during a project that<br />
is complicated enough,’’ Leisenring said. The IASB has<br />
said its current project to reduce the differences between<br />
IAS 12 and FAS 109 will lead to an exposure<br />
draft <strong>of</strong> an <strong>international</strong> financial reporting standard to<br />
replace IAS 12 by early 2009 and to a final standard in<br />
2010.<br />
Norway<br />
♦ Thomas Jaworski, Tax Analysts.<br />
E-mail: tjaworsk@<strong>tax</strong>.org<br />
Government Proposes Carryback Rule<br />
For Losses<br />
The Norwegian government on January 26 presented<br />
a NOK 20 billion (about $2.93 billion) ‘‘crisis<br />
package’’ that includes <strong>tax</strong> proposals that would allow<br />
companies to carry back losses in 2008 and 2009 and<br />
would expand the research and development credit.<br />
Norway has not been hit hard by the global financial<br />
crisis, but the government is concerned about rising<br />
unemployment levels. Unemployment is expected<br />
to reach 4 percent this year, a small number by <strong>international</strong><br />
standards but high by Norwegian standards.<br />
<strong>Business</strong> and opposition politicians are disappointed<br />
that the package does not contain more <strong>tax</strong> reductions,<br />
but the government has concluded that most <strong>tax</strong> reduction<br />
proposals are expensive compared with the number<br />
<strong>of</strong> jobs they create. Therefore, most <strong>of</strong> the package’s<br />
money would go to municipalities, public works,<br />
and environmental investments.<br />
The most important <strong>tax</strong> proposal would grant companies<br />
a carryback for losses in 2008 and 2009. Under<br />
NORWAY<br />
the ordinary rules, such a carryback is granted only<br />
when the <strong>tax</strong>payer’s business is terminated. Under the<br />
proposal, companies with pr<strong>of</strong>its in previous years,<br />
back to 2006, but losses in 2008 and/or 2009 would be<br />
granted the deduction earlier — perhaps much earlier<br />
— than under the ordinary carryforward rules, immediately<br />
increasing cash flow. However, the proposed<br />
rules would apply only to losses up to NOK 5 million<br />
for each <strong>of</strong> the income years 2008 and 2009. There is<br />
no rule regarding consolidated companies belonging to<br />
the same group, so presumably, one cap <strong>of</strong> NOK 5<br />
million would apply to each company <strong>of</strong> a group. The<br />
rules would also apply to a nonresident company doing<br />
business in Norway through a branch.<br />
To avoid complicated recalculations <strong>of</strong> <strong>tax</strong>able income<br />
and <strong>tax</strong>es for earlier years, the rule is technically<br />
framed as a cashing out in 2009 and/or 2010 <strong>of</strong> 28<br />
percent <strong>of</strong> the losses sustained in 2008 and/or 2009, to<br />
the extent that these losses do not exceed the <strong>tax</strong>able<br />
pr<strong>of</strong>its <strong>of</strong> 2006 to 2008. The 28 percent reflects the<br />
company <strong>tax</strong> rate for all the relevant years. As a consequence,<br />
the right to carry forward losses from 2006 to<br />
2008 is reduced by the same amount as the losses in<br />
2008 and 2009, the <strong>tax</strong> value <strong>of</strong> which has been cashed<br />
out.<br />
The revenue loss, and the corresponding cash flow<br />
for the companies, is estimated to amount to NOK<br />
3.25 billion in 2008 and a similar amount in 2009.<br />
However, because the rules imply that losses to be carried<br />
forward to later years are correspondingly reduced,<br />
future <strong>tax</strong>es would increase.<br />
The other <strong>tax</strong> proposal would raise the cap on the<br />
R&D <strong>tax</strong> credit. Currently, <strong>tax</strong>payers can claim an income<br />
<strong>tax</strong> credit <strong>of</strong> 20 percent <strong>of</strong> costs for R&D (and<br />
have the difference cashed out if the credit exceeds the<br />
calculated <strong>tax</strong>es) if the project is accepted by the Norwegian<br />
Research Council. The cap would be raised<br />
from NOK 4 million to NOK 5.5 million for the company’s<br />
own research and from NOK 8 million to NOK<br />
11 million for a project carried out by a research institution.<br />
This proposal would reduce <strong>tax</strong> revenue, and<br />
increase the relevant companies’ cash flow, by NOK<br />
180 million in 2009. Unlike the loss carryback proposal,<br />
this proposal is not limited to 2009 and 2010.<br />
♦ Frederik Zimmer, Department <strong>of</strong> Public and<br />
International Law, University <strong>of</strong> Oslo<br />
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OECD<br />
OECD<br />
OECD Group Addresses CIVs,<br />
Cross-Border Investors<br />
An informal consultative group (ICG) organized by<br />
the OECD has released two reports that address the<br />
application <strong>of</strong> treaty benefits to collective investment<br />
vehicles and cross-border investors<br />
Issued on January 12, the reports — ‘‘Granting <strong>of</strong><br />
Treaty Benefits With Respect to the Income <strong>of</strong> Collective<br />
Investment Vehicles’’ (the CIV report) and ‘‘Possible<br />
Improvements to Procedures for Tax Relief for<br />
Cross-Border Investor’’ (the procedures report) — were<br />
commissioned by the OECD in December 2006 when<br />
the informal consultative group was established.<br />
The CIV report deals with conceptual and practical<br />
issues relating to income <strong>tax</strong> treaty benefits when investors<br />
in one country invest, through a fund organized in<br />
a second country, in investments in a third country.<br />
The procedures report deals more generally with the<br />
practical problems <strong>of</strong> making claims for treaty relief<br />
when investors hold investments through intermediary<br />
institutions, such as banks and brokerages, and are not<br />
the owners <strong>of</strong> record <strong>of</strong> the investments.<br />
Fund managers with cross-border investments or<br />
investors, banks, and brokerages should be aware <strong>of</strong><br />
this development, since it might be a harbinger <strong>of</strong> future<br />
developments in <strong>international</strong> <strong>tax</strong> treaty practice.<br />
It must be emphasized that at this stage, the reports<br />
contain only the views <strong>of</strong> the ICG. The OECD’s Committee<br />
for Fiscal Affairs has not adopted the ICG’s<br />
conclusions as a statement <strong>of</strong> the OECD’s <strong>of</strong>ficial<br />
views, although it may do so in the future.<br />
The CIV Report<br />
It is very common for an investment fund organized<br />
in one country (the fund country) owned by investors<br />
in a second country (the investor country) to invest in<br />
securities issued by residents <strong>of</strong> a third country (the<br />
source country). Most source countries impose withholding<br />
<strong>tax</strong>es on payments <strong>of</strong> interest, dividends, or<br />
both to foreign investors, and some (such as Canada,<br />
Spain, and Australia) impose <strong>tax</strong> on some capital gains<br />
realized by foreign investors.<br />
Thus, investors are <strong>of</strong>ten very interested in whether<br />
relief from source-country <strong>tax</strong> is available under an<br />
applicable income <strong>tax</strong> treaty. There may be a treaty<br />
between the source country and the fund country, a<br />
treaty between the source country and the investor<br />
country, or both. Unfortunately, even if the source<br />
country has <strong>tax</strong> treaties with both the fund country and<br />
the investor country, it is <strong>of</strong>ten very difficult for investments<br />
made by such a fund to qualify for benefits un-<br />
der either treaty. There are conceptual and practical<br />
reasons for this. (The practical reasons are discussed in<br />
the procedures report.)<br />
Source-Country/Fund-Country Treaty<br />
A fund typically will be able to claim treaty benefits<br />
in its own right under the source-country/fund-country<br />
treaty only if it is a resident <strong>of</strong> the treaty country. Article<br />
4(1) <strong>of</strong> the 2008 OECD model income <strong>tax</strong> treaty<br />
defines a resident <strong>of</strong> a treaty country as ‘‘any person<br />
who, under the laws <strong>of</strong> that State, is liable to <strong>tax</strong><br />
therein by reason <strong>of</strong> his domicile, residence, place <strong>of</strong><br />
management or any other criterion <strong>of</strong> a similar nature.’’<br />
There are three common reasons why a source<br />
country might not treat a fund as a resident <strong>of</strong> the<br />
fund country for treaty purposes, thereby denying<br />
treaty benefits.<br />
First, the source country might not view the fund as<br />
a ‘‘person’’ for treaty purposes. Some types <strong>of</strong> vehicles<br />
commonly used for investment funds are treated as<br />
contractual relationships, and not legal entities, as a<br />
matter <strong>of</strong> domestic law. One very common example is<br />
the Luxembourg fond commun de placement (mutual<br />
fund). Also, funds organized as trusts create problems<br />
because the concept <strong>of</strong> a trust frequently does not exist<br />
under the laws <strong>of</strong> non-English-speaking countries.<br />
Second, a fund most likely is not subject to <strong>tax</strong> in<br />
the fund country at the full statutory rate. It might be<br />
exempt from <strong>tax</strong> or <strong>tax</strong>able at a special low rate, it<br />
might be fiscally transparent, or it might get a deduction<br />
for dividends paid (like U.S. mutual funds <strong>of</strong> the<br />
usual type). The source country might not view such a<br />
fund as subject to <strong>tax</strong> in the fund country.<br />
The view <strong>of</strong> the United States is that an entity is<br />
subject to <strong>tax</strong> in the fund country if the fund country<br />
has <strong>tax</strong>ing jurisdiction over the entity, so under general<br />
principles <strong>of</strong> fund-country law, the entity could be subject<br />
to fund-country <strong>tax</strong>, even if the entity is subject to<br />
a special <strong>tax</strong> exemption. Other countries are not as lenient.<br />
Third, although limitation on benefits clauses historically<br />
were unique to U.S. income <strong>tax</strong> treaties, sometimes<br />
a source country will want some assurance that<br />
the fund is not being misused by investors resident in<br />
countries that do not have an income <strong>tax</strong> treaty with<br />
the source country. There are several situations in<br />
which a source country will not grant treaty relief to a<br />
fund without knowing something about who owns the<br />
fund.<br />
Source-Country/Investor-Country Treaty<br />
The problem with a claim by an investor for relief<br />
under the source-country/investor-country treaty is that<br />
the fund is in the middle. Treaties based on the OECD<br />
model provide relief to a beneficial owner <strong>of</strong> income.<br />
But the OECD model treaty does not purport to define<br />
what a beneficial owner is, and this issue is the subject<br />
<strong>of</strong> much debate.<br />
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Internal Revenue Code section 894(c) and Treas.<br />
reg. section 1.894-1(d) deal with this issue in cases<br />
when the United States is the source country. An investor<br />
can claim benefits <strong>of</strong> the U.S./investor-country<br />
treaty on the investor’s share <strong>of</strong> the fund’s income if<br />
the fund is fiscally transparent in the investor country<br />
and the investor is not fiscally transparent in the investor<br />
country. The analysis in other countries can be different,<br />
or unclear.<br />
The CIV report is limited in scope to funds that are<br />
both widely held and subject to investor protection<br />
regulations, that is, are under the Investment Company<br />
Act <strong>of</strong> 1940 in the United States, or the UCITS Directive<br />
in the EU. It does not address the usual type <strong>of</strong><br />
hedge fund or private equity fund.<br />
The report concludes that under existing treaties, a<br />
fund that does not have legal personality under domestic<br />
law, such as a fond commun de placement, most likely<br />
is not a person for treaty purposes and therefore cannot<br />
claim benefits under the source-country/fund-country<br />
treaty in its own right. On the other hand, a fund organized<br />
as a corporation or a trust should be regarded<br />
as a person for treaty purposes, the report says.<br />
It concludes that a fund that receives an exemption<br />
for specific types <strong>of</strong> income should be viewed as subject<br />
to <strong>tax</strong> for treaty purposes, as should a fund that<br />
receives a deduction for dividends paid (as is the case<br />
with U.S. mutual funds). But a fund that is fiscally<br />
transparent (treated like a partnership) in the fund<br />
country or is exempt from fund-country <strong>tax</strong> on all <strong>of</strong><br />
its income should not be subject to <strong>tax</strong> in the fund<br />
country.<br />
The majority view in the report, though not without<br />
dissent, is that a fund that is a resident should be<br />
viewed as the beneficial owner <strong>of</strong> its income for treaty<br />
purposes. In any event, it is important that source<br />
countries clarify their views as to whether CIVs are<br />
entitled to benefits under current treaties.<br />
The ICG also considered situations under existing<br />
treaties in which a fund cannot claim benefits under<br />
the source-country/fund-country treaty in its own right.<br />
In those cases, the report concludes that in principle,<br />
investors should be able to claim treaty benefits on<br />
their share <strong>of</strong> the fund’s income under the sourcecountry/investor-country<br />
treaties.<br />
This approach — investor-level benefits under the<br />
source-country/investor-country treaties — was viewed<br />
as less desirable than fund-level benefits because <strong>of</strong> the<br />
difficulty <strong>of</strong> allocating the fund’s income among the<br />
investors in a widely held fund with investors coming<br />
and going daily. It was also recognized that many investors<br />
would not bother to file requests for relief under<br />
the source-country/investor-country treaties for<br />
small amounts <strong>of</strong> money. Thus, it was argued in these<br />
cases that the fund should be able to file claims for<br />
relief under the source-country/investor-country treaties<br />
on behalf <strong>of</strong> the investors. However, a minority <strong>of</strong><br />
OECD<br />
the ICG did not believe that investors resident outside<br />
<strong>of</strong> the fund country should be able to claim treaty benefits<br />
under the applicable source-country/investorcountry<br />
treaty. This view would allow investor-level<br />
claims only to residents <strong>of</strong> the fund country.<br />
The CIV report suggests that future treaties should<br />
address the issues raised by CIVs directly, and contains<br />
draft language for revisions to the commentary to the<br />
OECD model income <strong>tax</strong> treaty. The preferred approach<br />
is that a fund should always be a treaty beneficiary<br />
in its own right, although perhaps with relief cut<br />
back proportionately to the extent that the investors are<br />
not themselves entitled to benefits under a sourcecountry/investor-country<br />
treaty with benefits comparable<br />
to the source-country/fund-country treaty.<br />
For example, if the fund was 80 percent owned by<br />
treaty-protected investors and 20 percent owned by<br />
non-treaty-protected investors, one might limit benefits<br />
under the source-country/fund-country treaty to 80<br />
percent <strong>of</strong> the fund’s income. (The issues regarding<br />
how such a fund is to ascertain who owns it are discussed<br />
in the procedures report.)<br />
The ICG felt that allowing funds to claim treaty<br />
benefits under the source-country/fund-country treaty<br />
for the future is preferable to allowing an investor to<br />
claim treaty benefits under the source-country/investorcountry<br />
treaty on the investor’s share <strong>of</strong> the fund’s income.<br />
But the latter alternative might be preferable if,<br />
for example, a substantial number <strong>of</strong> investors in the<br />
investor country are pension funds that are entitled to<br />
special treaty benefits not available to ordinary investors.<br />
This would allow pension funds to claim their<br />
special treaty rates on their share <strong>of</strong> the fund’s income,<br />
albeit at the cost <strong>of</strong> more complexity.<br />
The Procedures Report<br />
Under modern securities processing, interests in a<br />
fund or any widely held or publicly traded security<br />
might be owned through multiple levels <strong>of</strong> brokers,<br />
banks, and other financial intermediaries. For example,<br />
the investor <strong>of</strong> record might be a central securities depository<br />
such as the Depository Trust Company in the<br />
United States or Clearstream or Euroclear in Europe.<br />
The depository holds investments for the account <strong>of</strong><br />
its participants, which typically are banks and brokerages.<br />
The banks and brokerages in turn hold investments<br />
on account <strong>of</strong> their customers, typically through<br />
omnibus accounts that combine securities held on behalf<br />
<strong>of</strong> multiple customers.<br />
This system exists for reasons that have nothing to<br />
do with <strong>tax</strong>. But as a result, the payers in the source<br />
country might have no idea who the ultimate owners<br />
<strong>of</strong> the income that they are paying are, and a fund<br />
might not know who owns it. Obtaining this information<br />
can be very difficult. This can be even more<br />
troublesome if some <strong>of</strong> the intermediaries are subject<br />
to bank secrecy rules.<br />
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OECD<br />
Furthermore, a source country frequently will want<br />
some documentary pro<strong>of</strong> that someone claiming treaty<br />
benefits is in fact entitled to them. Can the payers in<br />
the source country deal with a mountain <strong>of</strong> paperwork<br />
from all <strong>of</strong> the ultimate customers and investors, especially<br />
given that the fund or financial intermediary<br />
looks like one investor on the books <strong>of</strong> the sourcecountry<br />
payers?<br />
If some <strong>of</strong> the investors can benefit under an income<br />
<strong>tax</strong> treaty with the source country and others<br />
cannot, will the source country allow withholding on<br />
only a proportion <strong>of</strong> the payments?<br />
If relief at source is impossible, the investors might<br />
be able to request refunds from the source country. But<br />
what documentation will they need from the fund or<br />
financial intermediary that will be acceptable to the<br />
source country?<br />
Can the fund or financial intermediary generate the<br />
necessary documentation without undue burden? Will<br />
the investors bother to file claims for refunds <strong>of</strong> small<br />
amounts?<br />
These problems may not be too troublesome for<br />
funds with a small number <strong>of</strong> sophisticated investors,<br />
such as the pension pooling vehicles that are coming<br />
into use in Europe. But these issues are daunting for<br />
financial intermediaries with a large number <strong>of</strong> customers<br />
and for retail funds with a large number <strong>of</strong><br />
small investors.<br />
The goal <strong>of</strong> the procedures report is to set forth best<br />
practices for how countries should handle claims for<br />
treaty relief when an investor that is entitled to treaty<br />
relief in its own right does not own the investment directly,<br />
but owns it through a CIV or through one or<br />
more levels <strong>of</strong> intermediaries.<br />
The ICG considered how to reduce costs and ensure<br />
that <strong>tax</strong> administrators’ rules were being followed. Its<br />
conclusions are as follows:<br />
• As much as possible, source countries should allow<br />
treaty relief at source, rather than requiring<br />
investors to file claims for refunds afterward.<br />
• Intermediaries that have been authorized by the<br />
source country should be allowed to make claims<br />
for treaty relief on behalf <strong>of</strong> their customers on a<br />
pooled basis, without having to provide detailed<br />
information on customers for each payment. 1<br />
• Authorized intermediaries should be required to<br />
pass along detailed information about customers<br />
that have claimed treaty benefits to the source<br />
country after the fact so that the source country<br />
can verify that the treaty claims are proper. The<br />
source country would share this information with<br />
1 This suggestion clearly bears a resemblance to the U.S. qualified<br />
intermediary system and the Irish qualifying intermediary<br />
system.<br />
the investor countries so that they can confirm<br />
that the income is being reported properly. 2<br />
• Countries that do not use unique <strong>tax</strong>payer identification<br />
numbers should do so, to allow information<br />
to be properly matched. 3<br />
• Investors should be permitted to claim treaty benefits<br />
based on their own self-certification, rather<br />
than being required to obtain residence certificates,<br />
at least for small accounts. 4<br />
Implications<br />
As stated earlier, the conclusions <strong>of</strong> these reports<br />
have not been accepted by the OECD, and the OECD<br />
does not make <strong>tax</strong> laws. But the OECD’s recommendations<br />
have been very influential on the treaty policies<br />
<strong>of</strong> developed countries. Thus, if these reports are<br />
adopted by the OECD, <strong>international</strong> treaty practice<br />
might move in the direction outlined in the reports.<br />
The Committee for Fiscal Affairs now is considering<br />
the reports, and has invited public comments on them.<br />
Comments are due by March 6.<br />
♦ Matthew Blum, Ernst & Young LLP, Boston.<br />
The author appreciates the assistance <strong>of</strong> Alastair Campbell,<br />
a senior in Ernst & Young’s International Tax Services<br />
Group in Boston.<br />
2<br />
This is not like the U.S. qualified intermediary system because<br />
the U.S. system is designed to respect bank secrecy for<br />
non-U.S. investors.<br />
3<br />
Note that the United States does not require foreign persons<br />
claiming treaty benefits relating to publicly traded investments<br />
(and some other types <strong>of</strong> investments) to obtain U.S. <strong>tax</strong>payer<br />
identification numbers.<br />
4<br />
As is the practice in the United States.<br />
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Portugal<br />
Government Submits Budget<br />
Supplement<br />
The Portuguese government on January 19 submitted<br />
to the parliament a budget supplement proposal<br />
containing several <strong>tax</strong> measures, including a new investment<br />
<strong>tax</strong> credit for 2009, an expansion <strong>of</strong> the research<br />
and development <strong>tax</strong> credit, and the extension<br />
<strong>of</strong> the Portuguese holding regime to EU-incorporated<br />
entities moving their seat or place <strong>of</strong> effective management<br />
into Portugal. (For prior coverage <strong>of</strong> the recently<br />
passed 2009 Budget Law, see Tax Notes Int’l, Jan. 12,<br />
2009, p. 137, Doc 2009-232, or2009 WTD 4-1.)<br />
The supplementary budget bill, titled ‘‘Initiative for<br />
Employment and Investment,’’ is the government’s reaction<br />
to the worsening economic conditions in Portugal.<br />
If approved, the bill’s measures would be effective<br />
from January 1, 2009.<br />
New Investment Tax Credit<br />
The bill includes a new <strong>tax</strong> incentive designed to<br />
stimulate investment. The Regime Fiscal de Apoio ao<br />
Investimento (RFAI 2009) would provide several <strong>tax</strong><br />
benefits for qualified investments made in some business<br />
sectors.<br />
The RFAI 2009 includes the following <strong>tax</strong> benefits:<br />
• an ITC that operates as a deduction against corporate<br />
income <strong>tax</strong> otherwise payable (up to a limit<br />
<strong>of</strong> 25 percent <strong>of</strong> the <strong>tax</strong> due) equal to 20 percent<br />
(for qualified investments lower than €5,000,000)<br />
or 10 percent (for qualified investments higher<br />
than €5,000,000) <strong>of</strong> the qualified investment; any<br />
unused credit may be carried forward for four<br />
years; and<br />
• an exemption on real estate transfer <strong>tax</strong> (IMT),<br />
property <strong>tax</strong> (IMI), and stamp <strong>tax</strong> on the acquisition<br />
<strong>of</strong> real estate for investment purposes; the<br />
real estate <strong>tax</strong> exemptions are subject to the approval<br />
<strong>of</strong> the municipality where the investment is<br />
made.<br />
The following investments are eligible for the <strong>tax</strong><br />
incentive:<br />
• new tangible assets; however, the following new<br />
assets are excluded: land (except when used for<br />
resource extraction), buildings (except when used<br />
for factories or administrative <strong>of</strong>fices), noncommercial<br />
vehicles, furniture (except when used for<br />
tourism purposes), social equipment (except if acquired<br />
under legal obligation), and other assets<br />
that are not directly connected with the activity<br />
developed; and<br />
• intangible assets that qualify as expenses with<br />
transfer <strong>of</strong> technology through the acquisition <strong>of</strong><br />
patent rights, licenses, know-how, or unpatented<br />
technical knowledge; for large companies (that is,<br />
those not qualifying as small and medium-size<br />
enterprises under the EU definition), the investments<br />
in intangible fixed assets may not exceed 50<br />
percent <strong>of</strong> the qualified investment.<br />
Under the RFAI 2009, qualifying investments must<br />
be maintained for a five-year period subject to a recapture<br />
rule and the qualifying investment must be designed<br />
to promote the creation <strong>of</strong> employment during<br />
2009.<br />
The RFAI 2009 is limited to <strong>tax</strong>payers engaged in<br />
the following business sectors: agriculture, forestry,<br />
agro industries, energy, tourism, and manufacturing or<br />
extraction industries (except steelwork industries, shipbuilding,<br />
and synthetic fibers as defined in article 2 <strong>of</strong><br />
Commission Regulation 800/2008). The <strong>tax</strong> incentive<br />
is also extended to companies that realize investments<br />
in next-generation broadband equipment. The RFAI<br />
2009 is not applicable to companies that fall within the<br />
meaning <strong>of</strong> ‘‘company in difficulty’’ as defined by the<br />
EU guidelines on state aid for rescuing and restructuring<br />
firms in difficulty.<br />
This ITC may not be used concurrently with any<br />
other similar <strong>tax</strong> incentive, and the total <strong>tax</strong> incentive<br />
cannot exceed the maximum amount <strong>of</strong> aid for a given<br />
region as stipulated by the guidelines on national regional<br />
aid for 2007 to 2013. 1<br />
R&D Tax Incentive<br />
PORTUGAL<br />
The bill would also amend the Portuguese R&D<br />
investment <strong>tax</strong> credit. The Sistema de Incentivos<br />
Fiscais em Investigação e Desenvolvimento Empresarial<br />
(SIFIDE) would ultimately increase the amount<br />
<strong>of</strong> <strong>tax</strong> credit available for qualifying R&D investments.<br />
Under the proposal, credits against corporate <strong>tax</strong> liability<br />
would be available for qualifying R&D expenses up<br />
to the following amounts:<br />
• a basic credit equal to 32.5 percent <strong>of</strong> the qualifying<br />
expenses for the relevant year; and<br />
• an additional credit equal to 50 percent <strong>of</strong> the<br />
amount by which the qualifying expenses for the<br />
relevant year exceed the average R&D expenses<br />
incurred over the two preceding years, with a ceiling<br />
<strong>of</strong> €1.5 million. This deduction would only be<br />
applicable to costs that have not been subsidized<br />
by the state. Any unused credit would remain to<br />
be carried forward for six years.<br />
1<br />
Guidelines on national regional aid for 2007-2013 (2006/C<br />
54/08).<br />
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PORTUGAL<br />
Extension <strong>of</strong> Portuguese Holding Regime<br />
The proposal would extend the <strong>tax</strong> regime applicable<br />
to Portuguese incorporated holding companies<br />
(Sociedade Gestora de Participações Sociais, or SGPS)<br />
to foreign EU-incorporated entities that move their<br />
statutory seat or place <strong>of</strong> effective management into<br />
Portugal. The objective <strong>of</strong> this amendment is tw<strong>of</strong>old.<br />
First, the measure is designed to eliminate a potential<br />
incompatibility with EU law regarding the nonapplication<br />
<strong>of</strong> this beneficial regime to foreign EU holding<br />
companies effectively managed in Portugal. Second,<br />
the measure aims to stimulate investment and to create<br />
an incentive to transfer capital into the Portuguese territory.<br />
Under the proposal, the more favorable regime for<br />
participation exemption on dividends received and<br />
capital gains realized that is applicable to SGPSs<br />
would apply equally to companies incorporated under<br />
the law <strong>of</strong> another EU member state that have their<br />
statutory seat or place <strong>of</strong> effective management located<br />
within Portuguese territory and that have as their sole<br />
corporate purpose the management <strong>of</strong> participations in<br />
other companies provided the conditions established<br />
for SGPSs under the Portuguese legal framework are<br />
met. 2<br />
Under the current applicable legal framework, the<br />
activities defined as holding activities include only:<br />
mere holding <strong>of</strong> investments in which at least 70 percent<br />
<strong>of</strong> the total investments must be in companies in<br />
which the holding company owns directly or indirectly<br />
a minimum <strong>of</strong> 10 percent <strong>of</strong> the share capital with voting<br />
rights for more than one year 3 ; rendering <strong>of</strong> technical<br />
services and/or management services to companies<br />
in which the holding company holds directly or indirectly<br />
a qualified participation; and lending <strong>of</strong> funds<br />
and providing cash management to subsidiaries and<br />
other qualifying holdings (that is, minimum direct or<br />
indirect holding <strong>of</strong> 10 percent). Also, the holding company<br />
is restricted to acquiring or holding real estate<br />
unless the real estate is used for the premises <strong>of</strong> its<br />
head <strong>of</strong>fice or <strong>of</strong> its subsidiaries.<br />
2<br />
The legal framework <strong>of</strong> SGPSs is contained in Decree Law<br />
495/88 as amended by Decree Law 318/94, Decree Law 378/<br />
98, and Law 109-B/2001. Article 32 <strong>of</strong> the Tax Benefits Statute<br />
incorporates the <strong>tax</strong> regime applicable to SGPSs.<br />
3<br />
The holding company may nonetheless invest in mere passive<br />
holdings (that is, less than 10 percent <strong>of</strong> the voting rights) if:<br />
the amount does not exceed 30 percent <strong>of</strong> the investments made<br />
in other holdings; the value <strong>of</strong> each passive holding is not less<br />
than €5 million; the purchase results from the target company’s<br />
merger or demerger; and the holding company has formalized a<br />
managerial subordination agreement with the target company,<br />
under which the management <strong>of</strong> the subordinated company’s<br />
business activities is entrusted to the holding company.<br />
Other Amendments<br />
The proposal would reduce the minimum amount <strong>of</strong><br />
special advance corporate <strong>tax</strong> payments, which is essentially<br />
meant to function as a minimum <strong>tax</strong>, to<br />
€1,000. The amount <strong>of</strong> the advance corporate <strong>tax</strong> payment<br />
is basically equal to 1 percent <strong>of</strong> annual turnover<br />
capped with a limit <strong>of</strong> €70,000 and payable in two or<br />
three installments.<br />
When VAT return shows a credit balance, the excess<br />
input <strong>tax</strong> may be carried forward or a refund may be<br />
requested if the credit balance during a period <strong>of</strong> 12<br />
calendar months exceeded €250. The bill proposes a<br />
reduction to €3,000 (from the previous €11,250) <strong>of</strong> the<br />
minimum excess input VAT necessary to request a refund<br />
before the 12-month period elapses.<br />
The bill would allow the government to establish a<br />
reverse charge rule for VAT payers covering the supply<br />
<strong>of</strong> goods and services within public procurement contracts<br />
<strong>of</strong> a value equal to or greater than €5,000 when<br />
the acquirer <strong>of</strong> the goods or services is the Portuguese<br />
state or other public entities.<br />
The bill would extend the <strong>tax</strong> credit available<br />
against personal income <strong>tax</strong> for acquisition <strong>of</strong> personal<br />
computers and related equipment to cover expenses<br />
from the acquisition <strong>of</strong> next-generation broadband<br />
equipment. The <strong>tax</strong> credit would remain equal to 50<br />
percent <strong>of</strong> the acquisition costs <strong>of</strong> the <strong>tax</strong>payer with a<br />
limit <strong>of</strong> €250.<br />
Russia<br />
♦ Paulo Núncio and Tiago Cassiano Neves,<br />
Garrigues, Lisbon<br />
Court Dismisses Claim for Back Taxes<br />
Against Ernst & Young<br />
The Moscow Arbitration Court on January 27<br />
quashed a RUB 390 million claim for back <strong>tax</strong>es<br />
against Ernst & Young’s Russian subsidiary, Ernst &<br />
Young Vneshaudit, according to a January 27 report by<br />
RIA Novosti, the state news agency.<br />
Further details on the court’s decision were not<br />
available.<br />
The company had challenged a December 29, 2007,<br />
decision <strong>of</strong> the Moscow Tax Inspectorate ordering it to<br />
pay RUB 390 million in pr<strong>of</strong>its <strong>tax</strong>es, VAT, and fines<br />
and penalties for 2004. The <strong>tax</strong> authorities accused the<br />
company <strong>of</strong> underreporting its 2004 pr<strong>of</strong>its <strong>of</strong> RUB<br />
10.5 million by RUB 630.3 million.<br />
Ernst & Young Vneshaudit had deducted that sum<br />
as expenses for consulting services performed by its<br />
parent company in Cyprus. The authorities said those<br />
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expenses were unjustified and that the services were<br />
actually performed by the Russian <strong>of</strong>fice.<br />
In a similar case, Russia’s Higher Arbitration Court<br />
on January 20 quashed a RUB 260 million claim for<br />
back <strong>tax</strong>es against the Moscow branch <strong>of</strong> PricewaterhouseCoopers,<br />
according to media reports. The<br />
<strong>tax</strong> authorities had accused PwC <strong>of</strong> illegally deducting<br />
consulting service payments made to PwC’s Dutch<br />
branch, saying those services were actually performed<br />
by the Russian <strong>of</strong>fice. (For prior coverage, see Tax Notes<br />
Int’l, Apr. 21, 2008, p. 230, Doc 2008-8429, or2008<br />
WTD 75-1.)<br />
Spain<br />
♦ Kristen A. Parillo, Tax Analysts.<br />
E-mail: kparillo@<strong>tax</strong>.org<br />
Directors’ Remuneration Not<br />
Deductible, Supreme Court Says<br />
Spain’s Supreme Court recently issued two judgments<br />
denying corporate income <strong>tax</strong> deductions for the<br />
remuneration <strong>of</strong> directors <strong>of</strong> a public limited company<br />
(PLC). The November 13, 2008, judgments (2578/2004<br />
and 3991/2004), which were only recently made public,<br />
have caused quite a debate.<br />
The Tax Inspectorate had initiated two separate proceedings<br />
against a PLC, claiming that the directors’<br />
remuneration it had included as a deductible expense<br />
did not qualify.<br />
After exhausting all appeal procedures, the company<br />
brought its case to the Supreme Court, which also concluded<br />
that the directors’ remuneration was nondeductible.<br />
The company’s bylaws described the directors’<br />
remuneration as ‘‘a fixed amount that could be reviewed<br />
annually, in addition to a share <strong>of</strong> the company’s<br />
pr<strong>of</strong>its in line with the limits laid down by legislation.’’<br />
In its interpretation <strong>of</strong> the current Public Limited<br />
Companies Act and <strong>of</strong> section 13(ñ) <strong>of</strong> the Corporate<br />
Income Tax Act 1978 (now abrogated), the Court concluded<br />
that for the remuneration <strong>of</strong> the directors <strong>of</strong> a<br />
PLC to be <strong>tax</strong> deductible, the company bylaws must<br />
specify the directors’ remuneration ‘‘with certainty.’’<br />
The remuneration will be considered certain if it meets<br />
the following conditions:<br />
(a) the bylaws must specify a definite earnings<br />
system and not contemplate several systems from<br />
which the board <strong>of</strong> directors can choose;<br />
(b) for variable earnings based on pr<strong>of</strong>it sharing,<br />
the bylaws must establish a definite percentage,<br />
and not a maximum percentage; and<br />
SPAIN<br />
(c) for fixed earnings, the bylaws must establish a<br />
definite amount, or alternatively, must establish<br />
criteria to calculate the exact amount without<br />
leaving scope for discretion.<br />
The Court’s conclusions, which appear to diverge<br />
from the current corporate income <strong>tax</strong> regulation,<br />
could have significant practical repercussions.<br />
The finding on fixed remuneration in point (c) is<br />
particularly controversial because the bylaws <strong>of</strong> many<br />
companies define directors’ remuneration as a fixed<br />
amount to be established every year by the general<br />
shareholders meeting.<br />
Points (a) and (b), on the other hand, reflect existing<br />
common practice: The bylaws must specify the earnings<br />
system, and, in the case <strong>of</strong> variable earnings, they<br />
must specify a definite percentage <strong>of</strong> pr<strong>of</strong>it sharing.<br />
Under the previous regulation on corporate income<br />
<strong>tax</strong> (section 13(ñ) <strong>of</strong> the Corporate Income Tax Act<br />
1978) applicable to the fiscal years subject to the Supreme<br />
Court’s analysis, for an expense to qualify as <strong>tax</strong><br />
deductible, it must be a mandatory expense and, therefore,<br />
necessary for the company to engage in its activity.<br />
The current regulation does not refer to those requirements.<br />
It states that an expense is considered <strong>tax</strong><br />
deductible if the company enters it into its books and<br />
meets the conditions <strong>of</strong> the commercial regulation on<br />
directors’ remuneration. Thus, controversy may arise if<br />
the <strong>tax</strong> authorities rely on the Supreme Court’s judgments<br />
and not on the criteria <strong>of</strong> the Directorate General<br />
<strong>of</strong> Registries and Notarial Affairs (Dirección General<br />
de los Registros y del Notariado), concluding that<br />
companies that do not specify the remuneration<br />
amount in their bylaws are in breach <strong>of</strong> the commercial<br />
regulation. This would result in the remuneration<br />
<strong>of</strong> the directors not being <strong>tax</strong> deductible.<br />
This risk is limited to PLCs and does not extend to<br />
limited liability companies (the most common type <strong>of</strong><br />
company in Spain). Under section 66.3 <strong>of</strong> the Limited<br />
Liability Companies Act, fixed remuneration ‘‘will be<br />
set every fiscal year by agreement <strong>of</strong> the shareholders<br />
general meeting.’’ The act itself thus prevents LLCs<br />
from establishing a definite amount in their bylaws,<br />
stating that the shareholders general meeting must set<br />
the amount annually.<br />
The Court’s judgments <strong>of</strong> November 2008 are especially<br />
relevant for listed PLCs. The Spanish <strong>tax</strong> authorities<br />
may consider that the remuneration those companies<br />
pay to their directors is nondeductible if their<br />
bylaws do not specify a definite remuneration amount,<br />
or alternatively, the criteria needed to calculate the exact<br />
amount without leaving scope for discretion. Therefore,<br />
it is important to pay close attention to how the<br />
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SPAIN<br />
<strong>tax</strong> authorities interpret the judgments in the context <strong>of</strong><br />
the current wording <strong>of</strong> the Corporate Income Tax Act.<br />
Sweden<br />
♦ Ana Martinez, senior <strong>tax</strong> associate,<br />
Cuatrecasas, Barcelona <strong>of</strong>fice, and<br />
Sonia Velasco, <strong>tax</strong> partner,<br />
Cuatrecasas, New York <strong>of</strong>fice<br />
Government Proposes to Defer<br />
Employee Tax Payments<br />
In the face <strong>of</strong> growing liquidity problems experienced<br />
by Swedish companies, the Swedish government<br />
on January 22 proposed allowing employers to defer<br />
paying employee <strong>tax</strong>es (arbetsgivaravgifter) for two<br />
months, according to a statement posted on the Swedish<br />
government’s website.<br />
Finance Minister Anders Borg and Enterprise Minister<br />
Maud Ol<strong>of</strong>sson focused on corporate liquidity during<br />
a press conference in Stockholm, pointing out that<br />
current turmoil in global financial markets has made it<br />
increasingly difficult to arrange borrowing. Without the<br />
proposed <strong>tax</strong> deferral measure, they said, companies<br />
will soon find themselves short <strong>of</strong> cash needed to meet<br />
even minimal operating needs.<br />
The government has estimated that the proposal will<br />
cost about SEK 500 million (approximately $61 million).<br />
The employee <strong>tax</strong> deferral proposal follows a 1.7<br />
percentage point corporate <strong>tax</strong> rate cut, from 28 percent<br />
to 26.3 percent, that took effect on January 1. The<br />
government announced the corporate <strong>tax</strong> cut in September.<br />
(For prior coverage, see Tax Notes Int’l, Sept.<br />
22, 2008, p. 984, Doc 2008-19804, or2008 WTD 181-1.)<br />
The government is now referring the <strong>tax</strong> deferral<br />
plan to the Council on Legislation (Lagrådet), which<br />
will decide whether the proposal is legally valid.<br />
♦ Randall Jackson, Tax Analysts.<br />
E-mail: rjackson@<strong>tax</strong>.org<br />
United States<br />
Drafters <strong>of</strong> Temporary Branch Regs<br />
Defend Rules’ Complexity<br />
Drafters <strong>of</strong> the recently issued section 954(d)(2) temporary<br />
branch rules on January 23 defended the complexity<br />
<strong>of</strong> the foreign base company sales income regulations<br />
issued a month earlier. (For the final and<br />
temporary contract manufacturing regulations (T.D.<br />
9438), see Doc 2008-27115 or 2008 WTD 249-34; for accompanying<br />
proposed regulations (REG-150066-08),<br />
see Doc 2008-27116 or 2008 WTD 249-35.)<br />
‘‘Complexity <strong>of</strong> business necessitates a complex<br />
rule,’’ Michael DiFronzo, IRS deputy associate chief<br />
counsel (<strong>international</strong>), said during a BNA Tax Management<br />
International Tax luncheon in Washington<br />
sponsored by Buchanan Ingersoll & Rooney.<br />
Itai Grinberg <strong>of</strong> Treasury’s Office <strong>of</strong> the International<br />
Tax Counsel said the most important evolution<br />
between proposed regulations (REG-124590-07) issued<br />
in February 2008 and the temporary regulations was<br />
the creation <strong>of</strong> a uniform rule on the location <strong>of</strong><br />
manufacturing. (For REG-124590-07, see Doc 2008-4147<br />
or 2008 WTD 40-31.) He told the group that the drafters<br />
made the change in response to commenter recommendations<br />
that suggested that the rules should not treat<br />
CFCs satisfying the physical manufacturing test differently<br />
from CFCs that satisfy the substantial contribution<br />
test. (For prior coverage, see Tax Notes Int’l, Jan.<br />
26, 2009, p. 274, Doc 2009-756, or2009 WTD 9-1.)<br />
‘‘The temporary regulations are concerned with the<br />
deflection <strong>of</strong> income to jurisdictions that fail the <strong>tax</strong><br />
rate disparity test, not with the mere dispersion <strong>of</strong> activities,’’<br />
Grinberg said.<br />
Asked about the complexity <strong>of</strong> the branch rules,<br />
Grinberg explained that while developing the rules <strong>of</strong>ficials<br />
decided to work from the preexisting branch rules<br />
and to address more complicated fact patterns to arrive<br />
at the temporary regulations.<br />
Herman Bouma, a <strong>tax</strong> attorney with Buchanan<br />
Ingersoll & Rooney, questioned the rules’ complexity,<br />
arguing that they could achieve the same outcome by<br />
comparing a CFC’s effective foreign <strong>tax</strong> rate for sales<br />
income and its effective foreign <strong>tax</strong> rate for manufacturing<br />
income to determine if there is a <strong>tax</strong> rate disparity.<br />
‘‘We made a determination early on in the project<br />
not to open the <strong>tax</strong> rate disparity test question,’’ Di-<br />
Fronzo said. He also noted that current statutory provisions<br />
may prevent such a regulatory solution.<br />
During an earlier discussion <strong>of</strong> the final contract<br />
manufacturing rules, Jeffrey Mitchell, branch chief, IRS<br />
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Office <strong>of</strong> Associate Chief Counsel (Income Tax and<br />
Accounting) discussed proposals that had been rejected<br />
in the course <strong>of</strong> developing the rules. He said the<br />
drafters considered and received comments on including<br />
a substantial contribution safe harbor, but decided<br />
not to adopt the safe harbor because <strong>of</strong> the ‘‘broad<br />
range <strong>of</strong> activities covered by the regulations’’ preventing<br />
the creation <strong>of</strong> an appropriate rule.<br />
Mitchell added that the IRS rejected including an<br />
antiabuse provision that would have precluded CFCs<br />
from meeting the substantial contribution test if a related<br />
person had significant involvement in the production<br />
process.<br />
‘‘We decided that the CFC’s contribution really<br />
should be evaluated on its own and we ultimately decided<br />
that even more than one person could make a<br />
substantial contribution,’’ Mitchell said. ‘‘If another<br />
party makes a contribution to the manufacturing process,<br />
it doesn’t preclude the CFC from having a substantial<br />
contribution.’’<br />
♦ David D. Stewart, Tax Analysts.<br />
E-mail: dstewart@<strong>tax</strong>.org<br />
CORRECTION<br />
An article in the January 26, 2009, issue <strong>of</strong> Tax<br />
Notes International (‘‘U.S. Tax Returns for Foreign Nationals,’’<br />
p. 337) contained an error. On p. 340, in the<br />
section titled ‘‘Disclosure Requirements,’’ references to<br />
Schedule A should be to Schedule B.<br />
Tax Analysts regrets the error.<br />
UNITED STATES<br />
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U.K. Tax Update<br />
Buddy, Can You Spare a Dime?<br />
by Trevor Johnson<br />
Trevor Johnson, FTII, AITI, ATT, is a chartered <strong>tax</strong> adviser and a past president <strong>of</strong> the Association <strong>of</strong><br />
Taxation Technicians. However, the views expressed are entirely his own.<br />
In the words <strong>of</strong> Private Frazer <strong>of</strong> the popular British<br />
sitcom Dad’s Army, ‘‘We’re all doooomed!’’ Socalled<br />
experts are queuing up to outdo each other with<br />
prophesies <strong>of</strong> gloom and despondency. The Bank <strong>of</strong><br />
England base rate, which stood at 5 percent last September,<br />
is now at 1.5 percent. This is the lowest rate<br />
since the bank was formed in 1694, the year in which<br />
Sir Isaac Newton discovered gravity and about 80 years<br />
before the United States came into existence.<br />
The Bank’s Monetary Policy Committee meets<br />
again on February 5, when some commentators expect<br />
a further cut and predict that at some point this year it<br />
will end up at, or very close to, zero. These dramatic<br />
reductions conjure up an image <strong>of</strong> desperation; the<br />
bank is at the wheel <strong>of</strong> the British economy careering<br />
down the mountain toward the abyss, and is pumping<br />
the foot brake harder and harder because that’s all it<br />
can do.<br />
And yet as far as businesses are concerned, the base<br />
rate is meaningless as the banks are neither passing on<br />
the reductions to existing borrowers nor advancing new<br />
loans. Their point is that the London Interbank Offered<br />
Rate, the rate at which banks borrow in the London<br />
Interbank Market, is 2.7 percent for 12-month sterling.<br />
They also have become more defensive since the<br />
subprime fiasco and are trying to rebuild their capital<br />
and pr<strong>of</strong>itability, which is why they are incurring the<br />
wrath <strong>of</strong> the government and the public at large. We,<br />
the public, see the government giving our money to the<br />
banks so that they can lend it back to us — a crazy<br />
situation, but one that isn’t working as the money is<br />
sticking in the bank’s c<strong>of</strong>fers.<br />
After handing out £37 billion to the banks, the government<br />
has introduced two sets <strong>of</strong> measures to increase<br />
the banks’ liquidity and get them lending again.<br />
These include:<br />
• Guaranteeing up to 50 percent <strong>of</strong> borrowings to<br />
businesses with turnovers below £500 million and<br />
taking as security some <strong>of</strong> the banks’ ‘‘toxic’’ investments<br />
and loans.<br />
• An extension <strong>of</strong> the Small <strong>Business</strong> Finance<br />
Scheme outlined in last autumn’s prebudget report,<br />
available to businesses with a turnover <strong>of</strong> up<br />
to £25 million. This scheme will guarantee 75 percent<br />
<strong>of</strong> loans <strong>of</strong> up to £1 million over 10 years.<br />
• The establishment <strong>of</strong> a fund to allow businesses<br />
to sell debt to the government in exchange for<br />
equity. In other words, they will swap some <strong>of</strong><br />
their debt for a slice <strong>of</strong> their business. Companies<br />
with a turnover <strong>of</strong> up to £50 million will be able<br />
to gain equity <strong>of</strong> between £250,000 and £2 million.<br />
• Allowing banks to take up government insurance<br />
against their expected bad debts, but only up to 90<br />
percent <strong>of</strong> those loans.<br />
• The Bank <strong>of</strong> England buying high-quality assets<br />
from companies in all sectors in return for cash.<br />
• Restructuring last October’s bailout by allowing<br />
Northern Rock more time to repay its government<br />
loan and allowing Royal Bank <strong>of</strong> Scotland to issue<br />
ordinary shares to the government in exchange<br />
for the preference shares to reduce the<br />
dividend burden on the bank.<br />
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FEATURED PERSPECTIVES<br />
We, the <strong>tax</strong>payers, are now in a situation in which<br />
not only are we giving the banks money to lend to<br />
businesses, we are also going to relieve the banks <strong>of</strong><br />
most <strong>of</strong> the risk <strong>of</strong> lending. I can’t help but ask why<br />
we now need the banks at all. The government could<br />
just cut out the middlemen and take over the banking<br />
sector, lock, stock, and barrel.<br />
Of course there is one sector that is immediately<br />
affected by the reduction in base rate — those with<br />
savings. The banks and building societies have taken<br />
the opportunity to reduce interest rates paid to investors,<br />
though some have not passed on the full reduction.<br />
Nevertheless, it was recently reported that some<br />
40 percent <strong>of</strong> savings accounts were paying less than 1<br />
percent and 26 percent were paying less than 0.5 percent.<br />
If rates on the majority <strong>of</strong> accounts get much<br />
lower, investors may well consider withdrawing all their<br />
savings and keeping them under the floorboards. At<br />
least there the money will not be at the mercy <strong>of</strong> the<br />
bank and they can derive pleasure from taking it out<br />
and counting it every once in a while. If we ever experience<br />
deflation, as the more pessimistic have<br />
claimed, the investors will find their savings’ purchasing<br />
power increased and there would be no <strong>tax</strong> to pay!<br />
As savings income is dropping, there is clearly going<br />
to be a drop in the income <strong>tax</strong> receipts on that income,<br />
which is why the Conservatives’ latest <strong>tax</strong> policy seems<br />
an empty gesture. The proposal was to exempt savings<br />
income from income <strong>tax</strong> for all but those who pay <strong>tax</strong><br />
at the highest rate <strong>of</strong> 40 percent (currently those who<br />
have a total <strong>tax</strong>able income, after the deduction <strong>of</strong> allowances,<br />
<strong>of</strong> £36,000 and above). This, coupled with a<br />
large increase in the personal allowance for those over<br />
65, was stated to be to help the ‘‘innocent victims <strong>of</strong><br />
the downturn.’’ All very laudable, but would it really<br />
be <strong>of</strong> any help at a time when there is little or no income<br />
to be exempted? The cynic in me thinks this is<br />
just posturing before an expected spring general election.<br />
The real practical help for these times has taken the<br />
form not <strong>of</strong> rate cuts, which are unlikely to stimulate<br />
the economy and in any event would have a delayed<br />
impact, but <strong>of</strong> allowing businesses to spread their <strong>tax</strong><br />
payments over an agreed period. This was a measure<br />
announced in the prebudget report with the setting up<br />
<strong>of</strong> the HM Revenue & Customs’ <strong>Business</strong> Payment<br />
Support Service (BPSS). The objective at the time was<br />
to enable ‘‘businesses in temporary financial difficulty<br />
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and unable to pay their <strong>tax</strong> bills to spread payment <strong>of</strong><br />
their bills over a timetable they can afford.’’ All <strong>tax</strong>es<br />
paid by businesses are covered: corporation <strong>tax</strong>, income<br />
<strong>tax</strong>, value added <strong>tax</strong> on sales, income <strong>tax</strong> deducted<br />
from the wages and salaries <strong>of</strong> employees, and<br />
national insurance contributions. This is a nonstatutory<br />
measure and therefore will not feature in the forthcoming<br />
Finance Bill. It also means that if the Revenue do<br />
not agree to a postponement, there is no right <strong>of</strong> appeal.<br />
When it was first announced, some business proprietors<br />
thought that it meant they were free to pay their<br />
<strong>tax</strong>es when they wanted. Instead, it is a matter <strong>of</strong> negotiating<br />
with someone in the BPSS a planned program<br />
<strong>of</strong> payments for liabilities becoming due. It is not<br />
an option open to all — only trading companies, sole<br />
traders, and partnerships. The Revenue have set out<br />
three conditions: The business must be in genuine difficulty,<br />
unable to pay the <strong>tax</strong> on time, and likely to be<br />
able to pay if it was allowed more time.<br />
The real practical help for<br />
these times has taken the<br />
form not <strong>of</strong> rate cuts, but<br />
<strong>of</strong> allowing businesses to<br />
spread their <strong>tax</strong> payments<br />
over an agreed period.<br />
I have no experience <strong>of</strong>, nor have I heard <strong>of</strong>, any<br />
anecdotal evidence <strong>of</strong> how this facility is working. According<br />
to a January 14 press release, the Revenue state<br />
that over 20,000 businesses had been allowed to defer<br />
more than £350 million <strong>of</strong> <strong>tax</strong>es, which sounds impressive,<br />
but averages out at only £1,750 each. The press<br />
statement also claims that, in the majority <strong>of</strong> cases, it<br />
can take the Revenue as little as 10 minutes to reach a<br />
decision, although we are not told what that decision<br />
is.<br />
For sole traders and partners, any income <strong>tax</strong> that<br />
remains unpaid 28 days after the due date attracts a 5<br />
percent late payment surcharge and a further 5 percent<br />
if it is still unpaid six months later. If a deferment plan<br />
is agreed on, there is no surcharge imposed for late<br />
payment. However, there is, <strong>of</strong> course, a price to pay,<br />
and that is in the form <strong>of</strong> interest, currently 4.5 percent<br />
(in other words, 3 percentage points above base rate).<br />
When I had a real job and was running my own<br />
practice on overdraft, I was being charged 2.5 percentage<br />
points above my bank’s own base rate. This would<br />
currently mean a rate <strong>of</strong> 4 percent; so the rate charged<br />
by the Revenue is not too bad, at least at first sight. It<br />
is easy to overlook the fact that interest charged on late<br />
FEATURED PERSPECTIVES<br />
payment <strong>of</strong> <strong>tax</strong> is not itself <strong>tax</strong> deductible. Depending<br />
on the rate and type <strong>of</strong> <strong>tax</strong> being paid, it is an effective<br />
gross rate <strong>of</strong> between 5.62 percent to 7.5 percent. So a<br />
business with cash flow problems would be better using<br />
its existing overdraft facilities if possible.<br />
The problem is, <strong>of</strong> course, that many will probably<br />
be at the limits <strong>of</strong> their permitted borrowings, and<br />
therefore agreeing on a deferral plan with the Revenue<br />
may be the only way out. Certainly it is much more<br />
advisable than for the business proprietor to seek a personal<br />
unsecured loan, which can carry interest <strong>of</strong> at<br />
least 8 percent, which again would not be <strong>tax</strong> deductible<br />
(or, for that matter, to stick his head in the sand<br />
and hope the problem goes away).<br />
Although 200,000 businesses were said to have<br />
made use <strong>of</strong> this deferral option, I expect there will be<br />
many more applications in the next couple <strong>of</strong> weeks.<br />
Most companies in the U.K. tend to have a March 31<br />
or December 31 year-end, and as the corporation <strong>tax</strong><br />
<strong>of</strong> small and medium-size companies is due nine<br />
months after the year-end, many will have had to pay<br />
the <strong>tax</strong> on October 1, 2008, for the year to March 31,<br />
2008, or on January 1, 2009, for the year to March 31,<br />
2008. Possibly the majority <strong>of</strong> the 200,000 businesses<br />
referred to in the Revenue’s press release are in that<br />
category. The next category to apply for deferment will<br />
be the sole traders and partnerships. Their <strong>tax</strong> liabilities<br />
are not as straightforward as companies.<br />
To begin with, they are charged <strong>tax</strong> for a <strong>tax</strong> year,<br />
not for the period for which they prepare their accounts.<br />
The amount charged for an ongoing business<br />
for the <strong>tax</strong> year 2007-2008, for example, will be the<br />
<strong>tax</strong>-adjusted pr<strong>of</strong>its <strong>of</strong> its accounting period ending in<br />
that <strong>tax</strong> year. As sole traders and partnerships are free<br />
to choose whatever accounting date they wish, those<br />
pr<strong>of</strong>its may have been earned as long ago as the year<br />
to April 30, 2007, in the days when the word<br />
‘‘subprime’’ had not entered into common parlance<br />
and most people thought Northern Rock was a popular<br />
dance. Income <strong>tax</strong> for 2007-2008 is payable by two<br />
amounts, each being half <strong>of</strong> the final liability for the<br />
<strong>tax</strong> year 2006-2007, due on January 31, 2008, and July<br />
31, 2008, and a final ‘‘catch-up’’ payment on January<br />
31, 2009, if the actual liability for the year turns out to<br />
be more than that for the previous year, as it should do<br />
if the business is growing.<br />
Although a prudent small-business proprietor who<br />
had made good pr<strong>of</strong>its in the year to April 30, 2007,<br />
will make sure he has the cash available to pay the <strong>tax</strong><br />
when it comes due, life is not like that. Most business<br />
proprietors pay last year’s <strong>tax</strong> out <strong>of</strong> this year’s income.<br />
The problem is that there may not be any income<br />
this year. On January 31, 2009, the proprietor is<br />
therefore faced with having to pay a large <strong>tax</strong> bill on<br />
income earned in the year ended April 30, 2007, which<br />
has been spent when there’s nothing in the kitty this<br />
year to pay it. But that’s not all — on that same date<br />
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FEATURED PERSPECTIVES<br />
he has to pay the first installment <strong>of</strong> his 2008-2009 liability,<br />
which is half <strong>of</strong> the large 2007-2008 liability<br />
based on his pr<strong>of</strong>its for the year to April 30, 2008, a<br />
year when we had heard <strong>of</strong> subprime and Northern<br />
Rock, but before the recession hit. Those pr<strong>of</strong>its may<br />
have been equally as high as the previous years, so a<br />
real problem exists.<br />
The reality is that instead <strong>of</strong> the business having to<br />
go to its bank to ask for a loan to pay the <strong>tax</strong> (which it<br />
probably will not get), the government is taking over<br />
the role <strong>of</strong> banker and lending the business the money<br />
instead. Once more, we have to ask, ‘‘Do we really<br />
need the banks?’’ ◆<br />
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The Global Tax Revolution: The Rise <strong>of</strong> Tax<br />
Competition and the Battle to Defend It<br />
The Global Tax Revolution: The Rise <strong>of</strong> Tax<br />
Competition and the Battle to Defend It<br />
by Chris Edwards and Daniel J. Mitchell<br />
Published by the Cato Institute: Washington<br />
(2008).<br />
255 pages<br />
Price: $21.95<br />
Reviewed by Gary Clyde Hufbauer, Reginald Jones<br />
senior fellow, Peterson Institute for International<br />
Economics.<br />
Simply because it’s published by Cato, this book<br />
might be dismissed by the <strong>tax</strong> engineers <strong>of</strong> the<br />
Obama administrations — people like Chief Economist<br />
Lawrence Summers, Treasury Secretary Timothy<br />
Geithner, House Ways and Means Committee Chair<br />
Charles B. Rangel, D-N.Y., and Senate Finance Committee<br />
Chair Max Baucus, D-Mont. That would be a<br />
mistake.<br />
In response to globalization, many countries have<br />
adopted simpler <strong>tax</strong> systems with lower rates, seeking<br />
to improve their competitive position in the world<br />
economy. By and large, these efforts have succeeded.<br />
Critics may deplore the outbreak <strong>of</strong> <strong>tax</strong> competition,<br />
but Chris Edwards and Daniel Mitchell come to celebrate<br />
the revolution, not reverse it. It’s hard to argue<br />
with success; yet three criticisms are <strong>of</strong>ten voiced: Tax<br />
competition undermines the ability <strong>of</strong> government to<br />
collect revenue; with the result that public goods and<br />
social programs are underfunded; and as collateral<br />
damage, progressivity is eroded because <strong>tax</strong> cuts favor<br />
capital income and highly paid personnel.<br />
Where others see vice, Edwards and Mitchell find<br />
virtue. Small government is their goal. America’s problem<br />
is not the starvation <strong>of</strong> public programs, it’s too<br />
much money thrown at social entitlements and bridges<br />
to nowhere. Progressive <strong>tax</strong>ation loads the heaviest burdens<br />
on human and physical capital, and thereby<br />
cripples economic performance.<br />
Surveying reforms around the world, the authors<br />
conclude that <strong>tax</strong> competition spurs investment and<br />
promotes growth. Not only does <strong>tax</strong> competition unleash<br />
entrepreneurial energy at home, it also attracts<br />
foreign investment and skilled labor. The authors award<br />
special merit to countries that join the ‘‘flat <strong>tax</strong> club’’<br />
— in its ideal form (who can forget the famous Hall-<br />
Rabushka postcard return?), a single low-rate <strong>tax</strong><br />
across all forms <strong>of</strong> income. On this prescription, Edwards<br />
and Mitchell would especially like the Obama<br />
administration to take notice. A simple flat <strong>tax</strong> system<br />
is the path the United States must follow, in their view,<br />
to meet rising competition from the likes <strong>of</strong> Brazil,<br />
Russia, India, China, and Korea — the BRICKs. As<br />
the first step, the authors recommend sharp cuts in<br />
both individual and corporate <strong>tax</strong> rates: slashing individual<br />
<strong>tax</strong> rates to a range between 15 percent and 25<br />
percent, and corporate <strong>tax</strong> rates to 15 percent.<br />
The rationale behind a ‘‘starve the beast’’ strategy<br />
for reaching smaller and more efficient government is<br />
straightforward: Reduced revenues will restrain public<br />
spending and eventually force government to curtail<br />
excessive promises. On this proposition, I must note<br />
two ironies. First, in recent years, an absence <strong>of</strong> revenue<br />
has persuaded neither Italy nor the United States<br />
to curb expenditure, despite the ‘‘conservative’’ leadership<br />
<strong>of</strong> Berlusconi and Bush. Second, as the authors<br />
recognize, <strong>tax</strong> competition has yet to reduce public revenues<br />
as a share <strong>of</strong> GDP. Laffer-curve effects — base<br />
broadening and less <strong>tax</strong> avoidance — are sufficiently<br />
strong that <strong>tax</strong> revenues typically remain stable or even<br />
rise in the wake <strong>of</strong> rate cuts.<br />
Recent experience not only contradicts critics who<br />
fear a race to the bottom in terms <strong>of</strong> public expenditure,<br />
but also disappoints advocates who devoutly urge<br />
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BOOK REVIEW<br />
smaller government. But the authors are more optimistic<br />
than the critics: They keep their fingers crossed that<br />
future installments <strong>of</strong> <strong>tax</strong> competition will eventually<br />
‘‘starve the beast.’’ Count me a skeptic. Given demographic<br />
aging in all OECD countries and sharp income<br />
inequalities among the elderly, it seems doubtful that<br />
<strong>tax</strong> competition will curtail entitlement spending. Indeed,<br />
entitlement spending could easily double over the<br />
next generation, with medical care accounting for most<br />
<strong>of</strong> the expansion. In the contest between <strong>tax</strong> cuts and<br />
grandmother’s heart surgery, guess who wins.<br />
For me, the compelling argument for <strong>tax</strong> competition<br />
is that it serves to align fiscal charges with public<br />
benefits — just as that hero <strong>of</strong> public finance, Charles<br />
Tiebout, described a half century ago. Tiebout, <strong>of</strong><br />
course, was talking about local governments. But in the<br />
face <strong>of</strong> rising <strong>tax</strong> competition, many national governments<br />
have not only reformed their <strong>tax</strong> systems but<br />
also have enhanced the business environment by improving<br />
transportation, power grids, telecommunications,<br />
schools, hospitals, and museums.<br />
Given the virtues <strong>of</strong> <strong>tax</strong> competition, Edwards and<br />
Mitchell condemn attempts to harmonize national <strong>tax</strong><br />
systems, led by the OECD and the European Union.<br />
In fact, the anti-<strong>tax</strong>-competition crowd has gradually<br />
lost its voice in recent debates. However, it seems<br />
wrong to dismiss wholesale the arguments advanced<br />
for <strong>tax</strong> harmonization.<br />
One subject where I agree with the <strong>tax</strong> harmonization<br />
school is the need to share information on investments<br />
by nonresidents between the host country and<br />
the home country. In the Cato view, the creation <strong>of</strong><br />
efficient reporting networks will suppress <strong>tax</strong> competition.<br />
That’s true, if the term ‘‘<strong>tax</strong> competition’’ is<br />
stretched to encompass means <strong>of</strong> furthering <strong>tax</strong> evasion.<br />
But my belief is that the country <strong>of</strong> citizenship or<br />
residence <strong>of</strong> natural persons has the right to <strong>tax</strong> their<br />
worldwide income if it chooses; accordingly, capital<br />
income earned abroad should be reported by the host<br />
country as a matter <strong>of</strong> comity between nations.<br />
This issue is closely related to an important but <strong>of</strong>ten<br />
overlooked question: Do the virtues <strong>of</strong> <strong>tax</strong> competition<br />
apply with equal force to personal income <strong>tax</strong>ation<br />
as to corporate income <strong>tax</strong>ation? That’s where Tiebout<br />
entered the debate, with the metaphor <strong>of</strong> disaffected<br />
citizens ‘‘voting with their feet.’’ But citizens cannot<br />
change nationality as easily as residence; and in some<br />
countries, the rights and privileges associated with citizenship<br />
are extremely valuable. Against this factual<br />
background, I think it’s an open question whether unfettered<br />
<strong>tax</strong> competition is appropriate in the realm <strong>of</strong><br />
personal <strong>tax</strong>ation.<br />
Edwards and Mitchell have written a most entertaining<br />
book — not an easy feat when the subject is <strong>tax</strong>ation.<br />
Casual readers will enjoy stories about celebrities<br />
— Ringo Starr <strong>of</strong> Beatles fame, Irish rock band U2,<br />
Swedish pop group ABBA, and others — who have<br />
channeled their wealth and royalties to <strong>tax</strong> haven jurisdictions.<br />
Policy wonks will appreciate the comprehensive<br />
surveys <strong>of</strong> <strong>tax</strong> reform. There’s something for<br />
everyone — even the Obama team and its congressional<br />
allies. ◆<br />
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New Rules for Valuing Intangible Assets in Spain<br />
by Sonia Velasco and Ana Colldefors<br />
Sonia Velasco is a partner with Cuatrecasas in New York, and Ana Colldefors is an associate with Cuatrecasas<br />
in Barcelona.<br />
The <strong>tax</strong> treatment <strong>of</strong> some intangible assets in<br />
Spain has been modified and presents substantial<br />
advantages. (See Tax Notes Int’l, Feb. 18, 2008, p. 597,<br />
Doc 2008-2042, or2008 WTD 35-11.)<br />
Under Act 16/2007 <strong>of</strong> July 4, 2007, Spain grants a<br />
50 percent corporate <strong>tax</strong> credit for income derived from<br />
the rights to use and exploit patents and other intangible<br />
assets.<br />
On February 13, 2008, the European Commission<br />
announced that this Spanish corporate <strong>tax</strong> credit designed<br />
to promote research and development is compatible<br />
with EU rules on state aid, as the <strong>tax</strong> credit<br />
applies to all companies, regardless <strong>of</strong> their size or sector.<br />
In relation to the application <strong>of</strong> this 50 percent <strong>tax</strong><br />
credit, the Spanish <strong>tax</strong> authorities issued a binding <strong>tax</strong><br />
ruling (V1299-08) on June 19, 2008, to clarify which<br />
expenses must be taken into account when determining<br />
the value <strong>of</strong> intangible assets. The value <strong>of</strong> intangible<br />
assets is relevant because this <strong>tax</strong> credit may only be<br />
applied until the <strong>tax</strong> period following the year in which<br />
the value <strong>of</strong> the income was more than six times<br />
greater than the cost <strong>of</strong> the intangible assets. The intangible<br />
assets must be created by the entity applying<br />
the exemption or by a group company in a <strong>tax</strong> group.<br />
As a general rule, the value <strong>of</strong> an asset for <strong>tax</strong> purposes<br />
is its book value with modifications mentioned in<br />
the Spanish Corporate Tax Act. The expenses incurred<br />
in the development <strong>of</strong> an intangible asset constitute its<br />
book value. The year’s expenses can only be registered<br />
as the asset’s book value if the expenses are clearly<br />
individualized and allocated to one particular project<br />
or intangible asset, and there are sufficient reasons to<br />
believe in the technical and economic success <strong>of</strong> the<br />
intangible asset. Therefore, only some expenses incurred<br />
in creating an intangible asset can be registered<br />
as an increase in the value <strong>of</strong> the intangible asset being<br />
developed.<br />
With this ruling, the Spanish <strong>tax</strong> authorities took a<br />
<strong>tax</strong>payer-friendly position because they considered that<br />
the cost basis for <strong>tax</strong> purposes <strong>of</strong> the intangible asset,<br />
in particular when calculating the limit on the 50 percent<br />
<strong>tax</strong> credit, should take into account the intangible<br />
asset’s book value (following the rules above) but also<br />
expenses incurred that may not be registered as an increase<br />
<strong>of</strong> the book value <strong>of</strong> the assets (for example,<br />
R&D expenses <strong>of</strong> the year).<br />
The Spanish <strong>tax</strong> authorities’ interpretation reduces<br />
substantially the effect <strong>of</strong> the limit to six times the<br />
value <strong>of</strong> the intangible asset, given that this value can<br />
sometimes be much higher than the intangible asset’s<br />
book value. This makes the <strong>tax</strong> regime for patents and<br />
other intangible assets, in effect in Spain since January<br />
2008, more attractive. ◆<br />
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Deduction <strong>of</strong> <strong>School</strong> Fees Under German Law<br />
by Marko Wohlfahrt and Katrin Köhler<br />
Marko Wohlfahrt is a consultant and Katrin Köhler is a senior manager with Deloitte Touche Tohmatsu in<br />
Düsseldorf.<br />
Copyright © 2009 Deloitte Touche Tohmatsu. All rights reserved.<br />
German <strong>tax</strong> law allows a <strong>tax</strong> deduction for school<br />
fees paid during the German <strong>tax</strong> year (the calendar<br />
year) for some accredited private German schools.<br />
Fees paid to foreign private schools, however, generally<br />
cannot be deducted from the German income <strong>tax</strong> base.<br />
This limit on the deductibility <strong>of</strong> school fees has given<br />
rise to issues as to whether the rules are compatible<br />
with EC law, specifically the freedom to provide services<br />
in another EU member state.<br />
German Domestic Law<br />
According to article 10 <strong>of</strong> the German Income Tax<br />
Code (Einkommensteuergesetz, or EStG), 30 percent <strong>of</strong><br />
fees paid for private German schools can be treated as<br />
special expenses on a <strong>tax</strong>payer’s German income <strong>tax</strong><br />
return if the following requirements are met:<br />
1) the <strong>tax</strong>payer is entitled to receive German<br />
child benefit payments or the child allowance for<br />
the child attending the private school;<br />
2) the expenses relate to education costs (that is,<br />
expenses for accommodation, meals, and general<br />
mentoring are excluded); and<br />
3) the school is recognized as an approved substitute<br />
or supplementary school to the German public<br />
school system.<br />
In late 2004 the Federal Finance Court (Bundesfinanzh<strong>of</strong>)<br />
decided that some private German and European<br />
schools also are within the scope <strong>of</strong> requirement<br />
3 above, even if the schools are located outside <strong>of</strong><br />
Germany but are within the European Economic Area.<br />
Fees for other private schools are not considered deductible<br />
as special expenses, even though the schools<br />
are located in Germany.<br />
The Case<br />
The case involved German resident spouses who<br />
were jointly assessed German income <strong>tax</strong> and whose<br />
children attended a private school in Scotland in the<br />
years at issue, 1998 and 1999. The German <strong>tax</strong> authorities<br />
denied a deduction for the school fees paid to<br />
the Scottish private school as special expenses for income<br />
<strong>tax</strong> purposes.<br />
The case was appealed to the local Finance Court <strong>of</strong><br />
Cologne (Finanzgericht Köln), which in 2005 had to<br />
decide whether fees paid by German <strong>tax</strong> residents to a<br />
private non-German school in Scotland could be considered<br />
special expenses. The court had concerns about<br />
the compatibility <strong>of</strong> the German legal position with the<br />
freedom <strong>of</strong> services provision <strong>of</strong> the EC Treaty, because<br />
restricting the deduction for school fees to German<br />
schools could discriminate against foreign individuals<br />
who move to work in Germany but whose<br />
children attend schools in their home countries, as well<br />
as German individuals who move to work abroad (but<br />
remain subject to worldwide German <strong>tax</strong> liability) and<br />
whose children attend schools abroad. Therefore, the<br />
Finance Court <strong>of</strong> Cologne referred the issue to the European<br />
Court <strong>of</strong> Justice.<br />
The ECJ issued its decision on September 11, 2007,<br />
concluding that while German law allows the deduction<br />
for some accredited schools within Germany and<br />
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PRACTITIONERS’ CORNER<br />
for German schools within the EEA, the practice <strong>of</strong><br />
the German <strong>tax</strong> authorities disallowing a <strong>tax</strong> deduction<br />
for school fees for private schools located outside Germany<br />
but within the EEA is not compatible with EC<br />
law, in particular with the freedom <strong>of</strong> services and freedom<br />
<strong>of</strong> movement principles in articles 49 and 18 <strong>of</strong><br />
the EC Treaty (Schwarz/Gootjes-Schwarz (Case C-76/<br />
05)).<br />
The ECJ concluded that the German rule constitutes<br />
an obstacle to the freedom to provide services<br />
because it dissuades German residents from sending<br />
their children to private schools established in another<br />
member state and impedes private schools established<br />
in other member states from <strong>of</strong>fering education to the<br />
children <strong>of</strong> German residents. The German rule generally<br />
results in a higher <strong>tax</strong> burden for <strong>tax</strong>payers who<br />
sent their children to a private school located in another<br />
EU member state because the school fees would<br />
not be deductible. Finally, the ECJ ruled that the German<br />
provision violates the free movement <strong>of</strong> citizens<br />
because it places the <strong>tax</strong>payers who have children attending<br />
schools in another member state at an unjustifiable<br />
disadvantage compared with persons who have<br />
not exercised that right.<br />
Consequences <strong>of</strong> the ECJ Decision<br />
Based on the ECJ decision, the Finance Court <strong>of</strong><br />
Cologne ruled on February 14, 2008, that the fees paid<br />
by the <strong>tax</strong>payers to the school in Scotland had to be<br />
treated as special expenses on the <strong>tax</strong>payer’s German<br />
income <strong>tax</strong> return. However, the fiscal court granted<br />
leave to the German <strong>tax</strong> authorities to appeal to the<br />
German Federal Finance Court to obtain further clarification<br />
on the impact on domestic <strong>tax</strong> law if EU law<br />
is violated (for example, because <strong>of</strong> pro<strong>of</strong> required by<br />
the <strong>tax</strong> authorities related to requirement 3 above). The<br />
<strong>tax</strong> authorities filed an appeal in April 2008, and the<br />
outcome is still pending.<br />
Following the ECJ’s decision, the German <strong>tax</strong> authorities<br />
generally intend to consider fees paid to<br />
schools within the EU/EEA as special expenses for<br />
German income <strong>tax</strong> purposes. The <strong>tax</strong> authorities require,<br />
however, that the foreign school leads to a<br />
graduation approved by the Conference <strong>of</strong> Cultural<br />
Ministers <strong>of</strong> the German Federal States or the Ministry<br />
<strong>of</strong> Culture <strong>of</strong> a German federal state. Also, the German<br />
<strong>tax</strong> resident claiming the <strong>tax</strong> deduction must provide<br />
the <strong>tax</strong> authorities with confirmation from the foreign<br />
school that access to the school is not limited to<br />
students who can afford to pay the school fees (that is,<br />
for purposes <strong>of</strong> meeting requirement 3 above), but that<br />
students with limited financial funds also can attend<br />
the school (for example, through scholarships).<br />
Should the school fees not be taken into account in<br />
a German income <strong>tax</strong> assessment notice (for example,<br />
the <strong>tax</strong>payer could not provide the requested pro<strong>of</strong> because<br />
the school had not forwarded necessary documents),<br />
the <strong>tax</strong>payer should file an objection and request<br />
a postponement <strong>of</strong> the final assessment until the<br />
Federal Finance Court issues its decision in the case.<br />
2009 Tax Act<br />
The lower house <strong>of</strong> the German Parliament (Bundestag)<br />
on November 28, 2008, approved the 2009 annual<br />
Tax Act (Jahressteuergesetz 2009), and the upper house<br />
(Bundesrat) approved it on December 19, 2008. The<br />
Tax Act provides that school fees for private non-<br />
German schools in the EU/EEA whose graduation is<br />
approved by the German authorities will be treated as<br />
special expenses. While the act maintains the 30 percent<br />
deduction level for school fees, the deduction will<br />
be capped at €5,000. The new rule is retroactive from<br />
January 1, 2008, and for all prior-year cases for which<br />
a relevant income <strong>tax</strong> assessment notice has not become<br />
final. ◆<br />
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Different Methods <strong>of</strong> Attributing Pr<strong>of</strong>its to Agency<br />
PEs<br />
by Carlos Eduardo Costa M.A. Toro<br />
Carlos Eduardo Costa M.A. Toro is a partner with Zilveti e Sanden Advogados in São Paulo.<br />
This article is based on the advanced LL.M. paper the author submitted in fulfillment <strong>of</strong> the requirements<br />
<strong>of</strong> the advanced LL.M. in <strong>international</strong> <strong>tax</strong> law at the International Tax Center Leiden (Leiden University).<br />
I. Introduction<br />
It has been said that article 7 is the heart <strong>of</strong> the<br />
OECD model convention. 1 Indeed, article 7 <strong>of</strong> the<br />
OECD model2 deals with the most important category<br />
<strong>of</strong> income — business pr<strong>of</strong>its, which comprise most <strong>of</strong><br />
the income that arises in <strong>international</strong> transactions. 3 It<br />
therefore covers a wide extent <strong>of</strong> activities carried out<br />
by an enterprise, either by forbidding the host state to<br />
<strong>tax</strong> when the permanent establishment threshold is not<br />
met or by allowing <strong>tax</strong>ation when such requirement is<br />
fulfilled.<br />
Its acknowledged importance aside, article 7 still<br />
presents some debatable issues regarding its interpretation,<br />
such as the attribution <strong>of</strong> pr<strong>of</strong>its to agency PEs.<br />
This issue becomes even more controversial when the<br />
PE is a separate enterprise associated with its principal,<br />
in most cases a subsidiary constituting a PE <strong>of</strong> its foreign<br />
parent company. In this context, despite being one<br />
<strong>of</strong> the most important concepts <strong>of</strong> <strong>international</strong> <strong>tax</strong>ation<br />
and being extensively dealt with in the OECD<br />
model convention and its commentary, PE characterization<br />
is still a controversial issue around the world,<br />
1<br />
Alberto Xavier, Direito Tributário Internacional do Brasil, 6th ed.<br />
(Rio de Janeiro: Forense, 2004), p. 695.<br />
2<br />
Unless otherwise indicated, all references are to the 2005<br />
OECD model convention.<br />
3<br />
Klaus Vogel, Klaus Vogel on Double Taxation Conventions, 3rd<br />
ed. (London: Kluwer Law International, 1997), p. 399.<br />
since it involves a factual analysis that can only be<br />
made on a case-by-case basis. 4<br />
As pointed out by the OECD in the introduction to<br />
its model convention, member countries have long recognized<br />
the need to ‘‘clarify, standardize, and confirm<br />
the fiscal situation <strong>of</strong> <strong>tax</strong>payers who are engaged in<br />
economic activities in other countries through the application<br />
by all countries <strong>of</strong> common solutions to identical<br />
cases <strong>of</strong> double <strong>tax</strong>ation.’’ 5 However, this aim <strong>of</strong><br />
the OECD is not always met in practice, as the interpretation<br />
<strong>of</strong> relevant provisions <strong>of</strong> the OECD model<br />
convention <strong>of</strong>ten diverges between states. The OECD<br />
itself recognizes that the practices <strong>of</strong> the countries<br />
around the world regarding the attribution <strong>of</strong> pr<strong>of</strong>its to<br />
PEs and the interpretation <strong>of</strong> article 7 differ significantly.<br />
6<br />
The OECD’s findings were confirmed by a study<br />
carried out by the International Fiscal Association on<br />
the occasion <strong>of</strong> its 60th Congress held in Amsterdam<br />
in 2006. The general report <strong>of</strong> this congress indicated a<br />
wide divergence among the branch reporters regarding<br />
the interpretation <strong>of</strong> article 7. According to the general<br />
report, the only point on which most <strong>of</strong> the branch<br />
4 Massimiliano Gazzo, ‘‘Permanent Establishment Through<br />
Related Corporations: New Case Law in Italy and Its Impact on<br />
Multinational Flows,’’ Bulletin (June 2003), pp. 257-264.<br />
5 Para. 2 <strong>of</strong> the introduction to the 2005 OECD model.<br />
6 Para. 1 <strong>of</strong> the update <strong>of</strong> the status <strong>of</strong> the OECD project on<br />
the attribution <strong>of</strong> pr<strong>of</strong>its to PEs (2006), available at http://<br />
www.oecd.org/dataoecd/55/14/37861293.pdf.<br />
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SPECIAL REPORTS<br />
reports were <strong>of</strong> the same view is that there is little or<br />
no guidance from the <strong>tax</strong> authorities on the issue <strong>of</strong><br />
attribution <strong>of</strong> pr<strong>of</strong>its to PEs. Moreover, most jurisdictions<br />
have little, if any, case law on this issue. 7<br />
The existence <strong>of</strong> different interpretations on the<br />
scope <strong>of</strong> article 7 is therefore against the purpose <strong>of</strong> a<br />
<strong>tax</strong> convention for the avoidance <strong>of</strong> double <strong>tax</strong>ation,<br />
giving rise to harmful consequences on the exchange <strong>of</strong><br />
goods and services between states. The lack <strong>of</strong> consistency<br />
in applying a treaty provision is a major contradiction<br />
to the purpose <strong>of</strong> that treaty in providing a harmonized<br />
sharing <strong>of</strong> <strong>tax</strong>ing rights between the<br />
contracting states. 8<br />
In this context, this article discusses the application<br />
<strong>of</strong> the provisions <strong>of</strong> article 7 <strong>of</strong> the OECD model convention<br />
regarding the situation when an agency PE is<br />
found to exist, especially in the case when a subsidiary<br />
constitutes an agency PE <strong>of</strong> its foreign parent company.<br />
In other words, it is intended to analyze through<br />
the existing case law the main features <strong>of</strong> this particular<br />
type <strong>of</strong> PE.<br />
Furthermore, the different approaches to attribute<br />
pr<strong>of</strong>its to agency PEs will be addressed, namely the<br />
functionally separate entity approach, also known as<br />
the authorized OECD approach or dual <strong>tax</strong>payer approach;<br />
and the single <strong>tax</strong>payer approach, also referred<br />
to as the zero-sum approach. It is intended to provide<br />
an answer to the question <strong>of</strong> whether there may be a<br />
pr<strong>of</strong>it attributable to an agency PE in excess <strong>of</strong> the<br />
arm’s-length remuneration paid to the dependent agent.<br />
Phrased differently, the issue at stake is whether it is<br />
possible to attribute a separate pr<strong>of</strong>it to an agency PE<br />
once the agent had an arm’s-length reward for the service<br />
provided for the nonresident enterprise. This is a<br />
very controversial issue, as there is much disagreement<br />
in the <strong>international</strong> <strong>tax</strong> community with the OECD<br />
preferred approach.<br />
It is a very sensitive issue in practice as it directly<br />
affects the supply chain management <strong>of</strong> multinational<br />
enterprises, when the characterization <strong>of</strong> an agency PE<br />
may have a significant impact on the overall costs. 9<br />
Through their supply chain management, multinational<br />
enterprises will <strong>of</strong>ten seek to structure their activities in<br />
a foreign country in a manner that either avoids the<br />
7<br />
Philip Baker and Richard S. Collier, General Report, ‘‘The<br />
Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments,’’ Cahiers de<br />
Droit Fiscal International, Vol. 91b, Subject II (Amersfoort: Sdu<br />
Fiscale & Financiële Uitgevers, 2006), pp. 34-35.<br />
8<br />
In some situations, the existence <strong>of</strong> different interpretations<br />
may derive from the domestic legislation <strong>of</strong> a particular state,<br />
giving rise to the issue <strong>of</strong> treaty override.<br />
9<br />
Hans Pijl, ‘‘The Zero-Sum Game, the Emperor’s Beard and<br />
the Authorized OECD Approach,’’ Eur. Tax’n (Jan. 2006), pp.<br />
29-35.<br />
characterization <strong>of</strong> an agency PE 10 or provides for the<br />
most advantageous allocation <strong>of</strong> functions, assets, and<br />
risks. Generally, multinational enterprises will seek to<br />
allocate functions, assets, and risks in a low-<strong>tax</strong> jurisdiction<br />
to achieve a lower worldwide effective <strong>tax</strong> rate.<br />
In this context, the lack <strong>of</strong> clear guidance on the appropriate<br />
atribution <strong>of</strong> pr<strong>of</strong>its to agency PEs is a significant<br />
obstacle to the structuring <strong>of</strong> an optimal supply<br />
chain from a multinational enterprise’s perspective.<br />
Indeed, it is widely recognized that in the field <strong>of</strong><br />
<strong>tax</strong>ation the lack <strong>of</strong> certainty is harmful to both <strong>tax</strong>payers<br />
and states as it may hinder cross-border trade. 11<br />
The importance <strong>of</strong> this subject can also be deduced<br />
from the decision <strong>of</strong> the International Fiscal Association<br />
to dedicate a plenary session to the attribution <strong>of</strong><br />
pr<strong>of</strong>its to PEs at its 60th Congress. Among the issues<br />
discussed in the plenary session was the attribution <strong>of</strong><br />
pr<strong>of</strong>its to agency PEs when there is a supplementary<br />
pr<strong>of</strong>it attributable to such PE in addition to the arm’slength<br />
reward paid to the agent. The lack <strong>of</strong> consensus<br />
among the panel members indicates the extent <strong>of</strong> the<br />
controversy on this issue.<br />
Therefore, it is hoped that the analysis <strong>of</strong> the relevant<br />
case law, especially Morgan Stanley and SET Satellite,<br />
and the opinions <strong>of</strong> prominent <strong>tax</strong> scholars might<br />
point towards a predominant direction on the interpretation<br />
<strong>of</strong> the issue at stake that could avoid the uncertainty<br />
on the <strong>tax</strong> consequences <strong>of</strong> setting up a business<br />
involving an agency PE.<br />
II. The Agency PE<br />
The main rule <strong>of</strong> article 7 <strong>of</strong> the OECD model <strong>tax</strong><br />
convention basically states that the pr<strong>of</strong>its <strong>of</strong> an enterprise<br />
must only be <strong>tax</strong>ed in its state <strong>of</strong> residence (home<br />
state) unless the enterprise carries on business in the<br />
other contracting state through a PE situated therein<br />
(host state). In this latter case, the pr<strong>of</strong>its <strong>of</strong> the enterprise<br />
may be <strong>tax</strong>ed in the other state, but only so much<br />
<strong>of</strong> them as are attributable to that PE.<br />
It derives from the wording <strong>of</strong> the provisions <strong>of</strong> article<br />
7 that the existence <strong>of</strong> a PE is the decisive factor<br />
for the allocation <strong>of</strong> <strong>tax</strong>ing rights regarding the business<br />
pr<strong>of</strong>its <strong>of</strong> an enterprise. As stated by Brian J. Arnold,<br />
the PE requirement ‘‘is a minimum threshold<br />
10<br />
Avoiding the characterization <strong>of</strong> a PE is not only a matter<br />
<strong>of</strong> achieving a lower worldwide effective <strong>tax</strong> rate, but also avoiding<br />
a high burden <strong>of</strong> compliance costs.<br />
11<br />
As early as 1776, Adam Smith outlined certainty as one <strong>of</strong><br />
the four principles <strong>of</strong> an ideal <strong>tax</strong> system, along with equity, convenience,<br />
and economy. Adam Smith, An Inquiry Into the Nature<br />
and Causes <strong>of</strong> the Wealth <strong>of</strong> Nations (London: Methuen and Co.,<br />
Ltd., ed. Edwin Cannan, 1904), available at http://<br />
www.econlib.org/library/Smith/smWN21.html.<br />
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that must be satisfied before a country can <strong>tax</strong> residents<br />
<strong>of</strong> other treaty countries on their pr<strong>of</strong>its derived<br />
from the other country.’’ 12<br />
At this stage, it is worthwhile to remember what<br />
Kees van Raad cited as one <strong>of</strong> the fundamental rules<br />
in applying <strong>tax</strong> treaties, that ‘‘<strong>tax</strong> treaties restrict the<br />
application <strong>of</strong> internal <strong>tax</strong> law.’’ 13 Stated differently, a<br />
<strong>tax</strong> treaty might restrict <strong>tax</strong>ation, but not impose a <strong>tax</strong><br />
that does not otherwise exist under domestic law. The<br />
main purpose <strong>of</strong> <strong>tax</strong> treaties is to establish a mechanism<br />
to avoid double <strong>tax</strong>ation by restricting <strong>tax</strong> claims<br />
in areas where overlapping <strong>tax</strong> claims are expected to<br />
occur. 14<br />
In this sense, the PE threshold must be met to allow<br />
the host state to <strong>tax</strong> the items <strong>of</strong> income arising within<br />
its territory, if its domestic law so provides. Broadly<br />
speaking, the rationale behind the PE provision is that<br />
as the enterprise is deriving pr<strong>of</strong>its in the host state by<br />
having a presence there<strong>of</strong>, that is, by being economically<br />
connected with that state and using its infrastructure,<br />
the host state should be entitled to <strong>tax</strong> such<br />
pr<strong>of</strong>its.<br />
The characterization <strong>of</strong> a PE is governed by article<br />
5, provided that the relevant states concluded an<br />
OECD-patterned treaty. For the present analysis, what<br />
is relevant is the characterization <strong>of</strong> an agency PE,<br />
which is governed by the provisions <strong>of</strong> article 5, paragraph<br />
5 <strong>of</strong> the OECD model <strong>tax</strong> convention.<br />
The first use <strong>of</strong> article 5, paragraph 5 in a model<br />
dates back to the 1935 League <strong>of</strong> Nations draft. 15 The<br />
underlying principle <strong>of</strong> this provision is that a person<br />
acting on behalf <strong>of</strong> the enterprise in the host state<br />
leads to a <strong>tax</strong>able presence there<strong>of</strong>, that is, a PE, even<br />
though the enterprise may not have a fixed place <strong>of</strong><br />
business in that state in the sense <strong>of</strong> paragraphs 1 and<br />
2 <strong>of</strong> article 5. 16 This particular feature <strong>of</strong> the agency<br />
PE — irrelevance <strong>of</strong> a fixed place <strong>of</strong> business — illustrates<br />
the difficulty in characterizing such a PE in practice,<br />
as opposed to the physical PE set forth in article<br />
5, paragraphs 1 and 2. While the characterization <strong>of</strong><br />
the latter type is rather obvious, <strong>tax</strong> authorities face a<br />
more difficult task in identifying agency PEs because <strong>of</strong><br />
12<br />
Brian J. Arnold, ‘‘Threshold Requirements for Taxing <strong>Business</strong><br />
Pr<strong>of</strong>its Under Tax Treaties,’’ Bulletin — Tax Treaty Monitor<br />
(Oct. 2003), pp. 476-492.<br />
13<br />
Kees van Raad, ‘‘Five Fundamental Rules in Applying Tax<br />
Treaties,’’ Liber Amicorum Luc Hinnekens (Bruxelles: Bruylant,<br />
2002), pp. 587-597.<br />
14<br />
Vogel, supra note 3, at 27.<br />
15 John F. Avery Jones et al., ‘‘The Origins <strong>of</strong> Concepts and<br />
Expressions Used in the OECD Model and Their Adoption by<br />
States,’’ Bulletin — Tax Treaty Monitor (June 2006), p. 237.<br />
16 Vogel, supra note 3, at 329.<br />
the need to focus on the activities <strong>of</strong> the enterprise as<br />
carried out by the dependent agent. 17<br />
Under article 5, paragraph 5 <strong>of</strong> the OECD model<br />
<strong>tax</strong> convention, an agency PE is found to exist when<br />
the following characteristics are met: (i) a person (individual<br />
or company) is acting on behalf <strong>of</strong> the enterprise,<br />
(ii) other than an agent <strong>of</strong> independent status,<br />
(iii) with authority to conclude contracts, (iv) in the<br />
name <strong>of</strong> the enterprise, (v) on a regular basis. In the<br />
OECD language, as long as these requirements are<br />
met, the agency PE is characterized a dependent agent<br />
(DA) and a dependent agent PE (DAPE). There are<br />
countless debatable questions in connection with each<br />
<strong>of</strong> these requirements, all <strong>of</strong> which, however, fall outside<br />
the scope <strong>of</strong> this article. 18 For the purposes <strong>of</strong> this<br />
article, it is assumed that every time an agency PE is<br />
mentioned, the requirements at stake were met.<br />
In this context, though this is not the core issue <strong>of</strong><br />
this article, the scope <strong>of</strong> article 5, paragraphs 5 and 6<br />
<strong>of</strong> the OECD model convention is quite disputable<br />
among scholars, especially when it comes to the difference<br />
between common-law and civil-law practitioners.<br />
From a common-law perspective, it is <strong>of</strong>ten argued that<br />
article 5, paragraphs 5 and 6 cover only agents concluding<br />
contracts binding on their principal. 19 However,<br />
a different view based on civil law is that article 5(5) <strong>of</strong><br />
the OECD model convention refers to direct representatives,<br />
while article 5(6) relates to indirect representatives.<br />
20 These diverse views reflect the essential difference<br />
between common and civil law:<br />
When an agent makes a contract in his own<br />
name, but on behalf <strong>of</strong> an undisclosed principal,<br />
as a general rule under common law, the principal<br />
is bound by the contract, whereas under civil<br />
law, again as a general rule, only the agent, and<br />
not the principal, is bound by such a contract. 21<br />
This difference between common and civil law is<br />
<strong>of</strong>ten viewed as a <strong>tax</strong> planning opportunity. Multinational<br />
enterprises will take into account all the abovementioned<br />
factors that characterize an agency PE<br />
when setting up a business abroad. Under their supply<br />
chain management and <strong>international</strong> <strong>tax</strong> planning strategy,<br />
multinational enterprises will <strong>of</strong>ten seek to structure<br />
their activities in a foreign country in a manner<br />
17 Arnold, supra note 12, at 479.<br />
18 For reference to the controversial issues involving the<br />
agency PE notion, see Giuseppe Persico, ‘‘Agency Permanent<br />
Establishment Under Article 5 <strong>of</strong> the OECD Model Convention,’’<br />
Inter<strong>tax</strong>, Vol. 28, No. 2 (2000), pp. 66-82.<br />
19 John F. Avery Jones and David A. Ward, ‘‘Agents as Permanent<br />
Establishments Under the OECD Model Tax Convention,’’<br />
Eur. Tax’n (May 1993), pp. 154-181.<br />
20 Sidney I. Roberts, ‘‘The Agency Element <strong>of</strong> Permanent Establishment:<br />
The OECD Commentaries From the Civil Law<br />
View,’’ Eur. Tax’n (Mar. 2008), pp. 107-113.<br />
21 Avery Jones and Ward, supra note 19, at 156.<br />
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that either avoids the characterization <strong>of</strong> an agency<br />
PE 22 or provides for an optimal allocation <strong>of</strong> functions,<br />
assets, and risks to shift income to a low-<strong>tax</strong> jurisdiction.<br />
Taking into account a particular company willing to<br />
distribute its goods in a foreign country, there are basically<br />
two distribution models that may be adopted to<br />
accomplish this goal: (i) the buy-sell model, involving a<br />
local distributor that may be related to the company,<br />
and (ii) the agency model. Both models have their variances,<br />
triggering different <strong>tax</strong> consequences, and <strong>of</strong>ten<br />
multinational enterprises play around with the features<br />
<strong>of</strong> each model to shift income to a low-<strong>tax</strong> jurisdiction<br />
(for example, by using a limited risk distribution<br />
model, under which part <strong>of</strong> the risk is shifted from the<br />
distributor to the principal, so the former is entitled to<br />
a lower pr<strong>of</strong>it). Essentially, the allocation <strong>of</strong> functions,<br />
assets, and risks will determine the arm’s-length remuneration<br />
<strong>of</strong> a distributor in a buy-sell model. However,<br />
one <strong>of</strong> the main <strong>tax</strong> consequences <strong>of</strong> the agency model<br />
is the possibility <strong>of</strong> the constitution <strong>of</strong> an agency PE in<br />
the host state once the requirements <strong>of</strong> article 5, paragraph<br />
5 <strong>of</strong> the OECD model <strong>tax</strong> convention are met.<br />
Because <strong>of</strong> the extensive use <strong>of</strong> the OECD model<br />
convention and its commentary and the development<br />
<strong>of</strong> case law and doctrine, it can be said that nowadays<br />
the characterization <strong>of</strong> an agency PE is not as complicated<br />
as it was in the past, although it still requires a<br />
case-by-case analysis. Nonetheless, an open question,<br />
both to <strong>tax</strong> authorities and <strong>tax</strong>payers, is how much<br />
pr<strong>of</strong>its must be attributed to that PE.<br />
III. Subsidiary Constituting an Agency PE<br />
Before addressing the core issue <strong>of</strong> the different approaches<br />
to attribute pr<strong>of</strong>its to agency PEs, attention<br />
should be given to the particular phenomenon <strong>of</strong> a<br />
subsidiary constituting an agency PE <strong>of</strong> its foreign parent<br />
company, as this might lead to different consequences<br />
regarding the attribution <strong>of</strong> pr<strong>of</strong>its to that PE.<br />
The provisions <strong>of</strong> article 5, paragraph 7 <strong>of</strong> the<br />
OECD model <strong>tax</strong> convention set forth that:<br />
the fact that a company which is a resident <strong>of</strong> a<br />
contracting state controls or is controlled by a<br />
company which is a resident <strong>of</strong> the other contracting<br />
state, or which carries on business in that<br />
other state (whether through a PE or otherwise),<br />
shall not <strong>of</strong> itself constitute either company a PE<br />
<strong>of</strong> the other.<br />
This ‘‘anti-single-entity’’ clause makes clear that a<br />
subsidiary should not be considered a PE <strong>of</strong> its parent<br />
company for the mere fact <strong>of</strong> their corporate relationship<br />
(that is, that they belong to the same group <strong>of</strong><br />
companies).<br />
22 Arnold, supra note 12, at 483.<br />
The commentaries on article 5, paragraph 7 <strong>of</strong> the<br />
OECD model <strong>tax</strong> convention reaffirm this rule and<br />
stress that the fact that the trade or business carried on<br />
by the subsidiary company is managed by the parent<br />
company is not sufficient to consider the former a PE<br />
<strong>of</strong> the latter.<br />
However, it is also generally accepted that the subsidiary<br />
cannot hide behind its independent legal status<br />
to avoid an agency PE characterization because ‘‘there<br />
is no reason why a subsidiary company acting as an<br />
agent <strong>of</strong> its parent company should be treated differently<br />
than a third party acting as an agent.’’ 23 In the<br />
same way, the commentaries on article 5, paragraph 7<br />
provide for this possibility.<br />
As will be demonstrated below, several decisions<br />
were issued recently recognizing the existence <strong>of</strong> a subsidiary<br />
constituting a PE <strong>of</strong> its parent company. The<br />
decisions were not always received by the <strong>international</strong><br />
<strong>tax</strong> community free <strong>of</strong> criticism.<br />
A. Interhome<br />
The Interhome case24 involves a decision <strong>of</strong> the Conseil<br />
d’Etat (Supreme Administrative Court <strong>of</strong> France)<br />
ruling that a French subsidiary (Interhome Gestion)<br />
may constitute an agency PE <strong>of</strong> its Swiss parent company<br />
(Interhome AG), but only if the former:<br />
• cannot be regarded as an independent agent <strong>of</strong> its<br />
parent company; and<br />
• habitually exercises an authority to bind the Swiss<br />
parent in commercial activities that are related to<br />
those <strong>of</strong> the parent.<br />
Interhome AG is a group <strong>of</strong> companies headquartered<br />
in Switzerland engaged in the business <strong>of</strong> renting<br />
holiday accommodations. In this context, Interhome<br />
AG concluded mandate contracts with owners in several<br />
European countries and promoted the houses in a<br />
catalogue, while its subsidiary in France — Interhome<br />
Gestion — was responsible for the proper execution <strong>of</strong><br />
these contracts within the French territory. 25 (See Figure<br />
1.)<br />
Under this scenario, French <strong>tax</strong> authorities argued<br />
that Interhome Gestion should be considered an<br />
agency PE <strong>of</strong> Interhome AG and therefore the income<br />
received by the latter, comprised <strong>of</strong> commission on the<br />
rents, should be <strong>tax</strong>ed in France as pr<strong>of</strong>its attributable<br />
to that PE. 26<br />
23<br />
Arthur Pleijseir, ‘‘The Agency Permanent Establishment,<br />
Practical Applications. Part Two,’’ Inter<strong>tax</strong>, Vol. 29, Nos. 6-7,<br />
(2001), pp. 223-224.<br />
24<br />
Conseil d’Etat (Supreme Administrative Court <strong>of</strong> France),<br />
June 20, 2003, decision 224407.<br />
25<br />
Id.<br />
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Switzerland<br />
France<br />
Execution <strong>of</strong><br />
contracts<br />
The French <strong>tax</strong> authorities’ arguments were overruled<br />
by the Court <strong>of</strong> Appeals <strong>of</strong> Paris because the<br />
activities carried out by Interhome Gestion were legally<br />
different from those <strong>of</strong> Interhome AG and the former<br />
did not have legal authority to bind the latter. 27<br />
Later on, the case was brought before the Supreme<br />
Administrative Court, which held that Interhome Gestion<br />
would only constitute a PE <strong>of</strong> its parent company<br />
if the requirements <strong>of</strong> article 5 <strong>of</strong> the France-<br />
Switzerland treaty, equivalent to article 5(5) <strong>of</strong> the<br />
OECD model, were met. In other words, such characterization<br />
would only occur if Interhome Gestion<br />
could not be considered an independent agent and if it<br />
habitually exercised in France an authority, legal or<br />
factual, to conclude contracts in the name <strong>of</strong> Interhome<br />
AG that relate to ordinary business activities <strong>of</strong><br />
that company. 28 Therefore, the Supreme Administrative<br />
Court maintained the core part <strong>of</strong> the decision <strong>of</strong> the<br />
Court <strong>of</strong> Appeals <strong>of</strong> Paris, rejecting the characterization<br />
<strong>of</strong> Interhome Gestion as a PE <strong>of</strong> its parent company.<br />
Despite this outcome (that is, no characterization <strong>of</strong><br />
the subsidiary as being a PE <strong>of</strong> its parent company),<br />
the relevance <strong>of</strong> this case to the present analysis is that<br />
the Supreme Administrative Court <strong>of</strong> France clearly<br />
described the requirements by which a subsidiary<br />
might constitute a PE <strong>of</strong> its parent company, emphasizing<br />
the possibility <strong>of</strong> a subsidiary binding de facto<br />
its parent company and not only legally. According to<br />
27<br />
Court <strong>of</strong> Appeals <strong>of</strong> Paris, decision 96-859 2e (released<br />
June 13, 2000).<br />
28<br />
Klaus Vogel in cooperation with the IBFD’s Tax Treaty<br />
Unit, ‘‘1. Subsidiaries as Permanent Establishments?’’ Bulletin —<br />
Tax Treaty Monitor, Tax Treaty News (Oct. 2003), p. 474.<br />
Figure 1. Interhome<br />
Interhome AG<br />
Interhome<br />
Gestion<br />
SPECIAL REPORTS<br />
Other European States<br />
Mandate contracts with<br />
house owners<br />
Payment <strong>of</strong> commission on<br />
the rents<br />
the Conseil d’Etat, the exercise <strong>of</strong> the authority to bind<br />
the Swiss parent should be determined not only by reference<br />
to a legal mandate, but also by reference to the<br />
actual circumstances.<br />
This factual approach adopted by the Conseil d’Etat<br />
would prove to be decisive in a later case — Zimmer —<br />
analyzed below, that was heavily criticized by some<br />
scholars.<br />
B. Philip Morris<br />
The importance <strong>of</strong> the Philip Morris case29 to the<br />
present work resides not only in that it involves a dependent<br />
agent that is a subsidiary <strong>of</strong> its principal, but<br />
also, and most important, because <strong>of</strong> the particular<br />
features envisaged by the Italian Supreme Court for the<br />
characterization <strong>of</strong> what it called a ‘‘multiple PE’’ — a<br />
PE within a group <strong>of</strong> companies.<br />
Philip Morris involves an audit carried out by the<br />
Italian <strong>tax</strong> authorities regarding the character <strong>of</strong> the<br />
activities performed by Intertaba SpA, the Italian company<br />
<strong>of</strong> the Philip Morris group, which was structured<br />
at the time <strong>of</strong> the facts as shown in Figure 2.<br />
The decision <strong>of</strong> the Supreme Court <strong>of</strong> Italy stated<br />
that because <strong>of</strong> the activities carried out by Intertaba<br />
SpA in supervising the performance <strong>of</strong> the licensing<br />
and distribution contracts concluded among the other<br />
companies <strong>of</strong> the Philip Morris group and its participation<br />
in negotiating such contracts, the company could<br />
be deemed to be a ‘‘place <strong>of</strong> management’’ at the disposal<br />
<strong>of</strong> the entire group. Intertaba SpA was then considered<br />
to constitute a ‘‘multiple subsidiary’’ PE in<br />
29 Italian Supreme Court, Dec. 20, 2001, decisions 3367 and<br />
3368; Italian Supreme Court, Dec. 20, 2001, decision 7682; and<br />
Italian Supreme Court, Dec. 20, 2001, decision 10925.<br />
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SPECIAL REPORTS<br />
U.S.<br />
Germany Switzerland FTR<br />
Italy<br />
Italy under the notion provided in article 5(1) <strong>of</strong> the<br />
OECD model convention, as well as an agency PE as<br />
provided in article 5(3). 30<br />
The reasoning <strong>of</strong> the Supreme Court <strong>of</strong> Italy is that<br />
the incorporation <strong>of</strong> Intertaba SpA was intended to<br />
disguise the existence <strong>of</strong> a PE in Italy to avoid full<br />
<strong>tax</strong>ation <strong>of</strong> the royalties derived from the licensing contracts<br />
concluded with the Italian state monopoly for<br />
the sale <strong>of</strong> tobacco products. 31<br />
In addition to the introduction <strong>of</strong> the concept <strong>of</strong> a<br />
multiple PE, the Supreme Court <strong>of</strong> Italy identified the<br />
following principles to determine the existence <strong>of</strong> a<br />
PE: 32<br />
• an Italian company may be a multiple PE <strong>of</strong> foreign<br />
companies belonging to the same group and<br />
pursuing a common strategy;<br />
• the supervision or control <strong>of</strong> the performance <strong>of</strong> a<br />
contract cannot, in principle, be considered an<br />
30 Gazzo, supra note 4, at 259.<br />
31 Id. at 258.<br />
Royalties<br />
Italian State<br />
Monopoly Co.<br />
32 Caterina Innamorato, ‘‘The Concept <strong>of</strong> a Permanent Establishment<br />
Within a Group <strong>of</strong> Multinational Enterprises,’’ Eur.<br />
Tax’n (Feb. 2008), p. 81.<br />
Figure 2. Philip Morris<br />
Sale <strong>of</strong> filters<br />
Philip Morris<br />
U.S.<br />
98% 2%<br />
Intertaba SpA<br />
Philip Morris<br />
Europe<br />
auxiliary activity within the meaning <strong>of</strong> article<br />
5(4) <strong>of</strong> the OECD model convention and the corresponding<br />
article <strong>of</strong> the Germany-Italy <strong>tax</strong> treaty;<br />
• the participation <strong>of</strong> representatives or employees<br />
in a phase <strong>of</strong> the conclusion <strong>of</strong> a contract may be<br />
regarded as an authority to conclude contracts;<br />
• the entrusting <strong>of</strong> the management <strong>of</strong> business<br />
transactions to a resident company by a corporation<br />
that is not resident in Italy makes the resident<br />
company a PE <strong>of</strong> the foreign corporation; and<br />
• the existence <strong>of</strong> a PE should be verified by adopting<br />
a substantial rather than formalistic approach.<br />
The line <strong>of</strong> reasoning <strong>of</strong> the Supreme Court <strong>of</strong> Italy<br />
has been extensively criticized. The criticism focused<br />
on the characteristics that the Italian Supreme Court<br />
took into account to determine the existence <strong>of</strong> a PE,<br />
which somewhat deviates from what is provided in<br />
article 5 <strong>of</strong> the OECD model convention and the<br />
treaty applicable to the case. Indeed, the reasoning <strong>of</strong><br />
the decision and especially the statement that the participation<br />
in the negotiation <strong>of</strong> contracts was sufficient<br />
to create an agency PE caused great concern and repercussions<br />
in the <strong>international</strong> <strong>tax</strong> community.<br />
Apparently, that was not the intention <strong>of</strong> the Court.<br />
Justice Enrico Altieri from the Tax Division <strong>of</strong> the Italian<br />
Supreme Court later stated that the Court did not<br />
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U.K.<br />
France<br />
Until 1995<br />
Distribution<br />
capacity<br />
intend to create a new notion <strong>of</strong> permanent establishment<br />
(the multiple PE <strong>of</strong> a group), but that it simply<br />
identified a common structure for the pursuit <strong>of</strong> a<br />
group strategy. 33<br />
Intentional or not, the repercussions <strong>of</strong> this case and<br />
the concern that other courts could follow the Supreme<br />
Court <strong>of</strong> Italy’s reasoning and adopt such principles in<br />
deviation from what is stated in the OECD model convention<br />
and its commentary led the OECD to amend<br />
the commentary on article 5 for clarification purposes.<br />
34<br />
Apart from the criticism that it may have been subjected<br />
to, the importance <strong>of</strong> this decision to this article<br />
is that the factual analysis <strong>of</strong> the activities performed<br />
by a company, as provided for by the audit carried out<br />
by the Italian <strong>tax</strong> authorities, might well lead to the<br />
constitution, by that company, <strong>of</strong> a PE <strong>of</strong> its affiliated<br />
companies.<br />
C. Zimmer<br />
As mentioned above, the main purpose <strong>of</strong> <strong>tax</strong> planning<br />
in an <strong>international</strong> setting is to achieve a lower<br />
worldwide effective <strong>tax</strong> rate. Therefore, the location <strong>of</strong><br />
the key business functions <strong>of</strong> a company (for example,<br />
manufacturing, distribution, sales, and research and<br />
development) should be, as much as possible, in a low<strong>tax</strong><br />
jurisdiction. Significant functions and risk, and<br />
therefore the associated pr<strong>of</strong>it, should be allocated in a<br />
low-<strong>tax</strong> jurisdiction to provide for a lower worldwide<br />
effective <strong>tax</strong> rate. Establishing core business functions<br />
in low-<strong>tax</strong> jurisdictions or shifting such functions or the<br />
risk associated with such functions to low-<strong>tax</strong> jurisdictions<br />
is likely to result in the migration <strong>of</strong> income to<br />
such locations. As a consequence, a reduction in the<br />
worldwide effective <strong>tax</strong> rate is achieved, provided the<br />
Figure 3. Zimmer<br />
Zimmer<br />
Ltd.<br />
Zimmer<br />
SAS<br />
shift in income and risk is supported by operational<br />
substance and arm’s-length transfer pricing principles. 35<br />
In this context, a typical example <strong>of</strong> functions and<br />
risk shifting that occurred in the past few years is the<br />
conversion <strong>of</strong> fully fledged distributors into commissionaires.<br />
36 This phenomenon is well illustrated in Zimmer,<br />
a recent decision <strong>of</strong> the Court <strong>of</strong> Appeals <strong>of</strong> Paris<br />
involving a U.K. company, Zimmer Ltd., and the<br />
French <strong>tax</strong> authorities. 37 Zimmer commercialized its<br />
orthopedic products in France until 1995 through a<br />
French distributor, Zimmer SAS. However, from March<br />
27, 1995, Zimmer SAS commercialized Zimmer Ltd.’s<br />
products in a commissionaire capacity under a commissionaire<br />
agreement. The French <strong>tax</strong> administration<br />
assessed corporate income <strong>tax</strong> (plus 10 percent surcharge)<br />
for the years 1995 and 1996 on the grounds<br />
that it had a PE. Zimmer Ltd. objected to the assessment<br />
and brought the case before the court. 38<br />
33 Id. at 83.<br />
SPECIAL REPORTS<br />
Zimmer Ltd.<br />
Main Functions/Risks<br />
• Manufacturing function<br />
Zimmer SAS<br />
Main Functions/Risks<br />
Distribution function<br />
Marketing function<br />
Market risk<br />
Inventory risk<br />
Credit risk<br />
34<br />
Most <strong>of</strong> the changes, first released as a public discussion<br />
draft (available at http://www.oecd.org/dataoecd/34/9/<br />
31483903.pdf), were later adopted in the 2005 commentary to<br />
the OECD model <strong>tax</strong> convention to avoid the repetition <strong>of</strong> the<br />
interpretation <strong>of</strong> the Supreme Court <strong>of</strong> Italy.<br />
35<br />
Raffaele Russo et al., Fundamentals <strong>of</strong> International Tax Planning<br />
(Amsterdam: IBFD Publications BV, 2007), p. 75.<br />
36<br />
As pointed out by Giuseppe Persico, ‘‘the commissionaire<br />
structure is particularly attractive and widely used since it provides<br />
the opportunity to centralize the entrepreneurial risks in the<br />
hands <strong>of</strong> the principal’’ (emphasis added); Persico, supra note 18,<br />
at 76.<br />
37<br />
Court <strong>of</strong> Appeals <strong>of</strong> Paris, Feb. 2, 2007, decision<br />
05PA02361.<br />
38<br />
Id.<br />
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SPECIAL REPORTS<br />
The operations carried out by the Zimmer group are<br />
described in figures 3 and 4.<br />
The main issue was whether Zimmer SAS constituted<br />
an agency PE <strong>of</strong> Zimmer Ltd. and as a consequence<br />
a part <strong>of</strong> the latter’s company pr<strong>of</strong>its were attributable<br />
to that PE and subject to <strong>tax</strong> in France. The<br />
court concluded that Zimmer SAS constituted a PE <strong>of</strong><br />
Zimmer Ltd., and the pr<strong>of</strong>its realized in France by<br />
Zimmer Ltd. were <strong>tax</strong>able in France. 39<br />
There was a lengthy discussion on the characterization<br />
<strong>of</strong> an agency PE because the parties concluded a<br />
commissionaire arrangement, a particular feature <strong>of</strong><br />
civil-law jurisdictions. A commissionaire can be defined<br />
as an intermediary that acts on behalf <strong>of</strong> its principal,<br />
in its agency capacity, but in its own name. The commissionaire<br />
performs an indirect representation; it assumes<br />
personally the rights and obligations arising<br />
from the contracts concluded with a third party and<br />
the latter does not have a legal relationship with the<br />
principal. This particular feature <strong>of</strong> the commissionaire<br />
arrangement gives rise to two separately legal relationships:<br />
• a principal and commissionaire relationship; and<br />
• a commissionaire and third-party relationship. 40<br />
Thus, the two main differences <strong>of</strong> the commissionaire<br />
under French law and the agent described in the<br />
OECD model convention and its commentary are:<br />
• the commissionaire is legally responsible before<br />
the client, while the typical agent described in the<br />
OECD model convention and its commentary is a<br />
person acting on behalf <strong>of</strong> the enterprise and not<br />
on its own capacity; and<br />
39 Id.<br />
U.K.<br />
France<br />
40 Persico, supra note 18, at 76.<br />
After 1995<br />
Commissionaire<br />
arrangement<br />
Figure 4. Zimmer<br />
Zimmer<br />
Ltd.<br />
Zimmer<br />
SAS<br />
Zimmer Ltd.<br />
Main Functions/Risks<br />
Manufacturing function<br />
Marketing function<br />
Market risk<br />
Inventory risk<br />
Credit risk<br />
Zimmer SAS<br />
Main Functions/Risks<br />
Sales function<br />
• the commissionaire concludes contracts in its own<br />
name, whereas the agent has authority to conclude<br />
contracts in the name <strong>of</strong> the enterprise. This<br />
notion is strange to common law, in which a contract<br />
concluded by an agent always binds the principal,<br />
irrespective <strong>of</strong> whether the principal was<br />
disclosed. 41<br />
In the <strong>tax</strong>payer’s view, these features <strong>of</strong> the commissionaire<br />
arrangement would be sufficient to avoid the<br />
characterization <strong>of</strong> a PE in France. Indeed, unlike a<br />
conventional distribution carried out through a typical<br />
agent, a commissionaire should not be considered to<br />
constitute an agency PE in the sense <strong>of</strong> article 5(5) <strong>of</strong><br />
the OECD model convention because it does not have<br />
power to bind the principal and because it concludes<br />
sale contracts in its own name, rather than in the name<br />
<strong>of</strong> the principal. In practice customers may not be<br />
aware that they are dealing with an agent because they<br />
only have a contractual relationship with the commissionaire.<br />
Of course, one should not rely on an extreme<br />
formalistic approach to limit the application <strong>of</strong> article<br />
5(5) <strong>of</strong> the OECD model convention to agents that<br />
enter into contracts literally in the name <strong>of</strong> the enterprise,<br />
as such provisions equally apply to agents that<br />
conclude binding contracts that are not actually in the<br />
name <strong>of</strong> the enterprise. 42 However, under a commissionaire<br />
arrangement the issue is not only the name <strong>of</strong><br />
whom the contract is entered into with, but also, and<br />
more important, the lack <strong>of</strong> binding effects regarding<br />
the principal.<br />
I believe that as a result, in a typical commissionaire<br />
arrangement the requirements <strong>of</strong> article 5(5) <strong>of</strong> the<br />
41<br />
See Avery Jones et al., supra note 15, at 236; Persico, supra<br />
note 18, at 68.<br />
42<br />
Vogel, supra note 3, at 329. The same view is expressed in<br />
para. 32.1 <strong>of</strong> the OECD commentary on article 5.<br />
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OECD model convention are not met and therefore no<br />
agency PE is found to exist. 43 It is up to dispute<br />
among scholars whether commissionaires fall under the<br />
scope <strong>of</strong> article 5(5) <strong>of</strong> the OECD model convention,<br />
especially because <strong>of</strong> the diverse views arising from the<br />
common-law and civil-law notions <strong>of</strong> agents.<br />
One might argue that economically the commissionaire<br />
performs basically the same activities as a conventional<br />
agent under article 5(5) <strong>of</strong> the OECD model<br />
convention, but legally there is no contractual relationship<br />
between the customer and the principal. The customers<br />
only have a contractual relationship and therefore<br />
can only sue the commissionaire, not the<br />
principal, which is why the characterization <strong>of</strong> a typical<br />
commissionaire as an agent within the meaning <strong>of</strong><br />
article 5(5) <strong>of</strong> the OECD model convention is, in my<br />
view, unreasonable.<br />
That was not the interpretation <strong>of</strong> the Court <strong>of</strong> Appeals<br />
<strong>of</strong> Paris in concluding that Zimmer SAS could<br />
de facto bind its parent company, Zimmer Ltd. Phrased<br />
differently, the court clearly adopted an economic substance<br />
approach to conclude that the principal was actually<br />
bound by the commissionaire.<br />
This should not be considered a good decision because<br />
it ignored the particular features <strong>of</strong> a commissionaire<br />
arrangement, a typical concept <strong>of</strong> civil-law<br />
jurisdictions. It is therefore expected that <strong>tax</strong> authorities,<br />
especially in France, will feel encouraged to challenge<br />
commissionaire structures on the basis <strong>of</strong> an economic<br />
approach.<br />
Despite this controversial issue <strong>of</strong> the substanceover-form<br />
approach adopted by the Court <strong>of</strong> Appeals<br />
<strong>of</strong> Paris, the question <strong>of</strong> what portion <strong>of</strong> pr<strong>of</strong>its should<br />
be attributed to that PE remained unanswered. This<br />
question is addressed in the following section.<br />
A. Introduction<br />
IV. Different Approaches<br />
The origins <strong>of</strong> article 7 <strong>of</strong> the current OECD model<br />
convention dates back to the 1920s and to the work <strong>of</strong><br />
the League <strong>of</strong> Nations, predecessor <strong>of</strong> the OECD. At<br />
that time, under the 1927 League <strong>of</strong> Nations draft convention,<br />
article 5 governed the <strong>tax</strong>ation <strong>of</strong> what was<br />
then called ‘‘income from a trade or pr<strong>of</strong>ession’’; there<br />
was little guidance on how to determine the income<br />
<strong>tax</strong>able in each contracting state. 44<br />
43 See Stéphane Gelin and David Sorel, ‘‘French Commissionnaire:<br />
A PE for Its Foreign Principal?’’ Tax Notes Int’l, Aug.6,<br />
2007, p. 581, Doc 2007-16318, or2007 WTD 154-6.<br />
44 Raffaele Russo, ‘‘Tax Treatment <strong>of</strong> ‘Dealings’ Between Different<br />
Parts <strong>of</strong> the Same Enterprise Under Article 7 <strong>of</strong> the<br />
OECD Model: Almost a Century <strong>of</strong> Uncertainty,’’ Bulletin — Tax<br />
Treaty Monitor (Oct. 2004), pp. 472-485.<br />
SPECIAL REPORTS<br />
The current wording <strong>of</strong> article 7(2) establishing the<br />
separate enterprise concept — that the pr<strong>of</strong>its <strong>of</strong> a PE<br />
will be ‘‘the pr<strong>of</strong>its which it might be expected to make<br />
if it were a distinct and separate enterprise engaged in<br />
the same or similar activities under the same or similar<br />
conditions and dealing wholly independently with the<br />
enterprise <strong>of</strong> which it is a PE’’ — has its origins in<br />
article 3 <strong>of</strong> the 1933 League <strong>of</strong> Nations draft convention<br />
and was generally followed by the subsequent<br />
Mexico and London model conventions <strong>of</strong> 1943 and<br />
1946, respectively. 45<br />
There are two main<br />
interpretations <strong>of</strong> article 7<br />
regarding the attribution <strong>of</strong><br />
pr<strong>of</strong>its to PEs.<br />
Since then, the study <strong>of</strong> the issue <strong>of</strong> attribution <strong>of</strong><br />
pr<strong>of</strong>its to PEs has evolved greatly, but despite the efforts<br />
<strong>of</strong> the OECD no consensus has been achieved<br />
among states until the recent adoption <strong>of</strong> the revised<br />
commentary on the current article 7 to be included in<br />
the 2008 update to the model <strong>tax</strong> convention. This revised<br />
commentary is a great achievement and will provide<br />
more guidance on this issue.<br />
There are two main interpretations <strong>of</strong> article 7 regarding<br />
the attribution <strong>of</strong> pr<strong>of</strong>its to PEs: the functionally<br />
separate entity approach, also known as the authorized<br />
OECD approach; and the relevant business<br />
activity approach.<br />
Generally, the authorized OECD approach provides<br />
that the pr<strong>of</strong>its to be attributed to a PE must be the<br />
pr<strong>of</strong>its that it ‘‘would have earned at arm’s length if it<br />
were a legally distinct and separate enterprise performing<br />
the same or similar functions under the same or<br />
similar conditions.’’ 46 The relevant business activity<br />
approach provides that the expression ‘‘pr<strong>of</strong>its <strong>of</strong> an<br />
enterprise’’ in article 7(1) <strong>of</strong> the OECD model convention<br />
refers to the pr<strong>of</strong>its <strong>of</strong> business activities in which<br />
the PE has participated. The main feature <strong>of</strong> this approach<br />
is that ‘‘pr<strong>of</strong>its are earned only from transactions<br />
with third parties (or with associated enterprises):<br />
no pr<strong>of</strong>it is earned from a transaction between the PE<br />
and the enterprise <strong>of</strong> which it is part.’’ 47 Under the<br />
relevant business activity approach, article 7(1) limits<br />
45<br />
Id. at 474; see also para. 81 <strong>of</strong> the OECD ‘‘Report on the<br />
Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments,’’ Part I<br />
(General Considerations), (2006).<br />
46<br />
Para. 10 <strong>of</strong> the ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent<br />
Establishments,’’ Part I (General Considerations), (2006).<br />
47<br />
Baker and Collier, supra note 7, at 30.<br />
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SPECIAL REPORTS<br />
the pr<strong>of</strong>its that may be attributable to a PE, on the basis<br />
<strong>of</strong> article 7(2), to the overall pr<strong>of</strong>its <strong>of</strong> the whole<br />
enterprise. One major consequence <strong>of</strong> this is the impossibility<br />
<strong>of</strong> attributing pr<strong>of</strong>its to a particular PE if<br />
the enterprise, considered as whole, makes a loss.<br />
When it comes to the attribution <strong>of</strong> pr<strong>of</strong>its to<br />
agency PEs, the controversial issue is determining<br />
whether there may be a pr<strong>of</strong>it attributable to the<br />
agency PE in excess <strong>of</strong> the arm’s-length remuneration<br />
paid to the dependent agent. The issue is whether it is<br />
possible to attribute a separate pr<strong>of</strong>it to an agency PE<br />
once the agent had an arm’s-length reward for the service<br />
provided.<br />
The two different approaches provide for completely<br />
different answers: The application <strong>of</strong> the authorized<br />
OECD approach to agency PEs leads to the possibility<br />
<strong>of</strong> a separate pr<strong>of</strong>it and loss attribution to that PE,<br />
while the single <strong>tax</strong>payer approach provides that once<br />
the dependent agent received an arm’s-length reward,<br />
no pr<strong>of</strong>it or loss can be attributed by the host state.<br />
The authorized OECD approach leads to the treatment<br />
<strong>of</strong> the dependent agent and the agency PE as two different<br />
<strong>tax</strong>able entities (also known as the dual <strong>tax</strong>payer<br />
approach). Conversely, the single <strong>tax</strong>payer approach<br />
provides that an arm’s-length remuneration paid only<br />
to the dependent agent is in compliance with the PE<br />
treshhold.<br />
B. OECD Project on Attribution <strong>of</strong> Pr<strong>of</strong>its to PEs<br />
Before analyzing the authorized OECD approach in<br />
detail, it is important to present an overview <strong>of</strong> the<br />
OECD project on attribution <strong>of</strong> pr<strong>of</strong>its to permanent<br />
establishments to examine what is the legal status <strong>of</strong><br />
such approach as well as its role in interpreting current<br />
treaties. This analysis is necessary since one <strong>of</strong> the<br />
main controversies regarding the authorized OECD<br />
approach refers to its applicability regarding treaties<br />
currently in force. While some argue that the approach<br />
is the most proper interpretation <strong>of</strong> article 7 <strong>of</strong> the current<br />
version <strong>of</strong> the OECD model convention, others<br />
argue that the application <strong>of</strong> the authorized OECD<br />
approach is dependent on changes to be made in the<br />
wording <strong>of</strong> <strong>tax</strong> treaties and therefore cannot be applied<br />
to the treaties currently in force.<br />
The starting point <strong>of</strong> this project was the OECD’s<br />
attempt to analyze how the principles developed in the<br />
1995 OECD transfer pricing guidelines, which deals<br />
with the application <strong>of</strong> the arm’s-length principle to<br />
transactions between associated enterprises, should apply<br />
in the context <strong>of</strong> the relationship between a PE and<br />
its general enterprise. 48 The aim <strong>of</strong> this effort was to<br />
achieve a greater consensus on the attribution <strong>of</strong> pr<strong>of</strong>its<br />
48 Para. 2 <strong>of</strong> the update <strong>of</strong> the status <strong>of</strong> the OECD project on<br />
the attribution <strong>of</strong> pr<strong>of</strong>its to PEs (2006).<br />
to PEs and the interpretation <strong>of</strong> article 7 <strong>of</strong> the OECD<br />
model <strong>tax</strong> convention, avoiding the risk <strong>of</strong> double <strong>tax</strong>ation.<br />
In this context, the OECD released in 2001 parts I<br />
(General Considerations) and II (Banks) 49 and in 2003<br />
Part III (Global Trading) 50 <strong>of</strong> a discussion draft on the<br />
attribution <strong>of</strong> pr<strong>of</strong>its to PEs. In 2004 a revised discussion<br />
draft <strong>of</strong> parts I, 51 II, and III was released for public<br />
comment. Finally, in December 2006, the Committee<br />
on Fiscal Affairs released new versions <strong>of</strong> parts I,<br />
II, and III <strong>of</strong> its ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its<br />
to Permanent Establishments.’’ 52<br />
Moreover, in December 2006 the OECD Committee<br />
on Fiscal Affairs decided that to provide ‘‘improved<br />
certainty for the interpretation <strong>of</strong> existing treaties based<br />
on the current text <strong>of</strong> article 7, a revised Commentary<br />
should be prepared taking into account those aspects <strong>of</strong><br />
the Report that do not conflict with the existing Commentary’’<br />
(aspects that constitute a mere clarification<br />
<strong>of</strong> the proper interpretation <strong>of</strong> article 7). 53 Therefore,<br />
on April 10, 2007, as a first part <strong>of</strong> the implementation<br />
package, a discussion draft <strong>of</strong> the revised commentary<br />
on article 7 was released for public comment taking<br />
into account many <strong>of</strong> the conclusions included in parts<br />
I, II, and III <strong>of</strong> the ‘‘Report on the Attribution <strong>of</strong><br />
Pr<strong>of</strong>its to Permanent Establishments.’’ 54<br />
The revised commentary on the current article 7 <strong>of</strong><br />
the OECD model <strong>tax</strong> convention was then included in<br />
the 2008 update to the model <strong>tax</strong> convention, which<br />
was adopted by the committee at its meeting <strong>of</strong> June<br />
24-25, 2008, when the committee also adopted the<br />
‘‘Report on Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments.’’<br />
The revised commentary will be included<br />
in the new version <strong>of</strong> the OECD model <strong>tax</strong> convention<br />
that will soon be published; the report will also be published<br />
separately. 55<br />
Furthermore, the OECD Committee on Fiscal Affairs<br />
intends to implement the conclusions <strong>of</strong> the report<br />
not only through a new version <strong>of</strong> the commentary<br />
on the current text <strong>of</strong> article 7, but also through a<br />
new version <strong>of</strong> article 7 itself with accompanying new<br />
49<br />
See http://www.oecd.org/LongAbstract/<br />
0,3425,en_2649_201185_1923011_1_1_1_1,00.html.<br />
50<br />
See http://www.oecd.org/LongAbstract/<br />
0,3425,en_2649_201185_2497688_1_1_1_1,00.html.<br />
51<br />
See http://www.oecd.org/LongAbstract/<br />
0,3425,en_2649_201185_33637686_1_1_1_1,00.html.<br />
52<br />
See http://www.oecd.org/LongAbstract/<br />
0,3425,en_2649_201185_37861284_1_1_1_1,00.html.<br />
53<br />
See http://www.oecd.org/LongAbstract/<br />
0,3425,en_2649_201185_38361712_1_1_1_1,00.html.<br />
54<br />
See http://www.oecd.org/document/52/<br />
0,3343,en_2649_201185_38376628_1_1_1_1,00.html.<br />
55<br />
See http://www.oecd.org/document/52/<br />
0,3343,en_2649_33747_38376628_1_1_1_1,00.html.<br />
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commentary to be used in the negotiation <strong>of</strong> future<br />
treaties and <strong>of</strong> amendments to existing treaties. Thus,<br />
the OECD Committee on Fiscal Affairs recently released<br />
as a discussion draft what it called the second<br />
part <strong>of</strong> the implementation package — a new version<br />
<strong>of</strong> article 7 and related commentary changes. The committee<br />
will be receiving comments on this discussion<br />
draft until December 31, 2008, and it is expected that<br />
the new article and the commentary changes will be<br />
included in the next update to the OECD model <strong>tax</strong><br />
convention, which is tentatively scheduled for 2010. 56<br />
Considering that this article is focused on case law<br />
on the attribution <strong>of</strong> pr<strong>of</strong>its to agency PEs, and the<br />
decisions were held before the release <strong>of</strong> the discussion<br />
draft <strong>of</strong> the new version <strong>of</strong> article 7 and related commentary<br />
changes, all comments made refer to the current<br />
wording <strong>of</strong> the OECD model convention and the<br />
‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent<br />
Establishments.’’ One first important issue that arises is<br />
what weight should be given to this report in applying<br />
<strong>tax</strong> treaties currently in force. The specialized doctrine<br />
has already discussed at length the legal status <strong>of</strong> the<br />
commentary to the OECD model convention, and it<br />
can be said that there is no generally accepted view on<br />
this controversial issue. 57 If the legal status <strong>of</strong> the commentary<br />
is unclear and subject to a variety <strong>of</strong> different<br />
interpretations, more obscure is the role <strong>of</strong> a report<br />
that was, at the time the decisions being analyzed were<br />
held, not implemented yet.<br />
The OECD recognizes in paragraph 7 <strong>of</strong> the revised<br />
commentary on article 7 that there are differences between<br />
some <strong>of</strong> the conclusions <strong>of</strong> the report and the<br />
interpretation <strong>of</strong> article 7 previously given in the commentary<br />
in a way that the report should only provide<br />
guidelines for the application <strong>of</strong> the arm’s-length principle<br />
incorporated in the article to the extent that it<br />
does not conflict with the commentary. In case <strong>of</strong> conflict<br />
between the two, the commentary should always<br />
prevail over the report. 58<br />
This is not mere academic debate; rather, it is a very<br />
important issue in practice as the conclusions <strong>of</strong> the<br />
report lead to major consequences on the attribution <strong>of</strong><br />
pr<strong>of</strong>its to PEs in general and particularly to agency<br />
PEs. The Indian Income Tax Appellate Tribunal had to<br />
56 See id.<br />
57 See, e.g., Vogel, supra note 3, at 43; David A. Ward, ‘‘The<br />
Role <strong>of</strong> the Commentaries on the OECD Model in the Tax<br />
Treaty Interpretation Process,’’ Bulletin — Tax Treaty Monitor<br />
(Mar. 2006), p. 98; and John F. Avery Jones, ‘‘The Effect <strong>of</strong><br />
Changes in the OECD Commentaries After a Treaty Is Concluded,’’<br />
Bulletin — Tax Treaty Monitor (Mar. 2002), pp. 102-109.<br />
58 Mary Bennett and Raffaele Russo, ‘‘OECD Project on Attribution<br />
<strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments: An Update,’’<br />
Int’l Transfer Pricing J. (Sept./Oct. 2007), p. 283.<br />
SPECIAL REPORTS<br />
face this dilemma in the SET Satellite case; the <strong>tax</strong>payer<br />
referred to the report as ‘‘what the law should be and<br />
not what the law is.’’ 59<br />
To address the different interpretations, I will first<br />
present a summary <strong>of</strong> the authorized OECD approach<br />
to attribute pr<strong>of</strong>its to PEs in general, followed by an<br />
analysis <strong>of</strong> its specific features regarding agency PEs,<br />
and finally the particularities <strong>of</strong> the single <strong>tax</strong>payer approach.<br />
C. The Authorized OECD Approach<br />
Between the two main interpretations <strong>of</strong> the provisions<br />
<strong>of</strong> article 7 <strong>of</strong> the OECD model convention regarding<br />
the attribution <strong>of</strong> pr<strong>of</strong>its to PEs, the OECD<br />
opted for the functionally separate entity approach,<br />
rather than the relevant business activity approach.<br />
Now one can see that the reason why the first is also<br />
called the authorized OECD approach is because it<br />
provides for the OECD preferred interpretation <strong>of</strong> article<br />
7. 60<br />
The authorized OECD approach provides that the<br />
pr<strong>of</strong>its to be attributed to a PE must be the pr<strong>of</strong>its that<br />
it ‘‘would have earned at arm’s length if it were a legally<br />
distinct and separate enterprise performing the<br />
same or similar functions under the same or similar<br />
conditions.’’ 61 Conversely, the functionally separate entity<br />
approach does not limit the pr<strong>of</strong>its <strong>of</strong> the PE by<br />
reference to the pr<strong>of</strong>its <strong>of</strong> the enterprise as a whole. As<br />
a consequence, it is perfectly possible under this approach<br />
to attribute pr<strong>of</strong>its to a PE even if the enterprise,<br />
considered as whole, incurs a loss.<br />
The OECD report reaffirms the primacy <strong>of</strong> the<br />
arm’s-length principle in attributing pr<strong>of</strong>its to PEs by<br />
determining the adoption <strong>of</strong> the functionally separate<br />
entity approach. As shown below, the application <strong>of</strong><br />
this approach requires a stretch: The PE is supposed to<br />
be treated as a functionally separate entity <strong>of</strong> its head<br />
<strong>of</strong>fice, though it is part <strong>of</strong> the same enterprise. Once<br />
the PE cannot enter into actual transactions with other<br />
parts <strong>of</strong> the enterprise <strong>of</strong> which it is part, it is necessary<br />
to provide for the recognition <strong>of</strong> the dealings between<br />
the PE and its head <strong>of</strong>fice, which goes against<br />
the axiom that an enterprise cannot make a pr<strong>of</strong>it from<br />
dealing with itself.<br />
1. The Authorized OECD Approach to PEs<br />
The application <strong>of</strong> the functionally separate entity<br />
approach under the report requires a two-step analysis:<br />
• the functional and factual analysis; and<br />
• the comparability analysis.<br />
59<br />
Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision<br />
535/Mum/04 and 205/Mum/04.<br />
60<br />
Para. 78 <strong>of</strong> the ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent<br />
Establishments,’’ Part I (General Considerations), (2006).<br />
61<br />
Id. at para. 10.<br />
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SPECIAL REPORTS<br />
In essence, the first step involves the application, by<br />
analogy, <strong>of</strong> the principles described in the 1995 OECD<br />
transfer pricing guidelines to identify the economically<br />
significant activities and responsibilities undertaken by<br />
the PE, while the second step is the comparability<br />
analysis and the application <strong>of</strong> the transfer pricing<br />
methods to determine an arm’s-length pr<strong>of</strong>it <strong>of</strong> the PE.<br />
The two-step analysis is summarized as follows in<br />
the OECD ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to<br />
Permanent Establishments’’:<br />
Step One<br />
A functional and factual analysis, leading to:<br />
• The attribution to the PE as appropriate <strong>of</strong> the<br />
rights and obligations arising out <strong>of</strong> transactions<br />
between the enterprise <strong>of</strong> which the PE is a part<br />
and separate enterprises;<br />
• The identification <strong>of</strong> significant people functions<br />
relevant to the attribution <strong>of</strong> economic ownership<br />
<strong>of</strong> assets, and the attribution <strong>of</strong> economic ownership<br />
<strong>of</strong> assets to the PE;<br />
• The identification <strong>of</strong> significant people functions<br />
relevant to the assumption <strong>of</strong> risks, and the attribution<br />
<strong>of</strong> risks to the PE;<br />
• The identification <strong>of</strong> other functions <strong>of</strong> the PE;<br />
• The recognition and determination <strong>of</strong> the nature<br />
<strong>of</strong> those dealings between the PE and other parts<br />
<strong>of</strong> the same enterprise that can appropriately be<br />
recognised, having passed the threshold test; and<br />
• The attribution <strong>of</strong> capital based on the assets and<br />
risks attributed to the PE.<br />
Step Two<br />
The pricing on an arm’s length basis <strong>of</strong> recognised<br />
dealings through:<br />
• The determination <strong>of</strong> comparability between the<br />
dealings and uncontrolled transactions, established<br />
by applying the Guidelines’ comparability factors<br />
directly (characteristics <strong>of</strong> property or services,<br />
economic circumstances and business strategies)<br />
or by analogy (functional analysis, contractual<br />
terms) in light <strong>of</strong> the particular factual circumstances<br />
<strong>of</strong> the PE; and<br />
• Applying by analogy one <strong>of</strong> the Guidelines’ traditional<br />
transaction methods or, where such methods<br />
cannot be applied reliably, one <strong>of</strong> the transactional<br />
pr<strong>of</strong>it methods to arrive at an arm’s length<br />
compensation for the dealings between the PE<br />
and the rest <strong>of</strong> the enterprise, taking into account<br />
the functions performed by and the assets and<br />
risks attributed to the PE.<br />
The functional and factual analysis described in step<br />
one <strong>of</strong> the report resembles the analysis provided in<br />
the 1995 OECD transfer pricing guidelines. The difficulty<br />
in replicating the principles developed in the<br />
guidelines in a PE setting is that, differently from what<br />
happens when applying article 9 to associated enter-<br />
prises dealings, a PE is not legally a separate enterprise<br />
but is part <strong>of</strong> the same enterprise <strong>of</strong> its head <strong>of</strong>fice.<br />
The solution found by the OECD Committee on<br />
Fiscal Affairs to cope with this difficulty was to look at<br />
the functions <strong>of</strong> the people working for the enterprise<br />
to attribute the assets, risks, capital, rights, and obligations<br />
belonging to the PE. 62 As a result, under the authorized<br />
OECD approach, economic ownership <strong>of</strong> assets<br />
should be attributed to the PE in accordance with<br />
the significant people functions as well as the risks related<br />
to the functions performed by people in that PE.<br />
Also, the authorized OECD approach establishes<br />
mechanisms to attribute capital to the PE in line with<br />
the assets and risks attributed to it and criteria for the<br />
recognition and determination <strong>of</strong> the dealings between<br />
the PE and its general enterprise.<br />
The second step involves the determination <strong>of</strong> remuneration<br />
<strong>of</strong> any dealings between the hypothesized<br />
enterprises on the basis <strong>of</strong> the functions performed,<br />
assets used, and risks assumed, as provided for in the<br />
1995 OECD transfer pricing guidelines. 63<br />
2. The Authorized OECD Approach to Agency PEs<br />
Regarding the attribution <strong>of</strong> pr<strong>of</strong>its to agency PEs,<br />
the OECD believes that the same principles adopted<br />
for other types <strong>of</strong> PEs should apply. As a matter <strong>of</strong><br />
consistency, the OECD believes there is no reason to<br />
apply a different mechanism <strong>of</strong> pr<strong>of</strong>its attribution when<br />
it comes to agency PEs.<br />
Consequently, pr<strong>of</strong>its should be attributed to the<br />
agency PE on the basis <strong>of</strong> the assets and risks <strong>of</strong> the<br />
nonresident enterprise relating to the functions performed<br />
by the former on behalf <strong>of</strong> the latter.<br />
The authorized OECD<br />
approach leads to the<br />
treatment <strong>of</strong> the<br />
dependent agent and the<br />
agency PE as two different<br />
<strong>tax</strong>able entities.<br />
As pointed out by Hans Pijl, the authorized OECD<br />
approach takes the functions performed in the host<br />
state as the starting point for the attribution <strong>of</strong> pr<strong>of</strong>its.<br />
Moreover, under the notion that assets and risks follow<br />
functions, the functional and factual analysis will determine<br />
the assets and risks that must be attributed to the<br />
62 Id. at para. 18.<br />
63 Id. at para. 13.<br />
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Home State<br />
Host State<br />
Figure 5. Authorized OECD Approach to Agency PEs<br />
Agent P&L<br />
Gross income 200<br />
Cost <strong>of</strong> services (150)<br />
Pr<strong>of</strong>it 50<br />
agency PE. 64 Considering, for example, the situation<br />
when the credit risk on accounts receivable is not<br />
borne by the dependent agent itself but directly by the<br />
principal, a reward for such risk will have to be attributed<br />
to the agency PE. 65<br />
One major aspect <strong>of</strong> the authorized OECD approach<br />
is that it leads to the treatment <strong>of</strong> the dependent<br />
agent and the agency PE as two different <strong>tax</strong>able<br />
entities. This means that the agency PE is not the dependent<br />
agent per se; its hypothetical existence is apart<br />
from the dependent agent and is derived because the<br />
general enterprise in the home state has a dependent<br />
agent in the host state. As a consequence, the authorized<br />
OECD approach challenges the widespread idea<br />
that the pr<strong>of</strong>it <strong>of</strong> an agency PE is zero by definition.<br />
Under the authorized OECD approach, it is not<br />
only the income earned by the dependent agent itself<br />
that matters but also the income the general enterprise<br />
earns through its agency PE in the host country. Whatever<br />
is paid to the dependent agent (for example, salary,<br />
fixed amount, or percentage <strong>of</strong> sales) should be<br />
considered as an expense in ascertaining the agency PE<br />
pr<strong>of</strong>its.<br />
This is precisely when the authorized OECD approach<br />
differs from the single <strong>tax</strong>payer approach. The<br />
payment <strong>of</strong> the dependent agent remuneration and its<br />
deduction on the computation <strong>of</strong> the agency PE pr<strong>of</strong>its<br />
does not mean that there will be no pr<strong>of</strong>its left. Those<br />
pr<strong>of</strong>its will be determined on the basis <strong>of</strong> the functions<br />
performed by the agency PE.<br />
In this context, it is possible that no pr<strong>of</strong>it be attributable<br />
to the agency PE depending on the functions<br />
performed by that PE. 66 Indeed, under the OECD report,<br />
there is no presumption that the agency PE will<br />
always generate pr<strong>of</strong>its, as it may well happen that little<br />
or no pr<strong>of</strong>it is attributed to it if only routine functions<br />
General Enterprise<br />
Permanent Establishment<br />
Agent<br />
are performed. Nothing prevents the general enterprise<br />
from organizing its business in the host state in a manner<br />
in which little or no functions are performed by the<br />
agency PE and, as a consequence, little or no <strong>tax</strong> must<br />
be attributable to it under the authorized OECD approach.<br />
The authorized OECD approach determines that the<br />
dependent agent be rewarded for the service provided<br />
to the nonresident enterprise on an arm’s-length basis;<br />
that is, taking into account its assets and risks, while<br />
the pr<strong>of</strong>its <strong>of</strong> the agency PE should be determined on<br />
the basis <strong>of</strong> the assets and risks <strong>of</strong> the nonresident enterprise<br />
in relation to the functions performed by the<br />
dependent agent on behalf <strong>of</strong> the enterprise, added by<br />
sufficient capital to support those assets and risks. 67<br />
By definition, the overall <strong>tax</strong>able income <strong>of</strong> the dependent<br />
agent plus the income <strong>of</strong> the agency PE<br />
(deemed to be independent) must be equal to the <strong>tax</strong>able<br />
income a company would earn in an arm’s-length<br />
transaction. In a simplistic fashion, the authorized<br />
OECD approach can be described on the basis <strong>of</strong> the<br />
example illustrated in Figure 5. 68<br />
Under the authorized OECD approach, there is a<br />
pr<strong>of</strong>it attributable to the agency PE in excess <strong>of</strong> the<br />
64 Pijl, supra note 9, at 30-31.<br />
65 Raffaele Russo, ‘‘Application <strong>of</strong> Arm’s Length Principle to<br />
Intra-Company Dealings: Back to the Origins,’’ Int’l Transfer Pricing<br />
J. (Jan./Feb. 2005), p. 14.<br />
66 Pijl, supra note 9, at 32.<br />
67 Bennett and Russo, supra note 58, at 282.<br />
SPECIAL REPORTS<br />
GE P&L<br />
Gross income 2,000<br />
Cost <strong>of</strong> goods (500)<br />
Agent fee (200)<br />
Pr<strong>of</strong>it 1,300<br />
PE P&L<br />
Gross income 2,000<br />
Cost <strong>of</strong> goods (1,000)<br />
Agent fee (200)<br />
Pr<strong>of</strong>it 800<br />
68 This example was drafted based on a similar diagram provided<br />
by Hans Pijl in ‘‘The Zero-Sum Game, the Emperor’s<br />
Beard and the Authorized OECD Approach,’’ supra note 9, at<br />
32.<br />
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SPECIAL REPORTS<br />
Figure 6. Single Taxpayer Approach to Agency PEs — Agent Is PE<br />
Home State<br />
Host State<br />
Agent P&L<br />
Gross income 200<br />
Cost <strong>of</strong> services (150)<br />
Pr<strong>of</strong>it 50<br />
arm’s-length remuneration paid to the dependent agent.<br />
In other words, the $200 ‘‘paid’’ by the general enterprise<br />
to its dependent agent, which is assumed to be an<br />
arm’s-length reward, does not eliminate the need to<br />
attribute a separate pr<strong>of</strong>it to the agency PE in accordance<br />
with the assets, risks, capital, and rights and obligations<br />
referring to that PE.<br />
As shown below (referring to the single <strong>tax</strong>payer<br />
approach), the arm’s-length remuneration <strong>of</strong> $200 is<br />
sufficient to comply with the <strong>tax</strong> liabilities that arose in<br />
the host state.<br />
D. The Single Taxpayer Approach to Agency PEs<br />
The single <strong>tax</strong>payer approach is based on the axiom<br />
that the agency PE pr<strong>of</strong>it is zero by definition. Under<br />
this approach, an arm’s-length remuneration paid to<br />
the dependent agent extinguishes any PE <strong>tax</strong> liability<br />
in the host state. The rationale behind this approach is<br />
that if the dependent agent is fully rewarded at arm’s<br />
length for all functions performed, assets used, and<br />
risks assumed, then there can be no additional pr<strong>of</strong>it to<br />
be attributed to the agency PE. 69<br />
Differently from the authorized OECD approach<br />
(which leads to the treatment <strong>of</strong> the dependent agent<br />
and the agency PE as two different <strong>tax</strong>able entities),<br />
under the single <strong>tax</strong>payer approach the ‘‘individual or<br />
entity whose activities create the PE is considered to be<br />
the PE himself/itself,’’ 70 that is, one single <strong>tax</strong>payer.<br />
69 Baker and Collier, supra note 7, at 33.<br />
70 Annika Deitmer, Ingmar Dörr, and Alexander Rust, ‘‘Invitational<br />
Seminar on Tax Treaty Rules Applicable to Permanent<br />
Establishments — in Memoriam <strong>of</strong> Pr<strong>of</strong>. Dr. Berndt Runge,’’<br />
Bulletin — Tax Treaty Monitor (May 2004), p. 187.<br />
General Enterprise P&L<br />
Permanent Establishment<br />
Agent<br />
This particular feature <strong>of</strong> the single <strong>tax</strong>payer approach<br />
— that the agent is the PE — can be described<br />
on the basis <strong>of</strong> the example illustrated in Figure 6. 71<br />
By comparing the two hypothetical figures, it is<br />
clear that the single <strong>tax</strong>payer approach leads to a lesser<br />
portion <strong>of</strong> pr<strong>of</strong>it to be attributable to the host state,<br />
that is, $50 instead <strong>of</strong> $850. This is an inherent consequence<br />
<strong>of</strong> the assumption that the dependent agent<br />
and the agency PE are one and the same thing.<br />
Now that the main features <strong>of</strong> both the authorized<br />
OECD approach and the single <strong>tax</strong>payer approach<br />
have been outlined, it is time to analyze the interpretation<br />
<strong>of</strong> this controversial issue by the courts. Sadly,<br />
there are only a few decisions dealing with the attribution<br />
<strong>of</strong> pr<strong>of</strong>its to agency PEs. The lack <strong>of</strong> a significant<br />
amount <strong>of</strong> case law highlights the importance <strong>of</strong> the<br />
Morgan Stanley and SET Satellite cases. Both cases were<br />
judged in Indian courts, but many scholars felt the<br />
cases had opposite outcomes, demonstrating that the<br />
controversy <strong>of</strong> this issue remains, even within the<br />
boundaries <strong>of</strong> a single state.<br />
E. Morgan Stanley<br />
The Morgan Stanley case involves the <strong>tax</strong>ation on<br />
activities carried out between entities <strong>of</strong> the Morgan<br />
Stanley group. 72 Morgan Stanley and Co. (MSCo), an<br />
investment bank located in the United States, entered<br />
into a services agreement with Morgan Stanley Advantages<br />
Services Pvt. Ltd. (MSAS), a service company<br />
71 See supra note 68.<br />
GE P&L<br />
Gross income 2,000<br />
Cost <strong>of</strong> goods (500)<br />
Agent fee (200)<br />
Pr<strong>of</strong>it 1,300<br />
PE P&L<br />
Gross income 200<br />
Agent fee (200)<br />
Pr<strong>of</strong>it 0<br />
72<br />
Supreme Court <strong>of</strong> India, July 9, 2007, decision 2114/07<br />
and 2415/07.<br />
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U.S.<br />
India<br />
established in India, by which the latter provided support<br />
services to the former. The services were characterized<br />
as back-<strong>of</strong>fice activities and comprised:<br />
• equity and fixed income research;<br />
• account reconciliation; and<br />
• information technology services (for example,<br />
back-<strong>of</strong>fice operation, data processing, and support<br />
centers). 73<br />
In connection with the services agreement concluded<br />
by the parties, MSCo staff was seconded to<br />
MSAS, although continued to be legally employed and<br />
receiving salary from MSCo.<br />
The transactions entered into by MSCo and MSAS<br />
are summarized in Figure 7.<br />
Of great importance to this case is that MSCo filed<br />
with the Indian <strong>tax</strong> authorities a request for an advance<br />
ruling to determine whether the services provided by<br />
MSAS, under the services agreement entered into between<br />
the two, could lead to the constitution <strong>of</strong> a PE<br />
in India <strong>of</strong> MSCo within the meaning <strong>of</strong> article 5(1) <strong>of</strong><br />
the treaty concluded between India and the United<br />
States, and if so, the amount <strong>of</strong> pr<strong>of</strong>it attributable to<br />
that PE. 74<br />
The Authority for Advanced Ruling (AAR) in India<br />
decided:<br />
• MSCo cannot be regarded as having a fixed PE<br />
within the meaning <strong>of</strong> article 5(1) <strong>of</strong> the India-<br />
U.S. treaty;<br />
• MSAS cannot be regarded as being an agency PE<br />
in the sense <strong>of</strong> article 5(4) <strong>of</strong> the India-U.S.<br />
treaty;<br />
• MSCo would be regarded as having a PE in India<br />
within the meaning <strong>of</strong> article 5(2)(l) <strong>of</strong> the India-<br />
U.S. treaty ‘‘if it were to send some <strong>of</strong> its em-<br />
73 Id. at 2-3.<br />
74 Id. at 3.<br />
Arm’s-length<br />
remuneration for<br />
support services<br />
Figure 7. Morgan Stanley<br />
Morgan Stanley<br />
and Company<br />
Morgan Stanley<br />
AS Pvt. Ltd.<br />
ployees to India as stewards or as deputationists<br />
in the employment <strong>of</strong> MSAS’’; and<br />
• the transactional net margin method was the most<br />
appropriate transfer pricing method to determine<br />
the arm’s-length price <strong>of</strong> the services provided by<br />
MSAS. 75<br />
Both the Indian Department <strong>of</strong> Revenue and MSCo<br />
filed an appeal before the Supreme Court <strong>of</strong> India. The<br />
arguments <strong>of</strong> both appellants can be summarized as<br />
follows: 76<br />
• The Department <strong>of</strong> Revenue argued that MSCo<br />
should be considered to have a fixed PE in India<br />
in the sense <strong>of</strong> article 5(1) <strong>of</strong> the India-U.S. treaty<br />
as it proposes to carry on its business in India<br />
through MSAS and there was a fixed place <strong>of</strong><br />
business in Mumbai; and MSAS should be considered<br />
to constitute an agency PE <strong>of</strong> MSCo in<br />
India under article 5(4) <strong>of</strong> the India-U.S. treaty, as<br />
the former was legally and financially dependent<br />
on the latter.<br />
• MSCo argued that the activities carried out by<br />
MSAS did not constitute a PE under article 5(2)(l)<br />
<strong>of</strong> the India-U.S. treaty.<br />
Because <strong>of</strong> its importance to the analysis <strong>of</strong> this<br />
case and the fact that the provisions <strong>of</strong> article 5(2)(l) <strong>of</strong><br />
the India-U.S. treaty are not standard provisions under<br />
the OECD model convention, a full look at the relevant<br />
provisions <strong>of</strong> the India-U.S. treaty is necessary.<br />
(See Table 1.)<br />
Regarding the existence <strong>of</strong> a fixed PE within the<br />
meaning <strong>of</strong> article 5(1) <strong>of</strong> the India-U.S. treaty, the<br />
Supreme Court <strong>of</strong> India recognized the existence <strong>of</strong> a<br />
fixed place <strong>of</strong> business, but held that the second requirement<br />
<strong>of</strong> article 5(1) <strong>of</strong> the treaty — through<br />
75 Id. at 4-5.<br />
76 Id.<br />
SPECIAL REPORTS<br />
Support Services<br />
Equity and fixed income research<br />
Account reconciliation<br />
IT services<br />
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SPECIAL REPORTS<br />
Table 1. Comparison <strong>of</strong> OECD Model Convention and India-U.S. Treaty<br />
OECD Model Convention Convention Between the Government <strong>of</strong> the United States <strong>of</strong> America and the<br />
Government <strong>of</strong> the Republic <strong>of</strong> India for the Avoidance <strong>of</strong> Double Taxation<br />
and the Prevention <strong>of</strong> Fiscal Evasion with respect to Taxes on Income, signed<br />
in New Delhi on September 12, 1989<br />
Article 5—Permanent Establishment Article 5 —Permanent Establishment<br />
1. For the purposes <strong>of</strong> this Convention, the term<br />
‘‘permanent establishment’’ means a fixed place <strong>of</strong> business<br />
through which the business <strong>of</strong> an enterprise is wholly or<br />
partly carried on.<br />
2. The term ‘‘permanent establishment’’ includes especially:<br />
a) a place <strong>of</strong> management;<br />
b) a branch;<br />
c) an <strong>of</strong>fice;<br />
d) a factory;<br />
e) a workshop, and<br />
f) a mine, an oil or gas well, a quarry or any other place<br />
<strong>of</strong> extraction <strong>of</strong> natural resources.<br />
(...)<br />
4. Notwithstanding the preceding provisions <strong>of</strong> this Article,<br />
the term ‘‘permanent establishment’’ shall be deemed not to<br />
include:<br />
a) the use <strong>of</strong> facilities solely for the purpose <strong>of</strong> storage,<br />
display or delivery <strong>of</strong> goods or merchandise belonging to<br />
the enterprise;<br />
b) the maintenance <strong>of</strong> a stock <strong>of</strong> goods or merchandise<br />
belonging to the enterprise solely for the purpose <strong>of</strong><br />
storage, display or delivery;<br />
c) the maintenance <strong>of</strong> a stock <strong>of</strong> goods or merchandise<br />
belonging to the enterprise solely for the purpose <strong>of</strong><br />
processing by another enterprise;<br />
d) the maintenance <strong>of</strong> a fixed place <strong>of</strong> business solely for<br />
the purpose <strong>of</strong> purchasing goods or merchandise or <strong>of</strong><br />
collecting information, for the enterprise;<br />
e) the maintenance <strong>of</strong> a fixed place <strong>of</strong> business solely for<br />
the purpose <strong>of</strong> carrying on, for the enterprise, any other<br />
activity <strong>of</strong> a preparatory or auxiliary character;<br />
f) the maintenance <strong>of</strong> a fixed place <strong>of</strong> business solely for<br />
any combination <strong>of</strong> activities mentioned in subparagraphs<br />
a) to e), provided that the overall activity <strong>of</strong> the fixed<br />
place <strong>of</strong> business resulting from this combination is <strong>of</strong> a<br />
preparatory or auxiliary character.<br />
5. Notwithstanding the provisions <strong>of</strong> paragraphs 1 and 2,<br />
where a person — other than an agent <strong>of</strong> an independent<br />
status to whom paragraph 6 applies — is acting on behalf <strong>of</strong><br />
an enterprise and has, and habitually exercises, in a<br />
Contracting State an authority to conclude contracts in the<br />
name <strong>of</strong> the enterprise, that enterprise shall be deemed to<br />
have a permanent establishment in that State in respect <strong>of</strong><br />
any activities which that person undertakes for the<br />
enterprise, unless the activities <strong>of</strong> such person are limited to<br />
those mentioned in paragraph 4 which, if exercised through<br />
a fixed place <strong>of</strong> business, would not make this fixed place <strong>of</strong><br />
business a permanent establishment under the provisions <strong>of</strong><br />
that paragraph.<br />
1. For the purposes <strong>of</strong> this Convention, the term ‘‘permanent establishment’’<br />
means a fixed place <strong>of</strong> business through which the business <strong>of</strong> an enterprise is<br />
wholly or partly carried on.<br />
2. The term ‘‘permanent establishment’’ includes especially:<br />
(a) a place <strong>of</strong> management;<br />
(b) a branch;<br />
(c) an <strong>of</strong>fice;<br />
(d) a factory;<br />
(e) a workshop;<br />
(f) a mine, an oil or gas well, a quarry, or any other place <strong>of</strong> extraction <strong>of</strong><br />
natural resources;<br />
(...)<br />
(l) the furnishing <strong>of</strong> services, other than included services as defined in<br />
Article 12 (Royalties and Fees for Included Services), within a Contracting<br />
State by an enterprise through employees or other personnel, but only if:<br />
(i) activities <strong>of</strong> that nature continue within that State for a period or periods<br />
aggregating more than 90 days within any twelve month period; or<br />
(ii) the services are performed within that State for a related enterprise<br />
(within the meaning <strong>of</strong> paragraph 1 <strong>of</strong> Article 9 (Associated Enterprises)).<br />
(...)<br />
3. Notwithstanding the preceding provisions <strong>of</strong> this Article, the term<br />
‘‘permanent establishment’’ shall be deemed not to include any one or more <strong>of</strong><br />
the following:<br />
(a) the use <strong>of</strong> facilities solely for the purpose <strong>of</strong> storage, display, or occasional<br />
delivery <strong>of</strong> goods or merchandise belonging to the enterprise;<br />
(b) the maintenance <strong>of</strong> a stock <strong>of</strong> goods or merchandise belonging to the<br />
enterprise solely for the purpose <strong>of</strong> storage, display, or occasional delivery;<br />
(c) the maintenance <strong>of</strong> a stock <strong>of</strong> goods or merchandise belonging to the<br />
enterprise solely for the purpose <strong>of</strong> processing by another enterprise;<br />
(d) the maintenance <strong>of</strong> a fixed place <strong>of</strong> business solely for the purpose <strong>of</strong><br />
purchasing goods or merchandise, or <strong>of</strong> collecting information, for the<br />
enterprise;<br />
(e) the maintenance <strong>of</strong> a fixed place <strong>of</strong> business solely for the purpose <strong>of</strong><br />
advertising, for the supply <strong>of</strong> information, for scientific research or for other<br />
activities which have a preparatory or auxiliary character, for the enterprise.<br />
4. Notwithstanding the provisions <strong>of</strong> paragraphs 1 and 2, where a person —<br />
other than an agent <strong>of</strong> an independent status to whom paragraph 5 applies —<br />
is acting in a Contracting State on behalf <strong>of</strong> an enterprise <strong>of</strong> the other<br />
Contracting State, that enterprise shall be deemed to have a permanent<br />
establishment in the first-mentioned State if:<br />
(a) he has and habitually exercises in the first-mentioned State an authority to<br />
conclude contracts on behalf <strong>of</strong> the enterprise, unless his activities are limited<br />
to those mentioned in paragraph 3 which, if exercised through a fixed place<br />
<strong>of</strong> business, would not make that fixed place <strong>of</strong> business a permanent<br />
establishment under the provisions <strong>of</strong> that paragraph;<br />
(b) he has no such authority but habitually maintains in the first-mentioned<br />
State a stock <strong>of</strong> goods or merchandise from which he regularly delivers goods<br />
or merchandise on behalf <strong>of</strong> the enterprise, and some additional activities<br />
conducted in that State on behalf <strong>of</strong> the enterprise have contributed to the<br />
sale <strong>of</strong> the goods or merchandise; or<br />
(c) he habitually secures orders in the first-mentioned State, wholly or almost<br />
wholly for the enterprise.<br />
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which the business <strong>of</strong> an enterprise is wholly or partly<br />
carried on — was not satisfied regarding the back<strong>of</strong>fice<br />
activities.<br />
Moreover, the Court considered that the back-<strong>of</strong>fice<br />
services to be provided by MSAS fall under article<br />
5(3)(e) <strong>of</strong> the India-U.S. treaty, which excludes the<br />
characterization <strong>of</strong> a PE regarding ‘‘the maintenance<br />
<strong>of</strong> a fixed place <strong>of</strong> business solely for the purpose <strong>of</strong><br />
advertising, for the supply <strong>of</strong> information, for scientific<br />
research or for other activities which have a preparatory<br />
or auxiliary character, for the enterprise.’’ 77<br />
Concerning the existence <strong>of</strong> an agency PE, the Supreme<br />
Court <strong>of</strong> India concluded that there was no PE<br />
because MSAS did not have authority to enter into or<br />
conclude contracts (which were entered and concluded<br />
in the United States). 78<br />
Moreover, regarding the stewards seconded by<br />
MSCo to work in India as employees <strong>of</strong> MSAS, the<br />
Supreme Court <strong>of</strong> India disagreed with the ruling provided<br />
by the AAR and held that their activity did not<br />
lead to the constitution <strong>of</strong> a PE within the meaning <strong>of</strong><br />
article 5(2)(l) <strong>of</strong> the India-U.S. treaty. According to the<br />
Court, the stewardship activities did not constitute a<br />
service provided by MSCo to MSAS, rather, ‘‘MSCo is<br />
merely protecting its own interests in the competitive<br />
world by ensuring the quality and confidentiality <strong>of</strong><br />
MSAS services.’’ 79 The underlying idea is that the enterprise<br />
must provide a service to a third party to<br />
qualify as a PE — a PE does not arise when the enterprise<br />
is providing a service to itself. Under the Court’s<br />
view, as no service was being provided to a third party<br />
by the stewards, no PE was found to exist.<br />
However, regarding the deputationists deployed by<br />
MSCo to work in India as employees <strong>of</strong> MSAS, the<br />
Supreme Court <strong>of</strong> India held that they did not become<br />
employee <strong>of</strong> MSAS; they retained their employment<br />
lien with MSCo and therefore constituted a service PE<br />
in the sense <strong>of</strong> article 5(2)(l) <strong>of</strong> the India-U.S. treaty.<br />
The Court found that MSAS was therefore a service<br />
PE in India regarding the services performed by the<br />
deputationists deployed by MSCo. 80<br />
Once the Supreme Court <strong>of</strong> India concluded that<br />
MSCo had a service PE in India, the question was<br />
how much pr<strong>of</strong>it could be attributed to that PE. The<br />
Court first made reference to the ruling provided in the<br />
AAR that when the nonresident compensates a PE at<br />
arm’s length no further pr<strong>of</strong>its could be attributable to<br />
India. Then the judges presented their agreement with<br />
this ruling:<br />
77 Id. at 15, 16, and 18.<br />
78 Id. at 16.<br />
79 Id. at 20-21.<br />
80 Id. at 21-22.<br />
The impugned ruling is correct in principle ins<strong>of</strong>ar<br />
as an associated enterprise, that also constitutes<br />
a PE, has been remunerated on an arm’s<br />
length basis taking into account all the risk-taking<br />
functions <strong>of</strong> the enterprise. In such cases nothing<br />
further would be left to be attributed to the PE.<br />
The situation would be different if the transfer<br />
pricing analysis does not adequately reflect the<br />
functions performed and the risks assumed by the<br />
enterprise. In such a situation, there would be a<br />
need to attribute pr<strong>of</strong>its to the PE for those<br />
functions/risks that have not been considered. 81<br />
The widespread interpretation <strong>of</strong> this case law supports<br />
that it is in line with the single <strong>tax</strong>payer approach<br />
since it provides that no further pr<strong>of</strong>it is left to be attributed<br />
to the PE once the dependent agent has received<br />
an arm’s-length reward for the service provided.<br />
Nevertheless, there is a dissenting view headed by<br />
Hans Pijl (and shared by me) that considers this decision<br />
as favoring the authorized OECD approach. 82<br />
Indeed, a careful reading <strong>of</strong> the decision’s reasoning<br />
reveals that the Supreme Court <strong>of</strong> India left open the<br />
possibility <strong>of</strong> a further pr<strong>of</strong>it attribution to the PE as<br />
long as there are other functions performed or risks<br />
assumed by the enterprise that are not reflected in the<br />
dependent agent remuneration. This conclusion results<br />
from the final part <strong>of</strong> the decision: ‘‘The situation<br />
would be different if the transfer pricing analysis does<br />
not adequately reflect the functions performed and the<br />
risks assumed by the enterprise. In such a situation,<br />
there would be a need to attribute pr<strong>of</strong>its to the PE for those<br />
functions/risks that have not been considered.’’ 83 (Emphasis<br />
added.) This is clearly in line with, if not a definition<br />
<strong>of</strong>, the authorized OECD approach.<br />
It can be derived from the decision that no further<br />
pr<strong>of</strong>it was attributed to the PE in India precisely because<br />
no other functions or risks were identified in the<br />
framework <strong>of</strong> the activities carried out by that PE, not<br />
because the Supreme Court <strong>of</strong> India opted as a matter<br />
<strong>of</strong> principle for the single <strong>tax</strong>payer approach.<br />
It is interesting that this decision is always promoted<br />
as being one <strong>of</strong> the most important precedents in favor<br />
<strong>of</strong> the single <strong>tax</strong>payer approach when it really invalidates<br />
it.<br />
All the conflicting views presented above result from<br />
the confusing wording <strong>of</strong> the decision in its concluding<br />
section. Although the wording <strong>of</strong> the decision is somewhat<br />
ambiguous, I feel it safe to conclude that this is a<br />
81 Id. at 46.<br />
SPECIAL REPORTS<br />
82 Hans Pijl, ‘‘Morgan Stanley: Issues Regarding Permanent<br />
Establishments and Pr<strong>of</strong>it Attribution in Light <strong>of</strong> the OECD<br />
View,’’ Bull. for Int’lTax’n (May 2008), pp. 174-182.<br />
83 Supreme Court <strong>of</strong> India, July 9, 2007, decision 2114/07<br />
and 2415/07, p. 46.<br />
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SPECIAL REPORTS<br />
Singapore<br />
India<br />
precedent in favor <strong>of</strong> the authorized OECD approach,<br />
rather than the single <strong>tax</strong>payer approach as it might<br />
look at first sight.<br />
F. SET Satellite<br />
SET Satellite involves a Singaporean broadcasting<br />
company named SET Satellite (Singapore) Pte. Ltd.<br />
that was engaged in the business <strong>of</strong> marketing and distributing<br />
satellite television channels in India. 84 SET<br />
Satellite appointed SET India Pvt as its agent in India,<br />
whose activity mainly comprised marketing airtime<br />
slots to various advertisers in India on behalf <strong>of</strong> SET<br />
Satellite, as illustrated in Figure 8.<br />
When filing its <strong>tax</strong> returns, SET Satellite assumed<br />
the position that it was not subject to <strong>tax</strong> in India because<br />
it did not have a PE within the meaning <strong>of</strong> article<br />
5(8) <strong>of</strong> the India-Singapore <strong>tax</strong> treaty. For the sake<br />
<strong>of</strong> clarity, the provisions <strong>of</strong> article 5(8) <strong>of</strong> the treaty<br />
deviate from the wording <strong>of</strong> the OECD model convention<br />
by enlarging the notion <strong>of</strong> agency PE to other activities,<br />
such as:<br />
• maintenance <strong>of</strong> stock <strong>of</strong> goods or merchandise to<br />
be delivered on behalf <strong>of</strong> the enterprise; or<br />
• habitually securing orders wholly or almost<br />
wholly for the enterprise itself or for the enterprise<br />
and other enterprises controlling, controlled<br />
by, or subject to the same common control as that<br />
enterprise.<br />
However, the India-Singapore treaty provides for the<br />
essential features <strong>of</strong> the typical concept <strong>of</strong> agency PEs<br />
as established in the OECD model: (i) a person (individuals<br />
or companies) acting on behalf <strong>of</strong> the enterprise,<br />
(ii) other than an agent <strong>of</strong> independent status,<br />
84 Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision<br />
535/Mum/04 and 205/Mum/04. As both appeals pertained<br />
to the same person, involved interconnected issues, and were<br />
heard together, the tribunal disposed <strong>of</strong> both appeals in a consolidated<br />
order.<br />
Figure 8. SET Satellite<br />
SET Satellite<br />
Arm’s-length<br />
remuneration for<br />
marketing services SET India<br />
(iii) with authority to conclude contracts, (iv) in the<br />
name <strong>of</strong> the enterprise, (v) on a regular basis. Different<br />
from the OECD model, the India-Singapore treaty<br />
does not require that the dependent agent concludes<br />
contracts ‘‘in the name <strong>of</strong> the enterprise,’’ but ‘‘on behalf<br />
<strong>of</strong> the enterprise.’’ In my opinion, however, this<br />
difference does not lead to major consequences because,<br />
as explained above regarding the Zimmer case,<br />
one should not rely on an extreme formalistic approach<br />
to limit the application <strong>of</strong> article 5(5) <strong>of</strong> the OECD<br />
model convention to agents that enter into contracts<br />
literally in the name <strong>of</strong> the enterprise, as such provisions<br />
apply equally to agents that conclude binding<br />
contracts that are not actually in the name <strong>of</strong> the enterprise.<br />
For the sake <strong>of</strong> clarity, a full look at the relevant<br />
provisions <strong>of</strong> the India-Singapore treaty is necessary.<br />
(See Table 2.)<br />
According to the court, there was no dispute about<br />
whether SET Satellite had a dependent agent in India.<br />
The issue was whether once the dependent agent (SET<br />
India) was paid an arm’s-length remuneration for the<br />
services rendered to its principal (SET Satellite), any<br />
further income, other than the income earned by the<br />
dependent agent, can be said to be attributed to the<br />
dependent agent PE and therefore subject to <strong>tax</strong> in India.<br />
85<br />
Indian <strong>tax</strong> authorities argued that:<br />
• though the purchase and sale <strong>of</strong> airtime are effected<br />
in Singapore, the receipt regarding broadcasting<br />
advertisement is in the territory <strong>of</strong> India;<br />
• the income regarding, or in connection with the<br />
relay <strong>of</strong>, advertisements, accrues in India; and<br />
• SET Satellite has a PE in India in the form <strong>of</strong><br />
SET India, and therefore, advertisement revenue<br />
from AXN channel is <strong>tax</strong>able in India as business<br />
income.<br />
85 Id. at paras. 6 and 31.<br />
Marketing services in<br />
the Indian market<br />
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Table 2. Comparison <strong>of</strong> OECD Model Convention and India-Singapore Treaty<br />
OECD Model Convention Agreement Between the Government <strong>of</strong> the Republic <strong>of</strong> Singapore<br />
and the Government <strong>of</strong> the Republic <strong>of</strong> India for the Avoidance <strong>of</strong><br />
Double Taxation and the Prevention <strong>of</strong> Fiscal Evasion with respect<br />
to Taxes on Income concluded January 24, 1994<br />
Article 5—Permanent Establishment Article 5—Permanent Establishment<br />
1. For the purposes <strong>of</strong> this Convention, the term ‘‘permanent<br />
establishment’’ means a fixed place <strong>of</strong> business through which the<br />
business <strong>of</strong> an enterprise is wholly or partly carried on.<br />
2. The term ‘‘permanent establishment’’ includes especially:<br />
a) a place <strong>of</strong> management;<br />
b) a branch;<br />
c) an <strong>of</strong>fice;<br />
d) a factory;<br />
e) a workshop, and<br />
f) a mine, an oil or gas well, a quarry or any other place <strong>of</strong><br />
extraction <strong>of</strong> natural resources.<br />
(...)<br />
5. Notwithstanding the provisions <strong>of</strong> paragraphs 1 and 2, where a<br />
person — other than an agent <strong>of</strong> an independent status to whom<br />
paragraph 6 applies — is acting on behalf <strong>of</strong> an enterprise and has,<br />
and habitually exercises, in a Contracting State an authority to<br />
conclude contracts in the name <strong>of</strong> the enterprise, that enterprise shall<br />
be deemed to have a permanent establishment in that State in respect<br />
<strong>of</strong> any activities which that person undertakes for the enterprise,<br />
unless the activities <strong>of</strong> such person are limited to those mentioned in<br />
paragraph 4 which, if exercised through a fixed place <strong>of</strong> business,<br />
would not make this fixed place <strong>of</strong> business a permanent<br />
establishment under the provisions <strong>of</strong> that paragraph.<br />
To support its arguments, Indian <strong>tax</strong> authorities relied<br />
mainly on the OECD ‘‘Report on the Attribution<br />
<strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments.’’ SET Satellite<br />
argued that, according to the provisions <strong>of</strong> article 7(2)<br />
<strong>of</strong> the India-Singapore treaty, since SET India was remunerated<br />
on an arm’s-length basis there was no additional<br />
pr<strong>of</strong>it to be <strong>tax</strong>ed in India regarding the advertisement<br />
revenues. The arguments raised by SET<br />
Satellite were supported by the writings <strong>of</strong> Philip Baker<br />
and Richard S. Collier, guidance previously issued by<br />
the Indian <strong>tax</strong> authorities, and the decision <strong>of</strong> the<br />
AAR in Morgan Stanley, in which an arm’s-length reward<br />
paid by a foreign enterprise to its dependent<br />
SPECIAL REPORTS<br />
1. For the purposes <strong>of</strong> this Agreement, the term ‘‘permanent<br />
establishment’’ means a fixed place <strong>of</strong> business through which the<br />
business <strong>of</strong> the enterprise is wholly or partly carried on.<br />
2. The term ‘‘permanent establishment’’ includes especially:<br />
(a) a place <strong>of</strong> management;<br />
(b) a branch;<br />
(c) an <strong>of</strong>fice;<br />
(d) a factory;<br />
(e) a workshop;<br />
(f) a mine, an oil or gas well, a quarry or any other place <strong>of</strong><br />
extraction <strong>of</strong> natural resources;<br />
(g) a warehouse in relation to a person providing storage facilities<br />
for others;<br />
(h) a farm, plantation or other place where agriculture, forestry,<br />
plantation or related activities are carried on;<br />
(i) premises used as a sales outlet or for soliciting and receiving<br />
orders;<br />
(j) an installation or structure used for the exploration or<br />
exploitation <strong>of</strong> natural resources but only if so used for a period<br />
<strong>of</strong> more than 120 days in any fiscal year.<br />
(...)<br />
8. Notwithstanding the provisions <strong>of</strong> paragraphs 1 and 2, where a<br />
person — other than an agent <strong>of</strong> an independent status to whom<br />
paragraph 9 applies — is acting in a Contracting State on behalf <strong>of</strong><br />
an enterprise <strong>of</strong> the other Contracting State that enterprise shall be<br />
deemed to have a permanent establishment in the first-mentioned<br />
State, if:<br />
(a) he has and habitually exercises in that State an authority to<br />
conclude contracts on behalf <strong>of</strong> the enterprise, unless his activities<br />
are limited to the purchase <strong>of</strong> goods or merchandise for the<br />
enterprise;<br />
(b) he has no such authority, but habitually maintains in the<br />
first-mentioned State a stock <strong>of</strong> goods or merchandise from which<br />
he regularly delivers goods or merchandise on behalf <strong>of</strong> the<br />
enterprise; or<br />
(c) he habitually secures orders in the first-mentioned State, wholly<br />
or almost wholly for the enterprise itself or for the enterprise and<br />
other enterprises controlling, controlled by, or subject to the same<br />
common control, as that enterprise.<br />
agent for the service provided extinguishes the <strong>tax</strong><br />
liability <strong>of</strong> the foreign enterprise in India.<br />
The court clearly adopted an interpretation in line<br />
with the authorized OECD approach or dual <strong>tax</strong>payer<br />
approach by treating the dependent agent and the<br />
agency PE as two different <strong>tax</strong>able units:<br />
A dependent agent cannot, strictly speaking, be<br />
termed as PE because neither the Dependent<br />
Agent belongs to the PE, nor can one have something<br />
as a result <strong>of</strong> having the same thing, i.e. if<br />
a dependent agent is itself a PE, one cannot have<br />
a PE as a result <strong>of</strong> having a dependent agent. In<br />
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SPECIAL REPORTS<br />
such a case, the treaty could have simply stated<br />
that a dependent agent or agency shall be deemed<br />
to be PE <strong>of</strong> the enterprise; there was no need to<br />
say, as has actually been said, that an enterprise<br />
shall be deemed to have a PE by the virtue <strong>of</strong><br />
having a dependent agent and meeting one <strong>of</strong><br />
tests set out in the relevant sub article. Dependent<br />
Agent and the Dependent Agent PE, therefore,<br />
cannot be one and the same thing. 86<br />
Regarding the determination <strong>of</strong> the pr<strong>of</strong>its <strong>of</strong> the<br />
agency PE, the court relied on the OECD ‘‘Report on<br />
the Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments’’<br />
and followed the functionally separate entity<br />
approach by stating that:<br />
the pr<strong>of</strong>it computations <strong>of</strong> the PE have to proceed<br />
on the basis that the PE is wholly independent<br />
<strong>of</strong> its GE [General Enterprise], which from a<br />
purely accounting and commercial point <strong>of</strong> view,<br />
generally means nothing more than the hypothesis<br />
that intra organization transactions are to be<br />
taken into account at arm’s length price. 87<br />
According to the court:<br />
the DAPE and DA88 has to be, therefore, treated<br />
as two distinct <strong>tax</strong>able units. The former is a hypothetical<br />
establishment, <strong>tax</strong>ability <strong>of</strong> which is on<br />
the basis <strong>of</strong> revenues <strong>of</strong> the activities <strong>of</strong> the GE<br />
attributable to the PE, in turn based on the<br />
FAR89 analysis <strong>of</strong> the DAPE, minus the payments<br />
attributable in respect <strong>of</strong> such activities, in<br />
simple words, whatever are the revenues generated<br />
on account <strong>of</strong> functional analysis <strong>of</strong> the<br />
DAPE are to be taken into account as hypothetical<br />
income <strong>of</strong> the said DAPE, and deduction is<br />
to be provided in respect <strong>of</strong> all the expenses incurred<br />
by the GE to earn such revenues, including,<br />
<strong>of</strong> course, the remuneration paid to the DA.<br />
The second <strong>tax</strong>able unit in this transaction is the<br />
DA itself, but this <strong>tax</strong>ability is in respect <strong>of</strong> the<br />
remuneration <strong>of</strong> the DA. 90<br />
Regarding the AAR’s ruling in Morgan Stanley, the<br />
court stated that this argument was not persuasive as it<br />
is ‘‘well settled in law that these rulings have binding<br />
value only on the assessee and on the Commissioner<br />
with reference to that particular transaction.’’ 91<br />
The court went on to conclude:<br />
86 Id. at para. 8.<br />
87 Id. at para. 10.<br />
88<br />
DAPE stands for ‘‘dependent agent permanent establishment,’’<br />
and DA means ‘‘dependent agent.’’<br />
89<br />
The court uses this acronym to refer to functions performed,<br />
assets used, and risks assumed.<br />
90<br />
Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision<br />
535/Mum/04 and 205/Mum/04, para. 11.<br />
91<br />
Id. at para. 17.<br />
We are <strong>of</strong> the considered view that in addition <strong>of</strong><br />
the <strong>tax</strong>ability <strong>of</strong> the DA in respect <strong>of</strong> remuneration<br />
earned by him, which is in accordance with<br />
the domestic law and which has nothing to do<br />
with the <strong>tax</strong>ability <strong>of</strong> the foreign enterprise <strong>of</strong><br />
which he is dependent agent, the foreign enterprise<br />
is also <strong>tax</strong>able in India, in terms <strong>of</strong> the provisions<br />
<strong>of</strong> Article 7 <strong>of</strong> the <strong>tax</strong> treaty, in respect <strong>of</strong><br />
the pr<strong>of</strong>its attributable to the dependent agent<br />
PE. 92<br />
SET Satellite is an important case because it involves<br />
the effective application <strong>of</strong> the conclusions <strong>of</strong> the ‘‘Report<br />
on the Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments,’’<br />
despite the arguments raised by the <strong>tax</strong>payer<br />
against its legal status and applicability while no<br />
change in the wording <strong>of</strong> the OECD model convention<br />
or its commentary has been put in place. The judges<br />
had to reconcile the interpretation that seemed to be<br />
more appropriate with the relevant arguments raised by<br />
the <strong>tax</strong>payer, especially the legal status <strong>of</strong> the report,<br />
which, at the time <strong>of</strong> the judgment, was not part <strong>of</strong><br />
the commentary to the current OECD model convention.<br />
The report was not part <strong>of</strong> the commentary in<br />
place at the time <strong>of</strong> the conclusion <strong>of</strong> the India-<br />
Singapore treaty, which creates an additional argument<br />
for those that defend a static, rather than an ambulatory,<br />
interpretation <strong>of</strong> the commentary to the OECD<br />
model convention.<br />
As shown below, I believe this decision is correct<br />
and provides for the most appropriate interpretation <strong>of</strong><br />
article 7 regarding the attribution <strong>of</strong> pr<strong>of</strong>its to PEs.<br />
However, this decision was made by the Indian Income<br />
Tax Appellate Tribunal, so it is unclear whether<br />
the Supreme Court <strong>of</strong> India will uphold the decision or<br />
whether it will clarify its earlier ruling in Morgan Stanley<br />
and rule in favor <strong>of</strong> the <strong>tax</strong>payer.<br />
V. The Most Suitable Approach<br />
It seems safe to conclude that the authorized OECD<br />
approach is indeed the most appropriate approach to<br />
attribute pr<strong>of</strong>its to PEs.<br />
A. Adequate Allocation <strong>of</strong> Risks<br />
The single <strong>tax</strong>payer approach is quite attractive at<br />
first sight, as it provides for an outcome that is apparently<br />
quite logical: As the dependent agent is remunerated<br />
on an arm’s-length basis, both home and host<br />
states seem to get their fair share <strong>of</strong> the income that<br />
arises in a particular transaction. 93 The home state<br />
<strong>tax</strong>es the pr<strong>of</strong>its <strong>of</strong> the enterprise, while the host state<br />
is entitled to <strong>tax</strong> the income paid to the dependent<br />
92 Id. at para. 11.<br />
93 Para. 272 <strong>of</strong> the ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to<br />
Permanent Establishment,’’ Part I (General Considerations),<br />
(2006).<br />
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agent in accordance with the functions it performs —<br />
an arm’s-length remuneration.<br />
This apparently logical reasoning hides the possibility<br />
<strong>of</strong> other functions being performed in the host state<br />
as risks are allocated to the agency PE in the framework<br />
<strong>of</strong> its dealings with its head <strong>of</strong>fice.<br />
Indeed, the single <strong>tax</strong>payer approach is firmly rejected<br />
by the OECD in its report precisely because:<br />
it ignores assets and risks that relate to the activity<br />
being carried on in the source jurisdiction simply<br />
because those assets and risks legally belong<br />
to the non-resident enterprise....Thesingle <strong>tax</strong>payer<br />
approach simply does not consider that if<br />
the risks (and reward) legally belong to the nonresident<br />
enterprise it is nonetheless possible to<br />
attribute those risks (and reward) to a PE <strong>of</strong> the<br />
nonresident enterprise created by the activity <strong>of</strong><br />
its dependent agent in the host country. 94<br />
Undeniably, the single <strong>tax</strong>payer approach ignores the<br />
possibility <strong>of</strong> other risks being assumed in the host<br />
state, which may not reflect the entire activities <strong>of</strong> the<br />
enterprise in that state. This is what Raffaele Russo<br />
called a misallocation <strong>of</strong> the risks within the enterprise:<br />
‘‘that the risk is legally borne by the nonresident enterprise<br />
should not impede the allocation <strong>of</strong> it to the PE<br />
for purposes <strong>of</strong> pr<strong>of</strong>it attribution.’’ 95<br />
If, for example, the credit risk on accounts receivable<br />
is not borne by the dependent agent itself but directly<br />
by the principal, a reward for such risk must be<br />
attributed to the agency PE. 96<br />
In my view, the strange outcome <strong>of</strong> ignoring such<br />
functions and risks is a direct consequence <strong>of</strong> the<br />
axiom that involves the notion <strong>of</strong> the single <strong>tax</strong>payer<br />
approach, that the individual or entity whose activities<br />
create the PE is considered to be the PE himself/<br />
itself. 97<br />
As, under the single <strong>tax</strong>payer approach, the figures<br />
<strong>of</strong> the dependent agent and the agency PE are mixed<br />
into one, the eventual other functions performed and<br />
risks assumed in the framework <strong>of</strong> the agency PE are<br />
blurred into this single <strong>tax</strong>able unit and remain unrevealed.<br />
Therefore, it can be said that the single <strong>tax</strong>payer approach<br />
might lead to a hidden pr<strong>of</strong>it escaping <strong>tax</strong>ation<br />
<strong>of</strong> the host state depending on the facts and circumstances.<br />
94 Id.<br />
95<br />
Raffaele Russo, The Attribution <strong>of</strong> Pr<strong>of</strong>its to Permanent Establishments:<br />
The Taxation <strong>of</strong> Intra-Company Dealings (Amsterdam:<br />
IBFD Publications BV, 2005), p. 30.<br />
96<br />
Russo, supra note 65, at 14.<br />
97 Deitmer, Dörr, and Rust, supra note 70, at 187.<br />
SPECIAL REPORTS<br />
It is only the authorized OECD approach that allows<br />
the host state to ‘‘see’’ and be able to <strong>tax</strong> eventual<br />
other functions that are being performed or risks being<br />
assumed within its territory. Considering the example<br />
<strong>of</strong> a typical agency PE, only a functional and factual<br />
analysis as provided by the authorized OECD approach<br />
will reveal to the host state a pr<strong>of</strong>it that otherwise<br />
would be completely hidden.<br />
The single <strong>tax</strong>payer<br />
approach might lead to<br />
a hidden pr<strong>of</strong>it escaping<br />
<strong>tax</strong>ation <strong>of</strong> the host state<br />
depending on the facts and<br />
circumstances.<br />
With the characterization <strong>of</strong> two clear separate <strong>tax</strong>able<br />
units — the dependent agent and the agency PE<br />
— the precise amount <strong>of</strong> income is attributed to each<br />
one <strong>of</strong> them in accordance with the functions performed,<br />
assets used, and risks assumed by each <strong>tax</strong>able<br />
unit.<br />
The Supreme Court <strong>of</strong> India, though ruling in Morgan<br />
Stanley that there was no further pr<strong>of</strong>it to be attributed<br />
to the PE in excess <strong>of</strong> an arm’s-length remuneration,<br />
was able to see the possibility that other functions<br />
might be performed and risks assumed in the host<br />
state, different from those relating to the dependent<br />
agent:<br />
The impugned ruling is correct in principle ins<strong>of</strong>ar<br />
as an associated enterprise, that also constitutes<br />
a PE, has been remunerated on an arm’s<br />
length basis taking into account all the risk-taking<br />
functions <strong>of</strong> the enterprise. In such cases nothing<br />
further would be left to be attributed to the PE.<br />
The situation would be different if the transfer pricing<br />
analysis does not adequately reflect the functions performed<br />
and the risks assumed by the enterprise. In such a<br />
situation, there would be a need to attribute pr<strong>of</strong>its to the<br />
PE for those functions/risks that have not been considered.<br />
98 [Emphasis added.]<br />
A careful reading <strong>of</strong> the decision’s reasoning reveals<br />
that the Supreme Court <strong>of</strong> India left open the possibility<br />
<strong>of</strong> a further pr<strong>of</strong>it attribution to the PE as long as<br />
there are other functions performed or risks assumed<br />
by the enterprise that are not reflected in the dependent<br />
agent remuneration.<br />
98 Supreme Court <strong>of</strong> India, July 9, 2007, decision 2114/07<br />
and 2415/07, p. 46.<br />
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SPECIAL REPORTS<br />
If the single <strong>tax</strong>payer approach is adopted, these<br />
eventual additional functions or risks <strong>of</strong> the enterprise<br />
in the host state will never be remunerated, which is<br />
clearly against the wording <strong>of</strong> article 7, and which is<br />
intended to provide for <strong>tax</strong> sharing between home and<br />
host states weighted on the basis <strong>of</strong> the functions performed,<br />
assets used, and risks assumed.<br />
This interpretation is shared by Richard Vann;<br />
though he believes that the existing theories regarding<br />
the allocation <strong>of</strong> pr<strong>of</strong>its to PEs are not convincing, he<br />
expresses his preference for what he called the ‘‘rowing<br />
or relay theory,’’ under which:<br />
every transaction within the boundaries <strong>of</strong> the<br />
firm is intended to produce a pr<strong>of</strong>it over and<br />
above the market price <strong>of</strong> any intra-firm transaction<br />
or dealing that operates as an input into that<br />
pr<strong>of</strong>it and that pr<strong>of</strong>it is allocated to all parts <strong>of</strong><br />
the firm which participate in the realisation <strong>of</strong><br />
the ultimate pr<strong>of</strong>it on the sale to the third party. 99<br />
The name <strong>of</strong> this theory refers to the idea that each<br />
member <strong>of</strong> the team contributes to the overall pr<strong>of</strong>it as<br />
they all work together towards the same goal, which<br />
resembles a rowing race.<br />
Therefore, it is clear that the authorized OECD approach<br />
is the only method that entails an adequate allocation<br />
<strong>of</strong> risks within the enterprise, avoiding an undue<br />
limitation <strong>of</strong> the host state <strong>tax</strong>ing rights. If the<br />
resulting increase in host state <strong>tax</strong>ation is undesirable,<br />
this is an issue <strong>of</strong> <strong>tax</strong> policy that does not overcome<br />
the conclusion that the authorized OECD approach<br />
provides for a proper allocation <strong>of</strong> risks within the enterprise,<br />
as opposed to its contrary single <strong>tax</strong>payer approach.<br />
B. The Rationale Behind Article 7<br />
In my view, it is undisputable that the rationale <strong>of</strong><br />
the OECD report is in line with the underlying principle<br />
codified in article 7.<br />
Article 7 upholds primacy <strong>of</strong> the arm’s-length principle<br />
in attributing pr<strong>of</strong>its to PEs as a natural consequence<br />
<strong>of</strong> the adoption <strong>of</strong> the separate entity fiction. 100<br />
The OECD report reaffirms the primacy <strong>of</strong> the<br />
arm’s-length principle in attributing pr<strong>of</strong>its to PEs by<br />
determining the adoption <strong>of</strong> the functionally separate<br />
entity approach. In the framework <strong>of</strong> an agency PE,<br />
the host state is therefore entitled to <strong>tax</strong> the pr<strong>of</strong>its that<br />
99<br />
Richard J. Vann, ‘‘Tax Treaties: The Secret Agent’s Secrets,’’<br />
Brit. Tax Rev. (50th Anniversary Edition), no. 3 (2006), p.<br />
345.<br />
100<br />
In 1933 the League <strong>of</strong> Nations draft already provided for<br />
the arm’s-length principle as the guidance for the allocation <strong>of</strong><br />
pr<strong>of</strong>its to intracompany dealings; see Russo, supra note 65, at 7.<br />
In this sense, the convention determined that a PE must be<br />
treated in the same manner as independent enterprises operating<br />
under the same or similar conditions.<br />
the agency PE might be expected to make if it were a<br />
separate enterprise engaged in the same or similar activities<br />
under the same or similar conditions and dealing<br />
wholly independently with the enterprise <strong>of</strong> which<br />
it is a PE.<br />
Some authors expressed concern about the requirement,<br />
under the authorized OECD approach, <strong>of</strong> the<br />
PE recognizing notional payments as a deduction or as<br />
basis for attributing pr<strong>of</strong>its, based on the notion that<br />
‘‘an enterprise cannot make a pr<strong>of</strong>it from dealing with<br />
itself.’’ 101<br />
However, by adopting the transfer pricing guidelines<br />
to a general enterprise and PE relationship, the only<br />
result that is harmonious is that the PE pr<strong>of</strong>its must be<br />
determined in accordance with the assets and risks <strong>of</strong><br />
the nonresident enterprise relating to the functions performed<br />
by the dependent agent on behalf <strong>of</strong> the nonresident<br />
enterprise, together with sufficient capital to<br />
support those assets and risks. As a matter <strong>of</strong> principle,<br />
the authorized OECD approach is the only one that<br />
leads to an outcome that is coherent with the fiction <strong>of</strong><br />
independence provided in article 7(2). It is undeniable<br />
that the single <strong>tax</strong>payer approach does not fully accomplish<br />
the fiction <strong>of</strong> independence <strong>of</strong> article 7(2), which<br />
is the same as saying that it results in a partial application<br />
<strong>of</strong> its provisions. This outcome cannot be accepted,<br />
as it is against the rationale and wording <strong>of</strong><br />
article 7.<br />
In this sense, as noted by Hans Pijl, the authorized<br />
OECD approach is correct from the perspective <strong>of</strong> <strong>tax</strong><br />
treaty interpretation because the result ‘‘coincides with<br />
the source principle ...that the state in which the activities<br />
are carried on has the right to levy <strong>tax</strong>.’’ 102<br />
Moreover, it is clear that, under the OECD report,<br />
there is no presumption that the agency PE will always<br />
generate pr<strong>of</strong>its. Sometimes little or no pr<strong>of</strong>it is attributable<br />
to it if only routine functions are performed. As<br />
the pr<strong>of</strong>its will be allocated among the relevant states<br />
in accordance with the functions performed and the<br />
risks assumed by the enterprise, each state will always<br />
be entitled to <strong>tax</strong> the pr<strong>of</strong>its that arise from activities<br />
carried out within its territory.<br />
Other criticism to the authorized OECD approach<br />
raised by Philip Baker and Richard Collier is that it<br />
‘‘represents a significant departure from the interpretation<br />
<strong>of</strong> article 7 as set out in the current commentary.’’<br />
103 In other words, they argue that the current<br />
wording <strong>of</strong> article 7 <strong>of</strong> the OECD model convention<br />
and its commentary does not leave room for the application<br />
<strong>of</strong> the authorized OECD approach and therefore<br />
amendments must be made at least in the commentary.<br />
Further, they conclude that considering the<br />
101 Baker and Collier, supra note 7, at 57.<br />
102 Pijl, supra note 9, at 32.<br />
103 Baker and Collier, supra note 7, at 31.<br />
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existing case law and guidance, the adoption <strong>of</strong> the<br />
authorized OECD approach will be very hard in several<br />
jurisdictions without an explicit change in the<br />
wording <strong>of</strong> article 7. 104<br />
In this sense, it is argued that the current wording <strong>of</strong><br />
article 7(3) only allows actual expenses to be taken into<br />
account and not notional expenses, in a way that the<br />
fiction <strong>of</strong> independence <strong>of</strong> the PE, on the basis <strong>of</strong> the<br />
current wording <strong>of</strong> article 7(2), is not complete.<br />
An analysis <strong>of</strong> the history <strong>of</strong> article 7 demonstrates<br />
that the underlying rationale <strong>of</strong> this provision has always<br />
been the separate entity fiction. In this sense, the<br />
outcome resulting from the adoption <strong>of</strong> the single <strong>tax</strong>payer<br />
approach is clearly against this rationale, leading<br />
to an unreasonable reduction <strong>of</strong> the host state <strong>tax</strong>ing<br />
rights.<br />
Despite this, it is worth remembering that the<br />
OECD Committee on Fiscal Affairs recently adopted<br />
the revised commentary on the current article 7 <strong>of</strong> the<br />
OECD model <strong>tax</strong> convention and included it in the<br />
2008 update to the model <strong>tax</strong> convention, which will<br />
be soon published. 105<br />
Also, as mentioned above, the OECD Committee on<br />
Fiscal Affairs intends to implement the conclusions <strong>of</strong><br />
the report not only through a new version <strong>of</strong> the commentary<br />
on the current text <strong>of</strong> article 7, but also<br />
through a new version <strong>of</strong> article 7 itself with accompanying<br />
commentary to be used in the negotiation <strong>of</strong> future<br />
treaties and amendments to existing treaties.<br />
Therefore, although it seems that the most proper<br />
interpretation <strong>of</strong> article 7, on the basis <strong>of</strong> the current<br />
OECD model convention and commentary, requires<br />
the adoption <strong>of</strong> the authorized OECD approach irrespective<br />
<strong>of</strong> any modification in its wording, the necessary<br />
changes to improve certainty on this interpretation<br />
are being made by the OECD.<br />
C. The Need for Consistency<br />
Another argument against the single <strong>tax</strong>payer approach<br />
is that its acceptance would result in applying<br />
the OECD approach in different manners depending<br />
on what type <strong>of</strong> PE is involved.<br />
In this sense, regarding other types <strong>of</strong> PEs, assets<br />
and risks would be attributed to the PE in accordance<br />
with the functions carried on by it, with the consequent<br />
attribution <strong>of</strong> pr<strong>of</strong>its. No one would dispute that<br />
these assets and risks legally belong to the nonresident<br />
enterprise, but are attributable to the PE under the<br />
OECD approach because <strong>of</strong> the functions performed<br />
by that PE. However, once the single <strong>tax</strong>payer approach<br />
is adopted, no pr<strong>of</strong>its would be attributed to an<br />
104 Id. at 57.<br />
105 See http://www.oecd.org/document/52/<br />
0,3343,en_2649_33747_38376628_1_1_1_1,00.html.<br />
agency PE regarding the risks and assets <strong>of</strong> the nonresident<br />
enterprise, even if they arise from activities<br />
carried out through the agency PE. 106<br />
There is no relevant difference between the fixed PE<br />
and the agency PE to justify a different methodology<br />
in attributing pr<strong>of</strong>its to them.<br />
As analyzed above, the single <strong>tax</strong>payer approach is<br />
based on the axiom that the agency PE pr<strong>of</strong>it is zero<br />
by definition. However, there is no empirical, theoretical,<br />
or legal basis for achieving this conclusion. First,<br />
there is no significant difference between the characteristics<br />
<strong>of</strong> a fixed PE and an agency PE that may justify<br />
a difference in treatment regarding the attribution <strong>of</strong><br />
pr<strong>of</strong>its. Second, no convincing theoretical support has<br />
been provided in favor <strong>of</strong> the single <strong>tax</strong>payer approach.<br />
107 Third, nothing in the wording <strong>of</strong> articles 5<br />
and 7 <strong>of</strong> the OECD model seems to support a difference<br />
in treatment. Quite the opposite, the basis for attributing<br />
pr<strong>of</strong>its to all types <strong>of</strong> PEs is precisely the<br />
same provision <strong>of</strong> article 7 and the arm’s-length principle.<br />
Therefore, there is no reason why the attribution <strong>of</strong><br />
pr<strong>of</strong>its to an agency PE should be treated differently<br />
from the attribution <strong>of</strong> pr<strong>of</strong>its to other types <strong>of</strong> PE.<br />
D. Do Not Assume the Law Is Redundant<br />
One <strong>of</strong> the principles that guides the legal interpretation<br />
process is that the law does not have useless<br />
words.<br />
Adopting the single <strong>tax</strong>payer approach would make<br />
article 5(5) <strong>of</strong> the OECD model superfluous and this<br />
outcome is against the principle <strong>of</strong> the effective interpretation<br />
<strong>of</strong> conventions incorporated into the concept<br />
<strong>of</strong> good faith in article 31(1) <strong>of</strong> the Vienna Convention<br />
on the Law <strong>of</strong> Treaties. 108<br />
Indeed, it must be recognized that the adoption <strong>of</strong><br />
the single <strong>tax</strong>payer approach leads to the concept <strong>of</strong><br />
agency PE becoming meaningless, because the pr<strong>of</strong>its<br />
<strong>of</strong> the agency PE will be <strong>tax</strong>ed anyway by its state <strong>of</strong><br />
residence. Therefore, if there is no additional pr<strong>of</strong>it to<br />
be attributed to the agency PE over and above the<br />
arm’s-length reward <strong>of</strong> the dependent agent, there is no<br />
need to have article 5(5).<br />
The characterization <strong>of</strong> an agency PE would have<br />
the sole consequence <strong>of</strong> ensuring that the dependent<br />
agent receives an arm’s-length remuneration. Basically,<br />
once an agency PE is found to exist, the consideration<br />
paid by the nonresident enterprise to its dependent<br />
106<br />
Para. 273 <strong>of</strong> the ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to<br />
Permanent Establishment,’’ Part I (General Considerations),<br />
(2006).<br />
107<br />
Pijl, supra note 9, at 35.<br />
108 Id. at 32.<br />
SPECIAL REPORTS<br />
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SPECIAL REPORTS<br />
agent would be as if the parties were associated enterprises,<br />
an outcome similar to subjecting them to the<br />
provisions <strong>of</strong> article 9.<br />
However, no attribution <strong>of</strong> pr<strong>of</strong>its would be made to<br />
the agency PE, which is a major contradiction to the<br />
sole purpose <strong>of</strong> article 7.<br />
There is no doubt that when dealing with the transactions<br />
between associated enterprises (that is, the remuneration<br />
<strong>of</strong> the dependent agent regarding the services<br />
provided to the nonresident enterprise), article 9 is<br />
the relevant article in determining whether the transactions<br />
were carried out on an arm’s-length basis. 109<br />
However, regarding the attribution <strong>of</strong> pr<strong>of</strong>its to the<br />
agency PE in the host state, article 7 is clearly the relevant<br />
provision. 110 In this context, as discussed above,<br />
‘‘the assets and risks <strong>of</strong> the nonresident enterprise relating<br />
to the functions performer on its behalf by the<br />
dependent agent enterprise, together with sufficient free<br />
capital to support those assets and risks,’’ should first<br />
be attributed to the agency PE. 111 Under the authorized<br />
OECD approach, this factor will be the measure<br />
<strong>of</strong> the pr<strong>of</strong>its to be attributed to the agency PE. In this<br />
scenario, the arm’s-length remuneration <strong>of</strong> the dependent<br />
agent mentioned in the previous paragraph should<br />
be deducted in the determination <strong>of</strong> the agency PE<br />
pr<strong>of</strong>its.<br />
As a consequence, a legal reasoning that has the<br />
consequence <strong>of</strong> not attributing pr<strong>of</strong>its to a PE, as it is<br />
the single <strong>tax</strong>payer approach, should be rejected because<br />
it does not comply with the traditional standards<br />
<strong>of</strong> legal interpretations, which should not assume that<br />
the law, for articles 5 and 7 <strong>of</strong> OECD model, is redundant.<br />
E. Practical Difficulties Should Not Prevent<br />
Adoption<br />
Philip Baker and Richard S. Collier raise arguments<br />
<strong>of</strong> a practical nature against the authorized OECD approach.<br />
According to Baker and Collier, it is particularly<br />
difficult to determine the pr<strong>of</strong>it, if any, to be attributed<br />
to the agency PE in excess <strong>of</strong> the arm’s-length<br />
reward to the dependent agent because there are many<br />
implementation difficulties, namely the need to provide<br />
documentation <strong>of</strong> an agency PE when the nonresident<br />
enterprise is not aware <strong>of</strong> its existence. 112<br />
Some <strong>tax</strong> authorities, especially in common-law<br />
countries, adopt the single <strong>tax</strong>payer approach because<br />
<strong>of</strong> practical considerations and try to charge, to the<br />
extent possible, the pr<strong>of</strong>it left from the dependent<br />
109<br />
Para. 276 <strong>of</strong> the ‘‘Report on the Attribution <strong>of</strong> Pr<strong>of</strong>its to<br />
Permanent Establishments,’’ Part I (General Considerations),<br />
(2006).<br />
110<br />
Id. at para. 277.<br />
111 Id. at para. 278.<br />
112 Baker and Collier, supra note 7, at 33.<br />
agent. 113 It would be much easier for the <strong>tax</strong> authorities<br />
<strong>of</strong> the host state to challenge the arm’s-length remuneration<br />
paid to the dependent agent, rather than<br />
seek to <strong>tax</strong> the agency PE. 114<br />
A higher difficulty in determining the pr<strong>of</strong>it to be<br />
attributed to an agency PE in excess <strong>of</strong> the arm’slength<br />
reward paid to the dependent agent should not<br />
be an obstacle to the implementation <strong>of</strong> the authorized<br />
OECD approach. Simplicity in the field <strong>of</strong> <strong>tax</strong>ation is<br />
always welcome, but not if the price to pay is ignoring<br />
one <strong>of</strong> the basics <strong>of</strong> the <strong>tax</strong>ation <strong>of</strong> business pr<strong>of</strong>its.<br />
Although recognizing the positive aspects <strong>of</strong> the<br />
single <strong>tax</strong>payer approach as being a simple system from<br />
an administrative perspective, there is no need for complicated<br />
functional and factual analysis, and this approach<br />
has no theoretical support. 115<br />
Therefore, an interpretation that entails an adequate<br />
allocation <strong>of</strong> the risks within the enterprise and that is<br />
in line with the rationale underlying article 7 precedes<br />
any considerations <strong>of</strong> a practical nature. The need for<br />
simplicity in the field <strong>of</strong> <strong>tax</strong>ation should never overcome<br />
a legal interpretation that is harmonious with the<br />
wording <strong>of</strong> the legal text.<br />
VI. Conclusion<br />
It seems safe to conclude that the authorized OECD<br />
approach is indeed the most appropriate approach to<br />
attribute pr<strong>of</strong>its to PEs.<br />
The authorized OECD approach is the only one<br />
that entails an adequate allocation <strong>of</strong> the risks within<br />
the enterprise because the single <strong>tax</strong>payer approach<br />
ignores the possibility <strong>of</strong> other functions being performed<br />
or risks being assumed in the host state, which<br />
may not reflect the entire activities <strong>of</strong> the enterprise in<br />
that state. Therefore, the single <strong>tax</strong>payer approach<br />
might lead to a hidden pr<strong>of</strong>it escaping from <strong>tax</strong>ation <strong>of</strong><br />
the host state, while the authorized OECD approach<br />
allows the host state to ‘‘see’’ and be able to <strong>tax</strong> eventual<br />
other functions or risks that are being performed<br />
or assumed within its territory.<br />
Moreover, it is undisputable that the rationale <strong>of</strong> the<br />
authorized OECD approach is in line with the underlying<br />
principle codified in article 7. This provision upholds<br />
the primacy <strong>of</strong> the arm’s-length principle in attributing<br />
pr<strong>of</strong>its to PEs as a natural consequence <strong>of</strong> the<br />
adoption <strong>of</strong> the separate entity fiction. By adopting the<br />
arm’s-length principle to dealings between the general<br />
enterprise and its PE, the only result that is harmonious<br />
is that the PE pr<strong>of</strong>its must be determined in accordance<br />
with the assets and risks <strong>of</strong> the nonresident enterprise<br />
relating to the functions performed by the<br />
113 Pijl, supra note 9, at 33.<br />
114 Baker and Collier, supra note 7, at 33.<br />
115 Pijl, supra note 9, at 33.<br />
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dependent agent on behalf <strong>of</strong> the nonresident enterprise,<br />
together with sufficient capital to support those<br />
assets and risks. Therefore, the authorized OECD approach<br />
is the only one that leads to an outcome that is<br />
coherent with the fiction <strong>of</strong> independence provided in<br />
article 7(2).<br />
Furthermore, there is no reason why the attribution<br />
<strong>of</strong> pr<strong>of</strong>its to an agency PE should be treated differently<br />
than the attribution <strong>of</strong> pr<strong>of</strong>its to other types <strong>of</strong> PEs.<br />
The adoption <strong>of</strong> the single <strong>tax</strong>payer approach results in<br />
applying the OECD approach in different manners depending<br />
on what type <strong>of</strong> PE is involved, which is<br />
clearly unreasonable.<br />
Also, the adoption <strong>of</strong> the single <strong>tax</strong>payer approach<br />
would make article 5(5) <strong>of</strong> the OECD model superfluous,<br />
which is against one <strong>of</strong> the main principles that<br />
guides the legal interpretation process — that the law<br />
does not have useless words.<br />
Finally, considerations <strong>of</strong> a practical nature should<br />
not overcome a legal interpretation that is harmonious<br />
with the wording <strong>of</strong> the legal text, and is the reason<br />
why the authorized OECD approach should prevail<br />
over the single <strong>tax</strong>payer approach, even if the former<br />
may be a more difficult application in practice.<br />
SPECIAL REPORTS<br />
The analysis <strong>of</strong> the relevant case law shows that attribution<br />
<strong>of</strong> pr<strong>of</strong>its to PEs is still a controversial issue,<br />
although a trend towards the adoption <strong>of</strong> the authorized<br />
OECD approach can be seen.<br />
Moreover, the criticisms <strong>of</strong> the application <strong>of</strong> the<br />
authorized OECD approach to treaties currently in<br />
force are somehow weakened as the OECD Committee<br />
on Fiscal Affairs adopted, at its meeting <strong>of</strong> June 24-25,<br />
2008, the revised commentary on the current article 7<br />
<strong>of</strong> the OECD model and included it in the 2008 update<br />
to the model.<br />
Tax practice shows that there will always be room<br />
to discuss the legal status <strong>of</strong> the OECD commentary<br />
as well as the historical debate between the static and<br />
ambulatory interpretation <strong>of</strong> the commentary.<br />
Therefore, the states that concluded OECDpatterned<br />
treaties should put all their efforts into implementing<br />
the necessary changes to adopt the authorized<br />
OECD approach because only a uniform interpretation<br />
<strong>of</strong> article 7 <strong>of</strong> the OECD model among the states can<br />
ensure that no double <strong>tax</strong>ation will arise, greatly benefiting<br />
cross-border trade. ◆<br />
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U.S. Tax Review<br />
by James P. Fuller<br />
James P. Fuller is an attorney and a partner at Fenwick & West in Mountain View, Calif.<br />
Contract Manufacturing: Final Regulations<br />
The IRS and Treasury issued final contract manufacturing<br />
regulations that will apply to <strong>tax</strong> years <strong>of</strong><br />
controlled foreign corporations beginning after June 30,<br />
2009. (For the final regulations, see Doc 2008-27115 or<br />
2008 WTD 249-34.) New branch rule regulations were<br />
also issued, albeit in temporary form. Those are discussed<br />
separately below. A <strong>tax</strong>payer may choose to apply<br />
the new contract manufacturing regulations and the<br />
temporary branch rule regulations retroactively for its<br />
open <strong>tax</strong> years. A <strong>tax</strong>payer may so choose only if the<br />
<strong>tax</strong>payer and all members <strong>of</strong> its affiliated group apply<br />
both the contract manufacturing regulations and the<br />
temporary branch rule regulations in their entirety to<br />
the earliest <strong>tax</strong> year <strong>of</strong> each CFC that ends with or<br />
within an open <strong>tax</strong> year <strong>of</strong> the <strong>tax</strong>payer and to all subsequent<br />
<strong>tax</strong> years <strong>of</strong> the <strong>tax</strong>payer.<br />
Substantial Contribution Test: Employees<br />
The proposed regulations provided that a CFC will<br />
satisfy the substantial important contribution test regarding<br />
personal property only if all the facts and circumstances<br />
show that the CFC made a substantial contribution<br />
through the activities <strong>of</strong> its employees to the<br />
manufacture <strong>of</strong> the property. The proposed regulations<br />
provided a nonexclusive list <strong>of</strong> activities to be considered<br />
in determining whether the CFC satisfies the substantial<br />
contribution test.<br />
The final regulation defines employees by reference<br />
to Treas. reg. section 31.3121(d)-1(c). That provision,<br />
entitled ‘‘Common-Law Employees,’’ states that every<br />
individual is an employee if, under the usual commonlaw<br />
rules, the relationship between him and the person<br />
for whom he performs services is the legal relationship<br />
<strong>of</strong> employer and employee. It continues by stating that<br />
generally, such a relationship exists when the person<br />
for whom services are performed has the right to con-<br />
trol and direct the individual who performs the services,<br />
not only as to the result to be accomplished by<br />
the work but also as to the details and means by which<br />
that result is accomplished. That is, the regulation<br />
states, an employee is subject to the will and control <strong>of</strong><br />
the employer and not only as to what will be done but<br />
how it will be done.<br />
It is not necessary under that provision that the employer<br />
direct or control the manner in which the services<br />
are performed; it is sufficient if he has the right to<br />
do so.<br />
The right to discharge is also an important factor<br />
indicating that the person possessing that right is an<br />
employer. Other factors characteristic <strong>of</strong> an employer,<br />
but not necessarily present in every case, are the furnishing<br />
<strong>of</strong> tools, and the furnishing <strong>of</strong> a place to work,<br />
to the individual who performs the services.<br />
If an individual is subject to the control and direction<br />
<strong>of</strong> another merely as to the result to be accomplished<br />
by the work and not as to the means and<br />
methods for accomplishing the result, he generally is<br />
an independent contractor. An individual performing<br />
services as an independent contractor is not as to those<br />
services an employee under the usual common-law<br />
rules. Whether the relationship <strong>of</strong> an employer and<br />
employee exists will be determined upon an examination<br />
<strong>of</strong> the facts <strong>of</strong> each case.<br />
The IRS and Treasury state that this clarification <strong>of</strong><br />
the term ‘‘employee’’ will promote more effective application<br />
<strong>of</strong> the contract manufacturing regulations. The<br />
IRS and Treasury believe that the activities performed<br />
by certain nonpayroll workers should be considered in<br />
determining whether a CFC provides a substantial contribution<br />
through its employees. The IRS and Treasury<br />
concluded that it would be inappropriate to broaden<br />
the definition <strong>of</strong> employee to include anyone in an<br />
agency relationship with the CFC, because it could<br />
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SPECIAL REPORTS<br />
create unintended branch rule issues for <strong>tax</strong>payers (for<br />
example, as a result <strong>of</strong> employees <strong>of</strong> a contract manufacturer<br />
being treated as employees <strong>of</strong> the CFC under<br />
such a definition). 1<br />
Thus, the final regulations, the preamble states, provide<br />
that employee means any individual who under<br />
Treas. reg. section 31.3121(d)-1(c) has the status <strong>of</strong> an<br />
employee for U.S. federal income <strong>tax</strong> purposes. This<br />
definition <strong>of</strong> the term ‘‘employee’’ may encompass<br />
some seconded workers, part-time workers, workers on<br />
the payroll <strong>of</strong> a related employment company whose<br />
activities are directed and controlled by CFC employees,<br />
and contractors, so long as those individuals<br />
are deemed to be employees <strong>of</strong> the CFC under Treas.<br />
reg. section 31.3121(d)-1(c).<br />
The preamble <strong>notes</strong> that this definition may result in<br />
an individual being treated as an employee <strong>of</strong> two or<br />
more entities simultaneously.<br />
Substantial Contribution Activities<br />
The substantial contribution activities, that is, the<br />
nonexclusive list <strong>of</strong> activities that will be considered in<br />
determining whether manufacturing takes place, are at<br />
the heart <strong>of</strong> the new regulation. They were reworded<br />
somewhat and are set forth below:<br />
1. Oversight and direction <strong>of</strong> the activities or<br />
processes pursuant to which the property is<br />
manufactured, produced, or constructed (under<br />
the ‘‘physical manufacturing’’ rules).<br />
2. Activities that are considered in, but that are<br />
insufficient to satisfy, the tests for ‘‘physical<br />
manufacturing.’’<br />
3. Material selection, vendor selection, or control<br />
<strong>of</strong> the raw materials, work-in-process, or finished<br />
goods.<br />
4. Management <strong>of</strong> manufacturing costs or capabilities<br />
(for example, managing the risk <strong>of</strong> loss,<br />
cost reduction, or efficiency initiatives associated<br />
with the manufacturing process, demand planning,<br />
production scheduling, or hedging raw material<br />
costs).<br />
5. Control <strong>of</strong> manufacturing-related logistics.<br />
6. Quality control (for example, sample testing or<br />
establishment <strong>of</strong> quality control standards).<br />
7. Developing, or directing the use or development<br />
<strong>of</strong>, product design and design specifications,<br />
as well as trade secrets, technology, or other intellectual<br />
property for the purpose <strong>of</strong> manufacturing,<br />
producing, or constructing the personal property.<br />
1 See below for a discussion <strong>of</strong> the possible effects <strong>of</strong> this new<br />
rule under the temporary branch rule regulations.<br />
Under Treas. reg. section 1.954-3(a)(4)(iv)(c), all<br />
CFC employee functions contributing to the manufacture<br />
<strong>of</strong> the personal property will be considered in the<br />
aggregate when determining whether a substantial contribution<br />
is made to the manufacture <strong>of</strong> the personal<br />
property through the activities <strong>of</strong> the CFC’s employees.<br />
There is no single activity that will be accorded more<br />
weight than any other activity in every case or that will<br />
be required to be performed in all cases. There is no<br />
minimum threshold for functions performed by employees<br />
<strong>of</strong> a CFC before the functions regarding a<br />
given activity may be taken into account as part <strong>of</strong> the<br />
substantial contribution test. Therefore, all functions<br />
performed by a CFC’s employees are considered (and<br />
given appropriate weight) under the substantial contribution<br />
test, even if the CFC’s employees perform only<br />
some <strong>of</strong> the functions in connection with any one activity<br />
(for example, some <strong>of</strong> the vendor selection) considered<br />
under that test.<br />
The weight given to any functions performed by employees<br />
<strong>of</strong> the CFC regarding any activity will be<br />
based on the economic significance <strong>of</strong> those functions<br />
to the manufacture, production, or construction <strong>of</strong> the<br />
relevant personal property and will vary with the facts<br />
and circumstances. Only activities <strong>of</strong> the CFC’s employees<br />
are considered in the substantial contribution<br />
analysis, and, consequently, purely contractual assumptions<br />
<strong>of</strong> risk are not considered in the substantial contribution<br />
analysis. A CFC will not be precluded from<br />
making a substantial contribution simply because other<br />
persons make a substantial contribution to the manufacture,<br />
production, or construction <strong>of</strong> that property.<br />
The importance <strong>of</strong> oversight and direction <strong>of</strong> the<br />
activities or processes under which personal property is<br />
manufactured, produced, or constructed will vary<br />
based on the facts and circumstances associated with<br />
the manufacture, production, or construction at issue.<br />
The preamble states that oversight and direction <strong>of</strong> the<br />
activities or process under which personal property is<br />
manufactured are likely to be important elements in<br />
many substantial contribution analyses. In some industries,<br />
a substantial contribution could be made by a<br />
CFC without its employees engaging in oversight and<br />
direction <strong>of</strong> the activities or process under which personal<br />
property is manufactured.<br />
Since the regulations provide that only activities <strong>of</strong><br />
the CFC’s employees are considered in the analysis,<br />
mere contractual rights, legal title, <strong>tax</strong> ownership, or<br />
assumption <strong>of</strong> economic risk are not considered in the<br />
substantial contribution analysis. The CFC does not<br />
need to own the raw materials that are used in the<br />
manufacturing process.<br />
The proposed regulations used the term ‘‘management<br />
<strong>of</strong> the manufacturing pr<strong>of</strong>its.’’ The IRS and Treasury<br />
intend that the substantial contribution test recognize<br />
contributions made by a CFC’s employees to the<br />
manufacturing process through functions that help ensure<br />
a plant is run in an economically efficient manner,<br />
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such as optimization <strong>of</strong> plan capacity and reduction <strong>of</strong><br />
waste (for example, waste <strong>of</strong> raw materials). However,<br />
not all corporate managerial decisions are intended to<br />
be considered in the substantial contribution test, because<br />
they may not be directly related to the manufacture<br />
<strong>of</strong> the personal property. For example, the IRS<br />
and Treasury do not intend that corporate finance decisions<br />
be considered in the substantial contribution test.<br />
Similarly, the IRS and Treasury do not intend that the<br />
general management <strong>of</strong> enterprise risk be considered in<br />
the substantial contribution test.<br />
In considering logistics, the activity is intended to<br />
include, for example, arranging for delivery <strong>of</strong> raw materials<br />
to a contract manufacturer, but to exclude delivery<br />
<strong>of</strong> finished goods to a customer. Thus, the final<br />
regulations revised the activities’ description to read<br />
‘‘control <strong>of</strong> manufacturing related logistics.’’<br />
Changes were made in the ‘‘use <strong>of</strong> trade secrets’’<br />
provision (number 7 above) to clarify that developing,<br />
or directing the use or development <strong>of</strong>, trade secrets,<br />
technology, or other intellectual property are considered<br />
under the substantial contribution test, but only<br />
when activities <strong>of</strong> this nature are undertaken for the<br />
purpose <strong>of</strong> the manufacture <strong>of</strong> the personal property.<br />
The term ‘‘protection’’ regarding trade secrets was<br />
deleted. The IRS and Treasury were concerned that<br />
absent this clarification, the final regulations could read<br />
to provide that legal work performed by a CFC’s inhouse<br />
legal staff was considered under the substantial<br />
contribution test, including in cases in which, for example,<br />
litigation success could be heavily correlated to<br />
pr<strong>of</strong>itability or business failure regarding a product.<br />
The activity as described in both the proposed and<br />
final regulations concerns intellectual property used in<br />
the manufacture <strong>of</strong> the personal property. Thus, developing,<br />
or directing the use or development <strong>of</strong>, marketing<br />
intangibles is not intended to be considered in the<br />
substantial contribution test.<br />
Other Matters<br />
The IRS and Treasury had requested comments on<br />
whether the substantial contribution test should include<br />
an antiabuse rule and safe harbor. In particular, comments<br />
were requested as to whether it would be appropriate<br />
to add an antiabuse rule to prevent a CFC from<br />
satisfying the substantial contribution test when a significant<br />
part <strong>of</strong> the direct or indirect contributions to<br />
the manufacture <strong>of</strong> personal property provided collectively<br />
by the CFC and any related U.S. persons are provided<br />
by one or more related U.S. persons. Commentators<br />
recommended that in determining whether a CFC<br />
makes a substantial contribution, it should not be relevant<br />
whether other persons (whether U.S. or foreign,<br />
related or unrelated) contribute to the manufacturing<br />
process. The IRS and Treasury agreed with those commentators.<br />
Thus, the final regulations do not adopt an<br />
antiabuse rule.<br />
SPECIAL REPORTS<br />
The IRS and Treasury also concluded that no safe<br />
harbor could fairly apply across the range <strong>of</strong> industries<br />
potentially subject to these contract manufacturing<br />
rules, and therefore no safe harbor was provided in the<br />
final regulations.<br />
A CFC may provide a<br />
substantial contribution to<br />
a largely automated<br />
manufacturing process<br />
through its employees.<br />
Commentators requested that the regulations adopt<br />
principles to determine when the employees <strong>of</strong> a partnership<br />
should be treated as employees <strong>of</strong> the CFC for<br />
purposes <strong>of</strong> determining whether the CFC’s relative<br />
economic interest in the partnership should be relevant<br />
to determining whether the CFC satisfies the substantial<br />
contribution test. The IRS and Treasury concluded<br />
that this issue was beyond the scope <strong>of</strong> the regulatory<br />
project, but they continue to study the issue and welcome<br />
comments. Thus, the final regulation provides<br />
only that a CFC’s distributive share <strong>of</strong> income <strong>of</strong> a<br />
partnership will be considered earned from products<br />
manufactured, produced, or constructed by the CFC<br />
only if the manufacturing exception would have applied<br />
to exclude the income from subpart F income if<br />
the CFC had earned the income directly, determined<br />
by taking into account only the activities <strong>of</strong> the employees<br />
<strong>of</strong>, and the property owned by, the partnership.<br />
The proposed regulations contained a rebuttable presumption<br />
that a CFC does not satisfy the substantial<br />
contribution test when the activities <strong>of</strong> a branch <strong>of</strong> the<br />
CFC satisfy the physical manufacturing test. In response<br />
to comments, the IRS and Treasury concluded<br />
that the substantial contribution test can be administered<br />
without the benefit <strong>of</strong> a rebuttable presumption,<br />
and the final regulations do not contain this rebuttable<br />
presumption.<br />
Automated manufacturing (Example 4 in the proposed<br />
regulations) was the subject <strong>of</strong> significant comment.<br />
A number <strong>of</strong> examples were added to clarify<br />
that a CFC may provide a substantial contribution to a<br />
largely automated manufacturing process through its<br />
employees. The examples are discussed below.<br />
The IRS and Treasury generally agreed with commentators<br />
that if the substantial contribution test is<br />
sufficient to constitute the manufacture <strong>of</strong> the personal<br />
property where a CFC substantially contributes to the<br />
manufacture, production, or construction <strong>of</strong> that property,<br />
then it should be equally sufficient if those activities<br />
are performed by a related person in the CFC’s<br />
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SPECIAL REPORTS<br />
country <strong>of</strong> organization. Therefore, the final regulations<br />
provide that the same-country manufacturing exception<br />
is available to <strong>tax</strong>payers in cases when a related<br />
person provides a substantial contribution to the manufacture<br />
<strong>of</strong> the personal property in the CFC’s country<br />
<strong>of</strong> organization. The final regulations also retain the<br />
rule provided in the proposed regulations to reflect that<br />
personal property manufactured, produced, or constructed<br />
in the country <strong>of</strong> organization <strong>of</strong> the selling<br />
corporation will qualify for the same country exception<br />
regardless <strong>of</strong> whose employees engage in the qualifying<br />
manufacturing activities in that country.<br />
The IRS and Treasury continue to believe, as described<br />
in the preamble to the proposed regulations,<br />
that the so-called ‘‘its’’ argument is contrary to existing<br />
law and represents an incorrect reading <strong>of</strong> section<br />
954(d)(1). Thus, despite some criticism by commentators<br />
and at the hearings on the proposed regulations,<br />
the final regulations maintain the rules provided in the<br />
proposed regulations regarding when personal property<br />
sold by a CFC will be considered to be other than the<br />
property purchased by the CFC: ‘‘A controlled foreign<br />
corporation will not be treated as having manufactured,<br />
produced, or constructed personal property which the<br />
corporation sells merely because the property is sold in<br />
a different form than the form in which it was purchased.’’<br />
Examples<br />
Example 1<br />
FS, the CFC in question, does not exercise, through<br />
its employees, its powers to control the raw materials,<br />
work in process, or finished goods, and FS also does<br />
not exercise its powers <strong>of</strong> oversight and direction. Likewise,<br />
FS does not through its employees, develop, or<br />
direct the use or development <strong>of</strong> the intellectual property<br />
for the purpose <strong>of</strong> manufacturing Product X. FS<br />
does not satisfy the substantial contribution test.<br />
Example 2<br />
The facts are the same as in Example 1, except that<br />
FS, through its employees, engages in product design<br />
and quality control and controls manufacturing-related<br />
logistics. FS’s employees exercise the right to oversee<br />
and direct the activities <strong>of</strong> the third-party contract<br />
manufacturer in the production <strong>of</strong> Product X. FS satisfies<br />
the substantial contribution test.<br />
Example 3<br />
FS, a CFC, enters into a contract with an unrelated<br />
contract manufacturer to produce Product X. Employees<br />
<strong>of</strong> FS select the materials that will be used to<br />
manufacture the product. FS does not own the materials<br />
or work-in-process during the manufacturing process.<br />
FS, through its employees, exercises oversight and<br />
direction <strong>of</strong> the manufacturing process and provides<br />
quality control. FS manages the manufacturing costs<br />
and capabilities <strong>of</strong> the product by managing the risk <strong>of</strong><br />
loss and engaging in demand planning and production<br />
scheduling. FS satisfies the substantial contribution<br />
test.<br />
Example 4<br />
FS purchases raw materials from a related person.<br />
They are manufactured into Product X by an unrelated<br />
contract manufacturer under an agreement. The contract<br />
manufacturer contracts with another corporation<br />
for its employees to operate the contract manufacturer’s<br />
plant and transform, assemble, or convert the raw materials<br />
into Product X. Apart from physical performance<br />
<strong>of</strong> the substantial transformation, assembly, or<br />
conversion <strong>of</strong> the raw materials into Product X, employees<br />
<strong>of</strong> FS perform all <strong>of</strong> the other manufacturing<br />
activities required in connection with the manufacture<br />
<strong>of</strong> Product X (for example, oversight and direction <strong>of</strong><br />
the manufacturing process; vendor selection; control <strong>of</strong><br />
raw materials, work-in-process and finished goods; control<br />
<strong>of</strong> manufacturing-related logistics; and qualify control).<br />
FS satisfies the substantial contribution test.<br />
Example 5<br />
FS purchases raw materials from a related person.<br />
The raw materials are manufactured into Product X by<br />
an unrelated contract manufacturer selected by FS. At<br />
all times, FS retains ownership <strong>of</strong> the raw materials,<br />
work-in-process, and finished goods. FS retains the<br />
right to oversee and direct the activities or process according<br />
to which the product is manufactured, but does<br />
not exercise, through its employees, its powers <strong>of</strong> oversight<br />
and direction. FS is the owner <strong>of</strong> sophisticated<br />
s<strong>of</strong>tware and network systems that remotely and automatically<br />
(without human involvement) take orders,<br />
route them to the contract manufacturer, order raw materials,<br />
and perform quality control. FS has a small<br />
number <strong>of</strong> computer technicians who monitor the s<strong>of</strong>tware<br />
and network systems to ensure that they are running<br />
smoothly and apply any necessary patches or<br />
fixes. The s<strong>of</strong>tware and systems were developed by employees<br />
<strong>of</strong> the U.S. parent company. The parent company’s<br />
employees supervise the computer technicians,<br />
evaluate the results <strong>of</strong> the automated manufacturing<br />
business, and make operational and manufacturing decisions.<br />
The parent’s employees develop and provide to<br />
FS all <strong>of</strong> the upgrades to the s<strong>of</strong>tware and network<br />
systems. The parent’s employees also direct and control<br />
other aspects <strong>of</strong> the manufacturing process such as<br />
vendor material selection, management <strong>of</strong> the manufacturing<br />
costs and capabilities, and the selection <strong>of</strong> the<br />
contract manufacturer. FS does not satisfy the substantial<br />
contribution test.<br />
Example 6<br />
Assume the same facts as in Example 5, except that<br />
FS, through its employees, engages in the activities undertaken<br />
by the parent’s employees in Example 5. The<br />
parent’s employees also contribute to product and<br />
manufacturing process design and provide support and<br />
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oversight to FS in connection with the functions performed<br />
by FS through its employees. FS satisfies the<br />
substantial contribution test. Selection <strong>of</strong> the contract<br />
manufacturer, even though not specifically identified on<br />
the nonexclusive factors list, is considered in determining<br />
whether FS makes a substantial contribution to the<br />
manufacture <strong>of</strong> Product X through its employees.<br />
Example 7<br />
Assume the same facts as in Example 6, except that<br />
the s<strong>of</strong>tware and network systems, and the upgrades to<br />
those systems, were purchased by FS rather than developed<br />
by employees <strong>of</strong> FS. FS satisfies the substantial<br />
contribution test. The lack <strong>of</strong> performance <strong>of</strong> s<strong>of</strong>tware<br />
and network system development activities is not determinative<br />
under the facts and circumstances <strong>of</strong> the business.<br />
Further, this determination does not require a<br />
comparison between the activities <strong>of</strong> FS and the activities<br />
<strong>of</strong> the domestic parent.<br />
Example 8<br />
FS has raw materials manufactured into Product X<br />
by an unrelated contract manufacturer. FS controls the<br />
raw materials, work-in-process, and finished goods. FS<br />
controls the manufacturing-related logistics, manages<br />
the manufacturing costs and capabilities, and provides<br />
quality control for the contract manufacturer’s manufacturing<br />
process and product. No intellectual property<br />
<strong>of</strong> significant value is required to manufacture the<br />
product. FS does not own any intellectual property or<br />
hold an exclusive or nonexclusive right to manufacture<br />
Product X. FS satisfies the substantial contribution test.<br />
Example 9<br />
FS1 and FS2, unrelated CFCs, contract with an unrelated<br />
contract manufacturer to manufacture Product<br />
X. Neither FS1 nor FS2 owns the materials or work-inprocess<br />
during the manufacturing. FS1, through its employees,<br />
designs Product X. FS1 directs the use <strong>of</strong> the<br />
product design and design specifications and other intellectual<br />
property for the purpose <strong>of</strong> manufacturing<br />
Product X. Employees <strong>of</strong> FS1 also select the materials<br />
that will be used in the manufacture <strong>of</strong> the product<br />
and the vendors to provide those materials. FS2,<br />
through its employees, designs the process for manufacturing<br />
Product X. FS2, through its employees, manages<br />
the manufacturing costs and capabilities for Product X.<br />
FS1 and FS2 each provide quality control and oversight<br />
and direction <strong>of</strong> the contract manufacturer’s<br />
manufacturing activities for different aspects <strong>of</strong> the<br />
manufacture <strong>of</strong> Product X. Both FS1 and FS2 satisfy<br />
the substantial contribution test. Each independently<br />
makes a substantial contribution through the activities<br />
<strong>of</strong> its employees for the manufacture <strong>of</strong> the product.<br />
Example 10<br />
FS purchases raw materials and has them manufactured<br />
into Product X by an unrelated contract manufacturer.<br />
Products in the X industry are distinguished<br />
(and vary widely in value) based on the raw materials<br />
used to make the product and the product design. FS<br />
SPECIAL REPORTS<br />
designs the product and selects the materials that the<br />
contract manufacturer will use to manufacture the<br />
product. FS also manages the manufacturing costs and<br />
capabilities. Product X can be manufactured from the<br />
raw materials to FS’s design and specifications without<br />
significant oversight and direction, quality control, or<br />
control <strong>of</strong> manufacturing-related logistics. The activities<br />
most relevant to the substantial contribution analysis<br />
under these facts are material selection, product design,<br />
and management <strong>of</strong> the manufacturing costs and capabilities.<br />
FS makes a substantial contribution through<br />
the activities <strong>of</strong> its employees to the manufacture <strong>of</strong><br />
the product.<br />
Example 11<br />
FS purchases raw materials and has them manufactured<br />
into Product X by an unrelated contract manufacturer.<br />
FS controls the raw material, work-in-process,<br />
and finished goods; manages the manufacturing costs<br />
and capabilities; and provides oversight and direction<br />
<strong>of</strong> the manufacture <strong>of</strong> Product X. Employees <strong>of</strong> FS<br />
visit the manufacturer’s facility for one week each<br />
quarter and perform quality control tests on a random<br />
sample <strong>of</strong> the units <strong>of</strong> Product X produced during the<br />
week. In the industry, quarterly visits to a manufacturing<br />
facility by qualified persons are sufficient to control<br />
the quality <strong>of</strong> manufacturing. FS satisfies the substantial<br />
contribution test.<br />
Manufacturing Branch Rules<br />
The manufacturing branch rule regulations that were<br />
proposed with the contract manufacturing regulations<br />
were adopted as temporary regulations. (For the proposed<br />
regulations, see Doc 2008-27116 or 2008 WTD 249-<br />
35.) Treasury and the IRS presumably concluded that<br />
there were sufficient changes in these regulations such<br />
that they should be issued in temporary form and also<br />
reproposed. A public hearing has been scheduled for<br />
the proposed version <strong>of</strong> these regulations on April 20,<br />
2009. The temporary regulations apply to <strong>tax</strong> years <strong>of</strong><br />
CFCs beginning after June 30, 2009, and for <strong>tax</strong> years<br />
<strong>of</strong> U.S. shareholders in which these <strong>tax</strong> years <strong>of</strong> CFCs<br />
end. As discussed above, the temporary regulations<br />
under some conditions may be applied retroactively by<br />
a <strong>tax</strong>payer for its open <strong>tax</strong> years.<br />
Branch Definition: Important Issues<br />
The proposed regulations did not define the term<br />
‘‘branch.’’ Some commentators suggested that the regulations<br />
define the term. These commentators suggested<br />
various definitions for the IRS and Treasury to consider.<br />
Some commentators suggested, for example, that<br />
a branch be defined as a permanent establishment, as a<br />
business activity in a jurisdiction outside a CFC’s<br />
country <strong>of</strong> organization that has separate books and<br />
records, or as a trade or business outside a CFC’s<br />
country <strong>of</strong> organization. Commentators pointed to precedents<br />
in the section 367 and section 987 regulations.<br />
Alternatively, some commentators requested that the<br />
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SPECIAL REPORTS<br />
regulations make clear that a de minimis amount <strong>of</strong><br />
activity outside a CFC’s country <strong>of</strong> organization (for<br />
example, traveling employees) does not constitute a<br />
branch.<br />
Other commentators warned that requiring too high<br />
a level <strong>of</strong> activity outside a CFC’s country <strong>of</strong> organization<br />
before a CFC is treated as having a branch<br />
would make it possible for a CFC organized in a<br />
lower-<strong>tax</strong>ed jurisdiction to contribute substantially to<br />
manufacturing activities in a higher-tier jurisdiction<br />
without causing the CFC to operate through a branch.<br />
Still other commentators suggested that courts have<br />
concluded that the IRS and Treasury lack the regulatory<br />
authority to determine what constitutes a branch,<br />
and that they may address only the consequences flowing<br />
from the existence <strong>of</strong> a branch.<br />
The IRS and Treasury determined that defining a<br />
branch was beyond the scope <strong>of</strong> this regulatory project.<br />
However, the temporary regulations retain an example<br />
similar to an example in the proposed regulations that<br />
illustrates that employees <strong>of</strong> a CFC that travel to a<br />
contract manufacturer’s location outside the CFC’s<br />
country <strong>of</strong> organization do not necessarily give rise to<br />
a branch in that location.<br />
An important issue in this regard, however, was left<br />
unstated and unaddressed in both the branch rule regulations<br />
and the preamble to those regulations. The contract<br />
manufacturing regulations define ‘‘employee’’ by<br />
reference to section 3121. The branch rule regulations<br />
are silent on this point. 2<br />
If employees <strong>of</strong> one corporate entity (Corp B) can<br />
be treated as a branch <strong>of</strong> another corporate entity,<br />
Corp A, so that Corp A has a branch in Country B<br />
simply because an IRS examining agent contends that<br />
Corp A’s employees have section 3121 control over<br />
Corp B’s employees, then the new branch rule is much<br />
different from the old branch rule.<br />
Ashland Oil and Vetco may have been overruled, or at<br />
least placed in question. There is no reason this lookthrough,<br />
if it is the rule, couldn’t apply to unrelated<br />
persons, as well as related persons. It also has nothing<br />
necessarily to do with contract manufacturing; this rule<br />
also presumably could apply in other branch rule contexts,<br />
for example, under the sales branch rule.<br />
Should it make a difference whether it is the <strong>tax</strong>payer<br />
who asserts that certain persons are employees<br />
for purposes <strong>of</strong> the contract manufacturing rules, or<br />
can IRS examining agents on their own make that assertion?<br />
Could one such ‘‘employee’’ constitute a<br />
branch, or does it require many ‘‘employees’’?<br />
The court in Ashland Oil considered the dictionary<br />
definition <strong>of</strong> branch (‘‘division, <strong>of</strong>fice or other unit <strong>of</strong><br />
business located at a different location from the main<br />
2 See, however, note 1, supra.<br />
<strong>of</strong>fice or headquarters’’; a business dictionary similarly<br />
stated an ‘‘<strong>of</strong>fice’’ in a different location from the ‘‘parent<br />
company.’’)<br />
The court in Ashland stated that regardless <strong>of</strong> the<br />
precise ordinary meaning <strong>of</strong> branch, the court was<br />
confident that it didn’t encompass Tensia, an unrelated<br />
corporation operating under an arm’s-length contractual<br />
arrangement with the <strong>tax</strong>payer’s CFC.<br />
Until this treatment <strong>of</strong> ‘‘employees’’ is made clearer<br />
under the branch rule regulations, it might be a reason<br />
not to apply the contract manufacturing regulations<br />
retroactively. To do so, the branch rule regulations also<br />
must be applied retroactively.<br />
Also, a recent statement by an IRS spokesperson<br />
raises more questions. It was to the effect that a sales<br />
branch might exist even in the absence <strong>of</strong> selling activities:<br />
‘‘If a branch is booking sales income, the IRS will<br />
argue that it is a sales branch.’’ I certainly do not see<br />
such a rule anywhere in the regulations, where selling<br />
activity is necessary to have a sales branch. It seems at<br />
odds with the court’s discussion in Ashland Oil as well<br />
as the statutory language. To be consistent with Ashland<br />
Oil and section 954(d), a branch would need to be<br />
present before this could arise. But that was not the<br />
question being addressed. The statement was in response<br />
to a question about whether the existence <strong>of</strong> a<br />
sales branch is based on earning income or sales activities.<br />
We may have some new rules.<br />
Hypothetical Effective Tax Rate<br />
The <strong>tax</strong> rate disparity tests take into account the<br />
actual <strong>tax</strong> rate paid on the sales income by the selling<br />
branch or remainder and the hypothetical effective <strong>tax</strong><br />
rate that would be paid by the manufacturing branch<br />
(or remainder) on that sales income under the rules <strong>of</strong><br />
the country in which the manufacturing branch is located<br />
(or, in the case <strong>of</strong> a remainder, the country <strong>of</strong><br />
organization <strong>of</strong> the CFC) if it were derived from the<br />
sources within that country. The IRS and Treasury<br />
agreed with commentators that uniformly available <strong>tax</strong><br />
incentives are to be considered in determining the hypothetical<br />
effective <strong>tax</strong> rate to be used in applying the<br />
<strong>tax</strong> rate disparity tests.<br />
On the other hand, if a sales affiliate in the country<br />
<strong>of</strong> manufacturing can theoretically receive certain <strong>tax</strong><br />
relief by taking certain actions, for example, by applying<br />
for special treatment under a ruling process, but the<br />
<strong>tax</strong>payer has not affirmatively obtained that <strong>tax</strong> relief<br />
for the manufacturing branch (or a remainder), then<br />
the hypothetical effective <strong>tax</strong> rate that would be paid<br />
by the manufacturing branch (or remainder) were it to<br />
derive the sales income should be the effective <strong>tax</strong> rate<br />
that would be applicable in that jurisdiction without<br />
such relief.<br />
The IRS and Treasury state that no change to the<br />
text <strong>of</strong> the existing regulation is necessary to address<br />
these points. However, a new Example 8 is included in<br />
the temporary regulations to illustrate that uniformly<br />
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applicable incentive <strong>tax</strong> rates are taken into account in<br />
determining the hypothetical effective <strong>tax</strong> rate.<br />
Location <strong>of</strong> Manufacturing<br />
Under the proposed regulations, the relevant <strong>tax</strong> rate<br />
disparity test was applied by giving satisfaction <strong>of</strong> the<br />
physical manufacturing test precedence over satisfaction<br />
<strong>of</strong> the substantial contribution test when multiple<br />
branches, or one or more branches and the remainder<br />
<strong>of</strong> the CFC, perform manufacturing activities for the<br />
same item <strong>of</strong> personal property.<br />
If more than one branch (or one or more branches<br />
and the remainder <strong>of</strong> the CFC) each independently<br />
satisfies the physical manufacturing test, then the<br />
branch or the remainder <strong>of</strong> the CFC located or organized<br />
in the jurisdiction that would impose the lowest<br />
effective rate <strong>of</strong> <strong>tax</strong> is treated as the location <strong>of</strong> manufacturing,<br />
producing, or constructing the personal property<br />
for purposes <strong>of</strong> applying the <strong>tax</strong> rate disparity<br />
tests.<br />
If none <strong>of</strong> the branches or the remainder <strong>of</strong> the<br />
CFC independently satisfies the physical manufacturing<br />
test, but the CFC as a whole satisfies the substantial<br />
contribution test, then under the proposed regulations,<br />
the location <strong>of</strong> manufacturing was the location <strong>of</strong> the<br />
branch or the remainder <strong>of</strong> the CFC that provides the<br />
predominant amount <strong>of</strong> the CFC’s substantial contribution<br />
to the manufacturing <strong>of</strong> the personal property.<br />
If a predominant amount <strong>of</strong> the CFC’s contribution is<br />
not provided by any one location, then under the proposed<br />
regulations, the location <strong>of</strong> manufacturing for<br />
purposes <strong>of</strong> applying the manufacturing branch <strong>tax</strong><br />
rate disparity test was that place (either the remainder<br />
<strong>of</strong> the CFC or one <strong>of</strong> its branches) where the manufacturing<br />
activity for that property is performed and that<br />
would impose the highest effective <strong>tax</strong> rate.<br />
Commentators suggested that the same rule should<br />
apply consistently when a branch (or remainder) independently<br />
satisfies the manufacturing test, regardless <strong>of</strong><br />
whether it satisfies the physical manufacturing test or<br />
the substantial contribution test. The IRS and Treasury<br />
agree. Therefore, the rules in the proposed regulations<br />
were modified. The temporary regulations provide that<br />
the lowest-<strong>of</strong>-all-rates rule will apply whenever a<br />
branch (or remainder) independently satisfies the<br />
manufacturing test.<br />
The IRS and Treasury also believe, however, that<br />
providing for parity <strong>of</strong> treatment for satisfaction <strong>of</strong> the<br />
physical manufacturing test and the substantial contribution<br />
test regarding the lowest-<strong>of</strong>-all-rates rule is not<br />
sufficient to determine the location <strong>of</strong> manufacturing<br />
in cases in which a CFC satisfies the substantial contribution<br />
test, yet no branch (or remainder) independently<br />
satisfies the substantial contribution test.<br />
The temporary regulations thus revise the rules for<br />
determining the location <strong>of</strong> manufacture <strong>of</strong> the personal<br />
property when more than one branch (or one or<br />
more branches and the remainder) contributes to the<br />
SPECIAL REPORTS<br />
manufacture <strong>of</strong> the personal property, but no branch<br />
(or remainder) independently satisfies the physical<br />
manufacturing test or the substantial contribution test.<br />
If a demonstrably greater amount <strong>of</strong> manufacturing<br />
activity regarding personal property occurs in jurisdictions<br />
without <strong>tax</strong> rate disparity relative to the sales or<br />
purchase branch, the location <strong>of</strong> the sales or purchase<br />
branch will be deemed to be the location <strong>of</strong> manufacture<br />
<strong>of</strong> the personal property. Otherwise, the location<br />
<strong>of</strong> manufacture <strong>of</strong> the personal property will be<br />
deemed to be the location <strong>of</strong> a manufacturing branch<br />
(or remainder) that has <strong>tax</strong> rate disparity relative to the<br />
sales or purchase branch.<br />
The location <strong>of</strong> any activity<br />
with respect to the<br />
manufacture <strong>of</strong> the<br />
personal property is where<br />
the CFC’s employees<br />
engage in that activity.<br />
The location <strong>of</strong> any activity for the manufacture <strong>of</strong><br />
the personal property is where the CFC’s employees<br />
engage in that activity. When an employee travels to<br />
perform his or her activities, those activities are<br />
credited to the location in which the activities are conducted<br />
if there is a branch or remainder <strong>of</strong> the CFC in<br />
that jurisdiction. The activities <strong>of</strong> employees while traveling<br />
to a country with a CFC that does not maintain<br />
a branch or remainder are not credited to the branch or<br />
remainder where the traveling employees are regularly<br />
employed for purposes <strong>of</strong> determining the location <strong>of</strong><br />
manufacturing under the branch rule. Those activities,<br />
however, can be taken into account for purposes <strong>of</strong><br />
satisfying the manufacturing exception and the substantial<br />
contribution test.<br />
Multiple Manufacturing Branch Rules Summary<br />
In summary, the rules for multiple locations performing<br />
activities that contribute to the manufacture <strong>of</strong><br />
the product are as follows:<br />
1. If one or more branches or the remainder <strong>of</strong><br />
the CFC independently satisfies the manufacturing<br />
test, the location <strong>of</strong> manufacturing is the<br />
branch with the lowest effective rate <strong>of</strong> <strong>tax</strong> on the<br />
income allocated to the remainder for branch rule<br />
testing purposes.<br />
2. If no location independently satisfies the<br />
manufacturing test, but the CFC as a whole<br />
makes a substantial contribution to the manufacture<br />
<strong>of</strong> personal property, then the location <strong>of</strong><br />
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SPECIAL REPORTS<br />
manufacturing is the tested manufacturing location<br />
unless the tested sales location provides a<br />
demonstrably greater contribution to the manufacture<br />
<strong>of</strong> the property.<br />
3. The tested manufacturing location is the location<br />
<strong>of</strong> any branch or remainder that contributes<br />
to the manufacture <strong>of</strong> the property and that<br />
would be treated as a separate corporation under<br />
the <strong>tax</strong> rate disparity test and that would have the<br />
lowest effective rate <strong>of</strong> <strong>tax</strong> under the <strong>tax</strong> rate disparity<br />
test.<br />
4. The tested sales location is where the CFC<br />
purchases or sells the personal property. The<br />
tested sales location includes the activities <strong>of</strong> any<br />
branch or remainder that would not be treated as<br />
a separate corporation under the <strong>tax</strong> rate disparity<br />
test.<br />
5. The tested manufacturing location will be<br />
deemed to include the activities <strong>of</strong> any branch or<br />
remainder that would be treated as a separate<br />
corporation from the tested sales location under<br />
the <strong>tax</strong> rate disparity test.<br />
6. If the tested sales location provides a demonstrably<br />
greater contribution to the manufacturing,<br />
or if there is no tested manufacturing location,<br />
then the tested sales location is the location <strong>of</strong><br />
manufacturing.<br />
Coordination <strong>of</strong> Branch Rules<br />
The current manufacturing branch rule contemplates<br />
the existence <strong>of</strong> a sales or purchase branch and a<br />
manufacturing branch. The rules provide that in some<br />
instances, the sales or purchase branch is treated as the<br />
remainder <strong>of</strong> the CFC for purposes <strong>of</strong> applying the <strong>tax</strong><br />
rate disparity test. However, the sales or purchase<br />
branch rules <strong>of</strong> the existing regulations do not indicate<br />
that those rules do not apply in cases in which the<br />
manufacturing branch rules are applied. Treasury and<br />
the IRS believe that if one or more sales or purchase<br />
branches are used in addition to a manufacturing<br />
branch, and the manufacturing branch rule’s multiple<br />
branch rule test is applied for income from the sale <strong>of</strong><br />
an item <strong>of</strong> personal property, then the sales or purchasing<br />
branch rules should not apply to determine<br />
whether that income is foreign base company sales income<br />
(FBCSI). The temporary regulations reflect this<br />
new clarifying coordination rule.<br />
Unrelated to Unrelated Transactions<br />
Commentators suggested that there was uncertainty<br />
as to whether a substantial contribution to the manufacture,<br />
production, or construction <strong>of</strong> personal property<br />
by a CFC could cause the CFC to earn FBCSI in<br />
cases when, in the absence <strong>of</strong> the substantial contribution<br />
test, some <strong>tax</strong>payers had taken the position that<br />
they were outside the scope <strong>of</strong> the FBCSI rules. For<br />
example, the CFC might purchase property from unrelated<br />
persons and sell that property to unrelated per-<br />
sons. Some commentators expressed concern that<br />
transactions that are not currently subject to the existing<br />
regulations may become subject to the regulations<br />
as a result <strong>of</strong> the interaction <strong>of</strong> the substantial contribution<br />
test and the manufacturing branch rule. Other<br />
commentators suggested more generally that it was unclear<br />
if the substantial contribution test might create a<br />
branch through which a CFC carries on activities in a<br />
contract manufacturer’s jurisdiction.<br />
The IRS and Treasury agree that <strong>tax</strong>payers may be<br />
subject to the FBCSI rules as a result <strong>of</strong> CFC employees<br />
performing indicia <strong>of</strong> manufacturing activities<br />
through a branch outside the country <strong>of</strong> organization<br />
<strong>of</strong> the CFC. The IRS and Treasury believe this result is<br />
clear in the proposed regulations, and therefore no<br />
modifications are made to the text <strong>of</strong> the temporary<br />
regulations to further clarify this result.<br />
The IRS and Treasury note in the preamble that in<br />
response to comments, physical manufacturing and<br />
activities satisfying the substantial contribution test are<br />
treated with equal importance. Thus, the IRS and Treasury<br />
did not incorporate in the temporary regulations<br />
an exception for activities performed through a branch<br />
located outside the country <strong>of</strong> organization <strong>of</strong> a CFC<br />
for cases in which, in the absence <strong>of</strong> the substantial<br />
contribution test, some <strong>tax</strong>payers have taken the position<br />
that they were outside the scope <strong>of</strong> the FBCSI<br />
rules.<br />
One commenter recommended that the IRS and<br />
Treasury consider a special delayed effective date to<br />
allow <strong>tax</strong>payers with unrelated to unrelated transactions<br />
that may now become subject to the FBCSI rules<br />
time to restructure their operations in light <strong>of</strong> the regulations.<br />
The commenter argued that these <strong>tax</strong>payers<br />
were outside the scope <strong>of</strong> the FBCSI rules before adoption<br />
<strong>of</strong> these regulations and should be provided<br />
enough time to restructure. A special effective date was<br />
not provided, but the temporary regulations generally<br />
have a delayed effective date.<br />
Examples<br />
I will describe the regulation’s examples in the order<br />
in which they appear in the temporary regulation, and<br />
I will not renumber them. This hopefully will help<br />
readers match up the examples with the text in the<br />
regulation. Unless stated otherwise, FS is a CFC organized<br />
under the laws <strong>of</strong> Country M.<br />
1. Example — Figure 1<br />
FS operates three branches. Branch A in Country A<br />
manufactures Product X. Branch B located in Country<br />
B sells Product X manufactured by Branch A to customers<br />
for use outside Country B. Branch C located in<br />
Country C sells Product X manufactured by Branch A<br />
to customers for use outside Country C. FS conducts<br />
no manufacturing or selling activities <strong>of</strong> its own. Country<br />
M imposes an effective <strong>tax</strong> rate on sales income <strong>of</strong><br />
0 percent. Country A imposes an effective <strong>tax</strong> rate on<br />
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sales income <strong>of</strong> 20 percent. Country B imposes an effective<br />
<strong>tax</strong> rate on sales income <strong>of</strong> 20 percent. Country<br />
C imposes an effective <strong>tax</strong> rate on sales income <strong>of</strong> 18<br />
percent. The manufacturing branch rule is applied to<br />
the sales income derived by Branch B by treating<br />
Branch B as though it alone were the remainder <strong>of</strong> the<br />
CFC. The use <strong>of</strong> Branch B does not have the same <strong>tax</strong><br />
effect as if Branch B were a wholly owned subsidiary,<br />
because the <strong>tax</strong> rate applicable to income allocated to<br />
Branch B (20 percent) is not less than 90 percent <strong>of</strong>,<br />
and at least 5 percentage points less than, the effective<br />
rate <strong>of</strong> <strong>tax</strong> that would apply to that income under the<br />
laws <strong>of</strong> Country A (20 percent). The rules are applied<br />
separately to the sales income derived by Branch C by<br />
treating Branch C as though it alone were the remainder<br />
<strong>of</strong> the CFC. The use <strong>of</strong> Branch C also does not<br />
have the tainted <strong>tax</strong> effect under the rate disparity test.<br />
Under the temporary regulation’s new coordination<br />
rule, the sales branch rules do not apply. (See Figure<br />
1.)<br />
FS<br />
A B C<br />
20%<br />
Mfgs<br />
Figure 1<br />
Does not Mfg or Sell<br />
20% 18%<br />
Sells Sells<br />
2. Example — Figure 2<br />
FS purchases raw materials and sells finished products.<br />
FS is subject to a 10 percent <strong>tax</strong> rate on its sales<br />
income. It has two branches, A, which makes Product<br />
X, and B, which makes Product Y. A’s country <strong>tax</strong>es<br />
sales at 20 percent, and B’s country <strong>tax</strong>es sales at 12<br />
percent. As to Branch A, the branch rule applies, and<br />
A is treated as a separate corporation. As to B, the<br />
branch rule does not cause B to be treated as a separate<br />
corporation. (See Figure 2.)<br />
3. Example 1 — Figure 3<br />
FS has three branches. Branch A located in Country<br />
A designs Product X. Branch B located in Country B<br />
provides quality control and oversight and direction.<br />
Branch C physically manufactures Product X. The<br />
activities <strong>of</strong> Branch A and Branch B do not independently<br />
satisfy the manufacturing rules. Employees<br />
FS<br />
A B<br />
Product<br />
X<br />
20%<br />
Figure 2<br />
<strong>of</strong> FS in Country M purchase the raw materials used<br />
in the manufacture <strong>of</strong> Product X from a related person<br />
and control the work-in-process and finished goods<br />
throughout the manufacturing process. Employees <strong>of</strong><br />
FS in Country M also manage the manufacturing cost<br />
and capabilities and oversee the coordination between<br />
the branches. Employees <strong>of</strong> FS in Country M sell<br />
Product X to unrelated persons for use outside Country<br />
M. The sales income from the sale <strong>of</strong> Product X is<br />
<strong>tax</strong>ed in Country M at an effective rate <strong>of</strong> 10 percent.<br />
Country C imposes an effective rate <strong>of</strong> <strong>tax</strong> <strong>of</strong> 20 percent<br />
on sales income.<br />
Country C is the location <strong>of</strong> manufacture for purposes<br />
<strong>of</strong> applying the branch rule tests, because only<br />
the activities <strong>of</strong> Branch C independently satisfy the<br />
manufacturing rules. Under the branch rule <strong>tax</strong> rate<br />
disparity test, Branch C is treated as a separate corporation.<br />
Therefore, sales <strong>of</strong> Product X by the remainder<br />
<strong>of</strong> FS are treated as sales on behalf <strong>of</strong> Branch C. In<br />
determining whether the remainder <strong>of</strong> FS will qualify<br />
for the manufacturing exception, the activities <strong>of</strong> FS<br />
will include the activities <strong>of</strong> Branch A and Branch B,<br />
respectively, if each <strong>of</strong> those branches would not be<br />
treated as a separate corporation under the <strong>tax</strong> rate<br />
disparity test. (See Figure 3.)<br />
4. Example 2 — See Figure 3.<br />
10%<br />
Product<br />
Y<br />
12%<br />
SPECIAL REPORTS<br />
Sells X and Y<br />
Assume the same facts in Example 1 (3. above), except<br />
that in addition to the design <strong>of</strong> Product X,<br />
Branch A also performs in Country A other manufacturing<br />
activities, including those ascribed to FS in Example<br />
1 that are sufficient to satisfy the substantial<br />
contribution test. Country A imposes a 12 percent <strong>tax</strong><br />
on sales income. Branch A and Branch C through their<br />
activities each independently satisfy the manufacturing<br />
test. Therefore, the branch rule is applied using the<br />
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SPECIAL REPORTS<br />
FS<br />
A B C<br />
Designs X<br />
Figure 3<br />
QC<br />
Oversight<br />
Sells<br />
Purchases RM<br />
Controls inventories<br />
Manages cost/capabilities<br />
Oversees manufacturing<br />
10% <strong>tax</strong><br />
Physical<br />
Mfg X<br />
20% <strong>tax</strong><br />
Location<br />
<strong>of</strong> Mfg<br />
lowest effective <strong>tax</strong> rate that would apply to sales income<br />
in either Country A or Country C. Therefore,<br />
Branch A is treated as the location <strong>of</strong> manufacture.<br />
Neither Branch A nor Branch C is treated as a separate<br />
corporation. Sales <strong>of</strong> Product X by the remainder <strong>of</strong><br />
FS are not treated as made on behalf <strong>of</strong> any branch.<br />
5. Example 3 — Figure 5<br />
FS purchases from a related person raw materials<br />
that are manufactured into Product X by an unrelated<br />
corporation under a contract manufacturing agreement.<br />
FS has two branches. Branch A located in Country A<br />
designs Product X. Branch B in Country B controls<br />
manufacturing-related logistics, provides oversight and<br />
direction during the manufacturing process, and controls<br />
the raw materials and work-in-process. FS manages<br />
the manufacturing costs and capabilities related to<br />
the manufacture <strong>of</strong> Product X through employees located<br />
in Country M. Employees <strong>of</strong> FS located in<br />
Country M oversee the coordination between the<br />
branches. Employees <strong>of</strong> FS located in Country M also<br />
sell Product X to unrelated persons for use outside<br />
Country M. Country M imposes an effective <strong>tax</strong> rate<br />
on sales income <strong>of</strong> 10 percent. Country A imposes an<br />
effective rate <strong>of</strong> <strong>tax</strong> on sales income <strong>of</strong> 20 percent, and<br />
Country B imposes an effective rate <strong>of</strong> <strong>tax</strong> on sales<br />
income <strong>of</strong> 24 percent. Neither the remainder <strong>of</strong> FS nor<br />
any branch <strong>of</strong> FS independently satisfies the manufacturing<br />
test. As a whole, FS provides a substantial contribution<br />
to the manufacture <strong>of</strong> Product X.<br />
The tested sales location is Country M. The location<br />
<strong>of</strong> Branch A is the tested manufacturing location, because<br />
the effective rate <strong>of</strong> <strong>tax</strong> (10 percent) is less than<br />
90 percent <strong>of</strong>, and at least five percentage points less<br />
than, the effective rate <strong>of</strong> <strong>tax</strong> that would apply to this<br />
income in Country A (20 percent), and Country A has<br />
the lowest effective rate <strong>of</strong> <strong>tax</strong> among the manufacturing<br />
branches that would be treated as separate corporations.<br />
The activities <strong>of</strong> Branch B will be included in the<br />
contribution <strong>of</strong> Branch A for purposes <strong>of</strong> determining<br />
the location <strong>of</strong> manufacture, because Branch B would<br />
also be treated as a corporation separate from FS under<br />
the <strong>tax</strong> rate disparity test. The activities <strong>of</strong> the remainder<br />
<strong>of</strong> FS would not provide a demonstrably<br />
greater contribution to the manufacture <strong>of</strong> Product X<br />
than the activities <strong>of</strong> Branch A and Branch B considered<br />
together. Therefore, the location <strong>of</strong> manufacture is<br />
Country A, the location <strong>of</strong> Branch A. (See Figure 5.)<br />
CM<br />
6. Example 4 — Figure 6<br />
Figure 5<br />
FS<br />
A B<br />
Design design<br />
20%<br />
Location<br />
<strong>of</strong> MFG Mfg<br />
10% <strong>tax</strong><br />
manages Manages<br />
Oversees oversees<br />
Oversight oversight<br />
24%<br />
The facts are the same as in Example 3 (5. above),<br />
except that the effective rate <strong>of</strong> <strong>tax</strong> on sales income in<br />
Country B is 12 percent. Also, the activities <strong>of</strong> employees<br />
<strong>of</strong> FS located in Country B and Country M, if<br />
considered together, provide a demonstrably greater<br />
contribution to the manufacture <strong>of</strong> Product X than the<br />
activities <strong>of</strong> employees <strong>of</strong> FS located in Country A.<br />
The tested sales location is Country M. The location <strong>of</strong><br />
Branch A is the tested manufacturing location because<br />
<strong>of</strong> the <strong>tax</strong> rate disparity and the fact that Branch A is<br />
the only branch that would be treated as a separate<br />
corporation. The activities <strong>of</strong> Branch B will be considered<br />
in the contribution <strong>of</strong> the remainder <strong>of</strong> FS for<br />
purposes <strong>of</strong> determining the location <strong>of</strong> manufacture<br />
<strong>of</strong> Product X, because there is no <strong>tax</strong> rate disparity.<br />
Since the activities <strong>of</strong> Branch X and the remainder <strong>of</strong><br />
FS provide a demonstrably greater contribution to the<br />
manufacture <strong>of</strong> Product X than the activities <strong>of</strong> Branch<br />
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B, neither Branch A nor Branch B will be treated as a<br />
separate corporation. (See Figure 6.)<br />
Same as in Example 3 (Figure 5 above), except B is 12%<br />
<strong>tax</strong>. In addition, B and FS in Country country M together provide<br />
demonstrably greater contribution than A.<br />
FS<br />
10%<br />
A B<br />
20%<br />
Tested Mfg<br />
Location<br />
Figure 6<br />
12%<br />
No branch is a<br />
separate corp.<br />
7. Example 5 — Figure 7<br />
The facts are the same as in Example 3 (5. above),<br />
except that selling activities are also performed by<br />
Branch D in Country D, where Country D imposes a<br />
16 percent effective rate <strong>of</strong> <strong>tax</strong> on sales income. Also,<br />
the activities <strong>of</strong> FS located in Country A and Country<br />
M, considered together, provide a demonstrably greater<br />
contribution to the manufacture <strong>of</strong> Product X than the<br />
activities <strong>of</strong> employees <strong>of</strong> FS located in Country B.<br />
The results for the remainder <strong>of</strong> FS are the same as<br />
in Example 3: A is treated as a separate corporation.<br />
These rules also must be applied regarding Branch<br />
D because it performs selling activities for Product X.<br />
Figure 7<br />
Same as in Example 3 (Figure 5 above) except<br />
Branch D sells.<br />
FS<br />
10% Sells<br />
A B D<br />
20% 24% Sells<br />
16%<br />
SPECIAL REPORTS<br />
Thus, for purposes <strong>of</strong> that sales income, the location <strong>of</strong><br />
Branch D is the tested sales location. The location <strong>of</strong><br />
Branch B is the tested manufacturing location because<br />
there is a <strong>tax</strong> rate disparity between Country D and<br />
Country B, and Branch B is the only branch that<br />
would be treated as a separate corporation. The manufacturing<br />
activities performed in Country M by the remainder<br />
<strong>of</strong> FS and the manufacturing activities performed<br />
in Country A by Branch A will be included in<br />
Branch D’s contribution to the manufacture <strong>of</strong> Product<br />
X for purposes <strong>of</strong> determining the location <strong>of</strong> manufacture<br />
<strong>of</strong> Product X regarding Branch D’s sales income.<br />
Branch D, Branch A, and the remainder <strong>of</strong> FS,<br />
considered together, provide a demonstrably greater<br />
contribution to the manufacture <strong>of</strong> Product X than the<br />
activities <strong>of</strong> Branch B. Therefore, the branch rules will<br />
not apply to Branch D, and neither Branch A nor<br />
Branch D will be treated as a separate corporation.<br />
(See Figure 7.)<br />
8. Example 6 — Figure 8<br />
FS purchases from a related person raw materials<br />
that are manufactured into Product X by an unrelated<br />
contract manufacturer (CM). CM physically manufactures<br />
the goods in Country C. Employees <strong>of</strong> FS located<br />
in Country M sell Product X to unrelated persons<br />
for use outside Country M.<br />
Employees <strong>of</strong> FS located in Country M engage in<br />
product design, manage the manufacturing costs and<br />
capabilities for Product X, and direct the use <strong>of</strong> intellectual<br />
property for purposes <strong>of</strong> manufacturing Product<br />
X. Quality control and oversight and direction <strong>of</strong> the<br />
manufacturing process are conducted in Country C by<br />
employees <strong>of</strong> FS who are located in Country M but<br />
who regularly travel to Country X. Branch A is the<br />
only branch <strong>of</strong> FS. Product design for Product X conducted<br />
by employees <strong>of</strong> FS located in Country A are<br />
supplemental to the bulk <strong>of</strong> the design work, which is<br />
done by employees <strong>of</strong> FS located in Country M. At all<br />
times, employees <strong>of</strong> Branch A control the raw materials,<br />
work-in-process, and finished goods. Employees <strong>of</strong><br />
FS located in Country A also control manufacturingrelated<br />
logistics for Product X. Country M imposes an<br />
effective rate <strong>of</strong> <strong>tax</strong> on sales income <strong>of</strong> 10 percent.<br />
Country A imposes an effective rate <strong>of</strong> <strong>tax</strong> on sales<br />
income <strong>of</strong> 20 percent. Neither the remainder <strong>of</strong> FS nor<br />
Branch A independently satisfies the manufacturing<br />
test, although FS as a whole provides a substantial<br />
contribution to the manufactured Product X.<br />
The tested sales location is Country M because the<br />
remainder <strong>of</strong> FS performs the selling activities regarding<br />
Product X. The tested manufacturing location is<br />
the location <strong>of</strong> Branch A because there is a <strong>tax</strong> rate<br />
disparity, and Branch A is the only branch that would<br />
be treated as a separate corporation. Although the activities<br />
<strong>of</strong> traveling employees are considered in determining<br />
whether FS as a whole makes a substantial<br />
contribution, the activities <strong>of</strong> the employees <strong>of</strong> FS that<br />
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SPECIAL REPORTS<br />
are performed in Country C are not taken into consideration<br />
in determining whether Country M, the jurisdiction<br />
under the laws <strong>of</strong> which FS is organized, is the<br />
location <strong>of</strong> manufacture. The activities <strong>of</strong> employees <strong>of</strong><br />
FS performed in Country M do not provide a demonstrably<br />
greater contribution to the manufacture <strong>of</strong><br />
Product X than the activities <strong>of</strong> employees <strong>of</strong> FS located<br />
in Country A. Therefore, the location <strong>of</strong> manufacture<br />
is Country A. (See Figure 8.)<br />
Employees Employee travel<br />
FS<br />
20%<br />
A<br />
Location<br />
<strong>of</strong> Mfg MFG<br />
Some design<br />
controls materials<br />
CM<br />
Country C<br />
Figure 8<br />
Product design, etc.<br />
10%<br />
employees<br />
Employees<br />
travel for QC<br />
and oversight<br />
9. Example 3 — Figure 9<br />
This is an example in the current regulations that is<br />
modified in the temporary regulations. CFC E, incorporated<br />
under the laws <strong>of</strong> Country X, is a wholly<br />
owned subsidiary <strong>of</strong> CFC D, also incorporated under<br />
the laws <strong>of</strong> Country X. E maintains Branch B in<br />
Country Y. E’s sole activity, carried on through Branch<br />
B, consists <strong>of</strong> the purchase <strong>of</strong> articles manufactured in<br />
Country X by Corporation D and the sale <strong>of</strong> those<br />
articles through Branch B to unrelated persons. Branch<br />
B is treated as a wholly owned subsidiary corporation<br />
<strong>of</strong> E because <strong>of</strong> a <strong>tax</strong> rate disparity. Income derived by<br />
Branch B, treated as a separate corporation, constitutes<br />
FBCSI.<br />
If instead D were unrelated to E, none <strong>of</strong> the income<br />
would be FBCSI because E’s branch would be<br />
purchasing from and selling to unrelated persons, and<br />
if Branch B were treated as a separate corporation, it<br />
likewise would be purchasing from and selling to unrelated<br />
persons. Alternatively, if D were related to E, but<br />
Branch B manufactured the articles before sale, the income<br />
would not be FBCSI because Branch B, treated<br />
as a separate corporation, would qualify for the manufacturing<br />
exception. (See Figure 9.)<br />
10. Example 8 — Figure 10<br />
Figure 9<br />
Dx<br />
Ex<br />
By<br />
FS operates one branch, Branch A, that physically<br />
manufactures Product X. Raw materials used in the<br />
manufacture <strong>of</strong> Product X are purchased by FS from<br />
an unrelated person. FS engages in activities in Country<br />
M to sell Product X to a related person for use outside<br />
Country M. Employees <strong>of</strong> FS located in Country<br />
M perform only sales functions. The effective rate imposed<br />
in Country M on the income from the sale <strong>of</strong><br />
Product X is 10 percent. Country A generally imposes<br />
an effective rate <strong>of</strong> <strong>tax</strong> on income <strong>of</strong> 20 percent, but<br />
imposes a uniformly applicably incentive rate <strong>of</strong> <strong>tax</strong> <strong>of</strong><br />
10 percent on manufacturing income and related sales<br />
income. The use <strong>of</strong> Branch A to manufacture Product<br />
X does not have substantially the same <strong>tax</strong> effect as if<br />
Branch A were a wholly owned subsidiary corporation<br />
<strong>of</strong> FS, because the effective rate <strong>of</strong> <strong>tax</strong> on FS’s sales<br />
income from the sale <strong>of</strong> Product X in Country M (10<br />
percent) is not less than 90 percent <strong>of</strong>, and at least 5<br />
percentage points less than, the effective rate <strong>of</strong> <strong>tax</strong><br />
that would apply to that income in the country in<br />
which Branch A is located (10 percent). Branch A is<br />
not treated as a separate corporation. (See Figure 10.)<br />
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Figure 10<br />
FS<br />
A<br />
Mfg<br />
20%<br />
10% incentive rate<br />
11. Example 9 — Figure 11<br />
FS has two branches, Branch A and Branch B, located<br />
in Country A and Country B, respectively. FS<br />
purchases from a related person raw materials that are<br />
physically manufactured into Product X by an unrelated<br />
corporation (CM). CM manufactures the product<br />
outside FS’s country <strong>of</strong> organization. FS manages<br />
manufacturing costs and capacities for the manufacture<br />
<strong>of</strong> Product X through employees located in Country<br />
M. Employees <strong>of</strong> FS located in Country M oversee the<br />
coordination between the branches.<br />
Branch A, through the activities <strong>of</strong> employees <strong>of</strong> FS<br />
located in Country A, designs Product X, controls<br />
manufacturing-related logistics, and controls the raw<br />
materials and work-in-process during manufacturing.<br />
Branch B, through activities <strong>of</strong> employees <strong>of</strong> FS located<br />
in Country B, provides quality control and oversight<br />
and direction during the manufacturing process.<br />
Employees <strong>of</strong> FS located in Country M sell Product X<br />
to unrelated persons for use outside Country M. Country<br />
M imposes an effective rate <strong>of</strong> <strong>tax</strong> on sales income<br />
<strong>of</strong> 10 percent, Country A imposes an effective rate <strong>of</strong><br />
<strong>tax</strong> on sales income <strong>of</strong> 12 percent, and Country B imposes<br />
an effective rate <strong>of</strong> <strong>tax</strong> on sales income <strong>of</strong> 24<br />
percent. None <strong>of</strong> the remainder, Branch A or Branch<br />
B, independently satisfies the manufacturing tests, although<br />
FS as a whole provides a substantial contribution<br />
to the manufacture <strong>of</strong> Product X. The activities <strong>of</strong><br />
the remainder <strong>of</strong> FS and Branch A, if considered together,<br />
would not provide a demonstrably greater contribution<br />
to the manufacture <strong>of</strong> Product X than the<br />
activities <strong>of</strong> Branch B.<br />
The tested sales location is Country M. The location<br />
<strong>of</strong> Branch B is the tested manufacturing location because<br />
there is a <strong>tax</strong> rate disparity and Branch B is the<br />
only manufacturing branch that would be treated as a<br />
separate corporation. The manufacturing activities performed<br />
in Country A will be included in the contribution<br />
<strong>of</strong> the remainder <strong>of</strong> FS for purposes <strong>of</strong> determin-<br />
ing the location <strong>of</strong> the manufactured Product X,<br />
because there is not a <strong>tax</strong> rate disparity. The location <strong>of</strong><br />
manufacture is Country B. Branch B is treated as a<br />
separate corporation. To determine whether income<br />
from the sale <strong>of</strong> Product X is FBCSI, the remainder <strong>of</strong><br />
FS takes into account the activities <strong>of</strong> Branch A because<br />
there is no <strong>tax</strong> rate disparity. The remainder <strong>of</strong><br />
FS is considered to have manufactured Product X because<br />
the manufacturing activities <strong>of</strong> the remainder<br />
and Branch A, considered together, make a substantial<br />
contribution to the manufacture <strong>of</strong> Product X. Therefore,<br />
income from the sale <strong>of</strong> Product X by the remainder<br />
<strong>of</strong> FS does not constitute FBCSI. (See Figure 11.)<br />
Figure 11<br />
FS<br />
A B<br />
SPECIAL REPORTS<br />
Activities<br />
10%<br />
Activities 12% Activities 24%<br />
Location <strong>of</strong><br />
Mfg MFG<br />
Cost Sharing: Temporary Regulations<br />
The IRS and Treasury issued temporary and proposed<br />
regulations that cover cost-sharing arrangements<br />
(CSAs) beginning on January 5, 2009, but with important<br />
grandfather rules for existing CSAs. (For the temporary<br />
regs, see Doc 2008-27341 or 2009 WTD 1-24.) The<br />
temporary regulations apply to buy-in transactions<br />
(now called platform contribution transactions, or<br />
PCTs) that occur on or after the date <strong>of</strong> a material<br />
change in the scope <strong>of</strong> a grandfathered CSA. Whether<br />
a material change in scope has occurred is determined<br />
on a cumulative basis, and a series <strong>of</strong> expansions, any<br />
one <strong>of</strong> which is not a material expansion by itself, may<br />
collectively constitute a material expansion.<br />
While the temporary regulations represent an improvement<br />
over the proposed regulations, the temporary<br />
regulations still rely heavily on the controversial<br />
‘‘investor model’’ and the special pricing methods for<br />
PCTs. At the inception <strong>of</strong> a CSA, all participants in<br />
the CSA should expect to earn a return on their total<br />
investment that is appropriate given the risk associated<br />
with each participant’s activities under the CSA. The<br />
investor model treats each participant in the CSA as<br />
having made an investment composed <strong>of</strong> its share <strong>of</strong><br />
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SPECIAL REPORTS<br />
the intangible development costs incurred on an ongoing<br />
basis and any contribution <strong>of</strong> existing resources<br />
and capabilities. The alternatives realistically available<br />
to the participants must be considered. Most commentators<br />
criticized the model on the grounds that its valuation<br />
principles are too restrictive.<br />
Taxpayers may need to amend their written agreements,<br />
as described in temp. Treas. reg. section 1.482-<br />
7T(k)(1), for CSAs existing before the effective date <strong>of</strong><br />
the new regulations. If the <strong>tax</strong>payer has no agreement<br />
in place that complies with these requirements by July<br />
6, 2009, the <strong>tax</strong>payer’s CSA may not be grandfathered.<br />
A CSA statement will also need to be filed by September<br />
2, 2009.<br />
One final introductory note: The Ninth Circuit has<br />
yet to make a decision in Xilinx. That decision could<br />
ultimately have an important effect on these regulations.<br />
General<br />
Several commentators questioned whether and how<br />
the proposed regulations conformed to the arm’s-length<br />
standard and the commensurate with income rules. In<br />
response, the preamble states that the temporary regulations<br />
provide further guidance on the evaluation <strong>of</strong><br />
the arm’s-length results <strong>of</strong> cost-sharing transactions<br />
(CSTs) and PCTs. The regulations address the material<br />
functional and risk allocations in the context <strong>of</strong> a CSA,<br />
including the reasonably anticipated duration <strong>of</strong> the<br />
commitments, the intended scope <strong>of</strong> the intangible development,<br />
the degree and uncertainty <strong>of</strong> pr<strong>of</strong>it potential<br />
<strong>of</strong> the intangibles to be developed, and the extent<br />
<strong>of</strong> platform and other contributions <strong>of</strong> resources, capabilities,<br />
and rights to the development and exploitation<br />
<strong>of</strong> cost-shared intangibles (CSA activity).<br />
If available data concerning uncontrolled transactions<br />
reflect, or may be reasonably adjusted to reflect,<br />
similar facts and circumstances concerning a CSA,<br />
they may be the basis for application <strong>of</strong> the comparable<br />
uncontrolled transaction method to value the<br />
CST and PCT results. Because <strong>of</strong> the difficulty <strong>of</strong> finding<br />
data that reliably reflect these facts and circumstances,<br />
the preamble states, the temporary regulations<br />
also provide for other methods. Those include the income,<br />
acquisition price, market capitalization, and residual<br />
pr<strong>of</strong>it-split methods.<br />
The temporary regulations also provide <strong>tax</strong>payers<br />
with more flexibility in designing some aspects <strong>of</strong><br />
CSAs.<br />
R&D Cost Sharing That Is Not a CSA<br />
The proposed regulations defined the contractual<br />
terms, risk allocations, and other material provisions <strong>of</strong><br />
a CSA covered by the cost-sharing rules. While other<br />
intangible development arrangements might in general<br />
be referred to as cost-sharing arrangements, they were<br />
not treated as CSAs by the proposed regulations unless<br />
either: (1) the <strong>tax</strong>payer substantially complied with the<br />
CSA administrative requirements and reasonably concluded<br />
that its arrangement was a CSA; or (2) the <strong>tax</strong>payer<br />
substantially complied with the CSA administrative<br />
requirements and the IRS determined that the<br />
CSA rules should be applied to the arrangement.<br />
The IRS and Treasury continue to believe that these<br />
rules, provided for CSAs, should apply only to the intended<br />
transactions. The rules are to be applied only to<br />
the defined scope <strong>of</strong> intangible development arrangements<br />
and to apply no more broadly or narrowly than<br />
intended. Thus, this portion <strong>of</strong> the proposed regulations<br />
was adopted.<br />
Nonconforming arrangements are governed by other<br />
provisions <strong>of</strong> the section 482 regulations. Intangible<br />
development arrangements, including partnerships, outside<br />
the scope <strong>of</strong> the cost-sharing rules are governed by<br />
the transfers <strong>of</strong> intangible rules or the controlled services<br />
provisions, as appropriate. Nevertheless, the preamble<br />
states that the methods and best method considerations<br />
under the cost-sharing rules may be adapted<br />
for purposes <strong>of</strong> evaluating nonconforming intangible<br />
development arrangements.<br />
Four examples illustrate these rules. In Example 1,<br />
P and S execute an agreement that purports to be a<br />
CSA, but they fail to enter into a PCT for some relevant<br />
s<strong>of</strong>tware. P and S substantially complied with the<br />
contractual requirements and the documentation, accounting,<br />
and reporting requirements and thus have<br />
met the administrative requirements. However, because<br />
they did not enter into a PCT for s<strong>of</strong>tware that was<br />
reasonably anticipated to contribute to the development<br />
<strong>of</strong> the cost-shared product, they cannot reasonably conclude<br />
that their arrangement is a CSA. Nevertheless,<br />
the arrangement between P and S closely resembles a<br />
CSA. If the Service concludes that the CSA rules provide<br />
the most reliable measure <strong>of</strong> an arm’s-length result,<br />
the Service may apply the CSA rules and treat P<br />
and S as entering into a PCT for the s<strong>of</strong>tware. Or the<br />
Service may conclude that other provisions in the section<br />
482 rules apply.<br />
In Example 2, the facts are the same as in Example<br />
1, except that P and S enter into and implement a PCT<br />
for the s<strong>of</strong>tware. The Service determines that the PCT<br />
payments for the s<strong>of</strong>tware were not arm’s length. However,<br />
P and S reasonably concluded that their arrangement<br />
is a CSA. The Service must apply the CSA rules<br />
and make an adjustment to the PCT payments as appropriate.<br />
In Example 3, the facts are the same as in Example<br />
1, except that P and S enter into a PCT for the s<strong>of</strong>tware.<br />
The agreement provides for a fixed consideration<br />
<strong>of</strong> $50 million per year for four years, payable at the<br />
end <strong>of</strong> each year. The agreement satisfies the arm’slength<br />
standard; however, S actually pays P consideration<br />
at the end <strong>of</strong> each year in the form <strong>of</strong> four annual<br />
royalties equal to 2 percent <strong>of</strong> sales. P and S<br />
failed to implement the terms <strong>of</strong> their agreement and<br />
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could not reasonably conclude that their agreement<br />
was a CSA. Nevertheless, the arrangement closely resembles<br />
a CSA, and the Service may apply the CSA<br />
rules and make appropriate adjustments.<br />
In Example 4, the facts are the same as in Example<br />
1, except that P does not own proprietary s<strong>of</strong>tware and<br />
P and S determine that the arm’s-length amount for<br />
PCT payments is $10 million. The IRS determines that<br />
the PCT payments should be $100 million. To determine<br />
the $10 million present value, P and S assumed a<br />
useful life <strong>of</strong> eight years for the platform contribution,<br />
because that is when the relevant patent expires. However,<br />
use <strong>of</strong> the PCT patent rights in research is expected<br />
to lead to benefits attributable to exploitation <strong>of</strong><br />
the cost-shared intangibles extending many years beyond<br />
expiration <strong>of</strong> the PCT patent. P and S expect to<br />
apply for additional patents.<br />
The method used by P and S also uses a declining<br />
royalty based on an application <strong>of</strong> the CUT method in<br />
which the purported CUTs all involve licenses to<br />
manufacture and sell the current generation <strong>of</strong> the<br />
product. These make or sell rights are fundamentally<br />
different from use <strong>of</strong> the PCT patent rights to generate<br />
a new product. This further reduces the reliability <strong>of</strong><br />
the method used by P and S.<br />
The example concludes that the method used by P<br />
and S is so unreliable and so contrary to the provisions<br />
<strong>of</strong> the CSA rules that P and S could not reasonably<br />
conclude that they had contracted to enter into a CSA.<br />
Accordingly, the Service is not required to apply the<br />
CSA rules. Nevertheless, if the Service concludes that<br />
the CSA rules provide the most reliable measure <strong>of</strong> an<br />
arm’s-length result, it may apply the CSA rules and<br />
make appropriate adjustments.<br />
Territorial Interests<br />
The proposed regulations required the controlled<br />
participants in a CSA to receive nonoverlapping territorial<br />
interests that entitled each controlled participant to<br />
the perpetual and exclusive right to the pr<strong>of</strong>its in its<br />
territory attributable to cost-shared intangibles. Commentators<br />
said this was overly restrictive and did not<br />
align with common business models.<br />
The temporary regulations thus permit use <strong>of</strong> a new<br />
basis — a field <strong>of</strong> use division <strong>of</strong> interests — in addition<br />
to the territorial division <strong>of</strong> interests. The regulations<br />
also authorize other nonoverlapping divisional<br />
interest, provided that the basis used meets criteria:<br />
(1) the basis must clearly and unambiguously divide all<br />
interests in cost-shared intangibles among the controlled<br />
participants; (2) the consistent use <strong>of</strong> this basis<br />
can be dependably verified from the participant’s<br />
records; (3) the rights <strong>of</strong> the controlled participants to<br />
exploit cost-shared intangibles are nonoverlapping, exclusive,<br />
and perpetual; and (4) the resulting benefits<br />
associated with each controlled participant’s interest in<br />
cost-shared intangibles are predictable with reasonable<br />
reliability.<br />
SPECIAL REPORTS<br />
If the CSA divides all interests in cost-shared intangibles<br />
on a territorial basis (territorial divisional interests),<br />
the entire world must be divided into two or<br />
more nonoverlapping geographic territories. Each controlled<br />
participant must receive at least one such territory,<br />
and in the aggregate all the participants must receive<br />
all <strong>of</strong> the territories. Each controlled participant<br />
must be assigned the perpetual and exclusive right to<br />
exploit the cost-shared intangibles through the use, consumption,<br />
or disposition <strong>of</strong> property or services in its<br />
territories. Thus, compensation will be required if other<br />
members <strong>of</strong> the controlled group exploit the costshared<br />
intangibles in that territory.<br />
If the CSA divides all interests in the cost-shared<br />
intangibles on the basis <strong>of</strong> all uses (whether or not<br />
known at the time <strong>of</strong> the division) to which the costshared<br />
intangibles are to be put (field <strong>of</strong> use divisions<br />
interests), all anticipated uses <strong>of</strong> the cost-shared intangibles<br />
must be identified. Each controlled participant<br />
must be assigned at least one such anticipated use, and<br />
in the aggregate all the participants must be assigned<br />
all <strong>of</strong> the anticipated uses. Each controlled participant<br />
will be assigned a perpetual and exclusive right to exploit<br />
the cost-shared intangible through the use or uses<br />
assigned to it, and one controlled participant must be<br />
assigned the exclusive and perpetual right to exploit the<br />
cost-shared intangibles through any unanticipated uses.<br />
Three examples illustrate these rules. In Example 1,<br />
P receives the interest in Product Z in the U.S., and S<br />
receives the interest in the product in the rest <strong>of</strong> the<br />
world. Both P and S have plants for manufacturing<br />
Product Z located in their respective geographic territories.<br />
For commercial reasons, Product Z is nevertheless<br />
manufactured by P in the U.S. for sale to customers in<br />
certain jurisdictions just outside the U.S. in close proximity<br />
to P’s U.S. manufacturing plant. Because S owns<br />
the territorial rights outside the U.S., P must compensate<br />
S to ensure that S realizes all the cost-shared intangible<br />
pr<strong>of</strong>its from P’s sale <strong>of</strong> products in S’s territory.<br />
Benefits projected for these sales will be included<br />
for purposes <strong>of</strong> estimating S’s reasonably anticipated<br />
benefits (RAB) share.<br />
In Example 2, the facts are the same in Example 1,<br />
except that P and S agree to divide their interests in<br />
Product Z based on site <strong>of</strong> manufacturing. P will have<br />
exclusive and perpetual rights in Product Z manufactured<br />
in facilities owned by P. S will have exclusive and<br />
perpetual rights to Product Z manufactured in facilities<br />
owned by S. Both facilities that will manufacture Product<br />
Z, and the relative capacities <strong>of</strong> these sites, are<br />
known. All facilities are operating at near capacity and<br />
are expected to continue to operate at near capacity<br />
when Product Z enters production, so it will not be<br />
feasible to shift product between P’s and S’s facilities.<br />
P and S also have no plans to build new facilities. The<br />
basis for the division <strong>of</strong> interest is unambiguous and<br />
clearly defined and can be dependably verified.<br />
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SPECIAL REPORTS<br />
In Example 3, the facts are the same as in Example<br />
2, except that P’s and S’s manufacturing facilities are<br />
not expected to operate at full capacity when Product<br />
Z enters production. Production <strong>of</strong> Product Z can be<br />
shifted at any time between sites owned by P and sites<br />
owned by S, although neither P nor S intends to shift<br />
production as a result <strong>of</strong> the agreement. In this case,<br />
the production <strong>of</strong> interests based on manufacturing<br />
sites is not a division that is satisfactory because the<br />
parties’ relative shares <strong>of</strong> benefits are not predictable<br />
with reasonable reliability.<br />
Platform and Other Contributions<br />
The proposed regulations described external contributions<br />
for which compensation was due from other<br />
controlled participants. Under the proposed regulations,<br />
an external contribution (buy-in) generally consisted <strong>of</strong><br />
the rights in a ‘‘reference transaction’’ in any resource<br />
or capability reasonably anticipated to contribute to<br />
developing cost-shared intangibles. The reference transaction,<br />
a concept that is not in the temporary regulations,<br />
essentially was a non-arm’s-length hypothetical<br />
comparable.<br />
A platform contribution is<br />
any resource, capability, or<br />
right that is reasonably<br />
anticipated to contribute<br />
to developing cost-shared<br />
intangibles.<br />
The temporary regulations replace the term ‘‘external<br />
contribution’’ with the term ‘‘platform contribution’’<br />
and use the term ‘‘platform contribution transaction.’’<br />
The temporary regulations define a platform<br />
contribution as any resource, capability, or right that a<br />
controlled participant has developed, maintained, or<br />
acquired externally to the intangible development activity<br />
(whether before or during the course <strong>of</strong> the CSA)<br />
that is reasonably anticipated to contribute to developing<br />
cost-shared intangibles. A resource, capability, or<br />
right reasonably determined earlier not to be a platform<br />
intangible may be reasonably determined later to be a<br />
platform intangible. The PCT obligation regarding a<br />
resource or capability or right once determined to be a<br />
platform contribution does not terminate merely because<br />
it may later be determined that the resource or<br />
capability or right has not contributed, and is not<br />
longer reasonably anticipated to contribute, to developing<br />
cost-shared intangibles.<br />
For purposes <strong>of</strong> a PCT, the PCT payee’s provision<br />
<strong>of</strong> a platform contribution is presumed to be exclusive.<br />
It also is presumed that the platform resource, capabil-<br />
ity, or right is not reasonably anticipated to be committed<br />
to any business activities other than the CSA activity.<br />
The controlled participants may rebut the<br />
presumption. For example, if the platform resource is a<br />
research tool, the controlled participants could rebut<br />
the presumption by establishing to the Service’s satisfaction<br />
that as <strong>of</strong> the date <strong>of</strong> the PCT, the tool is reasonably<br />
anticipated not only to contribute to CSA activity<br />
but also to be licensed to an uncontrolled<br />
<strong>tax</strong>payer.<br />
To the extent a controlled participant contributes the<br />
services <strong>of</strong> its research team for purposes <strong>of</strong> developing<br />
cost-shared intangibles under the CSA, the other controlled<br />
participant would owe compensation for the<br />
services <strong>of</strong> the team under temp. Treas. reg. section<br />
1.482-9T, just as would be the case in a contract service<br />
arrangement. 3 When there is a combined contribution<br />
<strong>of</strong> research services, intangibles in process, or<br />
other resources, capabilities, or rights, the temporary<br />
regulations provide for an aggregate valuation where<br />
that would provide the most reliable measure <strong>of</strong> an<br />
arm’s-length result.<br />
Any right to exploit an existing intangible without<br />
further development, such as the right to make, replicate,<br />
license, or sell existing products, does not constitute<br />
a platform contribution to a CSA, and the arm’slength<br />
consideration for such rights (make or sell<br />
rights) does not satisfy the compensation obligation<br />
under a PCT.<br />
In an example, P and S enter into a CSA to develop<br />
the second generation <strong>of</strong> ABC, a computer s<strong>of</strong>tware<br />
program. Before that arrangement, P had incurred substantial<br />
costs and risks to develop ABC. P executed a<br />
license with S as the licensee by which S may make<br />
and sell copies <strong>of</strong> the existing ABC. This make or sell<br />
right does not constitute a platform contribution.<br />
In another example, P and S enter into a CSA in<br />
accordance with which P will commit to the project its<br />
research team that has developed a number <strong>of</strong> other<br />
vaccines. The expertise and existing integration <strong>of</strong> the<br />
research team is a unique resource or capability <strong>of</strong> P<br />
that is reasonably anticipated to contribute to the development<br />
<strong>of</strong> the cost-shared product. Therefore, P’s provision<br />
<strong>of</strong> the capabilities <strong>of</strong> the research team constitutes<br />
a platform contribution for which compensation<br />
is due from S as a part <strong>of</strong> the PCT. The controlled parties<br />
designate the platform contribution as a provision<br />
<strong>of</strong> services that would otherwise be governed by temp.<br />
3 Interestingly, the treatment available under the cost-sharing<br />
rules for the contribution <strong>of</strong> the services <strong>of</strong> a research team as<br />
controlled services is stated to be ‘‘without any inference’’ concerning<br />
the potential status <strong>of</strong> workforce-in-place as an intangible<br />
under section 936(h)(3)(B). The status <strong>of</strong> workforce-in-place as<br />
an intangible, <strong>of</strong> course, has arisen as an issue in the context <strong>of</strong><br />
section 936 exits.<br />
462 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL<br />
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Treas. reg. section 1.482-9T if entered into by controlled<br />
parties. The applicable method for determining<br />
the arm’s-length value <strong>of</strong> the compensation obligation<br />
under the PCT will be governed by those regulations as<br />
supplemented by the CSA rules.<br />
The platform contribution is presumed to be the exclusive<br />
provision <strong>of</strong> the benefits by Company P <strong>of</strong> its<br />
research team to the development <strong>of</strong> Vaccine Z. Because<br />
the intangible development costs (IDCs) include<br />
the ongoing compensation <strong>of</strong> the researchers, the compensation<br />
obligation under the PCT is only for the<br />
value <strong>of</strong> the commitment <strong>of</strong> the research team by P to<br />
the CSA’s development efforts net <strong>of</strong> the researcher<br />
compensation. The value <strong>of</strong> the compensation obligation<br />
<strong>of</strong> S for the PCT will reflect the full value <strong>of</strong> the<br />
provision <strong>of</strong> services as limited by S’s RAB share.<br />
Intangible Development Activity and Costs<br />
The scope <strong>of</strong> the intangible development activity<br />
(IDA) includes all activities that could reasonably be<br />
anticipated to contribute to developing the reasonably<br />
anticipated cost-shared intangibles. The IDA cannot be<br />
described merely by a list <strong>of</strong> particular resources, capabilities,<br />
or rights that will be used in the CSA, since<br />
the IDA is a function <strong>of</strong> what are the reasonably anticipated<br />
cost-shared intangibles.<br />
The scope <strong>of</strong> the IDA may change as the nature or<br />
identity <strong>of</strong> the reasonably anticipated cost-shared intangibles<br />
or the nature <strong>of</strong> the activities necessary for their<br />
development becomes clearer. For example, the relevance<br />
<strong>of</strong> certain ongoing work to developing reasonably<br />
anticipated cost-shared intangibles or the need for<br />
additional work may become clear only over time.<br />
Regarding stock options and other stock-based compensation,<br />
the IRS and Treasury continue to consider<br />
the technical changes and issues described in Notice<br />
2005-99, 2005-22 C.B. 1214, and comments they have<br />
received and intend to address the issue in a subsequent<br />
regulations project.<br />
Changes in Participation<br />
A change in participation under a CSA occurs when<br />
there is either a controlled transfer <strong>of</strong> interests or a capability<br />
variation. A controlled transfer occurs when a<br />
participant in a CSA transfers all or part <strong>of</strong> its interest<br />
in cost-shared intangibles under the CSA in a controlled<br />
transaction, and the transferee assumes the associated<br />
obligations under the CSA. In that case, the<br />
transferee will be treated as succeeding to the transferor’s<br />
prior history under the CSA as it relates to the<br />
transferred interest, including the transferor’s cost contributions,<br />
benefits received, and PCT payments attributable<br />
to such rights or obligations.<br />
A capability variation occurs when, in a CSA in<br />
which interests in cost-shared intangibles were divided<br />
on a basis such as plant capacity, the controlled participants’<br />
division <strong>of</strong> interests, or their relative capabilities<br />
or capabilities to benefit from the cost-shared intan-<br />
SPECIAL REPORTS<br />
gibles are materially altered. The capability variation is<br />
considered to be a controlled transfer <strong>of</strong> interests.<br />
If there is a change in participation, the arm’slength<br />
amount <strong>of</strong> consideration must be determined<br />
consistent with the reasonably anticipated incremental<br />
change in returns to the transferee or transferor resulting<br />
from the change in participation.<br />
In one <strong>of</strong> the examples, P and S agree to divide<br />
their interests based on the site <strong>of</strong> manufacturing. Two<br />
years after formation <strong>of</strong> the CSA, because <strong>of</strong> a change<br />
in plans not reasonably foreseeable at the time the<br />
CSA was entered into, S acquires additional facilities<br />
for the manufacture <strong>of</strong> the product. The acquisition is<br />
a capability variation. Accordingly, there was a compensable<br />
change in participation.<br />
RABs<br />
RAB shares must be updated to account for changes<br />
in economic conditions, the business operations and<br />
practices <strong>of</strong> the participants, and the ongoing development<br />
<strong>of</strong> intangibles under the CSA. For purposes <strong>of</strong><br />
determining RAB shares at any given time, reasonably<br />
anticipated benefits must be estimated over the entire<br />
period, past and future, <strong>of</strong> exploitation <strong>of</strong> the costshared<br />
intangibles, and must reflect appropriate updates.<br />
Indirect bases for measuring anticipated benefits<br />
include units used, produced, or sold; sales; operating<br />
pr<strong>of</strong>its; and other bases.<br />
Other bases for measuring anticipated benefits may<br />
in some circumstances be appropriate, but only to the<br />
extent that there is expected to be a reasonably identifiable<br />
relationship between the basis <strong>of</strong> measurement<br />
used and additional income generated or costs saved by<br />
use <strong>of</strong> the cost-shared intangibles.<br />
In one example, operating pr<strong>of</strong>it is determined to be<br />
appropriately used to determine RABs because the<br />
pharmaceutical product will be sold by USP at a<br />
higher pr<strong>of</strong>it than FS will be able to sell the product in<br />
foreign countries. In another example, sales are inappropriate<br />
for determining RABs because FP distributes<br />
the product directly to customers while the U.S. subsidiary<br />
sells to independent distributors. Sales could be<br />
used only if adjustments were made to account for differences<br />
in market levels at which the sales occur.<br />
General Principles and Best Method Considerations<br />
The proposed regulations articulated ‘‘general principles’’<br />
— such as the realistic alternatives principle —<br />
applicable to any method to determine the arm’s-length<br />
charge in a PCT. These provisions were intended to<br />
provide supplementary guidance on the application <strong>of</strong><br />
the best method rule to determine which method, or<br />
application <strong>of</strong> a method, provides the most reliable<br />
measure <strong>of</strong> an arm’s-length result in a CSA context.<br />
That is, these principles provide best method considerations<br />
to aid in the competitive evaluation <strong>of</strong><br />
methods or applications, and they were not intended<br />
themselves to be methods or trumping rules.<br />
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SPECIAL REPORTS<br />
The investor model was a core principle <strong>of</strong> the proposed<br />
regulations. A PCT payer, through cost sharing<br />
and payments made in accordance with the PCT, is<br />
investing for the term <strong>of</strong> the CSA activity and should<br />
expect returns over time consistent with the riskiness <strong>of</strong><br />
that investment. Commentators, however, criticized the<br />
investor model for stripping away risk returns from the<br />
PCT payer.<br />
The temporary regulations retain the investor model,<br />
including the requirement to analyze the alternatives<br />
realistically available to the <strong>tax</strong>payer, but provide additional<br />
guidance to explain that when the PCT payer<br />
assumes risks, it accordingly enjoys the returns (or suffers<br />
the detriments) that may result from those risks.<br />
In doing a best method analysis, the relative reliability<br />
<strong>of</strong> the application <strong>of</strong> a method depends on the degree<br />
<strong>of</strong> consistency <strong>of</strong> the analysis with the assumption<br />
that, as <strong>of</strong> the date <strong>of</strong> the PCT, each controlled participant’s<br />
aggregate net investment in the CSA activity<br />
(attributable to platform contributions, operating contributions,<br />
and operating cost contributions) is reasonably<br />
anticipated to earn a rate <strong>of</strong> return equal to the appropriate<br />
discount rate for the controlled participant’s<br />
CSA activity over the entire period <strong>of</strong> the CSA activity.<br />
The regulation states that if the cost-shared intangibles<br />
themselves are reasonably anticipated to contribute<br />
to developing other intangibles, then the period that<br />
is used includes the period, reasonably anticipated as <strong>of</strong><br />
the date <strong>of</strong> the PCT, <strong>of</strong> developing and exploiting the<br />
indirectly benefited intangibles. The example in temp.<br />
Treas. reg. section 1.482-7T(g)(2)(ii)(B) indicates that,<br />
based on industry experience, the period does not need<br />
to be infinite.<br />
The relative reliability <strong>of</strong> a method also depends on<br />
the degree <strong>of</strong> consistency <strong>of</strong> the analysis with the assumption<br />
that uncontrolled <strong>tax</strong>payers dealing at arm’s<br />
length would have evaluated the terms <strong>of</strong> the transaction,<br />
and entered into the transaction, only if no alternative<br />
is preferable. This condition is not met, the regulation<br />
states, when for any controlled participant the<br />
total anticipated present value <strong>of</strong> its income attributable<br />
to its entering into the CSA, as <strong>of</strong> the date <strong>of</strong> the<br />
PCT, is less than the total anticipated present value <strong>of</strong><br />
its income that could be achieved through an alternative<br />
arrangement realistically available to that controlled<br />
participant.<br />
The regulation states that realistic alternatives may<br />
involve varying risk exposure and thus may be more<br />
reliably evaluated using different discount rates. Determination<br />
<strong>of</strong> the applicable discount rates obviously will<br />
be important under these rules. In some circumstances,<br />
the regulation states, a party may have less risk as a<br />
licensee <strong>of</strong> intangibles needed in its operations, and so<br />
require a lower discount rate than it would have by<br />
entering into a CSA to develop the intangibles, which<br />
may involve the party’s assumption <strong>of</strong> additional risk<br />
in funding its cost contributions to the IDA. Similarly,<br />
self-development <strong>of</strong> intangibles and licensing out may<br />
be riskier for the licensor, and so require a higher discount<br />
rate than entering into a CSA to develop the intangibles,<br />
which would relieve the licensor <strong>of</strong> the obligation<br />
to fund a portion <strong>of</strong> the IDCs <strong>of</strong> the IDA.<br />
A discount rate should be used that most reliably<br />
reflects the risk <strong>of</strong> the set <strong>of</strong> activities or transactions<br />
based on all the information potentially available at the<br />
time for which the present value calculation is to be<br />
performed. The discount rate may differ among a company’s<br />
various activities and transactions. The proposed<br />
regulations indicated that the weighted average<br />
cost <strong>of</strong> capital (WACC) <strong>of</strong> the <strong>tax</strong>payer, or an uncontrolled<br />
<strong>tax</strong>payer, could provide the most reliable basis<br />
for a discount rate if the CSA activity involves the<br />
same risk as projects undertaken by the <strong>tax</strong>payer, or<br />
uncontrolled <strong>tax</strong>payer, as a whole. In appropriate situations,<br />
a company’s internal hurdle rate for projects <strong>of</strong><br />
comparable risk might provide a reliable basis for a<br />
discount rate in the cost-sharing analysis.<br />
Commentators criticized the proposed regulations<br />
discount rate guidance. Some concluded that the proposed<br />
regulations inappropriately emphasized the <strong>tax</strong>payer’s<br />
WACC as a basis for analysis. The specific references<br />
to WACC and hurdle rates are eliminated, but<br />
without any inference as to a WACC or a hurdle rate<br />
being an appropriate discount rate, or an appropriate<br />
starting rate in ascertaining a discount rate, depending<br />
on the facts.<br />
While the regulation discusses the possibility <strong>of</strong> using<br />
different discount rates to reflect varying risk levels<br />
— and that is important — there is little additional<br />
guidance in the regulation in this regard. The <strong>tax</strong>payer’s<br />
or other <strong>tax</strong>payers’ WACC and hurdle rates<br />
seem to be lurking in the background, perhaps as default<br />
rates. Taxpayers will need to carefully analyze<br />
and document their discount rates. If the new regulation<br />
is to work, this is the place where it will need to<br />
work.<br />
In an example, P and S form a CSA to develop intangible<br />
X, which will be used in Product Y. P has a<br />
platform contribution for which S commits to make a<br />
PCT payment <strong>of</strong> 5 percent <strong>of</strong> its sales <strong>of</strong> Product Y. In<br />
determining whether P had a more favorable realistic<br />
alternative, the Service compares P’s anticipated post<strong>tax</strong><br />
discounted present value <strong>of</strong> the financial projections<br />
under the CSA with P’s anticipated post<strong>tax</strong> discounted<br />
present value <strong>of</strong> the financial projections<br />
under a reasonably available alternative licensing arrangement.<br />
In undertaking the analysis in the example,<br />
the Service determines that because it would be funding<br />
the entire development <strong>of</strong> the intangible, P takes<br />
greater risk in the licensing scenario than in the costsharing<br />
scenario. The Service concludes that because<br />
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there are differences in market-correlated risks between<br />
the two scenarios, different discount rates should be<br />
used for the two scenarios. 4<br />
Arm’s-Length Range<br />
The temporary regulations provide guidance on the<br />
use <strong>of</strong> arm’s-length ranges for some methods in computing<br />
PCT payments. Some <strong>of</strong> the methods specified<br />
in the temporary regulations (for example, the income<br />
method) have a structure in which an arm’s-length result<br />
is estimated by performing calculations that depend<br />
on two or more impute parameters such as the<br />
relevant discount rate, certain financial projections, and<br />
a return for routine activities. The temporary regulations<br />
address the arm’s-length range in the context <strong>of</strong><br />
these methods.<br />
CUT Method<br />
The proposed regulations provided for possible use<br />
<strong>of</strong> the CUT method to determine the arm’s-length<br />
charge in the PCT when appropriate in accordance<br />
with the standards <strong>of</strong> the intangibles transfer and controlled<br />
services provisions <strong>of</strong> the section 482 regulations.<br />
Some commentators suggested that any arrangements<br />
that uncontrolled parties may call a cost-sharing<br />
arrangement should serve as a CUT, even though the<br />
arrangement may involve materially different risk allocations<br />
and provisions than addressed in the costsharing<br />
rules.<br />
The temporary regulations, in response, describe the<br />
relevant considerations for purposes <strong>of</strong> evaluating<br />
whether a potential CUT may reflect the most reliable<br />
measure <strong>of</strong> an arm’s-length result. Although all <strong>of</strong> the<br />
factors entering into a best method analysis must be<br />
considered, comparability and reliability under the<br />
CUT method in the CSA context are particularly dependent<br />
on: similarity <strong>of</strong> contractual terms; degree to<br />
which allocation <strong>of</strong> risks is proportional to reasonably<br />
anticipated benefits from exploiting the results <strong>of</strong> intangible<br />
development; similar period <strong>of</strong> commitment as<br />
to the sharing <strong>of</strong> intangible development risks; and<br />
similar scope, uncertainty, and pr<strong>of</strong>it potential <strong>of</strong> the<br />
subject intangible development.<br />
This includes a similar allocation <strong>of</strong> the risks <strong>of</strong> any<br />
existing resources, capabilities, or rights, as well as <strong>of</strong><br />
the risks <strong>of</strong> developing other resources, capabilities, or<br />
rights that would be reasonably anticipated to contrib-<br />
4 At least, I think this is the conclusion in the example. The<br />
concluding sentence <strong>of</strong> the analysis states that ‘‘the Commissioner<br />
concludes that the differences in market-correlated risks<br />
between the two scenarios, and therefore the differences in discount<br />
rates between the two scenarios, relate to the differences in<br />
these components <strong>of</strong> the financial projections.’’ Temp. Treas. reg.<br />
section 1.482-7T(g)(2)(v), Example. Examples illustrating the income<br />
method rules are clearer in illustrating the use <strong>of</strong> different<br />
discount rates. Temp. Treas. reg. section 1.482-7T(g)(4)(vii), Examples<br />
1-3.<br />
SPECIAL REPORTS<br />
ute to exploitation within the parties’ divisions that are<br />
consistent with the actual allocation <strong>of</strong> risks between<br />
the controlled participants.<br />
Income Method<br />
The proposed regulations made the income method<br />
a specified method for purposes <strong>of</strong> evaluating the<br />
arm’s-length charge in a PCT. The arm’s-length charge<br />
was an amount that equated to a controlled participant’s<br />
present value <strong>of</strong> entering into a CSA with the<br />
present value <strong>of</strong> the controlled participant’s best realistic<br />
alternative.<br />
In one application, based on a CUT analysis, the<br />
PCT payee’s best realistic alternative was assumed to<br />
be to develop the cost-shared intangible on its own,<br />
bearing all the intangible development costs (IDCs)<br />
itself, and then to license the cost-shared intangibles. In<br />
the second application, based on a comparable pr<strong>of</strong>its<br />
method analysis, it was assumed that the PCT payer’s<br />
best realistic alternative would be to acquire the rights<br />
to external contributions (renamed platform contributions<br />
under the temporary regulations) for payments<br />
with a present value equal to the PCT payer’s anticipated<br />
pr<strong>of</strong>it, after reward for its routine contributions<br />
to its operations, from the CSA activity in its territory.<br />
Both income method applications provided for a<br />
cost contribution adjustment in order to allocate to the<br />
PCT payer the return for its additional risk, as compared<br />
to its realistic alternative, <strong>of</strong> bearing its RAB<br />
share <strong>of</strong> the IDCs.<br />
Commentators criticized the income method because<br />
it strips away risk returns from the PCT payer.<br />
Commentators pointed to the potential risk differentials<br />
between cost sharing and the alternative arrangements.<br />
Cost sharing would generally be more risky for the<br />
PCT payer than licensing as a result <strong>of</strong> its sharing with<br />
the PCT payee the risks <strong>of</strong> the IDA. Cost sharing, on<br />
the other hand, would generally be less risky for the<br />
PCT payee than licensing. Those comments observed<br />
that these risk differentials would ordinarily be reflected<br />
in different discount rates being appropriate under<br />
the cost-sharing and licensing alternatives.<br />
The temporary regulations in any event adopt the<br />
income method but provide more guidance. In general,<br />
they provide that the best realistic alternative <strong>of</strong> the<br />
PCT payer to entering into the CSA would be to license<br />
intangibles to be developed by an uncontrolled<br />
licensor that undertakes the commitment to bear the<br />
entire risk <strong>of</strong> intangible development that would otherwise<br />
have been shared under the CSA. Similarly, the<br />
best realistic alternative <strong>of</strong> the PCT payee to entering<br />
into the CSA would be to undertake the commitment<br />
to bear the entire risk <strong>of</strong> intangible development that<br />
would otherwise have been shared under the CSA and<br />
license the resulting intangibles to an uncontrolled licensee.<br />
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SPECIAL REPORTS<br />
The licensing alternative is derived on the basis <strong>of</strong> a<br />
functional and risk analysis <strong>of</strong> the cost-sharing alternative,<br />
but with a shift <strong>of</strong> the risk <strong>of</strong> cost contributions to<br />
the licensor. The licensing alternative also should assume<br />
contractual provisions regarding nonoverlapping<br />
divisional intangible interests, and regarding allocations<br />
<strong>of</strong> other risks, that are consistent with the actual CSA<br />
in accordance with the cost-sharing rules.<br />
The temporary regulations describe both CUT-based<br />
applications and CPM-based applications <strong>of</strong> the income<br />
method. However, they differ from applications<br />
described in the proposed regulations by equating the<br />
cost-sharing and licensing alternatives <strong>of</strong> the PCT<br />
payer using discount rates appropriate to those alternatives.<br />
If the market-correlated risks as between the costsharing<br />
and licensing alternatives are not materially<br />
different, a reliable analysis may be possible by using<br />
the same discount rates for both alternatives. Otherwise,<br />
as recognized in the best method considerations<br />
concerning discount rates, realistic alternatives having<br />
the same reasonably anticipated present value may nevertheless<br />
involve varying risk exposure and thus generally<br />
are more reliably evaluated using different discount<br />
rates. The discount rate for the cost-sharing alternative<br />
will also depend on the form <strong>of</strong> the PCT payments<br />
assumed (for example, lump sum, royalty on sales, and<br />
royalty on divisional pr<strong>of</strong>it).<br />
The temporary regulations clarify the opportunities,<br />
depending on the facts and circumstances, for the PCT<br />
payer to assume risks and accordingly to enjoy the returns<br />
(or suffer the detriments) that may result from<br />
those risks. For example, in addition to its cost contributions<br />
to developing cost-shared intangibles, a PCT<br />
payer may also make significant operating contributions,<br />
such as existing marketing or manufacturing process<br />
intangibles, as well as make significant operating<br />
cost contributions toward further developing the intangibles.<br />
To the extent parties to comparable transactions<br />
undertake risks <strong>of</strong> similar scope and duration, the PCT<br />
payer will be appropriately rewarded based on a<br />
method that relies in whole or part on returns in the<br />
comparable transactions under an application <strong>of</strong> the<br />
income method whether based on a CUT or CPM.<br />
Some commentators criticized the income method<br />
as positing an unrealistic perpetual life. The income<br />
method, the preamble states, is premised on the assumption<br />
that, at arm’s length, an investor will make a<br />
risky investment (for example, in a platform for developing<br />
additional technology) only if the investor reasonably<br />
anticipates that the present value <strong>of</strong> its reasonably<br />
anticipated operational results will be increased at<br />
least by a present value equal to the platform investment.<br />
It may be that the technology is reasonably expected<br />
to achieve an incremental improvement and results<br />
for only a finite period. The period <strong>of</strong> enhanced<br />
results that justifies the platform investment in those<br />
circumstances effectively would correspond to a finite,<br />
not a perpetual, life.<br />
This is helpful. There is not an automatic assumption<br />
<strong>of</strong> an infinite period. As noted in the best method<br />
discussion, an example states that, based on industry<br />
experience, the period may be limited to a finite period.<br />
P and S in the example are confident that the<br />
cost-shared product will be replaced by a new type <strong>of</strong><br />
genetic testing based on an unrelated technology after<br />
10 years and that then, the cost-shared product will<br />
have no further value. See temp. Treas. reg. section<br />
1.482-7T(g)(2)(ii)(B), Example. In temp. Treas. reg. section<br />
1.482-7T(g)(4)(vii), Example 3, one <strong>of</strong> the income<br />
method examples, some cost-shared s<strong>of</strong>tware will have<br />
a five-year life. Thereafter it will be rendered obsolete<br />
and unmarketable by obsolescence <strong>of</strong> the storage media<br />
to which it relates.<br />
Acquisition Price and Market Capitalization<br />
Methods<br />
The proposed regulations included guidance on the<br />
acquisition price and market capitalization methods for<br />
evaluating the arm’s-length charge in a PCT. Under the<br />
acquisition price method, the arm’s-length charge for a<br />
PCT is the adjusted acquisition price, that is, the acquisition<br />
price increased by the value <strong>of</strong> the target’s liabilities<br />
on the date <strong>of</strong> the acquisition, and decreased by<br />
the value on that date <strong>of</strong> the target’s tangible property<br />
and other resources and capabilities not covered by the<br />
PCT.<br />
Under the market capitalization method, the arm’slength<br />
charge for a PCT is the adjusted average market<br />
capitalization, that is, the average daily market capitalization<br />
over the 60 days ending with the date <strong>of</strong> the<br />
PCT, increased by the value <strong>of</strong> the PCT payee’s liabilities<br />
on that date, and decreased on account <strong>of</strong> tangible<br />
property and any other resources and capabilities <strong>of</strong><br />
the PCT payee not covered by the PCT.<br />
Commentators questioned the reliability <strong>of</strong> these<br />
methods in light <strong>of</strong> volatility <strong>of</strong> stock prices and lack<br />
<strong>of</strong> correlation between stock prices and underlying assets,<br />
for example, owing to control premiums or economics<br />
<strong>of</strong> integration.<br />
The IRS and Treasury recognize that these comments<br />
point to considerations that, depending on the<br />
facts and circumstances, will need to be taken into account<br />
in a best method analysis that compares the reliability<br />
<strong>of</strong> the results under application <strong>of</strong> these<br />
methods as against the results under application <strong>of</strong><br />
other methods.<br />
The temporary regulations retain the best method<br />
considerations stated in the proposed regulations that<br />
observed that reliability is reduced under these methods<br />
if a substantial portion <strong>of</strong> the target’s nonroutine contributions<br />
to business activities is not required to be<br />
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covered by a PCT and, in the case <strong>of</strong> the market capitalization<br />
method, if the facts and circumstances demonstrate<br />
the likelihood <strong>of</strong> a material divergence between<br />
the PCT payee’s average market capitalization<br />
and the value <strong>of</strong> its underlying resources, capabilities,<br />
and rights for which reliable adjustments cannot be<br />
made.<br />
Residual Pr<strong>of</strong>it-Split and Other Methods<br />
The temporary regulations conform the modified<br />
residual pr<strong>of</strong>it-split method from the proposed regulations<br />
to the changes made to the income method.<br />
Other unspecified methods also may be used, but they<br />
must be acceptable under general and cost-sharing best<br />
method considerations. They also must consider the<br />
realistic alternatives to the transaction.<br />
Form <strong>of</strong> Payment<br />
The proposed regulations provided that the form <strong>of</strong><br />
payment selected for any PCT had to be specified no<br />
later than the date <strong>of</strong> the PCT. In the case <strong>of</strong> a postformation<br />
acquisition, the consideration under the PCT<br />
had to be paid in the same form as the consideration<br />
in the uncontrolled transaction in which the postformation<br />
acquisition was made. An example indicated that<br />
acquisitions for stock were considered to be for a fixed<br />
form <strong>of</strong> payment. The temporary regulations do not<br />
retain the special rule for postformation acquisitions.<br />
Subsequent acquisitions remain an important source <strong>of</strong><br />
platform contributions that occasion the requirement <strong>of</strong><br />
PCT compensation. Controlled participants may<br />
choose the form <strong>of</strong> payment for these PCTs.<br />
The temporary regulations incorporate rules to ensure<br />
that a contingent form for PCT payments is applied<br />
properly by both <strong>tax</strong>payers and the IRS. A CSA<br />
contractual provision that provides for payments for a<br />
PCT to be contingent on the exploitation <strong>of</strong> costshared<br />
intangibles will be respected as consistent with<br />
economic substance only if the allocation between the<br />
controlled participants <strong>of</strong> the risks attendant on this<br />
form <strong>of</strong> payment is determinable before the outcomes<br />
<strong>of</strong> the allocation that would have materially affected<br />
the PCT pricing are known or reasonably knowable.<br />
The contingent payment provision must clearly and<br />
unambiguously specify the basis on which the obligations<br />
are to be determined.<br />
Periodic Adjustments<br />
The proposed regulations used the commensurate<br />
with income provisions so that the Service can make<br />
periodic adjustments for an open <strong>tax</strong> year and all subsequent<br />
years <strong>of</strong> the CSA activity in the event <strong>of</strong> a periodic<br />
trigger. A periodic trigger arose if the PCT payer<br />
realized, over the period beginning with the earliest<br />
date on which the intangible development occurred<br />
through the end <strong>of</strong> the adjustment year, an actually<br />
experienced return ratio (AERR) <strong>of</strong> the present value<br />
<strong>of</strong> its total territorial operating pr<strong>of</strong>its divided by the<br />
present value <strong>of</strong> its investment consisting <strong>of</strong> the sum <strong>of</strong><br />
SPECIAL REPORTS<br />
its cost contributions plus PCT payments, outside the<br />
periodic return ratio range (PRRR) <strong>of</strong> between 0.5 and<br />
2. The Service would use an applicable discount rate,<br />
which in the case <strong>of</strong> some publicly traded entities<br />
would be their WACC, unless the Service determined,<br />
or the controlled participants established, that another<br />
discount rate better reflected the degree <strong>of</strong> risk <strong>of</strong> the<br />
CSA activity.<br />
Commentators <strong>of</strong>fered several criticisms <strong>of</strong> the periodic<br />
adjustment rules. Some considered the periodic<br />
adjustment rules to be inconsistent with the arm’slength<br />
standard and, through hindsight, to strip away<br />
returns for risk. Other commentators said <strong>tax</strong>payers<br />
should have the same ability as the Service to make<br />
periodic adjustments.<br />
The IRS and Treasury reaffirm that the commensurate<br />
with income principle is consistent, and periodic<br />
adjustments are to be administered consistently, with<br />
the arm’s-length standard. Accordingly, the temporary<br />
regulations continue to provide for periodic adjustments<br />
along lines similar to those in the intangible<br />
transfers portion <strong>of</strong> the section 482 regulations, as<br />
adapted for the cost-sharing context.<br />
In an important narrowing, the temporary regulations<br />
provide that a periodic trigger occurs if the<br />
AERR falls outside the PRRR <strong>of</strong> between 0.667 and<br />
1.5 (or between 0.8 and 1.25 if the <strong>tax</strong>payer has not<br />
substantially complied with the documentation requirements).<br />
The preamble states that this is intended to<br />
isolate situations in which the actual results suggest the<br />
potential <strong>of</strong> an absence <strong>of</strong> arm’s-length pricing as <strong>of</strong><br />
the date <strong>of</strong> the PCT.<br />
The IRS and Treasury believe that the periodic trigger<br />
under the temporary regulations more realistically<br />
targets the threshold at which periodic adjustment scrutiny<br />
is appropriate. In determining whether to make<br />
any periodic adjustments, the Service will consider<br />
whether the outcome as adjusted more reliably reflects<br />
an arm’s-length result under all relevant facts and circumstances.<br />
Periodic adjustments will not be made if the controlled<br />
participants establish to the satisfaction <strong>of</strong> the<br />
Service that all the conditions described in one <strong>of</strong> the<br />
exceptions below will apply regarding a trigger PCT.<br />
The first exception is that the same platform contribution<br />
was furnished to an uncontrolled <strong>tax</strong>payer under<br />
substantially the same circumstances as those <strong>of</strong><br />
the relevant trigger PCT and with a similar form <strong>of</strong><br />
payment as the trigger PCT. This applies only if the<br />
transaction served as the basis for the application <strong>of</strong><br />
the CUT method in the first year and all subsequent<br />
years in which substantial PCT payments relating to<br />
the trigger PCT were required to be paid. The amount<br />
<strong>of</strong> the PCT payments in the first year must have been<br />
at arm’s length.<br />
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SPECIAL REPORTS<br />
The second exception is that the differential is due<br />
to extraordinary events beyond the control <strong>of</strong> the controlled<br />
participants that could not reasonably have been<br />
anticipated as <strong>of</strong> the date <strong>of</strong> the trigger PCT.<br />
The third exception is that the periodic trigger<br />
would not have occurred had the PCT payer’s divisional<br />
pr<strong>of</strong>its or losses used to calculate its present<br />
value <strong>of</strong> total pr<strong>of</strong>its (PVTP) excluded those pr<strong>of</strong>its or<br />
losses attributable to the PCT payer’s routine contributions<br />
to its exploitation <strong>of</strong> the cost-shared intangibles,<br />
attributable to its operating cost contributions, and attributable<br />
to its nonroutine contributions to the CSA<br />
activity.<br />
In an important narrowing,<br />
the temporary regulations<br />
provide that a periodic<br />
trigger occurs if the AERR<br />
falls outside the PRRR <strong>of</strong><br />
between 0.667 and 1.5.<br />
The fourth exception is that the periodic trigger<br />
would not have occurred had the divisional pr<strong>of</strong>its or<br />
losses <strong>of</strong> the PCT payer used to calculate its PVTP<br />
included its reasonably anticipated divisional pr<strong>of</strong>its or<br />
losses after the adjustment year from the CSA activity,<br />
including its routine contributions, its operating cost<br />
contributions, and its nonroutine contributions to that<br />
activity, and had the cost contributions and PCT payments<br />
<strong>of</strong> the PCT payer used to calculate its PVI<br />
(present value <strong>of</strong> the PCT payer’s investment at the<br />
start date) included its reasonably anticipated cost contributions<br />
and PCT payments after the adjustment year.<br />
Also, a periodic trigger will not be deemed to have<br />
occurred in any year subsequent to the 10-year period<br />
beginning with the first <strong>tax</strong> year in which there is substantial<br />
exploitation <strong>of</strong> the cost-shared intangibles resulting<br />
from the CSA, if the AERR is within the<br />
PRRR for each year <strong>of</strong> the 10-year period. It also will<br />
not be deemed to have occurred in any year <strong>of</strong> the<br />
five-year period beginning with the first <strong>tax</strong> year in<br />
which there is exploitation <strong>of</strong> the cost-shared intangibles<br />
resulting from the CSA if the AERR falls below<br />
the lower bound <strong>of</strong> the PRRR.<br />
The IRS and Treasury intend to issue by revenue<br />
procedure separate published guidance that provides an<br />
exception to periodic adjustments in the context <strong>of</strong> an<br />
advance pricing agreement. The guidance would provide<br />
that no periodic adjustments will be made in any<br />
year based on a trigger PCT that is a covered transaction<br />
under the APA. An APA process generally is contemporaneous<br />
with the <strong>tax</strong>payer’s original transactions<br />
and involves transparency concerning a <strong>tax</strong>payer’s upfront<br />
efforts to conform to the arm’s-length standard.<br />
Treatment <strong>of</strong> Payments<br />
CST payments generally will be considered the<br />
payer’s cost <strong>of</strong> developing intangibles at the location<br />
where the development is conducted. For these purposes,<br />
IDCs borne directly by a controlled participant<br />
that are deductible are deemed to be reduced to the<br />
extent <strong>of</strong> any CST payments owed to it by other controlled<br />
participants under the CSA.<br />
The PCT payer’s payment is deemed to be reduced<br />
to the extent <strong>of</strong> any payments owed to it from other<br />
controlled participants. PCT payments will be characterized<br />
consistently with the <strong>tax</strong>payer’s designation <strong>of</strong><br />
the type <strong>of</strong> transaction. Depending on the designation,<br />
the payments will be treated as either consideration for<br />
a transfer <strong>of</strong> an interest in intangible property or for<br />
services.<br />
Administrative Requirements<br />
Temp. Treas. reg. section 1.482-7T(k) contains the<br />
CSA administrative requirements. There are four main<br />
sections: contractual; documentation; accounting; and<br />
reporting requirements. This section <strong>of</strong> the temporary<br />
regulations is lengthy.<br />
The contractual rules are important. CSA agreements<br />
already in effect will need to be modified by<br />
July 6, 2009, by integrating those rules with the transition<br />
rules in temp. Treas. reg. section 1.482-7T(m). A<br />
CSA statement also will need to be filed by September<br />
2, 2009.<br />
Documentation is especially important under the<br />
temporary regulations. For example, careful analysis<br />
and documentation <strong>of</strong> discount rate choices could be<br />
very important. Also, the periodic adjustment trigger<br />
range is narrower for <strong>tax</strong>payers that fail to maintain<br />
adequate documentation.<br />
New Best Method Examples<br />
Example 13. USP and FS enter into a CSA to develop<br />
a new drug. Immediately before entering into the<br />
CSA, USP acquires Company X. X is engaged in research<br />
relevant to the product area, and its only significant<br />
resources and capabilities are its workforce and<br />
sole patent. The patent is associated with a compound<br />
that USP reasonably anticipates will contribute to developing<br />
the CSA product. The acquisition price<br />
method, based on the lump sum price paid by USP for<br />
Company X, is likely to provide a more reliable measure<br />
<strong>of</strong> an arm’s-length result than any other method.<br />
Example 14. Company X is a publicly traded U.S.<br />
company engaged in pharmaceutical research. Its only<br />
significant resources and capabilities are workforce and<br />
its sole patent. Company X has no marketable products.<br />
Company X enters into a CSA with FS, its newly<br />
formed foreign subsidiary, to develop a new drug. The<br />
new drug will be derived from the compound covered<br />
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y USP’s patent. All <strong>of</strong> Company X’s researchers will<br />
be engaged solely in research that is related to developing<br />
that product. Given that Company X’s platform<br />
contributions covered by PCTs relate to its entire economic<br />
value, application <strong>of</strong> the market capitalization<br />
method provides a reliable measure <strong>of</strong> an arm’s-length<br />
result.<br />
Example 15 describes a U.S. company (MDI) that<br />
developed a new dental surgical microscope that drastically<br />
shortens many surgical procedures. MDI entered<br />
into a CSA with a wholly owned foreign subsidiary to<br />
develop the next generation <strong>of</strong> the product. The interests<br />
are divided on a territorial basis. The rights associated<br />
with the current product, as well as MDI’s research<br />
capabilities, are reasonably expected to<br />
contribute to the development <strong>of</strong> the next generation<br />
product and are therefore platform contributions. At<br />
the time <strong>of</strong> the PCT, MDI’s only product is the microscope,<br />
although MDI was developing the next generation<br />
microscope. Concurrent with the CSA, MDI separately<br />
transfers exclusive and perpetual exploitation<br />
rights associated with the existing product to FS in the<br />
same territory as assigned to FS in the CSA. The example<br />
states that it is likely to be more reliable to<br />
evaluate the combined effect <strong>of</strong> the transactions than to<br />
evaluate them in isolation. This is because the combined<br />
transactions relate to all <strong>of</strong> the economic value<br />
<strong>of</strong> MDI. The market capitalization method is likely to<br />
produce a reliable measure <strong>of</strong> an arm’s-length payment<br />
for the aggregated transactions.<br />
Example 16 states the same facts as in Example 13,<br />
except that the acquisition occurred significantly in advance<br />
<strong>of</strong> the CSA and reliable adjustments cannot be<br />
made for this time difference. Also, Company X has<br />
other valuable molecular patents and associated research<br />
capabilities, apart from Compound X, that are<br />
not reasonably anticipated to contribute to the development<br />
<strong>of</strong> the CSA product and that cannot be reliably<br />
valued. The CSA divides divisional interests on a territorial<br />
basis. Under the terms <strong>of</strong> the CSA, USP will<br />
undertake all R&D and manufacturing as well as the<br />
distribution activities for its territory (the United<br />
States). FS will distribute the product in its territory<br />
(the rest <strong>of</strong> the world). FS’s distribution activities are<br />
routine in nature, and the pr<strong>of</strong>itability from its activities<br />
may be reliably determined from third-party comparables.<br />
FS does not furnish any platform intangibles.<br />
At the time <strong>of</strong> the PCT, reliable financial projections<br />
associated with development <strong>of</strong> the CSA product and<br />
its separate exploitation in each <strong>of</strong> the markets are undertaken.<br />
Application <strong>of</strong> the income method using CPM<br />
is likely to provide a more reliable measure <strong>of</strong> an<br />
arm’s-length result than application <strong>of</strong> the acquisition<br />
price method.<br />
Example 17 states the same facts as in Example 13,<br />
except that the acquisition occurred some time before<br />
the CSA, and Company X had some areas <strong>of</strong> promising<br />
research that are not reasonably anticipated to con-<br />
SPECIAL REPORTS<br />
tribute to developing the CSA product. The CSA divides<br />
divisional interests on a territorial basis. The<br />
Service determines that the acquisition price stated is<br />
useful in forming the arm’s-length price, but not necessarily<br />
determinative. Under the terms <strong>of</strong> the CSA, USP<br />
will undertake all R&D and manufacturing associated<br />
with the product as well as distribution activity for its<br />
territory (the United States). FS will distribute the CSA<br />
product in its territory (the rest <strong>of</strong> the world). FS’s activities<br />
are routine in nature, and the pr<strong>of</strong>itability from<br />
its activities may be reliably determined from thirdparty<br />
comparables. It is possible that the acquisition<br />
price method or the income method using CPM might<br />
reasonably be applied. Whether the acquisition price<br />
method or the income method provides the most reliable<br />
evidence <strong>of</strong> an arm’s-length price for USP’s contributions<br />
depends on a number <strong>of</strong> factors, including<br />
the reliability <strong>of</strong> the financial projections, the reliability<br />
<strong>of</strong> the discount rate chosen, and the extent to which<br />
the acquisition price <strong>of</strong> Company X could be reliably<br />
adjusted to account for changes in value over the period<br />
between the acquisition and the formation <strong>of</strong> the<br />
CSA and to account for the value <strong>of</strong> the in-process<br />
research work done by Company X that does not constitute<br />
platform contributions to the CSA.<br />
Example 18 states that the facts are the same in Example<br />
17, except that FS has a patent on Compound<br />
Y, which the parties reasonably anticipate will be useful<br />
in mitigating potential side effects associated with<br />
Compound X and could thereby contribute to the development<br />
<strong>of</strong> the product. The rights in Compound Y<br />
constitute a platform contribution for which compensation<br />
is due from USP as a part <strong>of</strong> the PCT. The value<br />
<strong>of</strong> FS’s platform contribution cannot be reliably measured<br />
by market benchmarks. Under the facts, it is possible<br />
that either the acquisition price or the income<br />
method together or the residual pr<strong>of</strong>it-split method<br />
might reasonably be applied to determine the arm’slength<br />
PCT payment due between USP and FS. Under<br />
the first option, the PCT payment for the platform contributions<br />
related to Company X’s workforce, and<br />
Compound X would be determined using the acquisition<br />
price referring to the lump sum price paid by USP<br />
for Company X. Because the value <strong>of</strong> these platform<br />
contributions can be determined by reference to a market<br />
benchmark, they are considered routine platform<br />
contributions. Accordingly, the platform contribution<br />
related to Compound Y would be the only nonroutine<br />
platform contribution, and the relevant PCT payment<br />
is determined using the income method. Alternatively,<br />
rather than looking to the acquisition price for Company<br />
X, all the platform contributions are considered<br />
nonroutine and the residual pr<strong>of</strong>it-split method is applied<br />
to determine the PCT payments for each platform<br />
contribution. Under either option, the PCT payments<br />
will be netted against each other.<br />
Whether the acquisition price method together with<br />
the income method or the residual pr<strong>of</strong>it-split method<br />
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SPECIAL REPORTS<br />
provides the most reliable evidence <strong>of</strong> the arm’s-length<br />
price <strong>of</strong> the platform contributions depends on a number<br />
<strong>of</strong> factors, including the reliability <strong>of</strong> the determination<br />
<strong>of</strong> the relative values <strong>of</strong> the platform contributions<br />
for purposes <strong>of</strong> the residual pr<strong>of</strong>it-split method,<br />
and the extent to which the acquisition price <strong>of</strong> the<br />
company can be reliably adjusted to account for<br />
changes in value over the period between the acquisition<br />
and the formation <strong>of</strong> the CSA and to account for<br />
the value <strong>of</strong> the rights and in-process research done by<br />
Company X that does not constitute platform contributions<br />
to the CSA. It is also relevant to consider<br />
whether the results <strong>of</strong> each method are consistent with<br />
each other, or whether one or both methods are consistent<br />
with other potential methods that could be applied.<br />
Transition Rules<br />
The proposed regulations included transition rules<br />
for existing qualified cost-sharing arrangements. Grandfather<br />
treatment would have been terminated in some<br />
events, including the occasion <strong>of</strong> a periodic trigger as a<br />
result <strong>of</strong> a subsequent PCT, a material change in the<br />
scope <strong>of</strong> the arrangement, such as a material expansion<br />
<strong>of</strong> the activities undertaken beyond the scope <strong>of</strong><br />
the intangible development area, or a 50 percent or<br />
greater change in the ownership <strong>of</strong> interests in costshared<br />
intangibles. Commentators objected to the<br />
grandfather termination events.<br />
The temporary regulations do not terminate the<br />
grandfather treatment upon a 50 percent change <strong>of</strong><br />
ownership or on account <strong>of</strong> a subsequent periodic trigger<br />
or a material change in the scope <strong>of</strong> the arrangement.<br />
The temporary regulations instead adopt a targeted<br />
provision that applies the temporary regulations’ periodic<br />
adjustment rules to PCTs that occur on or after<br />
the date <strong>of</strong> a material change in the scope <strong>of</strong> a grandfathered<br />
CSA. A material change in scope would include<br />
a material expansion <strong>of</strong> the activities undertaken<br />
beyond the scope <strong>of</strong> the IDA. For this purpose, a contraction<br />
<strong>of</strong> the scope <strong>of</strong> the CSA, absent the material<br />
expansion into one or more lines <strong>of</strong> research and development<br />
beyond the scope <strong>of</strong> the IDA, does not constitute<br />
a material change in the scope <strong>of</strong> the CSA.<br />
Whether a material change in scope has occurred is<br />
determined on a cumulative basis. Therefore, a series<br />
<strong>of</strong> expansions, any one <strong>of</strong> which is not a material expansion<br />
by itself, may collectively constitute a material<br />
expansion.<br />
An arrangement in existence on January 5, 2009,<br />
will be considered a CSA if before that date it was a<br />
qualified cost-sharing arrangement under Treas. reg.<br />
section 1.482-7, but only if the written agreement is<br />
amended if necessary to conform with, and only if the<br />
activities <strong>of</strong> the controlled participants substantially<br />
comply with, the provisions <strong>of</strong> the new rules by July 6,<br />
2009. Temp. Treas. reg. section 1.482-7T(m) sets forth<br />
specific rules for how the temporary regulations apply<br />
to existing CSAs.<br />
Other Regulations<br />
Entity Classification<br />
The IRS finalized regulations to make the federal<br />
<strong>tax</strong> classification <strong>of</strong> the Bulgarian public limited liability<br />
company (aktsionerno druzhestevo) consistent with the<br />
federal <strong>tax</strong> classification <strong>of</strong> public limited liability companies<br />
organized in other countries <strong>of</strong> the European<br />
economic area: a per se corporation. (For the final<br />
regs, see Doc 2008-25013 or 2008 WTD 230-26.)<br />
Conduit Financing Arrangements<br />
The IRS and Treasury proposed regulations under<br />
sections 881 and 7701(l) dealing with conduit financing<br />
structures. (For the proposed regs, see Doc 2008-26696<br />
or 2008 WTD 246-27.) Treas. reg. section 1.881-3 allows<br />
the IRS to disregard the participation <strong>of</strong> one or more<br />
intermediate entities in a financing arrangement in<br />
which the entities are acting as conduit entities, and to<br />
recharacterize the financing arrangement as a transaction<br />
directly between the remaining parties to the financing<br />
arrangement for purposes <strong>of</strong> imposing <strong>tax</strong> under<br />
sections 871, 881, 1441, and 1442.<br />
Since the publication <strong>of</strong> Treas. reg. section 1.881-3,<br />
the IRS and Treasury issued the so-called check-thebox<br />
regulations. The preamble to the newly proposed<br />
regulations states that Treasury and the IRS are aware<br />
that issues have arisen regarding the proper treatment<br />
<strong>of</strong> disregarded entities under Treas. reg. section<br />
1.881-3. These proposed regulations clarify that a disregarded<br />
entity is a person under Treas. reg. section<br />
1.881-3. Thus, transactions that a disregarded entity<br />
enters into will be taken into account for purposes <strong>of</strong><br />
determining whether a financing arrangement exists.<br />
The preamble also states that the IRS and Treasury<br />
are continuing to study conduit financing arrangements<br />
and may issue separate guidance to address the treatment<br />
under those regulations <strong>of</strong> some hybrid instruments.<br />
Specifically, the IRS and Treasury are studying<br />
transactions in which a financing entity advances cash<br />
or other property to an intermediate entity in exchange<br />
for a hybrid instrument that is treated as debt under<br />
the laws <strong>of</strong> the foreign jurisdiction in which the intermediate<br />
entity is resident and is not treated as debt for<br />
U.S. federal <strong>tax</strong> purposes.<br />
The issue is whether these instruments should constitute<br />
a financing transaction under the section 881<br />
regulations. One possible approach, the preamble<br />
states, is to treat all transactions involving these hybrid<br />
instruments between a financing entity and an intermediate<br />
entity as financing transactions. Comments are<br />
requested. Another possible approach is to add additional<br />
factors to consider in determining when stock in<br />
a corporation (or other similar interest in a partnership<br />
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or trust) may constitute a financing transaction. The<br />
additional factors would focus on whether, based on<br />
the facts and circumstances surrounding the stock, the<br />
financing entity has sufficient legal rights to, or other<br />
practical assurances regarding, the payment received by<br />
the intermediate entity to treat the stock as a financing<br />
transaction. Comments are requested.<br />
Consolidated Return Regs: Intercompany Debt<br />
The IRS and Treasury finalized a new version <strong>of</strong><br />
Treas. reg. section 1.1502-13(g), which deals with intercompany<br />
debt obligations in the context <strong>of</strong> a U.S. consolidated<br />
<strong>tax</strong> return. The regulation involves mostly<br />
domestic issues, which I will not cover here. However,<br />
it also addresses two potential <strong>international</strong> issues.<br />
The new regulations allow the transfer <strong>of</strong> intercompany<br />
debt obligations in a <strong>tax</strong>-free manner in some<br />
situations. It also contains antiavoidance rules to preserve<br />
a proper matching within the consolidated return.<br />
In one case, the assignment <strong>of</strong> an intercompany obligation<br />
by a creditor member under section 351 can be a<br />
triggering transaction, which means the intercompany<br />
debt obligation is deemed paid and reissued, with<br />
whatever consequences that brings.<br />
One <strong>of</strong> the situations in which the intercompany<br />
debt obligation is triggered by the creditor’s transfer<br />
under section 351 is when the transferor or transferee<br />
member has a loss subject to a limitation (for example,<br />
a loss from a separate return limitation or a dual consolidated<br />
loss that is subject to limitation under Treas.<br />
reg. section 1.1503(d)-4), but only if the other member<br />
is not subject to a comparable limitation.<br />
When debt becomes an intercompany obligation,<br />
the deemed satisfaction and deemed reissuance are<br />
treated as transactions separate and apart from the<br />
transaction in which the debt becomes an intercompany<br />
obligation, and the <strong>tax</strong> consequences <strong>of</strong> the transaction<br />
in which the debt becomes an intercompany<br />
obligation must be determined before the deemed satisfaction<br />
and reissuance occurs. The regulation states<br />
that ‘‘for example, if the debt became an intercompany<br />
obligation in a transaction in which section 351 applies,<br />
any limitation imposed by section 362(e) on the<br />
basis <strong>of</strong> the intercompany obligation in the hands <strong>of</strong><br />
the transferee member is determined before the deemed<br />
satisfaction and reissuance.’’ Section 362(e)(1) provides<br />
for a limitation on the importation <strong>of</strong> built-in losses,<br />
and section 361(e)(2) provides for a limitation on the<br />
transfer <strong>of</strong> built-in losses in section 351 transactions.<br />
The example might involve a foreign parent company<br />
contributing to its U.S. subsidiary (the parent <strong>of</strong> the<br />
U.S. consolidated group) an obligation that thereafter<br />
becomes an intercompany obligation.<br />
IRS Rulings and Notices<br />
Withholding Tax<br />
The Internal Revenue Service announced that it is<br />
adding withholding <strong>tax</strong>es to the tier 1 list <strong>of</strong> issues.<br />
SPECIAL REPORTS<br />
Dual Capacity Taxpayers<br />
LTRs 200850023, 200850024, and 200850025<br />
granted permission to <strong>tax</strong>payers to revoke their previous<br />
elections to use the dual capacity <strong>tax</strong>payer safe<br />
harbor method described in Treas. reg. section 1.901-<br />
2A(c)(3) in determining the amount <strong>of</strong> their foreign<br />
income <strong>tax</strong>es paid or accrued to a foreign country. The<br />
safe harbor method election may not be revoked without<br />
the consent <strong>of</strong> the Service. Consent is normally<br />
given, provided the conditions in the regulations are<br />
satisfied. The three rulings appear to have been issued<br />
to the same U.S. consolidated group.<br />
Subpart F and Partnerships<br />
In Notice 2009-7, 2009-3 IRB 312, the IRS identified<br />
as transactions <strong>of</strong> interest transactions in which a<br />
CFC owns an interest in a domestic partnership that in<br />
turn owns interests in lower-tier CFCs. (For Notice<br />
2009-7, see Doc 2008-27221 or 2008 WTD 250-22.) The<br />
stated concern is that the lower-tier CFC’s subpart F<br />
income may not be included in income by the U.S. parent<br />
company. This would seem to be in accord with<br />
the statute, in which a domestic partnership is classified<br />
as a U.S. person. Most interesting, however, is that<br />
the Service approved just such a structure in a recent<br />
letter ruling. LTR 200838003, discussed in a previous<br />
column, approved such a structure in the context <strong>of</strong><br />
the PFIC rules. (For prior coverage, see Tax Notes Int’l,<br />
Oct. 27, 2008, p. 343, Doc 2008-22362, or2008 WTD<br />
211-9.) It is curious that the Service was willing to favorably<br />
rule on just such a structure, yet a couple <strong>of</strong><br />
months later described it as a transaction <strong>of</strong> interest.<br />
Restructured Transaction<br />
CCA 200849012 describes a U.S. parent company<br />
that in concert with a Country Y bank adopted a <strong>tax</strong><br />
strategy developed and marketed by a promoter. A special<br />
purpose vehicle was incorporated in Country Y.<br />
The SPV was formed with funds <strong>of</strong> the parent and the<br />
bank. The parent received an equal number <strong>of</strong> shares<br />
<strong>of</strong> preferred stock and common stock. Each share <strong>of</strong><br />
preferred stock was stapled to each share <strong>of</strong> common<br />
stock, making a combined unit (referred to as the Class<br />
B securities). The value <strong>of</strong> the preferred shares vis-à-vis<br />
that <strong>of</strong> the common shares was highly disproportionate<br />
(1,000-1 ratio). The bank received an equal number <strong>of</strong><br />
Class A securities, which were similarly stapled units.<br />
SPV purchased accounts receivable at a discount<br />
from the parent’s subsidiaries and transferred/assigned<br />
most <strong>of</strong> the remaining funds to the parent as a loan.<br />
According to the transactional documents, SPV was to<br />
purchase monthly accounts receivable from the parent’s<br />
group with monies repaid to it by the parent on the<br />
loan. SPV was to simultaneously relend the excess <strong>of</strong><br />
the monthly loan repayments over the monthly purchase<br />
amounts to the parent’s group. In reality, the<br />
CCA states, the purchase <strong>of</strong> accounts receivable, collection<br />
<strong>of</strong> loan repayments, and relending to the parent<br />
never took place other than perhaps as book entries.<br />
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SPECIAL REPORTS<br />
The <strong>tax</strong>payer asserts that SPV’s two business activities<br />
were factoring accounts receivable and lending<br />
money. The simultaneous lending and alleged purchase<br />
activities essentially operated with monies contributed<br />
by the parent to SPV as a circular cash flow, because<br />
those funds were immediately retransferred to the parent’s<br />
group as loan proceeds and/or purchase monies.<br />
The simultaneous lending and alleged purchase activities<br />
also operated with respect to monies contributed<br />
by the bank to SPV as loan proceeds (some amount <strong>of</strong><br />
which was purchase money to buy the parent’s accounts<br />
receivable). SPV (the purported factor) had<br />
hired the parent’s group to service and collect on the<br />
accounts receivable that the parent’s group allegedly<br />
sold to SPV.<br />
The CCA concludes that SPV did not in effect or in<br />
substance factor the parent’s accounts receivable. SPV<br />
never owned the accounts receivable. At no time did<br />
SPV ever physically possess the accounts receivables<br />
files or any <strong>of</strong> the funds collected on the accounts receivable.<br />
The funds essentially stayed with the parent<br />
group, and SPV appears to have received only a security<br />
interest in the accounts receivable and the collections<br />
thereon. SPV was not given a present possessory<br />
interest on either the accounts receivable or the funds<br />
collected on those accounts receivable.<br />
The steps involved in the transactions, when taken<br />
together, the CCA states, closely resemble, and have<br />
many <strong>of</strong> the same characteristics as a revolving line <strong>of</strong><br />
credit from the bank to the parent, with the parent’s<br />
accounts receivable being used as collateral for the<br />
loan. The parent and its subsidiaries maintained lockboxes<br />
in their own names into which they put the<br />
monies collected in servicing the accounts receivable<br />
they allegedly sold to SPV. SPV would acquire dominion<br />
and control over the contents <strong>of</strong> those boxes only<br />
on the occurrence <strong>of</strong> a termination event.<br />
The purported factoring transactions permitted the<br />
parent to deduct on its consolidated federal income <strong>tax</strong><br />
returns both the losses in the aggregate amount <strong>of</strong> the<br />
discounts arising from the sale <strong>of</strong> the accounts receivable<br />
and the interest payment by the parent’s group<br />
made on the loans received from SPV. No U.S. income<br />
<strong>tax</strong> was paid on the interest or discount income earned<br />
by SPV. SPV did not treat its discount and interest income<br />
as attributable to a U.S. permanent establishment,<br />
nor did the parent withhold 30 percent U.S. <strong>tax</strong><br />
on the interest and discount paid to SPV. Further, the<br />
parent did not treat SPV as a controlled foreign corporation.<br />
The Service held that when viewed in substance, the<br />
series <strong>of</strong> transactions constituted solely lending activities,<br />
that is, monies loaned by the bank to SPV for the<br />
purpose <strong>of</strong> having SPV relend those same funds to the<br />
parent. SPV’s main role in the series <strong>of</strong> transactions<br />
was merely that <strong>of</strong> a lender <strong>of</strong> monies to the parent, or<br />
a conduit through which the bank passed the loan proceeds<br />
to the parent. The Service may alternatively ar-<br />
gue that either the loans were between SPV and the<br />
parent or that they were between the bank and the parent,<br />
with SPV acting merely as a conduit through<br />
which the loan proceeds passed. Either way, the parent<br />
is not entitled to deduct the purported losses arising<br />
from the factoring transactions, but should be allowed<br />
additional interest deductions resulting from the new<br />
recharacterization <strong>of</strong> these items.<br />
As an alternative position to recasting the transaction<br />
as a direct loan from the bank to SPV, the CCA<br />
recommends that the Service assert that the bank’s interest<br />
in SPV is strictly a debt interest with an equity<br />
kicker, rather than a stock interest in SPV. In that case,<br />
the parent would be the sole shareholder <strong>of</strong> SPV,<br />
which would be a CFC. The CCA states that recharacterizing<br />
the Class A securities as debt instruments<br />
would effectively deny the parent’s deduction for the<br />
factoring discount through the use <strong>of</strong> section 267.<br />
The CCA states that recasting the transaction as<br />
merely a loan between the bank and the parent with<br />
SPV’s role as that <strong>of</strong> a conduit provides the correct<br />
and most satisfactory resolution <strong>of</strong> the matter. Recharacterizing<br />
the transaction in this manner more accurately<br />
captures the true substance <strong>of</strong> the transaction. It<br />
also would serve to eliminate any section 267 issue,<br />
because under this recast, no sale <strong>of</strong> accounts receivable<br />
between the parent and SPV would be considered<br />
to have taken place, and, therefore, the parent would<br />
not have realized any loss on a purported sale <strong>of</strong> the<br />
receivables.<br />
Publicly Traded Partnerships<br />
LTR 200852005 described X, which was originally<br />
organized as a foreign entity that constitutes a per se<br />
corporation for U.S. <strong>tax</strong> purposes. (For LTR<br />
200852005, see Doc 2008-27159 or 2008 WTD 251-17.)<br />
A acquired all <strong>of</strong> the outstanding ordinary shares <strong>of</strong><br />
X. X then reregistered as an eligible entity under the<br />
laws <strong>of</strong> that foreign country and filed a check-the-box<br />
election to be treated as a partnership for U.S. <strong>tax</strong> purposes.<br />
In addition to its ordinary shares, X has outstanding<br />
B shares that are nonvoting, noncumulative preference<br />
shares that are widely held. The B shares previously<br />
were listed and traded on a stock exchange, although<br />
they since have been delisted. Holders <strong>of</strong> B shares have<br />
the right to sell their shares to X on a certain date each<br />
year. Also, X implemented an <strong>of</strong>f-market repurchase<br />
program under which the owners <strong>of</strong> the B shares may<br />
sell their shares to X twice per month. X has the right<br />
to repurchase all outstanding B shares without the consent<br />
<strong>of</strong> the B shareholders at a certain time for a specified<br />
price. X intends to exercise its right to redeem all<br />
<strong>of</strong> the B shares at that time.<br />
The <strong>tax</strong>payer sought and obtained a ruling that X is<br />
not a publicly traded partnership under section 7704(b).<br />
Section 7704(b) provides that the term ‘‘publicly traded<br />
partnership’’ means any partnership if: (1) interests in<br />
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the partnership are traded on an established securities<br />
market; or (2) interests <strong>of</strong> the partnership are readily<br />
tradable on a secondary market (or the substantial<br />
equivalent there<strong>of</strong>). The section 7704 regulations provide<br />
that transfers under a closed end redemption plan<br />
are disregarded in determining whether interests in a<br />
partnership are readily tradable on a secondary market<br />
or the substantial equivalent there<strong>of</strong>.<br />
Interests in X are not traded on an established securities<br />
market. The repurchase program and the rights <strong>of</strong><br />
B shareholders to sell their B shares to X each year<br />
qualify as closed end redemption plans under section<br />
7704 regulations. Therefore, the redemptions under<br />
those plans are disregarded in determining whether the<br />
interests in X are readily tradable on a secondary market<br />
or the substantial equivalent there<strong>of</strong>.<br />
FIRPTA<br />
LTR 200851023 describes the <strong>tax</strong>payers as four foreign<br />
corporations that raise funds from non-U.S. investors<br />
to invest in real estate and real-estate-related investments<br />
located in the United States. (For LTR<br />
200851023, see Doc 2008-26742 or 2008 WTD 247-32.) X,<br />
a U.S. partnership, was created at the same time that<br />
the foreign corporations were created to raise funds<br />
from U.S. investors to invest in the same real estate and<br />
real-estate-related investments. The foreign corporations<br />
and X are collectively referred to as ‘‘feeder funds.’’ As<br />
funds were periodically raised by one or more <strong>of</strong> the<br />
feeder funds, a new domestic corporation was created,<br />
and those funds were contributed to the new domestic<br />
corporation. Each <strong>of</strong> these newly created domestic corporations<br />
constituted a U.S. real property holding company<br />
under section 897. The corporations used the<br />
contributed funds to purchase assets that constituted<br />
U.S. real property interests. One <strong>of</strong> these corporations<br />
is A. A owns interests in a U.S. limited partnership,<br />
which owns interests in some U.S. real property.<br />
The <strong>tax</strong>payers have proposed to form a new foreign<br />
partnership (FP) and to contribute all <strong>of</strong> their equity<br />
interests in the corporations, including A (transferred<br />
property), to FP in a transaction qualifying under section<br />
721. Each <strong>of</strong> the <strong>tax</strong>payers represents that, for purposes<br />
<strong>of</strong> section 897(g), the interests in FP that the <strong>tax</strong>payers<br />
receive in exchange for the transferred property<br />
will be a U.S. real property interest to the extent attributable<br />
to U.S. real property interests <strong>of</strong> FP.<br />
Shortly after the <strong>tax</strong>payer’s contribution, the U.S.<br />
limited partnership will dispose <strong>of</strong> all <strong>of</strong> its assets in a<br />
fully <strong>tax</strong>able transaction. The partnership will use the<br />
proceeds to settle any outstanding liabilities and then<br />
distribute its remaining assets to its partners, including<br />
A, in a complete liquidation. A will use the proceeds<br />
received in the liquidation to settle its outstanding<br />
liabilities and then distribute its remaining assets to its<br />
shareholders, which will include FP and X, in a complete<br />
liquidation under section 331.<br />
Provided that FP adopts the remedial allocation<br />
method under the section 704 regulations and complies<br />
with the filing requirements <strong>of</strong> temp. Treas. reg. section<br />
1.897-5T(d)(1)(iii), the Service ruled that the <strong>tax</strong>payers’<br />
transfer <strong>of</strong> the transferred property in exchange for<br />
partnership interests in FP will constitute a nonrecognition<br />
transaction under section 721 and section 897(e).<br />
The Service also ruled that any gain that FP realizes<br />
in connection with the liquidation <strong>of</strong> A is not gain realized<br />
in connection with the disposition <strong>of</strong> a U.S. real<br />
property interest under section 897, provided that A<br />
satisfies the exclusion described in section 897(c)(1)(B).<br />
Section 897(c)(1)(B) provides that a <strong>tax</strong>payer can establish<br />
that a corporation was not a USRPHC during the<br />
five-year period ending on the date <strong>of</strong> the disposition<br />
<strong>of</strong> the interest by showing that the corporation did not<br />
hold any USRPIs on the date <strong>of</strong> the disposition <strong>of</strong> that<br />
interest and all <strong>of</strong> the USRPIs held by that corporation<br />
during the five-year period were disposed <strong>of</strong> in a transaction<br />
in which the full amount <strong>of</strong> gain was recognized.<br />
Treaties<br />
CCA 200848032 states that the U.S. competent authority<br />
has interpreted the mutual agreement procedure<br />
language in most U.S. treaties to mean that if the foreign<br />
country raises an adjustment, the U.S. can grant<br />
relief (a refund) even if it is for a <strong>tax</strong> year for which<br />
the statute <strong>of</strong> limitations has closed. The U.S. would<br />
not be able to increase a <strong>tax</strong>payer’s income under the<br />
treaty unless the IRS examiners had already assessed<br />
additional <strong>tax</strong>.<br />
Treaties<br />
Canada, Iceland, and Bulgaria<br />
Treasury announced on December 15, 2008, that the<br />
protocol to the Canada-U.S. treaty and the new treaties<br />
with Iceland and Bulgaria entered into force. (For the<br />
Treasury announcement, see Doc 2008-26353 or 2008<br />
WTD 242-30.)<br />
New Zealand<br />
SPECIAL REPORTS<br />
Treasury also announced that the U.S. and New<br />
Zealand agreed to enter into a treaty protocol. (For the<br />
treaty protocol, see Doc 2008-25303 or 2008 WTD 232-<br />
15.) The new agreement provides for the elimination <strong>of</strong><br />
source country <strong>tax</strong>ation on some direct dividends and<br />
on interest paid to banks and other financial enterprises<br />
when the payer <strong>of</strong> the interest is not a related party. It<br />
also reduces the limit <strong>of</strong> <strong>tax</strong>ation on cross-border payments<br />
<strong>of</strong> royalties from 10 percent to 5 percent.<br />
France<br />
Treasury announced that the U.S. and France signed<br />
a treaty protocol providing for the elimination <strong>of</strong><br />
source country <strong>tax</strong>ation <strong>of</strong> some direct dividends and<br />
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SPECIAL REPORTS<br />
the elimination <strong>of</strong> source country <strong>tax</strong>ation <strong>of</strong> crossborder<br />
royalty payments. (For the protocol and memorandum<br />
<strong>of</strong> understanding (MOU), see Doc 2009-670 or<br />
2009 WTD 8-30; for a U.S. Treasury news release, see<br />
Doc 2009-671 or 2009 WTD 8-31.) It also provides for<br />
mandatory arbitration in cases that cannot be resolved<br />
by the competent authorities within a specified period<br />
<strong>of</strong> time.<br />
Germany<br />
The U.S. and German competent authorities agreed<br />
on an MOU to a set <strong>of</strong> operating guidelines that detail<br />
how the mandatory binding arbitration provisions <strong>of</strong><br />
the U.S.-German <strong>tax</strong> treaty will operate. (For the MOU<br />
on the arbitration process, see Doc 2008-27070 or 2008<br />
WTD 249-32. For the operating guidelines, see Doc 2008-<br />
27071 or 2008 WTD 249-33.)<br />
The MOU was signed on December 8, 2008. It provides<br />
detailed guidance on several procedural issues<br />
relating to the arbitration process, including when the<br />
commencement date <strong>of</strong> a case is established; when arbitration<br />
proceedings must begin; how arbitration<br />
board members are appointed; what information to<br />
include in position papers; what to do when a case<br />
involves a permanent establishment issue or was initially<br />
submitted as a bilateral advance pricing agreement<br />
request; how to compensate the arbitration board<br />
members; and how to terminate arbitration proceedings.<br />
The MOU states that the competent authorities may<br />
not appoint as an arbitration board member current<br />
government employees or those who have left the government<br />
less than two years ago. Board members must<br />
have significant <strong>international</strong> <strong>tax</strong> experience.<br />
The MOU provides that each competent authority<br />
will be permitted to submit a proposed resolution paper<br />
(not to exceed 5 pages) and a supporting position paper<br />
(not to exceed 30 pages) within 90 days <strong>of</strong> the appointment<br />
<strong>of</strong> the arbitration board’s chair. In a PE case, the<br />
competent authorities may submit a paper that takes alternative<br />
positions. That is, the competent authority may<br />
take the position that no PE exists, but may also propose<br />
what amount <strong>of</strong> income should be allocated to the PE<br />
should the board determine that a PE does exist.<br />
Future Tax Policy<br />
In a previous column, I suggested that it might be<br />
helpful to reinstate section 965 for reasons discussed<br />
there. (For prior coverage, see Tax Notes Int’l, Nov.24,<br />
2008, p. 675, Doc 2008-24320, or2008 WTD 229-10.) Section<br />
965 encouraged repatriation <strong>of</strong> a huge amount <strong>of</strong><br />
low-<strong>tax</strong>ed foreign earnings and injected the cash into<br />
the U.S. economy.<br />
I noted that the American Shipping Reinvestment<br />
Act <strong>of</strong> 2008, introduced as H.R. 6374 and S. 3359,<br />
would provide an incentive to reinvest foreign shipping<br />
earnings in the U.S. in accordance with a modified section<br />
965. I also noted that an article in The New York<br />
Times on December 9, 2008, discussed the benefits <strong>of</strong><br />
reinstating section 965. The U.K. government has announced<br />
that it is considering such a provision.<br />
One alternative to section 965 that some <strong>tax</strong>payers<br />
have suggested involves allowing foreign subsidiaries to<br />
lend funds to their U.S. parent company for up to two<br />
years without triggering section 965. Reinstating section<br />
965 seems cleaner, but this is an alternative. ◆<br />
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February 9<br />
U.S. International Tax Reporting and<br />
Compliance — Fort Lauderdale, Fla.<br />
The Council for International Tax Education<br />
will sponsor a two-day seminar<br />
focusing on the latest IRS <strong>tax</strong> reporting<br />
requirements for U.S. companies with<br />
foreign operations.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
International Tax — New York. Networking<br />
Seminars will sponsor a oneday<br />
introduction to <strong>international</strong> <strong>tax</strong><br />
with topics including expense apportionment,<br />
earnings and pr<strong>of</strong>its, the foreign<br />
<strong>tax</strong> credit, and Subpart F income.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
elizabeth@networkingseminars.net<br />
February 10<br />
International Tax — New York. Networking<br />
Seminars will sponsor a oneday<br />
<strong>international</strong> <strong>tax</strong> update with topics<br />
including new contract manufacturing<br />
regulations, recent changes to the foreign<br />
<strong>tax</strong> credit, new service rules under section<br />
482, and treaty developments.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
elizabeth@networkingseminars.net<br />
February 11<br />
International Tax — New York. Networking<br />
Seminars will sponsor a oneday<br />
advanced <strong>international</strong> <strong>tax</strong> seminar<br />
with topics including inbound and outbound<br />
transactions, transfers <strong>of</strong> intangible<br />
assets, permanent establishments<br />
under <strong>tax</strong> treaties, foreign exchange, and<br />
financing foreign subsidiaries.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
elizabeth@networkingseminars.net<br />
February 16<br />
U.S. International Tax — Houston.<br />
ATLAS will sponsor a two-day introduction<br />
to U.S. <strong>international</strong> <strong>tax</strong> with topics<br />
including key issues involving the<br />
American Jobs Creation Act and the<br />
U.S. <strong>tax</strong> effects <strong>of</strong> generating income or<br />
losses from operations overseas.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
February 18<br />
U.S. International Tax — Houston.<br />
ATLAS will sponsor a two-and-a-halfday<br />
intermediate-level seminar on U.S.<br />
<strong>international</strong> <strong>tax</strong>ation.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
February 23<br />
U.S. Transfer Pricing — New York. The<br />
Council for International Tax Education<br />
will sponsor a two-day intermediate- to<br />
advanced-level seminar focusing on U.S.<br />
transfer pricing issues.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
Tax Accounting for U.S. Multinationals<br />
— New York. The Council for International<br />
Tax Education will sponsor a<br />
two-day conference on topics including<br />
computing <strong>tax</strong>es in assembling the corporate<br />
<strong>tax</strong> provision under FAS 109, <strong>tax</strong><br />
accounting requirements for reporting<br />
domestic production benefits, and how<br />
FIN 48 rules apply to uncertain <strong>tax</strong> positions<br />
for public and nonpublic companies.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
February 25<br />
Cross-Border Tax Controversies —<br />
Washington. The Tax Council Policy<br />
Institute will hold a two-day symposium<br />
focusing on topics including dispute<br />
resolution, transfer pricing, indirect <strong>tax</strong>ation,<br />
and permanent establishment and<br />
nexus. The keynote speaker will be IRS<br />
Commissioner Douglas Shulman.<br />
Contact: Donna Cox-Davies or Roger<br />
LeMaster.<br />
• Tel: (914) 686-5599 or<br />
(202) 822-8062<br />
• E-mail: dcox-davies@riverinc.com or<br />
rlemaster@tcpi.org<br />
• Web site: http://www.tcpi.org<br />
Global Transfer Pricing — Frankfurt.<br />
The C5 business information group will<br />
sponsor a two-day conference on minimizing<br />
corporate transfer pricing risks,<br />
with a special focus on regulatory requirements<br />
in France, Germany, India,<br />
Russia, the U.K., and the U.S.<br />
Contact: Susan Jacques.<br />
• Tel: +44 (0) 20 7878 6888<br />
• E-mail: s.jacques@C5-Online.com<br />
• Web site: http://www.C5-<br />
Online.com/transferpricing<br />
February 26<br />
Cyprus Double Tax Treaties —<br />
Moscow. The Moscow Times and Eur<strong>of</strong>ast<br />
Global Ltd. will sponsor a seminar<br />
on confidentiality agreements, <strong>tax</strong> treaties,<br />
and exchange <strong>of</strong> information.<br />
• Tel: +7 495 232 4774, 232 1769<br />
International Tax — Washington. The<br />
U.S. branch <strong>of</strong> the International Fiscal<br />
Association will sponsor a two-day conference<br />
on <strong>tax</strong> treaties, transfer pricing,<br />
The calendar is available online as<br />
Doc 2009-1789.<br />
Submissions to the Tax<br />
Calendar may be sent by fax to<br />
(703) 533-4646 or by e-mail to<br />
tni@<strong>tax</strong>.org.<br />
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TAX CALENDAR<br />
financially distressed companies from a<br />
Canadian perspective, and <strong>tax</strong>-effective<br />
supply chain management.<br />
• Tel: (866) 298-9464<br />
• E-mail: info@ifausa.org<br />
March 2<br />
International Tax — Miami. Networking<br />
Seminars Inc. will sponsor a one-day<br />
introductory course on <strong>international</strong><br />
<strong>tax</strong>ation and <strong>tax</strong>ation <strong>of</strong> foreign earnings<br />
<strong>of</strong> U.S. corporations.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
info@networkingseminars.net<br />
• Web site: http://<br />
www.networkingseminars.net<br />
March 3<br />
International Tax — Miami. Networking<br />
Seminars Inc. will sponsor a one-day<br />
intermediate course on <strong>international</strong><br />
<strong>tax</strong>ation focusing on recent U.S. rulings<br />
and changes to the <strong>international</strong> <strong>tax</strong><br />
regulations.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
info@networkingseminars.net<br />
• Web site: http://<br />
www.networkingseminars.net<br />
March 4<br />
International Tax — Miami. Networking<br />
Seminars Inc. will sponsor a one-day<br />
advanced course on <strong>international</strong> <strong>tax</strong>ation<br />
focusing on recent court decisions<br />
and U.S. and foreign <strong>tax</strong> rulings.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
info@networkingseminars.net<br />
• Web site: http://<br />
www.networkingseminars.net<br />
March 9<br />
U.S. International Tax Reporting and<br />
Compliance — Dallas. The Council for<br />
International Tax Education will sponsor<br />
a two-day seminar focusing on the<br />
latest IRS <strong>tax</strong> reporting requirements for<br />
U.S. companies with foreign operations.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
U.S. Infrastructure Investments — New<br />
York. ATLAS will sponsor a two-day<br />
seminar <strong>of</strong> the <strong>tax</strong> advantages <strong>of</strong> U.S.<br />
infrastructure investments, including<br />
information regarding public-private<br />
partnerships transactions.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
March 16<br />
International Tax Forum — San Francisco.<br />
ATLAS will sponsor a two-day<br />
forum on topics including new transfer<br />
pricing regulations, strategies for repatriating<br />
foreign earnings, and FAS 48 reporting.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
March 23<br />
U.S. Transfer Pricing — San Francisco.<br />
The Council for International Tax Education<br />
will sponsor a two-day introductory<br />
seminar on the U.S. transfer pricing<br />
rules.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
China Tax Update — San Francisco.<br />
The Council for International Tax Education<br />
will sponsor a two-day technical<br />
update on the latest legal, <strong>tax</strong>, and accounting<br />
issues facing companies with<br />
operations or business opportunities in<br />
China.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
U.S. International Tax — Seattle.<br />
ATLAS will sponsor a two-day introduction<br />
to U.S. <strong>international</strong> <strong>tax</strong> with topics<br />
including key issues involving the<br />
American Jobs Creation Act and the<br />
U.S. <strong>tax</strong> effects <strong>of</strong> generating income or<br />
losses from operations overseas.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
European and U.S. Cross-Border Financial<br />
Products — London. ATLAS and<br />
Structured Finance Institute will sponsor<br />
a two-day conference on the technical<br />
details <strong>of</strong> European and U.S. crossborder<br />
financial products.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
March 25<br />
U.S. International Tax — Seattle.<br />
ATLAS will sponsor an intermediatelevel<br />
three-day seminar on U.S. <strong>international</strong><br />
<strong>tax</strong> provisions using examples and<br />
case studies.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
March 30<br />
U.S. Tax Planning — Chicago. ATLAS<br />
will sponsor a two-day seminar on <strong>tax</strong><br />
planning in the current economic environment.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
April 2<br />
Corporate Taxation — Washington and<br />
Webcast. ALI-ABA and the ABA Section<br />
<strong>of</strong> Taxation will cosponsor a twoday<br />
course on topics including <strong>tax</strong>able<br />
merger and acquisition structures, crossborder<br />
issues, treatment <strong>of</strong> contingent<br />
liabilities, executive compensation and<br />
compensatory interests, and structures to<br />
accommodate private equity investors.<br />
• Tel: (800) 253-6397<br />
April 20<br />
Taxation <strong>of</strong> Financial Products —<br />
Chicago. ATLAS will sponsor a twoday<br />
introduction to <strong>tax</strong> and accounting<br />
issues regarding financial products and<br />
derivatives.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
U.S. International Tax Reporting and<br />
Compliance — Atlanta. The Council<br />
for International Tax Education will<br />
sponsor a two-day course on IRS <strong>tax</strong><br />
reporting requirements for U.S. companies<br />
with foreign operations.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
April 26<br />
Offshore Companies — Miami.<br />
Offshore Alert will sponsor a three-day<br />
conference on topics including defense<br />
against IRS administrative and criminal<br />
investigations, the limits <strong>of</strong> Chapter 15,<br />
Ponzi schemes, anti-money laundering,<br />
<strong>of</strong>fshore insurance products, and flagship<br />
<strong>tax</strong> investigations. Contact: Naomi<br />
Comerford.<br />
• Tel: (305) 372-6296<br />
• Web site: http://<br />
www.<strong>of</strong>fshorealertconference.com<br />
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April 27<br />
U.S. International Tax — New York.<br />
ATLAS will sponsor a two-day introduction<br />
to U.S. <strong>international</strong> <strong>tax</strong> with topics<br />
including key issues involving the<br />
American Jobs Creation Act and the<br />
U.S. <strong>tax</strong> effects <strong>of</strong> generating income or<br />
losses from operations overseas.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
April 29<br />
U.S. International Tax — New York.<br />
ATLAS will sponsor an intermediatelevel<br />
three-day seminar on U.S. <strong>international</strong><br />
<strong>tax</strong> provisions using examples and<br />
case studies.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
May 4<br />
International Tax — Chicago. Networking<br />
Seminars Inc. will sponsor a one-day<br />
introductory course on <strong>international</strong><br />
<strong>tax</strong>ation and <strong>tax</strong>ation <strong>of</strong> foreign earnings<br />
<strong>of</strong> U.S. corporations.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
info@networkingseminars.net<br />
• Web site: http://<br />
www.networkingseminars.net<br />
Foreign Tax Credit — Chicago. ATLAS<br />
will sponsor a two-day overview course<br />
on U.S. foreign <strong>tax</strong> credit mechanics<br />
under various code sections.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
May 5<br />
International Tax — Chicago. Networking<br />
Seminars Inc. will sponsor a one-day<br />
intermediate course on <strong>international</strong><br />
<strong>tax</strong>ation focusing on recent U.S. rulings<br />
and changes to the <strong>international</strong> <strong>tax</strong><br />
regulations.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
info@networkingseminars.net<br />
• Web site: http://<br />
www.networkingseminars.net<br />
May 6<br />
International Tax — Chicago. Networking<br />
Seminars Inc. will sponsor a one-day<br />
advanced course on <strong>international</strong> <strong>tax</strong>ation<br />
focusing on recent court decisions<br />
and U.S. and foreign <strong>tax</strong> rulings.<br />
• Tel: (914) 874-5395<br />
• E-mail:<br />
info@networkingseminars.net<br />
• Web site: http://<br />
www.networkingseminars.net<br />
May 7<br />
U.S. International Tax — Philadelphia.<br />
ATLAS will sponsor a two-day forum<br />
on topics including cross-border <strong>tax</strong><br />
planning for corporations and U.S. regulatory<br />
guidance.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
May 13<br />
Partnerships, LLCs, and Joint Ventures<br />
— Chicago. The Practising Law Institute<br />
will sponsor a three-day seminar on<br />
partnership <strong>tax</strong> rules.<br />
• Tel: (800) 260-4754<br />
• Web site: http://www.pli.edu<br />
May 18<br />
Earnings and Pr<strong>of</strong>its <strong>of</strong> Foreign Subsidiaries<br />
— Philadelphia. ATLAS will<br />
sponsor a two-day seminar focusing on<br />
new regulations for earnings and pr<strong>of</strong>its,<br />
subpart F income, and foreign <strong>tax</strong> credits.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
Latin America Tax Update — Miami.<br />
The Council for International Tax Education<br />
will sponsor a two-day conference<br />
that examines <strong>tax</strong> issues in doing business<br />
in Latin America.<br />
• Tel: (914) 328-5656<br />
• E-mail: info@citeusa.org<br />
U.S. International Transfer Pricing —<br />
Miami. The Council for International<br />
Tax Education will sponsor a two-day<br />
course on U.S. transfer pricing rules<br />
under IRC section 482.<br />
• Tel: (914) 328-5656<br />
TAX CALENDAR<br />
• E-mail: info@citeusa.org<br />
Tax Aspects <strong>of</strong> International Acquisitions<br />
— Philadelphia. ATLAS will<br />
sponsor a two-day seminar on crossborder<br />
business mergers and acquisitions.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
May 27<br />
Partnerships, LLCs, and Joint Ventures<br />
— New York. The Practising Law Institute<br />
will sponsor a three-day seminar on<br />
partnership <strong>tax</strong> rules.<br />
• Tel: (800) 260-4754<br />
• Web site: http://www.pli.edu<br />
June 4<br />
International Transfer Pricing —<br />
Chicago. ATLAS will sponsor a two-day<br />
seminar on pricing documentation, audits,<br />
competent authority procedures,<br />
and advanced pricing agreements.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
June 10<br />
Partnerships, LLCs, and Joint Ventures<br />
— San Francisco. The Practising Law<br />
Institute will sponsor a three-day seminar<br />
on partnership <strong>tax</strong> rules.<br />
• Tel: (800) 260-4754<br />
• Web site: http://www.pli.edu<br />
June 15<br />
U.S. International Tax — Boston.<br />
ATLAS will sponsor a two-day introduction<br />
to U.S. <strong>international</strong> <strong>tax</strong> with topics<br />
including key issues involving the<br />
American Jobs Creation Act and the<br />
U.S. <strong>tax</strong> effects <strong>of</strong> generating income or<br />
losses from operations overseas.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
June 17<br />
U.S. International Tax — Boston.<br />
ATLAS will sponsor an intermediatelevel<br />
three-day seminar on U.S. <strong>international</strong><br />
<strong>tax</strong> provisions using examples and<br />
case studies.<br />
• Tel: (800) 206-4432<br />
• Web site: http://www.atlas-sfi.com<br />
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Africa: Zein Kebonang<br />
Albania: Adriana Civici<br />
Angola: Trevor Wood<br />
Anguilla: Alex Richardson<br />
Antigua: Donald B. Ward<br />
Argentina: Cristian E. Rosso Alba; Sebastian Lopez-Sanson<br />
Armenia: Suren Adamyan<br />
Asia: Laurence E. Lipsher<br />
Australia: Graeme S. Cooper; Richard Krever; Philip Burgess<br />
Austria: Markus Stefaner; Clemens Philipp Schindler<br />
Bahamas: Hywel Jones<br />
Bangladesh: M. Mushtaque Ahmed<br />
Barbados: Patrick B. Toppin<br />
Belgium: Werner Heyvaert; Marc Quaghebeur<br />
Bermuda: Wendell Hollis<br />
Botswana: I.O. Sennanyana<br />
Brazil: David Roberto R. Soares da Silva<br />
Bulgaria: Todor Tabakov; Lubka Tzenova<br />
Cameroon: Edwin N. Forlemu<br />
Canada: Brian J. Arnold; Jack Bernstein; Steve Suarez<br />
Caribbean: Bruce Zagaris<br />
Cayman Islands: Timothy Ridley<br />
Chile: Macarena Navarrete<br />
China (P.R.C.): Laurence E. Lipsher; Peng Tao; Huiyan Qiu<br />
Cook Islands: David R. McNair<br />
Costa Rica: Alvaro Castro Mendez<br />
Croatia: Hrvoje Šimovic<br />
Cuba: Cristian Óliver Lucas-Mas<br />
Cyprus: Theodoros Philippou<br />
Czech Republic: Niko Härig<br />
Denmark: Nikolaj Bjørnholm; Jens Wittendorff<br />
Dominican Republic: Dr. Fernándo Ravelo Alvarez<br />
Eastern Europe: Iurie Lungu<br />
Ecuador: Roberto Silva Legarda<br />
Egypt: Abdallah El Adly<br />
Estonia: Viktor Trasberg; Inga Klauson<br />
European Union: Marco Rossi; Clemens Philipp Schindler<br />
Fiji: Bruce Sutton<br />
Finland: Marjaana Helminen<br />
France: Olivier Delattre; Michel Collet; Hervé Bidaud<br />
Gambia: Samba Ebrima Saye<br />
Germany: Jörg-Dietrich Kramer; Thomas Eckhardt; Clemens Philipp<br />
Schindler; Wolfgang Kessler; Rolf Eicke<br />
Ghana: Seth Terkper<br />
Gibraltar: Charles D. Serruya<br />
Greece: Alexandra Gavrielides<br />
Guam: Stephen A. Cohen<br />
Guernsey: Neil Crocker<br />
Guyana: Lancelot A. Atherly<br />
Hong Kong: Laurence E. Lipsher<br />
Hungary: Farkas Bársony<br />
Iceland: Indridi H. Thorlaksson<br />
India: Nishith M. Desai; Shrikant S. Kamath; Vaishali Mane; Mundachalil<br />
Padmakshan<br />
Indonesia: Freddy Karyadi<br />
Iran: Mohammad Tavakkol<br />
Ireland: Kevin McLoughlin<br />
Isle <strong>of</strong> Man: Richard Vanderplank<br />
Israel: Joel Lubell; Guy Katz<br />
Italy: Alessandro-Adelchi Rossi; Gianluca Queiroli; Marco Rossi; Federico<br />
Pacelli<br />
Japan: Paul Previtera<br />
Jersey: J. Paul Frith<br />
CORRESPONDENTS<br />
Kenya: Glenday Graham<br />
Korea: Sangmoon Chang<br />
Kuwait: Abdullah Kh. Al-Ayoub<br />
Latvia: Andrejs Birums; Valters Gencs<br />
Lebanon: Fuad S. Kawar<br />
Libya: Ibrahim Baruni<br />
Lithuania: Nora Vitkuniene<br />
Luxembourg: Jean-Baptiste Brekelmans<br />
Malawi: Clement L. Mononga<br />
Malaysia: Jeyapalan Kasipillai<br />
Malta: Dr. Antoine Fiott<br />
Mauritius: RamL.Roy<br />
Mexico: Jaime Gonzalez-Bendiksen; Koen van ’t Hek<br />
Middle East: Aziz Nishtar<br />
Monaco: Eamon McGregor<br />
Mongolia: Baldangiin Ganhuleg<br />
Morocco: Mohamed Marzak<br />
Myanmar: Timothy J. Holzer<br />
Nauru: Peter H. MacSporran<br />
Nepal: Prem Karki<br />
Netherlands: Eric van der Stoel; Michaela Vrouwenvelder; Jan Ter Wisch<br />
Netherlands Antilles: Dennis Cijntje; Koen Lozie<br />
New Zealand: Adrian Sawyer<br />
Nigeria: Elias Aderemi Sulu<br />
Northern Mariana Islands: John A. Manglona<br />
Norway: Frederik Zimmer<br />
Oman: Fudli R. Talyarkhan<br />
Panama: Leroy Watson<br />
Papua New Guinea: Lutz K. Heim<br />
Philippines: Benedicta Du Baladad<br />
Poland: Dr. Janusz Fiszer; Michal Tarka<br />
Portugal: Francisco de Sousa da Câmara; Manuel Anselmo Torres<br />
Qatar: Finbarr Sexton<br />
Russia: ScottC.Antel<br />
Saint Kitts-Nevis: Mario M. Novello<br />
Saudi Arabia: Fauzi Awad<br />
Serbia and Montenegro: Danijel Pantic<br />
Sierra Leone: Shakib N.K. Basma; Berthan Macaulay<br />
Singapore: Linda Ng<br />
Slovakia: Niko Härig<br />
South Africa: Peter Surtees<br />
Spain: Florentino Carreño; Sonia Velasco<br />
Sri Lanka: D.D.M. Waidyasekera<br />
Sweden: Leif Mutén; Mattias Dahlberg<br />
Switzerland: Thierry Boitelle<br />
Taiwan: Yu Ming-i<br />
Trinidad & Tobago: Rolston Nelson<br />
Tunisia: Lassaad M. Bediri<br />
Turkey: Mustafa Çamlica<br />
Turks & Caicos Islands, British West Indies: Ariel Misick<br />
Uganda: Frederick Ssekandi<br />
United Arab Emirates: Nicholas J. Love<br />
United Kingdom: Trevor Johnson; Nikhil Mehta; Tom O’Shea<br />
United States: James Fuller<br />
U.S. Virgin Islands: Marjorie Rawls Roberts<br />
Uruguay: Dr. James A. Whitelaw; Alberto Varela<br />
VAT Issues: Richard Ainsworth<br />
Vanuatu: Bill L. Hawkes<br />
Venezuela: Ronald Evans; Pedro Palacios Rhode<br />
Vietnam: Frederick Burke<br />
Zambia: W Z Mwanza<br />
Zimbabwe: Pr<strong>of</strong>. Ben Hlatshwayo<br />
478 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL<br />
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