International Tax Monthly – June Issue

Australia Outlines Approach to Cross-Border Financing

In a long-awaited move, the Australian Taxation Office (ATO) released draft guidelines setting out its approach to cross-border related party financing arrangements.

The guidance will apply to existing and new financing arrangements beginning July 1, 2017.

The ATO views these arrangements as a major tax compliance risk. The release of the proposal followed a landmark profit-shifting court decision against Chevron Australia Holdings Pty Ltd. The Full Federal Court had unanimously upheld a lower-court ruling that Chevron engaged in transfer pricing by paying a higher rate of interest on a loan from its subsidiary to shift profits from Australia to the United States. Those arrangements were aimed at reducing the company’s Australian tax bill. Chevron has said it will appeal the ruling to the Australian High Court.

The proposed guidance doesn’t provide formal safe harbors for cross-border related party financing arrangements. It also doesn’t contain detailed technical or legal analysis of the issues.

Implications for Intragroup Financing Arrangements

According to the guidance, the ATO expects “any pricing of a related party debt to be in line with the commercial incentive of achieving the lowest possible ‘all-in’ cost to the borrower.” In most cases, it expects “the cost of the financing to align with the costs that could be achieved, on an arm’s-length basis, by the parent of the global group to which the borrower and lender both belong,” the guidance states.

The document provides taxpayers with a clear road map for assessing their transfer pricing risk associated with intragroup financing arrangements, ranging from “green zone — low risk” to “red zone — very high risk.” Related party arrangements covered by an advance pricing arrangement or court decision, or settled or otherwise reviewed in the last three years, fall in the white zone where no further risk assessment is required.

Further, the guidance anticipates an amnesty period of broadly 18 months for taxpayers to align their intragroup cross-border financing arrangements for a green zone risk rating. Within this period, the tax commissioner will exercise his discretion to remit penalties and potential shortfall interest charges. There are clear indications that the ATO wants to cooperatively work with taxpayers with risk levels below red.

However, many taxpayers may be surprised by the risk calibration weighting. Those with financing arrangements structured around the arm’s-length principle and thin capitalization provisions may yet find themselves with a red rating.

For example, a taxpayer will have a “red — high risk” financing arrangement if its borrowing interest rate is more than 201 basis points over the cost of “referrable debt” (global group cost of debt, traceable third party debt or relevant third party debt) and any one of the following factors applies:

  • The lender is resident in a low-tax jurisdiction (tax rate between 1% and 15%).
  • The interest coverage ratio is below 3.3 (earnings before interest, tax, depreciation and amortization (EBITDA) divided by gross interest expense).
  • Gearing is greater than 60% (any taxpayer using a method other than safe harbor under the thin capitalization provisions).
  • There are “exotic features or instruments,” such as interest deferrals, conversion features and derivatives.

The principles would apply consistently to both inbound and outbound financing arrangements, but inbound deals are generally more likely to fall within the red zone.

Taxpayers with a red risk rating wouldn’t be allowed into the advance pricing agreement program. For them, the ATO has indicated it will likely move directly to an audit after a risk review and use its formal powers for information gathering.

The ATO will be monitoring attempts by taxpayers to notch up aspects of their financings to take full advantage of the indicators in the draft guidance.

Legal Agreements and Documentation

The guidance also highlights that taxpayers will need to ensure they have appropriate legal agreements in place to support their financing arrangements. The Full Federal Court in the Chevron decision highlighted the need for careful analysis of the parties’ precise legal relationships.

Intragroup agreements may be shorter than what might be found with independent lenders, but the ATO expects them to be complete and to accurately reflect the terms and conditions of the arrangement, including any relevant loan covenants. The ATO also expects that the higher the level of risk, the higher the quality of documentation.

Additionally, the guidance stresses that taxpayers subject to the expanded reportable tax positions schedule (a tax return attachment on which large businesses disclose their most contestable and material tax positions) will need to disclose their financing arrangement assessment.

What Should Affected Taxpayers Do?

In light of the draft guidance, enhanced ATO processes and required disclosures above, taxpayers would be strongly advised to review their intercompany financing arrangements to:

  • Determine the risk rating of their intragroup arrangements and whether any risk remediation is warranted to bring the financing arrangement in line with the guidance,
  • Consider whether additional transfer pricing or other supporting documentation should be prepared,
  • Prepare for their reportable tax position schedules to disclose their risk assessment,
  • Take care to ensure the ATO doesn’t view their risk remediation as notching up to take advantage of the guidance, and
  • Monitor the planned further ATO guidance material in relation to international tax matters.

Close of Feedback Period

Taxpayers’ internal tax risk management and tax governance processes will need to document the responses. The ATO welcomes feedback by June 30, 2017.

District Court: Definition of ‘Willful’ is Unclear in FBAR Case

The U.S. District Court for the Eastern District of Pennsylvania denied summary judgment to both the IRS and a taxpayer with regard to his Swiss bank account. In the case, the tax agency slapped the maximum penalty on the taxpayer for willfully failing to file a Report of Foreign Bank and Financial Accounts (FBAR).

The court concluded that whether the taxpayer willfully failed to submit an accurate FBAR was an inherently factual question and that genuine disputes existed as to what the taxpayer knew about his reporting requirements and when he knew it.

Case Background and Facts

Each U.S. person who has a financial interest in (or signature or other authority over) financial accounts in a foreign country with an aggregate value that exceeds $10,000 at any time during the calendar year must report that relationship each calendar year by filing an FBAR with the Department of the Treasury. Civil penalties can range up to $10,000 for each nonwillful violation. Generally, the penalties for willful violations can be the greater of $100,000 or 50% of the amount in the account at the time of the violation. Criminal penalties for violating the FBAR requirements while also violating certain other laws can range up to a $500,000 fine or 10 years in prison — or both. Civil and criminal penalties may be imposed together.

In the case at hand, a U.S. citizen who had a successful career in the pharmaceutical industry over the past several decades, including as Chief Executive Officer of a maker and distributor of generic medications, opened two savings accounts in Switzerland.

Throughout the years he maintained the accounts, his accountant prepared his tax returns. The taxpayer didn’t tell his accountant about the bank accounts until the 1990s, because, he stated, the accountant never asked about them. His accountant then told the taxpayer he’d been breaking the law for 20 years by not reporting the accounts. According to the taxpayer’s testimony, the accountant also said that:

  • The damage was already done,
  • Nothing could be done about it, and
  • The issue would be resolved on the man’s death when the assets in the accounts would be repatriated as part of his estate, and taxes would be paid on them then.

New Accountant Steps In

Based on this advice, as well as fear that he would be penalized for his years of noncompliance, the taxpayer didn’t report the accounts on his tax returns until 2007, when the accountant died and he hired a new accountant.

His 2007 tax return reflected the Swiss assets for the first time. He also filed his first FBAR in 2007. But he only reported the existence of one of his Swiss accounts, which had assets totaling approximately $240,000. The unreported account had assets of about $2.3 million. He didn’t report any of the income that he earned on either Swiss account.

Sometime after 2008, the Swiss bank told the man it would be providing his account information to the U.S. government. Around this time, he hired an attorney to look into his reporting obligations for the Swiss accounts and, in August 2010, he filed an amended 2007 federal return on which he reported the approximately $220,000 of income he had earned from the Swiss accounts. He also filed an amended FBAR for 2007, on which he reported both bank accounts. Although the taxpayer took this corrective action before the government began its audit, he didn’t do it until after the IRS learned of the accounts.

Focus 2008

The IRS began its investigation in April 2011, with a focus on tax year 2008. The taxpayer cooperated with the IRS and provided it with all documentation requested. The investigation culminated in a case panel of IRS agents recommending that the taxpayer be penalized for nonwillful violations of the FBAR reporting requirement and that the case be closed. For reasons unclear in the record, the case wasn’t closed but was reassigned to another IRS agent, who conducted her own review and concluded that the taxpayer’s violations had been willful.

On July 18, 2013, the IRS sent a letter telling the taxpayer it was imposing a penalty of $975,789, 50% of the maximum value of the account ($1,951,578), the largest penalty possible under the regulations.

The man sued in district court, alleging that an unwarranted penalty was imposed on him. The IRS counterclaimed for full payment of the penalty, as well as accrued interest on the penalty, a late payment penalty, and other statutory additions to the penalty. Both parties sought summary judgment.

The Issue of Intent

The district court denied both parties’ request for summary judgment. It found that the key question was whether either party had pointed to a lack of genuine dispute of material fact on their claims. The answer was “no.”

The court reasoned that the determinative issue for both claims was the taxpayer’s intent. Whether he’d willfully failed to submit an accurate FBAR for 2007 was an inherently factual question and one that couldn’t be resolved at this stage. Genuine disputes existed as to what the man knew regarding his reporting requirements and when he knew it. This was especially true as these issues related to his relationship with his accountant.

Although the court acknowledged that there was no good cause exception for willful violations of the FBAR filing requirements, it found that the taxpayer’s testimony on the information provided to him by his first accountant and what exactly he did with that information, if anything, would be relevant to a determination of his intent.

Various Conclusions

As various federal courts, the Internal Revenue Manual and the IRS Office of Chief Counsel had reached different conclusions about the level of intent necessary to satisfy the willfulness requirement, the court noted that precisely what “willful” means in context of the FBAR civil penalty provision wasn’t settled. It concluded that it didn’t need to determine what the appropriate standard of willfulness was at this juncture in the case. However, the court did note that the jurisprudential trend was toward one that would encompass reckless violations of the FBAR filing requirement.

Returned Tax Payments Were Refunds for Purposes of Foreign Tax Credit

The Tax Court ruled that certain payments received by a U.S. citizen working abroad from a foreign taxing authority were in fact refunds under the Internal Revenue Code.

Facts of the Case

A U.S. citizen worked for the London office of Goldman Sachs and received employee compensation from which United Kingdom income tax was withheld. The taxpayer filed both U.S. and UK income tax returns for each year at issue. On a timely filed U.S. return for each year, she claimed a foreign tax credit in an amount equivalent to the UK tax withheld by her employer.

On her UK tax return for each year, the taxpayer claimed substantial deductions attributable to investments in UK film partnerships allowed under UK tax law. Based on these deductions, the taxpayer applied for, and received, refunds on her UK tax returns.

However, the taxpayer took the position that these payments weren’t refunds under the U.S. tax code, because her entitlement to refunds remained under investigation by the UK taxing authority. Her Majesty’s Revenue and Customs (HMRC) characterized the film partnerships in which she had invested as “tax shelters.”

Litigation on this subject was still pending in various UK courts and, in the view of the woman’s tax advisors, HMRC was likely to prevail in its challenge to the deductions generated by the film partnerships. As a result, she didn’t file amended U.S. returns reporting reduced foreign tax credits or otherwise notify the IRS.

The IRS began a review of the woman’s returns and, at some point before or during the audit, the IRS was informed by UK taxing authorities that the taxpayer had invested in film partnerships, claimed substantial deductions, and filed UK returns requesting refunds. The IRS determined that the taxpayer had received UK income tax refunds of $413,216 in 2003, $292,663 in 2004, and $239,202 in 2005. The IRS disallowed the corresponding amounts of foreign tax credits that she had claimed on her U.S. returns.

The Question Before the Court

The IRS sought summary judgment on the ground that the overpayments of the UK income tax returned to the taxpayer were refunded. The woman acknowledged that she’d received these payments, but contended that they hadn’t been refunded, because her ultimate entitlement to refunds remained under investigation in the UK As a result, she argued, she wasn’t required to notify the IRS (by filing amended returns or otherwise). The question the Tax Court had to decide was how these amounts should be characterized for U.S. tax purposes.

The court held that the repayments of UK income tax that the taxpayer received represented previously paid foreign taxes that were “refunded in whole or in part” within the meaning of the U.S. tax code. She had indisputably received repayments of tax dollars from HMRC, and she agreed that she’d received these repayments under a claim of right.

The court accepted as true her statements that HMRC was challenging these repayments and that it might likely succeed in its efforts. However, it found that that was irrelevant in determining whether the repayments of UK tax that she’d received were refunds.

The court reasoned that, for U.S. tax purposes, the term “refund” didn’t connote finality or the final determination of a tax liability. The court noted that millions of Americans file Forms 1040 every year showing an overpayment and indicating the amount of the overpayment they want refunded. Generally, the IRS pays such refunds more or less automatically. Notwithstanding the payment of these refunds, the IRS routinely examines such returns and, if it concludes that the taxpayer incorrectly computed the tax, it may assess additional tax. In short, the fact that taxpayers may ultimately have to repay the money initially refunded doesn’t mean they didn’t get a refund.

As a cash basis taxpayer, the woman in this case was entitled to claim a credit for foreign income taxes when paid. If HMRC later collects additional tax, she would be entitled to claim a credit for those taxes. On the other hand, if the credits she claimed weren’t reduced to reflect the UK tax that was previously refunded, she would in effect be allowed a double credit for the same tax.

The court wasn’t persuaded by her contention that rejection of her argument might result in double taxation, contrary to the policies underlying the foreign tax credit and the tax treaty between the United States and the United Kingdom. She based this contention on the assertion that. if she were required to repay refunds previously received from HMRC, and if such repayments were considered creditable foreign taxes in the year they were paid, she would obtain no U.S. tax benefit from the credits.

Unpredictable Future

The court noted that the woman offered no explanation or factual support for this vague assertion. It concluded that, in any event, this didn’t demonstrate any structural defect in the tax code or give rise to double taxation. It often happens that taxpayers, because of individual circumstances or passage of time, are unable to derive full benefit from contingent tax assets they have booked or expect to receive, such as carryforwards of foreign tax credits, net operating losses, passive losses, or investment interest. Those circumstances simply reflect the facts that the future is unpredictable and that taxable income must be determined on an annual basis.