International Tax Monthly – November Issue

EU Gets a New System to Resolve Double-Taxation Disputes

The European Council recently approved a new system for resolving disputes between European Union (EU) nations, including disagreements related to double taxation.

The new procedures are designed to ensure that businesses and citizens can resolve disputes related to the interpretation of tax treaties more swiftly and effectively. It will also cover issues related to double taxation.

Mismatch or Differing Interpretations

Double taxation refers to cases where two or more countries claim the right to tax the same income or profits of a company or person. It can occur due to a mismatch in national rules or different interpretations of a bilateral tax treaty.

Pierre Moscovici, Commissioner for Economic and Financial Affairs, Taxation and Customs, said: “We proposed this new system to improve legal certainty and EU competitiveness by creating a binding obligation … to resolve tax disputes in a timely manner. This is an important step to allow EU citizens and businesses alike to have fair tax treatment.”

The European Commission (EC) said the changes will give taxpayers much more certainty when it comes to seeking resolution to their interpretations of tax treaties or double-taxation problems. In particular, a wider range of cases will be covered and EU nations will have clear deadlines to agree on a binding solution and a legal duty to take conclusive and enforceable decisions under the new mechanism. If not, the national courts will do this for them.

Arbitration Panel

The agreement is designed to ensure that taxpayers faced with tax treaty disputes can initiate a procedure whereby the nations in question must try to resolve the dispute amicably within two years. If at the end of this period no solution has been found, the nations must set up an Advisory Commission to arbitrate.

If member nations fail to do this, the taxpayer can bring an action before the national court. This commission will comprise three independent members and representatives of the competent authorities in question. It will have six months to deliver a final, binding decision, which will be immediately enforceable and must resolve the dispute.

Under the new dispute resolution process:

  • There will be an enforceable obligation on EU member nations to arrive at a resolution of all disputes that originate in tax treaties, including transfer pricing, and affect the tax position of businesses,
  • There will be clearly defined and enforceable timelines with a standard period of 18 months for the arbitration phase,
  • The scope of the dispute resolution will be extended to all tax disputes between EU member nations that derive from tax treaties and other international agreements, such as the elimination of double taxation for businesses and citizens, and
  • There will be an obligation to notify taxpayers and publish abstracts of the arbitration decisions.

$12.3 Billion in Disputes

The EC said that estimates show that there are currently around 900 double-taxation disputes in the EU today, estimated to be worth €10.5 billion ($12.3 billion).

OECD Issues Handbooks on CbC Reporting

New handbooks on country-by-country (CbC) reporting were issued by the Organisation for Economic Co-operation and Development (OECD).

Specifically, the handbooks deal with effective implementation and effective tax risk assessment. In general, 2018 will be the first year that tax authorities will receive more detailed transfer pricing information on large multinational enterprises (MNEs), with data on the groups’ revenue, profits, tax and other indicators of economic activity broken down by tax jurisdiction.

The reports should help both jurisdictions and enterprises better understand how these reports should be filed.

Effective implementation Handbook

Country-by-Country Reporting: Handbook on Effective Implementation contains information that countries should consider when implementing CbC reporting, including technical issues related to the filing, exchange and use of the reports.

In setting up CbC reporting, a jurisdiction must ensure that it has processes in place for:

  • Identifying entities required to file CbC reports,
  • Receiving CbC reports filed by resident entities,
  • Checking the completeness of CbC reports and preparing to exchange these reports with other jurisdictions, and
  • Imposing sanctions for noncompliance.

Chapter 4 of this handbook says that a number of jurisdictions — including Australia, Hungary, Ireland, Japan and Switzerland — emphasize the importance of electronic filing of CbC reports in the XML schema format, as it facilitates the handling and transmission of CbC reporting information.

Effective Tax Risk Assessment Handbook

Once the reporting processes are in place, tax authorities will need to begin using the transfer pricing information it receives. Country-by-Country Reporting: Handbook on Effective Tax Risk Assessment takes into account the various approaches applied in different countries, the types of tax risk indicators that may be identified in the CbC reports, and potential challenges. It shows how the reports can be an important tool for detecting and identifying transfer pricing and other risks related to the base erosion and profit shifting (BEPS) project.

Chapter 2 of this handbook notes that the following six core characteristics should be present for tax risk assessment processes to be effective:

1. Officials involved in risk assessment should be adequately trained and experienced in key areas.

2. The reports should be used to select taxpayers for further investigation, possibly including tax audit or other compliance activity. They shouldn’t be used as a substitute for such activity, to make tax adjustments, or to directly assess taxes.

3. Risk assessment processes should be dynamic and be responsive to feedback from the tax authority to ensure continuous improvement.

4. Strategies should combine different tools and take into account different elements of a group’s risk profile to minimize the chance that a higher-risk taxpayer is able to avoid detection by disguising a particular risk flag.

5. Governance processes should be in place to ensure adequate monitoring of the risk assessment function within the tax authority.

6. Processes should form part of a tax authority’s overall risk management framework.

Chapter 4 discusses several ways in which tax authorities may test for tax risks using CbC reporting data and sets out the following, and other, indicators:

1. The footprint of a group in a particular jurisdiction,

2. A group’s activities in a jurisdiction being limited to those that pose less risk,

3. A high value or high proportion of related-party revenues in a jurisdiction,

4. Results in a jurisdiction deviating from potential comparable results or not reflecting market trends,

5. Jurisdictions with significant profits, but little substantial activity or low levels of tax accrued, or with significant activities but low levels of profit (or losses),

6. A group being active in jurisdictions posing a BEPS risk,

7. Mobile activities of a group in jurisdictions where it pays a lower rate or level of tax,

8. Changes in a group’s structure, including the location of assets,

9. Intellectual property (IP) being separated from related activities within a group,

10. A group’s marketing or procurement entities in jurisdictions outside its key markets or manufacturing locations,

11. Income tax paid being consistently lower than income tax accrued, and

12. A group including dual resident entities or entities with no tax residence.

A Bit of Advice

The handbook ends with the following advice concerning the assessment of high-level transfer pricing risk and other BEPS-related risks:

“The results of this assessment using [reporting] information cannot be taken as conclusive evidence that the submitted tax position is incorrect…. No tax adjustments should be proposed on the basis of this initial analysis.”

IRS Outlines Penalty for not Filing International Information Return

IRS examiners received an updated international practice unit (IPU) explaining the penalty imposed on taxpayers who fail to file Form 5471, “Information Return of U.S. Persons With Respect to Certain Foreign Corporations.”

The IPU includes insight as to what constitutes reasonable cause for failing to file. (Note: IPUs aren’t official IRS pronouncements of law or directives and they can’t be used, cited, or relied upon as such. Nonetheless, they can let companies and shareholders identify strategic areas of importance to the IRS and give them insight into how IRS examiners may audit a particular issue or transaction.)

Timely and Accurate

IRS examiners are instructed to determine whether a taxpayer who is required to file the information return filed a timely and accurate form. Form 5471 must be filed along with the taxpayer’s income tax return, taking into account if the last day for filing was a weekend or legal holiday. If one isn’t timely filed, or it isn’t complete, penalties may be assessed unless the failure was due to reasonable cause.

In determining whether the form was complete, examiners should make sure that the following items aren’t omitted or incorrect:

  • The filer’s category,
  • The percentage of voting stock owned in the foreign corporation,
  • Information about the foreign corporation, such as address and principal business, and
  • Reference identification number.

Substantial Compliance

Common types of noncompliance include stating that required information will be furnished upon request or audit, and providing consolidated financial statements of multiple foreign corporations. The IPU notes that the doctrine of substantial compliance may apply in considering whether a Category 2 or 3 filer (see “Category 2 and 3 filers” below) timely submitted a complete Form 5471.

The substantial compliance doctrine is a narrow equitable doctrine used to avoid hardship in cases where the taxpayer establishes that he or she intended to comply with a provision and did everything reasonably possible to comply — but was unable to meet the provision’s specific requirements. The doctrine can only be applied where invocation of it wouldn’t defeat the policies of the underlying statutory provisions.

An IRS examiner who determines that the taxpayer failed to file a timely and accurate information return should establish a penalty case file and issue a notice letter. The letter should inform the taxpayer of the failure to file and explain that the initial $10,000 penalty will be imposed and that a continuation penalty will apply. Continuation penalties apply for each 30-day period (or fraction thereof) beginning 90 days after the date of the letter until a substantially complete Form 5471 is provided.

The notice letter should be mailed as soon as possible, both to obtain information early to effectively conduct the exam, and to start the initial 90-day period the taxpayer had to provide the form. There’s no provision to extend the 90-day period under the tax code. Such extensions can be allowed when reasonable, including for extreme hardship or a natural disaster.

Designated Representatives

Examiners are cautioned not to discuss the notice letter, or penalty issues generally, with a representative who isn’t designated on a Form 2848, “Power of Attorney and Declaration of Representative.” The IPU cautions that a power of attorney for the underlying income tax return doesn’t cover the penalty issue.

In determining penalties, the examiner must consider whether the taxpayer has shown that the failure was due to reasonable cause. Only the initial penalty — not the continuation penalty — can be considered for the reasonable cause exception. The taxpayer must provide a written statement that provides all of the facts alleged as reasonable cause, as well as a declaration that the statement was made under penalties of perjury.

Examiners should consider the taxpayer’s compliance with reporting and recordkeeping requirements and whether the taxpayer exercised ordinary care and prudence but still wasn’t able to provide any item of required information. Facts indicating reasonable cause include:

  • Erroneous advice,
  • An inability to obtain records, and
  • Death or serious illness.

Ignorance of the Law

Ignorance of the law isn’t by itself reasonable cause (but it might be in conjunction with other factors). The fact that a foreign jurisdiction would penalize the taxpayer for disclosing the information doesn’t generally constitute reasonable cause.

Form 8278 is the assessment document for international penalties. If both a continuation penalty and initial penalty are proposed, a separate Form 8278 is required for each.

Taxpayers should consult with their advisors if they have any doubts about compiling and filing this information return to help ensure they aren’t penalized.

Category 2 and 3 filers

The instructions for Form 5471 separate U.S. persons into different filing categories based on their relationship to the foreign corporation.

The category determines the type of information the U.S. person must provide. This international practice unit concerns penalties on Category 2 filers and Category 3 filers.

Category 2

A Category 2 filer is a U.S. citizen or resident who is an officer or director of a foreign corporation in which a taxpayer has acquired, in one or more transactions:

  • Stock that meets the 10% stock ownership requirement in the corporation, or
  • An additional 10% or more (in value or voting power) of the outstanding stock of the foreign corporation.

For purposes of both Categories 2 and 3, the stock ownership threshold is met if a taxpayer owns 10% or more of the total value of the foreign corporation’s stock, or of the total combined voting power of all classes of stock with voting rights.

Category 3:

A Category 3 filer:

  • Acquires stock in a foreign corporation that, when added to any stock already owned, meets the 10% stock ownership requirement,
  • Obtains stock that, without regard to stock already owned, meets the 10% stock ownership requirement,
  • Is treated as a U.S. shareholder of the foreign corporation,
  • Becomes a U.S. person while meeting the 10% stock ownership requirement, or
  • Disposes of sufficient stock in the foreign corporation to reduce his or her interest to less than the 10% requirement.

There are a number of exceptions to the filing requirement for Category 2 and 3 filers, so it’s best to consult with your advisors.