International Tax Monthly: October 2016

Australia Proposes Rules on Transfer Pricing and Offshore Marketing Hubs

Australia outlined how it plans to treat transfer pricing issues related to the location and relocation of certain business activities and operating risks into centralized operating models, commonly referred to as “hubs.”

The outline comes in a discussion paper the Australian Taxation Office (ATO) released as a draft practical compliance guideline. The types of activities that are commonly centralized include marketing, sales and distribution functions. The draft, open for comment until September 30, is aimed at helping taxpayers:

  • Assess whether their hub arrangements pose a transfer pricing risk and how they can work with the tax office to mitigate that risk,
  • Understand when the ATO may take a closer look at their hub arrangements and the documentation and evidence it will expect them to have readily available, and
  • Understand their disclosure obligations.

Color-Coded Hubs

The draft lays out ATO risk classification for offshore marketing hubs. For offshore marketing hubs, a Green Zone of low risk applies where the hub profit is less than a 100% mark-up of hub costs. For hub profits exceeding the 100% mark, the risk zones are:

  • Blue – low to moderate risk where net tax impact is less than AUD$5 million a year,
  • Yellow – moderate to high risk, with a net tax impact falling between AUD$5 million and AUD$50 million a year,
  • Amber – high risk, with net tax impact exceeding AUD$50 million a year, and
  • Red – very high risk for those not able or choose not to apply risk methodology or calculate tax impact.

The different zones reflect a number of variables including pricing indicators, possible tax at risk, taxpayer engagement and behavior and the quality of transfer pricing analysis and evidence. Typically a “hub” would have significant substance; however it is likely the ATO may consider any entity performing any activity having a “markup on cost above 100%” out of the low risk green zone.

Being out of that zone means you can expect the tax commissioner to monitor, test and/or verify the transfer pricing outcomes of the hub. High-risk-rated hubs will be reviewed as a matter of priority, the ATO said.

Not a Safe Harbor

The documents identify and describe the features and attributes (scenarios) of hubs that are considered at low risk of not complying with the transfer pricing rules. The ATO says that following the hub protocols doesn’t limit or waive the law but acknowledges that if you choose to follow it, or your hub already aligns with it, the tax office generally won’t allocate compliance resources to examine the transfer pricing outcomes of the hub.

The ATO stresses that the protocol doesn’t constitute a “safe harbor” and that the information doesn’t replace, alter or affect in anyway the interpretation of tax law.

If you determine that a hub’s potential risk is outside the green zone, the ATO says there is no presumption that the hub arrangement is priced incorrectly. What it means is that the ATO considers the hub is at risk and it generally will conduct some form of compliance activity to further test the pricing outcomes.

Testing for Green

The ATO says an offshore marketing hub will be assessed as being in the green zone if it satisfies both of these tests:

1. The “cost plus” indicator. Based on the cost plus methodology, this is the primary test. The cost plus indicator is: Hub profit is less than or equal to a 100% mark-up of hub costs.

2. The “commercial realism” indicator. This secondary test is applied to offshore marketing hubs that satisfy the primary test to cross-check that the profit outcomes of the hub are commercially realistic.

In recognition that this is the first time, the commissioner has publicly released guidance in relation to hubs and to encourage willing and co-operative compliance going forward, the commissioner, for a limited time, is willing to remit penalties and interest if certain conditions are met. Specifically, if you make a voluntary disclosure in relation to back years and adjust its pricing to come within the green zone, the commissioner will exercise his discretion to remit certain penalties and interest charges.

In recognition of the complexity of these arrangements, the commissioner’s undertaking will remain in place for 12 months from the date of publication.

Date of Effect

Once completed, the new protocol will be effective from its date of issue and will apply to existing and newly created hubs. The ATO says the use and application of the rules will be continuously reviewed over the next three years. Any revisions to improve its efficacy will be made at the end of the review period or on an “as necessary” basis. The ATO says it will consult with taxpayers over proposed material changes.

BEPS Is Just a Patch Job Until Tax Secrecy Is Eradicated: UK Group

A cross-party U.K. parliamentary group says international proposals to fight global tax evasion don’t go far enough and may create loopholes that could be used to avoid taxes.

In a report, the group says that while the Organisation for Economic Cooperation and Development (OECD) had made major progress in gaining cross-country agreement on sharing tax information, the rules aren’t enough.

Falling Short

In its first report, the All-Party Parliamentary Group said it believes that the Base Erosion and Profit Shifting (BEPS) process will fall short of creating the fair and transparent global system needed to tackle global tax avoidance.

The BEPS proposals will reform existing rules and give tax authorities better tools to crack down on tax avoidance, the 21-page report said. But it added that the proposals are “sticking plaster” on a global tax system that’s struggling to remain fit with the growth of multinational companies operating in a digital environment. The BEPS process should represent the first step in a longer process of radical reform, the group added.

According to the report, the OECD proposals are likely to add to an already complicated global tax system. The new complex rules could provide opportunities for new loopholes. National governments should consider acting collectively to prevent companies from exploiting new loopholes. For example, jurisdictions could require companies to seek prior approvals through tax rulings before they use new tax avoidance measures.

The United States Is a Key Challenge

The report considers that a key challenge for the BEPS project is the need to ensure that the United States executes the proposals, particularly as it has been one of the more skeptical participants. As the resident country of many of the digitally based multinational companies that have received a lot of public scrutiny, the skepticism in the United States comes from the view that the BEPS project originated in part as a means for foreign governments to capture more tax revenue from U.S.-based multinationals.

The United States is fiercely protective of its global companies and its corporate tax revenue, the report notes. It said there are fears that in the wake of the BEPS Action Plan, multinational companies will be tempted to move their businesses away from the United States with its high corporate tax rate to Europe with its lower rates.

Another concern is that aggressive European Union (EU) countries will lay claim to tax revenues that should belong to the United States. However, the report says the evidence indicates that the United States itself is by far the biggest loser of revenues due to tax avoidance of U.S. multinationals.

To restore public confidence in the integrity of the tax system, there’s a need for transparency. The BEPS proposals don’t deliver the level of transparency needed, the report said.

More Talking Points

Other key elements from the report – titled A more responsible global tax system or a “sticking plaster?” An examination of the OECD’s Base Erosion and Profit Shifting (BEPS) process and recommendations – include:

  • By failing to secure public country-by-country (CbC) reporting, the OECD has missed a real opportunity to open up the tax system. Simply providing more information to tax authorities isn’t enough to restore confidence
  • The OECD didn’t explore or challenge the principles at the heart of the international tax system. As a result, while it may improve existing rules in the short term, it will fail to stamp out corporate tax avoidance. The UK government should take the lead and pass laws to introduce public CbC reporting for UK publicly quoted companies while pressing the case for such reporting on a multilateral basis
  • The success of the BEPS process lies in its execution across all participating jurisdictions. There are also concerns about the capacity and capability of developing countries to take advantage of the new protocols. The parliamentary group recommended that the OECD monitor strictly the execution of BEPS year-on-year to ensure that its recommendations are being fully executed and that developing countries are given the tools to successfully put the proposals into effect and to challenge multinational companies who shift profits out of their jurisdictions. Their monitoring data should be publicly available
  • The OECD didn’t question the basic concepts of residence and source. The current rules underpinning the allocation rights for tax between “source” (where the income is earned) and “resident” (where the person who earned it is based) need to be revisited in a digital world. The aim of the tax system should be to ensure that tax is paid where value is created.

BEPS Implementation Concerns

The OECD’s proposals aren’t legally binding but there’s an expectation that participating countries will put them into effect. Where consensus couldn’t be reached, the OECD adopted best practice and common approach guidelines that could be ignored or be adopted on a basis of the lowest common denominator, thus limiting their effectiveness. The report considers this is a weak alternative to binding rules.

Court Says International Financing Was Debt, not Equity

The U.S. Tax Court held that the financing of a sale partnership interests by a foreign seller to a U.S. buyer was not debt, but equity.

The court found that the parties failed to consistently act with an arm’s-length creditor-debtor relationship, despite the obvious U.S. tax advantages of debt treatment to both sides — the portfolio interest exemption for the foreign seller and interest deductions for the U.S. buyer. But the court found that several of the formalities of debt weren’t undertaken and the U.S. entity put no money down. Moreover, the court held that the U.S. entity was liable for a substantial understatement penalty related to interest deductions it took on the putative debt.

Details of the Case

The taxpayer, Norse Group, consisted of American Metallurgical Coal Co. and its subsidiaries, which included Heimdal Investment Co. The Norse corporations were domestic and the company had a significant amount of net operating loss (NOL) carry forward.

The court case involved a transaction between Lausanne and Heimdal that took place over the course of tax years 1995 through 2008.

Since 1984, Norse Services provided management services to Lausanne, a Liberian corporation. It also acted as that company’s agent in the United States and the two businesses had some directors in common.

In 1984, Lausanne purchased Heimdal from Norse. In 1986 Lausanne invested in Caithness Geothermal 1980 (CG) by contributing $1,080,000 in exchange for three limited partnership units (Units). CG was a domestic privately held partnership and independent power producer.

In 1991, distributions from CG caused Lausanne to turn a profit, which gave rise to a liability for U.S. branch profits tax. One of the common directors of Lausanne initiated discussions with Norse over how the partnership investment could be restructured to avoid “branch profits taxation problems.” The taxpayer sought advice from a U.S. accountant, who worked with the parties to come up with an agreement.

Terms of the Contract

The eventual agreement dated December 1992 provided that:

  • The seller would transfer its partnership interests to the buyer in exchange for a note with principal ($5 million) due at maturity and fixed interest at 12% over a 10-year term,
  • Additional “interest” would allow the seller to participate in “excess cash flow” (i.e., earnings from the partnership investment that exceeded an amount defined in the contract), and
  • Heimdal couldn’t liquidate, merge or consolidate, sell all or substantially all of its assets or engage in any business other than ownership of the partnership interests.

The accountant advised in a memo that the transaction would be characterized as an installment sale for tax purposes, that Heimdal could use Norse’s NOL to offset the income it received from CG, and that Lausanne would defer recognition of gain on the sale of its CG partnership interest until Lausanne recovered the note’s principal.

The accountant also concluded that the interest paid to Lausanne would be considered “portfolio interest,” free from withholding taxes, provided Heimdal obtain a Form W-8, “Certificate of Foreign Status,” from Lausanne before making payment, and obtain an independent appraisal of the CG units to support the $5 million selling price. The parties never created Form W-8 or obtained the independent appraisal.

In 2002, the parties extended the term of the note. The buyer failed to pay interest in 2003 and 2004, and the seller subsequently allowed those years’ interest to accrue rather than finding the note in default. In 2006, the term of the note was extended again, and the parties agreed to reduced the fixed interest rate to 6% and prohibit prepayment of the principal. Despite the revised terms, the buyer continued to pay fixed interest at 12% rather than 6%.

No ‘Genuine Intention’

The court concluded that the financing that Lausanne provided Heimdal was equity and not debt.

Citing factors from the controlling precedent, Estate of Mixon, (5th Cir. 1972), the court concluded that the parties lacked “a genuine intention to create a debt.” The factors in Mixon are used to answer the ultimate question: Was there a reasonable expectation of repayment and did that intention comport with the economic reality of creating a debtor-creditor relationship? A significant factor was the buyer’s lack, at the time of the transaction, of any assets to repay the putative debt (other than income from the purchased partnership interests).

According to the court, the fact that repayment was completely contingent on the success of the partnership investment favored equity classification. The court also noted that the contingent “excess cash flow” interest part of the agreement suggested that the seller’s position in the partnership investment hadn’t significantly changed.

The court further observed that there was no evidence that the agreement’s terms were even negotiated and that the contract’s conditions limiting the buyer’s activities gave the seller effective management of the buyer.

“Self-Serving” Claim

In the end, the court found that forgoing an appraisal, requiring no down payment, extending the note’s term repeatedly, failing to pay interest timely or, later, at the agreed-upon reduced rate highlighted the taxpayer’s “self-serving” claim of intent to create debt.

Note: Earlier this year, the IRS released controversial proposed regs addressing whether a direct or indirect interest in a related corporation is treated as stock, debt, or as in part stock and in part debt, for U.S. federal tax purposes. Much concern was expressed by the business community and others about the unintended consequences of these proposed rules.