The outgoing Obama Administration issued an unusual number of lengthy tax regulations just before and after year end. Many seemed to ignore the statute and clear Congressional legislative history. We will discuss three of the most important of these regulations.
Section 385 is entitled "Treatment of Certain Corporate Interests as Stock or Indebtedness." It was enacted in 1969. The initially proposed version of these new regulations, issued decades after § 385 was enacted, attacked many common cross-border, related-party debt structures. After major taxpayer negative commentary and testimony at the IRS's hearings, Treasury and the IRS narrowed the regulations so that the final version will apply internationally only to inbound related-party debt structures and transactions (foreign parent-U.S. subsidiary).
Stringent documentation requirements supporting debt characterization will need to be satisfied when the regulations are fully in effect. Certain blacklisted transactions will result in automatic characterization of a debt instrument as equity, and a so-called "funding rule," which far exceeds anything Congress could have had in mind in enacting § 385 in 1969, will no doubt create many problems in the future. It has three year look-back and three year look-forward testing periods. The final regulations' package, including the preamble and a lengthy cost-benefit analysis, is 518 pages. One reason for the length is that there seem to be exceptions to exceptions to exceptions.
Section 987 regulations were issued that also far exceed the statutory authority granted to the IRS under the statute. Section 987, which was enacted in 1986, is entitled "Branch Transactions." It consists of one sentence and essentially provides that a foreign currency branch of a U.S. parent or of a controlled foreign corporate subsidiary of a U.S. parent corporation must compute its income in its functional currency and translate that income or loss at the appropriate exchange rate in its owner's functional currency. Further, "proper adjustments" must be made for transfers of property between § 987 qualified business units of the taxpayer that have different functional currencies. The statute seems quite straight-forward.
Treasury and the IRS proposed complex § 987 regulations in 1991 and subsequently decided that they didn't like them. Completely different regulations were proposed in 2006. They were not workable, and remained in proposed form for the next decade. The 2017 final and temporary regulations are substantially based on the 2006 proposed regulations, workable or not. The new regulations are so complex that compliance will likely be impossible for most U.S. corporate taxpayers.
Congress directed that branch profit and loss would be calculated on the basis of the "profit and loss" method. The proposed regulations will produce results different from that method. Transactions, such as sales, between the U.S. entity and its branch, or between branches, can result in two § 987 transactions for each sale, one for the sale and the other for the payment. Currency gain and loss will have to be calculated even though there really never was a distribution to the branch's owner.
The regulations, when they apply, also turn what heretofore were straightforward and tax-free transactions, such as a contribution to a controlled domestic subsidiary, a contribution to a partnership, and a distribution from a partnership, into taxable events.
Tax Executives Institute submitted comments asking that the regulations be withdrawn or in the alternative that the effective date be delayed to 2019. Not only will compliance be close to impossible given the complexity of the regulations, as noted above, but IRS examining agents also will have a nearly impossible task in trying to determine whether taxpayers have complied properly with them. Not a good result.
Treasury and the IRS also issued regulations under § 367 regarding the outbound transfer (U.S. parent to foreign subsidiary) of assets that completely ignore the very clear 1984 congressional intent and directive when the statute was enacted. In an outbound incorporation transfer, for example, when a foreign subsidiary is formed and assets are transferred to it, certain transferred assets are subject to tax in the hands of the transferring U.S. shareholder. Assets used in the active conduct of a foreign trade or business, however, generally are not taxed.
Intangibles transferred in such a transaction are subject to special treatment: § 367(d) provides for deemed-royalty treatment. Foreign goodwill and going concern value are specifically not included in the statute definition of intangibles. The legislative history explains that this was intentional. They can qualify for the active foreign trade or business exception.
The new IRS regulations provide that goodwill and going concern value can no longer qualify for that exception. Instead, taxpayers must pay full tax on the value of those assets (assuming a zero basis) in such a transaction or elect to treat them as intangibles subject to the perpetual periodic royalty rules of § 367(d). This regulation, too, was the subject of substantial negative taxpayer commentary in written submissions to the IRS and at the relevant government hearings.
Section 482 Transfer Pricing
Medtronic is an important transfer-pricing case in which the IRS's income adjustment was approximately $1.4 billion for the two years in issue. It involved a U.S. parent company and its foreign manufacturing subsidiary. The taxpayer won a complete victory. The two keys to the case were: (1) the court held that the IRS should not have aggregated different kinds of transactions and allocated a combined net income amount because the transactions could be priced separately in the marketplace; and (2) the IRS ignored the importance of quality at the foreign-manufacturing location (the products in issue were medical-device heart products).
The IRS also asserted that as an alternative to its § 482 adjustment, the taxpayer "must have" transferred intangible property to the foreign subsidiary which is subject to the periodic royalty rules of § 367(d). The court stated that the IRS did not identify or allege any specific intangibles that were transferred to the subsidiary. Rather, the IRS's argument seemed to be that the foreign manufacturing company could not possibly be as profitable as it was unless some of the parent company's intangibles were transferred to it. The court was not persuaded by this argument. The court also stated that it also was unclear which intangibles the IRS believed are subject to § 367(d).
BEPS Transfer Pricing Will Create Issues
A fundamental principle of US transfer pricing rules is that transactions as structured between related parties are to be respected unless the transactions lack economic substance. See Treas. Reg. §§ 1.482-1(d)(3)(ii)(B) and (iii)(B). This is an important rule that respects a central pillar of the U.S. tax system–separate entities should be treated separately. The rule also contributes to predictability and stability in worldwide tax administration.
However, while this principle has generally been adhered to worldwide, the BEPS (Base Erosion and Profit Shifting) project has begun to erode it. An example provided in BEPS Actions 8-10 (and now incorporated in the OECD Transfer Pricing Guidelines) illustrates how business arrangements between related entities (and not just their transfer pricing) are subject to a greater risk of disruption.
The example provides that Company P and Company S, P's wholly owned subsidiary, have entered into a written contract pursuant to which Company P licenses intellectual property to Company S for use in Company S's business. Company P performs negotiations with third-party customers to achieve sales for Company S, provides regular technical services support to Company S so that Company S can deliver contracted sales to its customers, and regularly provides staff to enable Company S to fulfil customer contracts. Among other factors, A majority of customers insist on including Company P as joint contracting party along with Company S, although fee income under the contract is payable to Company S. The example states that Company S is not capable of providing the contracted services to customers without significant support from Company P, and is not developing its own capability. The example concludes that while Company P has given a license to Company S, it in fact controls the business risk and output of Company S such that it has not transferred risk and function consistent with a licensing arrangement, and acts not as the licensor but the principal. Therefore, the license agreement may be disregarded.
The result put forward under the example above makes the issue more than a simple transfer pricing issue. Now, the very relationship between the parties can be under question. This can have far-reaching ramifications, for example involving withholding tax and income characterization under anti-deferral regimes. It also could lead to more complicated competent authority proceedings since not only transfer pricing, but also income source and characterization issues could be at stake.
For example, if the US, in applying the traditional standard (the U.S. has not changed its transfer pricing rules as a result of BEPS), were to respect the transaction described in the example as a license, but a BEPS country were to treat the transaction as, say, the provision of a service, then a competent authority proceeding could get very complicated. Coming to an agreement on pricing be more difficult since license and services transactions are priced with different comparables, and often using different methods. Further, ancillary (and very important issues) such as the applicability of withholding tax, and source of income/creditability could also be at issue.
Further, could an IRS examining agent assert, or a US competent authority official agree, that this BEPS example applies for U.S. tax purposes in an inbound context? US Treasury representatives have stated that BEPS and the new OECD transfer pricing guidelines are sufficiently similar to the U.S. transfer pricing rules that changes in the § 482 regulations are not necessary. However, the example arrives at a conclusion different from that under the U.S. transfer pricing rules unless the facts were to show that there was no economic substance to the parties' transaction as governed by their written agreement.
Indeed, an OECD spokesperson recently stated that the new BEPS-influenced transfer pricing rules might not be exactly an application of arm's length principles. Is this example one of those instances where the OECD is deviating from the arm's length standard, and therefore will create conflicts between a country that follows the OECD but has a treaty with another country (the U.S.) that incorporates the arm's length standard?
Only time will tell if the BEPS project will, as it purports to do, foster transfer pricing unity amongst the world's economies or will, in fact, create more disunity than existed before.
U.S. Concerns Regarding European Commission
The U.S. government has become increasingly concerned about actions of the European Commission ("EC") regarding subsidiaries of U.S. parent companies. Apple was order to pay a record €13 billion ($14.5 billion) in purportedly unpaid back taxes as a result of an EC assertion that the company had received state aid from Ireland. Not only had Apple entered into an advance transfer-pricing agreement with Ireland to provide certainty, but Apple U.S. and subsidiary in issue had cost-shared development of the relevant intangibles for 30 years. The subsidiary owned the foreign rights to those intangibles. The EC ignored these important facts (especially the relevant cost sharing agreement) and proceeded to use its own self-created methods of transfer pricing that obviously had no regard for the arm's length standard which has been the foundation of international transfer pricing for decades. The EC has made state-aid assertions regarding certain other subsidiaries of U.S. parent companies as well.
The U.S. also is concerned about the EC's challenging certain Luxembourg rulings regarding the U.S.Luxembourg treaty. A U.S. Treasury spokesperson stated that the EC apparently believes that it has the power to overrule a European Union country's interpretation of internationally agreed upon tax rules. This spokesperson stated in congressional testimony that the U.S. needs to question the value of its bilateral tax agreements with European Union countries if those agreements can seemingly be overturned by an administrative commission with supranational authority (the EC).
This U.S. Treasury spokesperson also expressed further frustration with the EC in December, 2016, stating that the EC's state-aid decisions and policies have done "immeasurable damage" to multilateral cooperation and taxation. He stated that the EC was retroactively applying a new rule for applying the arm's-length principle in a way that differs from OECD guidance. He said this is particularly troubling given the EU member states' disproportionate representation on the OECD's Committee for Fiscal Affairs ("CFA").
He further said that the CFA is a European-dominated institution. EU countries have 22 of the 35 members and constitute the largest block in this new inclusive framework that we have to implement BEPS yet this U.S. spokesperson complained that they sat there in "utter silence" as the EC has eviscerated the arm's-length standard and imposed restrictive rules on multinationals. He added that despite this, they continue to argue that the CFA and OECD should have a role in shaping international tax policies.
It is not clear where this U.S. frustration with the EC will lead, but the direction it's headed is not good.
We have yet to see what proposals will be made regarding tax reform by the new Trump Administration. There was a House Republican tax reform task force release, termed a "blue print." The blue print proposes some radical changes regarding the U.S. corporate and international income tax systems, including possibly a "border adjustability" feature. However, the blue print was not received favorably by all, and an Administration proposal is yet to be formulated.