On December 21st, 2015 the IRS proposed Country-by-Country (“CbC”) reporting rules requiring certain U.S. multinational companies to provide extensive information about business operations (including their revenue, number of employees, taxes paid or withheld, etc.) that may be shared with other taxing authorities under Information Exchange Agreements. The exchange of information is reciprocal; the IRS will expect to receive information regarding the operations of foreign multinational companies conducting business in the United States. This information may be used by the IRS or another country’s competent authority as a basis for making inquiries into potential tax avoidance arrangements. Unsurprisingly, the proposed regulations (and the OECD model on which these rules are based) have garnered criticism among some members of Congress and commentators. The key concerns are confidentiality and the potential for misuse of the information by competent authorities, which are heightened by the unprecedented amount and nature of the information to be disclosed. For a more detailed discussion of the proposed regulations, the confidentiality concerns and the potential concerns about how competent authorities might use such information, please continue reading.
Base erosion and profit sharing (BEPS) has been a concern for the OECD and national governments alike. A major part of the problem is the ability of multinational companies to move profits from high tax to low tax jurisdictions using a variety of techniques including transfer pricing on intercompany transactions. Measures like Country-by-Country reporting give national tax authorities key information to challenge such base erosion practices. The IRS’ proposed CbC reporting rules (denominated as Prop. Regs. Sec. 1.6038-4, amplified by the extensive Preamble thereto) align the United States with countries such as Ireland, Spain and the United Kingdom who have introduced similar proposals. However, CbC reporting raises a number of concerns, in particular confidentiality and the shielding of sensitive information from competitors. The IRS’ proposed rules raise these concerns and have garnered scrutiny from some journalists and Republican members of Congress.
The proposed rules would require the ultimate parent entity of a U.S. MNE group with annual revenues of at least $850 000 000 for the preceding annual accounting period to file a CbC report. The definition of a U.S. MNE group has two parts. Firstly, the U.S. parent of a U.S. MNE group controls a group of business entities, at least one of which is organized or tax resident outside the United States. Tax residency under these rules would be based on the place of management, place of organization or some other similar criterion. In other words, a business entity could not be resident in a jurisdiction where it is solely liable for tax on income from sources or capital situated in that jurisdiction. Secondly, a U.S. MNE group is required to consolidate its financial accounts under U.S. GAAP or would be required to do so if the equity interests of the U.S. business entity were publicly traded on a U.S. securities exchange. Generally under U.S. GAAP if an entity owns a majority voting interest in another legal entity, the majority owner must consolidate the financial statements.
The parent entity of a U.S. MNE group as described above would be required to provide the following information for each constituent entity:
- Revenues generated from transactions with other constituent entities of the MNE group
- Revenues not generated from transactions with other constituent entities of the MNE group
- Profit or loss before income tax
- Income tax paid on a cash basis in all jurisdictions including withholdings on payments received
- Accrued tax expenses recorded on taxable profits or losses for the relevant annual accounting period (excluding deferred taxes and provisions for uncertain tax positions)
- Stated capital
- Accumulated earnings
- Number of employees on a full time equivalent basis in the tax jurisdiction
- Net book value of tangible assets other than cash or cash equivalents
Given the extensive information required in a CbC report, it is not surprising that concerns have been raised about confidentiality. A Wall Street Journal article equates CbC reporting requirements to “handing over a sports team’s playbook.” According to the IRS, section 6103 imposes strict confidentiality rules on all return information. Furthermore, section 6103(k)(4) allows the IRS to exchange information with a competent authority in another tax jurisdiction only to the extent provided in an Information Exchange Agreement. Prior to entering into an Information Exchange Agreement, the Preamble explains that the Treasury Department and IRS closely review the counter party tax jurisdiction’s legal framework for maintaining confidentiality and their record of compliance with that legal framework, appearing to provide significant reassurance to potentially affected taxpayers. Generally, Information Exchange Agreements prohibit parties from using the information for any purpose other than the administration of taxes. Nonetheless, given how difficult or impossible it would be to undo the harm resulting from any breach of confidentiality (even if wholly inadvertent), confidentiality remains a key concern.
Even if the confidentiality measures taken by the IRS and other taxing authorities are sufficient with respect to third parties, the concern regarding how these authorities will use the information persists. The IRS will use CbC reports to investigate arrangements that generally minimize tax in the U.S., as other competent authorities will do in their local jurisdictions. The targeted arrangements could include a variety of base erosion techniques, such as the payment of royalties, services provided to related parties, etc. The targeted arrangements could result in the IRS imposing liability under numerous sections of the Code, from challenging the income earned by a foreign controlled corporation of a US entity under Subpart F to challenging transfer prices under Section 482. The IRS describes in the Preamble a proposed safeguard whereby CbC reports will form the basis for making further inquiries into base erosion arrangements but not as conclusive evidence that tax laws have been or continue to be violated. For example, in the transfer pricing context the proposed safeguard, if adopted, would require the IRS to conduct a transfer pricing determination using the currently applicable standard of the Section 482regulations, i.e. the best method analysis as set out under the arm’s length principle. However, it’s questionable whether a meaningful difference between the IRS’ use of the information as a basis for making further inquiries and treating the CbC report as conclusive evidence exists, making the potential benefit of the proposed safeguard arguably limited. These concerns regarding the use of the information by the IRS and confidentiality essentially get to the heart of the matter: whether these proposed rules achieve the right balance between the risks to stakeholders, such as U.S. MNE groups, on the one hand and combatting BEPS on the other.