On March 2, 2009 Senator Levin introduced the Stop Tax Haven Abuse Act (S. 506) in the Senate. Representative Doggett introduced a companion bill in the House of Representatives on the following day (H.R. 1265). The bills – which are identical – are aimed at preventing (1) U.S. taxpayers from avoiding U.S. taxes by investing through jurisdictions that are tax havens and/or have strict banking secrecy rules and (2) avoidance of U.S. withholding taxes through use of cross-border equity swaps.
The bills introduce the category of “offshore secrecy jurisdictions”, which include – among many others – the most popular jurisdictions for offshore investment funds and special purpose vehicles, such as:
- the Cayman Islands;
- the Channel Islands; and
The bills’ provisions go well beyond facilitating enforcement of current law. In addition, they would make far-reaching changes in long-established rules of law for determining source of income and tax residence of corporations incorporated anywhere outside the U.S. – not just in offshore secrecy jurisdictions.
This briefing summarizes the key provisions of the bills, which would:
- treat certain U.S.-managed foreign corporations as domestic for tax purposes;
- treat dividend-equivalent payments on notional principal contracts linked to U.S. equities as U.S.-source and thus subject to withholding tax of up to 30 percent;
- limit reliance on tax opinions to ?? avoid tax penalties on transactions involving offshore secrecy jurisdictions;
- restrict transactions involving offshore secrecy jurisdictions, including by creating a presumption that receipts from such jurisdictions are taxable income; and
- codify the economic substance doctrine.
While it is too early to predict whether any provisions of the bills will be enacted, public statements by administration officials – including Treasury Secretary Geithner – indicate that the Administration generally supports the legislation. Moreover the president’s recently released budget includes codification of the economic substance doctrine. On March 6, 2009, however, an aide to Senator Baucus, chairman of the Senate Finance Committee, stated that Senator Baucus is preparing competing legislation to address offshore tax noncompliance. The introduction of a competing bill by Senator Baucus would reduce the likelihood of the Stop Tax Haven Abuse Act passing in its proposed form.
Certain foreign corporations treated as domestic corporations
Under current law, a corporation organized under the laws of a foreign country generally is not treated as a U.S. corporation for tax purposes and thus is subject to U.S. net income tax only on items of income connected with a U.S. business. The bills would change this long-established rule by treating a corporation organized outside the U.S. as a taxable domestic corporation if (1) it is managed and controlled in the U.S. and (2) either (a) it is regularly traded on an established securities market or (b) its aggregate gross asset value in the current or any preceding tax year equals or exceeds $50 million. Importantly, gross assets for this purpose would include assets under management for investors. An exception would apply to certain controlled foreign corporations that are part of a U.S.-owned multinational group, provided the ultimate U.S. parent conducts an active business in the U.S.
Subject to detailed guidance in the bills, the Treasury would be required to draft regulations specifying what would constitute management and control. Under the bills, regulations would treat a corporation as managed and controlled in the U.S. if the personnel responsible for day-to-day decisions on strategic, financial and operational policies are located primarily in the U.S. Treasury regulations are to treat an investment company as managed and controlled in the U.S. if investment decisions are made in the U.S. even if the manager is an independent agent. The provision would apply to taxable years beginning on or after the second anniversary of enactment.
The practical effects of this change would be far-reaching. In his introductory remarks, Senator Levin explicitly took aim at offshore hedge funds managed from the U.S. But the effects would go well beyond hedge funds. For example, the bills would make offshore collateralized debt obligations (CDOs) and other managed securitization vehicles organized as corporations subject to U.S. net income tax if they have U.S. managers. Since most such vehicles were carefully structured to avoid net income tax under current law, and include tax-event triggers if they are ever subject to such tax, enactment of the bills would lead to the unwinding or restructuring of a large number of CDOs and other similar transactions. In many cases, CDOs and similar vehicles could not avoid the effects of this change by reorganizing as partnerships, since the “taxable mortgage pool” (TMP) and possibly the “publicly traded partnership” (PTP) rules would still treat them as corporations for U.S. tax purposes. Moreover, even if a vehicle could organize as a partnership and avoid the TMP and PTP rules, doing so would preclude investment by U.S. tax-exempts, which generally cannot hold equity interests in leveraged partnerships without liability for the unrelated business income tax (UBIT). If the bills are enacted, tax-exempts generally could not avoid tax by holding leveraged equity interests in partnership CDOs or hedge funds through an offshore “blocker” corporation. Although UBIT would not apply, the blocker itself would be subject to U.S. net income tax if managed in the U.S. Foreign persons investing in hedge funds or private equity funds managed from the U.S. also generally would no longer be able to invest through blocker corporations managed by the funds because those blockers would become subject to U.S. net income tax on their entire income – not just on income from any U.S. business.
Foreign investors could avoid this burden by investing in a partnership directly or through their own blocker corporation but may become subject to U.S. tax filing obligations at the investor or blocker level that previously would have been imposed only on the fund-sponsored blocker.
It should be noted that this provision would apply to all non-U.S. corporations meeting the specified conditions (subject to availability of certain waivers) – not only to corporations formed in offshore secrecy jurisdictions. In practice, however, corporations formed in those jurisdictions are most likely to be affected.
Dividend equivalent payments in equity swaps subject to U.S. withholding tax
Dividends paid by U.S. corporations to foreign shareholders are treated as payments from U.S. sources and thus subject to 30 percent U.S. gross basis withholding tax (unless a reduced treaty rate applies). In addition, by regulation, dividend substitute payments on repurchase agreements and securities lending transactions over U.S. equities (and “substantially similar” transactions) are treated as U.S. source and potentially subject to withholding tax. Payments under notional principal contracts, however, are sourced by reference to the residence of the payee and thus are generally exempt from U.S. withholding tax1. Accordingly, assuming a swap is respected as a notional principal contract, payments determined by reference to dividends on shares of U.S. corporations are generally not taxed.
In the past few years, the U.S. tax authorities have been investigating the use of equity swaps to avoid U.S. dividend withholding tax. However, under current law, they should be able to impose withholding tax on payments under a swap over U.S. equities only if the swap can be recharacterized under common law substance-over-form principles either as (1) passing tax ownership of the underlying shares to the foreign investor or (2) a securities loan, repurchase agreement or “substantially similar” transaction.
The bills would radically change current law. Not only would they codify the provisions in current Treasury regulations treating substitute payments under securities loans and repurchase transactions over U.S. equities as U.S. source, they would treat any dividend equivalent amounts paid under an equity swap as dividends for purposes of U.S. withholding tax rules even if the swap is respected as a notional principal contract. Payments to foreign investors contingent upon or referencing dividends on shares of U.S. corporations (or substantially similar property) thus would be subject to 30 percent withholding tax (or tax at a lower treaty rate). Under regulations to be issued by the Treasury, withholding tax also would apply where dividend equivalent payments are netted under a swap and where options or forward contracts are used to create an instrument that is substantially similar to an equity swap (e.g. by “rolling up” dividends and value payments into a single net payment on settlement).
It is important to note that the bills would require dividend equivalent payments to be treated as dividends, rather than as “other income” or “business profits”, for purposes of U.S. income tax treaties. Foreign investors therefore would be taxed (albeit at a reduced rate – typically 15 percent for portfolio investors) even if they are entitled to benefits under an income tax treaty with the U.S. A treaty would apply only if the foreign counterparty could satisfy limitation on benefits provisions, which may be difficult for investment funds and special purpose vehicles.
Reliance on tax opinions limited
Under current law, a taxpayer generally can avoid imposition of certain accuracy-related penalties if it can show that it had reasonable cause for taking the position resulting in an understatement of tax and acted in good faith. A taxpayer generally has reasonable cause for a position if it relies in good faith on advice of counsel that the position is more likely than not to be sustained. The bills would prevent a taxpayer from relying on an opinion of counsel for protection against penalties if an understatement “is attributable to a transaction any part of which involves an entity or financial account in an offshore secrecy jurisdiction”. This change would affect all tax opinions on transactions involving any entity or account in the Cayman Islands, Luxembourg, Cyprus, Switzerland, the Channel Islands, Bermuda, the British Virgin Islands, Hong Kong, Singapore or another designated offshore secrecy jurisdiction.
The bills would authorize the Treasury to issue regulations or other guidance disapplying this rule with respect to opinions that express a “should” or higher level of confidence but would not itself provide such an exception should the Treasury fail to act.
Restrictions on transactions with offshore secrecy jurisdictions
The bills would establish a number of presumptions applicable to civil judicial or administrative tax proceedings aimed at putting the burden of producing evidence from offshore secrecy jurisdictions on U.S. taxpayers investing or conducting business in those jurisdictions. Under one presumption established in the bills, any amount or item of value that is received by a U.S. person from an account or entity formed or operating in an offshore secrecy jurisdiction would be presumed to be income, and any amount or item of value transferred by a U.S. person to an account or entity in such jurisdiction would be presumed to be previously unreported income, in each case taxable in the year of transfer.
This presumption would not apply to U.S. entities, or with respect to transactions involving foreign entities, whose shares are regularly traded on an established securities market, and would be rebuttable upon a showing of clear and convincing evidence. The bills would restrict a taxpayer’s ability to rely on foreign-based documents or evidence supplied by persons outside the jurisdiction of U.S. courts when seeking to rebut any presumption.
Since the initial list of offshore secrecy jurisdictions includes several jurisdictions serving as international financial and business hubs not commonly thought of as tax havens – including Hong Kong, Switzerland and Singapore – many ordinary business transactions between unrelated parties would be subject to the presumptions.
The bill also would impose additional reporting requirements on withholding agents making payments to any foreign entity in which a U.S. person holds an interest and on financial institutions opening accounts or forming entities for U.S. persons in an offshore secrecy jurisdiction.
Codification of the economic substance doctrine
The economic substance doctrine is a common law doctrine applied by U.S. courts to disregard or recharacterize certain transactions for U.S. federal income tax purposes to deny tax benefits they might produce under a technical application of the tax law. Transactions have been found to lack economic substance in a wide variety of circumstances, typically where the claimed tax characterization of a transaction does not reflect its underlying economics or the transaction has little business purpose. The bills – which are closely based on previous proposals – would codify the definition of “economic substance” for the purposes of applying this common law doctrine.
The bills would not require taxpayers to demonstrate economic substance for all transactions giving rise to tax benefits. Instead, the bills would continue to leave to the courts the decision whether the economic substance doctrine is relevant. If, however, the courts determine that economic substance must be shown in a particular transaction, the bills would provide that the transaction would meet this test only if (1) the transaction changes the taxpayer’s economic position in a meaningful way (apart from federal tax effects) and (2) the taxpayer has a substantial non-federal tax purpose for entering into the transaction (which need not be the or even a principal purpose). Taxpayers would not be able to rely on the financial accounting benefits of a transaction to show a non-federal tax purpose if the accounting benefits derive from a reduction in federal taxes. Additionally, taxpayers would not be able to rely on non-federal tax savings to show a substantial purpose if the reduction in federal taxes is substantially equal to, or greater than, the reduction in non-federal taxes because of similarities between the relevant laws. Taxpayers could rely on profit potential to show economic substance only if the present value of the reasonably expected pre-federal tax profit from the transaction is “substantial” in relation to the present value of the expected tax benefits that would be allowed if the transaction were respected.
In addition to existing penalties, the bills would impose a 30 percent penalty where an understatement is attributable to a transaction lacking economic substance (reduced to 20 percent if the transaction is adequately disclosed). The bill also would restrict the ability to reduce understatement penalties attributable to transactions lacking economic substance through pre-litigation settlements with the U.S. Internal Revenue Service.
Increases in tax shelter promoter and aiding and abetting penalties
Under current law, civil penalties are imposed on promoters of abusive tax shelters and on persons aiding and abetting understatements of tax liability. The penalty for aiding and abetting understatements of tax can apply to anyone assisting in the preparation of any portion of a return, affidavit, claim or other document who knows or has reason to know that it will be used in a material U.S. federal tax matter and knows that such use would result in an understatement of another person’s tax liability. The bills would increase the promoter and aiding and abetting penalties to up to 150 percent of a person’s gross income derived from the activities giving rise to the penalties.