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is with great pleasure that McDermott Will & Emery presents the first quarterly issue of Focus on Tax Strategies & Developments, which addresses the complex issues surrounding tax planning in the United States and internationally. We intend for these reports to focus on tax strategies and developments both in the United States and abroad and this inaugural edition fittingly includes contributions from tax partners and associates based in some of our international locations as well as our U.S. offices. We hope that you enjoy these reports and find them informative and useful to you as you look to stay abreast of trends and developments in the tax law.
Lowell D. Yoder Head, U.S. & International Tax Practice Group
REIT Spin-Offs: Recent Transactions and IRS Rulings
By Andrea M. Whiteway, Caroline H. Ngo and Britt Haxton
Several recent corporate spin-offs in the United States have involved real estate investment trusts (REITs). Provided several requirements are satisfied, including qualification of the “spun-off” entity as a REIT and the spin transaction as a tax-free spin-off, REIT spin-offs can result in significant value to shareholders. In these transactions, a corporation distributes a subsidiary corporation holding real estate to the distributing corporation’s shareholders in a tax-free spin-off. Not only is the spin-off tax-free, but the distributed company elects REIT status and thus enjoys potentially substantial tax savings going forward. The Internal Revenue Service (IRS) recently has issued a number of favorable private letter rulings (PLRs) for such transactions. REIT spin-offs should be of potential interest to any U.S. corporation owning significant real estate.
As a general rule, a corporation’s distribution of property to its shareholders is taxable to both the distributing corporation and its shareholders. Under the spin-off provisions of
Table of Contents
1 REIT Spin-Offs: Recent Transactions and IRS Rulings
4 FATCA Primer for Non-Financial Enterprises
6 Corporate Inversions: The UK Perspective
8 Tax Considerations When Acquiring Non-U.S. Portfolio Companies—Mitigating Subpart F Inclusions
10 China’s Tax Authority: Recent Views on Deductibility of Cross-Border Intercompany Fees
11 Overview of the IRS Transfer Pricing Roadmap
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section 355 of the Internal Revenue Code, however, a distribution by a corporation of the stock of a controlled subsidiary corporation can be accomplished wholly tax-free if several requirements are satisfied.
One of the requirements for a tax-free spin-off is the so-called business purpose requirement. The distribution must be motivated, in whole or substantial part, by one or more non-federal-tax corporate business purposes. The regulations state that potential avoidance of federal taxes is relevant in determining the extent to which a corporate business purpose motivated the transaction. In satisfying the requirements for a tax-free spin-off involving a REIT, the business purpose requirement is likely to be the main pressure point.
A REIT generally is not subject to U.S. federal income tax on its taxable income to the extent distributed to its shareholders because of the application of a dividends paid deduction. REIT qualification depends on the REIT’s ability to meet various complex requirements, including the requirement that at least 75 percent of the value of the REIT’s assets consist of cash, cash items, government securities and “real estate assets,” and that at least 75 percent of the REIT’s gross income is derived from rents from real property and other real-estate-related income. The IRS historically has issued PLRs on the qualification of assets as real estate assets. However, the U.S. Department of the Treasury and the IRS recently issued proposed regulations establishing proposed guidelines on the types of assets that would qualify. Under the applicable guidance, a company with substantial non-real-estate assets generally is not eligible to elect REIT status. However, the company might be able to overcome this obstacle by transferring real estate assets to a subsidiary and distributing the stock of the subsidiary to its shareholders. Following the distribution, the subsidiary would elect REIT status.
The IRS recently issued three favorable PLRs addressing spin-offs of real estate by operating companies where, immediately after the spin-offs, REIT elections were to be made for the companies’ spun-off real estate subsidiaries.
IRS RULING POLICY
Over the years, the IRS has substantially carved back on the spin-off issues regarding which it will issue a PLR. In 2003, the IRS ceased ruling on highly factual aspects of spin-offs, including the business purpose requirement, but continued to rule on whether a transaction otherwise qualified for non-recognition under section 355. Although rulings contained a caveat that the IRS expressed no opinion on satisfaction of the business purpose requirement, the rulings were based in part on taxpayer representations regarding business purpose. In 2013, the IRS carved back further on its ruling policy and no longer rules on qualification under section 355 as such at all; rather, it only rules on “significant issues.”
RECENT PLRS AND TRANSACTIONS
PLR 201337007, apparently issued to Penn National Gaming, Inc., based on publicly available facts, involved a corporation’s distribution to its shareholders of the stock of a subsidiary holding substantially all of its casino-related real estate. The ruling concluded that the spin-off qualified under section 355 despite the stated intention to elect REIT status for the real estate company (based in part on business purpose representations). The PLR also confirmed that certain properties constituted “real estate assets” for REIT purposes.
An important aspect of the ruling is that, following the spin-off, most of the real estate was to be leased back to the distributing corporation. The rent paid presumably would be tax deductible to the distributing corporation, and, as a result of the REIT’s dividend paid deduction, the rental income in turn earned by the REIT generally would not be subject to corporate-level tax.
Regarding business purpose, the ruling relied on representations by the taxpayer that the spin-off was being carried out to facilitate strategic expansion opportunities by permitting the REIT the ability to pursue transactions with competitors, diversify into different businesses, pursue certain transactions that the distributing corporation would be disadvantaged by or precluded from pursuing because of regulatory constraints, and fund acquisitions with its equity on significantly more favorable terms than those that would be available to the distributing corporation.
PLR 201411002, apparently issued to CBS Corp. based on publicly available facts, relates to a corporation’s distribution to certain of its shareholders of the stock of a subsidiary holding
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certain of the corporation’s billboard displays in redemption of distributing corporation stock in a so-called split-off. The ruling concluded that the transaction qualified under section 355 (based in part on taxpayer representations regarding business purpose).
Regarding business purpose, the ruling relied on representations by the taxpayer that the transaction would enable the business’s management team to focus on its relevant business, requirements and performance without the distraction of one or more businesses operating under a different business model; to provide a more attractive equity currency for acquisitions; to enhance and align the equity-based incentive programs to better reflect business objectives, goals and financial performance of each business; and to better enable each business to independently optimize its capital structure and return of capital policies.
Finally, on July 29, 2014, Windstream, a network communications provider, announced plans to effect a REIT spin-off of certain of its telecommunications network assets. Windstream reported that it had received a favorable PLR, although it is unclear whether the PLR was issued under the IRS’s more limited spin-off ruling policy. As in the Penn National transaction, the spun-off REIT will lease its assets back to the distributing corporation, generating the attendant tax benefits described above.
SIGNIFICANCE OF THESE PLRS AND TRANSACTIONS
The PLRs contained the standard caveat that the IRS expresses no opinion on satisfaction of the business purpose requirement, which is likely the main pressure point for satisfaction of the spin-off requirements.
William Alexander, IRS Associate Chief Counsel (Corporate), has suggested that the IRS believes that the potentially substantial tax savings stemming from a REIT election following a spin-off does not preclude satisfaction of the business purpose requirement. Alexander said that although the IRS does not rule on whether the business purpose requirement is satisfied, “if we were sure it couldn’t be done [in a REIT spinoff], then you would know that.” Amy S. Elliot, ABA Meeting: Alexander Sets Reachable Bar for Business Purpose in REIT Spinoffs, 2014 TNT 19-5 (Jan. 29, 2014).
In any case, prudent taxpayers typically seek legal opinions on satisfaction of the spin-off requirements. Notably, a PLR cannot be used or cited as precedent by taxpayers other than the taxpayer to whom it is addressed.
The transactions discussed above suggest a trend in favor of the separation of real estate from related operating businesses resulting in significant associated tax savings and enhanced ongoing tax efficiency of ownership of real estate assets through a REIT.
For a corporation to engage in any spin-off, it must conduct extensive analysis as to the transaction’s feasibility. In the context of most REIT spin-offs, the businesses are vertically integrated, in that the real estate is needed in the operating business. The business need for a continuing economic and legal relationship created by the lease structure should be carefully analyzed before a corporation engages in the transaction. In the public company context, both the distributing corporation and the spun-off corporation will owe ongoing fiduciary duties to their shareholders in making business decisions.
Notably, in February 2014, Chairman Camp of the House Committee on Ways and Means released a discussion draft containing several REIT provisions, including a prohibition on REIT spin-offs. The administration’s 2015 budget proposal released in March 2014 did not contain a similar provision. While it is unclear whether any prohibition ultimately will be enacted, to the extent that a business case exists for the spin-off, the possibility of the prohibition should be taken into account in analyzing the timing of consummating such a transaction.
REIT spin-offs should be of particular interest to any corporate business with significant real estate holdings. A REIT spin-off can generate substantial tax efficiencies creating incremental value in the combined enterprises. Careful legal and financial analysis of these transactions should be undertaken.
Andrea Macintosh Whiteway and Caroline H. Ngo are partners, and Britt Haxton is an associate, in the law firm of McDermott Will & Emery LLP, based in the Washington, D.C., office. Andrea is the Head of the Tax Group’s Pass-Throughs practice.
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FATCA Primer for Non-Financial Enterprises
By Alan J. Schwartz and Chelsea E. Hess
The Foreign Account Tax Compliance Act (FATCA) added a new chapter 4 (sections 1471–1474) to the Internal Revenue Code and Treasury Regulations thereunder. While foreign financial institutions (FFIs) have the most substantial compliance burden under FATCA, the new law also affects non-financial foreign entities (NFFEs). The compliance burden on NFFEs is less onerous than the compliance obligations of FFIs, but failure to comply could result in a 30 percent withholding tax on certain U.S.-source payments. NFFEs may be required to make certifications as to their FATCA status even if they do not receive U.S.-source payments, and failure to provide such certifications may result in other administrative burdens, such as forced account closures.
FATCA went into effect on July 1, 2014, after numerous delays and multiple rounds of administrative guidance. Additional guidance and some transitional relief have been issued since FATCA’s effective date. In addition, the United States has entered into, and continues to negotiate, intergovernmental agreements (IGAs) with many non-U.S. jurisdictions with respect to FATCA. IGA partner jurisdictions have been issuing their own FATCA guidance and are expected to issue their own laws implementing FATCA. Thus, FATCA remains in the development stage. Nevertheless, FATCA is currently the law, and most entities should be able to substantially comply under the guidance currently available.
FATCA imposes a 30 percent withholding tax on certain U.S.-source payments made to foreign entities that do not certify to the withholding agent that they are “in compliance” with FATCA. The FATCA compliance obligations vary significantly depending on a foreign entity’s status as either an FFI or an NFFE. The Treasury Regulations define numerous categories of FFIs, including depository institutions, custodial institutions, investment entities and specified insurance companies. The Treasury Regulations also treat certain holding companies and treasury centers as FFIs.
In order to avoid the 30 percent withholding tax under FATCA, an FFI must certify to the withholding agent that it is either a “participating FFI” (i.e., it has registered with the Internal Revenue Service (IRS) and will comply with the terms of an FFI agreement, which requires it to conduct certain diligence and reporting with respect to U.S. accounts, including debt and equity interest held by U.S. persons) or a reporting IGA financial institution (i.e., it has registered with the IRS and will comply with the terms of an applicable IGA), or that it is otherwise “deemed compliant” with FATCA.
An entity that is not an FFI is treated as an NFFE. NFFEs generally are not required to register with the IRS. To avoid the 30 percent withholding tax, an NFFE receiving a withholdable payment must certify to the withholding agent its status as either a “passive NFFE” or an “excepted NFFE.” If the NFFE is a passive NFFE, it also must identify “substantial U.S. ownership” in the NFFE.
In addition to certifying FATCA status to payors of U.S. source income, foreign entities that maintain accounts at non-U.S. financial institutions will be required to certify their FATCA status to those financial institutions in order to enable the financial institutions to comply with their own FATCA obligations.
While a multinational enterprise engaged in a non-financial business might initially believe that the FATCA status of each entity within its group is that of NFFE, and this belief might ultimately be correct, a number of entities within an affiliated structure could, absent the application of a special rule, qualify as FFIs. In particular, holding companies, treasury centers, captive insurance companies and non-U.S. retirement funds warrant special analysis. Even if an entity’s status as an NFFE is correct, the entity must determine its status as either an excepted or passive NFFE. In addition, the FATCA certification forms may require an NFFE to indicate and certify more specifically its FATCA classification. Thus, as a first step in a non-financial enterprise’s FATCA compliance initiative, the group should conduct a review and analysis of each non-U.S. entity within its “expanded affiliated” group (i.e., 50 percent or more group ownership) to determine each entity’s FATCA classification as FFI, NFFE, passive, excepted or otherwise deemed compliant (including an analysis of any applicable IGA).
Entities Requiring Special Review
HOLDING COMPANIES AND TREASURY CENTERS
A holding company is an entity whose primary activity consists of holding all or part of the outstanding stock of one or more
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members of the expanded affiliated group. Absent a special exception, a holding company may be treated as an “investment entity” that qualifies as an FFI. Similarly, an entity that acts as the treasury center for an affiliated group also may appear to be an FFI, absent an exception. A treasury center is an entity whose primary activity is to enter into investment, hedging and financing transactions with or for members of its expanded affiliated group for one or more of the following purposes:
Managing price change, currency and interest rate risk with respect to property, borrowing, or the assets or liabilities with respect to group members
Managing the working capital of expanded affiliated group members
Acting as a financing vehicle for expanded affiliated group members
The Treasury Regulations provide an exception for certain “excepted non-financial group entities.” Under this exception, a holding company or treasury center generally will not be treated as an FFI if the holding company or treasury center is a member of a “non-financial group.” For this purpose, a non-financial group is broadly defined as an expanded affiliated group whose “passive” income constituted no more than 25 percent of its gross income during the previous three-year period. Passive income generally includes dividends, interest, rents and royalties, and certain other income not derived in an active trade or business. The exception for holding companies does not apply to holding companies that are formed in connection with, or are availed of by, an investment vehicle established with an investment strategy to acquire or fund companies and to treat the interest in those companies as capital assets held for investment purposes.
While the Treasury Regulations provide exceptions for holding companies and treasury centers within non-financial groups, the IGAs do not explicitly address these types of entities. Thus, until guidance is issued by each relevant IGA jurisdiction or by the IRS, the FATCA status of holding companies or treasury centers within IGA jurisdictions technically remains uncertain. However, a few IGA jurisdictions (e.g., the United Kingdom and Ireland) have issued guidance indicating that holding companies and treasury centers formed within their jurisdictions will be characterized using the approach of the Treasury Regulations or will otherwise not be treated as FFIs. Additional IGA partner countries are expected to issue similar guidance.
CAPTIVE INSURANCE COMPANIES
Captive insurance companies used by non-financial enterprises also require special FATCA consideration to ensure that they are not within any of the FFI categories specified by the Treasury Regulations or an applicable IGA. One category of FFI specified in the Treasury Regulations and the IGAs is a “specified insurance company,” which is an insurance company that issues or is obligated to make payments with respect to cash value insurance or annuity contracts. Foreign captive insurance companies likely will not have any cash value insurance policies or annuity contracts, and therefore generally will avoid qualification as a specified insurance company.
A foreign captive insurance company that avoids classification as a specified insurance company may nevertheless be an FFI as a depository institution if it accepts advance deposits for premiums that are callable by the policyholder. In addition, a foreign captive insurance company may qualify as an FFI as an investment entity. Most captive insurance companies will avoid treatment as an FFI under the investment entity classification because the FACTA regulations provide that the “reserving” activities of an insurance company will not cause the entity to be a depository institution, a custodial institution or an investment entity. Captive insurance companies that are not FFIs are generally treated as passive NFFEs in light of their income being limited to premiums and investment income.
The IRS recently has issued guidance with regards to captive insurance companies in relation to the section 953(d) election, which allows a foreign insurance company to be treated as a domestic insurance company for most tax purposes. An insurance company organized outside the United States that has elected to be classified as a U.S. person under section 953(d) is also a U.S. person for purposes of FATCA (and thus is neither an FFI nor an NFFE), provided that either (1) it is not a specified insurance company and is not licensed to do business in any state, or (2) it is a specified insurance company and is licensed to do business in one or more states. The 953(d) election commonly is made by captive insurance companies used by U.S.-headquartered companies, but is not typically used by companies with non-U.S. headquarters. In practice, captive insurance companies rarely are licensed within any state. Thus, captives with a 953(d) election generally will be treated as a U.S. person for purposes of FATCA.
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Non-U.S. retirement funds also must be specially analyzed for FATCA purposes. Absent a special exclusion, the entities or trusts generally would be FFIs. The Treasury Regulations provide, however, that non-U.S. retirement plans will avoid FFI status if they satisfy the requirements of one or more special categories listed in the regulations, or are otherwise included in Annex II to an applicable IGA. The special categories include treaty-qualified retirement funds, “broad participation” retirement funds, certain “narrow participation” retirement funds, 401(a) type plans, investment vehicles used exclusively by retirement funds, and certain retirement funds of entities that are classified as “exempt beneficial owners.” The specific characteristics of each category are listed in the Treasury Regulations, or the applicable IGA or treaty.
A retirement fund organized in an IGA jurisdiction will be exempt from FATCA FFI registration and reporting requirements if the fund is of a type specified in the applicable IGA. Annex II to the applicable IGA may list additional types of funds and other categories of entities that will be exempt from FATCA and that are not otherwise eligible for any of the exemptions described above.
Application of FATCA to NFFEs
Once an entity’s FATCA status as an NFFE has been determined, the 30 percent withholding tax on withholdable U.S.-source payments will be avoided if the NFFE prepares and submits IRS Form W-8BEN-E to the withholding agent certifying its chapter 4 (and chapter 3) status. In addition, if the NFFE is a passive NFFE, it also must disclose any “substantial” U.S. ownership. A passive NFFE is one where more than 50 percent of gross income is passive income (e.g., dividends, interest, rents and royalties, annuities and gains from the sale of passive assets) and more than 50 percent of assets are held for the production of passive income.
NFFEs also may be required to report their FATCA status and substantial U.S. ownership to non-U.S. financial institutions in which they have accounts and in connection with certain contractual arrangements, in order to enable the non-U.S. financial institutions to conduct their own FATCA diligence. The information may be provided by completing IRS form W-8BEN-E or through self-certification or other documentation provided by the financial institution.
FATCA Transitional Period
The IRS has stated that the 2014 and 2015 tax years will be treated as a transitional period during which “good faith” compliance with FATCA will be an acceptable defense to avoid penalties. Non-financial groups should use this period to develop and implement their FATCA compliance plan.
Alan J. Schwartz is a partner, and Chelsea E. Hess is an associate, in the law firm of McDermott Will & Emery LLP. They are based in the Firm’s New York office.
Corporate Inversions: The UK Perspective
By James Ross
In recent years, the United Kingdom has become an increasingly attractive holding company jurisdiction and, in the context of inversions, arguably a fashionable one. In the last year in particular, several U.S. groups have sought to merge with foreign groups or spin off divisions to them, with the resulting group sitting under a new non-U.S. holding company. UK-resident holding companies have also been adopted or considered in structuring European cross-border mergers.
Previously, however, the United Kingdom had experienced the other side of this coin: in 2008 and 2009, several UK-based multinationals inverted to Ireland and Switzerland. Critics of today’s U.S. tax system will recognize some of the criticisms leveled at the UK tax system in 2008 by multinationals seeking to escape it—namely, that the United Kingdom taxed worldwide profits with credit relief for foreign taxes, rather than applying a territorial exemption system, and had ill-focused and overly broad controlled foreign company (CFC) rules, which the then-government initially proposed to expand in scope as a quid pro quo for exempting foreign dividends from tax.
As a member of the European Union, which prohibits restrictions on businesses’ ability to establish themselves in other EU Member States, the United Kingdom did not have the option of adopting U.S.-style anti-inversion rules. This ultimately led the UK government to adopt more focused CFC rules, exemptions for foreign dividends and the profits of foreign branches, and aggressive cuts to the headline rate of corporation tax (which will reach 20 percent in 2015). These reforms supplemented the UK
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tax system’s existing attractive features, such as the absence of a dividend withholding tax, generous relief for interest expense and a broad tax treaty network.
The basics of the United Kingdom’s corporate tax system now stand in comparison with those of other holding company jurisdictions. From a non-tax perspective also, the United Kingdom is a credible holding company jurisdiction in which many multinationals already have a substantial presence or will be able to locate some substantial activity without too much difficulty.
Companies considering adopting a UK holding company structure should, however, be aware of potential complications that must be addressed as part of any inversion, as well as potential developments in the UK tax regime over the next few years.
Issues to Be Considered as Part of an Inversion
One frequently cited disadvantage of using a UK-incorporated holding company is that transfers of its shares are subject to stamp duty, a transaction tax charged at a rate of 0.5 percent of the consideration paid for the shares. Where the shares are traded on the London Stock Exchange, the duty is collected through the electronic settlement system, but there is no such mechanism for shares traded on foreign exchanges, which led the UK government to impose duty at a rate of 1.5 percent when shares are transferred into a clearance system or depositary receipts to enable them to be traded on a foreign exchange. Although the European Court of Justice (ECJ) has curtailed the scope of this charge in practice, the charge remains on the statute book and is thus a complicating factor when listing the shares of a UK company on a foreign exchange.
Because the stamp duty legislation only applies where the company is UK incorporated, some inverting groups have adopted the simple expedient of establishing a holding company that is managed and controlled (and thus tax resident) in the United Kingdom but incorporated in Jersey or another similar jurisdiction that does not impose a corporate income tax. Where a UK-incorporated company is used, however, it is often possible to obtain a ruling from HM Revenue & Customs (HMRC) that the reorganization will not attract a significant stamp duty charge.
Depending on the precise structure adopted, an inverting group might need assurance that the transaction as structured does not inadvertently trigger a taxable capital gain in the United Kingdom. Additionally, if any party to the transaction has significant UK-resident shareholders, that party should consider whether the transaction can be structured as a tax-free exchange for such shareholders.
With respect to the post-acquisition structure, the group may wish to seek assurance from HMRC with respect to the deductibility of interest on any debt taken on by UK group companies as part of the restructuring. It may also wish to obtain clarification as to how the CFC rules will apply to it in the future. While the new rules are intended to focus on profits diverted away from the United Kingdom, they are not necessarily straightforward to apply, although groups moving to the United Kingdom can take advantage of a one-year exemption from the application of the CFC rules to enable them to undertake any necessary restructuring.
HMRC is generally efficient and cooperative in providing clearances on these issues but is also wary of being perceived to endorse tax avoidance or of providing tax planning services. Any application for clearance is more likely to receive a positive reception if it is submitted as part of an arrangement that will result in more substantive economic activities being undertaken in the United Kingdom.
Potential Future Developments
In recent years, perceived tax avoidance has been subject to much public and parliamentary scrutiny in the United Kingdom. The United Kingdom is also an enthusiastic participant in the Organisation for Economic Co-operation and Development’s base erosion and profit shifting (BEPS) initiative. These factors are likely to result in further changes to the corporate tax regime in coming years, regardless of the government’s political complexion after the 2015 election.
It is reasonable to assume that the United Kingdom’s territorial tax system and modified CFC rules are here to stay, largely because it would be difficult to strengthen them in a way that is consistent with EU law. No major political party is advocating substantial increases in the rate of corporation tax, and ECJ case law has placed strict limits on the ability of Member States to impose “exit charges” on departing companies. The
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government has, however, recently indicated its intention to implement more comprehensive anti-arbitrage rules as contemplated by the BEPS project, and (in line with other major European economies) may also introduce tighter restrictions on the deductibility of interest in the future.
Groups should bear in mind the risk of these types of changes when considering their optimum structure. Equally importantly, they should consider how their tax structuring will be perceived: in the United Kingdom today, tax planning can be as much about reputation and brand management as it is about tax efficiency.
James Ross is a partner in the law firm of McDermott Will & Emery UK LLP and is based in the Firm’s London office.
Tax Considerations When Acquiring Non-U.S. Portfolio Companies—Mitigating Subpart F Inclusions
By Daniel N. Zucker, Jeffrey C. Wagner, Thomas P. Ward and Robert A. Clary, II
It is important for private equity purchasers to mitigate the creation of Subpart F income in structuring the acquisition and holding of the stock of a non-U.S. portfolio company. This article will explore what Subpart F income is, why it should be mitigated and the structuring techniques that can accomplish that goal.
Subpart F income is certain categories of income generated by non-U.S. entities that are classified as controlled foreign corporations (CFCs). Generally, this is income of a passive nature (i.e., dividends, interest, rents, royalties, capital gains). Subpart F income also includes certain income of a CFC from related party transactions, such as related party sales or services transactions.
Subpart F income is unattractive because it can be triggered in unfavorable circumstances and is subject to higher U.S. tax rates. The income is taxed to certain private equity (PE) fund investors irrespective of whether the investor actually receives cash. Said differently, Subpart F income is dry income—the recipient is in the unfortunate position of having a taxable event without necessarily having an associated cash inflow. In addition, for U.S. individual investors (whether through direct investment or investment through a flow-through vehicle, such as a limited liability company (LLC), limited partnership or S corporation), Subpart F income is taxed at ordinary income rates rather than the preferential rates that generally apply to capital gains and dividends. A U.S. investor in a PE fund will generally expect capital gains treatment (a top rate of 20 percent) on all income generated through a PE investment (with the exception of any interest income that is contemplated). Therefore, incurring a dry income inclusion at ordinary U.S. income tax rates (a top rate of 39.6 percent) as a result of a Subpart F inclusion is very unattractive. In addition, the 3.8 percent surtax on passive income enacted as part of the Affordable Care Act applies to Subpart F income. Thus, before taking into account any U.S. state or local taxes that may be due, a U.S. individual investor in a PE fund could be subject to a 43.4 percent U.S. federal tax on each dollar of Subpart F income that is created through the holding of a non-U.S. portfolio company by a PE fund. Furthermore, as noted above, it is unlikely the investor will have received any cash to pay the tax bill.
Base Case Example
To help illustrate the ill effects and structuring alternatives to mitigate Subpart F income in connection with an investment by a PE fund in a non-U.S. portfolio company, we’ll discuss various alternatives based on the hypothetical, but common, example below.
PE Fund is organized as a U.S. limited partnership. PE Fund’s investors consist of: (1) U.S. taxable individuals and flow-through entities owned by U.S. taxable individuals (e.g., LLCs and S corporations); (2) U.S. taxable corporations; (3) U.S. tax-exempt investors and (4) non-U.S. investors. PE Fund wishes to invest in a UK portfolio company, UK Target, and will acquire 90 percent of the equity of UK Target, with UK Target management receiving a 10 percent equity stake in UK Target going forward. UK Target owns multiple subsidiary companies around the world, including certain U.S. subsidiaries. To acquire the UK Target, the PE Fund establishes an acquisition vehicle in Luxembourg (LuxCo). LuxCo in turn establishes an acquisition vehicle in the United Kingdom. (UK TopCo) to acquire UK Target. PE Fund capitalizes LuxCo with cash in exchange for common equity and convertible preferred equity certificates (instruments generally characterized as equity for U.S. tax purposes, but debt for Luxembourg purposes). LuxCo then capitalizes UK TopCo with cash in exchange for common equity (90
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percent) and debt (generating an interest deduction in the United Kingdom) of UK TopCo. Management of UK Target rolls over into UK TopCo. UK TopCo then acquires the stock of UK Target.
In the structure above, because each of LuxCo, UK TopCo, UK Target and any non-U.S. subsidiary of UK Target constitute a CFC, Subpart F income risks exist. To the extent Subpart F income is generated, the taxable U.S. investors (individuals and corporations) in PE Fund will be subject to U.S. taxation on such income. First, under current law, the interest income on the loan from LuxCo to UK TopCo would constitute Subpart F income. Similar loans between CFCs in the structure could generate Subpart F income. Further, dividends paid from the non-U.S. subsidiaries of UK Target to UK Target could constitute Subpart F income under current law. In addition, sales or service arrangements between UK Target or one or more of its subsidiaries could give rise to Subpart F income. Finally, as PE Fund eventually looks to monetize its investment, an exit whereby LuxCo disposes of its shares of UK TopCo could generate Subpart F income.
Mitigating Subpart F
The recent expiration of certain U.S. tax provisions preventing Subpart F income on interest or dividend payments between related non-U.S. companies has created new challenges in mitigating the negative consequences of generating that type of income. During the last several years, a helpful provision has been Internal Revenue Code section 954(c)(6), which generally allows for dividends, interest, rents and royalties to be paid to related CFCs without creating Subpart F income. Under section 954(c)(6), the interest on the loan from LuxCo to UK TopCo in the base case example above would not be Subpart F income. However, section 954(c)(6) was enacted as a temporary provision and expired on December 31, 2013. While it is largely anticipated that the provision will be extended retroactively to the beginning of 2014 as part of the extension of a package of similar temporary measures (including, for example, the research and development tax credit), this provision is currently unavailable. Therefore, under current law, the interest on the loan from LuxCo to UK TopCo (and potentially others loans in the structure between related CFCs) constitutes Subpart F income.
One mechanism that is currently available to manage Subpart F income is through tax rules commonly referred to as “check-the-box” rules, allowing for the elective tax classification of non-U.S. entities. Specifically, these provisions allow taxpayers to choose the classification of a non-U.S. entity as between a corporation, partnership or branch (disregarded entity). As discussed above, Subpart F income can arise as a result of transactions between related companies. Thus, there is often a preference to make elections for U.S. tax purposes to treat entities as branches (or disregarded entities) of a single non-U.S. company such that transactions between the entities are disregarded for U.S. tax purposes. In the base case, it would likely be possible to check-the-box to treat all the entities below UK TopCo as disregarded entities. This strategy would allow transactions between subsidiaries of UK TopCo to be disregarded for U.S. tax purposes and limit the situations where Subpart F income can be created. However, because UK TopCo has two owners (LuxCo and management), an election cannot be made to treat it as a disregarded entity for U.S. tax purposes. Rather, under the check-the-box rules, UK TopCo can only be classified as a corporation or partnership. Therefore, there will continue to be risk of Subpart F income on the interest income of LuxCo on the loan to UK TopCo.
Separate from tax elections of the acquired entities themselves (and the holding company structure above them), proper fund structuring can mitigate Subpart F risks, as well. As discussed above, the Subpart F rules are only applicable to the extent one or more non-U.S. entities in the target’s structure are characterized as CFCs. A CFC is a non-U.S. entity that is owned more than 50 percent (by vote or value) by “U.S. Shareholders.” A U.S. Shareholder is any U.S. person (U.S. individual, corporation or partnership) that owns 10 percent or more of the voting stock of the CFC. Complex attribution rules apply to determine whether the above-described threshold is met. In the base case example, LuxCo, UK TopCo, UK Target and other non-U.S. subsidiaries of UK Target will be characterized as CFCs because PE Fund is organized as a U.S. partnership. PE Fund is a U.S. person that owns 10 percent of the voting stock of LuxCo (and, as a result, 10 percent of the voting stock of its subsidiaries, including UK TopCo and UK Target), which means PE Fund is a U.S. Shareholder. Further, PE Fund owns more than 50 percent by vote and value of the stock of LuxCo (and, as a result, 50 percent by vote and value of the stock of its subsidiaries, including UK Topco and UK Target), which means LuxCo and its subsidiaries are CFCs.
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The characterization of the above non-U.S. entities as CFCs creates Subpart F risk for all of the taxable U.S. investors in the PE Fund, irrespective of their economic interest in PE Fund. However, it could be and is likely the case that if the PE Fund were not organized as a U.S. partnership, the entities would not be characterized as CFCs. For example, assume that 50 percent of the Fund’s investors were non-U.S. investors and 50 percent of the investors consisted of 10 U.S. investors, each with a 5 percent stake. Under this example, if the investors owned the stock of LuxCo directly (or were treated as doing so for U.S. tax purposes), neither LuxCo nor any of its subsidiaries would be characterized as a CFC, thereby eliminating Subpart F concerns. Therefore, to mitigate Subpart F risks, PE Fund may want to consider creating a parallel fund or other alternative investment vehicle, such as in the Cayman Islands, for its investors to invest through (rather than a U.S. partnership).
Daniel N. Zucker, Jeffrey C. Wagner, Thomas P. Ward and Robert A. Clary, II are partners in the law firm of McDermott Will & Emery LLP and are based in the Firm's Chicago office.
China’s Tax Authority: Recent Views on Deductibility of Cross-Border Intercompany Fees
By William (Wenyu) Zhang and Lacoste Qian
Profit-shifting among associated companies within multinational enterprises (MNEs) is sometimes effected by intercompany charges of management and service fees, but as the 2007 China Enterprise Income Tax (EIT) law and its implementing regulations (collectively, EIT Laws) make clear, intercompany management fees generally are not deductible from EIT. As a result, MNEs sometimes impose intercompany charges for services in the form of consulting fees and general service fees in their transfer pricing arrangements, in the hope that those charges will be eligible for deduction in computing China EIT. China’s national tax authority, the State Administration of Taxation (SAT), recently has been scrutinizing these charges and disallowing deductions where it concludes that the charges were for the purpose of inappropriate profit-shifting (i.e., mainly for shifting taxable profits from China overseas) as opposed to a legitimate business purpose.
Service Fees in General
The SAT has adopted certain tests for determining whether an intercompany charge in the nature of a service fee is reasonable and, for EIT purposes, deductible, and has indicated that additional guidance may be forthcoming. In a recent document entitled “Views on Service Fees and Management Fees,” the SAT responded to a United Nations Tax Committee request for comments on this issue. A summary of the SAT’s position follows.
BENEFIT TEST – WHO PRINCIPALLY BENEFITED?
For the purpose of assessing compliance with the arm’s length principle, a “benefit test” will be applied to both the service provider and the service recipient to determine whether intercompany services warranting a charge have been rendered. For example, if management consulting services provided by a parent company to its subsidiary will benefit the parent company more than the subsidiary (even if the subsidiary also benefits from the services), the service fees paid to the parent company may be non-deductible.
NECESSITY TEST – WERE THE SERVICES NECESSARY?
Taking into account the nature of the purported services recipient’s activities and incorporating a cost-benefit analysis, if the SAT deems high-end services (e.g., sophisticated advisory or legal services) unnecessary, the fees charged for such services may not be considered deductible.
ANTI-DUPLICATION TEST – HAS A CHARGE FOR THE SERVICES ALREADY BEEN IMPOSED?
If a parent company already has been remunerated through, or benefited from, a separate transfer pricing arrangement (e.g., a profit-sharing arrangement) with regard to any specific service it renders to a Chinese subsidiary, the parent company may not be permitted to charge any further service fee to the subsidiary for that service.
MANAGEMENT FEE TEST – ARE THE FEES FOR MANAGEMENT SERVICES?
From the SAT’s perspective, most subsidiaries of MNEs in China have their own management teams. Therefore, the legitimate management function that the parent company performs for its subsidiaries is considered very limited. Many of the pertinent management services being performed are deemed duplicative
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and unnecessary, with the result that the Chinese tax authorities are likely to challenge the deductibility of fees imposed for parent-subsidiary services of a management nature.
In order for the preceding guidance to be implemented effectively, the Chinese tax authorities must address a number of issues:
Because of the lack of clear rules under the existing EIT Laws, tax authorities have too much discretion in the course of enforcement.
Given the wide variety of intercompany services, the authenticity of intercompany service charges is difficult to verify.
Tax authorities often have difficulty determining whether certain allocation methods for setting intercompany services changes comply with the arm’s length principle.
Offshore structures and overseas businesses obscure an MNE’s overall intercompany service arrangements, and existing international tax information exchange treaties do not provide a mechanism sufficient for the Chinese tax authorities to obtain the necessary information.
Technical Service Fees
In addition to service fees charged for management functions, the SAT recently has focused on technical service fees. Under EIT Laws, payments for the licensing of intangible assets such as proprietary technologies (e.g., royalties) are subject to withholding tax—typically 10 percent in the case of cross-border transfers. In comparison, service fees paid by a subsidiary in China to its overseas parent company likely will not have any Chinese income tax implications (except for turnover taxes) if there is no permanent establishment created in respect of the provision of the services in question.
The SAT has noted that, because it is difficult to draw a clear line between the provision of services and the transfer of intangible assets or licensing of technologies, MNEs tend to provide technical assistance services in tandem with the transfer or licensing of technologies, resulting in lower taxes. The SAT has developed principles and testing methodologies for management-related service fees, but the Chinese tax authorities are still seeking guidance from international organizations such as the United Nations and the Organisation for Economic Co-operation and Development in respect of technical services arrangements.
In summary, MNEs doing business in China face increasing difficulties in sustaining the deductibility of intercompany service fees without a strong demonstration of the value and necessity of the services in question. As the Chinese tax authorities become more sophisticated, technical service fees and similar arrangements currently passing muster may face increasing challenges, however well crafted they may be. As a result, it is critical that MNEs doing business in China continue to develop tax-efficient intra-group arrangements.
William (Wenyu) Zhang is a partner, and Lacoste Qian is an associate, at MWE China Law Offices based in Shanghai.
Overview of the IRS Transfer Pricing Roadmap
By Cym H. Lowell and Matthew Herrington
In February 2014, the Internal Revenue Service (IRS) overhauled its guidance on the conduct of transfer pricing examinations by publishing the Transfer Pricing Roadmap. The Roadmap is aimed at the IRS Large Business and International Division teams that conduct transfer pricing audits, and is intended as a tool for use by those teams. It is organized around a notional 24-month audit timeline and includes recommended audit procedures, along with links to reference materials.
The Roadmap does not represent formal or binding guidance, but it does incorporate various parts of the IRS Internal Revenue Manual, the primary official source of IRS internal guidance to caseworkers. It seems the IRS intends that IRS examiners give the Roadmap a certain weight in conducting transfer pricing audits, and that taxpayers take heed of it.
Overview of the Roadmap
The Roadmap is organized around the following key stages:
Planning (up to six months)
Execution (up to 14 months)
Resolution (up to six months)
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THE PLANNING PHASE
This phase comprises four separate sub-phases:
The pre-examination analysis sub-phase (which does not start the 24-month audit cycle and therefore could be as long in duration as is required in practice) involves a preliminary assessment of the potential transfer pricing risk involved, and also includes the gathering of necessary information.
The opening conference sub-phase starts the 24-month audit cycle and involves a formal opening conference with the taxpayer.
The taxpayer orientation sub-phase involves a study of the taxpayer’s particular circumstances. The Roadmap recommends that this study include, for example, a walk-through of the legal entity organization charts and a functional analysis of each relevant controlled party.
The preparation of initial risk analysis and examination plan sub-phase involves preparation of the formal risk assessment and the creation of a timeline for its resolution. The Roadmap recommends that the timeline contain key milestone dates for completion of the inquiry, and states that this sub-phase must be completed within six months of the opening conference sub-phase.
THE EXECUTION PHASE
The execution phase is broken down into two sub-phases. The first is the fact-finding and information gathering sub-phase, which involves a detailed engagement with the taxpayer. The second is the issue development sub-phase, which involves, for example, a consideration of whether the taxpayer’s method is the best method.
THE RESOLUTION PHASE
Following the execution phase, the final phase of the Roadmap commences. The resolution phase is broken down into three key sub-phases:
The issue presentation sub-phase involves a meeting with the taxpayer to discuss the IRS’s findings on all issues prior to finalizing a Notice of Proposed Adjustments (NOPA).
The issue resolution sub-phase provides the taxpayer with the opportunity to give input on the resolution process. During this sub-phase, the NOPA also is issued.
The resolution sub-phase involves the preparation of rebuttals to the taxpayer’s response to the NOPA (if the adjustment is contested) and the preparation of case-closing papers.
Key Themes in the Roadmap
In addition to the specific phases, the Roadmap contains several key themes:
Up-front planning in the conduct of a transfer pricing inquiry is critical. The Roadmap states that the proper development of a transfer pricing position may take two to three years (or possibly even longer), and that transfer pricing specialists must therefore be involved in the process.
Transfer pricing cases are generally won or lost on the facts. The Roadmap recognizes that facts are central to a transfer pricing audit and that a detailed understanding of a taxpayer’s supply chain is critical.
Effective presentation is important. The Roadmap recognizes that any NOPA must clearly present the facts (as well as the legal and economic arguments) in a cogent manner.
Reception of the Roadmap
The Roadmap is a welcome tool in many respects and has generally received a positive response from taxpayers and practitioners involved in transfer pricing work. The Roadmap provides taxpayers with a concrete framework for the resolution of a transfer pricing audit, together with assurances of internal reviews, active monitoring of the process and involvement of cross-disciplinary IRS teams (from economists and transfer pricing specialists to general fieldworkers).
The Roadmap is an element of the enhanced engagement process supported by the Organisation for Economic Co-operation and Development (OECD) and embraced by the IRS; as such, it places a heavy emphasis on collaboration, mutual trust, communication and exchange of information. It also demonstrates a desire on the part of the IRS to better understand the businesses with which it is dealing.
While some disappointment has been expressed at the notional two-year timeframe laid down by the Roadmap, it is considered to be a realistic approach on the part of the IRS.
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The Roadmap reflects appropriate principles and priorities for transfer pricing examinations. As always, the issue is whether in specific situations the taxpayer and IRS teams can coordinate in a cooperative and efficient manner to address and resolve the issues that may arise. Where such effective cooperation takes place, the Roadmap timelines may be longer than is needed for resolution, even in major situations. On the other hand, where such cooperation does not exist, the timelines may be unrealistically short.
It is too early to conclude whether the Roadmap will reduce the timeframe for resolving transfer pricing audits. What is clear, however, is that the Roadmap is a step in the right direction; to that extent, it is a welcome development, in principle, from a taxpayer perspective.
As the OECD passes the halfway point in its ongoing base erosion and profit shifting (BEPS) project, many taxpayers will be eager to ensure that changes to established international tax principles will not result in double taxation and irreconcilable disputes with tax authorities. It is hoped that the Roadmap will be a helpful tool in ensuring that IRS-initiated transfer pricing audits in the post-BEPS world can be resolved speedily and collaboratively.
Cym H. Lowell is a partner in the law firm of McDermott Will & Emery LLP and is based in the Firm’s Houston office. Matthew Herrington is an associate in the law firm of McDermott Will & Emery UK LLP, based in the Firm’s London office.
The material in this publication may not be reproduced, in whole or part without acknowledgement of its source and copyright. Focus on Tax Strategies & Developments is intended to provide information of general interest in a summary manner and should not be construed as individual legal advice. Readers should consult with their McDermott Will & Emery lawyer or other professional counsel before acting on the information contained in this publication.
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