The globalisation of the tax environment has made planning opportunities increasingly rare. Tightened credit markets, enhanced public scrutiny and rigorous local audits have all added to what was an already perilous landscape. But opportunities do still exist, particularly in business combination scenarios.
The typical business combination deal is negotiated at senior management level where core principles are agreed upon, such as the combination of the businesses on a global basis and the sharing of system profits in accordance with the relative contributed value. Once the agreement in principle is reached, more detailed discussions can take place and construction of the implementation framework can begin.
Entity or Contract
There are any number of reasons why the parties might elect to use a contract rather than a separate legal entity for the joint venture. For example, each of the businesses probably has proprietary information that it is willing to use in the joint venture, but that it is not willing to transfer outright. In addition, complex rules regarding employees and their pension rights might make it difficult and costly to move employees to a new legal entity. Re-titling real property, intangible property and manoeuvring through change of control provisions in various contracts, including debt instruments, may also be costly at best and prohibited at worst.
Although a contractual joint venture solves some of these concerns, the arrangement may nonetheless give rise to a separate business entity, most likely a partnership, for tax purposes. Under applicable tax regulations, a separate entity may exist where the agreement essentially results in the sharing of entrepreneurial risks and rewards,e.g., where profits and losses and management of the business are shared by the parties. A number of disruptive and potentially harmful consequences may, however, follow from classifying a contractual alliance as a partnership, e.g., gain recognition on the deemed contribution, application of special allocation rules for property with value and basis differences, and entity-level determinations regarding various expenditures that may result in a share of credits different to what the parties anticipated when striking their deal. Careful structuring at the outset can reduce the risk of an unexpected re-characterisation of the form of business.
A business combination might be an opportunity to move assets from one jurisdiction to another. For example, assume that the combination involves a US corporation and an unrelated non-US corporation. The US corporation may wish to relocate certain assets,e.g., intellectual property, to a jurisdiction with more growth opportunities. The transfer of those assets offshore may give rise to tax liabilities if the joint venture entity is a foreign corporation. Alternatively, if the joint venture entity is a partnership, the US corporation may, in some cases, be able to defer recognition of gain for an extended period of time.
The rules requiring gain recognition on an outbound transfer to a corporation do not apply to outbound transfers to a partnership. Other rules, however, may operate to mimic these gain recognition rules in certain circumstances. In addition, the Internal Revenue Service recently announced that an initiative to write rules on outbound transfers to joint ventures is on the business plan, with "high priority".
The joint venture parties will most likely have different tax positions coming into the venture,e.g., the ability to use foreign tax credits and availability of tax attributes such as loss carry-forwards, etc. The ability to structure the transaction to optimise the tax results for each of the parties may be difficult in a corporate entity. While different classes of corporate stock, including tracking stock, may be available, this type of capital structure may prove too inflexible.
A partnership entity may be more nimble owing to its ability to utilise special allocations and to otherwise allocate income among the partners in a manner that supports their respective tax goals. For example, the parties might agree to allocate income to one partner until a particular threshold is met; or the parties might agree to allocate foreign source income to one party and domestic source income to the other. Of course, this flexibility is not without limits. Partnership allocations are tested under a complex series of rules designed to ensure that the allocations are substantial and have economic effect. Stated simply, the tax results must marry up with the economic results.
Application of Income Tax Treaties
If the parties elect to use a partnership entity for the joint venture, they will each need to assess whether or not, and how, the treaty network will apply. For example, assume that a US business and a German business decide to enter into a joint venture that will exploit manufacturing resources in various EU locations. The joint venture will have subsidiaries and branches in these various locations. The parties decide that the joint venture entity will be an entity that is taxed as a partnership (a fiscally transparent entity) for US purposes, but taxed as a corporation for German purposes.
Tax treaties are intended to relieve double or excessive taxation. This fundamental principle may not easily apply when there are entity classification conflicts between the source country and the residence country. In some situations, the competent authorities of the jurisdictions reach an agreement with respect to the treatment of fiscally transparent entities and look through to the owners to assess eligibility for treaty benefits. Other treaties do not look through the fiscally transparent entity but instead look to whether or not the entity is subject to tax at the entity level in the particular jurisdiction. Careful consideration of the applicable treaty network can prevent an unexpected tax result where the parties may have assumed availability of treaty benefits.
Transfer Pricing Rules
Most joint venture participants will be well aware of the transfer pricing rules, which generally apply in transactions between commonly controlled parties and operate to impose arm’s length terms in these transactions. In the partnership context, however, transfer pricing rules can apply even when the parties do not view themselves as related. For example, the rules can apply in a 50/50 joint venture between unrelated parties. Once the parties enter into the joint venture, they act in concert to the benefit of the joint venture and, as a result, under certain circumstances can be viewed under the transfer pricing lens as related. These rules can apply at a number of important transactional points in the joint venture structure and should be considered before a definitive deal is negotiated, and throughout the life (and death) of the joint venture.
The tax advantages of a joint venture that is a tax partnership can be powerful, and most of the risks can be managed by careful consideration from the outset and throughout the life of the venture.