On November 28, the Treasury Department Office of Tax Policy released its long-awaited “Report to the Congress on Earnings Stripping, Transfer Pricing and U.S. Income Tax Treaties” (“Report”). The Report contains the results of the Treasury Department’s analysis of three studies on earnings stripping, transfer pricing and income tax treaties and provides recommendations on how the government can reduce abuse of U.S. tax laws and treaties and improve their effectiveness in preventing income shifting that erodes the U.S. tax base. The Report portends additional enforcement efforts and coincided with a proposal for some new information gathering on international transactions.
To collect additional information on foreign-controlled domestic corporations that are not the result of an inversion of a domestic corporation, the IRS released on November 28, in Announcement 2007-114, proposed new Form 8926, Disqualified Corporate Interest Expense Disallowed Under Section 163(j) and Related Information, which asks for specific information relating to the determination and computation of a corporate taxpayer’s Section 163(j) limitation.1 This appears to have been prompted by the Report’s findings on earnings stripping. The Report focuses on the use of earnings stripping to shift income offshore and analyzes a number of legislative proposals and presidential budget proposals to tighten the rules under Section 163(j).
Section 163(j) was added to the Code in 1989 to prevent erosion of the U.S. corporate tax base through excessive deductions for interest payments. Section 163(j) places limitations on the deductibility by any corporation of interest paid or accrued to related persons that are exempt or partially exempt from tax if the corporation’s debt-equity ratio exceeds 1.5 to 1 percent and its net interest expense exceeds 50 percent of its adjusted taxable income.
The earnings stripping provisions took center stage in the context of the congressional debate in 2004 over corporate inversions. A corporate inversion is a transaction or a series of transactions through which a U.S.- based multinational restructures its corporate structure so that the ultimate parent of the corporate group becomes a foreign entity. In addition to the basic reincorporation outside the U.S., the ownership of the group’s existing foreign operations is often shifted outside of the U.S. by transferring existing foreign subsidiaries to the new foreign parent.
Although abusive corporate inversions are now largely prohibited by the enactment of Section 7874 by the 2004 Jobs Act, the Treasury Department concluded that inverted corporations whose structures were grandfathered continue to siphon huge amounts of income offshore. The Treasury Department found that the data on inverted corporations “… strongly suggest that these corporations are shifting substantially all of their income out of the United States, primarily through interest payments.”2 The Report concludes that the current Section 163(j) rules are not effective at preventing the inappropriate shifting of income outside the U.S. by inverted corporations and need to be strengthened. Interestingly, the Report did not find conclusive evidence of earnings stripping by foreigncontrolled domestic corporations that have not inverted but determined that additional information is needed.
The second part of the Report focuses on the shifting of income from the U.S. through transactions between related parties. The study reviewed regulatory guidance under Section 482 and the effectiveness of current transfer pricing rules and compliance efforts against improper income shifting out of the U.S. The Report emphasizes the urgent need to finalize and implement the three transfer pricing regulatory projects on the treatment of cost sharing arrangements, services and global dealing and stated that they would be given the highest priority.
A cost sharing arrangement (“CSA”) involves related parties that share the costs and risks of developing intangible property in return for an interest in such intangible property. In a typical CSA, one or more participants makes an existing intangible available to the CSA (the “external contribution”) for further development. The Report found the need for additional guidance on the nature and scope of external contributions for which an arm’s length consideration (buy-in payment) must be provided as a condition of entering into a CSA. The Report states that the cost sharing area “is a crucial one regarding the shifting of income out of the United States” and noted that the 2005 proposed regulations set forth in Prop. Reg. §1.482-7 were an important first step. In a September 27 coordinated issues paper on cost sharing, LMSB 04-0907-62, the Treasury Department advised IRS personnel on how to analyze common positions taken by taxpayers in reporting reduced buy-in payments.
The Report states that the existing final services regulations, issued in 1968, were outdated and revisions were necessary due to the increased volume and complexity of multinational operations and transactions. The Report highlights the need for additional guidance on intercompany services transactions that may be charged at cost as well as services performed in connection with the development of intangible property. Temporary regulations were issued in July 2006 (T.D. 9278) in response to comments received by the Treasury Department on the 2003 proposed regulations. The 1968 regulations allow certain intercompany services transactions to be charged at cost (“Cost Safe Harbor”). In practice, the Cost Safe Harbor has been applied to services that were not intended to be included under the original rule. The 2006 temporary regulations provide that low-margin services may be charged at cost if the services are either identified in a revenue procedure published by the IRS or if the median comparable arm’s length markup for the service is 7 percent or less (“Services Cost Method”). Services eligible for the Services Cost Method must not contribute significantly to key competitive advantages, core capabilities, or the fundamental success or failure of the business. The 2006 temporary regulations also address the treatment of services performed in connection with the development of intangible property, particularly in the context of marketing intangibles.
The Report said that new rules are needed to allow taxpayers to determine the amount of income from global dealing in financial products subject to U.S. tax, the source of such income and the rules to determine when such income is effectively connected with a U.S. trade or business. The March 1998 proposed regulations on global dealing, which were never finalized, have become outdated and the Treasury Department has placed a high priority on reproposing global dealing regulations.
In recognition of the high burden of complying with complex transfer pricing rules, the Report did not recommend additional disclosure requirements, given the requirements already in place under Section 6662(e), the high audit rates of affected taxpayers, and the ability of the Competent Authority to exchange information with other tax jurisdictions. U.S. Income Tax Treaties
The focus of the third study on U.S. income tax treaties is on preventing third-country residents from inappropriately obtaining the benefits of U.S. income tax treaties. Recent U.S. treaties contain limitations on benefits (“LOB”) provisions aimed at denying treaty benefits to persons with insufficient business and economic nexus to the treaty party. Focusing on the agreements with Iceland, Hungary and Poland as treaties that the Treasury Department views as most vulnerable to treaty shopping, the study found that interest payments from foreign-controlled U.S. corporations to related parties in countries party to a U.S. income tax treaty without LOB provisions have surged in recent years. Indeed, the Treasury observed that the recent surge reflects relative compliance with the anti-treaty shopping provisions contained in other U.S. treaties, suggesting that such LOB provisions have acted as a deterrent.
The United States signed a new income tax treaty with Iceland with a comprehensive LOB provision in October 2007, and further negotiations are scheduled with Hungary. The Treasury Department also expects to begin negotiations for a new treaty to replace the 1976 agreement with Poland although it has not found conclusive evidence that the treaty has been subject to extensive exploitation. The Treasury Department continues to review the existing U.S. treaty network for deficiencies and has placed a high priority on renegotiating U.S. treaties with deficient or no LOB provisions.