China’s New Thin Capitalization Rules: Specific Debt/Equity Ratios Established

Excerpt from Practical China Tax and Finance Strategies by Peter Guang Chen (Deloitte Tax LLP, New York City)

Article 46 of China’s new Enterprise Income Tax Law (EITL) provides that a Chinese enterprise’s ability to deduct interest payments on borrowings from related parties is subject to a “prescribed standard.” However, the EITL, which became effective January 1, 2008, did not address what this “prescribed standard” would be. Without a clear answer on an acceptable debt-to-equity ratio in China, many financing and tax planning plans had to be put on hold, particularly for those multinational corporate groups doing cross-border intercompany financing of their subsidiary operations in China.

This important issue was addressed recently in Circular 121 issued jointly by the Ministry of Finance and the State Administration of Taxation.

Read More on Key Issues of Circular 121 (free)

Financial Bailout Package Contains International Tax Provisions

Excerpt from Practical US/International Tax Strategies by Lilo Hester, Ken Wood, Karen Jacobs, Eric Oman, Staci A. Scott and Carlos Probus (Ernst & Young LLP)

Earlier this month, President Bush signed into law the Emergency Economic Stabilization Act of 2008 (Division A), the Energy Improvement and Extension Act of 2008 (Division B), and the Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (Division C) (H.R.1424), herein collectively referred to as the Act. The Act was passed by the Senate on October 1, 2008, and by the House of Representatives on October 3, 2008. The Act has been widely publicized as the “bailout bill” because it provides the U.S. government with authority to purchase up to $700 billion in “troubled,” illiquid assets owned by various financial institutions.

International tax provisions of the Act include:

• Elimination of the distinction between foreign oil and gas extraction income (FOGEI) and foreign oil related income (FORI) and the combination of FOGEI and FORI into one foreign oil basket, applying the existing FOGEI limitation.

• Extension for an additional tax year (through December 31, 2009) of the controlled foreign corporation (CFC) look-through provision of Section 954(c)(6).

• Extension for an additional tax year (through December 31, 2009) of the exception to treatment as foreign personal holding company income for income derived in the active conduct of a banking, finance, or similar business.

• Extension for an additional tax year (through December 31, 2009) of the exception to treatment of certain insurance income as subpart F income.

Read more on international tax provisions with respect to individuals

IRS Enhances Opportunity for U.S. Multinationals to Access Cash from Controlled Foreign Corporations

Excerpt from Practical US/International Tax Strategies by Douglas S. Stransky, Lewis J. Greenwald, Ameek Ashok Ponda and Eric J. Fuselier (Sullivan & Worcester)

On October 3, 2008, the U.S. Internal Revenue Service (IRS) issued Notice 2008-91, which expands the ability of a controlled foreign corporation (CFC) to make short-term loans to its U.S. parent to fund operations without creating an income inclusion for U.S. federal income tax purposes. This Notice applies for a CFC’s first two taxable years ending after October 3, 2008. Thus, for a CFC with a calendar taxable year, the Notice applies for calendar years 2008 and 2009. On October 16, 2008, the IRS issued a correction to provide that Notice 2008-91 will not apply to the taxable year of a CFC beginning after December 31, 2009.

Current Law
Generally, under Internal Revenue Code (Code) section 956, a loan made from a CFC to its U.S. parent is considered to be an investment in U.S. property because the CFC holds an “obligation” of the U.S. parent. Under this Code section, the average amount of the CFC’s investment in U.S. property held at the end of each quarter of the taxable year is potentially treated as a “deemed dividend” to the U.S. parent and, thus, taxable on the U.S. parent’s federal income tax return.
In some circumstances, however, the U.S. parent can have a loan outstanding from its CFC without triggering any income inclusion. Under Notice 88-108, for example, even if a CFC makes a loan to its U.S. parent that extends over a quarter end, there should be no income inclusion provided that this loan is outstanding less than 30 days.

But if the CFC were to hold any number of obligations that would (without regard to the 30-day exception) constitute U.S. property for aggregate periods totaling 60 or more days during a taxable year, this 30-day exception would not apply.

Notice 2008-91
In Notice 2008-91, the IRS has supplemented Notice 88- 108 so that a loan from a CFC to its U.S. parent would only constitute an obligation that results in an income inclusion if the loan is held for more than 60 days from the time it is incurred. Notice 2008-91 further provides that if a CFC holds obligations that would (without regard to the 60-day exception) constitute U.S. property for aggregate periods totaling 180 or more days during a taxable year, then this 60-day exception would not apply. Thus, Notice 2008-91 effectively extends the periods within which a taxpayer can hold an obligation without triggering the application of Code section 956. A CFC can apply Notice 2008-91 or Notice 88-108, but not both.

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Proposed Section 108 Regulations May Result in Disparate Treatment of S Corporation Shareholders

Excerpt from Practical US/Domestic Tax Strategies by Jeanne Sullivan (KPMG LLP)

Recently, Treasury published proposed regulations under section 108 on the reduction of tax attributes for S corporations (73 FR 45656-01). The proposed regulations provide guidance on the manner in which an S corporation applies the rules of section 108(b) in a year in which the S corporation has discharge of indebtedness income (COD income) that is excluded from gross income under section 108(a). In particular, the proposed regulations address situations in which S corporation losses and deductions that are treated as net operating losses (NOLs) for purposes of section 108 exceed the amount of the S corporation’s excluded COD income (Excess Deemed NOL). The proposed regulations provide rules whereby the Excess Deemed NOLs are apportioned among the S corporation’s shareholders after tax attribute reduction. As we shall see, the rules may result in potentially disparate treatment of the S corporation shareholders.

Subchapter S generally provides simplified pass-through treatment for corporations that meet its eligibility requirements. To avoid the complexities that can result from the variations in economic rights associated with partnerships, subchapter S requires that each shareholder be allocated a pro rata share of an S corporation’s items of income (including tax-exempt income), loss, deduction and credit as well as a pro rata share of nonseparately computed income and loss (section 1366(a)) and that the S corporation issue only a single class of stock (section 1361(b)(1)(D)). Nevertheless, the S corporation is a separate entity that also retains certain corporate characteristics and the rules of section 108 are applied at the corporate entity level.

Read More: Discharge of Indebtedness and Section 108

Mexico Tax Audits

Excerpt from August 2008 Issue of Practical Mexican Tax Strategies by Jaime González-Béndiksen (Baker & McKenzie)

The Mexican tax administration continues to increase its audit activity in practically all sectors of taxpayers, with special emphasis being paid lately to the pharmaceutical and oil sectors. This article excerpt will briefly discuss some of the transfer pricing issues being raised in recent audits.

Transfer Pricing
Secret comparables. It appears that the tax administration is testing the waters with respect to the use of the so-called secret comparables. These are comparables that the tax administration gathers from its own internal records, such as customs records. The administration gathers information on imports of what it considers to be products similar to those of the taxpayer and, on the basis of such information, rejects the prices paid by the Mexican taxpayer to its related parties abroad. The taxpayer is allowed to review the information gathered by the tax administration and to make notes. It does not, however, have any access to the entire customs files of the administration such that it could confirm whether or not the information gathered by the administration is correct or such that it could locate other information to disprove the administration’s findings. In our view, use of the secret comparables violates Constitutional principles and, as such, should be overturned by our courts when this matter comes to their attention.

Business Restructuring. The tax administration continues to audit business or supply-chain restructurings. It is not that the restructuring, as such, are prohibited. The tax administration’s arguments are basically that the restructuring and, consequently the transfer pricing study to support it, lacks substance. The administration tries to disprov the functions and risks that have arguably being transferred from the Mexican entity to one or more foreign companies within the same group. Regarding functions, the administration generally argues that in fact no functions were transferred abroad. Typically, where the taxpayer argues that purchasing and sales functions are now outside of Mexico, the tax administration looks into whether the foreign entity now charged with the functions has, in fact, employees to carry on these functions and whether or not the Mexican personnel formerly charged with these functions has left the Mexican company or continues to work there. Where managerial functions have reportedly been moved outside of Mexico, the tax administration also looks into whether the employees of the Mexican company formerly charged with the managerial functions in question, have or have not been relocated. On the risks side, the administration looks into whether the Mexican company’s history shows any such risks in fact occurring in the past, such as inventory risks, product liability, bad debts, etc. Its motto is that where there is nothing to lose no risk is being assumed.

These audits, however, typically forget to address the fact that whatever flaws the functions or risks may have, assets have in fact moved. Intangibles are now owned by a foreign member of the group. The production is also owned by a foreign principal who either sells it to a commissionaire in Mexico or sells it to the Mexican company for distribution. No doubt the mere fact that the Mexican taxpayer now owns virtually no assets, calls for a lower return. As mentioned earlier, this is often ignored by the auditors.

More on Business Restructuring

Tax Auditors Look to Substance in Centralized IP Structures

Excerpt from August 2008 Issue of Practical US/International Tax Strategies by John Henshall (Deloitte & Touche LLP)

In the early 1990s the first businesses transformed corporate efficiency, and profitability, by taking a holistic view of their business and optimizing their supply chain networks—the complex web suppliers, production and R&D facilities, distribution centers, sales subsidiaries, channel partners and customers. Typically the best commercial structure involved a centralization of regional activity into “Principal” company supported by “contract” or “toll” manufacturers and “commissionaire” sales or “simple” distributors, supported by “shared service centers” to take care of back-office functions. Today most multinationals don’t derive a significant proportion of their profits from the physical act of making products but rather from the ideas they generate that lead those products, wherever products are made. As this state of affairs evolved so did the centralized business model and IP planning is now a signifi cant element in any business restructuring.

Business restructurings are by their nature an enormous strain on the organization and they are not undertaken purely for tax reasons. Tax is, however, taken into account when deciding where the centralized entity should locate; in most reorganizations high-tax countries then see high-profit activities moving away. These governments are fearful of the fiscal consequences of the more profitable element of their tax base moving offshore and will audit the transition vigorously.

Read More: Why Is Substance Important?

The Internal Revenue Service Provides Limited Relief from the AHYDO Rules for Pre-2009 Financing Commitments

Excerpt from Practical US/Domestic Tax Strategies by Yoram Keinan and Mark H. Leeds (Greenberg Traurig, LLP)

The Internal Revenue Service has responded again to the troubled credit markets by easing the potential tax burden on corporations that issue debt pursuant to previously established financing commitments (Commitments).

On August 8, 2008, the Service issued a Revenue Procedure that describes circumstances under which it will not treat a debt instrument issued pursuant to a Commitment as an applicable high yield discount obligation (AHYDO) for federal income tax purposes. The AHYDO rules can result in both deferral of interest and original issue discount (OID) deductions, as well as a disallowance of such deductions. As a result, corporate borrowers who were lucky enough to lock Commitments prior to the current credit crunch will not face possible deferral and/or disallowance of interest and OID deductions on their debt as a result of actions taken by their lenders.

Read More on the Background of the AHYDO Rules (free)

IRS Disallows Foreign Tax Credits Claimed for Cross-Border Trust

Excerpt from Practical US/International Tax Strategies by Lawrence Hill and Alexander Roberts (Dewey & LeBoeuf LLP)

Recently, the IRS issued a Chief Counsel Advice memorandum (CCA) advising the disallowance of foreign tax credits claimed by a U.S. corporation (U.S. Corporation) in connection with income and assets transferred to a cross-border trust (Trust) on the grounds that the Trust arrangement lacked economic substance. The IRS determined that the cross-border trust “served no legitimate non-tax purpose and was not reasonably expected to generate an economic profit for the taxpayer.” In the alternative, the IRS concluded that the series of transactions involved in the arrangement lacked economic substance as an integrated transaction. In addition, the IRS determined that the foreign tax credits should be denied under Section 269(a)(1) and (2) because the taxpayer formed and transferred funds to a subsidiary with the principal purpose of avoiding U.S. federal income tax.

Read More on IRS Challenges of Cross Border Trusts (free)

Dutch Cooperatives Provide Tax Planning Opportunities

Excerpt from Practical European Tax Strategies by Joseph B. Darby III, Thomas van der Vliet(Greenberg Traurig LLP) andShane Kigen (Ernst & Young)

There is a famous Dutch proverb that states, “The art is not in making money, but in keeping it.” To help achieve this laudable goal, the Dutch have thoughtfully provided a Dutch cooperative holding structure that allows multinational enterprises and private equity funds to keep a significantly greater after-tax share of the money they make.

Cooperatives have been a business form used in the Netherlands for well over a century. However, only recently have tax lawyers fully begun to exploit this distinctive vehicle in international tax planning. What makes a cooperative exciting to tax planners is its unique treatment under the Dutch dividend withholding tax. Unlike its close relatives, the Dutch private or public company (BV/NV), a cooperative is not subject to the 15 percent withholding tax on dividend distributions. The absence of a levy of dividend withholding tax makes the cooperative a logical choice as a holding company. In conjunction with the Netherlands’ extensive treaty network, a cooperative holding structure generally permits foreign members of a cooperative to repatriate profits free from Dutch withholding tax.

More on Legal Attributes of Dutch Cooperative

The IRS Fixes Subpart F -- Sort Of

Excerpt from Practical US/International Tax Strategies by Joseph B. Darby III (Greenberg Traurig LLP) and Brainard Patton (Counselor at Law)

Ronald Reagan famously commented that the most scary phrase in the English language is, “We’re from the government and we’re here to help you.”

An even more celebrated saying is, “If it ain’t broke, don’t fix it.”

Now comes the Internal Revenue Service—unquestionably, these people are from the government—and they have decided to “help” us by delving into Subpart F of the Internal Revenue Code and “fixing” some esoteric but very important rules, including rules that address the consequences of contract manufacturing under the so-called “branch rule.” The branch rule is a significant limitation on the so-called “manufacturing exception,” which in turn is arguably the most important exception to the often tangled and always confusing “Subpart F rules” governing controlled foreign corporations (CFCs).

Let’s be frank about this: The branch rule is unquestionably broken, and has been broken for a long time. Now, let’s be even more frank: The branch rule is “broken” primarily because the Internal Revenue Service tried to fix it in the first place. Needless to say, some people—OK, a lot of people—have concerns about sending the IRS to fix a rule that the IRS has made far worse on several previous occasions.

Read More on the Proposed Regulations (free)