Overview of the Evolving World

HISTORIC PERSPECTIVE

• League of Nations (1926): Residence vs. Source 

  • The balance struck between residence country taxation and source country taxation proceeded from the assumption residual income would be repatriated to the residence country. 

  • Also assumed—erroneously—that all countries would act consistently.

  • Result was extensive use of interim holding companies in international tax planning, against the backdrop of a paradigm accepting the separateness of discrete juridical entities even where related.

• Lesson for future: avoid making the same error

• MNE Planning paradigm: in view of the framework that was so established beginning with the League of Nations, multinational enterprises (MNEs) have seen the opportunity to reduce their effective tax costs and, as with any other cost of operations, have taken steps to do so. This has involved, in essence, a process of finding the seams between countries’ tax regimes to achieve a low effective tax rate:

  • Example: Common IP holding structure for US MNEs

  • Results:

    • Full deduction in local operating company jurisdictions

    • BV taxable on residual spread (differential between royalty income from local operating companies and royalty payments to CV)

• • • CV not taxed in Netherlands (Dutch partnership) or the US (reverse hybrid)

    • Results in “nowhere income”

BASE EROSION AND PROFIT SHIFTING (BEPS) PROJECT – KEY DRIVER OF INTERNATIONAL TAX REFORM

• Does not address balance between residence and source country taxation but, rather, the incidents of base erosion and profit shifting stemming from the current international system of taxation

• The new Country-by-Country Reporting (CbCR) rules represent the initial multilateral output of the BEPS project

  • All MNEs, over or close to the threshold, will be undertaking the process of preparing reports and analyzing the resulting data with the assistance of their advisors. The process is likely to prove interesting and to reveal issues and opportunities to be addressed with respect to the MNE’s existing effective tax rate planning strategies (ETR Strategies).

  • The most effective means of addressing these issues is to organize a working group of internal or external experts (or both), as appropriate to the situation, to design and supervise the data gathering and analytical process.

  • The immediate objective of such analyses is to prepare the CbC documentation, while the long-term objective should be to assess the group’s ETR Strategies to identify risks and opportunities to be addressed in due course. This is a time of epochal change likely to present both opportunities and problems.

• Many other BEPS initiatives are also being implemented

  • Taxation of hybrids and reverse hybrids

  • Revised permanent establishment (PE) standards

  • Caps on interest deductibility

  • Rollout of a multilateral instrument

• Challenges for MNE ETR planning strategies

  • Historic model rejection: The residence vs. source model developed in the post-World War I era largely has been rejected throughout the world, with the evolution of territorial regimes as well as efforts by all countries to defend their tax bases (including the United States). As with any material change, this produces opportunities for MNE ETR strategies as well as some hurdles.

  • Posture of the BRICs (Brazil, Russia, India, China)

    • Rejection of BEPS outputs

    • Desire to revisit source/residence status

    • Increased focus on profit splits

    • China premium and equivalent theories

    • Increasingly aggressive assertion of PE (coupled with “force of attraction” principle)

    • United Nations adoption of withholding on technical service payments

    • Extra-territorial taxation (e.g. Vodafone)—challenge to separate legal entity / holding company orthodoxies.

• EU state aid

• Unilateral actions 

  • UK tax reform (Diverted Profits Tax, state aid, Brexit, etc.)

  • United States (“border adjustability” below)

• Increasingly divergent approaches of tax administrations in the light of BEPS

  • “Race to the bottom”

HOUSE REPUBLICAN PROPOSAL FOR BORDER ADJUSTMENT TAX (BAT)

• Policy paper only—no details

• Intention:

  • Export: full deductibility of costs—exclusion of sales

  • Import: no deduction of foreign costs—full inclusion of sales

  • In essence, makes the United States a source country, seeking to expand its own tax base in its way, as the United Kingdom and other countries are seeking to do the same.

• Potential “baskets” (cost and other allocation): Since the focus of the BAT is to provide differential treatment for costs incurred domestically versus offshore, there will be a need to establish categories of costs to then be sourced. This is a familiar process in other contexts (such as Subpart F-related issues, cost-sharing and so on). For example, are costs incurred by a domestic contract manufacturer for a foreign party domestic or foreign?

• Issues: Cross-basket crediting; currency; and many more to be identified in specific company situations. 

• The border adjustability proposal presents clear issues for importers and opportunities for exporters. Of course, in the absence of statutory language or other details as to the contours of border adjustability, one can do no more than ballpark the issues to be addressed if border adjustability becomes a serious issue. For example, if a MNE group has APAs to which the United States is a party, will such a dramatic change in US tax law invalidate the APA?

• Even if border adjustability is not adopted, a territorial system is likely to be a feature of tax reform and this will pose many of the same issues as to situs of income and expense.

• Our experience in working with clients to assess the potential impact of border adjustability, territoriality and the other evolutions noted above on their ETR strategies is that it is an eye-opening process. Whenever there is material change in applicable laws or principles, some doors may close as others open. 

Way Forward

In short, it is time for companies to rejuvenate their ETR strategies for the epochal changes already underway and those likely to occur.