Whilst senior management will not deal with the details of cross border tax planning, there are a number of recurring themes that they will need to be sure have been addressed in any proposals aimed at reducing the overall group tax burden. What follows is a general, non jurisdictional review of common issues and pitfalls that may arise.
Intellectual property rights are often created in relatively high tax jurisdictions and tax departments in multinationals (and their advisors) frequently look at ways of structuring operations in an attempt to reduce the overall tax burden, usually involving a number of territories and the transfer of, or the creation of an interest in, intellectual property. The purpose of this article is to address the common concepts that, in some shape or form, will apply in most territories and to highlight the areas that senior management will need to know have been covered in reviewing any proposals put forward for consideration. It is not a detailed review of the applicable tax regime of any particular territories but more an overview of recurring themes.
The first basic principle to understand is the simple economics of taxation. The tax systems of most developed countries (by which is meant non tax haven territories) work on the basis that they expect tax revenue to reflect the economic benefit derived from an entity from the operations in that territory. Those operations may be active, such as buying, manufacturing, selling etc. through a physical presence (e.g. tax resident entity or branch) or passive, through royalty or licence fees payable for the use of intangible rights, or interest on loans. In both cases there is economic benefit for the entity and the “host” territory wants its proper share of tax on that benefit, either through direct assessment on active operations or imposing withholding obligations on the payor of passive income. In the context of international operations much of any particular territories’ so called “anti avoidance” legislation is aimed at preserving that underlying economic principle of taxation and preventing distortion of tax revenues through various legal structures. It is important to understand that there may be nothing artificial about the structure in question (i.e. it is perfectly legal and proper), and there is no element, in laymen’s terms, of avoidance, in the sense of dishonesty, but rather that the relevant territory wants to preserve what it regards to be it’s proper basis of tax revenues.
This basic approach is reflected in most countries’ double tax treaty network, particularly where, as is now normally the case, they are based on the OECD form of model convention. DTTs act as an overlay on top of a territory’s domestic legislation, and accordingly do not operate to increase an entity’s tax liability in a particular territory but potentially to reduce it, typically by providing for reduced rates of withholding tax on certain types of income. However, it is not necessarily all good news. Over recent years, may DTTs have been, or are in the process of being, renegotiated to deal with perceived abuse (or exploitation, depending on your standpoint) of the system. One of the issues increasingly addressed is that of so called “treaty shopping”, where an entity in Territory A incorporates a subsidiary in Territory B, so that subsidiary has the benefit of the DTT between Territory B and Territory C, which is more favourable than that between Territory A and Territory C. In such circumstances the subsidiary may find it is, or may be in the future, denied some or all of the benefits of the Territory B/C DTT.
A second trend in the renegotiating round is due to increasing recognition that certain domestic anti avoidance measures have themselves been used to achieve more favourable treatment under an applicable DTT. A prime example of this is interest payments on intra group loans. In many territories provisions exist that treat “excessive” interest payments on intra group debt as a non tax deductible dividend rather than tax relievable interest. However, many of these territories also have DTTs that provide for withholding taxes on dividends between treaty resident companies at a rate substantially lower than that which applies to interest, and thus there has been an advantage in consciously structuring debt to fall within the anti avoidance provision, particularly where non deductibility is not an issue for the payor because of start up losses. A number of territories have been amending their DTTs to prevent this.
With this background in mind of what tax authorities are trying to achieve and the (albeit slow) trend to introduce some anti avoidance concepts into DTTs, what particular factors should be considered when assessing a proposal that seeks to reduce the overall tax burden through an international structure? As this article is aimed at providing a tax overview, there are two that obviously need to be addressed but will not be dealt with further, namely legal and accounting reviews of the proposed structure and the transactions required for its implementation. From a tax perspective, there are five significant areas that will need to be covered, four relating to the prospective benefits and an equally crucial fifth dealing with what happens if it doesn’t work.
Taking the latter first, it is very important that the proposals should deal with an exit/unwind strategy assessing both whether one exists and if there are further tax costs associated with an exit. Surprisingly, this issue is overlooked more often than one would expect, perhaps because those most closely involved are keener to accentuate the positives rather than contemplate the negatives, or become too engrossed with the logistics and detail of implementation, but as a basic risk management issue it is ignored at your peril. Because a number of different tax authorities may be involved, there is likely to be a considerable time lapse between implementation and the tax treatment being settled, so not only should there be a fallback position but it should be regularly reviewed in the light of changing domestic tax rules and relevant DTTs.
The four interlocked factors in assessing prospective benefits can be illustrated as follows:
Before considering these factors in the context of an illustrative structure they need further explanation and background as to what is meant.
There are a number of elements that should be considered under this category. For example, does the proposal involve a switch from income arising directly to the entity to passive income (e.g. royalty, licence fee) from a different territory? If so, is there any withholding tax and at what rate, and is the position modified under an applicable DTT? Most territories deal with double tax relief by way of a credit against the domestic tax for the overseas tax suffered, and in some cases if there are surplus overseas tax credits they are lost, thereby increasing the overall tax level. Since our hypothesis is that the proposal is intended to reduce the overall tax burden, it is reasonable to assume that if there is withholding in the structure the headline rate will be lower than the headline rate for the recipient, but does the proposal deal with the tax capacity of the recipient to absorb the overseas tax credit in full? Are there factors such as start up losses or tax depreciation/amortisation that impact on that capacity? Assuming this is all satisfactory, there is still a timing issue to be considered for the gap between the withholding and when the recipient would otherwise be paying its own tax, which may impact on the benefit.
To the extent that transfers of assets or grants of rights are involved in the implementation of the structure, the proposal needs to address any direct tax costs arising, as again this impacts on the overall potential benefit. Equally, if deductible expenditure is being switched between territories (e.g. if some form of refinancing is involved) the tax treatment in the successor territory should be explored.
This is a fundamental element in international tax planning. As outlined above, domestic tax authorities want to ensure they get a fair share of the benefit from the economic activity and most developed countries have transfer pricing legislation. Put at its simplest, where you have goods or services being supplied between group companies in different jurisdictions transfer pricing will operate to adjust the consideration for tax purposes to reflect an areas’ length price. Clearly, one can expect a high level of scrutiny for a transaction that is intra group and involves the creation of an expense in an entity in a territory that imposes a higher level of tax than that of the recipient, and particularly acute if the recipient is in a tax haven.
Although transfer pricing is normally thought of in the context of cross border transactions and diverting income from high to low tax territories, it should not be forgotten that a number of territories operate transfer pricing in a wholly domestic context, and whilst economically in most cases the effect should be neutral if the same adjustment is applied to both parties, there may be a problem if the rationale for a particular transaction is to divert income into a loss making entity to accelerate the economic use of those tax losses.
Closely related to transfer pricing is the concept, in the context of financing transactions, of “thin capitalisation”, and in a number of jurisdictions they are dealt with together under a transfer pricing regime. Thin capitalisation is simply entities borrowing money from other group companies either in unrealistic amounts or on unrealistic terms given the state of the borrowers’ balance sheet. To return to one of the common themes, it is a domestic tool to prevent an uneconomic transfer of income to another territory. The approach to thin capitalisation differs between various territories; some operate statutory or published acceptable debt to equity ratios, so that if the entity’s debt is within their so called “safe harbours” deductibility is guaranteed, whereas others use a much vaguer general arm’s length test, which gives the relevant tax authority greater scope to argue. The proposal needs to make clear which is applicable, and the implications.
The treatment of “excessive” interest also differs. Some territories simply deny relief for the excess, others treat it as a dividend. The possible implications in terms of domestic withholdings and the impact of DTTs (and their possible modification) has already been noted.
There is also no common approach as to how transfer pricing issues are dealt with. In some territories it is possible to agree the position in advance with the relevant tax authority and thus have certainty before implementing the transaction; in others it will come to the surface only when the relevant tax returns are being considered. In either case it is important that the relevant entities have as much contemporaneous evidence as possible in support of their pricing policies, and where possible this should be from a third party (e.g. bank, financial adviser, economists etc).
It is also extremely important that entities adopt a consistent approach to these issues across territories. This may mean having to accept an element of give and take, in that the results may not always operate in your favour, but tax authorities react very adversely to evidence of inconsistency and it should be remembered that tax authorities do make use of the exchange of information powers contained in DTTs.
Controlled Foreign Companies
This is back to the diversion of income theme. By putting assets etc in subsidiaries in low tax territories parent companies could otherwise accumulate profits outside the scope of tax in their own domestic territories and to counter this many countries have rules that attribute the income of “money box” companies direct to their parent. Typically, such companies are located in territories that have few, if any, DTTs that would otherwise operate to prevent such a treatment.
The severity of CFC regimes vary, but it is not uncommon to have an exclusion for “genuine” commercial companies that have a real substance and purpose. Since such exclusions tend to rely on what actually happens, rather than what is proposed (i.e. advance clearance mechanisms are rare) there may be considerable delay between implementation and agreement with the relevant tax authorities, which needs to be addressed. Further, the exclusions may only operate on a year by year basis, which needs to be considered in the context of what on going resources may be required to maintain the availability of the exclusion.
There is the reasonably obvious consequence of potentially increasing the cost and complexity of the compliance burden, which has already been mentioned above. The more imponderable questions are what impact will the transactions have on your relationships with the relevant tax authorities and is it so aggressive that you are inviting challenge. Most tax authorities accept that multinationals will routinely carry out tax planning as a means of managing, and to the extent possible, minimising their overall tax burden. However, the process of managing the tax position of a multinational is one that by and large requires a collaborative working relationship with the relevant tax authorities. There is an element of give and take that is likely to mean that in a number of areas neither party is strictly applying the letter of the law but is operating on a concessionary basis that may be particular to the company or of more general application. The proposed transactions may be technically sound but may be seen as “crossing the line” with the result that the relevant tax authorities adopt a much stricter line going forward and in relation to outstanding issues. This is a very difficult area in terms of an exercise of judgment, but in some ways is as important as assessing the risk of challenge overall.
Governance has three related issues. Whilst you will be satisfied that the transaction is legal, is it something you should be seen to be doing? Is it a widely marketed, pre-packaged structure that has no real business purpose other than tax reduction? If it is being proposed by your auditors, are you required to have third party advice or should you as a matter of best practice?
Pulling some of these strands together set out below is an illustrative structure:
All four companies are in the same group and taxable in different territories with the Parent owning the IP rights. The intention is to maximise the profits in the low tax Subsidiary by having low margins in both the Manufacturer and the Distributor. Obvious issues are withholding on the licence fee, application of CFC rules to the low tax subsidiary (as it doesn’t have a bona fide trade) and transfer pricing both for the Manufacturer and the Distributor, probably serious for the latter as it takes the risk on the sales but for little reward, but equally the Manufacturer is not reflecting the value of the licenced IP in the sales price to the Subsidiary. Overall, there appears to be little commercial subsistence.
The position could be improved if the low tax Subsidiary acquires the relevant IPR, has a normal manufacturing contract with the Manufacturer and the Distributor acts as a sales agent and is paid a commission. As the Distributor is taking little risk the transfer pricing concern diminishes greatly, and the same is true for the Manufacturer, as it no longer has the IPR and thus no longer would be expected to reflect its value in the sale price for the goods. The subsidiary also has more commercial substance as it is dealing with third parties. However, is there any tax charge on the transfer of the IPR and what is the exit?
A few final thoughts:
Be cautious of ready made, marketed schemes
Don’t be too greedy
Think hard before you let a cost centre (tax) become a profit centre
It is looks too good to be true, it probably is!
This article was first published in the October/November 2005 issue of Intellectual Asset Management.