By Anthony Diosdi
An exam of a multinational’s tax return(s) will begin much the same manner as any other audit in that the corporation will receive a letter from the Internal Revenue Service (“IRS”) notifying it of the audit. However, unlike a typical garden variety audit which tends to focus on substantiating expenses claimed on a tax return or a probe of the income, an international audit will likely focus on cross–border transfers and reorganizations, transfer pricing, foreign tax credits, bilateral tax treaties, and international information returns. These matters tend to be extraordinarily complex. Furthermore, special procedural issues may arise in international audits that do not typically arise in more traditional audits. This article explores five areas that in our experience tend to come up in international tax audits of multinational corporations and potential strategies to deal with these unique situations.
The Examination and the Information Document Request
Once an international audit commences of a multinational corporation, as in any other audit, the IRS examiner will examine the multinational corporation’s tax returns, books, and records. The international examiner will often begin by issuing an Information Document Request (“IDR”) for information relevant to the scope of the audit. For example, if intercompany purchases or sales of inventory exist, a typical IDR would request a copy of any intercompany pricing agreements as well as any contemporaneous documentation of transfer pricing methodology. If an issue exists in the calculation of Foreign-Derived Intangible Income (“FDII”) and Global Intangible Low-Taxed Income (“GILTI”), a typical IDR would request supporting documentation determining how the Deduction Eligible Income (“DEI”) or Deemed Intangible Income (“DII”) was determined. If the international examiner is examining the deductibility of foreign taxes, the international examiner will generally request copies of appropriate foreign tax returns and proof of payment of foreign taxes to substantiate a foreign tax credit. After reviewing the information gathered from the initial IDRs, the international examiner will probably focus on the areas with the potential largest tax increase. At this point, the IDRs will generally become more narrow in scope.
We will now look at some common areas that the IRS targets multinational corporations in international tax audits.
A. Transfer Pricing Transactions
Multinational corporations are often the target of transfer pricing audits by the IRS. This is because a number of multinational corporations have attempted to exploit variations and interstices in tax rates and systems among countries by shifting income, deductions, or tax credits among commonly controlled entities to reduce the overall tax burden. One long-standing method of achieving such shifting is manipulating the transfer price for goods and services transactions between group members.
Internal Revenue Code Section 482 provides the IRS the power to reallocate, redistribute or reapportion gross income, deductions and other tax items among entities owned or controlled directly or indirectly by the same interests, to more properly reflect income or prevent evasion of taxes. Control for this purpose is not established by a specific threshold, but rather by the reality of control, in any form, direct or indirect, however exercisable or exercised, and whether or not legally enforceable. The Income Tax Regulations focus on various methods of approximating an arm’s length price for intercompany transactions involving tangible or intangible property. If the IRS attempts to utilize Section 482 or its regulations to change a multinational corporation’s cross-border transactions, the audit will likely become extremely complex and time consuming. The best way to avoid a transfer pricing audit is for a multinational corporation to enter into an approved advanced pricing agreement (“APA”) with the IRS before reallocating, reallocating income, or deductions to foreign controlled entities. An APA is an agreement between a taxpayer and the IRS determining the transfer pricing methodology for pricing the multinational’s international transactions for future years.
The failure to have an APA in place could have far greater consequences than adjustments to U.S. tax liabilities. Any unilateral reallocation of income or deductions by the IRS could subject the multinational corporation to double taxation in situations where another country might seek to impose tax on the same income. If a multinational taxpayer does not have an APA in place and is subject to an IRS unilateral reallocation of income or deductions, the taxpayer may seek relief under a treaty-based mutual agreement procedure (“MAPs”).
U.S. treaties allow a taxpayer to request a MAP if the taxpayer believes that it is, or will be subject to taxation inconsistent with a bilateral income tax treaty. A taxpayer may file a MAP request with the U.S. competent authority. The office of the U.,S. competent authority lies within the Large Business and International Division. Two primary offices within the U.S. competent authority conduct the MAP process. Those offices are the Advance Pricing and Mutual Agreement (“APMA”) and the Treaty Assistance and Interpretation Team (“TAIT”).
On receiving a MAP request, the U.S. competent authority will accept the request for consideration. The U.S. competent authority may however decline to accept the request if the request is defective (for example, lacking information) and the defect is not corrected, the taxpayer is not eligible under the terms of the relevant tax treaty, or the taxpayer has engaged in certain prejudicial conduct (such as impeding the IRS examination function or failing to comply with provisions regarding coordination of MAP with IRS Appeals). After accepting a case for consideration, the U.S. competent authority will first consider whether, based on its own analysis of the case, it is able to unilaterally provide full relief, which would be either a full withdrawal of the adjustment in the case of a U.S.- initiated adjustment, or correlative relief in the full amount of a foreign-initiated adjustment.
If the U.S. competent authority cannot unilaterally provide full relief, it will negotiate with the foreign competent authority. Four outcomes are possible that would grant full or partial relief: 1) the adjusting jurisdiction fully withdrawals the adjustment, 2) the non-adjusting jurisdiction provides full correlative relief (correlative relief in the full amount of the adjustment), 3) the adjusting jurisdiction partially withdraws the adjustment and non-adjusting jurisdiction provides partial correlative relief, with the correlative relief in an amount equal to the remaining relief, or both, but the withdrawal (if any) plus the correlative relief (if any) total to less than the original adjustment, so that double some double taxation remains. After the competent authorities tentatively agree on one of these outcomes, the U.S. competent presents the outcome to the taxpayer. If the taxpayer accepts the outcome, the U.S. competent authority normally then formalizes that outcome, directs the relevant offices with the IRS to implement its terms, and closes the case. Assuming the MAP request successfully resolves the double taxation issue, the competent authorities issue a mutual agreement letter, as well as a closing agreement (See Internal Revenue Code Section 7121, commonly known as a “Form 906” agreement) or alternatively, a Form 870-AD (“Offer to WAive Restrictions on Assessment and Collection of Tax Deficiency and to Accept Over Assessment”).
In contrast, if the MAP request is not successful, then the taxpayer has all judicial remedies available. To avoid the uncertainties regarding a MAP request, a better alternative for multinationals that shift income and expenses to offshore controlled entities is to seek a joint APA from the IRS and the foreign authority prior to taking positions on tax returns that can trigger an audit.
B. Conduit Financing
Conduit financing is also often a target in an international tax audit. Foreign multinational corporations tend to utilize conduit financing transactions to avoid a 30 percent U.S. withholding tax. (There is a U.S. federal income tax of 30 percent on a foreign taxpayer’s U.S. source “fixed or determinable, annual or periodical income.” This includes such items of income as interest, dividends, rents, and royalties). The 30 percent withholding tax is imposed on gross income, with no deductions allowed. This tax is assessed on gross income, with no deductions permitted. As a general rule, this tax is collected through withholding, and as a result, it is commonly known as a 30 percent “withholding tax.” Although U.S. source interest, dividends, rents, and royalties are subject to a statutory 30 percent U.S. withholding tax, many bilateral U.S. income tax treaties completely eliminate this withholding tax.
The Anti-Conduit Rules
Congress became aware of numerous “conduit” structures that multinational corporations were utilizing to minimize or eliminate the 30 percent withholding tax. One such example would be a foreign multinational corporation that resides in a country that does not have an income tax treaty with the United States but sets up an entity in a country that does have a treaty with the U.S. Consequently, if that foreign multinational corporation were to lend funds directly to a U.S. borrower, the foreign multinational corporation’s interest income would be subject to the 30 percent withholding tax. On the other hand, the foreign multinational corporation could loan funds to a company that is: 1) a tax resident in a country that has an income tax treaty with the United States that reduces or eliminates the 30 percent withholding tax and 2) that qualifies for benefits under that treaty. This company could then on-lend the funds to the U.S. borrower.
In 1993, Congress enacted Internal Revenue Code Section 7701(1). The Treasury was authorized under Internal Revenue Code Section 7701(1) to issue regulations that would allow multi-party financing arrangements to be reclassified as transactions directly between any two or more parties involved. In accordance with Section 7701(1), the Treasury introduced regulations in 1995 to clarify when the IRS can recharacterize multi-party financing transactions for U.S. withholding tax purposes. Under these regulations, an IRS direct director can ignore the involvement of an intermediate entity in a multi-party financial arrangement for withholding tax purposes if the intermediate entity is deemed to be a conduit entity. A conduit entity is one whose participation in the financing arrangement is designed to minimize U.S. withholding tax liability and is part of a tax avoidance plan, and is one that is either related to the financing/financed entity or entered into the transaction as a result of the financing entity.
The IRS often targets multi-party financing transactions in audits designed to avoid the 30 percent withholding tax. The best defense to these types is to understand the so-called “anti-conduit rules” and plan cross-border multi-party financing transactions accordingly. This subsection of our article ambitiously attempts to summarize the “anti-conduit rules” and discuss how a cross-border multi-party financing transaction may potentially survive IRS scrutiny.
In general, the regulations allow the IRS to disregard the participation of one or more “intermediate entities” in a “financing arrangement” where such entities are acting as conduit entities. The regulations define a financing arrangement as a series of financing transactions by which one person (the financing entity) advances money or other property, or grants rights to use property, and another person (the financed entity) receives money or other property, or rights to use property, if the advance and receipt are effected through one or more other persons (intermediate entities). See Treas. Reg. Section 1.881-3(a)(2)(i)(1)(A). The regulations grant the IRS discretion to disregard, for purposes of Internal Revenue Code Sections 871, 881, 1441, and 1442, the participation of one or more “intermediate entities” in certain “financing arrangements” involving multiple parties.
Under the current regulations, a financing transaction included a debt, lease or license. See Treas. Reg. Section 1.881-3(a)(2)(ii)(A). However, with certain exceptions, under these same regulations, an instrument that was classified as equity for U.S. tax purposes cannot constitute a financing transaction. As such, it was common for non-U.S. taxpayers to use a hybrid interest (an instrument treated as debt for foreign tax purposes but equity for U.S. tax purposes) in cross-border financing transactions to avoid the 30 percent withholding tax. In this situation, the payment of a U.S. person or entity to a foreign person or entity, followed by a payment that was treated as interest for foreign tax purposes, was typically not subject to the conduit financing regulations because the U.S. treated the subsequent interest payment as a dividend.
Recently, the IRS and the Department of Treasury issued proposed anti-conduit regulations. These regulations will cause the conduit financing regulations to expand the types of equity interests that are treated as financing transactions. The regulations include a financing transaction of so-called hybrid instruments.
An understanding of these terms is necessary to determine when a financing arrangement could be recharacterized under the regulations. We will next discuss the terms that make up a financing arrangement and when the anti-conduit rules could be triggered.
For the IRS to exercise its authority to collapse a transaction, there must be a financing arrangement. The regulations define a financing arrangement as: a series of transactions by which one person (the financing entity) advances money or other property….and another person (the financed entity) receives money or other property,…if the advance and receipt are effected through one or more other persons (intermediate entities) and…there are financing transactions linking the financing entity, each of the intermediate entities, and the finance entity. However, just because foreign taxpayers utilize a cross-border financing transaction does not automatically mean that the IRS can collapse the transaction. Whether or not the IRS has the legal authority to set aside a financing transaction depends whether or not the transaction was structured correctly. We will now walk through each element of a cross-border financing transaction and discuss areas
Defining The Advance of Money or Other Property
In order to have a financing transaction, there must be debt and an advance of money or other property through one or more persons or entities. Under the regulations promulgated by the Treasury in 1995, instruments treated as debt for foreign tax purposes but equity for U.S. tax purposes did not constitute a financing transaction. Thus, it was common for non-U.S. taxpayers in multinational cross-border transactions to utilize a hybrid instrument (an instrument treated as debt for foreign purposes but equity for U.S. purposes).
For example, A issues its debt to B in exchange for the stock of B’s subsidiary, C. B controls both A and C for purposes of Section 304 of the Internal Revenue Code, so the issuance is a distribution by A of its (and, if necessary, C’s) earnings and profits to B. D, another member of the group, advances cash to B in exchange for B’s debt. D’s advance of cash to B was clearly an advance of money. A hybrid instrument is executed between D and B. Under the 1995 regulations, the utilization of a hybrid instrument was not subject to anti-conduit financing regulations. However, under the Proposed Regulations, if a financing entity, (D in the above example) advances cash or other property to an intermediate entity (B in the example above) through a hybrid instrument, the transaction between D and B will be subject to the anti-conduit transaction rules and collapsed by the IRS.
Defining a Series of Transactions
The next important question raised by the conduit regulations is whether or not “a series of transactions” exists. Multinational corporations often transfer funds between subsidiaries in different countries. If the IRS sees these transitions as isolated from one another, no financing arrangement can be said to exit. If, however, the IRS views these transfers of such funds as a series of transactions, this type of transaction could be collapsed under the anti-conduit regulation. Unfortunately, regulations issued in 1995 and the newly promulgated regulations do not provide any guidance to determine when a series of transactions can be considered as part of a final arrangement that will trigger the anti-conduit rules.
Let’s consider the following example:
MassiveBank, a Swedish-based bank, indirectly owns a bank subsidiary organized in the United Kingdom (UKCo) that occasionally makes loans to customers that reside in the United States. Interest on the loans is exempt from U.S. tax under the U.K-U.S. income tax treaty. A Swiss entity (SwissCo) directly owns UKCo’s finances and makes loans for the purposes of lending to UK customers. Under the U.S. Swiss treaty, Swiss Co would be eligible for exemption from withholding tax on U.S. source interest paid to it. All members of the MassiveBank group that received interest directly from the U.S. customers would not be subject to the 30 percent tax on the interest under a tax treaty exemption.
A Hong Kong non-bank subsidiary of MassiveBank (HongCo), whose operations are separate from those of UKCo, borrows money from a Hong Kong Bank, (HongBank) on a long-term basis to finance the export sales of Hong Kong businesses. Interest derived by HongBank, if deemed derived from U.S. borrowers, would not be eligible for a treaty exemption.
This example demonstrates the difficulty of determining whether a series of transactions exists, and thus whether there is a potential problem under the conduit regulations. The issue is whether, in planning a series of plainly related transactions that should not be recharacterized under the conduit regulations, a group can isolate those transactions from unrelated transactions that it may undertake now or in the future and that the IRS might attempt to link to the series.
A financing arrangement involving UKCo, and U.S. customers would not present a problem because UKCo would be eligible for a treaty exemption and a direct loan from UKCo to U.S. customers therefore would not trigger U.S. withholding tax. Because the participation of SwissCo does not reduce U.S. tax, that financing arrangement would not cause UKco to be considered the lender to the U.S. customers. See Treas. Reg. Section 1.881-3(a)(4)(i)(A).
Even a financing arrangement that also involved HongBank would probably not cause a problem. This is because UKCo’s participation in that financing arrangement would not likely be deemed a tax avoidance plan (a tax avoidance plan is one of the requisites for exercise of the IRS’s authority). As discussed below, two of the factors pointing toward the presence of a tax avoidance plan would be absent because of UKCo’s ability to make an advance from its own funds and the lack of synchronicity between HongBank loans and either the UKCo or SwissCo loans. Thus, the loan from UKCo, even if deemed to have been made directly to the U.S. borrowers, should be respected. On this basis, any loan from HongBank, even if not respected under the regulations as made to HongCo, would, if deemed made to UKCo, be reclassified under the regulations as a transaction directly between the remaining parties to the financing arrangement. Interest, derived by HongCo from UKCo would be foreign-source income and not subject to the 30 percent withholding tax. However, a direct loan from HongBank to the U.S. customers would not likely qualify for an exemption to the 30 percent withholding tax.
The Rules Regarding Disregarding an Intermediate Entity
If the IRS were to disregard the participation of a conduit entity, the financing arrangement will be reclassified as a transaction directly between the financed and the financing entities. For example, assume a foreign parent (FP) located in a jurisdiction that does not have a tax treaty with the United States lends money to a foreign affiliate (FA) located in a jurisdiction that does not have a tax treaty with the U.S. The foreign affiliate then lends money to a U.S. affiliate (Uncle Sam) so that the payments out of the United States are subject to no withholding tax under a tax treaty with FA’s jurisdiction.
The conduit financing regulations permit the IRS to treat this transaction as a loan directly from FP to Uncle Sam so that interest payments are treated, for U.S. tax purposes, as going from Uncle Sam directly to FP.
A Tax Avoidance Plan Needs to be Established Before the IRS May Disregard a Conduit Entity
Once the existence of a financing arrangement has been established, an intermediate entity will be treated as a conduit if the intermediary’s participation in the financing arrangement is under a tax avoidance plan. The regulations describe a tax avoidance plan as:
A plan of which the principal purpose is the avoidance of tax imposed by Section 881 (the 30 percent tax). Avoidance of the tax imposed by Section 881 may be one of the principal purposes for such a plan even though it is outweighed by other purposes (taken together or separately). In this regard, the only relevant purpose are those pertaining to the participation of the intermediate entity in the financing arrangement and not those pertaining to the existence of a financing arrangement as a whole…In determining whether there is a tax avoidance plan, the district director will weigh all relevant evidence regarding the purpose for the intermediate entity’s participation in the financing arrangement. See Treas. Reg. Section 1.881-3(b)(1).
The regulations list three nonexclusive factors to be considered in determining whether the participation of an intermediate entity has as one of its principal purposes the reduction of the 30 percent tax: 1) whether the transaction results in a significant reduction of tax; 2) whether the intermediate entity had the ability to make the advance without advances from the financing entity; and 3) the length of time between the financing transitions. See Treas. Reg. Section 1.881-3(b)(2).
1. Was There a Significant Reduction in Withholding Tax?
The first factor in determining whether or not a tax avoidance plan existed is to determine if the transaction results in a significant reduction of the 30 percent withholding tax. The conduit regulations provide two examples of a significant tax reduction. In one case, the participation of the intermediate entity reduces the tax rate from the 30 percent rate to zero, and, in the other case, it reduces the tax rate from a blended rate from a blended rate (after application of a treaty benefit) of 27 percent to zero. See Treas. Reg. Section 1.881-3(e), Example 14. Because these are large reductions in percentage terms- from 100 percent and 90 percent of the statutory rate, respectively, to zero, the reductions are fairly obviously “significant” and not particularly helpful in determining when a rate reduction is not significant. These are easy examples to follow. It is not too difficult to imagine a far more complicated senior. Just such a scenario is detailed in the regulations.
For example, assume FP owns a 10 percent interest in the profits and capital of FX, a partnership organized in country N. The other 90 percent interest in FX is owned by G, an unrelated corporation that is organized in country T. FXis not engaged in business in the United States. On January 1, 1996, FP contributed $10,000,000 to FX in exchange for an instrument documented as perpetual subordinated debt that provides for quarterly interest payments at 9 percent annum. Under the terms of the instrument, payments on the perpetual subordinated debt do not otherwise affect the allocation of income between the partners. FP has the right to require the liquidation of FX if FX fails to make an interest payment. For U.S. tax purposes, the perpetual subordinated debt constitutes guaranteed payments within the meaning of Section 707(c). On July 1, 1996, FX made a loan of $10,000,000 to DS in exchange for a 7-year note paying interest at 8 percent per annum.
Because FP has the effective right to force payment of the “interest” on the perpetual subordinated debt, the instrument constitutes a financing transaction with the meaning of the regulations. Moreover, because the note between FX and DS is a financing transaction within the meaning of the regulations, together the transactions are a financing arrangement within the meaning of the regulations. Without regard to the conduit regulations, 90 percent of each interest payment received by FX would be treated as exempt from U.S. withholding tax because it is beneficially owned by G, while 10 percent would be subject to a 30 percent withholding tax because it is beneficially owned by FP. If FP held directly the note issued by DS, 100 percent of the interest payments on the note would have been subject to the 30 percent withholding tax. The significant reduction in the tax imposed by Section 881 resulting from the participation of FX in the financing arrangement is evidence that the participation of FX in financing arrangement is pursuant to a tax avoidance plan. However, other facts relevant to the presence of such a plan must also be taken into account. See Treas. Reg. Section 1.881-3(e), Example 16.
A more difficult example follows:
Over a period of years, FP has maintained a deposit with BK, a bank organized in the United States, that is unrelated to FP and its subsidiaries. FP often sells goods and purchases raw materials in the United States. FP opened the bank account with BK in order to facilitate this business and the amounts it maintains in the account are reasonably related to its dollar-denominated working capital needs. On January 1, 1995, BK lent $5,000,000 to DS. After the loan is made, the balance in FP’s bank account remains with a range appropriate to meet FP’s working capital needs.
FP’s deposit with BK and BK’s loan to DS are financing transactions within the meaning of the regulations and together constitute a financing arrangement within the meaning of the regulations. Pursuant to Section 881(i), interest paid by BK to FP with respect to the bank deposit is exempt from withholding tax. Interest paid directly by DS to FP would not be exempt from withholding tax under Section 881(i) and therefore would be subject to a 30 percent withholding tax. Accordingly, there is a significant reduction in the tax imposed by Section 881, which is evidence of the existence of a tax avoidance plan. However, the director of field operations also will consider the fact that FP historically has maintained an account with BK to meet its working capital needs and that, prior to and after BK’s loan to DS, the balance within the account remains within a range appropriate to meet those business needs as evidence that the participation of BK in the FP-BK-DS financing arrangement is not pursuant to a tax avoidance plan. See Treas. Reg. Section 1.881-3(e), Example 20.
As pointed out in the above example, determining whether there is a significant reduction in tax as per the regulations, will require a careful analysis of all the facts and circumstances of the transaction at issue.
2. Did the Intermediate Entity Have Sufficient Available Money or Other Property of Its Own to Have Made the Advance to the Financed Entity?
The next factor in determining whether or not an intermediate entity is a conduit is to consider whether the entity “had sufficient available money or other property of its own to have made the advance of money or other property to it by the financing entity.” See Treas. Reg. Section 1.881-3(b)(2)(ii). If, just before the advance, the intermediate entity had on hand liquid assets at least equal to the principal amount of the advance, this presumably would be a positive factor in the analysis. Also, liquid assets owned by a wholly owned subsidiary of the intermediate entity and easily accessed liquid assets would presumably constitute “available money or other property of [the intermediate entity’s] own.” See Tax Notes, Volume 146, Number 9, April 27, 2015, The Conduit Regulations Revisited, by Peter M. Daub.
3. Time Between Advances
The last factor in the determination of the existence of a tax avoidance plan is the time between the transactions. The regulations state as follows:
“The director of field operations will consider the length of the period of time that separates the advances of money or other property, or the grants of rights to use property, by the financing entity to the intermediate entity (in the case of multiple intermediate entities, from one intermediate entity to another), and ultimately by the intermediate entity to the financed entity. A short period of time is evidence of the existence of a tax avoidance plan while a long period of time is evidence that there is not a tax avoidance plan.” See Treas. Reg. Section 1.881-3(b)(2)(iii).
The regulations go on to state that a one-year lag between the first and last transaction of a conduit transaction can be considered “short” and can be considered evidence of a tax avoidance plan. For example, assume that on January 1, 1995, FP lends $10,000,000 to FS in exchange for a 10-year note that pays no interest annually. FS is obligated to pay $24,000,000 to FP. On January 1, 1996, FS lends $10,000 to DS in exchange for a 10-year note that pays interest annually at a rate of 10 percent per annum. The FS note held by FP and the DS note held by FS are financing transactions within the meaning of the regulations. Pursuant to the regulations, the short period of time (twelve months) between the loan by FP to FS and the loan by FS to DS is evidence that the participation of FS in the financing arrangement is pursuant to a tax avoidance plan. See Treas. Reg. Section 1.881-3(e), Example 17.
In analyzing whether an occasional short lag (or no lag) between the advance of FP to FS is evidence of a tax avoidance plan, one must bear in mind that the ultimate question is whether the involvement of DS is for a principal purpose of tax avoidance and if the transactions were deliberately timed to achieve a tax benefit.
Other Factors
In addition to the nonexclusive factors, the conduit regulations state that the IRS may consider other, unspecified factors in determining whether a tax avoidance plan exists. The examples in the conduit regulations suggest some unspecified factors. In Example 19, FP, a resident of a non-treaty country, issues debt in registered form that does not require the holder to issue a Form W-8 BEN. The purchasers of the debt are financial institutions and “there is no reason to believe that they would not furnish Forms W-8 BEN.” FP lends a portion of the debt proceeds to its U.S. subsidiary. The concludes by saying “because it is reasonable to assume that the purchasers of the FP debt would have provided certifications in order to avoid the withholding tax imposed by Section 881, there is not a tax avoidance plan. Accordingly, FP is not a “conduit entity.” See Treas. Reg. Section 1.881-3(e), Example 19.
The example indicates that the existence of a reasonable assumption that the purchasers would have provided certifications establishes conclusively that there is no tax avoidance plan. Accordingly, although the determination of whether a tax avoidance plan exists depends on a consideration of all the facts and circumstances.
Example 20 of the conduit regulations illustrates another unspecific factor. According to Example 20 of the conduit regulations, over a period of years, FP has maintained a deposit with BK, a bank organized in the United States, that is unrelated to FP and its subsidiaries. FP often sells goods and purchases raw materials in the United States. FP opened the bank account with BK in order to facilitate this business and the amounts it maintains in the account are reasonably related to its dollar-denominated working capital needs. On January 1 FP lends $5,000,000 to DS. After the loan is made, the balance in FP’s bank account remains within a range appropriate to meet FP’s working capital needs.
FP’s deposit with BK and BK’s loan to DS are financing transactions within the meaning of the regulations and together constitute a financing arrangement within the meaning of the regulations. Pursuant to Section 881(i), interest paid by BK to FP with respect to the bank deposit is exempt from withholding tax. Interest paid directly by DS to FP would not be exempt from withholding tax under Section 881(i) and therefore would be subject to a 30 percent withholding tax. Accordingly, there is a significant reduction in tax imposed by Section 881, which is evidence of the existence of a tax avoidance plan. However, the director of field operations also will consider the fact that FP historically has maintained an account with BK to meet its working capital needs and that, prior to and after BK’s loan to DS, the balance within the account remains within a range appropriate to meet those business needs as evidence that the participation of BK in the FP-BK-DS financing arrangement is not pursuant to a tax avoidance plan, all relevant facts will be taken into account.
Example 20 is helpful in that it suggests that the bank might not be a conduit entity even though it would not have made the loan to the subsidiary on substantially the same terms without the deposit. This is because, for an intermediate entity unrelated to both the financing entity and the financed entity to constitute a conduit, the intermediate entity’s financed entity could not have been on substantially the same terms without the financing from the entity. Thus, that the example even considers whether a tax avoidance plan exists logically must mean that the deposit favorably affects the loan terms.
The Rebuttable Presumption of Significant Financing Activities
The conduit regulations provide a rebuttable presumption that the participation of an intermediate entity in a financing arrangement is not under a tax avoidance plan if the intermediate entity is related to either or both the financing entity or the financed entity and the intermediate entity performs “significant financing activities” regarding the financing transactions forming part of the financing arrangement to which it is a party. See Tax Notes, Volume 146, Number 9, April 27, 2015, The Conduit Regulations Revisited, by Peter M. Daub. The performance of significant financing activities involves the satisfaction of several requirements:
1. The participation of the intermediate entity in the financing transactions produces efficiency savings by reducing transaction costs, overhead, and other fixed costs. See Treas. Reg. Section 1.881-3(b)(3)(ii)(B)(1).
2. The intermediate entity’s officers and employees participate actively and materially in arranging the intermediate entity’s participation in the financing transactions. See Treas. Reg. Section 1.881-3(b)(3)(ii)(B)(1).
3. In the country in which the intermediate entity is organized, its officers and employees manage and actively conduct the daily operations of the intermediate entity. Those operations must consist of a substantial trade or business or the supervision, administration, and financing for a substantial group of related persons. Any officer or employee of a related person cannot participate materially in these activities, other than to approve any guarantee of a financing transaction or to exercise general supervision and control over the policies of the intermediate entity. See Treas. Reg. Section 1.881-3(b)(3)(ii)(B)(2)(i).
4. In the country in which the intermediate entity is organized, its officers and employees actively and continuously manage material market risks arising from the financing transactions as an integral part of (a) the management of the intermediate entity’s financial and capital requirements (including management of risks of currency and interest rate fluctuations) and (b) the management of the intermediate entity’s short-term investments of working capital by entering into transactions with unrelated persons. Any officer or employee of a related person cannot participate materially in these activities, other than to approve any guarantee of a financing transaction or to exercise general supervision and control over the policies of the intermediate entity. See Treas. Reg. Section 1.881-3(b)(3)(ii)(B)(2)(ii).
A typical example of “significant financing activities” that satisfies requirements 1, 3, and 4 but not 2 can be found in Example 22 of the conduit financing regulations. The example states as follows:
FS is responsible for coordinating the financing of all of the subsidiaries of FP, which are engaged in substantial trades or businesses and are located in country T, country N, and the United States. FS maintains a centralized cash management accounting system for FP and its subsidiaries in which it records all intercompany payables and receivables; these payables and receivables ultimately are reduced to a single balance either due from or owing to FS and each of FP’s subsidiaries. FS is responsible for disbursing or receiving any cash payments required by transactions between its affiliates and unrelated parties. FS must borrow any cash necessary to meet those external obligations and invest any excess cash for the benefit of the FP group. FS enters into interest rate and foreign exchange contracts as necessary to manage the risks arising from mismatch in incoming and outgoing cash flows. The activities of FS are intended (and reasonably can be expected) to reduce transaction costs and overhead and other fixed costs. FS has 50 employees, including clerical and other back office personnel, located in country T. At the request of DS, on January 1, 1995, FS paid a supplier $1,000,000 for materials delivered to DS and charged DS an open account receivable for this amount. On February 3, 1995, FS reverses the account receivable from DS to FS when DS delivers to FP goods with a value of $1,000,000.
The accounts payable from DS to FS and from FS to other subsidiaries of FP constitute financing transactions within the meaning of the regulations and constitute a financing arrangement within the meaning of the regulations. FS’s activities constitute significant financing activities with respect to the financing transactions even though FS did not actively and materially participate in arranging the financing transactions because the financing transactions consisted of trade receivables and trade payables that were ordinary and necessary to carry on the trades or businesses of DS and the other subsidiaries of FP. Accordingly, FS’ participation in the financing arrangement is presumed not to be pursuant to a tax avoidance plan. See Treas. Reg. Section 1.881-3(e), Example 22.
In the next example in the conduit regulations, a U.S.-financed entity needs long-term financing to fund an acquisition of another U.S. company; the acquisition is scheduled to close on January 15, 1995. A non-U.S. affiliate entitled to benefits under its country’s treaty with the United States has a revolving credit agreement with a syndicate of banks located in a non-treaty country. On January 14, 1995, the affiliate, a U.S.-dollar-functional-currency business, borrowed 10 billion yen for 10 years under a revolving credit agreement. The affiliate enters into a currency swap with an unrelated bank under which it eliminates its risk of fluctuations in the yen/dollar exchange rate over the entire 10-year term of its borrowing under the credit agreement. The next day, the U.S.-affiliate entity borrows $100 million from the non-U.S. affiliate for 10 years. This example concludes that since the affiliate has eliminated all material market risks arising from the financing transactions through its currency swap, the presumption does not apply. See Treas. Reg. Section 1.881-3(e), Example 23.
In another example found in the anti conduit regulations, a non-U.S. affiliate in a treaty country borrows in deutsche marks for 10 years from its non-U.S. parent, which is not located in a treaty country. On January 1, 1995, FP lent FS DM 15,000,000 (worth $10,000,000) in exchange for a 10 year note that pays interest annually at a rate of 5 percent per annum. Also, on March 15, 1995, FS lends $10,000,000 to DS in exchange for a 10-year note that pays interest annually at a rate of 8 percent per annum. FS would have had sufficient funds to make the loan to DS without the loan from FP. FS does not enter into any long term hedging transactions with respect to these financing transactions, but manages the interest rate and currency risk arising from the transactions on a daily, weekly or quarterly basis by entering into forward currency contracts.
Because FS performs significant financing activities with respect to the financing transactions between FS, DS, and FP, the participation of FS in the financing arrangement is presumed not to be pursuant to a tax avoidance plan. The director of field operations may rebut this presumption by establishing that the participation of FS is pursuant to a tax avoidance plan, based on all the facts and circumstances. The mere fact that FS is a resident of country T is not sufficient to establish the existence of a tax avoidance plan. However, the existence of a plan can be inferred from other factors in addition to the fact that FS is a resident of country T. For example, the loans are made within a short time period and FS would not have been able to make the loan to DS without the loan from FP. See Treas. Reg. Section 1.881-3(e), Example 24.
Both Examples 23 and 24 involve long-term borrowers, as well as borrowing and on-loans that are precisely coordinated in timing and amount. See Tax Notes, Volume 146, Number 9, April 27, 2015, The Conduit Regulations Revisited, by Peter M. Daub. These examples are instructive in that they illustrate that the active and regular performance of risk management by intermediate entity management and employees will entitle a structure to the benefit of a rebuttable presumption that the participation of an intermediate entity in a financing arrangement is not under a tax avoidance plan.
C. Foreign Tax Credit Controversies
The deductibility of foreign taxes is often a target of an IRS international tax audit. A number of inexperienced tax advisors mistakenly assume that all foreign taxes can be claimed as foreign tax credits. This is not true, incorrectly assuming all foreign taxes qualify to be claimed as a foreign tax credit can result in significant additional taxes, penalties, and interest. The best way to survive an IRS international tax audit targeting the deductibility of foreign tax credits, it is extremely important to understand the rules governing the deductibility of foreign tax credits and the substantiation often required by the IRS to claim a foreign tax as tax credit. Prior to claiming a foreign tax credit, a two pronged analysis should be conducted. First, it must be determined if the foreign levy qualifies for foreign tax credit treatment. Second, it must be determined if the foreign tax credit can be substantiated in an audit.
Under Internal Revenue Code Section 901, U.S. corporations are entitled to a credit for a foreign tax they are legally liable to pay under foreign law. The foreign levy must be a tax that is levied by a foreign country pursuant to its taxing authority. Penalties, fines, interest and custom duties are not considered taxes and therefore cannot be claimed as foreign tax credits. Furthermore, the foreign levy cannot subject the U.S. corporation to a “specific economic benefit” in exchange for a payment. The U.S. corporation must exhaust all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, its liability for foreign tax. A foreign tax credit is permitted to the extent that the foreign tax is “paid or accrued.” In certain cases, U.S. corporations may also be allowed an “indirect” or “deemed paid” foreign tax credit for foreign taxes satisfied by foreign subsidiaries.
To prevent the use of foreign tax credits to offset U.S. tax on U.S. source income, Internal Revenue Code Section 904 provides a number of limitations on the use of foreign tax credits – including income categorization in baskets that cannot be used to offset income in another basket. In addition, under Internal Revenue Code Section 909, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by a corporation, the foreign income tax is not taken into account for U.S. tax purposes before the tax year in which the related income is taken into account by the corporate taxpayer. The definition of “foreign tax credit splitting event” is broad and can reach a variety of situations such as transfer pricing adjustments and timing differences under U.S. and foreign law. See Foreign Tax Credit Planning- What Every Practitioner Should Know (2016) Jeffrey L. Rubinger.
In order to reduce the probability of a costly IRS adjustment, a determination should be made if a foreign levy can potentially be claimed as a foreign tax credit under U.S. and foreign law before the foreign tax credit is claimed. If it is determined that a foreign levy may be claimed as a tax credit, the regulations should be carefully reviewed and followed when claiming the tax credit. Once it is determined a foreign levy is credible for U.S. tax purposes, the corporation or entity claiming the foreign tax credit should gather all necessary documentation needed to substantiate the foreign tax credits. The primary substantiation for foreign taxes paid by an accrual basis corporate taxpayer is a foreign tax return. See Treas. Reg. Section 1.905-2(a)(2). The primary substantiation for foreign income taxes paid by a cash basis multinational entity is a receipt for payment. If such documentation is not available, a multinational entity may furnish secondary substantiation during an audit. In lieu of a receipt for payment for foreign taxes paid, a cash basis multinational entity may be able to provide a photocopy of the check, draft or other medium of payment showing the amount and date, with evidence establishing that the tax was paid for a bank account. In lieu of a foreign return for foreign income taxes paid, an accrual basis multinational corporation must be able to provide a certified statement of the accrued amount, with excerpts from its books showing the computation of the accrued amount. See Treas. Reg. Section 1.905-2(b).
D. Form 5472 and Records Requirement
Foreign multinational corporations that own shares of a domestic corporation (included in this definition is an LLC) are subject to special reporting and record keeping requirements under U.S. tax law. The special reporting requirements and record keeping required by the Internal Revenue Code and its regulations is often the subject of an IRS international tax audit. The regulations under Internal Revenue Code Section 6038A require extensive reporting on IRS Form 5472 if a foreign parent owns at least 25 percent of a U.S. subsidiary. The reports required on IRS Form 5472 often determine the profit or loss from the transfer of intercompany transactions. In addition, the information that is required by Form 5472 is as follows:
1. The name and address of the reporting corporation and its employer identification number.
2. Identification of the foreign stockholder of the reporting corporation, including the country of organization, the country or countries where it conducts business and files tax returns.
3. Identification of the related party with which the reporting corporation is conducting reportable transactions.
4. Information about certain monetary transactions between the reporting corporation and the related party, listing the dollar amount involved in all sales of inventory or tangible property; payments of rent, royalties, license fees or other payments for intangible property rights, payments for services or commissions, borrowing and interest payments, and premiums.
5. Information about non-monetary transactions between the reporting corporation and the related party, describing the substance and the size of the transaction or group of transactions, with an estimate of the fair market value, or nature or importance of any non-monetary value transferred.
6. Specific questions regarding importing, directed to whether the value of imported goods differs for tax and customs purposes.
In addition to completing a Form 5472, the U.S. subsidiary of a foreign parent must keep the permanent books of account or records as required by Internal Revenue Code Section 6001 that are sufficient to establish the correctness of the federal income tax return of the corporation, including information, documents or records to the extent they may be relevant to determine the correct U.S. tax treatment of transactions with its foreign parent. The foreign parent must also appoint a U.S. agent to receive IRS summons. Internal Revenue Code Section 6038A(e) permits the IRS to reduce the cost of goods sold when a foreign parent does not obtain an agent for receipt of a summons.
In some cases, certain “safe-harbor” tests apply to reduce or simplify the required record-keeping, but the safe-harbors themselves have been criticized as unduly complex and burdensome. The record-keeping and agent requirements discussed do not apply if the total of the reporting corporation’s gross payments to and from (aggregated, not netted) all foreign related parties is less than $5 million annually and is less than ten percent of the reporting corporation’s U.S. gross income. See Treas. Reg. Section 1.6038A-1(i)(1).
The penalty for failure to timely file a Form 5472 and/or to maintain books and records is $25,000. If such failure continues for more than 90 days after notification by the IRS, there is an additional penalty of $25,000 for each 30-day period or fraction. There is no limitation on this penalty. Given the severity of the Form 5472 and record keeping penalties, these are not matters that a multinational corporation wants to wait until an IRS to determine if it is compliant with its Form 5472 and record keeping compliance requirements. Instead, the foreign parent of a domestic entity should make sure its Form 5472s and record keeping is compliant well before an IRS audit.
E. Computation of GILTI and Form 5471 Schedules
In order to provide the IRS with the information necessary to ensure compliance with various foreign reporting provisions, multinational corporations typically must attach a Form 5471 to its tax return annually. The Form 5471 requires disclosure concerning a multinational corporation’s foreign income, deductions, earnings and profits, cost of goods sold or operations, foreign taxes paid or accrued and a balance sheet. The Form 5471 is used to compute GILTI. The Form 5471 and its related forms are incredibly complicated. As a result of the complexity of the Form 5471 and its related forms, mistakes computing GILTI inclusions by tax preparers are common. This is particularly the case when it comes to determining the Section 250 deduction.
Below are a few real world examples of mistakes made by tax professionals that triggered costly international tax audits. By way of background, Internal Revenue Code Section 250 allows a domestic C corporation a deduction for a portion of the domestic corporation’s FDII and the corporation’s GILTI. Specifically, domestic corporations are allowed to deduct: 37.5 percent of the domestic corporation’s FDII and 50 percent of the domestic corporation’s GILTI (as determined under Section 951A) plus a Section 78 gross-up.
The Section 250 deduction is determined based on a multistep calculation discussed below.
First, a domestic corporation’s gross income is determined and then reduced by certain items of income, including amounts included under subpart F, GILTI income, dividends received from CFCs, income earned in foreign branches, financial services, and domestic oil and gas production. This amount is reduced by deductions (including taxes) properly allocable to such income, yielding deduction eligible income (“DEI”).
Second, the DII is determined. This is the excess (if any) of the domestic corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A domestic corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases is determined using straight line depreciation. A domestic corporation’s QBAI does not include land, intangible property or any assets that do not include land, intangible property or any assets that do not produce the deductible eligible income.
Third, the Section 250 calculation is made to determine the amount of deduction available from foreign source income characterized as FDII or GILTI.
IRS Form 8993 is utilized to determine the Section 250 deduction. All domestic corporations must utilize Form 8993 to determine the allowable Section 250 deduction. Completing the Form 8993 is no easy task. We have noticed that tax practitioners have had difficulties with the following questions on Form 8993.
Part 1, Line 1.
The instructions to Form 8993 for Line 1 of Part 1 states that the domestic corporation must list its total gross income. This includes both domestic and foreign source income. Some tax professionals erroneously list only foreign source income on Line 1 of Part 1. Only listing a domestic corporation’s foreign source income on line 1 of Part 1 will result in an incorrect Section 250 deduction and ultimately an erroneous GILTI computation. As incorrect GILTI computation can be an IRS international tax audit.
Part III Line 1a.
The instructions to Form 8993 for Line 1a of Part III states that a tax professional should include DEI derived from the sales, lease, exchange, or other disposition (other than license) of property to foreign person for foreign use. This question asks the tax return preparer to list a very specific category of foreign source income. This is, DEI income derived from the sales, lease, exchange, or disposition (other than a license) to a foreign person for foreign use. A number of tax professionals entered all foreign source income of CFCs on line 1a which ultimately resulted in costly IRS international tax audits. Tax preparers can check the accuracy of Line 1a. The DEI income reported on line 1a for Part III should not exceed the amount stated on line 3 of Part III of Form 8993.
Part IV Line 5
The instructions to line 5 for Part IV of Form 8993 asks a tax return preparer to enter the domestic taxable income (determined without regard to Section 250). The domestic taxable income of U.S. corporations can be found on line 30 of the Form 1120. For some reason a number of tax preparers seem to overthink this question and enter some other number. This mistake will result in the incorrect calculation of the Section 250 deduction and GILTI computation which can ultimately trigger an IRS audit.
Part IV Line 8 and Line 9
Line 8 of Part IV provides the Section 250 deduction amount for FDII. For domestic C corporations that sell goods and/or provide services to foreign customers, there is a deduction under Section 250 that reduces the effective tax rate on qualifying income to 13.125 percent. Line 9 of Part IV provides that Section 250 deduction for GILTI. Section 951A requires a U.S. shareholder of a CFC to include in the U.S. shareholder’s income an amount of its CFC income determined to be in excess of a specified return on the CFC’s investment in depreciable tangible personal property. Although the Section 250 reduction applies similarly when determining the Section 250 deduction to FDII and GILTI income. When the Section 250 formula is applied to these two items of income, the allocable deduction will also be different. Tax professionals must make sure they do not apply a FDII deduction to GILTI income or vica versa. We have seen this mistake trigger an IRS audit of a multinational corporation.
Computing the Section 250 deduction for GILTI is just one of the complexities associated with the Form 5471. Mistakes are often made on the Form 5471 that can trigger an IRS audit. In order to reduce the probability of an IRS audit of a Form 5471, a multinational corporation should review direct, indirect, and constructive ownership of each controlled foreign corporation (“CFC”) each year to determine the impact of any changes in percentages, filer categories, and CFC status of lower tier entities. It is also important that the international tax professional properly compute the multinational corporation’s U.S. GAAP adjustment and foreign exchange detailed for cross-transactions. Finally, previously taxed income that becomes PTEPs must be correctly computed on Schedule J, E-1, and J on Form 5471.
It is extremely important that the Form 5471 and GILTI computation be done correctly to avoid an international tax audit. An international tax audit targeting a Form 5471 and GILTI computation can potentially not only result in additional income tax, penalties, and interest, such an audit can trigger additional penalties for failing to accurately complete an IRS Form 5471. The penalty for not accurately completing a Form 5471 is $10,000 annually for each entity required to complete the form. An additional $10,000 continuation penalty may be assessed for each 30 day period that noncompliance continues up to $60,000 per return, per year. The IRS can also assess a 40 percent penalty and reduce foreign tax credits by 10 percent.
Conclusion
Procedurally and substantively, tax audits involving multinational corporations tend to be far more complicated than domestic audits of business entities and individuals. If you or your business is subject to an international examination by the IRS, make sure that you retain the services of a qualified international tax attorney.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.