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In this issue: The U.S. Department of Treasury and the IRS released proposed regulations under Section 163(j) and Section 956; the UK and Spanish governments commenced unilateral action to impose digital services tax regimes in their respective jurisdictions; the Utah Supreme Court upheld deductions for royalty payments made to a related party for the use of intellectual property; the Australian Taxation Office published Draft Taxation Determination TD 2018/D6; Vietnam signaled potential taxpayer friendly position on new interest expense deductibility rules; and conference highlights from the 2018 IP Value Summit.
On November 26, 2018 the U.S. Department of Treasury and the IRS released proposed regulations that provide guidance on the limitation on the business interest expense deduction for certain taxpayers. Section 163(j) was revised as part of the Tax Cuts and Jobs Act (TCJA), and the proposed regulations will impact companies claiming interest expense deductions for 2018.
As revised, 163(j) generally caps the amount allowed as a deduction for business interest expense to a taxpayer’s business interest income plus 30 percent of the taxpayer’s adjusted taxable income (ATI) plus the taxpayer’s floor plan financing interest expenses for the taxable year. Disallowed interest can be carried forward and treated as business interest paid or accrued in the next taxable year. A new form, Form 8990, Limitation on Business Interest Expense Under Section 163(j), should be used by taxpayers to calculate and report their deduction and the amount of disallowed business interest expense to carry forward to the next tax year.
163(j) will generally apply to all taxpayers, except:
Certain small businesses that meet a gross receipts test (i.e., less than an average of $25 million over the prior three-year period, adjusted for inflation); or
Taxpayers in certain trades or businesses (i.e., electing real property businesses, electing farming businesses, and certain regulated utility businesses).
The proposed regulations are organized into eleven sections. The first three sections include definitions, general rules on the computation of a taxpayer’s 163(j) limitation, and details on the interaction and ordering with respect to other Internal Revenue Code sections, respectively. The sections that follow include rules applicable to C Corporations (including REITS, RICs and consolidated group members) as well as tax exempt corporations and rules applicable to C Corporations with respect to carryforwards. There are then separate sections of rules with respect to Partnerships and S Corporations; Foreign Corporations and their shareholders; and Foreign Persons with effectively connected income. More details are then provided on rules regarding elections for excepted trades or businesses as well as a safe harbor for certain REITS. Detail around allocations between these excepted trades or businesses and non-expected trades or businesses is also provided. Lastly, there are rules around transition from the prior 163(j).
Of note, the proposed regulations define the term “interest” in the context of Federal tax law. The proposed regulations state that interest relates to an “instrument or a contractual arrangement, including a series of arrangements” and includes transactions that are indebtedness in substance but not in form. In addition, the proposed regulations contain an anti-avoidance rule whereby “any expense or loss predominately incurred in consideration of the time value of money is treated as interest expense.” In aggregate, the proposed regulations intend to provide clarity on the types of instruments/transactions that will be subject to 163(j) and to leave little room for taxpayers to structure debt-like arrangements in order to circumvent the business interest limitation as a tax-avoidance mechanism.
With respect to key international tax provisions in 163(j), the proposed regulations reserve for future guidance on the interaction of sections 163(j) and BEAT, but do address the effect of deemed inclusions from branch income, Subpart F income and GILTI as well as the effect of FDII on adjusted taxable income.
Also of note, several adjustments to the calculation of ATI are added to avoid double counting. Other adjustments specific to particular types of taxpayers are meant to ensure even treatment across different types of taxpayers.
Comments are due within 60 days of the date the proposed regulations are published in the Federal Register and a public hearing is scheduled for February 25, 2019. Also, according to the accompany IRS release, IR-2018-233, taxpayers may rely on the rules in these proposed regulations until final regulations are published in the Federal Register.
On October 31, 2018 the IRS released proposed regulations under Internal Revenue Code Section 956 (Section 956) which would reduce the amount determined under Section 956 with respect to certain transactions.
Section 956 was put in place alongside the subpart F regime in the Revenue Act of 1962 to ensure that a CFC’s earnings not subject to immediate tax when earned (under the subpart F regime) would be taxed when repatriated, either through a dividend or an effective repatriation. Congress recognized that repatriation of foreign earnings was possible through means other than a taxable distribution, and therefore enacted section 956 “to prevent the repatriation of income to the United States in a manner which does not subject it to U.S. taxation.” Section 956 serves as an anti-abuse measure to tax a CFC’s investment of earnings in United States property in the same manner as if it had distributed those earnings to the United States.
The Tax Cuts and Jobs Act (TCJA) enacted on December 22, 2017 established a participation exemption system for the taxation of certain foreign income. Under Section 245A of the TCJA, in the case of any dividend received from a specified 10% owned foreign corporation by a domestic corporation which is a U.S. shareholder with respect to such foreign corporation, there is allowed as a deduction an amount equal to the foreign-source portion of such dividend. In effect Section 245A allows these dividends to be repatriated to the U.S. on a tax-exempt basis due to the dividend received deduction.
The proposed regulations under Section 956 align Sections 956 and 245A with regards to actual dividends determined under Section 245A and substantially equivalent dividends determined under Section 956 by treating both types of dividends (actual dividends and substantially equivalent dividends) as not subject to additional U.S. tax for corporate U.S. shareholders of CFCs. The proposed regulations note that disparate treatment of actual dividends and amounts substantially the equivalent of a dividend would be directly at odds with the purpose of Section 956. The proposed regulations under Section 956 also indicate that one of their outcomes will be to significantly reduce complexity, costs, and compliance burdens for corporate U.S. shareholders of CFCs.
It should be noted that Section 956 will continue to apply without modification to U.S. shareholders other than corporate U.S. shareholders, such as individuals. In addition, Section 956 will continue to apply without reduction to regulated investment companies and real estate investment trusts because they are not allowed the dividends received deduction under section 245A.
The proposed regulations will apply to taxable years of a CFC beginning on or after the date of publication of the Treasury decision adopting these rules as final regulations in the Federal Register and to taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end. Taxpayers may rely on the proposed regulations for taxable years of a CFC beginning after December 31, 2017, and for taxable years of a U.S. shareholder in which or with which such taxable years of the CFC end, provided that the taxpayer and U.S. persons that are related to the taxpayer consistently apply the proposed regulations with respect to all CFCs in which they are U.S. shareholders.
The proposed Section 956 regulations (REG-114540-18) can be found here.
The EU’s member states continue to debate the introduction of a digital services tax (DST) within the EU but have thus far not achieved consensus. In late October 2018, both the UK and Spanish governments commenced unilateral action to impose DST regimes in their respective jurisdictions.
The UK government has announced in its autumn budget, delivered on October 29, 2018, that it will proceed unilaterally with its own DST from April 2020.1 The government presents the DST as an interim measure that will be disapplied if and when an appropriate approach to the taxation of digital businesses is agreed at the global level through the OECD.
Sitting outside the framework of double tax treaties, the DST will be a 2% tax on the gross revenues of specific business models, where those revenues are connected with the participation of UK users. The UK government has adopted the position that digital businesses create value in a novel way. It is the UK government’s view that highly digitalised business models derive value from the participation of their local users, but that value does not generate income tax in the jurisdiction of those users under the existing international corporate tax system.
The government expects to raise £1.5 billion from the DST over four years. The legislation takes aim at the internet giants, such as Google, Amazon and Facebook, which has raised concern in the U.S. over the apparent targeting of U.S. multinationals.2 The tax will apply to revenues derived from provision of a search engine, a social media platform or an online marketplace. It will not be a tax on online sales of goods; hence, Amazon, for example, would be liable to the DST on the revenues linked to the participation of UK users that it generates from its marketplace function, but not from its direct sales to customers. Also, explicitly outside the scope of DST will be revenues from financial and payment services, the provision of online content, sales of software or hardware and television and broadcasting services.
Businesses generating less than £500 million in revenues globally from in-scope activities will not be caught by the DST, nor will any business have to pay the tax on the first £25 million of relevant UK revenues. The government has also proposed a safe harbor for loss-making businesses and those with very low profit margins.
Because the tax will not be covered by the UK’s double tax treaties, it will not be creditable against UK corporation tax, but it will be treated as an allowable expense for the purpose of calculating UK corporation tax. The government has issued assurances that an assessment will be made in 2025 as to whether the DST is still required in light of international action and that it will be disapplied if an acceptable global solution has been implemented by that date.
The government issued a consultation document on November 7, 2018 on the design, implementation and administration of the DST, as a precursor to the introduction of legislation in Finance Bill 2019-20.3 The consultation seeks views on, inter alia: the approach proposed for defining business activities within the scope of the tax and for determining when the revenues become taxable; the design of the safe harbor; the effect of treating DST as a deductible expense; the proposed review mechanism; and reporting and payment. Comments are to be sent to the government by February 28, 2019.4
On October 23, 2018, the Spanish Government released the preliminary draft bill on the Digital Services Tax (DST), taking as the starting point the European Commission’s (EC) proposal presented on March 21, 2018 and leaving a door open to its future implementation in 2019, if approved.
Both the EC and the Spanish Government claim that the most practical way to tackle the challenge of fair taxation in a digital economy is the introduction of this DST that updates the notion of a (digital) permanent establishment (PE) by allocating the profit derived from the data and the value created by user participation, to the source country where those data and users are located. However, Spain currently precedes the EU consensus, as it is still a topic up in the air without clear practical measures.
For a related entity to qualify as taxable for the purposes of the DST, the group should meet two thresholds to ensure that the former poses both sufficient scale and significant digital footprint. These are quantified in terms of having a total amount of worldwide revenues reported by the group for the previous calendar year that exceeds EUR 750 mm, and €3 mm in Spain.
The DST consists of a 3% tax rate applicable to gross income derived from certain digital services net of VAT or other similar taxes. The relevant digital services for tax purposes must be characterized by user value creation (e.g. online intermediation, online advertising and data transmission services) and rendered within the Spanish territory, based on the place where the devices of these users have been used, generally located by their Internet Protocol (IP) addresses.
The EC’s proposal states that a series of services including, but not limited to: e-commerce, online financial services, online payment services and online intermediation services (to supply digital content, communication services, etc.,) are exempted from taxation. Yet, while the former transactions do not qualify as taxable, from the transfer pricing perspective, the Draft does not expressly neglect these when rendered between related entities. Hence, today, intra-group digital services in Spain lie within the DST scope.
On October 5, 2018, the Utah Supreme Court affirmed a Fourth Judicial District Court, thereby upholding deductions for royalty payments made to a related party for the use of intellectual property.
The case5 (opinion available here) involved See’s Candies, Inc. (See’s Candies), a California corporation that sells candy in Utah and Columbia Insurance Company (Columbia), an admitted insurance company in Utah. Both entities are wholly owned subsidiaries of Berkshire Hathaway. In 1997, Columbia purchased intellectual property from See’s Candies in exchange for stock in Columbia. The transaction was followed by a non-exclusive licensing agreement whereby Columbia would protect and develop the intellectual property, and See’s Candies would pay quarterly royalties to license back the intellectual property purchased by Columbia. An outside accounting firm was hired to set the value of Columbia stock, See’s intellectual property and the related royalty payments to ensure that the transaction met the arm’s-length standard as described under IRC Section 482.
Subsequently, the Utah State Tax Commission (UTC) audited the results of See’s Candies for 1999-2007 and disallowed the royalty deductions in their entirety under its authority under Utah Code Annotated § 59-7-113 via a 2009 Statutory Notice letter, noting a shifting of income leading to an understatement of income attributable to See’s Candies. See’s Candies disagreed with the audit results, resulting in the controversy moving to the Fourth Judicial District Court in Utah County. This court upheld 90% of the deductions for royalty payments made by See’s Candies, generally agreeing with the taxpayer that the payments met the requirements under IRC Section 482 and that the UTC was limited to adjustments allowed under the IRC Section 482 framework. The Court also indicated that Utah Code Ann. Sec. 59-7-113 was ambiguous and much of its language was nearly identical to IRC Sec. 482, necessitating a reliance on IRC Section 482 principles for any proposed adjustment.
The Utah Supreme Court decision provides insight on how individual U.S. states may be limited in their ability to price transfer pricing transactions in a manner not conforming with IRC Section 482, especially if the states do not have specific guidance which departs from IRC Section 482.
On October 31, 2018 the Australian Taxation Office (ATO) published Draft Taxation Determination TD 2018/D6 dealing with the interaction between the debt and equity rules in Division 974 and the transfer pricing rules in Subdivision 815-B of the Income Tax Assessment Act 1997.
TD 2018/D6 states that the transfer pricing rules prevail over the debt/equity rules and that the debt/equity rules apply to classify financing arrangements as either debt or equity by reference to the arm's length conditions, not the actual conditions. This is on the basis that Subdivision 815-B explicitly states that nothing in the income tax legislation limits the operation of the transfer pricing rules (with the exception of the thin capitalization rules).
The draft tax determination provides three examples to illustrate the effect of the transfer pricing rules on the debt equity rules.
The first example deals with an outbound loan to a distressed subsidiary with an interest moratorium until the foreign subsidiary makes an accounting profit. The loan would satisfy the equity test under the debt/equity rules because the payment of interest is contingent on the economic performance of the issuer. Although it’s questionable whether a distressed company would have been able to borrow in the first place, the ATO assumes that had arm's length conditions operated under the transfer pricing rules, interest would have accrued from start date of the loan and as a result any interest the Australian company receives would be included in its assessable income.
The second example involves an inbound discretionary, non-cumulative interest loan to an Australian company which would satisfy the equity test. As a result, no interest withholding tax would be payable on any interest paid by the Australian company. However, as interest is assumed to have been charged under arm’s length conditions, the ATO can make a determination and adjustment against the foreign resident company so as to deem an interest withholding tax liability. In this situation, the ATO may exercise its discretion to make a consequential adjustment by way of a deemed deduction for interest to the Australian-company which begs the question whether the ATO would seek to challenge the arrangement in the first place.
The third example deals with an outbound interest-free loan to a foreign subsidiary in the exploration stage of a mining business that could not obtain debt financing from an unrelated party which would satisfy the debt test. The arm's length conditions would give rise to an equity interest but as there is no transfer pricing benefit flowing from this the transfer pricing rules would not apply to deem interest income to the Australian lender. This is consistent with the approach taken in Taxation Ruling TR 92/11 dealing with the former transfer pricing rules under Division 13 of the ITAA 1936 whereby certain financing arrangement could be treated as “quasi-equity”.
The approach set out in the draft tax determination preserves the position under TD 2008/20 (since withdrawn) dealing with the interaction between the debt/equity rules and Division 13. However, it would appear to be somewhat at odds with the special rule under Subdivision 815-B which preserves the thin capitalization rules (which themselves depend on the debt/equity tests to identify whether financing arrangements constitute debt for thin capitalization purposes) in respect of their application to an entity’s amount of debt.
The draft tax determination does not address the situation where there is a genuine commercial reason for an inbound interest-free loan and the loan has not disadvantaged the Australian revenue. In this case, it could reasonably be expected that the ATO would not make a determination and adjustment against the foreign resident company to raise a withholding tax liability. Such a situation could conceivably arise where, if interest had been charged, the thin capitalization rules would operate to deny a deduction and therefore the interest free loan arrangement is designed to enable the Australian entity to satisfy the relevant thin capitalization test. Clarity on this would be welcome.
Taxpayers should review their cross-border financing arrangements in light of the draft tax determination.
In addition to the draft tax determination, the ATO is expected to release shortly a new draft schedule 3 to Practical Compliance Guideline 2017/4 on interest free related party loans, as well as new guidance on the application of the thin capitalization arm’s length debt test.
Comments are due by November 30, 2018.
TD 2018/D6 is available here.
Since May 2017, with the implementation of Decree 20/2017/ND-CP (Decree 20) and Circular 41/2017/TT-BTC (Circular 41), the cap on interest expense deductibility for income tax purpose has become one of the most controversial and important transfer pricing topics in Vietnam. The key issue under the new rules is that interest deductions arising from loans are capped, including loans from both related parties and those from third-parties such as commercial banks. Further, Decree 20 has no article providing any relief on such interest expense cap, which could further be interpreted that no interest expense is deductible if the tax payer has a loss.
In a recent public article before the coming discussion of National Assembly on Tax Administration, Mr. Cao Anh Tuan, Deputy Director of the General Department Taxation (GDT) mentioned that this issue will be addressed in the upcoming amendment of Law on Tax Administration:6
“The idea of the amended Law on Tax Administration is that the 20% EBITDA deductibility of interest expense will only be applicable on FDI enterprises and enterprises with loans between related parties who have different CIT rates. In addition, with corporations, parent companies and subsidiaries in Vietnam applying the same CIT rates and incentives, this cap shall apply only on their consolidated financial statements. The above content has been included in the draft of amended Law on Tax Administration to submit to the National Assembly during the 6th discussion session. The draft of the amendment will be discussed by delegates on November 8 but must wait until the next session to get approval”.
If endacted upon, this statement would be a positive development for taxpayers. First, it appears that Ministry of Finance (MOF) and GDT have recognized and are taking serious consideration of the needs for a relief measure for this issue. Second, authorities have acknowledged the international practice as well as BEPS action plan in which the main target should be cross-border transactions and profit shifting. This means that financing transactions between companies within Vietnam having the same tax treatment (CIT rates and incentives) should not be the main target and impacted by the regulation.
Another possibility is that a financing entity incorporated in Vietnam could be an acceptable option in the future. The financing entity should have enough creditability to obtain loans from financial institutions on behalf of the remaining group entities, and sufficient operating profit to ensure interest expense triggered from the loans is lower than the deductibility cap. In this case there could be a possibility that the loan interest paid to such financing entity from local enterprises will be deductible.
Nevertheless, demonstrating a full compliance with the prevailing regulations should be the top priority at this stage. As stated by Minister Dinh Tien Dung of the MOF, the aforementioned amendment of Law on Tax Administration is planned to take effect from July 2020, which means any change on the treatment and interpretation on this matter should only be expected for financial year 2020 onward, and the risks of noncompliance and/or additional tax payable still remain for financial years 2017, 2018 and 2019. Thus, it is a critical time to revisit the tax and transfer pricing declaration for FY2017 and kick-off the preparation for FY2018 tax filing with the note that the 20% EBITDA cap is applied to total interest expense.
Duff & Phelps’ 5th Annual IP Value Summit, held at The Lodge at Torrey Pines in La Jolla, California on November 28-29, 2018, delved deeply into current issues in valuation, tax and transfer pricing, and litigation and licensing issues surrounding intellectual property. The overarching theme of this year’s conference was disruptive technologies and how we view them as valuation professionals. The IP Value Summit, an intimate gathering of over 125 corporate executives, attorneys, investors and experts, provides a forum for the honest, and sometimes, animated exchange of best practices.
The conference was bookended by a pair of insightful and lively keynote speakers on the future of IP management in an integrated world and the history and trials of brand management in retail. In the afternoon, participants broke out into elective tracks that enabled them to interact and debate issues with panelists on focused discussions around valuation and M&A, tax and transfer pricing, and litigation and licensing.
Jonathan Wood, Executive Director of Innovation and Collaboration, Bridgestone Americas, Inc., through the lens of the advent of autonomous vehicles, expressed his views on how new value propositions require a new thinking on how we view IP. More than components and defensive measures, he inspired us to look at IP as interrelated components in an ecosystem and to look to other innovators in nearby technology areas as inspiration for how our portfolios will grow.
Tax and Transfer Pricing
In sometimes colorful and contentious discussions, moderators Susan Fickling-Munge, Simon Webber and Wade Owen led panels on issues facing taxpayers in the face of changing tax policies and disruptive technologies.
What does the storied Altera tax court decision mean, not only to the seemingly singular issue of stock-based compensation, but to the arm’s length standard more fundamentally? Have the courts enabled the IRS to redefine it? Our panelists warn us to look to the broader implications as the next chapter in the story is forthcoming, especially in light of the Tax Cuts and Jobs Act of 2017.
One would think that an “update on latest legislation and proposals” would be a stale discussion, but our panelists illuminated the risk and concern about inevitable imposition of new taxes on the digital economy, what a digital PE might look like, and how levees at levels above income fly in the face of international tax norms and may stifle innovation.
Lastly, we grappled with taxation of cryptoassets, with a specific focus on how to view the blockchain technology that enables these assets in a multinational enterprise. What does disintermediation mean to a supply chain? What is the separable and identifiable intangible, who controls this, and who is entitled to a return.
Stephen Lee, Assistant General Counsel, Intellectual Property, Target Corporation, shared with us the trials and tribulations of brand management in a digitized world. Highlighted by often humorous reflections on efforts to build brand loyalty from the ground up, Stephen reminds us how deeply IP professionals are invested and embedded in the business.
4 E-mail: [email protected]
5 Utah State Tax Commission v. See’s Candies, Inc., 2018 UT 57, October 5, rel="noopener noreferrer" 2018