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International Tax Planning as Viewed through the Eyes of BEPS

Lewis Rice attorney Timothy G. Stewart co-presented to the St. Louis International Tax Group on the OECD's efforts to address Base Erosion and Profit Shifting.

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International Tax Planning as Viewed through the Eyes of BEPS

  1. 1. SEPTEMBER 17, 2015 Basic (and Not So Basic) International Tax Planning as Viewed through the Eyes of BEPS St. Louis International Tax Group, Inc. TIMOTHY G. STEWART LEWIS RICE LLC PHILIP B. WRIGHT BRYAN CAVE LLP
  2. 2. International Income Tax Planning Fundamental Principals Base of Taxation  Source Based Taxation  Define Source  Residence Based Taxation  Define Residence (Organized/Incorporated – Management and Control) Treatment of Legal Entities as Separate Taxpayers  Fiscally Transparent Entities  Hybrid Entities Planning Techniques  Gross Income Earned In Lowest Tax Jurisdiction  E.g. – Migration of Intangibles  Deductions Incurred In Highest Tax Jurisdiction with low or no offsetting withholding or Income Taxation  E.g. – Leverage
  3. 3. BEPS – Background Prologue  Media Focus on MNE Tax Planning  Senate Permanent Committee on Investigations  Offshore Profit Shifting and the U.S. Tax Code - Part 1 (Microsoft & Hewlett-Packard) (Sept. 20, 2012) (S. Hrg. 112-781)  Offshore Profit Shifting and the U.S. Tax Code - Part 2 (Apple Inc.) (May 21, 2013) (S. Hrg. 113-90)  Caterpillar’s Offshore Tax Strategy (April 1, 2014) (S. Hrg. 113-408)  Impact of the U.S. Tax Code on the Market for Corporate Control and Jobs (July 30, 2015)
  4. 4. BEPS – Background  OECD Reports  Prior OECD Reports  BEPS Focus  OECD (2013) Addressing Base Erosion and Profit Shifting, OECD Publishing, Paris DOI:  OECD (2013), Action Plan on Base Erosion and Profit Shifting, OECD Publishing, Paris DOI:  Country Unilateral Action  U.S. Reaction  Hatch, Ryan Call on Treasury to Engage Congress on OECD International Tax Project (June 9, 2015)  Senate Finance Committee - The International Tax Bipartisan Tax Working Group Report (July 7, 2015)  Treasury Department Priority Guidance Plan - Regulations under §§6011 and 6038 relating to the country-by-country reporting of income, earnings, taxes paid, and certain economic activity for transfer pricing risk assessment (July 31, 2015)  Hatch, Ryan Question Treasury’s Planned Country-by-Country Reporting Regulations (August 27, 2015)
  5. 5. BEPS - Overview
  6. 6. What is BEPS? Base Erosion and Profit Shifting (“BEPS”) • Arrangements that result in low or no taxation by: • shifting profits away from jurisdictions where the activities related to those profits are performed, or • exploiting gaps in the interaction of domestic tax laws in order to avoid taxation
  7. 7. What is BEPS’ focus? • Focus on tax planning that shifts profits from high taxed countries to low taxed countries without materially changing the way in which the taxpayer operates • Examples include discrepancies where: • Products and services are produced; • Sales and distribution result; • Research and development is undertaken; • How a taxpayer’s capital and labor are used
  8. 8. What is the base being eroded? The base is the net taxable income (i.e., pre-tax income) in a particular country.
  9. 9. Key Pressure Areas Identified by the OECD • Key pressure areas identified by the OECD that create BEPS opportunities include: • Hybrids and mismatches that result in tax arbitrage • Residence-source tax (e.g., digital commerce) • Intragroup financing • Transfer pricing issues • Anti-avoidance rules • Preferential tax regimes
  10. 10. OECD BEPS - Actions
  11. 11. BEPS Actions Action 1: Address the tax challenges of the digital economy Actions 8, 9 & 10: Assure that transfer pricing outcomes are in line with value creation. Action 2: Neutralize the effects of hybrid mismatch arrangements Action 11: Establish methodologies to collect and analyze data on BEPS and the actions to address it Action 3: Strengthen CFC rules Action 12: Require taxpayers to disclose their aggressive tax planning arrangements Action 4: Limit base erosion via interest deductions and other financial payments Action 13: Re-examine transfer pricing documentation Action 5: Counter harmful tax practices more effectively, taking into account transparency and substance Action 14: Make dispute resolution mechanisms more effective Action 6: Prevent treaty abuse Action 15: Develop a multilateral instrument Action 7: Prevent the artificial avoidance of PE status
  12. 12. OECD Published Reports Action 1 – Addressing the Tax Challenges of the Digital Economy Action 2 – Neutralising the Effects of Hybrid Mismatch Arrangements Action 5 – Countering Harmful Tax Practices More Effectively, Taking into Account Transparency and Substance Action 6 – Preventing the Granting of Treaty Benefits in Inappropriate Circumstances Action 8 – Guidance on Transfer Pricing Aspects of Intangibles, Action 13 – Guidance on Transfer Pricing Documentation and Country-by-Country Reporting Action 15 – Developing a Multilateral Instrument to Modify Bilateral Tax Treaties
  13. 13. Digital Economy Primary conclusion  Digital economy is so widespread that that it represents more than a special part of the economy– it is the economy  Not possible to isolate the digital economy for purposes of creating separate tax rules Digital Economy Task Force (“DETF”) given authority to propose its own solutions  DETF raised certain specific points but provided no specific conclusions
  14. 14. Digital Economy Special points raised by the DETF include:  The OECD model treaty PE article needs to be reviewed  Reliance on concluding a contract in one territory to avoid taxation in another  Highlights the role of intangibles and the increasing importance of data  Highlights the possibility of changing CFC rules to target the types of income in a digital economy  Addresses consumption tax questions
  16. 16. E-Commerce structure Transfer of Intangibles with Hybrid Entities Žŵ ĂŶƉ LJ Ž ŶƵ ƚƌLJ Žŵ ĂŶƉ LJ Ž ŶƵ ƚƌ ͬLJ Žŵ ĂŶƉ LJ Ž ŶƵ ƚƌLJ Žŵ ĂŶƉ LJ Ž ŶƵ ƚƌLJ Sub-license Royalty (no withholding tax) Transfer of rights to pre- existing IP and IP from new R&D. “Buy-in” payment for pre-existing IP. Contract R&D service payments for IP from new R&D.
  17. 17. E Commerce Structure Background  Company A, organized in Country A, initially developed technology and intangibles to support its business in Country A  Rights to technology developed by Company A is licensed or transferred to Company C under a cost sharing or cost contribution arrangement  Company C is resident outside of Country A  Company C agrees to make a “buy in” payment equal to the value of the existing technology  Company C licenses all of its rights in the technology to Company D in exchange for a royalty  Company D is organized and managed and controlled in Country D  Company D sublicenses the technology to Company B  Company B employs significant workforce in Country B in its operations
  18. 18. E-Commerce Structure Result  Country B imposes corporate income tax on taxable profit in Country B but the taxable profit is substantially “eroded” as a result of the royalty payment from Company B to Company D  Country D taxes the profits of Company D such profits reduced by the royalty it pays to Company C  Company D performs no functions and holds no assets so Company D is allocated little income  Country D does not impose withholding tax on royalty payments under its domestic law  Company C is managed and controlled in Country C. Country C does not impose a corporate income tax. Company C has no presence in Country B.  The royalty income received by Company C is not taxed by Country D, Country C or Country B
  19. 19. Tax Residence – Residence Taxation • Conflict among jurisdictions over the right to tax (i.e., potential double tax) are resolved by treaty by either allocating exclusive taxing rights to one of the contracting states or by allocating the primary right to tax either to: • the country that is the source of the income, or • the country in which the profit earner is resident  Where the taxing right is based on residency, the ideal corporate entity for tax purposes is an entity that is a tax resident of a tax haven (i.e., no tax country) or a nowhere resident, so that no jurisdiction has a taxing right. Irish residency law provides asymmetry which provides planning opportunities. • For U.S. tax purposes tax residence is based on the place of incorporation • For Irish tax purposes, tax residence is based on where the company is “managed and controlled”
  20. 20. Apple Structure “Double Irish”
  21. 21. Apple Structure Irish Holdco (Company C) is managed and controlled in Bermuda. Ireland taxes only Irish source income generated by Irish Holdco. Non-Irish source income is not subject to tax in Ireland Netherlands does not tax the royalty income under the EU and the Netherlands Royalty Directive. The Netherlands also provides a favorable treaty to avoid withholding taxes on royalty payments Result: Irish source income is subject to Ireland’s 12.5% tax and non-Irish Source income is not taxed Apple’s effective tax rate on earnings through this structure is reportedly less than 3% --approx. 2.4%
  22. 22. Google Structure “Double Irish with a Dutch Sandwich” ' ŽŽŐůĞ h ^͘ ͘ Žŵ ĂŶƉ LJ / ĞůĂŶĚƌ ͬĞ ŵ ĚĂƌ Ƶ Ύ Žŵ ĂŶƉ LJ E Ğ ŚĞ ůĂŶĚƚ ƌ Ɛ Žŵ ĂŶƉ LJ / ĞůĂŶĚƌ Sub-license Interco Royalty “Buy-in” payment for pre- existing IP and IP from new R&D.. Transfer of rights to pre- existing IP and IP from new R&D. *Incorporated in Ireland, managed and controlled in Bermuda.
  23. 23. Google Structure The Irish Holdco (Company C) is managed and controlled outside of Ireland. Ireland taxes only Irish source income. Non Irish source income is treated as having no tax residence and is not taxed. The Netherlands does not tax the royalty income under the EU and the Netherlands Royalty Directive. The result – only Irish source income is subject to Ireland’s 12.5% tax and the result is not taxed.
  24. 24. Transfer of manufacturing operations and supporting intangibles cost contribution arrangement Žŵ ĂŶƉ LJ Žŵ ĂŶƉ LJ Žŵ ĂŶƉ LJ Žŵ ĂŶƉ LJ Principal operating company responsible for manufacture of Group products Contract manufacturing company Company A holds rights to the manufacture and sale of Group products in Country A ((100-s) percent of total Group sales). R&D carried out by Company A. Costs of R&D and rights to IP shared between Company A and B, under R&D cost sharing agreement (CSA). R&D Payments to Company C for manufacture of Group products to be sold in Country A ((100-s)of total Group sales). Payment covers costs and risks associated with manufacture. Cost-plus payments to Company D for manufacture of Group products (contract manufacturing agreement) Payments to Company A under CSA for (s) percent of R&D costs, giving Company B rights to the manufacture and the sale of Group products outside Contry A (s percent of the Group sales). license royalty
  25. 25. Transfer of Manufacturing Operations and Intangibles Background  Company A is a publicly traded company based in country A and parent of a multinational group (“Group”).  Group invests heavily in research, product design and development  Company A carried out all of the R&D and it owns all of the resulting IP  Company A has sole responsibility for all risks associated with the manufacture and sale of products throughout the world.  Company A creates Company B in Country B and assigns to Company B its IP and responsibility for the manufacture and sale of products outside Country A  Company A retained domestic IP rights related to the manufacture and sale of products within Country A and continues to carry out R&D for the Group  Group creates two additional foreign entities  Company C organized in Country C and serves as the principal company responsible for the manufacture and sale of Group products outside of Country A  Company D is a manufacturing entity responsible for the production of Group products outside of Country A  For U.S. tax purposes, both Company C and D are treated as disregarded for U.S. tax purposes but they are considered corporations in Country C and Country D.
  26. 26. Transfer of Manufacturing Operations and Intangibles Background  Transfer of IP from Company A to Company B is taxable in Country A via a cost- sharing arrangement (CSA)  Under CSA, Company B is required to make a buy-in payment to Company A for the pre- existing IP  Buy-in payment is either a lump sum or running royalty  Company B assumes responsibility to reimburse Company A for a share of ongoing R&D expense reflecting its share of the anticipated benefit Company B expects to derive from ongoing R&D  For example, if Company B is responsible for 45% of global revenues, it would be expected to reimburse Company A for approximately 45% of product area R&D under the CSA.  Even though Company B reimburses Company A for its R&D costs, Company A is entitled to an R&D credit in Country A for the full amount of its R&D expenditures.  Company B is treated as the owner of the non-Country A IP rights of the Group. Company B licenses those rights to Company C and Company C contractually assumes responsibility for producing and selling Group products outside Country A.
  27. 27. Transfer of Manufacturing Operations and Intangibles Result  Company C engages Company D to serve as a contract manufacturer. Under manufacturing agreement, Company D manufactures for a fee equal to direct and indirect production costs plus a 5% mark-up. Manufacturing agreement between Company C and Company D specifies that Company C bears the principal risks associated with the production of the product.  Actual production may take place in Country D or in a branch of Company D in a low-cost manufacturing country  Company D includes fee in its taxable income  Manufactured products are the property of Company C, which sells the products to or through related sales entities in high tax jurisdictions  Contractual arrangements between Company C and marketing companies specify that Company C assumes the principal risks related to the marketing of the products  Sales and marketing companies are compensated on a basis reflecting their limited risk (Limited Risk Distributor)  Company C earns profit equal to its gross sales revenue on sales, less fees paid to Company D for the manufacture of the goods, payments to any related commission based marketing entities and less royalties paid to Company B
  28. 28. Transfer of Manufacturing Operations and Intangibles Result  Royalties paid to Company B by Company C for its foreign IP rights are deductible by Company C. Country C does not impose withholding tax on royalty payments and Country B does not impose corporate income tax; thus, the royalty payment is free of withholding and income tax  Country A taxation is avoided on the royalty payment from Company C to Company B under Country A’s CFC rules due to “check the box” elections, royalty payment from Company C to Company B is disregarded for Country A tax purposes  Group erodes Country C tax base with deductible royalty payments and avoid Country A taxation on what would otherwise be passive royalty income  Dividends paid to Company B are free of tax at source as Country B does not tax dividend income and dividend payment is disregarded for Country A tax purposes
  29. 29. Leveraged Acquisition D E ' Žƌ ƵƉ >, ŽůĚĐŽ d, ŽůĚĐŽ dĂ ŐĞ Žƌ ƚ ͘ State P Ž State L Tax grouping Ğ ŶĂůĂŶŬdžƚ ƌ Interest Loan EUR 600m Dividends/ Interest Hybrid Instrument EUR 400 m ^ĞůůĞƌ State T Loan EUR 400m EUR 1 billion Tax grouping
  30. 30. Leveraged Acquisition Background  MNE is headquarter in State P with operations in various countries, including State L. MNE plans to acquire Target Co., a State T manufacturing company The purchase price is EUR 1 billion, 60% to be financed externally and 40% to be financed by MNE.  MNE sets up a holding company in State L (L Hold Co) which receives an intra-group loan for EUR 400 million. L Holdco, in turn, sets up a company in State T (T Holdco). T Holdco is financed party by L Hold Co through a hybrid instrument (EUR 400 million) and party with external bank debt (EUR 600 million).  T Holdco acquires Target Co and enters into a tax grouping with Target Co for State T tax purposes.
  31. 31. Leveraged Acquisition Benefit  Debt push-down ensures that subject to interest expense limitations interest expenses on the external bank debt are deducted from the target company’s operating income through the applicable group tax regimes  L Hold Co finances T Hold Co through a hybrid instrument, e.g., redeemable preferred shares. Financing is treated as debt in State T while it is treated as equity in State L.  Subject to applicable limitations, additional interest expense will be deducted against the income of Target Co for tax purposes.  Payment will be treated as a dividend for State L purposes and be exempt from tax under State L local law.  Interest L Hold Co. pays on the EUR 400 million intra-group loan can be deducted against the income of other group companies in State L  Upon exiting the investment, shares in T Hold Co can be sold tax-free to the purchaser. State T may be prevented from taxing the income under relevant double tax treaty, while State L exempts capital gain on shares under its domestic law.
  32. 32. BEPS Impact on Structuring and Planning Considerations
  33. 33. Residency Challenge Response to Residency mismatch: In October 2013, in response to international pressure arising from the media coverage of the Google arrangement, Ireland changed its domestic law. Ireland’s law change is basically a “throw back” rule. If an Irish incorporated entity fails the “management and control” test but it is not a tax resident of another jurisdiction, it will be subject to tax in Ireland. In October 2014, Ireland’s Finance Minister proposed a new budget, which includes a provision that would align its residency in line with incorporation. The current proposal phases in over six years, from 2015 through 2020. Taxpayers need to monitor this proposal. Regardless of the success of this proposal, residency reform is considered essential for the success of BEPs. Even assuming the proposal succeeds, the income “thrown back” to Ireland would be taxed at a 12.5%, resulting in a 22.5% tax arbitrage (35% less 12.5%).
  34. 34. Planning Considerations  MNEs can consider transferring the underlying intangibles to the Netherlands and access the Innovation Box regime  If the intangible assets are considered by Ireland to be owned in Bermuda (where the profit related to the intangibles has been attributed), a transfer to the Netherlands should not give rise to local tax on the outbound asset transfer. Even if Ireland considers the intangibles to be owned in Ireland, gain on the transfer may be exempt from tax under the Irish group relief provisions.  Transfer of intangibles may impact royalty withholding rates. If the intangibles are transferred to the Netherlands, the royalties attributed to the intangibles should be taxed at 5%. While this rate is higher than the effective tax rate from the current structure, it may still be an acceptable rate increase in light of the substantial changes that may result from international tax initiatives.  Consider dual incorporation
  35. 35. Withholding tax challenge  In the Dutch Sandwich structure, insertion of the Netherlands entity reduces withholding tax on the royalty payments. A royalty payment from Ireland to the Irish/Bermuda resident company would require withholding tax.  Within the EU, cross-border exemptions, such as the Royalties and Interest Directives are a foundation of the region’s economic unity. Adoption of anti-abuse rules to assess lower withholding tax on intra- group payments will quell certain structures, such as the Dutch Sandwich (i.e., intra-company payments will little business purpose other than tax avoidance would be subject to the anti-abuse rules).
  36. 36. Planning Considerations in Answer to Withholding Tax Challenge  The MNE could concentrate intangible assets in a patent box regime (e.g., Netherlands or UK).  Again, there may be no outbound capital gain tax on the transfer of the IP (i.e., the IP could be considered owned by Bermuda or gain on the transfer could be exempt under the Irish tax rules).  Payments from sales companies in many jurisdictions for the right to license the intangible should be distinguished from the Netherlands acting merely as an intermediary entity.  Locating the IP in a favorable withholding tax jurisdiction could alleviate anti-abuse challenges related to a mere intermediary entity.