Current US Inbound and Outbound DevelopmentsCurrent US Inbound and Outbound Developments

James WallJames Wall

J. H. Cohn LLPJ. H. Cohn LLP

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Circular 230 NoticeIn accordance with Treasury Regulations, please note that any tax advice given herein (an in any attachments) is not intended or written to be used and cannot be used by any taxpayer for the purpose of (i) avoiding tax penalties or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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Agenda

• Contract Manufacturing and Notice 2007-13

• Section 987 Method of Accounting Issue• Interaction of Sections 954 (c)(6) and

267(a)(3)• Treaty Update• Withholding Tax Issues

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Contract Manufacturing and Notice 2007-13

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Foreign Base Company Sales Income Manufacturing Exception

• Under Reg. §1.954-3(a)(4), foreign base company sales income does not include income of a controlled foreign corporation from the sale of personal property manufactured by such corporation in whole or in part from personal property which it has purchased

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Guidance on Contract Manufacturing• On February 27, 2008 the Internal Revenue

Service (the IRS) issued the long-awaited proposed regulations (the Proposed Regulations) dealing with whether contract manufacturing arrangements entered into by a controlled foreign corporation (CFC) will constitute manufacturing for subpart F purposes.

• The Proposed Regulations are prospective in nature and will apply to taxable years of CFCs beginning on or after the date they are published as final regulations.

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Contract Manufacturing – Treasury Guidance

• In general, the Proposed Regulations provide that a CFC can be treated as manufacturing a product when the physical manufacturing test of subpart F is not satisfied by the CFC but when the CFC is involved in the manufacturing process. In other words, a CFC can be treated as manufacturing a product by making substantial contributions to the manufacturing of personal property through a contract manufacturer arrangement (the “substantial contributions” test), but only if such contributions are made by its employees. This test, if passed, generally treats the CFC as the manufacturer for all purposes of the foreign base company sales income provisions and, if the foreign base company sales income branch rules are not implicated, will enable the CFC to obtain deferral under subpart F. 7

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Notice 2007-13: Changes to Substantial Assistance Rule

• Substantial assistance rule contained in the foreign base company services income rules has been significantly modified by Notice 2007-13

• Services income received by a CFC is taxable as foreign base company services income if the CFC received substantial assistance from a related party contributing to the performance of such services. Reg. §1.954-4(b)

• Existing regulations state that substantial assistance includes direction, supervision, services of know-how if such assistance provides the CFC with skills that are a principal element in producing the income from the services. If the cost of such assistance equals 50% or more of the total cost of performing the service by the CFC. Reg. §1.954-4(b)(2)(ii)(b) 8

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Notice 2007-13 (cont’d)• Notice 2007-13 modifies the existing regulations

by eliminating the subjective principal element test

• Substantial assistance is limited to cases where one or more domestic related persons provide assistance of 80% or more of the total cost to the CFC of performing the service

• Effective for taxable years of CFCs beginning in 2007

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Global Service Agreement• Global Service Center (CFC) executes

global service agreement with global customers and performs services in its country of incorporation

• Local country services are subcontracted out to Local Service Companies

• Substantial assistance rule does not apply if costs paid to US affiliates are less than 80 percent of the costs incurred by Global Service Center in performing the service

• Compare to a holding company with disregarded entities; separate subsidiaries provide more flexibility to utilize foreign tax credits and separate subsidiaries are not subject to section 987

USP

LocalService

Cos

GlobalServiceCenter

Customer

SubcontractLocal Country

Service

GlobalContracts

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Section 987 andChanges in Method of Accounting

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Global Service Agreement• CFC wants to apply a correct

method of accounting for section 987 gain/loss by adopting either the approach of the 1991 proposed regulations, an “earnings only" approach, or the approach of the 2006 proposed regulations

• Would the IRS process a Form 3115 filed by CFC to change its method of accounting for section 987?– In general, different taxpayers

may apply different methods of accounts. Sections 446(a) and (c), Treas. Reg. §§1.446-1(a), (c)

USP

CFC

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QBU1€

QBU2¥

USP has applied1991 proposed regulations toaccount for Sec. 987 gain/lossfor QBU1

CFC hasneveraccountedfor sec. 987gain/loss

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Interaction of Sections 954(c)(6) and 267(a)(3)

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§267(a)(3) Deferred Interest Expense• Interest expense accrued from

FC2 is allocated to non-subpart F income, subject to section 267(a)(3)

• If the deduction for FC2’s interest must be deferred under §267(a)(3) because it has accrued but not yet been paid to FC1, how is CFC2’s interest expense to be allocated for purposes of §954(c)(6)?– If the deduction is allocated to

non-subpart F income and the interest income is not subpart F, then the deduction is deferred under §267(a)(3)

– No guidance in Notice 2007-9

US

FC1 FC2$100 xaccrued interest

$500 xcurrent year

non-Subpart Fincome

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Treaty Update

• Canadian Treaty• More protocols/renegotiations from around

the world

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Canadian Treaty• Effective date• Interest withholding tax

– Immediate elimination for unrelated parties– Phase-out for related parties

• Interest doesn’t include contingent or excess amounts

• Guarantee fees free of withholding tax

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Canadian Treaty (cont’d)

• Services– Individual present more than 182 days in 12

month period• > 50% of income of enterprise in firm services

– Services provided (by whom?) more than 182 days during any 12 month period for the same or connected projects

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Canadian Treaty (cont’d)

• Dispute resolution– Binding arbitration is default, baseball style– Like Germany and Belgium protocols

• LOB– Applies to U.S. and Canada

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Canadian Treaty (cont’d)

• Movement (?) on hybrids– U.S. LLCs viewed as pass-through entities to

that dividends use lower rates– LLCs resident for permanent establishment

purposes?

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Canadian Protocol: New Article IV(7)(b)

• Scenario: USCo carries on business in Canada through ULC where ULC treated as disregarded for U.S. tax purposes

USCo

ULC

Dividend

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Canadian Protocol: Article IV(7)(b) Language

7. An amount of income, profit or gain shall be considered not to be paid to or derived by a person who is a resident of a Contracting State where:

b. The person is considered under the taxation law of the other Contracting State to have received the amount from an entity that is a resident of that other State, but by reason of the entity being treated as fiscally transparent under the laws of the first-mentioned State, the treatment of the amount under the taxation laws of that State is not the same as its treatment would be if that entity were not treated as fiscally transparent under the laws of that State.

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Current TreatyFacts ResultsC has a Canadian PE, Canadian subsidiary, or a Canadian ULC

USCo pays 35% Canadian tax on pre-tax profit• 32% Canadian mainstream tax (federal and provincial)• 3% branch profits/dividend tax on the 68% balance at the 5% treaty rate (reduced from 25% statutory rate)

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Impact of Article IV (7)(b)Facts ResultsC has a Canadian PE or Canadian subsidiary

Same results as under current Treaty

C has a Canadian ULC USCo incurs Canadian tax of 49% rather than 35%, as under the current rules• USCo does not benefit from 5% Treaty rate• Distributions subject to Canadian statutory rate of 25%•USCo incurring additional Canadian tax 17% (25% of 68)

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Recent U.S. Tax Treaties• Belgium – Effective January 1, 2008• Denmark – New Protocol – Effective January 1, 2008• Finland – New Protocol – Effective January 1, 2008• Germany - New Protocol – Generally effective January

1, 2008 (withholding taxes 1 year earlier)• Bulgaria – Treaty and Protocol signed – awaiting

ratification• Iceland - Treaty and Protocol signed – awaiting

ratification• Active negotiations with Hungary and Norway (LOB

provisions coming)

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Withholding Tax Update

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Withholding Tax Issues• Technical Developments

– 1441-3 Proposed Regulations• Total Return Swap Examinations• IRS Audit Activity

– Form 1042 Audit Scope– Domestic Backup Withholding and Reporting

Audits• Partnership Withholding

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Withholding on Redemptions• A cross border redemption distribution can

be treated either giving rise to gain (not subject to withholding) or a dividend (potentially subject to withholding)

• A distribution gives rise to gain if it is:– Not essentially equivalent to a dividend;– Substantially disproportionate; or– In complete redemption of all the

shareholder’s stock

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Withholding on Redemptions (cont’d)• Problem: A withholding agent paying such a

redemption distribution does not have the facts to determine whether it gives rise to gain or a dividend in the hands of a particular shareholder

• Treas. Reg. §1441-3(d)(1) currently provides in such situations that the withholding agent can either withhold in full (never a popular option) or make a “reasonable estimate” of the amount to be withheld and hold such amount in escrow until amount subject to withholding is determined (not easily done and quite a bit of risk if wrong)

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Withholding on Redemptions (cont’d)• Given the uncertainty of what to do under the current

regulations, a taxpayer requested a PLR on how to apply the escrow rule to redemptions. See PLR 200552007

• IRS promised to turn this PLR into a reg• Prop. Reg. §1441-3(c)(5) was published on 11/13/07 and

basically follows the PLR• Applies to redemption distributions after 12/31/08 but

preamble states withholding agents may apply the reg. before that date (many financial institutions have already adopted some variation of the PLR)

• Limited to redemptions of stock for which there is an established financial market

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Withholding on Redemptions (cont’d)• Essentially, withholding agent sets aside 30% of the

distribution and asks shareholder to provide under penalties of perjury a “§302 Payment Certification” within 60 days stating whether the shareholder received a dividend or a payment in exchange for stock

• Only U.S. financial institutions can apply the escrow procedure (not QIs or withholding foreign partnerships/trust)

• Amounts declared by shareholders as dividends or amounts for which no certification received within 60 days are subject to withholding and deposit

• Withholding agent releases escrowed withholding on amounts declared by shareholders to be “gain” transactions

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Total Return Swaps• IRS is concerned with total returns swaps

(“TRS”)• IRS had known that non-U.S. persons

could use TRSs in a manner similar to securities lending transactions to avoid the withholding that otherwise would apply by holding U.S. stocks and securities directly

• IRS avoided regulatory action for fear of destabilizing U.S. swap market

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Total Return Swaps (cont’d)• In the most simplistic terms, if a foreign individual wished

to avoid the withholding tax associated with receipt of a U.S. dividend on its U.S. stock, the individual could sell the stock to a U.S. broker, enter into a TRS with that broker to receive the economic equivalent of that dividend gross of the withholding tax, and then reacquire the stock after the transactionNOTE: There are many variations on this theme, with some

scenarios more problematic for the IRS than others• IRS – and Congress – have made it clear that they have

concerns with TRS structures

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Total Return Swaps (cont’d)• New articles have stated that IRS is examining

U.S. brokers on these transactions to see if they violate U.S. tax laws

• The most likely attack would be on the basis of economic substance if there are pre-arranged agreements to reacquire stock

• IRS may have difficulties attacking structures under current law given clarity of sourcing rules for swaps

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IRS Audit Activity• IRS examinations of TRS structures are only the tip of

the iceberg of IRS audit activity: IRS has publicly stated that it intends to audit ALL Form 1042 filers

• IRS offered a Voluntary Compliance Program (“VCP”) for withholding agents to clean up their withholding problems before being contacted for audit

• VCP ended last June (about 400 submissions)• IRS learned a great deal through these VCP

submissions– Form W-8 errors common– Greater sophistication about financial transactions (e.g., loan

syndications, REITs, swaps, securities lending, etc.)

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IRS Audit Activity (cont’d)• Most importantly, IRS learned that many non-

financial institution multinationals can have significant withholding tax failures– Account payables for services to foreigners (hint:

most U.S. Tax Directors do not even know where their A/P department is located)

– For 8233 failures (“Exemption from Withholding on Compensation for Independent Personal Services of Nonresident Alien Individual”)

– Royalties, dividends, interest, director fees etc.

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IRS Audit Activity (cont’d)• IRS systematically expanding scope of withholding tax audits• Searching its databases for clues to find non-filers• Following up with any Form 1042 filer who did not enter VCP• Checking VCP participants to determine compliance with

remediation plans (VCP was not a free pass as some had hoped)• IRS messages on audits have been consistently tough: strict liability

on documentation; no more leniency with application of the rules; no more generous penalty relief as in VCP

• Are audits of domestic backup withholding and Form 1099 reporting next?– Different compliance concern for the IRS

Many such problems surfaced in course of VCPs– Rules do not allow for retroactive cures

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Partnership Withholding

• If a non-U.S. person is a partner in a partnership doing business in the U.S., the partnership is required to withhold on each non-U.S. partner’s allocable share of Effectively Connected Taxable Income (ECTI)

• Accrual Basis

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Time and Manner of Calculating and Paying

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• Quarterly estimated payments• Prior year losses excluded from the calculation

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Tiered Partnership Structureand Look Through Rules

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• Complex set of rules that allow lower tier partnerships without non-U.S. partners to apply withholding• 1st partnership in the tier with non-U.S. partners has the primary obligation

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Special Rules to Reduce or Eliminate Withholding

• Certificate of partner level items

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