Tax Publications

Subscribe to Tax Publications feed
This is a feed of the latest BDO USA TaxPublications.
Updated: 12 hours 55 min ago

International Tax Alert - June 2016

Wed, 06/01/2016 - 12:00am
China Records Tremendous Progress in Tax Co-operation and Tax Transparency Download PDF Version
Overview On May 16, 2016, the heads of 44 tax administrations met in Beijing for the 10th Meeting of the OECD Forum on Tax Administration (“FTA”).

The Meeting came at a critical time, when tax co-operation and tax transparency have been a high priority for the G20 agenda under the Chinese Presidency, and there are increased expectations of progress.
The Meeting focused on the following three interlocking themes:
  • Effective implementation of the G20/OECD international tax agenda, requiring coordinated action from tax commissioners;
  • Building modern tax administrations that effectively respond to the challenges and opportunities of an increasingly digital world, and integrating it into the way tax commissioners work; and
  • Helping build capacity in tax administration so that all countries, and in particular developing countries, can benefit from the changes in the international tax landscape and better mobilize the resources they need. 
China Signed CBC MCAA 
During the FTA Meeting, China recorded tremendous progress in tax co-operation and tax transparency.

One of the key highlights is that on May 12, 2016, China signed the OECD’s Multilateral Competent Authority Agreement (“CbC MCAA”) for the Automatic Exchange of Country-by-Country (“CbC”) reports, joining a group of 38 other signatories.

China’s signing of the CbC MCAA presents a commitment to localize and implement Action 13 of the G20/OECD BEPS Project. China-based multinational companies (“MNCs”) with significant global revenues will be required to file CbC reports, in which high level information of the group and the affiliates should be disclosed on a tax jurisdiction-basis. In addition, China shall be granted the right to access and analyze CbC reports filed by foreign-based MNCs that have operations in China.

According to the discussion draft of “Implementation Measures of Special Tax Adjustment” (“Discussion Draft”) released on September 17, 2015, taxpayers that meet one of the following conditions shall prepare a CbC report form of the “Annual Reporting Forms for Related-Party Transactions”:
  • The taxpayer is the ultimate holding entity in the group, and its group consolidated revenues for the previous fiscal year exceed RMB 5 billion;
  • The ultimate holding entity of the taxpayer is outside China, but the taxpayer is assigned by the group as the reporting entity for the CbC report form.
Though the Discussion Draft is not yet finalized, it presents China’s tax authority’s positions on CbC reporting, which may give some preliminary guidance for MNCs to prepare in advance.

Signing of the CbC MCAA will expedite the release of China’s domestic regulations on CbC reporting.

A separate circular concerning related-party disclosures and transfer pricing contemporaneous documentation is expected to be issued by the end of May.

CBC Reporting Requirements 
In CbC reports, MNCs are required to report the following information on a CbC basis, aggregating information from all group entities (including permanent establishments) in each tax jurisdiction:
  • Revenues from unrelated parties;
  • Revenues from related parties;
  • Profit or loss before income tax;
  • Income tax paid (on a cash basis);
  • Income tax accrued (current year);
  • Stated capital;
  • Accumulated earnings;
  • Number of employees; and
  • Tangible assets (other than cash and equivalents).
In addition, MNCs will need to disclose the characterization of each entity in each jurisdiction and its business activities (e.g., manufacturing, sales, distribution, R&D, services, etc.).

Other Progress in International Tax Co-Operation 
During the FTA Meeting, China had concluded a series of achievements in international tax co-operation:
  • Signing the Memorandum of Bilateral Tax Co-operation with the Canada Revenue Agency;
  • Signing the Memorandum of Bilateral Tax Co-operation with Internal Revenue Service of USA;
  • Together with the Canada Revenue Agency, putting forward a number of initiatives for building capacity in tax administration;
  • Communicating with BRICS countries on in-depth tax co-operation.
Considerations
China-based and foreign MNCs are advised to pay close attention to upcoming updates on CbC reporting implementation in China.

Key considerations include:
  • Higher requirements for tax compliance and risk control capacity on MNCs’ global business;
  • Whether the current information systems of an affected taxpayer could support the compliance work;
  • How to build an appropriate procedure to collect data and information;
  • Assessments that should be made as to which accounting standards should be employed to report the required information, i.e., choosing among parent country GAAP, IFRS or local country GAAP; and
  • How to fit CbC reporting within the group’s broader transfer pricing planning and compliance frameworks.
​ ​Should the above topics affect your current situation, or should you require further information, please do not hesitate to contact the following practice leaders:
  Gordon Gao
+86 21 6313 8751
gordon.g@bdo.com.cn Jay Tang
+86 21 6313 9352 * 816
jay.t@bdo.com.cn 

BDO China SHU LUN PAN Certified Public Accountants LLP, a Chinese LLP company, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms.
 

BDO Transfer Pricing Alert - June 2016

Wed, 06/01/2016 - 12:00am
The Proposed Section 385 Regulations Impact On Certain Transfer Pricing Arrangements
Download PDF Version
Summary On April 4, 2016, the Internal Revenue Service (the “Service”) and the U.S. Department of the Treasury (“Treasury”) proposed new regulations under Section 385 of the Internal Revenue Code (“proposed regulations”), which address the recharacterization of certain related party debt transactions issued on or after April 4, 2016, as equity.  The proposed regulations apply to both inbound and outbound debt financing transactions between U.S. taxpayers and their foreign affiliates, as well as transactions among foreign affiliates.  The proposed regulations were released without advanced notice and will come into effect 90 days after they have been finalized.  For an in-depth discussion of the changes to debt and equity classifications, please refer to the following article. This article seeks to address the transfer pricing considerations arising from the contemporaneous requirements as contemplated in the proposed 385 regulations. Due to the immediate application date of proposed regulations, taxpayers should be aware of the impact these requirements may have on their current and future intercompany financing arrangements.  
Details On April 4, 2016, the Service and Treasury released their proposed regulations that address the treatment of interest in a related party financing transaction as debt, equity, or a combination of the two, in what appears to be an effort to limit the effectiveness of certain tax planning structures using related party debt.  The proposed regulations will apply to inbound and outbound transactions between U.S. taxpayers and their foreign affiliates, as well as outbound transactions among non-U.S. affiliates of a U.S. parent corporation.  Thus, the proposed regulations pose a significant impact to transfer pricing transactions subject to Section 482 of the Internal Revenue Code.  In particular, the proposed changes will impact traditional cross-border financing arrangements, such as cash pooling and intercompany loans, and will require rigorous contemporaneous documentation requirements for large taxpayer groups.

Contemporaneous Documentation Requirements

Section 1.385-2 of the proposed regulations implements contemporaneous documentation requirements for large taxpayer groups to substantiate their related party debt arrangements.  Under the proposed regulations, large taxpayer groups (i.e., those that contain at least one group member that is traded on a public exchange, have total assets exceeding $100 million, or have annual revenue that exceeds $50 million) must prepare and maintain certain documentation and information within 30 calendar days after the date (i) that the debt instrument becomes an expanded group indebtedness (“EGI”) or (ii) that an expanded group member becomes an issuer with respect to an EGI, each reflecting an essential characteristic of indebtedness for federal tax purposes.  The required documentation falls under the following categories:  (i) a binding obligation to repay the funds advanced, (ii) creditor's rights to enforce the terms of the EGI, and (iii) a reasonable expectation that the advanced funds can be repaid. 

The first two categories must be prepared in the form of a legally binding written agreement.  The requirement for indebtedness is a binding legal obligation to repay the funds advanced, prepared within 30 days of the indebtedness.  This written agreement must also establish that the creditor/holder of debt has the right to enforce certain terms of the agreement, such as the right to trigger a default or to accelerate payments.  The seniority of the loan should also be clearly defined as superior to that of shareholders.  

Under the third category, the taxpayer must provide timely-prepared documentation evidencing a reasonable expectation that the issuer could in fact repay the amount of a purported loan. The proposed regulations give examples of such documentation, including cash flow projections, financial statements, business forecasts, asset appraisals, determination of debt-to-equity, and other relevant financial ratios of the issuer.  In determining a taxpayer’s expectation of repayment, the proposed regulations do not provide much clarity as to how this is established aside from comparisons to industry averages.  In typical related party situations, the standard to be applied when determining the true taxable income of a related party taxpayer is defined in the Section 1.482 regulations.  Contrary to a typical intercompany debt transaction, the issue these documentation requirements seek to address is not whether the interest rate on the loan is arm’s length.  Rather, these documentation requirements aim to answer the question: Is the debt assumed by the issuer bona fide, in that the issuer can support and service the debt adequately? 

The level of debt supportable and serviceable by the issuer should in essence be arm’s length, since it will have an impact in determining the true taxable income of a controlled taxpayer.  The regulations under Section 1.482-1 specifically require that the arm’s-length standard be applied in these situations.  The level of debt an issuer can support and service should be evaluated based on financial data obtained from comparable third party companies (or transactions) under similar circumstances.  Thus, the application of the Section 1.482 regulations are necessary to demonstrate an arm’s-length level of debt capacity and debt serviceability of the issuer and satisfy the documentation criteria around an issuer’s reasonable expectation of repayment.

A fourth category of documentation must be produced 120 calendar days after the indebtedness arose that evidences a genuine debtor-creditor relationship.  This documentation must evidence that the issuer made timely interest or principal payments with respect to the EGI.  Such documentation might include a wire transfer record or a bank statement that reflects the payment.  Should the recipient default, or a similar event occurs, there must be timely written documentation that demonstrates the issuer has exercised the reasonable judgment and diligence as would a third-party creditor.

Despite satisfying these requirements, the proposed regulations leave open the chance for a related party debt instrument to be recharacterized as these requirements are not determinative.  Rather, these documentation requirements act as a threshold test for allowing the possibility of a related party instrument to be treated as debt.  If the contemporaneous documentation requirements are not satisfied, the related party debt instrument will be recharacterized as stock, and any federal tax benefit, with respect to the treatment of interest, claimed by the issuer would be disallowed.
BDO Insights
  • The proposed regulations will likely impact traditional debt instruments as well as other forms of debt such as revolving credit facilities, cash pooling, guarantee fees, and similar situations.
  • Large taxpayer groups are required to have contemporaneous documentation that identifies the rights, obligations, and intent of the parties engaged in a related party debt arrangement.  This documentation must be prepared within 30 calendar days that the debt instrument becomes an EGI or that an expanded group member becomes an issuer with respect to an EGI.  Further, documentation must be produced that evidences a genuine debtor-creditor relationship no later than 120 days after the indebtedness arises.  It is critical that taxpayers take the April 4, 2016, effective date into consideration regarding their intercompany financing arrangements.
  • The regulations under Section 482 provide the guidance necessary to adequately demonstrate an issuer’s reasonable expectation of repayment. 

For more information, please contact one of the following practice leaders:
 

Robert Pedersen
Partner and International Tax/Transfer Practice Leader

 

Veena Parrikar
Prinicipal, Transfer Pricing

 

Joe Calianno
Partner and International Technical
Tax Leader, Washington National Tax Office

 

Brad Rode
Partner

  Michiko Hamada
Senior Director, Transfer Pricing  

William F. Roth III
Partner, Washington National Tax Office

  Scott Hendon
Partner  

Jerry Seade
Principal

 
Kirk Hesser
Senior Director, Transfer Pricing  
Sean Caren
Senior Manager  
Chip Morgan
Partner  
Sean Dokko
Senior Manager   Monika Loving 
Partner    

State and Local Tax Alert - June 2016

Wed, 06/01/2016 - 12:00am
North Carolina Enacts Legislation Impacting Intangible Holding Companies Download PDF Version
Summary On May 11, 2016, North Carolina Governor Pat McCory (R) signed S.B. 729, which, for taxable years beginning after December 31, 2015, decreases the Corporation Income Tax related member interest expense deduction from 30 percent to 15 percent, and effectively establishes a conduit exception.  S.B. 729 also requires a taxpayer that receives a royalty payment from a related member to include the receipt in the sales factor even if the payer and the recipient elects to exclude the payment from the recipient’s income. 
  Details Related Member Interest Expense Deduction
Prior to the enactment of S.B. 729, under H.B. 97, which was enacted September 18, 2015, the related party interest expense deduction was simply limited to 30 percent of the taxpayer’s taxable income.  Under S.B. 729, the amount of related party interest expense is limited to the greater of: (i) 15 percent of the taxpayer’s taxable income; or (ii) the taxpayer’s proportionate share of interest paid or accrued to a person who is not a related member during the same taxable year.  As noted, this provision is effective for taxable years beginning after December 31, 2015.

Conduit Exception 
Under S.B. 729, proportionate share of interest for purposes of the related member interest expense deduction limitation is defined to mean the amount of the taxpayer's net interest expense paid to (or through to) a related member that pays the interest to an unrelated member, divided by the total net interest expense of all related members that is paid to (or through to) the same related member that pays the interest to an unrelated member, multiplied by the interest paid to an unrelated member by the related member that pays the interest to an unrelated member.  Thus, the proportionate share of interest limitation effectively creates a conduit exception where the related member interest expense exceeds the 15-percent limitation, and payment of the related member interest can be traced to an unrelated member.

Sales Factor
Where a taxpayer elects to add-back a deduction for related party royalty expense and exclude the related income from the recipient (i.e., in lieu of taking the deduction and including the payment in the income of the recipient), under S.B. 729, the recipient may not exclude the royalty payments from its calculation of sales under S.B. 729.  This provision is effective May 11, 2016.
BDO Insights
  • While a reduction in the related member interest expense deduction limitation to 15 percent may adversely affect some taxpayers, taxpayers who can trace payment of the interest expense to an unrelated member may find the law change more beneficial.
  • The provision related to the requirement to include related party royalty payments in the sales factor, even where the income itself is excluded from the tax base, appears to be a codification of existing Department policy.
  • Since the new law was enacted on May 11, 2016, North Carolina Corporation Income Tax taxpayers should assess what, if any, impact these law changes may have on their existing deferred tax balances, and adjust accordingly as of the enactment date.
 

For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Senior Director
  Paul McGovern
Tax Senior Director   Jonathan Liss
Tax Senior Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Senior Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Senior Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Senior Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Senior Director   Richard Spengler
Tax Senior Director       Southwest:     Gene Heatly
Tax Senior Director
      Tom Smith
Tax Partner

International Tax Newsletter - May 2016

Tue, 05/31/2016 - 12:00am
The Indian Tiffin VIII - from BDO India    The latest Indian Tiffin issue (VIII) covers:
  • Indian Economic Update - An overview of the budget; significant announcements and reforms likely to impact economic performance
  • M&A Tracker – Between February and April 2016, around 172 M&A deals were announced / completed aggregating to approx. $7.76 billion; dominated by domestic deals (110) followed by cross border deals. Read the full newsletter for more information.
  • Feature Story – “Getting Ready to Go Public” by Rajesh Thakkar, Partner, Transaction Advisory Services.
  • Guest Column – “Winning Economics – from the London Stock Exchange” by Nikhil Rathi, CEO, London Stock Exchange plc and Director of International Development, London Stock Exchange Group. 

Download

Federal Tax Alert - May 2016

Tue, 05/31/2016 - 12:00am
IRS Introduces Three New Automatic Method Changes and Provides Modified Procedures
Download PDF Version
Summary On May 5, 2016, the Internal Revenue Service (“IRS” or “Service”) issued Revenue Procedure 2016-29 to update the list of automatic changes in methods of accounting as applied under Rev. Proc. 2015-13.  In addition to adding three new automatic accounting method changes, the Rev. Proc. modifies certain existing automatic method changes, extends the waiver of certain eligibility waivers, and provides limited transition rules. 
 
For federal income tax purposes, once a taxpayer has adopted or established a method of accounting, that method, whether proper or improper, must continue to be used until the taxpayer files a Form 3115, Application for Change in Accounting Method, to secure the Service’s consent to change to a different method.  There are more than two hundred automatic method changes listed in Rev. Proc. 2016-29; taxpayers should carefully review the changes to identify any opportunities to file automatic Form 3115 requests to secure IRS consent to change to the most optimal method of accounting in order to reduce taxable income and increase cash tax savings. 
 
Rev. Proc. 2016-29 generally supersedes Rev. Proc. 2015-14, and is effective for automatic accounting method change requests filed on or after May 5, 2016, for a taxable year of change ending on or after September 30, 2015.  In light of the immediate effective date of this revenue procedure, all Form 3115 requests filed under the automatic procedures set forth in Rev. Proc. 2015-13 must now be filed pursuant to this new procedure. 
  New Automatic Method Changes Rev. Proc. 2016-29 contains a list of over two hundred automatic method changes.  In general, if the method change is identified as automatic by the Service, the Form 3115 request is subject to lower IRS scrutiny (i.e., the taxpayer is deemed to have “automatic consent” to change to the new method of accounting), there is no user fee, and the deadline for filing the request is extended.  If a method change is not identified as automatic by the Service, or the taxpayer did not meet an eligibility requirement under Rev. Proc. 2015-13, the taxpayer is required to file a non-automatic Form 3115.  A non-automatic change is subject to greater IRS scrutiny, requires an IRS user fee, and must be filed no later than the last day of the year of change.  A favorable development in Rev. Proc. 2016-29 is the addition of three new automatic method change procedures relating to the following Internal Revenue Code sections:
 
  • Start-up expenditures under Section 195 (Automatic Change #223): This new automatic procedure applies to a change in the characterization of an item as a start-up expenditure, or a change in the determination of the taxable year in which the taxpayer’s active trade or business to which the start-up expenditures relate begins. 
  • Interest capitalization under Section 263A (Automatic Change #224): This new automatic procedure applies to a change in which interest is capitalized with respect to the product of designated property, when previously no such interest was capitalized, or such interest was not capitalized in accordance with its book method of accounting, in accordance with sections 1.263A-8 through 14 of the Income Tax Regulations. 
  • Certain changes within the retail inventory method under Section 471 (Automatic Change #225): This new automatic procedure applies to a taxpayer using the retail inventory method and is changing from including to not including temporary markups and markdowns in determining the retail selling prices of goods on hand at the end of the taxable year. 

Modifications to Existing Method Changes Rev. Proc. 2016-29 sets forth significant changes, among others, to existing automatic method changes. 
 
The Service provides that the following method changes must now be made under the non-automatic change procedures of Rev. Proc. 2015-13: 
 
  • Change from impermissible to permissible methods of depreciation or amortization to any property for which a taxpayer has claimed a federal income tax credit such as the rehabilitation credit under section 47.  
  • Change from capitalizing to deducting amounts paid or incurred for repair and maintenance costs for which the taxpayer has claimed a federal income tax credit or elected to apply section 168(k)(4).       
  • Change to the percentage-of-completion method for long-term contracts under section 460. 

Additionally, the Service made modifications to the automatic changes in connection with the remodel-refresh safe harbor guidance for restaurants and retailers described in Rev. Proc. 2015-56.  Notably, the automatic change #221 under section 6.20 of Rev. Proc. 2016-29 has been modified to provide that the revocation of a partial disposition election under the safe harbor must be made, and certain eligibility rules in Rev. Proc. 2015-13 do not apply, for any tax year beginning after December 31, 2013, and ending before December 31, 2016.  Previously, this revocation had to be made and the eligibility rules did not apply for the first or second tax year beginning after December 31, 2013.  Similarly, the Service modified automatic change #222 under section 11.10 of Rev. Proc. 2016-29 to provide that certain eligibility rules in Rev. Proc. 2015-13 do not apply for any tax year beginning after December 31, 2013, and ending before December 31, 2016.
  Extension of Eligibility Waiver Normally, taxpayers are not permitted to make an automatic method change if they made a change to the same item within the previous five tax years, among other things.  This eligibility requirement was previously waived under Rev. Proc. 2015-13 for changes that implemented the tangible property regulations for any tax year beginning before January 1, 2015.  This waiver has now been extended by Rev. Proc. 2016-29 to any tax year beginning before January 1, 2016. 
  Effective Date and Limited Transition Relief Rev. Proc. 2016-29 is effective for automatic accounting method change requests filed on or after May 5, 2016, for a taxable year of change ending on or after September 30, 2015. 
 
Rev. Proc. 2016-29 provides transition rules for Form 3115 requests that were previously filed under the non-automatic method change procedures where the applicable method change is now an automatic method change.  If the non-automatic Form 3115 was filed prior to May 5, 2016 under Rev. Proc. 2015-13 and remains pending with the IRS National Office as of that date, the taxpayer may notify the Service to convert the application into an automatic change.
 
In addition, Rev. Proc. 2016-29 eliminated certain automatic method changes previously available under the now-superseded Rev. Proc. 2015-14.  By default, such method changes must now be filed under the non-automatic change procedures of Rev. Proc. 2015-13.  If the taxpayer properly filed the original or the duplicate copy of a Form 3115 under the prior automatic change procedures before May 5, 2016, that method change remains automatic.  However, if the taxpayer did not properly file the original or the duplicate copy of such Form 3115, that method change must be filed non-automatically. 
  BDO Insights
  • Automatic Form 3115 requests filed after May 5, 2016 for a taxable year of change ending before September 30, 2015, may be filed under Rev. Proc. 2015-14.  However, if the taxable year of change ends on or after September 30, 2015, taxpayers are required to adhere to the updated procedures of Rev. Proc. 2016-29 when preparing automatic Form 3115 applications.  It is important to note that certain section numbers have been modified as a result of Rev. Proc. 2016-29. For example, the automatic change #23 for section 263A, or uniform capitalization for producers and reseller-producers, which was previously filed under section 11.02 of Rev. Proc. 2015-14, has been renumbered as section 12.02 of Rev. Proc. 2016-29.
  • Over time, as more and more automatic method changes are instituted, it is expected that the Service will periodically issue a new automatic change Revenue Procedure to provide the latest list of changes. 

For more information, please contact one of the following practice leaders:
 

Travis Butler
Senior Director

 

Yuan Chou
Senior Director

 

Nathan Clark
Senior Director

 

Dave Hammond
Partner

 

Marla Miller
Senior Director

   

BEPS Ireland Profile

Fri, 05/27/2016 - 12:00am



1) Has Ireland implemented any BEPS recommendations? If so, which Action Items? 
Yes, country-by-country reporting is applicable with effect from January 1, 2016.
 
2) What is Ireland’s expected timeline for implementing country-by-country reporting? 
Country-by-country reporting is applicable with effect from January 1, 2016.
 
3) If Ireland has already implemented CbC, what has been the reaction from taxpayers? 
There has been no negative reaction so far.  In a number of cases, taxpayers have publicly welcomed the greater transparency brought about by country-by-country reporting.
 
4) What measures are multinationals in Ireland taking to prepare for country-by-country reporting?  
Country-by-country reporting is only applicable to large groups headquartered in Ireland.  Compared to larger jurisdictions, the pool of impacted multinationals in Ireland is relatively small.
 
5) If Ireland has already implemented CbC, what challenges are taxpayers facing or anticipated to face? 
From industry discussion, we understand that the primary challenge is accessing and collating data globally. In Ireland, there are some questions around the repercussions of the U.S. not implementing country-by-country reporting in 2016.  Furthermore, if the U.S. elects an Irish subsidiary as a deemed parent for one year, there are questions surrounding whether the Irish subsidiary can then access information globally, or it can require other subsidiaries to provide it with information.
 
6) Are Ireland’s taxing authorities taking any measures to prepare for any changes brought about by BEPS (e.g., changes in staffing, increases in budgets)? 
The Irish tax authorities are increasing transfer pricing resources and hiring more employees from industry. They are also hiring tech/IT personnel to increase data analytics resources.
 
7) How will country-by-country reporting affect how you provide services to your clients? 
Since BDO Ireland does not have its own transfer pricing resources, country-by-country reporting will increase the scope for BDO Ireland to seek a firm within the BDO network with a larger transfer pricing practice.

International Tax Alert - May 2016

Fri, 05/27/2016 - 12:00am
The UK Government Releases Consultation on Policy Design and Implementation of Corporate Interest Deductibility Legislation Download PDF Version
Summary On May 12, 2016, the UK government released a detailed consultation document in respect of its proposed implementation of the G20/OECD Base Erosion and Profit Shifting (“BEPS”) Final Report on Action Item 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments (“BEPS Action Item 4”). The UK government had previously announced its intention to introduce a restriction on the tax deductibility of corporate interest consistent with the recommendations in BEPS Action Item 4.  Responses to the consultation are requested from stakeholders by August 4, 2016, after which the draft legislation is expected to be issued in November 2016 for final consultation, prior to enactment with effect from April 1, 2017.
Details The UK will introduce a restriction on the tax deductibility of corporate interest that is consistent with the recommendations in BEPS Action Item 4, which will take effect on April 1, 2017.  The following offers an overview of the proposed changes, including the fixed ratio rule, the group ratio rule, the repeal of the worldwide debt cap, and a de minimis allowance.
 
Fixed ratio rule
A fixed ratio rule will be introduced that limits corporation tax deductions for net interest expense to 30 percent of taxable earnings before interest, tax, depreciation and amortization (“EBITDA”).  This applies to third party and related party net interest expense, and is tested on an aggregate UK group basis (including UK permanent establishments).
 
Net interest expense of a UK group is comprised of loan relationship debits and credits; debits and credits arising from derivative contracts; finance income/costs arising from certain leases; debt factoring income and costs; guarantee fees paid/received; and income or expenses under certain service concession arrangements treated as finance assets or liabilities.  The amounts subject to the cap are the taxable amounts after the application of other UK rules that relate to financing income and expenses, including transfer pricing, unallowable purpose and anti-hybrid restrictions.

EBITDA for the fixed ratio calculation will be measured by reference to amounts taxable and deductible for corporation tax purposes i.e., profits chargeable to corporation tax excluding net interest, tax depreciation (capital allowances), tax amortization, relief for losses of other taxable periods and group relief (loss sharing).
Any net interest in excess of the 30 percent cap will not be deductible in the testing period, and the group decides how much restricted interest to allocate to each UK group company.  Such restricted interest will be carried forward indefinitely and treated as interest expense of future periods where it should be deductible subject to sufficient capacity.

Any excess capacity can also be carried forward to future periods, but this carry forward is restricted to three years, after which the excess capacity expires.
 
Group ratio rule
It is recognized that some groups have relatively high borrowing levels for sound commercial reasons and in those cases, a 30 percent limitation may not allow full relief for third-party interest expense.  Therefore, an optional group ratio rule based on the net interest to EBITDA ratio for the worldwide group will also be implemented. 

The group ratio is defined as net qualifying interest expense over group EBITDA and will be calculated using, broadly, accounting numbers for the worldwide group.  The resulting ratio will be applied to the same tax EBITDA that is used for the fixed ratio limitation calculation to ascertain allowable net interest. 
 
Repeal of world-wide debt cap
The current worldwide debt cap rules will be repealed, but rules with a similar effect will be integrated into the new interest restriction rules.  In general, the application of this modified debt cap rule will mean that a group’s net interest deduction in the United Kingdom cannot exceed the consolidated worldwide group’s net interest expense.
 
De minimis
A de minimis allowance of GBP 2 million per annum is included in the rules.  This means that all UK groups should be able to deduct up to GBP 2 million of net interest expense, regardless of the outcome of the application of the fixed or group ratio rules, and the application of the modified debt cap rule. 
BDO Insights
  • While the consultation document sets out the United Kingdom’s proposals in terms of the detailed design of the proposed legislation implementing BEPS Action Item 4, further work is required around some of the detailed mechanics of the rules and application to certain specific regimes.  In particular, the UK government continues to consult further on the application of the proposed rules to profits arising from the Oil and Gas Ring Fence Corporation Tax regime and the banking and insurance sectors.  The expectation is that draft legislation will be issued in November 2016 for final consultation, prior to enactment with effect from April 1, 2017.
  • Groups currently deducting interest expenses in the United Kingdom should consider the potential impact of the proposed rules now to ensure that they understand any impact on the group’s effective tax rate.
  • For further information or a discussion about the impact of the proposed new rules on your particular circumstances, please contact Ingrid Gardner or your usual BDO tax advisor.
 
For more information, please contact one of the following practice leaders:
  Robert Pedersen
Partner and International Tax Practice Leader           Joe Calianno
Partner and International Technical Tax Practice Leader, National Tax Office   Ingrid Gardner
Managing Director UK/US Tax Desk   Scott Hendon
Partner    Veena Parrikar
Principal, Transfer Pricing   Chip Morgan
Partner    Monika Loving
Partner    Brad Rode
Partner    William F. Roth III
Partner, National Tax Office   Jerry Seade
Principal 

International Tax Alert - May 2016

Thu, 05/26/2016 - 12:00am
IRS Proposes Regulations Requiring New Reporting Requirements under Internal Revenue Code (“IRC”) Section 6038A for Foreign-Owned Domestic Disregarded Entities Download PDF Version
Summary On May 6, 2016, the Internal Revenue Service (“IRS”) and Treasury issued proposed regulations (“Proposed Regulations”) that would amend Treas. Reg. §301.7701-2(c) to treat a domestic disregarded entity that is wholly owned by one foreign person as a domestic corporation separate from its owner, for the limited purposes of the reporting and record maintenance requirements (including the associated procedural compliance requirements) under section 6038A. As with the existing special rules for employment and excise taxes, the Proposed Regulations would not alter the framework of the existing entity classification regulations, including the treatment of certain entities as disregarded. Such regulations are intended to provide the IRS with improved access to information that it needs to satisfy its obligations under U.S. tax treaties, tax information exchange agreements and similar international agreements, as well as to strengthen the enforcement of United States tax laws.
Timing The Proposed Regulations would apply to taxable years ending on or after the date that is 12 months after the date these regulations are published as final regulations in the Federal Register.
Details Reporting and maintenance requirements
The Proposed Regulations would treat the affected domestic entities as foreign-owned domestic corporations for the specific purposes of IRC section 6038A, and because such entities are foreign owned, they would be reporting corporations within the meaning of IRC 6038A. Consequently, they would be required to file Form 5472, an information return with respect to reportable transactions between the entity and its foreign owner or other foreign related parties (transactions that would have been regarded under general U.S. tax principles if the entity had been, in fact, a corporation for U.S. tax purposes), and would also be required to maintain records sufficient to establish the accuracy of the information return and the correct U.S. tax treatment of such transactions. In addition, because these entities would have a filing obligation, they would be required under the Proposed Regulations to obtain an EIN by filing a Form SS-4 that includes responsible party information.

The Proposed Regulations would specify that as an additional reportable category of transaction for these purposes any transaction within the meaning of Treas. Reg.  §1.482-1(i)(7) (with such entities being treated as separate taxpayers for the purpose of identifying transactions and being subject to requirements under IRC section 6038A) to the extent not already covered by another reportable category. The term “transaction” is defined in Treas. Reg. §1.482-1(i)(7) to include any sale, assignment, lease, license, loan, advance, contribution, or other transfer of any interest in or a right to use any property or money, as well as the performance of any services for the benefit of, or on behalf of, another taxpayer. For example, under the Proposed Regulations, contributions and distributions would be considered reportable transactions with respect to such entities. Accordingly, a transaction between such an entity and its foreign owner (or another disregarded entity of the same owner) would be considered a reportable transaction for purposes of the IRC section 6038A reporting and record maintenance requirements, even though, because it involves a disregarded entity, it generally would not be considered a transaction for other purposes, such as making an adjustment under IRC section 482. The penalty provisions associated with failure to file the Form 5472 and failure to maintain records would apply to these entities as well.

Moreover, the Proposed Regulations would also provide that the exceptions to the record maintenance requirements that are currently contained in Treas. Reg. §1.6038A-1(h) and (i) for small corporations and de minimis transactions will not apply to these entities.

The Proposed Regulations would impose a filing obligation on a foreign-owned disregarded entity for reportable transactions it engages in, even if its foreign owner already has an obligation to report the income resulting from those transactions—for example, transactions resulting in income effectively connected with the conduct of a U.S. trade or business.

In the preamble, the IRS also indicated that it is also considering modifications to corporate, partnership, and other tax or information returns (or their instructions) to require the filer of these returns to identify all the foreign and domestic disregarded entities it owns.
BDO Insights These Proposed Regulations would expand the reporting that is required under IRC section 6038A. Such enhanced reporting required by these Proposed Regulations should not come as a surprise, especially given the expanded reporting in other areas and the general theme of greater transparency and documentation that has been seen in recent years (e.g., BEPS and FATCA).  Please contact a BDO international tax specialist to assist you in reviewing how these Proposed Regulations may impact your Company’s reporting requirements.

 
For more information, please contact one of the following practice leaders:
 

Robert Pedersen
International Tax Practice Leader

 

William F. Roth III
Partner

 

Scott Hendon
Partner

 

Jerry Seade
Principal

  Monika Loving 
Partner  

Joe Calianno
Partner and International Technical
Tax Practice Leader

  Brad Rode
Partner  

Chip Morgan
Partner

     

State and Local Tax Alert - May 2016

Tue, 05/24/2016 - 12:00am
Mississippi Enacts Franchise Tax Phase-out and Minimum Taxable Capital Threshold Download PDF Version
Summary On May 13, 2016, Mississippi Governor Phil Bryant (R) signed into law S.B. 2858, which enacts a phase-out of the Corporation Franchise Tax via a gradual rate reduction starting with taxable years beginning in 2019 and ending with taxable years beginning in 2027.  S.B. 2858 also implements a $100,000 minimum taxable capital threshold starting with taxable years beginning on or after January 1, 2018.
  Details Franchise Tax Phase-Out
The current Corporation Franchise Tax rate is $2.50 for each $1,000 of taxable capital.  Under S.B. 2858, the Corporation Franchise Tax rate is scheduled to phase-out as follows. 
  Taxable Year Beginning on
or After
Rate Imposed January 1, 2019 $2.25 for each $1,000 of taxable capital January 1, 2020 $2.00 for each $1,000 of taxable capital January 1, 2021 $1.75 for each $1,000 of taxable capital January 1, 2022 $1.50 for each $1,000 of taxable capital January 1, 2023 $1.25 for each $1,000 of taxable capital January 1, 2024 $1.00 for each $1,000 of taxable capital January 1, 2025 $0.75 for each $1,000 of taxable capital January 1, 2026 $0.50 for each $1,000 of taxable capital January 1, 2027 $0.25 for each $1,000 of taxable capital    
Minimum Taxable Capital Requirement
Starting with taxable years beginning on or after January 1, 2018, Mississippi will impose the Corporation Franchise Tax only on taxable capital in excess of $100,000.  The $25 minimum tax applies, regardless.
  BDO Insights
  • It appears that Mississippi is following Pennsylvania’s lead, which phased-out its Capital Stock/Foreign Franchise Tax through a gradual rate reduction as of taxable years beginning after December 31, 2015.  Hopefully, Mississippi will not also periodically delay the phase-out of its franchise tax.
  • Since the new law was enacted on May 13, 2016, Mississippi Corporation Franchise Tax taxpayers should assess what, if any, impact these law changes may have on their existing contingent liability balances, and adjust accordingly as of the enactment date.
 

For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Senior Director
  Paul McGovern
Tax Senior Director   Jonathan Liss
Tax Senior Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Senior Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Senior Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Senior Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Senior Director   Richard Spengler
Tax Senior Director       Southwest:     Gene Heatly
Tax Senior Director
      Tom Smith
Tax Partner

Unclaimed Property Alert - May 2016

Thu, 05/12/2016 - 12:00am
Florida Expands the Authority of the Department to Estimate Unclaimed Property and Changes Domicile of an Unincoprorated Business  
Download PDF Version
Summary On March 24, 2016, Florida Governor Rick Scott (R) signed into law H.B. 783, which authorizes the Department of Financial Services to estimate unclaimed property where a holder fails to provide requested documents, changes the definition of domicile to mean the state of organization in the case of an unincorporated business association, and specifically includes limited liability company and an association of two or more individuals in the definition of business association.  These changes go into effect July 1, 2016.
  Details Authority to Estimate Unclaimed Property
Prior to the enactment of H.B. 783, Florida law limited the Department’s authority to estimate the unclaimed property of a holder in the event the holder’s available records are insufficient to prepare an unclaimed property report.  Effective July 1, 2016, the Department may also estimate unclaimed property where the holder fails to provide requested records.
 
Domicile of Unincorporated Association
Prior to the enactment of H.B. 783, Florida law defined “domicile” for an unincorporated business association to mean the principal place of business.  Effective July 1, 2016, the definition means the state where the business association is organized.
 
Definition of Business Association
Prior to the enactment of H.B. 783, Florida law defined business association to include only a corporation, joint stock company, investment company, business trust, partnership, or association.  Effective July 1, 2016, the definition specifically includes a limited liability company, and an association of two or more individuals.
  BDO Insights
  • Florida expanded the authority of the Department to estimate and issue unclaimed property assessments to a holder that chooses not to comply with the Department’s request for records.  This could embolden the Department to be more aggressive, in terms of quantity and quality, with respect to its unclaimed property audit efforts.
  • Unincorporated holders will need to remember that, effective July 1, 2016, unclaimed property should be reported to Florida only if the owner’s last known address is in Florida, or if the holder was formed under Florida law (i.e., not if the holder’s principal place of business is in the state).  This law change should make ascertaining domicile easier and more certain.
 
Should you have any questions, please contact Joseph Carr, Partner & National Unclaimed Property Practice Leader at (312) 616-3946 or jcarr@bdo.com
 

Compensation & Benefits Alert - May 2016

Thu, 05/12/2016 - 12:00am
IRS Clarifies Employment Tax Treatment for Partners in a Partnership Owning Disregarded Entities Download PDF Version
Summary On May 3, 2016, the Internal Revenue Service (“IRS”) issued temporary regulations, Section 301.7701-2T, that clarify the employment tax treatment of partners in a partnership that owns a disregarded entity.  The temporary regulations state that if a partnership is the owner of the disregarded entity, the disregarded entity is not treated as a corporation for purposes of employing a partner of the partnership.  Thus, a partner of a partnership that owns a disregarded entity is subject to the same self-employment tax rules as a partner of a partnership that does not own a disregarded entity. 

While the implications for partners that were being treated as employees for payroll taxes are obvious (i.e., they must be treated as self-employed for income tax and FICA purposes), there may also be implications related to participation in certain tax-favored employee benefit programs, such as cafeteria plans, health insurance benefits, and qualified plans.

In order to allow adequate time for partnerships to make appropriate adjustments to payroll and employee benefit plans, these temporary regulations will apply on the later of: (1) August 1, 2016; or (2) the first day of the latest starting plan year following May 4, 2016, of an affected plan sponsored by an entity that is disregarded as an entity separate from its owner.
Details Background
Prior to 2009, disregarded entities (e.g. a single member limited liability company) were not responsible for filing and paying employment taxes.  Accordingly, until 2009, the employment tax reporting, withholding, and remittance obligations were performed on behalf of most disregarded entities under the name and employer identification number (“EIN”) of their single-member owner.

The entity classification regulations were revised, effective January 1, 2009, to provide that a single-member entity that was disregarded for federal income tax purposes by default, would be deemed to have elected to be treated as a corporation for the purposes of federal employment taxes imposed under Subtitle C of the Internal Revenue Code (“Code”).   As a result, the disregarded entity, rather than the single-member owner, is now considered the employer of the disregarded entity’s employees, and is primarily responsible for filing and paying employment taxes imposed by Subtitle C of the Code.2  The new temporary regulations explain that this change to the entity classification regulations was only for the purpose of employment taxes and certain excise taxes, and did not affect the prohibition under the partnership or self-employment tax rules against owners participating in certain tax-favored employee benefits plans (e.g. qualified retirement plans, health and welfare plans, and fringe benefit plans).3

BDO Observations & Next Steps
The new guidance is aimed at clarifying a perceived misinterpretation of existing rules.  Based on interpretations of existing regulations, taxpayers may have permitted partners to participate in certain tax-favored employee benefit plans.  In addition, these partners may have been treated as though they were subject to employment tax as employees, rather than as self-employed individuals. 

With the issuance of these regulations, it is clear that a partner is not eligible to be treated as an employee of a lower-tier disregarded entity that is owned by the partnership.  This treatment applies for purposes of either coverage or participation under any qualified retirement plan, health plan, Code Section 125 cafeteria plan, or other tax-advantaged employee fringe benefit arrangement that is sponsored by the disregarded entity.  Further, such partners are subject to the same self-employment tax rules as a partner of a partnership that does not own a disregarded entity.  Consequently, affected partners and partnerships need to consider the impact of these rules and begin making necessary changes.

By comparison, however, there may continue to be a position in which partners of a partnership that owns a regarded, lower-tier corporation could be treated as the employees of the corporation, for employment tax and employee benefit plan purposes.  

Potential Modifications to Rev. Rul. 69-184
In addition to clarifying the existing regulations, Treasury noted its belief that the regulations do not alter the holding in Rev. Rul. 69-184, 1969-1 C.B. 256.  Under Rev. Rul. 69-184, bona fide members of a partnership are not employees of the partnership, and a partner who devotes time and energy in conducting the trade of business of the partnership, or who provides services to the partnership as an independent contractor, is considered to be self-employed, and is not an employee of the partnership. Treasury also indicated that these regulations do not address application of Rev. Rul. 69-184 in tiered partnership situations. 

Several commentators have requested guidance on the application of Rev. Rul. 69-184 in tiered partnership situations and have suggested modifying Rev. Rul. 69-184 to allow partnerships to treat partners as employees in certain circumstances.  For example, requests have included modification of Rev. Rul. 69-184 to allow recipients of small ownership interests as an employee compensatory award or incentive to continue to be treated as an employee. 

For partnerships that have wholly owned C corporations where partners are treated as employees of the C corporation for payroll tax and benefit plans, there remains uncertainty in the treatment of certain types of partnership interests, namely profits interests.

Treasury has requested comments on the appropriate application of the principles of Rev. Rul. 69-184 to arrangements involving tiered partnerships; the circumstances in which it may be appropriate to permit partners to also be employees of the partnership; and the impact on employee benefit plans (including, but not limited to, qualified retirement plans, health and welfare plans, and other fringe benefit arrangements) and employment taxes, if Rev. Rul. 69-184 were modified to permit partners to also be treated as employees in certain circumstances.
 
For more information please contact one of the following practice leaders:

Compensation & Benefits Group Ira Mirsky
Senior Director, National Tax Office Carlisle Toppin 
Senior Manager, National Tax Office Joan Vines
Senior Director, National Tax Office
Partnership Group Jeffrey N. Bilsky
Senior Director, National Tax Office David Patch
Senior Director, National Tax Office Julie Robins
Senior Director, National Tax Office

[1] Prior to 2009, disregarded entities could elect to report, remit, and withhold employment taxes on their own account. However, under prior rules, the owner of the disregarded entity remained principally responsible for these employment tax obligations. (See, generally, Notice 99-6.)
[2] Treas. Reg. §301.7701-2(c)(2)(iv)(B). Treas. Reg. §301.7701-2(c)(2)(iv)(C)(2) provides that the general rule of Treas. Reg. §301.7701-2(c)(2)(i) applies for self-employment tax purposes.
[3] Not including the additional taxes imposed under the Affordable Care Act.
 

Unclaimed Property Alert - May 2016

Wed, 05/11/2016 - 12:00am
There has been an increase in the amount of audit notices and penalty and interest assessments related to unclaimed property for non-compliance in Nevada that may impact your company. Please see this sample notice as an example of the notice that some companies have received. The penalty and interest can be substantial when compared to the amount of unclaimed property being reported to the State (in the sample notice the penalty and interest was 5X what was actually due to the State).  However, there is an avenue to avoid interest and penalty all together (see Sample Letter #2).  

Who is Affected:
  1. Entities incorporated in NV
  2. Entities that have significant income tax apportionment factors in NV (e.g., revenue, payroll, property)
  3. Entities with significant # of vendors, customers or employees located in NV
  4. Acquisitions of Entities in NV or incorporated in NV
What’s the Risk?
  1. Upon audit being sanctioned and assigned to a third party audit firm, the audit firm will solicit other states to join the audit prior to execution of NDA.
  2. Once a company receives an audit notice, they can no longer participate in the amnesty or VDA programs and interest and penalties may be assessed as follows:
    • Penalty: $5,000
    • Interest: 18% per annum from the date the property should have been reported to the State
Please contact Joeseph Carr or Ricardo Garcia for a complimentary discussion on this matter to determine how this can impact your company.

State and Local Tax Alert - May 2016

Tue, 05/10/2016 - 12:00am
New Guidance Issued for Tennessee's Sales and Use Tax for Remotely Accessed Software

Download PDF Version

The Tennessee Department of Revenue recently issued five letter rulings that address the application of Tennessee’s sales and use tax on remotely accessed software.  The tax was enacted as part of the 2015 Revenue Modernization Act, H.B. 644, 109th Gen. Assem. (Tenn. 2015) (enacted) (“RMA”), and applies to transactions occurring after June 30, 2015.  See the BDO SALT Alert that discusses the RMA.
Details Tennessee’s Sales and Use Tax on Remotely Accessed Software
Under the RMA, Tennessee amended its law to tax computer software stored on a server as a “deemed equivalent to the sale or licensing of the software and electronic delivery of the software,” effective for transactions occurring after June 30, 2015.  Where use of the software occurs in multiple states, Tennessee allows a seller or customer to allocate the sales price of the software based upon the percentage of users in the state to determine the portion taxable in Tennessee.
 
The RMA specifically provides that the tax on remotely accessed software does not apply to any services that are not currently subject to the tax, such as: (i) information or data processing services, (ii) payment or transaction processing services, (iii) payroll processing services, (iv) billing and collection services, (v) Internet access, (vi) the storage of data, digital codes, or computer software, or (vii) the service of converting, managing, and distributing digital products.  In addition, the RMA provides for an exemption for a “dealer that purchases computer software only for the purpose of reselling access and use of such software,” except where it is purchased by a qualified data center for access and use by an affiliated company.
 
In Sales and Use Tax Notice # 15-14 (Jun. 2015) (updated Dec. 2015), the Department instructs sellers to collect tax on the sale of remotely accessed software used within and without Tennessee, unless the seller receives a Streamlined Sales and Use Tax Certificate of Exemption (which does not require that the customer have a Tennessee sales and use tax account number) or a Remotely Accessed Software Direct Pay Permit (which requires that the customer have a Tennessee sales and use tax account number) from the customer for purposes of documenting the portion of the price that corresponds to the percentage of exempt users located outside Tennessee.  In case of the receipt of the former, the seller collects tax on the portion of the purchase price that relates to use in the state only.  In the case the receipt of the latter, the seller is not required to collect tax at all.  In Sales and Use Tax Notice # 15-24 (Dec. 2015), the Department informs taxpayers that it released a new Remotely Accessed Software Direct Pay Permit form, and instructs taxpayers on its use.
 
Letter Ruling # 15-07 (Nov. 23, 2015)
Use of Same Software, but for Different “True Objects”
FACTS - The taxpayer sells two types of software packages that assist in the management of its clients: a Subscription Package and Business Process Outsourcing Package.  Under the Subscription Package, a customer accesses the taxpayer’s proprietary software housed on servers outside Tennessee via a web portal. The software enables the customer to upload information and related documents, which then populates key data fields.  The customer may then view the documents and perform various actions.  With respect to the Business Process Outsourcing Package, a customer uses the same software as the Subscription Package, but the taxpayer provides services that the customer would perform under the Subscription Package.
 
RULING - The Department ruled the Subscription Package was a taxable sale or use of software, and declined to apply the “true object” test because “the sole value of the Subscription Package is the access to the software.”  Conversely, the Department ruled that the Business Process Outsourcing Package was not subject to tax because the “true object” of the Business Process Outsourcing Package is the provision of nontaxable services.
 
Letter Ruling # 15-08 (Dec. 17, 2015)
Multiple Software Applications Ruled Non-Taxable Services
FACTS - The taxpayer purchases remotely accessed software that it uses in Tennessee and other states for purposes of providing services to customers.  The taxpayer sells the following web-based services to its customers through affiliates located within and without the state: information management service, remote storage service, electronic delivery service, payment management service, and web-based information service. 
 
In connection with providing these services, the customer may be able to deliver, access, view, or receive information online through a portal via software provided by the taxpayer.  In addition, the customer may be separately charged for the following, which the taxpayer also sells: online storage, system configuration, stand-alone remotely accessed software, and other items.
 
RULING - The Department ruled that all of the services sold by the taxpayer are non-taxable because the “true object” is the provision of nontaxable services.  It found the customer’s access to the taxpayer’s portal operating software to be an “incidental medium for transmission of the taxpayer’s nontaxable services.”
 
The Department then ruled that the full sales price of the taxpayer’s remotely accessed software is subject to tax for any billing period beginning after June 30, 2015, if the taxpayer has notice that the customer is using the software in the state.  However, if the taxpayer receives a Streamlined Sales and Use Tax Certificate of Exemption, then it is only required to collect sales tax the portion of the sales price as indicated on the certificate.  If the taxpayer receives a Remotely Accessed Software Direct Pay Permit from the customer, then the taxpayer should not collect any tax. 
 
With respect to the taxpayer’s purchases of software, the Department ruled that if the taxpayer provides a Remotely Accessed Software Direct Pay Permit to the seller, it must remit tax on the portion of the sales price allocated to Tennessee users.  If the taxpayer provides a Streamlined Sales and Use Tax Certificate of Exemption to the seller, it must pay tax to the seller based on the percentage of taxpayer’s users in Tennessee.
 
Letter Ruling # 15-09 (Dec. 17, 2015)
Taxable and Non-Taxable Affiliate-Hosted, Vendor-Hosted and Internally-Hosted Software
FACTS - The taxpayer is comprised of a non-Tennessee headquartered corporation that has business units within and without Tennessee, and a limited liability company disregarded for federal income tax purposes that is headquartered and operates out of Tennessee.  The taxpayer purchases affiliate-hosted software, vendor-hosted software, and internally-hosted software.
 
The taxpayer purchases the affiliate-hosted software from foreign affiliates that purchase the software from third-party vendors, and host the software on servers in foreign countries.  In conjunction with the software, a foreign affiliate provides the following services the charge for which is bundled with the software, determined on a per-seat basis, and billed to each business unit of the taxpayer: hosting applications and data services, application monitoring, data storage, and backups, disaster recovery, technical support, and incident management.  The taxpayer’s employees may use the software to input, manipulate or process data, or run reports, and remotely access the software via a desktop icon, an application platform, or an intranet or web-based link.
 
The taxpayer purchases subscriptions to the vendor-hosted software from third-party vendors.  The taxpayer is billed for subscription costs at its headquarters located outside Tennessee, which the taxpayer then allocates to each of its internal business units located within and without Tennessee.  The software remains in the possession of the third-party vendor on servers located outside Tennessee, which the taxpayer’s employees within and without Tennessee access via a web browser to perform various functions that may be done on behalf of the taxpayer’s business units throughout the country, Tennessee included.
 
The taxpayer purchases the internally-hosted software from third-party vendors, which the taxpayer then downloads or installs on computers or servers located within and without Tennessee.  The taxpayer passes the charges for the software, along with any related costs, to each of its business units as an intercompany expense.
 
RULING - The Department noted that every person that accesses and uses software sold in any particular transaction is considered a user, and ruled that the taxpayer is responsible for reporting and remitting tax due on the purchase price of the affiliate-hosted software and related bundled services to the extent used by a business unit in the state. 
 
Next, the Department ruled that the vendor-hosted software is subject to tax to the extent access and use is attributable to users in Tennessee.  The Department noted that the seller is not obligated to collect tax on the sale if it is not readily apparent that the taxpayer is accessing and using the software in Tennessee or if the taxpayer provides the seller with a Remotely Accessed Software Direct Pay Permit.  If the taxpayer presents the seller with a Streamlined Sales and Use Tax Certificate of Exemption, the seller must collect and pay tax on the percentage of users located inside Tennessee based upon the residential street address or primary business address of each user. 
 
Lastly, the Department ruled that the taxpayer’s purchase of internally-hosted software is not subject to tax because it is purchased and hosted on servers located outside Tennessee, and no sale, lease, license or transfer of software occurs in Tennessee.
 
Letter Ruling # 16-01 (Jan. 26, 2016)
Taxable Access to Software
FACTS - The taxpayer provides its customers with web-based access to information on products, which allows a customer to review, make changes, or pull a report.  The taxpayer does not separately charge the customer for access to the information.  Rather, the access is part of the overall contract for services. 
 
The taxpayer provides its customers with the option to subscribe to a web-based technology solution that allows the customer to manage and administer its own information.  A customer accesses the solution through a hosted extranet site, and is separately billed for it.  The taxpayer licenses the software from a third-party that hosts the software on its own servers, which the taxpayer then modifies to identify it as being provided by the taxpayer.
 
In order to provide services to customers, the taxpayer purchases and uses software applications that its employees remotely access from locations within and without Tennessee.
 
RULING - The Department ruled that the web access is not taxable because the use of the website is incidental to the taxpayer’s provision of services (i.e., the “true object”). 
 
Next, the Department ruled that the taxpayer may license the web-based technology solution as an exempt sale for resale because the taxpayer is purchasing the license solely for the purpose of offering the software to its customers who must pay tax.
 
Lastly, the Department ruled that the seller should collect sales tax on the sale of software applications used by the taxpayer in providing services, unless it is not readily apparent that the taxpayer is accessing and using the software in Tennessee or if the taxpayer provides the seller with a Remotely Accessed Software Direct Pay Permit.  If the taxpayer presents the seller with a Streamlined Sales and Use Tax Certificate of Exemption, the seller must collect and pay tax on the number of users located inside Tennessee based upon the residential street address or primary business address of each user.
 
Letter Ruling # 16-02 (Mar. 8, 2016)
Non-taxable Access to Software
FACTS - The taxpayer delivers electronically generated products on behalf of its clients, and uses data-gathering tools to create reports for clients.  A client accesses the electronically generated products through a web-based interface that contains a layout design which allows the client to create electronically delivered products themselves and to specify to whom to send such products.  In addition, the web-based interface allows a client to upload and manage their information on the taxpayer’s system, and access data and analysis generated and complied by the taxpayer.  The taxpayer does not separately charge for web-based access.
 
The taxpayer had developed proprietary software that facilitates or automates these functions, which it stores on servers located in unnamed states.  The taxpayer’s employees determine what information is collected, how that information is best analyzed, and what information is automatically reported to clients through the web-based interface.
 
RULING - The Department considered the web-based interface to be computer software for sales and use tax purposes, but found the software to be incidental to the “true object” of the purchase – outsource the delivery of electronically generated products, and to receive reports and analytics.  The web-based interface merely facilitates communication between the taxpayer and the client.  Accordingly, the Department ruled that the product was a nontaxable service.
  BDO Insights
  • The Department of Revenue’s letter rulings provide helpful guidance regarding the Department’s application of the sales and use tax on remotely accessed software, including when the sale of such may be considered a non-taxable service performed “in the cloud,” or a taxable sale or license of software delivered in Tennessee.
  • Tennessee taxpayers that have not done so already should update their sales and use tax compliance systems and procedures for reporting and payment of the tax on remotely accessed software, and the Department’s related guidance.
 


For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Senior Director
  Paul McGovern
Tax Senior Director   Jonathan Liss
Tax Senior Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Senior Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Senior Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Senior Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Senior Director   Richard Spengler
Tax Senior Director       Southwest:     Gene Heatly
Tax Senior Director
      Tom Smith
Tax Partner

State and Local Tax Alert - May 2016

Fri, 05/06/2016 - 12:00am
Proposed Federal "Earnings Stripping" Regulations Could Have Unsuspected State Corporate Income and Franchise Tax Consequences
Download PDF Version
Summary On April 8, 2016, the U.S. Department of the Treasury and Internal Revenue Service published proposed regulations under Section 385 of the Internal Revenue Code of 1986, as amended (“IRC § 385”).  The proposed IRC § 385 or “earnings stripping” regulations would treat a broad group of intercompany financing, and some cash management arrangements, as stock, not debt, for federal income tax purposes. Although the proposed IRC § 385 regulations were issued in conjunction with proposed regulations addressing corporate inversion transactions, the proposed IRC § 385 regulations are not limited to inversion transactions and apply to wholly U.S., and not just to U.S./foreign, intercompany financing arrangements.  Based on the various ways in which states conform to the Internal Revenue Code and Treasury Regulations for purposes of a state income tax, the proposed IRC § 385 regulations could have unsuspected consequences for state corporate income and franchise tax purposes as well.   
  Details

Background

IRC § 385 was enacted in 1969 and amended in 1989 and 1992.  IRC § 385(a) authorizes the Secretary to prescribe regulations to determine whether an interest in a corporation is to be treated as stock or indebtedness, as is necessary or appropriate.  Although proposed and final IRC § 385 regulations existed between 1980 and 1984, those were withdrawn and the section has been essentially inoperative since. 
 
If the proposed IRC § 385 regulations are finalized, they will reclassify certain intercompany financing arrangements as stock, not debt, and thereby disallow any interest expense deduction for federal income tax purposes. The proposed regulations provide in part the following:

  • The proposed IRC § 385 regulations apply to an “Expanded Group,” which generally means a group of related U.S. and non-U.S. corporations that satisfy an 80% vote or value test.  To treat certain debt as part stock and part debt, however, the relatedness test is 50% vote or value.

  • Intercompany financing will be required to meet specific documentation preparation and maintenance requirements in order to be treated as debt.  The documentation requirements are onerous and apply not just at the time a debt instrument is issued, but throughout the term.

  • Although the proposed regulations do not follow some federal judicial decisions, they reiterate that federal case law applying the debt or equity doctrine continues to apply in general.

  • However, if an intercompany financing arrangement is (1) a note distributed by one related party to another, (2) a note issued by one related party in exchange for another’s stock, or (3) a note issued by one related party to another in an internal asset reorganization (“Targeted Transactions”), it will be treated as stock, regardless of whether the documentation requirements and federal case law are satisfied.

  • In addition, a note issued by one related party to another to fund an intercompany distribution, acquisition of stock, or acquisition of property in an internal asset reorganization will also be treated as stock.

The proposed IRC § 385 regulations are expressly inapplicable to intercompany financing arrangements by and among affiliates filing a federal consolidated return.
 
The proposed regulations become effective only when published in the Federal Register as final regulations.  Nonetheless, the regulations would apply to any debt instrument that is a Targeted Transaction issued on or after April 4, 2016 that is still outstanding 90 days after the proposed regulations are finalized.
 
Potential State Income Tax Considerations – a Host of Questions
Whether, and to what degree, any final IRC § 385 regulations could apply at the state level raises a number of questions.

  1. No affiliate member of a federal consolidated group will be subject to the proposed IRC § 385 regulations if they become final, but could a separate return state independently apply the regulations to determine state taxable income? 

While most states start with federal taxable income and then apply their addition and subtraction adjustments to arrive at state taxable income, separate return states require a pro forma federal return for the affiliate(s) taxable in the state.  Some separate return states specifically provide that an affiliate of a federal consolidated group must determine its federal taxable income starting point “as if” the affiliate filed a separate federal return.  Following this line of reasoning, a separate return state might try to justify an independent application of the regulations.  Although such a result could be considered by some as unsupportable, especially when the federal regulations expressly do not apply to a federal consolidated return, certain states could contemplate independent application of  the IRC § 385 regulations.  At a minimum, states should be expected to use the documentation requirements and other aspects of the proposed IRC § 385 regulations when challenging the debt or equity character of intercompany financing. 

  • Should a state be required to specifically adopt IRC § 385 (or like California, adopt subchapter C as a whole with exceptions) before IRC § 385 regulations could apply? 

 Other factors to consider in determining whether a state could apply the IRC § 385 regulations include how a state conforms to federal tax provisions, including fixed date conformity, moving date conformity, specific IRC section enactment, or does not conform to federal tax provisions, as well as whether the  state’s federal tax conformity includes federal tax regulations.      

  • For Targeted Transactions that are treated as stock and not debt by the proposed IRC § 385 regulations, the regulations could apply to a broader range of intercompany financing than the various state-related party interest expense add-back statutes.  If applicable in a state, could the IRC § 385 regulations disallow an interest expense deduction that is either not subject to or is excluded from the state’s related party interest expense add-back statute? 

For example, some states limit the interest expense add-back provisions to “intangible-related interest expense,” but other forms of intercompany interest are deductible, subject to traditional debt or equity case law (e.g., Kentucky).  The proposed IRC § 385 regulations are not so limited.  If such a state attempts to independently apply the regulations in this context, another question could be raised as to whether the state’s interest expense add-back statute is the sole basis to deny an intercompany interest expense deduction for state income tax purposes.      
 
There are concerns that common affiliated group business structures for cash management (“sweeps”) and cash pooling could be impacted by the proposed IRC § 385 regulations.  While these cash management arrangements serve a business purpose of managing cash and liquidity, they may be structured as an intercompany financing arrangement and thus may come under the purview of the IRC § 385 regulations. 


Insights
  • There are serious questions as to whether any IRC § 385 regulations could apply independently at the state level.  However, states continue to aggressively challenge intercompany financing arrangements, and the proposed IRC § 385 regulations would likely be contemplated for use by a number of state taxing authorities. 

  • Any corporate taxpayer that engages in an intercompany financing arrangement using a  Targeted Transaction on or after April 4, 2016, should not only address the potential federal income tax consequences of the proposed IRC § 385 regulations to the intercompany financing arrangement, but also the potential reach and effect for state corporate income tax purposes.

  • Other anticipated intercompany financings should take the proposed IRC § 385 regulations into consideration for federal and state corporate income tax purposes. 
     

For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Senior Director
  Paul McGovern
Tax Senior Director   Jonathan Liss
Tax Senior Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Senior Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Senior Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Senior Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Senior Director   Richard Spengler
Tax Senior Director       Southwest:     Gene Heatly
Tax Senior Director
      Tom Smith
Tax Partner  

Expatriate Tax Newsletter - May 2016

Mon, 05/02/2016 - 12:00am
BDO's Expatriate Newsletter covers timely tax-related updates and regulations from countries around the globe. The May 2016 issue highlights developments in Australia, Hungary,  United Kingdom, and more.
  Download

Unclaimed Property Alert - May 2016

Mon, 05/02/2016 - 12:00am
A California Superior Court Held Unredeemed Merchandise Return Credits Issued by Bed, Bath & Beyond do not Qualify as Escheatable Property
Download PDF Version
Summary On March 4, 2016, the Superior Court of California, County of San Diego Central issued its decision in Bed Bath & Beyond Inc. v. John Chiang, No. 37-2014-00012491-CU-MC-CTL (Cal. Super. Ct. Mar. 04, 2016), in which it held that merchandise return credits (“MRCs”) issued to California customers by Bed Bath & Beyond (“BB&B”) are gift certificates exempt from California’s Unclaimed Property Law.  The court awarded BB&B a $1.8 million judgment, the amount it reported and paid to the state between 2004 through 2012 with respect to MRCs.
Details Background
BB&B operates a chain of retail stores that sell domestic merchandise and home furnishings.  BB&B customers must present an original receipt when returning merchandise to obtain a cash refund.[1] As a matter of courtesy, however, BB&B provides MRCs to customers without receipts, which may be redeemed at BB&B and its affiliates for merchandise, but not cash.

BB&B filed suit (and later a motion for summary judgment) against John Chiang in his official capacity as Controller of the State of California, requesting a $1.8 million refund with respect to $1.8 million in MRCs it reported and paid to the state between 2004 and 2012.  BB&B claimed it had mistakenly remitted the $1.8 million because the MRCs were not properly escheatable to the state.

California Court’s Holding and Analysis
The court granted BB&B’s motion for summary judgment, and found that BB&B was entitled to the $1.8 million judgment.  The court first concluded that because the MRCs are not redeemable for cash, BB&B does not owe money to the owner of an MRC.  Therefore, there is nothing owed to the owner that would be escheated. 
In so concluding, the court rejected Chiang’s argument that BB&B would owe the owners of MRCs cash when the value is less than $10 and the customer requests cash, or when the customer provides an original receipt, because Chiang offered no evidence to suggest either scenario was present with respect to the MRCs at issue.  The court also took issue with a conflict in the law.  On the one hand, BB&B is authorized under California law to maintain its return policy of no receipt, no cash.   On the other hand, under Chiang’s analysis, MRCs could be escheated to the state and made available to the customer as cash when the customer was never entitled to cash.

Next, the court concluded that MRCs are not escheatable to the state because gift certificates that do not expire are not escheatable under California law, and MRCs bear the “same” characteristics as gift certificates.  The court conceded that MRCs are not obtained for purposes of gifting, but the court pointed out that California law recognizes that the classification of a “gift certificate” includes those that are distributed by the issuer to a consumer in non-gift situations, such as pursuant to an awards, loyalty, or promotional program.
BDO Insights
  • A retailer with a return policy similar to BB&B’s MRCs program that has paid money to California as unclaimed property should evaluate whether it may have mistakenly paid money to the state.  If so, the retailer may be entitled to a refund.  If such a retailer is presently under audit by California, and the state is arguing that MRCs or their equivalent are escheatable, the retailer may be able to use this decision as support that it is not. 
 
BDO’s National Unclaimed Property Practice has successfully assisted many clients in California and other states with unclaimed property audits and refunds, and can assist you. Should you have any questions or would like to discuss escheatment, please contact Joseph Carr, Partner & National Unclaimed Property Practice Leader at (312) 616-3946 or jcarr@bdo.com
    [1] BB&B would owe cash to the customer if the value owed is less than $10, and the customer requests cash back.  However, Chiang did not present evidence that either scenario was present with respect to the money that is the subject of the lawsuit.

State and Local Tax Alert - May 2016

Mon, 05/02/2016 - 12:00am
Michigan Court of Appeals Holds that Constructive Ownership Rules Do Not Apply to the Definition of Unitary Business Group for MBT Purposes


Download PDF Version 

Summary  On March 31, 2016, the Michigan Court of Appeals issued its decision in LaBelle Management, Inc. v. Dep’t of Treasury, Docket No. 324062 (Mich. Ct. Appeal, Mar. 31, 2016), in which it reversed a decision of the Court of Claims.  The Court of Appeals held that the taxpayer was not part of the same unitary business group with two entities for Michigan Business Tax (“MBT”) purposes due to the absence of more than 50 percent direct or indirect ownership or control.  The Court of Appeals rejected the Treasury and the Court of Claims’ use of attribution (or constructive ownership) rules to conclude that the control test had been satisfied.
  Details Background
LaBelle Management, Inc. (“LaBelle Management”) is a Michigan corporation that is primarily owned through direct ownership by brothers Barton and Douglas LaBelle, but neither brother directly owned more than 50 percent of Labelle Management’s common stock.  Each brother also owned similar interests in Pixie, Inc. (“Pixie”) and LaBelle Limited Partnership.  LaBelle Management was a subsidiary of Pixie until Pixie sold all of its stock interests in LaBelle Management to the brothers on January 1, 2008.  Thereafter, Pixie, Inc. reported MBT as a separate company.
 
During 2011 and 2012, the Treasury audited LaBelle Management’s returns for the two MBT taxable periods at issue.  As a result of the audit, the Treasury assessed MBT on the basis that LaBelle Management, Pixie, and LaBelle Limited Partnership should be treated as a unitary business group.  The Treasury applied the attribution (or constructive ownership) rules in Revenue Admin.  Bulletin 2010-01, Michigan Business Tax Unitary Business Control Test (Feb. 5, 2010) to determine that the same person owns or controls, directly or indirectly, more than 50 percent of the ownership interest of LaBelle Management, Pixie and LaBelle Limited Partnership as required by the definition of “unitary business group” under Mich. Comp. Laws § 208.1117(6).
 
LaBelle Management paid the assessed tax under protest, and filed a lawsuit in the Michigan Court of Claims.  Both parties brought cross-motions for summary judgment.  The Court of Claims granted the Treasury’s motion and denied LaBelle Management’s.  The Court of Claims found Internal Revenue Code (“IRC”) § 957, which defines “controlled foreign corporation” for purposes of international taxation, to be “contextually analogous” to Mich. Comp. Laws § 208.1117(6).  Both provisions refer to more than 50 percent ownership, and IRC § 957 applies the same attribution (or constructive ownership) rules under IRC § 318 as Revenue Admin. Bulletin 2010-01.   
 
LaBelle Management filed an appeal and a motion for summary judgment with the Court of Appeals.
 
The Court of Appeals’ Holding and Analysis
The Court of Appeals held that the Court of Claims erred in using the “contextually analogous” federal income tax definition of constructive ownership or control.  The Court of Appeals reasoned that, as emphasized by the Michigan Supreme Court in Town & Country Dodge, Inc. v. Dep’t of Treasury, 362 N.W.2d. 618 (Mich. 1984), Mich. Comp. Laws § 208.1103 allows for the adoption of a federal income tax definition in the case of an undefined MBT term such as “indirect ownership or control,” but only if used in a comparable context for federal income tax purposes.  Where no comparable context for federal income tax purposes exists, the ordinary and primarily understood meaning must be used.  The Court of Claims had noted the absence in the federal income tax law of a context comparable to Mich. Comp. Laws § 208.1117(6).  Accordingly, the Court of Claims should have applied the ordinary and primarily understood meaning of indirect ownership.
 
In addition, the Court of Appeals found the Court of Claims’ use of constructive ownership rules under IRC § 957 to be misplaced.  IRC § 957 looks at whether more than 50 percent of a corporation’s voting stock or total value is owned within the meaning of IRC § 958(a), or is considered as owned (i.e., not true ownership or a legal fiction) by applying the constructive ownership rules under IRC § 958(b).  IRC § 958 itself identifies three types of ownership: direct and indirect ownership under IRC § 958(a), and constructive ownership under IRC 958(b).  First, IRC § 958(a) would be the correct section to apply because it uses the direct and indirect terminology as found in Mich. Comp. Laws § 208.1117(6).  Next, IRC § 958 only defines “stock owned,” and merely applies the rules of constructive ownership to indirect ownership without defining that term.  Lastly, the federal statutes and regulations are replete with examples that illustrate the proposition that indirect ownership and constructive ownership are two different concepts, and at times expressly distinguish between the two ownership types, and do not broadly apply rules of constructive ownership anytime indirect ownership is used.
 
Given the lack of a comparable federal context, the court then examined the definitions of indirect and indirectly (i.e., indirectly is the adverbial form of indirect) in New Oxford American Dictionary (3d ed.), Merriam-Webster's Collegiate Dictionary (11th ed.), Black's Law Dictionary (10th ed.) to find the plain and ordinary meaning of indirect ownership to apply in the case of Mich. Comp. Laws § 208.1117(6).  The court held, based on the definitions in the aforementioned texts, indirect ownership in Mich. Comp. Laws § 208.1117(6) means “ownership through an intermediary, not ownership by operation of legal fiction,” which does not exist under the facts of this case.  Therefore, neither brother owns or controls, directly or indirectly, more than 50 percent of LaBelle Management, Pixie or LaBelle Limited Partnership as required by the definition of “unitary business group” under Mich. Comp. Laws § 208.1117(6).
  Insights
  • The Court of Appeals’ decision is presently subject to reversal on reconsideration or appeal to the Michigan Supreme Court.
  • A taxpayer that applied the attribution (or constructive ownership) rules in Revenue Admin. Bulletin 2010-01 for purposes of determining the existence of a unitary business group for MBT purposes, should consider whether they may benefit from filing a refund claim (or a protective refund claim in the event the Court of Appeals grants a motion for reconsideration or the matter is appealed to the Michigan Supreme Court) under Michigan’s four-year statute of limitations.
  • The reasoning applied by the court in LaBelle Management may apply for Corporate Income Tax (“CIT”) purposes given that, for CIT purposes, Michigan does not define indirect ownership and adopted statutory provisions very similar to those MBT statutory provisions relevant in this case.  If so, a similar refund (or protective refund) opportunity may exist for CIT purposes.
 


For more information, please contact one of the following regional practice leaders:
 

West:   Atlantic: Rocky Cummings
Tax Partner
    Jeremy Migliara
Tax Senior Director
  Paul McGovern
Tax Senior Director   Jonathan Liss
Tax Senior Director   Northeast:   Central: Janet Bernier 
Tax Partner
    Angela Acosta
Tax Senior Director
  Matthew Dyment
Tax Principal
    Nick Boegel
Tax Senior Director
 
Southeast:   Joe Carr
Tax Principal
  Ashley Morris
Tax Senior Director
    Mariano Sori
Tax Partner
  Scott Smith
Tax Senior Director   Richard Spengler
Tax Senior Director       Southwest:     Gene Heatly
Tax Senior Director
      Tom Smith
Tax Partner

International Tax Alert - April 2016

Mon, 04/25/2016 - 12:00am
Treasury Issues Latest Round of Anti-Inversion Guidance
Download PDF Version

On April 4, 2016, the Internal Revenue Service (the “Service”) and Treasury (“Treasury”) issued temporary regulations relating to inversion transactions, as well as final regulations that revise and add cross-references to the temporary regulations.  As discussed below, these regulations incorporate rules relating to inversions and post-inversion transactions included in prior notices, and include certain new rules relating to such transactions.  
Background A foreign corporation (“foreign acquiring corporation”) generally is treated as a surrogate foreign corporation under Internal Revenue Code (“IRC”) Section 7874(a)(2)(B) if pursuant to a plan (or a series of related transactions):
  1. The foreign acquiring corporation completes the direct or indirect acquisition of substantially all of the properties held directly or indirectly by a domestic corporation (“acquisition test”) after March 4, 2003;
  2. After the acquisition, at least 60 percent of the stock (by vote or value) of the foreign acquiring corporation is held by former shareholders of the domestic corporation by reason of holding stock in the domestic corporation (“ownership test”); and
  3. After the acquisition, the expanded affiliated group (“EAG”) that includes the foreign acquiring corporation does not have substantial business activities in the foreign country in which, or under the law of which, the foreign acquiring corporation is created or organized (relevant foreign country), when compared with the total business activities of the EAG ("substantial business activities test").

Similar provisions apply if a foreign acquiring corporation acquires substantially all of the properties constituting a trade or business of a domestic partnership.

The level of ownership in the foreign acquiring corporation by former shareholders of the domestic corporation (or former partners in the domestic partnership) under the ownership test determines the treatment of the transaction when the above three conditions are satisfied, thereby making the foreign acquiring corporation a surrogate foreign corporation. If the ownership percentage is at least 60 but less than 80, the foreign acquiring corporation is respected as a foreign corporation, but the domestic entity and certain related United States persons are treated as expatriated entities under IRC Section 7874(a)(2)(A). In such case, IRC Sections 7874(a)(1) and (e) prevent the use of certain tax attributes to reduce the United States tax owed with respect to certain income or gain recognized by an expatriated entity regarding certain transfers or licenses of property that occur as part of, or after, the inversion transaction. In contrast, if the ownership percentage is 80 or greater, IRC Section 7874(b) provides that a foreign corporation will be treated as a domestic corporation.

There are certain statutory anti-avoidance provisions in IRC Section 7874 (e.g., IRC Sections 7874(c)(4) and (g))  for which Treasury has previously issued guidance relating to the application of such provisions.

The 2014 and 2015 Notices

On September 22, 2014, Treasury issued Notice 2014-52, 2014-42 , I.R.B. 712 (the “2014 notice”), which announced its intention to issue regulations described therein to address certain transactions structured to avoid the purposes of IRC Section 7874 and Treasury Regulations Section1.367(a)-3(c), as well as certain post-inversion tax avoidance transactions. Some of the rules contained in the 2014 notice included the passive asset rule and the non-ordinary course distributions rule.  Subsequently, on November 19, 2015, Treasury issued Notice 2015-79, 2015-49 I.R.B. 775 (the “2015 notice”), which announced its intention to issue regulations described therein to address certain additional transactions structured to avoid the purposes of IRC Section  7874 and Treasury Regulations Section 1.367(a)-3(c), as well as certain additional post-inversion tax avoidance transactions.  The third country rule and the tax residency rule relating to the substantial business activities test were also included in the 2015 notice. The notices included rules relating to the application of IRC Sections 304, 367, 956, 7701(l), and 7874. 

The New Temporary Regulations

The temporary regulations address the rules described in the two notices with certain modifications.  In addition, the temporary regulations set forth new rules addressing issues that were not previously discussed, including:  
  1. Rules for identifying a foreign acquiring corporation when a domestic entity acquisition involves multiple steps;
  2. Rules that disregard stock of the foreign acquiring corporation that is attributable to certain prior domestic entity acquisitions; 
  3. Post-inversion rules that require a controlled foreign corporation (“CFC”) to recognize all realized gain upon certain transfers of assets described in IRC Section 351, which shift the ownership of those assets to a related foreign person that is not a CFC; and
  4. Rules clarifying the definition of group income for purposes of the substantial business activities test.

The temporary regulations also contain the rules described in Notice 88-108, 1988-2 C.B. 445; Notice 2008-91, 2008-43 I.R.B. 1001; Notice 2009-10, 2009-5 I.R.B. 419; and Notice 2010-12, 2010-4 I.R.B. 326, concerning the short-term obligation exception from United States property for purposes of IRC Section 956. In addition, the temporary regulations provide a new definitions section under Treasury Regulations Section 1.7874-12T that defines terms commonly used in certain of the regulations under IRC Sections 367(b), 956, 7701(l), and 7874.  

New rules (i) and (ii) mentioned above are discussed in more detail below.
 
Identifying a foreign acquiring corporation when a domestic entity acquisition involves multiple steps

In discussing rules for identifying a foreign acquiring corporation when a domestic entity acquisition is made, Treasury stated in the preamble to the temporary regulations that it is concerned that taxpayers may take the position that certain transactions are not domestic entity acquisitions, even if the transactions give rise to the policy concerns that motivated Congress to enact IRC Section 7874.  Treasury provided the example of a foreign corporation (“initial acquiring corporation”) that acquires substantially all of the properties held by a domestic entity (“initial acquisition”) in a transaction that does not result in the initial acquiring corporation being treated as a domestic corporation under IRC Section 7874(b) (e.g., the ownership percentage is less than 80 or the EAG purports to meet the substantial business activities exception in Treasury Regulations Section1.7874-3). Furthermore, pursuant to a plan that includes the initial acquisition (or a series of related transactions), another foreign corporation (“subsequent acquiring corporation”) acquires substantially all of the properties of the initial acquiring corporation (“subsequent acquisition”). In this case, Treasury indicated that a taxpayer may take the position that the form of the transactions is respected for U.S. federal income tax purposes and that Treasury Regulations Section 1.7874-2(c)(2) prevents the subsequent acquiring corporation from being considered to have indirectly acquired the properties of the domestic entity pursuant to the subsequent acquisition. Under this position, although the initial acquisition would be a domestic entity acquisition and the initial acquiring corporation would be a foreign acquiring corporation, the subsequent acquisition would not be a domestic entity acquisition, and the subsequent acquiring corporation would not be a foreign acquiring corporation. Moreover, for purposes of computing the ownership percentage, a taxpayer may assert that former domestic entity shareholders do not hold stock of the subsequent acquiring corporation by reason of holding stock in the domestic entity and, instead, hold stock of the subsequent acquiring corporation only by reason of holding stock in the initial acquiring corporation.

In certain cases, Treasury noted that these positions are contrary to the purposes of IRC Section 7874, including the purposes of (i) the third-country rule if the subsequent acquiring corporation and the initial acquiring corporation are subject to tax as residents of different foreign countries, or (ii) the substantial business activities exception if the EAG has substantial business activities in the foreign country in which, or under the laws of which, the initial acquiring corporation is created or organized but does not have substantial business activities in the foreign country in which, or under the laws of which, the subsequent acquiring corporation is created or organized.

To address these concerns, the temporary regulations provide the multiple-step acquisition rule that treats the subsequent acquisition as a domestic entity acquisition and the subsequent acquiring corporation as a foreign acquiring corporation. When the multiple-step acquisition rule applies, the temporary regulations treat stock of the subsequent acquiring corporation received, pursuant to the subsequent acquisition, in exchange for stock of the initial acquiring corporation (that is, stock of the initial acquiring corporation that, as a result of the initial acquisition, is by-reason-of stock) as stock of the subsequent acquiring corporation held by reason of holding stock in the domestic entity.

Further, if pursuant to the same plan (or a series of related transactions), a foreign corporation directly or indirectly acquires substantially all of the properties held by a subsequent acquiring corporation in a transaction that occurs after the subsequent acquisition, the principles of the multiple-step acquisition rule apply to also treat the further acquisition as a domestic entity acquisition and the foreign corporation that made such acquisition as a foreign acquiring corporation. 

For example, if pursuant to a plan, a foreign corporation (“F1”) acquires substantially all of the properties held by a domestic corporation, followed by another foreign corporation (“F2”) acquiring substantially all of the properties held by F1, followed in turn by another foreign corporation (“F3”) acquiring substantially all of the properties held by F2, then the multiple-step acquisition rule also would treat F3's acquisition of F2's properties as a domestic entity acquisition and F3 as a foreign acquiring corporation. In such a case, the principles of the multiple-step acquisition rule would apply in a similar manner to treat stock of F3 as by-reason-of stock to the extent the F3 stock is received in exchange for F2 stock that is itself treated as by-reason-of stock under the multiple-step acquisition rule.

The multiple-step acquisition rule applies in a similar manner when the domestic entity is a domestic partnership.
These rules do not affect the application of IRC Section 7874 to the initial acquisition and may also apply to the subsequent acquisition. As a result, IRC Section 7874 may apply to both the initial acquisition and the subsequent acquisition.  In addition, the multiple-step acquisition rule applies solely for IRC section 7874 purposes. Accordingly, this rule does not modify general tax principles (such as the step-transaction doctrine) or other rules or guidance that may apply to related transactions.

Disregarding stock of the foreign acquiring corporation that is attributable to certain prior domestic entity acquisitions

Treasury noted in the preamble to the temporary regulations that it is concerned that a single foreign acquiring corporation may avoid the application of IRC Section 7874 by completing multiple domestic entity acquisitions over a relatively short period of time, in circumstances where IRC Section 7874 would otherwise have applied if the acquisitions had been made at the same time or pursuant to a plan (or series of related transactions).  In these situations, the value of the foreign acquiring corporation increases to the extent it issues stock in connection with each successive domestic entity acquisition, thereby enabling the foreign acquiring corporation to complete another, potentially larger, domestic entity acquisition to which IRC Section 7874 will not apply. The preamble to the temporary regulations states that in some cases, a substantial portion of the value of a foreign acquiring corporation may be attributable to its completion of multiple domestic entity acquisitions over the span of just a few years, with that value serving as a platform to complete still larger subsequent domestic entity acquisitions that avoid the application of IRC Section 7874. That is, the ownership percentage determined with respect to a subsequent domestic entity acquisition may be less than 60, or less than 80, if the shares of the foreign acquiring corporation issued in prior domestic entity acquisitions are respected as outstanding (thus, included in the denominator but not the numerator) when determining the ownership fraction.

Treasury has concluded that it is not consistent with the purposes of IRC Section 7874 to permit a foreign acquiring corporation to reduce the ownership fraction for a domestic entity acquisition by including stock issued in connection with other recent domestic entity acquisitions. Moreover, Treasury further stated that it does not believe that the application of IRC Section 7874 in these circumstances should depend on whether there was a demonstrable plan to undertake the subsequent domestic entity acquisition at the time of the prior domestic entity acquisitions. Therefore, Treasury has issued regulations addressing this scenario by providing that the stock of the foreign acquiring corporation that was issued in connection with certain prior domestic entity acquisitions occurring within a 36-month look-back period should be excluded from the denominator of the ownership fraction. The temporary regulations provide under IRC Sections 7874(c)(6) and (g) that, for purposes of calculating the ownership percentage by value with respect to a domestic entity acquisition, (the relevant domestic entity acquisition),  stock of the foreign acquiring corporation attributable to certain prior domestic entity acquisitions is excluded from the denominator of the ownership fraction. This rule (the multiple domestic entity acquisition rule) applies if, within the 36-month period ending on the signing date with respect to the relevant domestic entity acquisition, the foreign acquiring corporation (or a predecessor) completed one or more other domestic entity acquisitions that are not excluded under an exception (each such other domestic entity acquisitions, a prior domestic entity acquisition).  In general, a domestic entity acquisition is excluded from the definition of a prior domestic entity acquisition if (i) the ownership percentage with respect to such domestic entity acquisition was less than five, and (ii) the fair market value of the by-reason-of stock received by the former domestic entity shareholders or former domestic entity partners did not exceed $50 million.  The temporary regulations provide details relating to the application and operation of this rule, including rules relating to the calculation of the ownership percentage when applying this rule.

Applicability Dates

The applicability dates for the rules that were previously announced in the 2014 notice and the 2015 notice are consistent with the dates announced in the new temporary regulations  Thus, the rules described in the 2014 notice address transactions that are structured to avoid the purposes of IRC Section 7874 apply to acquisitions completed on or after September 22, 2014, and the rules described in the 2015 notice that address transactions that are structured to avoid the purposes of IRC Section 7874 apply to acquisitions completed on or after November 19, 2015. Furthermore, the rules described in the 2014 notice that reduce the tax benefits of inversion transactions apply to post-inversion tax avoidance transactions completed on or after September 22, 2014. and the rules described in the 2015 notice that reduce the tax benefits of inversion transactions apply to post-inversion tax avoidance transactions completed on or after November 19, 2015. The rules apply only if the inversion transaction was completed on or after September 22, 2014, with one exception: consistent with the 2014 notice, the rule regarding the application of IRC Section 304(b)(5) is a generally applicable rule that applies without regard to whether there was an inversion transaction.

The new rules included in the temporary regulations, including any changes to rules described in the 2014 notice and the 2015 notice, generally apply to acquisitions or post-inversion tax avoidance transactions completed on or after April 4, 2016. In addition, the new rule in the temporary regulations that reduces post-inversion tax benefits (by requiring a CFC to recognize all realized gain upon certain IRC Section 351 transfers) applies only if the inversion transaction was completed on or after September 22, 2014. However, Treasury indicated in the preamble to the temporary regulations that no inference is intended as to the treatment of transactions described in the temporary regulations and the preamble under the law that applied before the applicability date of these regulations. The Service, where appropriate, may challenge transactions, including those described in the temporary regulations and this preamble, under applicable IRC or regulatory provisions or judicial doctrines.
BDO Insights The rules contained in the new regulations represent Treasury’s heightened focus on inversions and post-inversion transactions.   The professionals in BDO’s International Tax Services Group can assist you in navigating through the complexities of these rules.  
 
For more information, please contact one of the following practice leaders:
 

Robert Pedersen
Partner and International Tax Practice Leader

 

Chip Morgan
Partner

 

Joe Calianno
Partner and International Technical
Tax Practice Leader

 

Brad Rode
Partner

  Bob Brown
Partner  

William F. Roth III
Partner, National Tax Office

  Scott Hendon
Partner  

Jerry Seade
Principal

  Monika Loving 
Partner    

International Tax Alert - April 2016

Fri, 04/22/2016 - 12:00am
Canadian Government Proposes 2016 Federal Budget
Download PDF Version
Summary On March 22, 2016, Canadian Finance Minister the Honorable Bill Morneau presented his first budget. The Canadian Budget (“Budget”) includes several provisions that impact international business transactions.
Details

Some of the key international tax provisions included in the Budget are discussed below.

Base Erosion and Profit Shifting
Canada is actively engaged in coordinated multilateral efforts of the G20 and the Organisation for Economic Co-operation and Development (“OECD”) to address base erosion and profit shifting (“BEPS”). Today, the Budget announced the following actions related to the OECD BEPS recommendations:

Country-By-Country Reporting (“CbCR”) - The Budget proposes to implement CbCR as part of required transfer pricing documentation, applicable to large multinationals (groups with annual consolidated revenue of 750 million Euros or more). Multinational enterprises with an ultimate parent entity resident in Canada will be required to file a CbC report with the Canada Revenue Agency (“CRA”) within one year of the end of the fiscal year to which the report relates. This reporting will be required for tax years beginning after 2015, consistent with the OECD recommendations. The first exchanges of this information between tax authorities in other jurisdictions are expected to occur by June 2018, but only once exchange agreements are finalized, to ensure the confidentiality of taxpayer information is maintained.

Revised Transfer Pricing Guidelines - The OECD transfer pricing guidelines have been revised to improve the interpretation of the arm’s-length principle. These revisions generally support the CRA’s current interpretation and assessing practices.

Treaty Abuse - The Budget confirmed Canada’s intention to address tax treaty abuse in accordance with the minimum standard outlined in the OECD recommendations. Canada will look to amend its tax treaties, adopting either a limitation-on-benefits approach or a principal purpose test, depending on the particular circumstances and discussions with Canada’s treaty partners. Canada is also participating on work on a multilateral instrument that could streamline the amendment of its tax treaties.

Spontaneous Exchange of Tax Rulings - The Budget confirmed the government’s intention to implement the BEPS minimum standard for the spontaneous exchange of certain tax rulings with tax authorities in other jurisdictions, to improve transparency. This process will begin in 2016.
 
Cross Border Surplus Stripping 
Section 212.1 of the Income Tax Act contains an “anti-surplus stripping” rule that is intended to prevent a non-resident shareholder from entering into a transaction to extract (or “strip”) without tax a Canadian corporation’s retained earnings (or “surplus”) in excess of the paid-up capital (“PUC”) of its shares or to artificially increase the PUC of the shares. Subsection 212.1(4) is an exception to this “anti-surplus stripping” rule, that essentially turns off subsection 212.1 when certain conditions are met. The budget suggests that some non-resident corporations have misused this exception by reorganizing the group into a sandwich structure as part of a series of transactions designed to artificially increase the PUC of shares of those Canadian subsidiaries. To address this, subsection 212.1(4) will be amended so it will not apply if there is a sandwich structure, and a non-resident person (i) owns shares of the top-tier Canadian purchaser corporation and (ii) does not deal at arm’s length with the Canadian purchaser corporation. This amendment will apply to such dispositions that occur on or after March 22, 2016.
 
Extension of the Back-To-Back Loan Rules
There are currently rules in place to ensure that a back-to-back loan arrangement cannot be used to reduce the amount of withholding tax on a cross-border interest payment. The Budget proposes to build on the current back-to-back loan rules by:
  • Extending the application of the rules to royalty payments made after 2016.
  • Adding character substitution rules to the back-to-back rules, which will apply to interest and royalty payments made after 2016. These rules will prevent the avoidance of the back-to-back loan rules through the use of arrangements that provide payments that are economically similar to interest or royalty payments, which can be substituted between a non-resident intermediary and the other non-resident person.
  • Adding back-to-back loan rules to the existing shareholder loan rules which will generally apply to back-to-back shareholder loan arrangements as of March 22, 2016.
Also, the Budget clarifies the application of the back-to-back loan rules to multiple-intermediary structures, which will apply to payments of interest and royalties made after 2016 and to shareholder debts as of January 1, 2017.
BDO Insights United States businesses with Canadian activities should review the impact of the provisions on their business activities and structure. BDO can assist in evaluating the impact of the budget proposals in particular business’s facts and circumstances.
For more information, please contact one of the following practice leaders:
 

Robert Pedersen
Partner and International Tax Practice Leader

 

Chip Morgan
Partner

 

Joe Calianno
Partner and International Technical
Tax Practice Leader

 

Brad Rode
Partner

  Bob Brown
Partner  

William F. Roth III
Partner, National Tax Office

  Scott Hendon
Partner  

Jerry Seade
Principal

  Monika Loving 
Partner    

International Tax Alert - April 2016

Mon, 04/18/2016 - 12:00am
Internal Revenue Service and Treasury Release Proposed Regulations Addressing Debt/Equity Classifications for US Tax Purposes
Download PDF Version
Affecting Certain taxpayers issuing related-party debt instruments.
Background On April 4, 2016, the United States Department of the Treasury (“Treasury”) and the Internal Revenue Service (“Service”) published proposed regulations under Internal Revenue Code (“Code”) Section 385 addressing the characterization of certain related party debt instruments as debt or equity for United States tax purposes.

The proposed regulations under Code Section 385 would authorize the Service to treat certain related-party interests in a corporation as indebtedness in part and stock in part for federal tax purposes, and establish threshold documentation requirements that must be satisfied in order for certain related-party interests in a corporation to be treated as indebtedness for federal tax purposes.  Additionally, the proposed regulations would treat certain related-party interests as stock that otherwise would be treated as indebtedness for federal tax purposes.  Each of these areas is discussed below.

Code Section 385 was originally enacted to allow for the characterization of an interest in a corporation as either stock or indebtedness for United States tax purposes.  The code section provided for a number of factors to be considered in making this determination and these factors have since been expanded upon and developed in subsequent years through case law.  In general, no one factor was dispositive of debt or equity treatment and the determination was heavily based on the facts and circumstances in each particular case.

Treasury notes in the preamble to the proposed regulations that the historical factors used in this analysis have been applied somewhat inconsistently and can arrive at results in the related-party context that may be contrary to policy or the intent of the statute.
Taxpayers Affected In discussing the purpose of the proposed regulations, Treasury references excessive indebtedness in the cross-border context between related parties and how this can be used to significantly reduce a company’s tax liability.  They also note, however, that these regulations may apply to purely domestic situations (U.S. to U.S.) as well.  However, they generally exclude related-party indebtedness between members of the same U.S. consolidated group.

The scope of the proposed regulations generally is limited to purported indebtedness between members of an expanded group. The proposed regulations define the term expanded group by reference to the term affiliated group in Code Section 1504(a). However, the proposed regulations broaden the definition in several ways. Unlike an affiliated group, an expanded group includes foreign and tax-exempt corporations, as well as corporations held indirectly, for example, through partnerships. Further, in determining relatedness, the proposed regulations adopt the attribution rules of Code Section 304(c)(3). The proposed regulations also modify the definition of affiliated group to treat a corporation as a member of an expanded group if 80 percent of the vote or value is owned by expanded group members (instead of 80 percent of the vote and value, as generally required under Code Section 1504(a)). However, certain rules or thresholds are contained in the proposed regulations that would modify when the rules would or would not apply.  For instance, there is a rule limiting the application of Proposed Regulations Section1.385-2 to certain large taxpayers and a rule in Proposed Regulations Section1.385-3 providing a $50 million threshold exception.   
The Proposed Regulations The proposed regulations address three primary areas relating to debt/equity classification.  They are:
  1. Allowing the Service to recharacterize an instrument as part debt and part equity;
  2. Requiring contemporaneous documentation to support debt classification of related-party indebtedness; and
  3. Providing specific rules to characterize debt instruments as stock with respect to certain distributions, reorganization transactions and certain other types of transactions.

Allowing the Service to recharacterize an instrument as partly debt and partly equity
Proposed Regulations Section 1.385-1 provides the Service authority to recharacterize a related-party debt instrument as debt in part and equity in part.  This is a departure from the historical application of the rules, which generally seemed to require an instrument be treated wholly as debt or wholly as equity (the ‘all-or-nothing’ rule).  Treasury sees the ‘all-or-nothing’ approach as reaching consequences that may not reflect the economic substance of the transaction.  Therefore, in the proposed regulations Treasury has provided the ability for the Service to characterize an instrument partially as debt or partially as equity, depending on the facts and circumstances of the case. The proposed regulations authorize the treatment of an interest as indebtedness in part and stock in part in the case of instruments issued in the form of debt between parties that are related, but at a lesser degree of relatedness than that required to include them in an expanded group. Under the proposed regulations, treatment as indebtedness in part and stock in part can apply to purported indebtedness between members of modified expanded groups (which are defined in the same manner as expanded groups, but adopting a 50 percent ownership test and including certain partnerships and other persons).  The preamble provides an example for illustration of this rule by way of a five million dollar debt instrument of which the issuer can only reasonably be expected to repay three million dollars, and the instrument could be recharacterized as three million dollars of indebtedness and two million dollars of equity.

Requiring contemporaneous documentation to support debt classification of related-party indebtedness
Proposed Regulations Section 1.385-2 contains a new requirement for contemporaneous documentation for certain related-party indebtedness in order to allow for the indebtedness to be respected as debt for United States tax purposes.  The rules provide that if a taxpayer does not prepare and maintain the documentation such that they can provide it to the Service upon request, the related-party indebtedness will be treated as stock or equity. 

The documentation requirement focuses on taxpayer substantiation of four key elements of the instrument:
  1. Binding Obligation to Repay;
  2. Creditor’s Rights to Enforce Terms;
  3. Reasonable Expectation of Repayment; and
  4. Genuine Debtor-Creditor Relationship.

The preamble and the regulations provide some examples of the types of documentation that could be used to support these four elements.

As noted above, the preamble and regulations state that in the absence of this documentation treatment as indebtedness will not be allowed.  The preamble also states that satisfaction of these four factors by way of the contemporaneous documentation does not conclusively establish the instrument as indebtedness, but rather simply allows for the possibility of indebtedness treatment pending further analysis by the Service based on the facts and circumstances under existing federal tax principles and case law.

Treasury has provided a few limitations and exceptions to the applicability of the above documentation requirements.  The documentation requirement is intended to apply to taxpayers that are ‘highly related’ (i.e., over 80 percent relatedness by ownership) and also only to ‘large taxpayer groups’.  Therefore, an instrument is not subject to the documentation requirements unless one of the following conditions is met:
  • The stock of any member of the expanded group is publicly traded;
  • All or any of the portion of the expanded group’s financial results are reported on financial statements with total assets exceeding US$100 million; or
  • The expanded group’s financial results are reported on financial statements that reflect annual total revenue that exceeds US$50 million.

Providing specific rules to characterize debt instruments as stock in certain distributions or reorganization transactions
Proposed Regulations Section 1.385-3 is intended to address specific factual situations identified by Treasury as creating policy concerns.  Treasury identified three primary types of transactions of concern addressed in Proposed Regulation Section 1.385-3:
  1. Distributions of debt instruments by corporations to their related corporate shareholders;
  2. Issuances of debt instruments by corporations in exchange for stock of an affiliate; and
  3. Certain issuances of debt instruments as consideration in an exchange pursuant to internal asset reorganization.

Treasury also noted that similar concerns arise when a debt instrument is issued in order to fund future payments or transfers of cash.

The preamble to the proposed regulations suggests that of primary concern to Treasury is the issuance of debt instruments in situations where no cash or capital has been transferred as part of the transaction.  They discuss several cases in which instruments were treated as indebtedness that Treasury now feels creates policy concerns, and are situations now in which the instruments issued should be treated as stock.

The potential characterization of indebtedness as stock under Proposed Regulations Section 1.385-3 is accomplished through three different rules: a general rule, a funding rule and an anti-abuse rule.

The general rule provides that a debt instrument can be treated as stock to the extent it is issued by a corporation to a member of the corporation’s expanded group (1) in a distribution; (2) in exchange for expanded group stock (subject to a limited exception); or (3) in exchange for property in certain asset reorganizations. 

The funding rule is targeted at debt instruments issued with a principal purpose of funding a transaction described in the general rule.  The funding rule contains a non-rebuttable presumption of a principal purpose within a 72-month period surrounding the distribution or acquisition.  This would apply if the instrument is issued by a member during the period beginning 36 months before the distribution or acquisition and ending 36 months after the distribution or acquisition.  There is an exception in the proposed regulations to the non-rebuttable presumption rule for certain ordinary course debt instruments (as defined in the proposed regulations).

The anti-abuse rule is targeted towards specific situations that Treasury believes are abusive or may avoid the application of these rules, and the regulations contain several examples outlining these situations.

There are a few exceptions that may apply.  For instance, Proposed Regulations Section 1.385-3(c)(1) includes an exception pursuant to which distributions and acquisitions described in Proposed Regulations Section 1.385-3(b)(2) (the general rule) or Proposed Regulations Section 1.385-3(b)(3)(ii) (the funding rule) that do not exceed current year earnings and profits (as described in Code Section 316(a)(2)) of the distributing or acquiring corporation are not treated as distributions or acquisitions for purposes of the general rule or the funding rule. For this purpose, distributions and acquisitions are attributed to current year earnings and profits in the order in which they occur. Additionally, there is a threshold exception to the general rule and the funding rule if all of the expanded group debt instruments that could be treated as stock do not exceed US$50 million.  This is merely a threshold and not an exemption, so once group indebtedness exceeds US$50 million then all of the indebtedness potentially subject to recharacterization will be subject to these rules.  Additionally, there is an exception contained in the proposed regulations for certain funded acquisitions of subsidiary stock by issuance.

Potential Consequences of Recharacterization of Debt as Stock/Equity
In general, if debt is recharacterized as stock or equity, then interest deductions on the indebtedness could be disallowed and any payments could be treated as dividend distributions. 
Applicability Dates The provisions of Proposed Regulations Section 1.385-2 are proposed to be generally effective when the regulations are published as final regulations. Proposed Regulations Section 1.385-2 would apply to any applicable instrument issued on or after that date, as well as to any applicable instrument treated as issued as a result of an entity classification election under Treasury Regulations Section 301.7701-3 made on or after the date the regulations are issued as final regulations.

Proposed Regulations Sections 1.385-3 and 1.385-4 (dealing with the treatment of consolidated groups) generally are proposed to apply to any debt instrument issued on or after April 4, 2016 and to any debt instrument issued before April 4, 2016 as a result of an entity classification election made under Treasury Regulations Section 301.7701-3 that is filed on or after April 4, 2016. However, when certain rules of the proposed regulations (Proposed Regulations 1.385-3(b) and 1.385-3(d)(1)(i) through (d)(1)(iv) or 1.385-4) would otherwise treat a debt instrument as stock prior to the date of publication of final regulations, the debt instrument is treated as indebtedness until the date that is 90 days after the date of publication of final regulations. To the extent that the debt instrument in the prior sentence is held by a member of the issuer's expanded group on the date that is 90 days after the date of publication of final regulations, the debt instrument is deemed to be exchanged for stock on the date that is 90 days after the date of publication of final regulations.
How BDO Can Help Our Clients BDO can help our clients to understand the application and implications of these new proposed regulations to their company.  With the increase in scrutiny over cross-border financing of operations, especially in light of the proposed base erosion and profit shifting recommendations, cross border transactions have become increasingly complex.  These new proposed regulations add an additional layer of complexity and compliance to this area.  BDO can help our clients to understand what their obligations under these new proposed regulations will be and to comply with such obligations.  There will be increased need to document related party financing transactions in light of these new rules, and it is important for companies to understand what they need to do to be in compliance.
 
For more information, please contact one of the following practice leaders:
 

Robert Pedersen
Partner and International Tax Practice Leader

 

Chip Morgan
Partner

 

Joe Calianno
Partner and International Technical
Tax Practice Leader

 

Brad Rode
Partner

  Bob Brown
Partner  

William F. Roth III
Partner, National Tax Office

  Scott Hendon
Partner  

Jerry Seade
Principal

  Monika Loving 
Partner    

Pages