Washington Tax Insight November 2015
After several weeks of uncertainty about the leadership of the Republican party in the House and the resolution of several key fiscal issues with looming deadlines, October ends with the election of Congressman Paul Ryan (R-WI) as the new Speaker of the House and the approval of a bipartisan budget deal that resolves certain of those fiscal issues until early 2017. Since the Bipartisan Budget Act of 2015 addresses the debt ceiling limit issue and the approval of government spending levels, there should be no need for an end-of-the year omnibus fiscal bill, although there are key issues that remain as yet unresolved, including the extension of a package of business tax provisions and approval of individual appropriations bills or an omnibus appropriations bill.
In an effort to gain the support of several House conservatives for his election, Speaker Ryan promised several changes in the structure and operation of the House including an overhaul of the Republican Steering Committee, which selects Committee assignments for members and influences the approval of Committee chairmen, to provide more diversity in the membership. Congressman Kevin Brady (R-TX) and Congressman Pat Tiberi (R-OH) are two senior Republican members of the House Ways & Means Committee who have declared their interest in replacing Speaker Ryan as Chair of the Committee. No date has been announced for the election of Ryan’s successor, nor has he endorsed either Member but it is expected that the new W&M Chair will be selected in the near future.
Bipartisan Budget Act of 2015
The House and Senate have both approved H.R. 1314, the Bipartisan Budget Act of 2015, which would raise the debt ceiling until March 15, 2017, and increase authorized spending over the next two years by $80 billion. The President signed the bill on November 2nd, before the debt limit ceiling would have been reached.
The budget deal is intended to eliminate fiscal battles on the debt ceiling and government spending until 2017 when there will be a new President and a new Congress. This deal raises spending caps on domestic and defense spending from the restrictions resulting from sequestration over the past two years, and it gives new House Speaker Ryan a “clean slate” on fiscal issues going forward in the House.
The legislation includes revisions to the audit and tax administration rules for partnerships that raises $11.2 billion in revenue. It establishes a new process that would allow the IRS to assess taxes against and collect taxes directly from large partnerships, making it easier for the IRS to conduct audits of those entities.
Under the bill, which would be applicable to partnership tax years beginning after 2017, the current Tax Equity and Fiscal Responsibility Act (TEFRA) and Electing Large Partnership (ELP) audit rules (applicable to partnerships with more than 10 partners and audits of electing partnerships with 100 or more partners, respectively) would be replaced with one set of rules for auditing partnerships and their partners at the partnership level. Partnerships with 100 or fewer qualifying partners could elect out of the new rules. Under the new rules, the IRS could assess audit changes to the partnership as a whole, as opposed to targeting individual partners. Individual partners would no longer be subject to joint and several liability for partnership-level taxes under the new rules, and the partnership as a whole will have the ability to both contest the audit and divide the taxes among its partners.
Both the House and Senate passed a three-week extension of the Highway Bill to allow more time to complete work on a long-term bill including revenue funding offsets. The new extension expires on November 20th, and House leaders on this issue have suggested that the revenue offsets in the long-term bill will likely be similar to those included in the Senate approved long-term bill, including the sale of oil from the Strategic Petroleum Reserve (SPR) and reducing the dividend rate paid by the Federal Reserve on stock held by certain member banks. International tax reform proposals are not expected to be included as revenue offsets.
The House voted to renew the Export-Import Bank by a vote of 313-118, and the legislation has advanced to the Senate but faces opposition from Senate Majority Leader McConnell, who has said that he will not schedule a stand-alone vote on the bill but would consider attaching it as an amendment to the Highway bill.
The House passed a Budget Reconciliation package, which repeals key parts of the Affordable Care Act (ACA) and defunds Planned Parenthood, and the legislation is expected to be considered on the Senate Floor sometime this fall. The legislation repeals the individual and employer mandates in the ACA as well as the medical device tax and the Cadillac tax on high-cost benefit plans. Should the package pass the Senate, the President is expected to veto it.
Treasury and the IRS
Treasury and the IRS released final, temporary and proposed regulations under section 871(m) that treat “dividend equivalent” payments on certain financial contracts as US-source dividends that are generally subject to a 30 percent withholding tax when paid to non-US persons who are not eligible for the benefits of an income tax treaty. Under existing temporary regulations, Section 871(m) withholding currently applies only to securities lending transactions, sale-repurchase agreements and notional principal contracts (NPCs) that meet certain requirements. Under the final section 871(m) regulations, section 871(m) withholding will also generally apply to any financial contract that references an underlying security that could give rise to a US-source dividend if the contract has a “delta” (generally, the ratio of the change in the fair market value of the contract to the change in the fair market value of the underlying security) of 0.80 or greater. The final regulations are generally effective for transactions entered into on or after January 1, 2017. With respect to transactions entered into on or after January 1, 2016, and before January 1, 2017, the final regulations also apply to any payment of a dividend equivalent made on or after January 1, 2018.
The Treasury Department’s Inspector General for Tax Administration (TIGTA) has issued a report that cites problems at the IRS that have allowed some taxpayers to claim unjustified foreign tax credits (FTCs) to offset their federal taxes. The report cites as one example tax returns “for which taxpayers potentially received approximately $40 million in FTCs that were not supported by third-party information return documents as required.” Among the recommendations to improve IRS controls were: (1) establish controls to ensure that the Form 1116, Foreign Tax Credit, is attached when required; (2) develop a compliance strategy to address the risks identified with taxpayer FTC issues; and (3) improve education, outreach and enforcement activities to correct the paid preparer issues related to the FTC.
The US Foreign Account Tax Compliance Act (FATCA), which targets tax non-compliance by US taxpayers with foreign accounts, has been in place for over a year and has proven to be an effective tool for ensuring compliance with IRS financial reporting requirements, but there have been challenges associated with implementation and compliance. The Treasury and IRS have addressed some of these issues in Notice 2015-66, which announced that they will amend regulations under chapter 4 (sections 1471-1474) to extend the period of time that certain transitional rules will apply for compliance under FATCA. The amended regulations will extend: (1) the start date for withholding on gross proceeds and foreign passthrough payments; (2) the use of limited branches and limited foreign financial institutions (limited FFIs); and (3) the deadline for a sponsoring entity to register its sponsored entities and redocument such entities with withholding agents. The amended regulations will also modify the rules for grandfathered collateral obligations.
The IRS has also announced that it has begun to automatically exchange tax and financial account information with certain foreign tax authorities under FATCA. The US competent authority has signed agreements with the competent authorities of Australia and the UK regarding exchange of information pursuant to the countries’ respective tax treaties and FATCA intergovernmental agreements (IGAs). The agreements describe the time and manner of exchange, procedures for remediation and enforcement, and safeguards to protect confidentiality. Revenue Procedure 2015-50 updates the list of jurisdictions with which the IRS will conduct automatic information exchanges, listing 16 new countries under chapter 4 (FATCA) including: Brazil, Czech Republic, Estonia, Gibraltar, Hungary, Iceland, India, Latvia, Liechtenstein, Lithuania, Luxembourg, New Zealand, Poland, Slovenia, South Africa, and Sweden.
The IRS announced a complete reorganization of its Large Business & International Division (LB&I) around five practice areas, which include: (1) Passthrough Entities; (2) Enterprise Activities; (3) Cross Border Activities; (4) Withholding and International Individual Compliance; and (5) Treaty and Transfer Pricing Operations. LB&I will use data analysis and examiner feedback to identify areas of potential non-compliance and will design campaigns to address those issues and areas.
The IRS has amended regulations that it issued in May of 2015 to delay the effective date of its temporary regulations (under section 446(b)) on the treatment of nonperiodic payments made or received pursuant to certain notional principal contracts. The IRS notice states that “these amendments change the applicability date of the embedded loan rule for the treatment of nonperiodic payments from November 4, 2105, to the later of January 1, 2017, or six months after the date of publication of the Treasury decision adopting these rules as final.”
IRS Notice 2015-73 and Notice 2015-74 revoke Notice 2015-47 and Notice 2015-48, respectively and provide additional details on the types of transactions, referred to as “basket option contracts” and “basket contracts,” that are listed transactions or transactions of interest for purposes of Treas. Reg. section 1.6011-4 and sections 6111 and 6112 of the Code. The new notices narrow the scope of the original guidance by specifically describing the tax benefits that identify a transaction as a transaction of interest.
OECD/G20 Base Erosion and Profit Shifting (BEPS) project
On October 5th, the Organization for Economic Cooperation and Development (OECD) released the 2015 Final Reports on the OECD/G20 Base Erosion and Profit Shifting (BEPS) project two years after its launch in 2013 at the request of the G20 leaders. The G20 Finance Ministers approved the Final Reports at their meeting on October 8th, and the OECD will deliver the BEPS measures to the G20 Leaders at their annual summit on November 15-16th.
The overall aim of BEPS is to close gaps in international tax rules that allow multinational businesses to legally but artificially shift profits to low or no-tax jurisdictions. They aim to improve the coherence of international tax rules, reinforce their focus on economic substance and ensure a more transparent tax environment.
OECD Secretary-General Angel Gurria stated the following upon release of the Final Reports: “The measures we are presenting today represent the most fundamental changes to international tax rules in almost a century; they will put an end to double non-taxation, facilitate a better alignment of taxation with economic activity and value creation, and when fully implemented, these measures will render BEPS-inspired tax planning structures ineffective.”
The BEPS implementation phase is comprised of a structured framework that places all interested jurisdictions on equal footing. The Final Reports recommend changes to domestic laws, the OECD Model Tax Convention and the OECD Transfer Pricing Guidelines. Work on developing a multilateral instrument to implement the treaty-related BEPS measures into the existing network of bilateral tax treaties is underway with 90 jurisdictions participating, and the instrument will be open for signature in 2016. Toolkits are being developed to provide practical solutions and address specific issues faced by developing countries.
The final package of BEPS measures covers the 15 Actions that were established at the onset of the project and includes new minimum standards on: (1) country by country reporting; (2) treaty shopping; (3) curbing harmful tax practices, in particular in the area of intellectual property and through automatic exchange of tax rulings; and (4) effective mutual agreement procedures, so that the fight against double non-taxation does not result in double taxation. It also: (1) revises the guidance on the transfer pricing rules; (2) redefines the concept of Permanent Establishment; (3) strengthens the rules on Controlled Foreign Corporations and interest deductibility; and (4) provides new rules on hybrid mismatch arrangements related to the use of complex financial instruments.
In this issue, we will provide additional detail on Actions 8-10 and 13, relating to transfer pricing issues. In future issues, we will provide additional detail on the other Actions.
Actions 8-10: Assure that Transfer Pricing Outcomes are in Line with Value Creation
The first Actions to take effect will relate to the new transfer pricing rules covered in Actions 8-10. Although the new consolidated version of the Transfer Pricing Guidelines will not be published until 2017, it is expected that tax authorities will begin to apply the new rules to open cases. Transfer pricing rules, which are set out in Article 9 of tax treaties based on the OECD and UN Model Tax Conventions and the Transfer Pricing Guidelines, are used to determine the conditions, including the price, for transactions within a Multinational Enterprise (MNE) group on the basis of the arm’s length principle. The existing standards have been clarified and strengthened, including guidance on the arm’s length principle, and an approach to ensure the appropriate pricing of hard-to-value intangibles has been agreed upon within the arm’s length principle.
The work focused on three key areas, which are covered in one report that intends to ensure that transfer pricing rules result in outcomes that align operational profits with the economic activities which generate them. The revised guidance clarifies how risks and risk-related returns are to be allocated within a group of companies, how returns on intellectual property (IP) should be allocated, with detailed guidance on the transfer pricing treatment of synergies, location-savings and local market features, as well as assembled workforce. A special approach for hard-to-value intangibles has been devised recognizing the difficulty in valuing IP.
Action 8 covers transfer pricing issues relating to controlled transactions involving intangibles, since intangibles are by definition mobile and they are often hard-to-value. The OECD comments that misallocation of the profits generated by valuable intangibles has contributed to base erosion and profit shifting. Under Action 9, contractual allocations of risk are respected only when they are supported by actual decision-making and exercising control over these risks.
Action 10 focuses on other high-risk areas, including the scope for addressing profit allocations resulting from controlled transactions which are not commercially rational, the scope for targeting the use of transfer pricing methods in a way which results in diverting profits from the most economically important activities of the MNE group, and the use of certain types of payments between members of the MNE group (such as management fees and head office expenses) to erode the tax base in the absence of alignment with the value-creation. This Action also includes guidance on transactions involving cross-border commodity transactions as well as on low value-adding intra-group services.
The scope for new and more detailed guidance on the application of profit-split methods for global value chains has been agreed and will be finalized soon, according to the report. The 2014 Scope of Work document states that the revised guidance will be based on existing guidance in Chapter 11 of the Transfer Pricing Guidelines, but will clarify and supplement it with practical application illustrated by examples. A discussion draft on profit splits will be released for public comments in advance of a public consultation scheduled for May 2016 and is expected to be finalized by June of 2017.
Action 13: Re-examine Transfer Pricing Documentation
In an effort to create greater transparency on MNE operations and limit the compliance burden on businesses, this report includes substantial revisions of the transfer pricing documentation rules. Country-by-country reporting rules are intended to provide a clear overview of where profits, sales, employees and assets are located and where taxes are paid and accrued, and these rules will also take effect from hereon.
The report includes new guidance and tools including a three-tiered standardized approach to transfer pricing documentation. First, the guidance requires MNEs to provide tax administrations with high-level information regarding their global business operations and transfer pricing policies in a “Master File” that is to be available to all relevant tax administrations. Second, it requires that detailed transactional transfer pricing documentation be provided in a “Local File” specific to each country, identifying material related-party transactions, the amounts involved in those transactions, and the company’s analysis of the transfer pricing determinations they have made with regard to those transactions.
Third, large MNEs are required to file a Country-by-Country Report that will provide annually and for each tax jurisdiction in which they do business the amount of revenue, profit before income tax and income tax paid and accrued and other indicators of economic activities. Country–by-country reports should be filed in the ultimate parent entity’s jurisdiction and shared automatically through government-to-government exchange of information. The first country-by-country reports are expected to be filed and exchanged in 2017.
Representatives of the U.S. Treasury Department have indicated that they expect to issue country-by-country reporting guidance by the end of 2015. But this is an area that has been highlighted in public comments made by the leadership of the Congressional tax-writing committees. Senate Finance Committee Chair Hatch and Ways & Means Committee Chair Ryan in correspondence to Treasury cited concerns about some of the BEPS project decisions including those related to country-by-country reporting, including whether Treasury has the authority to implement it without legislation, and SFC Chair Hatch has requested a Government Accounting Office (GAO) report on BEPS issues including whether the IRS would be able to legally share tax information with foreign tax authorities.
Robert M. Gordon
Managing Director & Assistant General Counsel