Corporate Tax 2014

The Corporate Tax guide provides expert legal commentary on the key issues for businesses operating in the Corporate Tax sector. The guide covers the important developments in the most significant jurisdictions.

Introduction to Corporate Tax 2014

Skadden, Arps, Slate, Meagher & Flom LPP is very highly regarded for international work, with a great tax group located across the world. With the ability to serve clients in every major international financial centre, they can provide specific legal advice companies across a spectrum of industries worldwide. A corporate heavyweight, they have received high praise for their tax expertise.

Paul W. Oosterhuis is the global head of Skadden’s regulatory practices and represents clients in a wide range of international and domestic tax matters. Mr. Oosterhuis has extensive experience in international mergers and acquisitions, post-acquisition integration transactions, spin-off transactions, internal restructurings and joint venture transactions. He also represents multinational companies in non-transactional international tax planning and IRS controversy matters.

Tim Sanders is a chartered tax adviser and head of the European tax practice based in the London office. He works on corporate and banking taxation matters, including mergers and acquisitions, securitisations, debt restructurings, private equity transactions, cross-border and domestic structured finance, corporate reorganisations and restructurings related to international joint ventures.

Moshe Spinowitz advises clients on a range of tax matters related to corporate transactions, including public and private company mergers and acquisitions, and cross-border transactions.

International Tax Update

In the sixty years following World War II, most developed countries and multinational organisations worked together to reduce source-based taxation and increase residence-based taxation of cross border income. Bilateral treaties exempting royalties and interest from withholding tax mushroomed in the 1960s, 1970s and 1980s, with 179 treaties concluded between the introduction of the OECD draft model in 1963 through its first publication in final form in 1977 (Holmes, International Tax Policy and Double Tax Treaties 58 (2007)). Most of the treaties have also eliminated taxes on the sale of local country company stock by treaty residents. The implementation of the Maastricht Treaty throughout the EU in 1993 saw the elimination of withholding taxes, including dividend withholding taxes, amongst member states. In the past decade, the United States entered into a number of treaties reducing or eliminating withholding taxes on dividends paid to corporate affiliates.

One outgrowth of the move toward residency-based taxation, perhaps not so surprising in retrospect, has been a dramatic expansion of corporate affiliates of multinational groups resident in relatively low-taxed jurisdictions with extensive tax treaty networks. The use of finance companies, intellectual property holding companies and “entrepreneurial” risk-taking companies in places like Luxembourg, Switzerland, Ireland and Hong Kong has grown by leaps and bounds. Contract manufacturing and limited risk distribution arrangements that maximise risk and return in low-taxed jurisdictions are now commonplace.

With hindsight the last few years may be seen as the peak of planning designed to take advantage of residency-based rules to allocate income to low-taxed jurisdictions. We may now be seeing the beginning of a new reassertion of the primacy of source-based taxation.

This can be seen in recent efforts by certain governments and the OECD to address and combat some of the planning facilitated by residence-based taxation. For example, in December 2012, the UK House of Commons Committee of Public Accounts held a series of highly-publicised hearings that criticised the tax practices of several large multinational companies. The companies that were the focus of the hearings have significant operations and sales in the UK, but pay relatively little UK corporate income tax by virtue of the location of their intellectual property and risk-taking activities. Similarly, the G20 asked the OECD to create an action plan that culminated with the publication of the OECD Action Plan on Base Erosion and Profit Shifting (the BEPS Action Plan) in July 2013. The BEPS Action Plan seeks to address many of the issues raised by residency-based taxation, including the ability to separate the location of income for tax purposes from the location of the underlying activities and the jurisdictions in which the customers are located. The BEPS Action Plan acknowledges that this trend is facilitated by factors such as the removal of trade barriers and the use of technology. However, it also identifies the influence of tax considerations on the trend, many of which are likely to come under increased scrutiny. The BEPS Action Plan identifies the need to tighten rules on transfer pricing, end or neutralise tax arbitrage arrangements, increase disclosure requirements, and to prevent companies from artificially avoiding the creation of permanent establishments in a particular jurisdiction where economic activity takes place. In all the BEPS Action Plan identifies 15 areas for action that are likely to dramatically change the tax landscape for companies and businesses operating in the global economy.

Greater flows of information coupled with a more rigorous approach to transfer pricing are likely to be in the vanguard of these changes. One sees, and can expect to see increasingly, a trend towards transfer pricing rules that focus on activities rather than financial risk and that treat intangible value as earned in the country where intangibles are used. Limitations on interest deductions, and particularly on related party interest deductions, are expanding. In some countries the substance of special purpose treaty entities holding stock, debt or intellectual property is being challenged, and in some cases “long arm statutes” are taxing indirect gains on the sale of stock.

This overview highlights many of the key developments that may mark a coming trend. The country by country reviews provide an in depth insight into where we are and perhaps where we might be going in the future.

Source-Based Taxation of Non-Residents on Capital Gains

As a broad assertion of source-based taxation, perhaps no international tax case has grabbed more headlines than the Vodafone case in India. In 2007, Vodafone purchased a controlling interest in a Cayman Islands company that in turn owned the Indian business of Hutchinson Telecommunications, an international telecommunications company. The transaction involved a non-Indian purchaser, non-Indian seller, and a non-Indian asset – the stock of the Cayman holding company.

Nonetheless, Indian tax authorities claimed that Vodafone was liable for more than USD2 billion in Indian withholding taxes due on the purchase. India imposes capital gains taxation on non-resident sellers of Indian assets, and a corresponding withholding tax obligation on purchasers. In this case, the Indian tax authorities claimed that they could disregard the Cayman Islands holding company and treat this as a sale of Indian property. An Indian lower court initially agreed with the tax authorities and upheld the assessment. However, on appeal to the Indian Supreme Court, Vodafone prevailed, with the court holding that the tax authorities could not disregard the Cayman holding company.

The saga did not end there. Soon thereafter, the Indian Finance Ministry introduced legislation to effectively overturn the Indian Supreme Court’s ruling and grant authority to the tax authorities to treat sales of non-Indian holding companies as sales of Indian property. The legislation has a clear impact on future transactions – sellers and buyers of the stock of non-Indian companies may be subject to Indian tax on those transactions if the sale involves an underlying Indian business. Vodafone is currently in discussions with the Indian tax authorities regarding the application of the new legislation to Vodafone’s 2007 transaction. However, according to reports in The Times of India, Vodafone suffered a setback when in mid-December 2013 the Indian Government’s Income Tax Department assessed the company’s Indian arm for tax.

China has seen similar legislative and enforcement activity. China, like India, subjects non-resident companies to gains from the sale of Chinese property. And like India, China has recently been more aggressive in taxing gains from the sale of non-Chinese companies that hold Chinese assets. Under Directive 698, released in 2009, indirect sales of Chinese property can trigger Chinese capital gains taxation, and corresponding withholding obligations on the part of the purchaser. Common techniques used to minimise Chinese capital gains taxation, including the use of Hong Kong holding companies, can no longer be relied upon.

The Chinese and Indian examples evidence a trend among countries that have rejected the residence-based approach to capital gains taxation common among developed countries. For those countries that impose source-based capital gains taxation – and those investors who invest in such countries – common techniques used to avoid those taxes may no longer be reliable, and capital gains taxation will need to be a consideration in those investment decisions.

Source-based Taxation of Other Cross-border Income

In addition to capital gains taxes, much of the attention of the tax authorities and practitioners has shifted to the taxation of other types of income at its source. Here, there are three major trends of note. First, the increasing interest in formulary apportionment as an alternative to the now-prevalent separate-accounting and transfer pricing regimes. Second, the divergence between the OECD countries and large developing economies over the transfer pricing methods to be used to allocate income. Finally, the changes at the OECD itself regarding the approach to transfer pricing for intangible property.

Formulary Apportionment in the EU

On March 16, 2011, the European Commission published a proposal for a Directive that would implement an optional formulary apportionment system within the EU for multinational enterprises operating therein. Entitled the Common Consolidated Corporate Tax Base (“CCCTB”), the proposal would offer companies the option of calculating their taxable income on a consolidated basis using a single set of rules for determining the tax base. All EU affiliates and other affiliates with a taxable presence in the EU would be treated as a single corporation for these purposes; intragroup transactions would be ignored. Once calculated, the taxable income of the group would then be allocated within the group using a three-factor formula giving equal weight to assets, labour (determined based on both payroll and numbers of employees), and sales. Income as allocated would then be taxed in the member country at local tax rates.

The CCCTB does not cover non-EU affiliates of a multinational enterprise without a taxable presence in the EU – i.e. non-EU affiliates that do not operate through a permanent establishment in the EU. The income of such affiliates would still be determined on a separate-accounting basis, with transfer pricing rules applying to transactions between EU-affiliates and non-EU affiliates within a corporate group.

The CCCTB would represent a radical departure, at least within the EU, from the separate-accounting and transfer pricing principles that have prevailed for decades.

Transfer Pricing in China, Brazil, and India.

While the EU moves towards a formulary apportionment system, other large economies are bucking the OECD consensus on transfer pricing, and adopting their own approaches that serve to allocate more income to local country activities and sales.

In China, while the arm’s-length principle prevails, tax authorities have required allocations of income to take into account Chinese-specific factors that they consider relevant, including reduced labour costs, access to China’s large and growing consumer market, and unpaid pollution. These factors serve to increase the amount of profit allocated to Chinese members of a multinational enterprise.

India, which also requires arm’s-length pricing, requires the prices for intangibles to reflect the functions and risks associated with the development and exploitation of the intangible property. This approach has the effect of allocating additional income to Indian affiliates involved in developing and marketing intangible property, even where such property is owned and funded by a different affiliate.

Finally, Brazil has adopted a series of profit allocation formulae that apply a fixed percentage profit return unless a taxpayer can prove otherwise. With respect to intangible property, Brazil generally exempts payments associated with such property from arm’s-length pricing altogether, instead imposing special rules limiting the deductibility of payments for intangibles and subjecting such payments to withholding taxes in Brazil.

OECD Attribution of Profits and Transfer Pricing

The OECD, which has long been the arbiter of transfer pricing principles in the international arena, has also been making significant changes in its approach. The current process began in June 2012, when the OECD released its draft working paper on intangibles and transfer pricing, that was subsequently updated and released as a revised discussion draft on 30 July 2013 coupled with a white paper on documentation. Comments on the July draft, which were released on 22 October 2013, were followed by a formal public consultation in November 2013. The approach advocated is that returns on intangibles would be determined based on functions performed, assets used, and risks assumed – and not simply legal ownership. Under the OECD approach, relevant factors would include the functions that an entity performs through its employees related to the development of the IP. This process complements the BEPS action plan referred to above.

Despite the OECD’s efforts, what remains lacking is an international consensus on these transfer pricing issues – whether they should be eliminated altogether (such as through formulary apportionment), substantially revised (as per China, Brazil, and India), or simply left alone. Despite the divergence in views, one can detect an emerging trend toward allocating more profit to jurisdictions in which functions are performed and sales made, and less to those where intangible property is owned and funded.

Residency-based Taxation of Cross Border Income

Recent years have seen the implementation of significant international reforms by several large developed economies. Most notably, the United Kingdom and Japan abandoned their worldwide, residence-based taxation systems in favour of territorial systems with CFC rules that place a greater focus on preserving the tax base in the UK and Japan respectively than on the taxation of income earned outside of the home country. The changes implemented by Japan and the UK have left the United States as the only large developed economy that imposes worldwide taxation on its multinational enterprises, though proposed reforms may see the United States move in the direction of territoriality as well.

The UK’s international tax reforms have involved three major components – lower tax rates, the implementation of territoriality, and a reform to its CFC regime. The UK has reduced its corporate tax rate to 23%, and this will be reduced to 21% on 1 April 2014, and then by a further 1% to 20% from 1 April 2015. At the same time it has adopted a territorial tax system that generally exempts UK corporations from tax on dividends received from non-UK subsidiaries and capital gains realised from the sale of such subsidiaries, subject to the companies involved fulfilling certain trading conditions. Finally, it has substantially liberalised its CFC regime such that profits from business and financing activities generally will not be subject to UK tax unless a series of tests are flunked. These changes have made the UK a far more attractive location for corporate domicile. Perhaps not surprisingly, 2012 and 2013 saw a number of high profile corporate redomiciliations made, in part, to realise the tax benefits of a UK domicile under these new rules: including redomiciliations by public companies such as Aon and Rowan Companies, which redomiciled to the UK, and Virgin Media Inc. and Liberty Global, Inc. which merged under a new UK parent.

Japan has similarly reduced its corporate tax rate while adopting a territorial system that exempts non-Japanese income of multinational enterprises from Japanese tax. In the case of Japan, income of a foreign subsidiary will only be subject to tax in Japan if the subsidiary’s effective tax rate is less than 20% and the subsidiary is not engaged in an active business, does not manage that business in its country of residence, and does not conduct its business primarily in its home country.

The reforms in the UK and Japan have left the United States as the only major developed economy that taxes its domestic corporations on their worldwide income. Legislative proposals have been put forth that would change that. Representative Dave Camp, Chairman of the tax-writing House Ways & Means Committee, has authored a draft international tax reform proposal that would reduce the corporate rate to 25%, and adopt a participation exemption whereby dividends from foreign subsidiaries and capital gains realised on the sale of foreign subsidiaries would be 95% exempt from US tax. The discussion draft also includes a series of base erosion proposals that would impose thin capitalisation rules to limit interest deductions, and would reform the current CFC rules to impose taxation on CFC income that is either low-taxed or represents an excess return on intangible property.

The precise terms of the Camp proposal – most notably its base erosion proposals – are the subject of much discussion among practitioners and policy makers, and the outcome of these discussions remains uncertain. Whether and in what form the Camp proposal might be enacted remains subject to the uncertainties of the legislative process.

Conclusion

At this stage the trend towards expanded source-based transactions is focused principally on the major developing countries. Whether these trends are spreading to other countries is an important topic for discussion in this year’s – and future years – country analyses.