International Treasurer The Journal of Global Treasury and Financial Risk Management

February 16, 1998 • http ://www. intltreasurer.com

Commentary

Realizing EMU's Strategic Implications By Joseph Neu

MNCs that realize the competitive-risk implica­tions of EMU can capture high-level buy-in for euro preparedness, while highlighting a strategic role for treasury.

According to recent conversat ions with treasur­ers, a growing number of US multinationals are getting senior management and the board to wake up to the strategic business impl ications of European Econo mi c and Monetary Union (EMU).

Board support, of course, is a prerequisite for a full-blown EMU project-one that involves a multifunctional task force looking at both tacti­cal issues inherent to the new currency as well as the strategic pricing, sourcing and siting con­cerns and related competitive risks . More than anything, awa reness of EMU ' s compet it ive implications offers a welcome opportunity to build a case for treasury's strategic role in sup­porting company-wide business activities.

Why more awareness is in the offing

Since most companies turn to treasury first to "do something" regarding EMU, treasurers find themselves building the case for EMU prep at the board level. Their task is getting easier:

EMU isn't going away. Even skepti cs (not withstanding 155 German economists) now believe EMU wi ll go ahead on schedule-they just wonder whether it w ill last.

It is getting bigger. The initial euro zone looks to be much larger than originally anti c ipat­ed-11 of the EU-1 5 (less Sweden, the United Kingdom, Denmark, and Greece).

Treasury tax planning

Two Notices, One Chilling Effect By Nilly Essa ides

The combination of two IRS notices and one budget proposal has put some common MNC tax planning techniques under severe threat.

Wh at is leg itimate tax planning and what is abusive? For yea rs, the answer has been a gray area, a place where treasurers and tax direc­tors, w ith W all Street's help, ca refully bl ended foreign tax cred its and arb itraged differences in national tax treatments to lower a company's global tax bill.

Many of these structures are today under seri­ous threat from a double w hammy of IRS tax noti ces (98 -5 and 98- 11 ) reinforced by a request for new authori ty to pursue perceived tax abu ses conta in ed in the Clinton Administration's budget bill. Combined, the three may bring an end to a variety of tax plan­ning techniques- some creat ive, others more commonpl ace-raising severe objections on the part of industry practitioners.

The biggest complaint: The IRS seems to be changing the rul es in the middle of the game. " Notices of such broad sweeping nature may

1 have been an inappropriate way to make poli­cy," notes Lester Ezrati, general tax counsel at the Hewlett-Packard Co.

Retroactive rights?

"At the heart of this is a fundamental difference in what government and multinationals think is permissible," says Keith Martin, a lawyer w ith Chadbourne & Parke. The notices (the way the IRS lets taxpayers know it's intending to issue new rul es) attack two broad areas:

Asian influence. The Asian cri sis has everyone much more attuned to supply and demand • dynamics in an integrated global economy.

• 98-5 focuses on foreign tax credits. • 98-11 refers to hybrid branch structures. Both involve strategies-a llow ing tax payers

These factors also contribute to the competi­tive-risk implications. Perhaps the most effecti ve

continued on p. 8

to minimize the amount of res idual taxes on foreign-source income-that are technically

continued on p. 4

EMU's Strategic Implications By Joseph Neu

European companies rea lize that EMU's importance is less in lower transactional costs and more in gain­ing competitive advan­tages. US treasuries should leverage com­petitive-risk concerns to make EMU a strategic thrust.

page 7

Two Notices, One Chilling Effect By N ill y Essaides

The IRS recently issued two disturbing notices that attack global tax planning strategies. Combined with a new ca ll for broad authority to pursue abuses, they place some common tax planning techniques in serious jeopardy.

page 7

Anticipated Exposures EITF may consider the euro; BCCs and other tax havens may be bygones; Mexico may devalue the peso; Indonesia's currency board plan, and more.

page2

Sea-Land's Overlay Banking in Asia By Ni ll y Essaides.

Eager to rationalize its cash management and banking relations in Asia, the giant carrier instituted a bank over­lay program that cuts cost and increases the flow of information. It did so right in time for the current cash squeeze.

page 6

Treasury Tax Planning

"The IRS's Chilling Effecr· continued from page 1

"correct" yet violate the intent of US tax law. Hence the IRS's ire (see box this page) .

The specifics of the notices are described below (for full text, access the tax-pro corner of the IRS web site at www.USTREAS.gov).

The key to whether this threat becomes reality, however, is whether or not the IRS is within its authority to legislate retroactively.

Clearly, even the US Treasury has its doubts; it has hedged the authority risk by inserting a request for grant of authority in the new budget proposal. The request basically asks Congress to give the IRS the authority to go after any perceived abuses of hybrid trans­actions, entities or securities . But Congress may not oblige. "I believe the administration expects Congress to put constraints on the use of the authority / ' says Mr. Martin . Barry Ruddell, a partner at KPMG Peat Marwick, adds: "I think that it would be extraordinary for a Republican Congress to enact legislation that gives the IRS carte blanche authority."

Thumbing a rule of thumb

Mr. Ruddell and his colleagues may be correct. Regardless, MNCs must assess their exposures to the notices, since they are "law in effect" until withdrawn or turned into actual rules. The latter can take upward of a year.

Notice 98-5 is by far the more radi­cal departure from existing practice. "It deals with transactions that are entered into of an investment nature, that are not related to the business generating the foreign tax credit/' says Bill Zink, international tax partner at Grant Thornton International.

"98-5 is the IRS's attempt to close down techniques that violate the prin­ciple of capital export neutrality/' explains Mr. Ruddell of KPMG . FTCs are supposed to remove any disincen­tive to invest in a jurisdiction by removing the threat of double taxa-

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tion . According to 98-5, however, "Treasury and the Service are con­cerned that such tax payers may enter into foreign tax credit-generating schemes designed to abuse the cross­crediting regime and effectively trans­form the US worldwide system of taxa­tion into a system exempting foreign source income from residual US Tax."

Some FTC strategies are clearly aggressive, particularly ones such as (1) buying an asset just before it pays interest to capture withholding tax credits to offset low-tax income in another area, and (2) the Colgate/ACM-Iike structures, which involve arbitrage of different tax regimes to obtain duplicate benefits for foreign taxes .

The problem with 98-5, however, is that it seems to cast a net wide enough to catch legitimate business structures. "There is lots of fine print in the FTC system," notes Mr. Martin of C&P . "Many US MNCs cannot get credit for taxes paid abroad, hence they've set up ownership structures for foreign operations to defer US taxes on earn­ings as long as the earnings are left off­shore ." Take the case of high-tech firms, which often invest (venture cap­ital-style) in foreign start-ups. The lat­ter may not show profits for years, yet in many tax jurisdictions, the losses cannot be carried forward. As a result, high-tech earnings of US investors may not enjoy FTC relief under the notice. "There are a lot of reasons money is moved around that are obvi­ously legitimate, " notes Mr. Zink . "How the legislation will treat these arms-length transactions remains to be seen."

Says Mr. Ezrati of HP: "I think that they have to narrow (98-5) signifi­cantly so that it does not capture all the non-abusive stuff. At the moment, they threaten everybody."

The notice identifies two FTC plays : (1) Transfer of tax liability via the

acquisition of an asset that generates an income stream subject to foreign gross basis taxes (e.g., withholding) .

The Impetus for Change

Experienced Treasury/IRS watchers are not surprised by the recent double-strike at

tax shelters. Here's why: • Letter vs. Spirit. The IRS has been taking issue with structures that are technically legal but in practice violate the spirit of the law. "Some foreign jurisdictions already have general 'anti-abuse' provisions," explains Mr. Ruddell. In the US, the tax bar has been vigorously opposed to measures that introduce uncertainty of tax results.

• Chilling Wall Street's hot spots. The IRS learned from ACM and others that it cannot keep up with Wall Street's creativity on a case by case basis. Exasperated, it seems to have decided to ban creativity en masse.

• Corporate welfare. Treasury is part of the administration hence it follows President Clinton's tax agenda, which involves aggres­sively shutting down corporate loopholes, while providing middle-income families with more tax breaks. By going after abuses, the administration avoids squabbling about poli­cy with Republicans.

• Overseas income. US companies are earning more of their money overseas, hence the IRS is looking to ensure it does not lose its share of the global "now you see it, now you don't" corporate tax base. The IRS is also cooperating with foreign authorities in developed nations, all of which have real­ized that with investment tax breaks disap­pearing, no one benefits from the old "beg­gar thy neighbor" attitude .

(2) Cross-border tax arbitrage that permits effective duplication of tax benefits (or double dipping). The latter occurs when US and foreign tax authorities treat the same income dif­ferently (debt vs. equity).

The notice then offers five specific examples, the first three clearly repre­senting some of Wall Street's latest tax-avoidance wizardry.

But the danger is less in the specifics than in the standard of acceptabi I ity the IRS uses to determine what is abu­sive and what is not. The one in 98-5 pushes the envelope from tax abuse being not THE primary, or even A pri­mary motivation, to comparing pretax benefits with tax benefits.

As late as last year's Colgate/ACM case, the courts upheld a basic stan­dard of pretax economic benefit.

International Treasu rer/ February 16, 1998