no job name - dartmouth college...vodafone’s appeal in the case, which stemmed from vodafone’s...

Volume 53, Number 5 � February 2, 2009

tax notes internationalMinding the Book-Tax Gap

U.S. Widens Swiss Bank Probe

Indian Supreme Court Denies Vodafone Appeal

U.S. Companies Facing Chinese Compliance Burdens

Treatment of Intangibles in Spain

Attributing Profits to Agency PEs

Multinationals Accumulate to Repatriate

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ll rights reserved. Tax A

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ain or third party content.

369 IN THIS ISSUEby Cathy Phillips

HIGHLIGHTS

371 Minding the Book-Tax Gapby Joann M. Weiner

376 Multinationals Accumulate toRepatriateby Lee A. Sheppard and Martin A. Sullivan

380 U.S. Widens Investigation of Swiss Bankby Randall Jackson

381 Indian Supreme Court Denies VodafoneAppealby Kristen A. Parillo

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383 Canadian Budget Delivers OutboundTax Reliefby Steve Suarez

387 COUNTRY DIGEST

FEATURED PERSPECTIVES

411 Buddy, Can You Spare a Dime?by Trevor Johnson

BOOK REVIEW

415 The Global Tax Revolution: The Rise ofTax Competition and the Battle toDefend It

PRACTITIONERS’ CORNER

417 New Rules for Valuing IntangibleAssets In Spainby Sonia Velasco and Ana Colldefors

419 Deduction of School Fees UnderGerman Lawby Marko Wohlfahrt and Katrin Köhler

SPECIAL REPORTS

421 Different Methods of Attributing ProfitsTo Agency PEsby Carlos Eduardo Costa M.A. Toro

447 U.S. Tax Reviewby James P. Fuller

475 CALENDAR

ON THE COVERMinding the Book-Tax Gap. . . . . . . . . . . . . . .371

U.S. Widens Swiss Bank Probe . . . . . . . . . . . . 380

Indian Supreme Court Denies Vodafone Appeal . . . 381

U.S. Companies Facing Chinese ComplianceBurdens. . . . . . . . . . . . . . . . . . . . . . . .389

Treatment of Intangibles in Spain. . . . . . . . . . .417

Attributing Profits to Agency PEs. . . . . . . . . . .421

Multinationals Accumulate to Repatriate . . . . . . . 376

Cover photo: Newscom

TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 367

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ARGENTINA

387 Buenos Aires’ New Stamp TaxTriggered by Two Core Events

BANGLADESH

388 Government Revokes Import Tax onRenewable Energy Imports

CAMBODIA

388 Tax Breaks Targeted to CriticalGarment Industry

CHILE

389 Stimulus Package Wins UnanimousApproval

CHINA (P.R.C.)

389 U.S. Companies Facing ComplianceBurdens in China

ECUADOR

390 Congress Approves Tax Package

EUROPEAN UNION

391 Austrian Leasing Rules IncompatibleWith EC Treaty, ECJ Says

GERMANY

393 Former Deutsche Post CEO ConvictedOf Tax Evasion

HAITI

394 Mobile Phone Service ProvidersOppose Tax Hike

HUNGARY

394 Employer Tax Cut, VAT Increase UnderConsideration

INDIA

395 Indian PE Not Responsible forWithholding, Tax Tribunal Says

396 Subsidiaries in India Do Not ConstituteA PE, Tribunal Rules

INDONESIA

397 Exit Tax Rules Revised

398 Regulation Amends CFC Rules, ClarifiesExport Duty

JAMAICA

399 World Bank Backs Jamaican TaxReform Effort

JAPAN

399 Consumption Tax Measure Advances

MULTINATIONAL

400 IASB Rejects Proposal to AllowDiscounting of Current Tax in IAS 12

NORWAY

401 Government Proposes Carryback RuleFor Losses

OECD

402 OECD Group Addresses CIVs,Cross-Border Investors

PORTUGAL

405 Government Submits BudgetSupplement

RUSSIA

406 Court Dismisses Claim for Back TaxesAgainst Ernst & Young

SPAIN

407 Directors’ Remuneration NotDeductible, Supreme Court Says

SWEDEN

408 Government Proposes to DeferEmployee Tax Payments

UNITED STATES

408 Drafters of Temporary Branch RegsDefend Rules’ Complexity

NEWS ATA GLANCE

368 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL

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by Cathy Phillips

The news that Sarah Palin’s shoes recently sold formore than $2,000 on eBay shouldn’t fool anyone

into thinking the economic crisis is over. If you believethe pundits, the worst is yet to come as the globaleconomy continues its precipitous slide. Recoveringwill be an agonizingly slow process.

But how did we get here? Contributing editor JoannWeiner has some ideas, and tax policymakers shouldtake heed. As Weiner explains, financial transactionsare at the root of the crisis. But for too long, she says,policymakers have failed to see the impact of financialtransactions on the economy at large. Both the ac-counting community and tax policymakers should fo-cus on financial accounting. Together they might seehow differences in book and tax accounting have al-lowed companies to skew their financial statementsand tax filings — and engage in the kind of shenani-gans that got us in trouble in the first place (p. 371).

Squandering Stimulus?Big pharmaceuticals, software companies, and finan-

cial intermediaries are holding vast amounts of profitsoffshore in anticipation of another repatriation taxholiday. As you can imagine, battle lines are formingover whether these companies deserve another chanceto bring back the dough. Contributing editors LeeSheppard and Martin Sullivan make no bones abouttheir opposition to the idea, arguing that a second re-patriation ‘‘would constitute frittering of stimulus of ahigh order’’ (p. 376).

In the NewsU.S. prosecutors have increased their scrutiny of

Swiss bank UBS, and now believe that the bank helpedfar greater numbers of U.S. clients hide income in off-shore accounts than originally thought (p. 380). U.K.telecom giant Vodafone hit another roadblock in itsongoing challenge of a $2 billion capital gains taxclaim. India’s Supreme Court refused to hearVodafone’s appeal in the case, which stemmed fromVodafone’s 2007 merger with Indian telecom Hutchi-son Essar (p. 381). Canada has managed to escape the

worst of the global economic downturn, but its 2009budget nevertheless contains substantial stimulus meas-ures. The budget also features improvements to Cana-da’s outbound regime, as well as corporate and indi-vidual income tax relief measures (p. 383).

Commentary

Our first report, by Carlos Eduardo Costa M.A.Toro, deconstructs article 7 of the OECD model con-vention, which deals with business profits, in an at-tempt to clear up uncertainties on the tax consequencesof setting up a business involving an agency PE (p.421). Jim Fuller’s U.S. tax review returns this weekwith his expert analyses of the final contract manufac-turing regs, the temporary branch rules, and the revisedcost-sharing regs. He also discusses recent U.S. treatydevelopments and offers an alternative to reinstatingsection 965 (p. 447).

Do banks matter in an age of government take-overs? Trevor Johnson contends that U.K. businessowners needing a loan to pay the tax bill might as wellgo directly to the government for the money, ratherthan ask a bank for a loan that likely won’t be ap-proved (p. 411).

A practice article by Sonia Velasco and Ana Collde-fors discusses Spain’s advantageous new tax rules onvaluing intangible assets (p. 417). Another practice ar-ticle, by Marko Wohlfahrt and Katrin Köhler, reviewsGerman law on the deductibility of school fees (p.419).

Chris Edwards and Daniel J. Mitchell of the CatoInstitute have written a book on tax competition thateven a liberal could love. So says Gary Clyde Hufbauerin his review of The Global Tax Revolution: The Rise ofTax Competition and the Battle to Defend It. Hufbauer char-acterizes the book as ‘‘entertaining’’ and a good re-source for policy wonks (p. 415).

♦ Cathy Phillips is editor of Tax NotesInternational.


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NEWS ANALYSIS

Minding the Book-Tax Gap

by Joann M. WeinerFor too long, tax policy experts have acted as if

financial transactions have no impact on the realeconomy. If the current economic crisis, which finan-cial transactions largely spawned, hasn’t clearly estab-lished that connection, then it’s time for tax policy-makers to go back to business school.

Experts in financial accounting and tax policy madethat point loud and clear at the 12th annual UNC TaxSymposium held January 23 and 24 at the Kenan-Flagler Business School at the University of NorthCarolina in Chapel Hill.1

‘‘We want to take a big-tent approach and broadenour audience to scholars outside the accounting com-munity,’’ said Douglas A. Shackelford, the Meade H.Willis Distinguished Professor of Taxation at UNC.‘‘Accountants know the difference between reported taxexpenses and actual taxes paid. It is time for others tounderstand the implication of this difference.’’

The importance of this outreach should not be under-estimated as accounting rule makers and tax policy-makers begin to focus on issues such as how differ-ences in book and tax accounting may lead firms tomanipulate their financial statements, tax filings, orboth, Shackelford added.

Prof. Joel Slemrod of the University of Michiganwarned that economists might be missing the policyimpact because they ignore the financial accountingissues. ‘‘This could be a really, really big issue. If fi-nancial decisions are correlated across firms with re-spect to tax policy, the errors we make might be com-pounded,’’ Slemrod said.

Accounting for Income TaxesPublic corporations expend much effort properly

accounting for their income taxes, yet practitioners rou-

tinely condemn the poor quality of the information,implying that it is relatively useless. However, re-searchers disagree, as they use these data to analyzemany issues concerning the tax position of public cor-porations.

The tax information reported in financial accountsis critically important to researchers for one simple rea-son: The tax information reported on corporate taxreturns is confidential. Thus, financial statements aregenerally the only source of public information about acorporation’s tax situation.

The reliability of financial information is importantnot only in the academic world, but also in the realworld. Policymakers regularly rely on financial state-ment tax information, and studies based on that infor-mation, to guide their tax policies. Thus, understandingthe real implications of how firms account for theirincome taxes is one of the most critical issues taxpolicy analysts face today.

Along with coauthors John Graham of Duke Uni-versity and Jana Smith Raedy of UNC, Shackelfordpresented the report, ‘‘Research in Accounting for In-come Taxes,’’ highlighting the importance of under-standing how the financial accounting treatment of in-come taxes has a real effect on tax policy.

For example, the authors note that when tax lawand financial accounting treat transactions in the samemanner, the accounting for income taxes is ‘‘straight-forward, intuitive, and relatively simple.’’ But whenbook and tax treatment differ, the tax accounts canmaterially affect both the income statements and bal-ance sheets, the authors cautioned.

Those book-tax differences are not trivial. The mostrecent IRS data from 2005 show that corporations re-ported about $32 billion less in taxable income than inbook income, which reduced their 35 percent statutorytax rate to an effective tax rate of about 23.5 percent.

The authors evaluate how well the tax informationin financial statements does in approximating actualtax return information and for assessing a firm’s taxstrategy. In a word, the answer is ‘‘poorly.’’ This poorperformance is not the fault of the accounting state-ments, which are designed to provide informationabout the firm’s financial condition and not its tax sta-tus. But more worrisome to the authors is that ‘‘at-tempts to extract confidential tax return information

1The UNC Tax Symposium papers are available at http://areas.kenan-flagler.unc.edu/Accounting/taxsym09/Pages/AcceptedPapers.aspx.


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from the tax accounts in the financial statements canlead to erroneous and misleading inferences.’’

The confidentiality of corporate tax returns, how-ever, places researchers in an unenviable position.Either they apply to the IRS for permission to use con-fidential data, as many researchers have done, or theydevelop ways to tease tax information out of the finan-cial reports. Shackelford and his coauthors chose thelatter path and suggest ways to use this imperfect pub-lic information to better approximate information inthe confidential tax return.

Book-Tax Differences

As Shackelford noted, accountants and the IRS fre-quently take different views of what constitutes in-come. For a given accounting definition, the differencesin book and tax treatment largely arise from tax legisla-tion designed to encourage a specific behavior, such asadditional investment spending or simplification.

These differences may be permanent or only tempo-rary. For example, the tax law exempts municipal bondincome from tax, while accounting rules include theincome in book income. This creates a permanent dif-ference between book and tax income and will drivedown the reported effective tax rate (the income taxexpense divided by net income before taxes) in the fi-nancial statements. The income tax expense is theproduct of the statutory tax rate and book income ad-justed for permanent differences.

Temporary differences in book and tax income gen-erally do not cause effective and statutory tax rates todiffer. However, because permanent differences in bookand tax income reduce the effective tax rate, corporatemanagers likely value transactions that reduce perma-nent income more highly than those that reflect onlytemporary differences in tax payments.

Those differences have drawn the attention of manyresearchers. David Weisbach2 and George Plesko3 haveargued that firms seek to enter tax shelters preciselybecause they permanently reduce income reported tothe government while having no impact on financialstatement earnings. Mihir Desai4 suggests that the un-explained growth in book-tax differences may largelybe explained by the growth in tax shelters. Jeri

Seidman5 examined data from 1995 to 2004 and foundthat after narrowing during the 2001 economic down-turn, the book-tax gap significantly widened in 2003partly because of earnings management.

These book-tax differences are not inconsequential.As the Senate Homeland Security and GovernmentalAffairs Permanent Subcommittee on Investigations6

noted when investigating the collapse of Enron, thefirm regularly showed positive financial earnings whilereporting losses for tax purposes. The committee’s re-port concluded that:

some U.S. financial institutions have been design-ing, participating in, and profiting from complexfinancial transactions explicitly intended to helpU.S. public companies engage in deceptive ac-counting or tax strategies. This evidence alsoshows that some U.S. financial institutions andpublic companies have been misusing structuredfinance vehicles, originally designed to lower fi-nancing costs and spread investment risk, to carryout sham transactions that have no legitimatebusiness purpose and mislead investors, analysts,and regulators about companies’ activities, taxobligations, and true financial condition.While no one has yet accused any of the companies

involved in the current financial crisis of engaging inEnron-style abuses, I believe something seems wrongwhen a company can regularly report high, positiveearnings to the financial community while reportinglow or no taxable income to the tax authorities.

The Treasury Department had already placed book-tax differences under suspicion in its 1999 tax shelterstudy. (See Doc 1999-22641 or 1999 WTD 128-43 and Doc1999-22867 or 1999 WTD 128-44.) Whether tax sheltersor other, innocuous tax planning explains today’s book-tax differences has yet to be determined. I believe theIRS is years away from providing the data necessary todetermine the extent to which a favorable interactionbetween financial and tax reporting contributed to thecurrent financial crisis.

Shining a Spotlight on the AccountsBecause corporate tax returns are not public, it is

difficult to determine whether book-tax differences in-dicate that the firm is participating in a tax shelter orwhether it has legitimate tax deductions. Researcherswithout access to tax data have had to look elsewhere.

2David Weisbach, ‘‘Ten Truths About Tax Shelters,’’ 55 TaxLaw Review, 215-253 (2002).

3George Plesko, ‘‘Corporate Tax Avoidance and the Proper-ties of Corporate Earnings,’’ LVIII National Tax Journal, 729-737(2004).

4Mihir Desai, ‘‘The Divergence Between Book Income andTax Income,’’ Tax Policy and the Economy 17, edited by James M.Poterba, National Bureau of Economic Research and MIT Press(Cambridge, Mass.), 169-206 (2003).

5Jeri Seidman, ‘‘Interpreting Fluctuations in the Book-TaxIncome Gap as Tax Sheltering: Alternative Explanations,’’ work-ing paper, University of Texas (2008).

6U.S. Congress, Senate Committee on Governmental Affairs,‘‘Report on Fishtail, Bacchus, Sundance, and Slapshot: Four En-ron Transactions Funded and Facilitated by U.S. Financial Insti-tutions,’’ Permanent Subcommittee on Investigations, Jan. 2,2003. For a reference to the study, see Doc 2003-511 or 2003 TNT2-22.

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A few years ago, Lillian Mills, Kaye Newberry, andWilliam Trautman7 turned the spotlight on areas wherethe tax community may wish to start looking. First,financial firms and multinational corporations reportthe largest gap between book and taxable income, andthe gap is concentrated among the largest firms. Sec-ond, off-balance-sheet structured transactions or specialpurpose entities accounted for part of the differences.

These researchers may be on to something big. Off-balance-sheet structured transactions and special pur-pose entities have been identified as culprits behind theeconomic crisis. And financial institutions are the pri-mary players in this game.

As much as he might have liked to use that evidenceto conclude that firms exploit book-tax differences,Shackelford could not reassure users of financial state-ments that their data were up to the task. As the studynotes, because we do not know whether using the bestpublicly available firm-level tax data ‘‘leads to minormismeasurement or substantial errors in scholarship,practice, and policy,’’ we should ‘‘interpret scholarlyfindings with caution.’’

Firms’ ability to increase their book income withoutincreasing their tax liability has led many to call forconformity between the two measures. However, thereis no agreement on the wisdom of that move. JohnMcClelland of the Treasury Department and LillianMills of the University of Texas8 summarized the prosand cons of conformity and came out in favor of con-tinuing nonconformity. Shackelford also reports that astudy by Danqing Young and David A. Guenther9 ofbook and tax conformity in 13 countries reveals thatcountries with a high degree of conformity exhibit re-duced international capital mobility. From his surveyof the issue, Shackelford concludes that ‘‘the empiricalevidence suggests that conformity would adversely af-fect the information that financial reports provide thecapital markets.’’ Shackelford calls for more researchrather than for continued nonconformity.

International Financial Reporting StandardsSome conference participants mentioned that be-

cause they require more disclosure than U.S. generallyaccepted accounting principles, the move to interna-tional financial reporting standards might help addressthe issues that arise under book-tax nonconformity. In

August 2008 the Securities and Exchange Commissionissued for comment a proposal to start allowing volun-tary adopting of IFRS, and eventual mandatory adop-tion beginning in fiscal 2014. A more general move toadapt U.S. rules to IFRS may be postponed. The Glo-bal Oversight Committee of the Financial ExecutivesInstitute recently removed the Accounting PrinciplesBoard (APB) Opinion No. 23, ‘‘Accounting for IncomeTaxes — Special Areas,’’ exception for the treatment ofpermanently reinvested earnings (PRE) from the con-vergence project.

Other conference participants warned that althoughthe accounting profession is moving toward interna-tional rules, the U.S. Congress might be unwilling tocede its ability to provide tax incentives to an interna-tional forum.

Earnings Management

The General Rule

With Congress considering reintroducing a tempo-rary dividend repatriation tax holiday, the way thatcorporations account for their foreign earnings maygreatly influence whether a corporation repatriates divi-dends. That only a fraction of the firms that couldhave participated in the 2004 dividend repatriation taxholiday took advantage of it suggests that the repatria-tion decision may be more complicated than initiallyunderstood.

In general, a U.S. multinational pays U.S. tax onforeign earnings only when it receives the dividendfrom its foreign subsidiary. However, the accountingand the tax rules differ in how they treat the tax liabil-ity associated with those foreign earnings. And it isthat difference that can lead firms to alter their finan-cial decisions to benefit from the tax provisions.

Under GAAP, firms immediately recognize boththeir foreign earnings and the expected tax associatedwith those foreign earnings, although they pay the taxonly when the earnings are repatriated to the UnitedStates. Thus, for accounting purposes, the firm takes ahit on its financial earnings, but it benefits by avoidingan earnings reduction when it later repatriates theearnings.

That companies may continually reinvest their for-eign earnings complicates the decision. Because manyfirms never expect to return their foreign earnings tothe U.S., the accounting rules under APB 23 have,since 1972, provided an exception to that general rulethat allows the firm to disclose its potential U.S. taxliability only in a footnote to its financial statements.This treatment creates a permanent difference betweenbook and taxable income. The firm immediately ben-efits when it declares that it is permanently reinvestingits foreign earnings, because it recognizes those earn-ings without recognizing a related tax expense for theresidual U.S. tax on those earnings.

7Lillian Mills, Kaye Newberry, and William Trautman,‘‘Trends in Book-Tax Income and Balance Sheet Differences,’’Tax Notes, Aug. 19, 2002, p. 1109, Doc 2002-19155, or 2002 TNT161-49.

8John McClelland and Lillian Mills, ‘‘Weighing Benefits andRisks of Taxing Book Income,’’ Tax Notes, Feb. 19, 2007, p. 779,Doc 2007-1810, or 2007 TNT 35-61.

9Danqing Young and David A. Guenther, ‘‘Financial Report-ing Environments and International Capital Mobility,’’ 41 Journalof Accounting Research, 553-579 (2003).

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However, if the firm reconsiders and later decides torepatriate those earnings, it faces a disadvantage be-cause it must recognize an income tax expense onthose earnings but cannot recognize any earnings be-cause it has already recognized the income in an ear-lier accounting period. So firms that decide to repatri-ate PRE face a dilemma: Should they take advantageof the tax holiday and repatriate the earnings despitethe reduction in earnings, or should they continue toreinvest the earnings abroad and skip the tax holiday?As demonstrated by the surge in dividend repatriations,many firms decided the tax benefit outweighed the ad-verse impact on earnings.

The bottom line is that firms can increase their fi-nancial earnings without increasing their tax liabilityby increasing the amount of foreign profits designatedas PRE. This incentive to manipulate earnings is oneof many possibly unintended consequences that thedifferences between book and tax accounting may haveon real behavior — the repatriation of foreign earn-ings.

International Effects of the PREMultinational firms benefit from their PRE in many

ways. Empirical evidence suggests that they take ad-vantage of the discretion allowed under GAAP to des-ignate at least some portion of their foreign earnings aspermanently reinvested abroad so that they have theflexibility to manage their earnings as needed to meetmarket expectations. Shackelford and his coauthorsdiscussed research showing that the amount firms re-port as PRE depends on the difference between ana-lysts’ forecasts and their premanaged earnings.

This discretion in the treatment of foreign earningsmay have unintended consequences. Linda Krull10 ofthe University of Oregon examined the disclosures inthe financial statements of 267 multinational firmsfrom the 1990s and found that firms took advantage ofthe discretion allowed under the accounting rules toactively manage their PRE. Her research revealed thatwhen the firms increased their PRE, their earnings roseby an amount sufficient to meet analyst expectations.

Krull also noted that given the minimal informationthat firms report about their foreign operations, it isdifficult for analysts to understand the source of theseadditional earnings. As one conference participantnoted, stock analysts sometimes lack the expertise orexperience to understand these variations in earningsreporting.

So it isn’t surprising that multinational firms haveaccumulated more than $600 billion in permanent rein-vestment foreign earnings since the dividend repatria-

tion tax holiday expired. The discretion allowed underthe accounting rules makes this behavior an acceptableway to manage earnings. However, as Krull noted inher paper, firms that report large fluctuations in PREas the tax treatment of dividend repatriations changesmight deserve greater scrutiny regarding how long thefirms actually intend to reinvest the earnings abroad.

More on the Lock-In Effect

Krull and Leslie Robinson, in a paper titled ‘‘Is U.S.Multinational Intra-Firm Dividend Policy Influencedby Capital Market Incentives?,’’ revisited the issue ofthe lock-in effect of the dividend repatriation tax. Thepaper identifies two major disincentives public firmsface — an actual cash tax liability and a reduction intheir reported pretax earnings — when decidingwhether to repatriate their foreign earnings to theUnited States.

That research shows that financial accounting rulescan and do have large impacts on the real economy.For example, because the accounting rules do not re-quire firms to report a tax expense on PRE, firms(such as those operating in low-tax countries that didnot have foreign tax credits from high-tax countriesthat would shield their repatriations) may have beenencouraged to accumulate their earnings abroad ratherthan repatriate them to the United States.

Prior research on the impact of the American JobsCreation Act of 2004 largely ignored the financial ac-counting cost of repatriation. Krull and Robinson’sstudy shows that capital market pressures to reporthigh earnings deter firms from repatriating their foreignearnings and that those pressures are consistent withboth the buildup in undistributed foreign earnings andthe surge in dividend repatriations under the Jobs Act.This example demonstrates that financial rules had aclear impact on real tax decisions.

Firms have many avenues to minimize the repatria-tion tax cost, whether through borrowing funds abroad,corporate reorganizations, or by routing incomethrough low-tax locations and expenses through high-tax locations. As Krull noted, however, ‘‘These effectsare not costless.’’ Firms incur many costs — whetherin the form of actual tax expenses or in complianceand tax planning costs — to minimize the tax on re-turning their earnings to the United States. To the listof well-known tax costs to repatriation, Krull and Rob-inson add financial reporting costs.

The tax and accounting rules converge in one area.Because firms can defer their U.S. tax liability on for-eign earnings until they are repatriated, the tax codecreates a lock-in effect to keep earnings offshore, andthe accounting rules reinforce that effect. As Krull andRobinson noted, ‘‘The results of this study provide evi-dence that APB 23 creates incentives to leave earningsoffshore.’’ Conference participants added another cost

10Linda Krull, ‘‘Permanently Reinvested Foreign Earnings,Taxes, and Earnings Management,’’ 79 The Accounting Review745-767 (2004).

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to the dividend repatriation tax — a cost to the com-petitiveness of U.S. companies. Two of the UnitedStates’ major trading partners, Japan and the UnitedKingdom, are moving away from taxing dividend repa-triations, while a third major partner, the Netherlands,has few restrictions on income repatriations.

The evidence is overwhelming that the U.S. interna-tional tax system badly needs reform. I believe it istime for Congress to add the financial reporting andthe competitiveness costs when it considers changingthe tax treatment of the foreign profits of U.S. multina-tional corporations.

Cross-Country Differences in Tax SystemsSlemrod, along with coauthor Leslie Robinson of

the Tuck School of Business at Dartmouth College,took a global view of tax systems. They took advan-tage of new OECD information to analyze how varia-tions in tax systems beyond the tax rate and the taxbase affect real economic behavior. Their study, ‘‘Meas-uring the Impact of Tax Systems on Economic Behav-ior Using New Cross-Country Data,’’ examined howvariations in tax administration, enforcement, with-holding, and corruption, for example, help explainvariations in economic behavior across countries.

‘‘Tax systems are multidimensional,’’ Robinson ex-plained. ‘‘Ignoring these differences may skew our viewof how tax rates affect economic behavior. Leaving outimportant aspects of tax systems may bias estimatedpartial effects of tax rates, and/or miss entirely the ef-fects of other tax system features.’’ For example, whileprior research has shown that countries with high taxrates tend to have a smaller informal sector, Robinsonnoted that the tax rate impact largely disappears oncetax administration is taken into account. Somewhatcounterintuitively, she found that although countrieswith high penalty rates have a smaller informaleconomy, countries that use extensive withholding sys-tems have larger informal sectors.

The reason, she suggests, is that withholding sys-tems make it less attractive to work in the formal sec-tor, because withholding makes it difficult to avoid pay-ing taxes. Given that more corrupt countries exhibitgreater use of withholding, that may partially explainwhy prior research has found a strong positive associa-tion between corruption and the informal sector.

One main benefit of Slemrod and Robinson’s paperis that it references a 2006 OECD report11 that pro-vides internationally comparable data on the aspects oftax systems in 30 OECD countries and 14 non-OECDcountries.

It’s no surprise that tax systems vary significantlyacross countries — some countries have effective taxadministrations, while others have weak administra-tions; some countries tend to rely on withholding,while others rely on self-assessment; some countrieshave strong debt collection powers, while others havelow ratios of tax administrators per worker.

Until the OECD published its data, researchers hadno comparable cross-country information on how taxsystems varied, other than in their rates and theirbases, and so could not examine the factors that ex-plained why tax systems varied across countries. Slem-rod and Robinson used the OECD data to show thattax system differences affect real economic behavior,because they affect how the taxpayer perceives the ex-pected tax burden triggered by its actions.

The authors also explore a well-known tax fact:Rich countries levy more taxes per capita than poorcountries. The OECD data confirm that, but also showthat tax systems in high-income countries tend to sharesome characteristics and that there may be underlyingfactors about those countries that explain the tax bur-den.

Relative to low-income countries, high-income coun-tries impose withholding and reporting on fewer typesof income, have fewer powers to facilitate debt collec-tion, impose lower penalties, are less likely to use self-assessment principles, and hire more tax administra-tors, but they do not spend significantly more onadministrative costs as a share of income.

For example, Luxembourg, Iceland, and the Nether-lands are in the top per capita income quartile but tendto fall in the lowest quartiles for penalty rates, with-holding taxes, and information reporting. Chile, China,and South Africa fall in the lowest income bracket buttend to fall in the highest brackets for imposing penal-ties, levying withholding taxes, and relying on informa-tion reporting.

Those correlations suggest that high-income coun-tries tend to design their tax systems in ways that ex-plain why those countries have a relatively high taxburden. As Robinson noted, an analysis that considersonly tax rates will miss the effect of other factors thatmay affect the size of the informal economy and maybias the estimates of how tax rates affect tax burdens.Robinson said it might be a variation in tax systemdesign that is correlated with national income, ratherthan national income itself, that affects a country’s taxburden.

In conclusion, Slemrod emphasized: ‘‘Leaving outconsideration of administrative issues can lead to se-verely biased measures of the role of tax rates in theeconomy.’’

♦ Joann M. Weiner is a contributing editor to TaxAnalysts. E-mail: [email protected]

11For the report Tax Administration in OECD and Selected Non-OECD Countries: Comparative Information Series, see Doc 2006-22140or 2006 WTD 210-10; for related coverage, see Tax Notes Int’l,Sept. 25, 2006, p. 1046, Doc 2006-19457, or 2006 WTD 180-2.

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NEWS ANALYSIS

Multinationals Accumulate toRepatriate

by Lee A. Sheppard and Martin A. Sullivan

Printing lots of unsecured money is bad enough. Fritter-ing it away on courtiers is worse.

That was historian Paul Kennedy writing in TheWall Street Journal about the coming stimulus bill andthe dismal prospects for gargantuan U.S. budget deficitsstretching into the future (The Wall Street Journal, Jan.14, 2008, p. A13).

Elsewhere in his piece, Kennedy compared the U.S.budget to that of ‘‘Iceland or some poorly run ThirdWorld economy.’’ He could have mentioned Italy,which routinely incurs government debt equal to GDP,but has the luxury of selling its debt to its own citi-zens. The United States does not have that luxury, andKennedy predicts that the Chinese purchasers of U.S.government debt will demand higher interest.

Our subject today, however, is the courtiers askingthat money be frittered away on them in the stimulusbill. Big pharma, software companies, and financialintermediaries have accumulated vast amounts of for-eign profits that some of them are lobbying to repatri-

ate at very low tax rates. Since 2005, they have accu-mulated foreign profits at a greater rate thanhistorically.

Well, so what, don’t they just have very profitableforeign operations? Data examined in this articlestrongly suggest that section 965 may have encouragedmore shifting of profits offshore than usual in prepara-tion for another repatriation tax holiday. Of course,multinationals have always had ample incentives toshift profits offshore. Section 965 enlarged their incen-tives to do so. This phenomenon argues that repatria-tion tax holidays have the effect of encouraging thevery behaviors they were intended to reverse. In short,another repatriation tax holiday would constitute frit-tering of stimulus of a high order.

After their last repatriation tax holiday, U.S. multi-nationals went back to work building up earnings inforeign jurisdictions. Here we show the increase in un-distributed foreign earnings of 40 of the largest U.S.corporations since the American Jobs Creation Act of2004 allowed them ‘‘one-time’’ dividend relief. Al-though these 40 multinationals account for less than 5percent of the 832 multinationals that repatriated earn-ings under the Jobs Act provision, they received 44percent of the total $362 billion of repatriated earn-ings, as reported by the IRS. (Melissa Redmiles, ‘‘TheOne-Time Received Dividend Deduction,’’ IRS Statisticsof Income Bulletin, spring 2008.)

Figure 1. Accumulated Foreign Earnings of 40 U.S. Multinationals, 2002-2007

$261.7

$321.8

$389.4

$484.4

$580.7

$702.8

$518.0

$395.9

$300.3

$0

$100

$200

$300

$400

$500

$600

$700

$800

2002 2003 2004 2005 2006 2007

Fiscal Years

Bil

lion

s

Simulated Assuming No Jobs Act

Actual Accumulated Foreign Earnings

Source: Company annual reports as shown in table.

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For this group of 40, the accumulated stock of un-repatriated foreign earnings hit a temporary low in2005 of $300.3 billion. Under the Jobs Act provisions,these companies repatriated a total of $184.8 billion offoreign earnings — about 90 percent in that year. Bythe end of fiscal 2007 these multinationals had replen-ished their stash of unrepatriated earnings to $518 bil-lion — a 72 percent increase in two years. These totalsare shown in a solid line in Figure 1. Company-by-company figures are presented in the table at the endof the article.

Another view is provided in Figure 2. It showsgrowth in the stock of unrepatriated foreign earningsplus earnings repatriated under the Jobs Act. In otherwords, it shows the annual change in accumulated for-eign earnings that would have occurred each year with-out the Jobs Act. This is a measure of how muchprofit multinationals are keeping offshore to maximizetax advantages. From 2003 to 2007 the annual increaseapproximately doubled — from $60 billion to $122 bil-lion.

The two figures show multinationals are loading upon unrepatriated earnings at a far greater rate than be-fore the tax holiday legislated in 2004. This is a resultof higher worldwide profitability since the prior reces-sion and an increasingly larger share of business activ-ity taking place abroad. But as documented previouslyin these pages, it is also a result of greater profit shift-ing by multinationals out of the United States and into

foreign jurisdictions. (For that discussion, see Tax NotesInt’l, Mar. 17, 2008, p. 910, Doc 2008-4725, or 2008WTD 49-5.)

What’s Next?These data suggest that the pressure for another re-

patriation holiday may be greater than ever. Despitethis, it looks like the growing opposition could thwartany repeat.

First of all, there is widespread skepticism that theserepatriations work as advertised. For most lawmakers,the debate about the need for a repeat of the ‘‘one-time’’ tax relief for repatriated dividends centers on theeconomy and job creation. Did those lucky multina-tionals increase jobs as they told Congress they wouldand as they outlined in their legally required dividendrepatriation investment plans? The evidence is in, andthe answer clearly is no. (Dharmapala, Foley, andForbes, ‘‘The Unintended Consequences of the Home-land Investment Act: Implications for Financial Con-straints, Governance, and International Tax Policy,’’2008.)

Besides job creation, there is the additional issue ofhow temporary repatriation relief affects the web ofglobal tax checks and balances. Repeated ‘‘one-time’’relief would send a signal to multinationals that theyno longer need to consider profits shifted offshore astrapped. This increases the benefit of aggressive trans-fer pricing practices that would otherwise be held in

Figure 2. Annual Flow of Tax-Advantaged Foreign Earnings of 40 U.S. Multinationals, 2003-2007

$60.1

$67.6

$95.0 $96.4

$122.1

$0

$20

$40

$60

$80

$100

$120

$140

2003 2004 2005 2006 2007

Fiscal Years

Bil

lion

s

Source: Dotted line in Figure 1.

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check by full tax on any unlocking of offshore cash.And this in turn reduces U.S. tax revenue as well asprovides an added incentive for multinationals to locatefacilities abroad.

President Barack Obama campaigned on reducingthe incentives for offshore job creation that U.S. taxlaw provides by deferring tax on unrepatriated foreignearnings. Temporary repatriation relief is a pro-deferralprovision.

In early 2008, Senate Finance Committee memberJohn Ensign, R-Nev., tried to include an amendmentthat would provide another round of foreign dividendrelief in the Finance Committee markup of the firststimulus bill. His efforts failed then, and any repeatedeffort would likely run into even tougher opposition.And according to a January report by Ryan J. Don-moyer of Bloomberg News, there is little support in theHouse for another round of repatriation relief.

Business lobbyists know all this, so now there is talkof a substitute for section 965 for multinationals whoseforeign earnings are available in cash. Some policy-

makers see expansion of section 956, which treats acontrolled foreign corporation’s investment in U.S.property as gross income to its U.S. shareholder, as anacceptable alternative to a revival of section 965.

As also reported in the Donmoyer article, MorganStanley, United Technologies, General Electric, andunnamed other multinationals are promoting a plan toCongress that would waive U.S. tax under subpart Fon businesses that borrow from their offshore units.This would be a statutory expansion of the section 956relief the Treasury provided in October to the generalrule that loans from foreign subsidiaries should betreated as gross income. In Notice 2008-91, 2008-43IRB 1001, Doc 2008-22166, 2008 WTD 202-27, the IRSlengthened the permissible period of short-term loansfrom CFCs.

♦ Lee A. Sheppard is a contributing editor to TaxAnalysts. E-mail: [email protected] A. Sullivan is a contributing editor to TaxAnalysts. E-mail: [email protected]

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Reported Accumulated Foreign Profits and Jobs Act Repatriations of 40 U.S. Multinational Corporations,1996-2008 (millions of dollars)

Jobs ActRepatria-

tionAmount

Company Company Fiscal Year

2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996

1,200 General Electric - 62,000 47,000 36,000 29,000 21,000 15,000 * * * * * *37,000 Pfizer - 60,000 41,000 27,000 51,600 38,000 29,000 18,000 14,000 8,200 6,500 4,500 3,900

- Exxon Mobil - 56,000 47,000 41,000 25,000 22,000 17,000 17,000 14,000 11,100 8,400 6,600 6,200- American

InternationalGroup

- 21,200 17,600 13,800 7,000 6,500 5,100 4,500 3,500 3,100 3,300 2,900 3,100

3,200 Citigroup - 21,100 14,700 10,600 10,000 5,800 3,200 2,000 1,500 1,300 1,300 1,300 *- ChevronTexaco - 20,557 21,035 14,317 10,000 10,541 10,108 9,003 8,544 8,002 7,958 7,900 7,420

9,500 IBM - 18,800 14,200 10,100 19,644 18,120 16,631 16,851 15,472 14,900 13,165 12,511 12,11115,900 Merck - 17,200 12,500 8,300 20,100 18,000 15,000 12,400 9,700 7,500 5,800 6,600 5,4007,200 Procter &

Gamble21,000 17,000 16,000 10,300 16,750 14,021 10,698 9,231 8,828 7,764 6,739 6,108 5,078

1,200 Cisco Systems 21,900 16,300 11,100 6,800 4,300 2,500 1,200 707 411 133 * * *7,500 PepsiCo - 14,700 10,800 7,500 11,900 8,800 7,500 * * * * * 4,0009,000 Bristol-Myers-

Squibb- 14,100 11,300 8,400 16,900 12,600 9,000 8,800 6,000 4,400 3,200 2,600 2,506

1,800 Merrill Lynch - 13,000 9,800 7,700 8,100 5,900 4,300 4,800 3,700 3,300 2,230 1,645 1,2064,300 Abbott

Laboratories- 12,330 7,320 5,800 7,900 5,194 4,304 4,681 2,432 1,980 1,818 1,549 1,312

2,700 Wyeth - 12,060 9,420 7,480 8,790 6,435 6,000 * * * * * *6,100 Coca-Cola - 11,900 7,700 5,100 9,800 8,200 6,100 5,900 3,700 3,400 3,600 1,917 5425,500 Altria Group - 11,000 11,000 9,300 11,800 8,600 7,100 5,600 4,700 5,800 3,400 3,000 4,2009,100 DuPont - 9,644 7,866 7,031 13,865 13,464 10,320 9,106 8,865 6,666 5,996 7,007 5,9288,000 Eli Lilly - 8,790 5,700 4,100 2,800 9,500 8,000 6,400 5,200 2,610 1,010 115 1,833

- Alcoa - 8,753 8,470 7,562 7,248 6,154 5,893 4,399 3,861 1,838 1,528 1,389 1,115- Walmart Stores 10,700 8,700 6,800 5,300 4,000 2,141 1,000 722 * * * * *

4,100 Dell 10,800 7,900 5,700 2,900 5,100 4,100 711 492 541 263 127 97 7014,500 Hewlett-Packard 12,900 7,700 3,100 1,200 15,000 14,400 14,500 13,200 11,500 9,000 7,100 5,200 3,800

- Xerox - 7,500 7,000 3,900 6,000 5,000 5,000 3,400 5,000 4,900 4,700 4,500 3,9006,200 Intel - 6,300 4,900 3,700 7,900 7,000 6,300 5,500 4,200 2,200 2,200 1,505 992

780 Microsoft 7,500 6,100 n.a. 4,100 2,300 1,640 780 * * * * * *9,400 Schering-Plough - 5,800 4,200 3,100 2,200 11,100 9,400 7,600 6,400 5,020 3,475 2,850 2,1194,000 Morgan Stanley - 5,800 4,400 3,900 5,800 4,900 4,000 4,700 4,300 3,100 2,600 2,200 *

- Goldman SachsGroup

- 4,970 2,900 2,400 1,650 1,100 209 * * * * * *

- AmericanExpress

- 4,900 3,900 3,200 2,700 2,900 2,400 2,100 1,900 1,600 1,200 873 677

- Conoco Phillips - 4,381 3,597 2,773 2,091 2,046 2,171 1,687 1,661 Merger2,700 Honeywell

International- 4,100 2,900 2,100 3,900 3,300 2,200 2,000 2,100 1,600 552 355 326

4,600 Motorola - 4,100 4,000 2,800 5,600 6,100 7,600 7,100 7,900 * * * *2,100 International

Paper- 3,700 2,700 2,400 2,700 3,300 2,500 1,800 1,800 1,200 1,100 555 361

1,900 J.P. MorganChase Co.

- 3,400 1,900 1,500 2,600 2,300 1,900 1,667 1,404 1,054 764 *

755 Apple 3,800 2,400 823 1,200 972 822 755 755 755 520 437 395 3951,290 Texas

Instruments- 1,620 1,290 1,010 2,034 1,604 1,293 * * * 620 870 760

- Viacom - 939 457 351 155 2,000 1,900 1,600 1,600 1,400 1,500 1,500 1,3002,200 Verizon - 900 3,000 3,000 5,100 3,400 4,500 4,000 3,600 Merger1,100 Weyerhaeuser - 357 828 1,300 1,700 1,300 1,100 972 1,259 993 789 827 792

Note: * indicates information not available.Source: Company annual reports.

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U.S. Widens Investigation ofSwiss Bank

by Randall JacksonU.S. prosecutors reportedly are expanding their in-

vestigation of the actions of UBS AG, the Swiss bank-ing giant that has been accused of helping its U.S. cli-ents conceal taxable assets.

Officials are looking into the possibility that thebank helped tens of thousands of U.S. taxpayers hideincome in offshore accounts. New evidence reportedlyhas led investigators to believe that the original esti-mate that UBS helped about 17,000 U.S. residentsevade taxes may be too low and that thousands of pre-viously unknown accounts may exist.

Investigators now are looking into whether previ-ously unidentified investment vehicles may have beenused and whether divisions of the bank in addition tothe previously targeted wealth management sectionmay have been involved, according to a January 26Wall Street Journal report.

The talk of additional illegal activity comes close onthe heels of a January 13 order declaring former UBSofficial Raoul Weil a fugitive. Weil failed to surrenderto U.S. authorities after the November 12, 2008, un-sealing of an indictment charging him with conspiringto defraud the U.S. government. (For prior coverage,see Tax Notes Int’l, Jan. 26, 2009, p. 307, Doc 2009-856,or 2009 WTD 10-1.)

Weil was head of the international portion of UBS’swealth management division from 2002 to 2007 andwas appointed chair and CEO of the bank’s globalwealth management and business banking division onJuly 6, 2007.

Peter Kurer, who was appointed chair of UBS onApril 23, 2008, told investors in a January 15 presenta-tion that the bank’s key goals for 2009 include reachinga settlement with the U.S. Justice Department and en-suring the ‘‘recovery of UBS’s reputation,’’ accordingto the Wall Street Journal report.

UBS is at the center of both criminal and civil inves-tigations in the United States and reportedly is hopingto avoid felony indictments through ongoing talks withthe Justice Department. Unnamed sources close to thediscussions say UBS officials have offered to confess tocriminal activity and pay a fine in the neighborhood of$1.2 billion as part of a deal.

In the civil case, the Justice Department and theIRS reportedly are contemplating an additional, per-haps more comprehensive, summons aimed at forcingUBS to turn over the names of American accountholders. On July 1, 2008, a federal judge in Miami is-sued a John Doe summons requiring the bank to dis-close the U.S. account holders’ names. However, UBShas thus far failed to comply.

Unnamed individuals involved in the case say UBS’sbest hope appears to be a resolution of the criminalcase while the civil case continues. Furthermore, anydeal is likely to be between the U.S. government andUBS, and will not include the American taxpayers al-legedly involved.

‘‘It’s my impression that whatever the settlement isbetween the bank and the U.S. government, this willnot legally impact the taxability or non-taxability ofthe bank’s customers,’’ William M. Sharp Sr., a Tampatax attorney with UBS clients, said in the Journal re-port.

The criminal case has proven particularly damagingto UBS as it tries to cope with the global financial cri-sis. In October 2008 the bank reportedly required a $60billion bailout from the Swiss government to stayafloat.

♦ Randall Jackson is a legal reporter with Tax NotesInternational. E-mail: [email protected]

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Indian Supreme Court DeniesVodafone Appeal

by Kristen A. Parillo

India’s Supreme Court on January 23 declined tohear an appeal by U.K. telecom giant Vodafone in thecompany’s challenge of a $2 billion capital gains taxclaim stemming from its 2007 merger with Indian tele-com company Hutchison Essar. (For prior coverage,see Tax Notes Int’l, Dec. 15, 2008, p. 854, Doc 2008-25691, or 2008 WTD 236-3.)

The Court’s decision means Vodafone now will haveto reply to a show-cause notice issued in September2007 by the Indian Income Tax Department demand-ing that the company explain why it should not betreated as an ‘‘assessee in default’’ for failure to with-hold tax when it acquired the controlling stake inHutchison Essar. The tax department will then take a

‘‘final view’’ on the issue of Vodafone’s tax liability,said Sishir Jha, a spokesman for India’s Central Boardof Direct Taxes.

In February 2007 Vodafone (through its Dutch unit,International Holdings BV) paid Hong Kong-basedHutchison Telecom International Ltd. (HTIL) $11.2billion for the entire share capital of CGP Investments(Holdings), a Cayman Islands entity. CGP Investments,through a chain of intermediary entities (includingMauritius entities), indirectly held a 67 percent stake inHutchison Essar, which at the time was India’s fourth-largest mobile phone company.

India’s tax authorities claim that Vodafone shouldhave withheld approximately $2 billion in CGT at sourcewhen it paid HTIL. The authorities maintain that be-cause most of the assets were in India, the deal was sub-ject to Indian CGT, and that under Indian law the buyer

Vodafone hit another dead-end as it continues to challenge Indian tax authorities' claim that the telecom giant failed towithhold $2 billion in capital gains tax.

AP Photo/Martin Meissner

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is required to withhold CGT and pay it to the govern-ment. In September 2007 the authorities issued show-cause notices to Vodafone and Vodafone Essar. (The no-tice to the latter demanded that the company explainwhy it should not be treated as an agent, or representa-tive assessee, of Vodafone under Indian tax law.)

Vodafone and Vodafone Essar challenged the show-cause notices in writ petitions filed with the BombayHigh Court in October 2007. Vodafone argued that ithad no Indian tax liability on the transaction becausethe transfer of shares took place outside of India andthat any tax liability lies with the seller of the shares— that is, HTIL — and not the buyer.

The company submitted an amended writ petition inJune 2008 challenging the constitutionality of a retro-active amendment to India’s tax laws in May 2008 thatwidened the scope of the term ‘‘assessee in default’’ forwithholding tax purposes, thereby enabling Indian taxauthorities to take action against companies that donot withhold taxes when making a transaction.

The High Court dismissed Vodafone’s petition onDecember 3, 2008. (Vodafone Essar’s petition is stillpending.) Vodafone later filed an appeal with the In-dian Supreme Court.

Appeal DismissedAt a January 23 hearing on the matter, the Supreme

Court declined to intervene and directed the IncomeTax Department to decide whether it has jurisdictionto tax the transaction, saying that ‘‘the substantialquestion of law raised in the petition is left open.’’ TheCourt said that if the authorities decide againstVodafone on the jurisdictional issue, the company canchallenge the decision in the High Court.

The Supreme Court seemed to suggest thatVodafone’s petition was filed prematurely. ‘‘It’s only ashow-cause notice,’’ Justice S.B. Sinha reportedly toldVodafone’s counsel. The Court further questioned whyVodafone had refused to file with the Bombay HighCourt the agreements relating to the transaction. ‘‘Whywere the details not disclosed to the High Court? It hasnot even been shown to us,’’ Sinha said.

The government’s counsel, Additional Solicitor Gen-eral Mohan Parasaran, noted that Vodafone had finallysubmitted the agreements.

‘‘The ball is now in the court of the income tax au-thority,’’ Parasaran told the media after the hearing. ‘‘Itwill look into all the relevant material to arrive at theconclusion. However, we are now in possession of allrelevant documents of agreement between Vodafoneand HTIL.’’ He added that the tax department willnow issue a revised notice to Vodafone for a hearingon its tax liability.

In a January 23 statement, Vodafone said, ‘‘Giventhe fact that the petition filed by Vodafone involvesimportant questions of jurisdiction, the Honorable Su-

preme Court of India has asked the tax authorities todecide, as a preliminary issue only, whether it has juris-diction to proceed against Vodafone (and no other is-sues).’’

The company added, ‘‘Should Vodafone be ag-grieved by the order of the tax authorities’ preliminaryadjudication on jurisdiction, Vodafone has been per-mitted to again directly approach the High Court.’’

♦ Kristen A. Parillo is a legal reporter with Tax NotesInternational. E-mail: [email protected]

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Canadian Budget DeliversOutbound Tax Relief

by Steve Suarez

Canadian Finance Minister Jim Flaherty on January27 delivered to the House of Commons the 2009 fed-eral budget, which includes improvements to Canada’soutbound taxation system as well as corporate and in-dividual income tax relief measures. (For prior cover-age, see Doc 2009-1706 or 2009 WTD 16-1.)

The budget is the minority Conservative govern-ment’s first item of business since proroguing Parlia-ment near the end of 2008 to avoid being defeated inthe House by the three opposition parties. As TNIwent to press, newly installed Liberal leader MichaelIgnatieff signaled he would support the budget contin-gent on the government agreeing to provide quarterlyprogress reports starting in March. The other two op-position parties (the New Democratic Party and theBloc Québécois) have already declared their intentionto vote against the budget. Hence, it is likely but notcertain that the budget has the support necessary topass the House of Commons.1

Canada has enjoyed exceptional economic perform-ance over the past several years, running a series ofbudget surpluses and reducing Canada’s debt-to-GDPratio to the lowest level in the G-7. However, Canadais not immune to the dramatic economic downturnthat has swept across the globe over the past year; Fla-herty announced that he anticipates Canada’s realGDP will contract by 0.8 percent over the next year.As a result, the budget contains more spending thantaxing, and the government has clearly adopted thesame posture as other G-7 countries (particularly theU.S.) by embarking on a very substantial spending pro-gram in an effort to stimulate the economy. The budgetcontains a wide variety of stimulus measures amount-ing to about 1.9 percent of Canada’s GDP (near theIMF’s suggested target of 2 percent). The measures areforecast to lead to budgetary deficits totaling over C$60 billion during the next two years. The budget opti-mistically projects a return to budgetary surpluses by2013 to 2014.

The budget announces some very important changesto Canada’s outbound taxation system, which wouldbe improved by withdrawing (or potentially withdraw-ing) existing proposed amendments.

Outbound Taxation: A Brief HistoryCanada’s manner of taxing Canadian taxpayers’

foreign-source income and the entities they invest inhas been in a state of flux for almost a decade. First,very far-reaching and complex rules (the foreign invest-ment enterprise and nonresident trust (NRT) rules)were announced in 1999 and released as draft legisla-tion in June 2000 that dealt with the taxation of pas-sive (or what is supposed to be passive) foreign-sourceincome of Canadians. These rules, which have beencriticized for their extreme complexity (even by taxstandards) and overly broad scope, have gone througha number of variations and amendments and have stillnot been enacted into law (in their most recent form,they are proposed to be effective retroactively). (Forprior coverage of the FIE/NRT rules, see Doc 2005-16307 or 2005 WTD 148-2.)

In 2004 a number of proposed changes were an-nounced relating to Canada’s foreign affiliate regime,which governs the taxation of investments in foreignentities that meet a certain ownership threshold so asto make the foreign entity a foreign affiliate (or insome cases a controlled foreign affiliate) of the Cana-dian taxpayer. These changes were also very complexand far-reaching and in many cases, seem to produceunintended effects. Among the proposed amendments(much of which has not yet been enacted into law)were the expansion of the controlled foreign affiliatedefinition (with the effect of increasing the likelihoodthat foreign-source passive income would be imputedto the Canadian taxpayer and taxed on an accrual ba-sis) and so-called surplus suspension rules designed toprevent perceived abuses on the recognition of incomeon intragroup transactions. These provisions have cre-ated a great deal of uncertainty and made it difficultfor Canadian taxpayers with foreign affiliates to plantheir affairs on an ongoing basis (many of these rulesare also to be effective retroactively). (For prior cover-age of the 2004 package, see Doc 2004-6779 or 2004WTD 60-2.)

Finally, the 2007 federal budget included an initia-tive directed at foreign affiliates and the manner inwhich they are financed. The original proposal effec-tively eliminated the ability of Canadian taxpayers todeduct interest expense on money borrowed to investin a foreign affiliate earning exempt surplus (activebusiness income earned in a country with whichCanada has a tax treaty). The basis for this proposalwas that because exempt surplus is not taxable inCanada when repatriated, allowing interest deductibil-ity on borrowed money used to earn such incomeamounted to an undue subsidy of foreign business op-erations.

Widely condemned by the business community asputting Canadian multinationals at a severe disadvan-tage relative to their foreign competitors, these ruleswere ultimately scaled back to a more limited objectiveof denying interest deductibility on money borrowed

1Current standings in the House of Commons are: Conserva-tive, 143; Liberal, 77; Bloc Québécois, 49; New DemocraticParty, 37; Independent, 2. See http://www/parl.gc.ca.

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by a Canadian taxpayer and used to finance a foreignaffiliate that in turn made some kinds of intragrouploans that generated deductible interest in another juris-diction (double dipping). These more modest provi-sions were ultimately enacted in the form of section18.2 of the Income Tax Act (Canada), effective after2011, and remain controversial because of both theirunderlying rationale and the uncertainty of their appli-cation in a variety of circumstances. (For prior cover-age, see Doc 2007-7732 or 2007 WTD 60-1; see also Doc2007-11796 or 2007 WTD 94-1.)

The Advisory Committee’s ReportAn offshoot of the 2007 budget was the minister of

finance’s establishment of an advisory committee toreview Canada’s international taxation system andmake recommendations. The advisory committee deliv-ered its report to the minister in December 2008, mak-ing a number of detailed recommendations concerningboth inbound and outbound taxation. (For prior cover-age, see Tax Notes Int’l, Jan. 26, 2009, p. 345, Doc 2009-84, or 2009 WTD 15-11.)

Among the report’s recommendations were:

• Canada should move to a broader exemption sys-tem for taxing foreign-source active business in-come earned through foreign affiliates;

• the Department of Finance should reconsider theneed for the FIE/NRT rules, in particular with aview to reducing complexity and overlap in Cana-da’s antideferral regimes (while ensuring that pas-sive foreign-source income earned by Canadiantaxpayers is taxed on a current basis); and

• ITA section 18.2 should be repealed, and no newinterest deductibility restrictions should be im-posed on borrowing to finance foreign affiliates ofCanadian taxpayers.2

The BudgetThe budget’s most important business tax measure

is the announcement that ITA section 18.2 would berepealed as recommended by the advisory panel. Thegovernment cited the negative effect that this provisioncould have had on foreign investment by Canadianmultinationals. This development should please thatsegment of the tax community. In the current eco-nomic environment more than ever, Canadian busi-nesses must be competitive internationally in order tosurvive, and a disadvantageous tax system is an illogi-cal, unnecessary cost. The government should be com-mended for assembling a very knowledgeable panel ofexperts and then acting on their advice. The repeal of

section 18.2 is a very important and welcome develop-ment for Canadian business.

The budget also indicates that the government hascarefully considered the advisory panel’s views onother elements of the outbound taxation regime. Thebudget states that the government will: review the exist-ing FIE/NRT rules in light of the advisory panel’scomments and the many submissions it has receivedabout them; and consider the advisory panel’s com-ments on the foreign affiliate system before proceedingto enact the outstanding measures contained in the2004 foreign affiliate amendments (a number of whichwould be unnecessary under a full exemption regime).

Although statements about reconsidering legislativeinitiatives that have been so heavily criticized do notconstitute an outright abandonment of those proposals,they are a positive development for the many taxpayerswho are overwhelmed by the complexity of the taxsystem — and these provisions in particular — andwho would welcome simpler, more narrowly targetedrules that do a better job of focusing on the real areasof potential abuse. Many of the current proposals aresimply not working satisfactorily, and it would not besurprising if these statements are the first step toward alarger redesign of the outbound taxation system. Thegovernment should again be commended for listeningto the business community. Making the entire out-bound taxation system simpler, more efficient, andmore internationally competitive would significantlyboost the Canadian economy.

Other Business Tax Measures

Accelerated Capital Cost Allowance

Capital cost allowance (CCA) is the Canadian taxversion of the accounting concept of depreciation. Un-der the CCA system, the cost of capital property isdeducted from income over a period of years on a de-clining balance basis,3 matching (to some degree) theexpenditure on the property to the business income itproduces.

The 2007 budget provided a temporary incentive toinvest in capital equipment by accelerating the rate atwhich CCA could be claimed (thereby allowing alarger deduction from income sooner for tax purposes)on eligible machinery and equipment used in manufac-turing and processing. Instead of the usual 30 percentdeclining balance CCA rate generally applicable, the

2Measures against a specific practice referred to as debtdumping were advocated.

3Declining balance means that the depreciation rate is appliedin each year against the remaining portion of the property’s cost,such that each year’s deduction is smaller than the precedingyear’s. For example, a C $100 property depreciated at 50 percenton a declining balance yields a C $50 deduction in year 1 (C$100 x 50 percent), a C $25 deduction in year 2 (50 percent x (C$100 - C $50)), and so forth.

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2007 budget allowed most such property acquired be-fore 2009 to be written off entirely over three yearsunder a special 50 percent straight-line CCA rate (sub-ject to the usual half-year rule limiting the first year’sdeduction). The 2008 budget then extended this deduc-tion for an additional three years by proposing that:

• for eligible property acquired in 2009, the sameCCA rate announced in the 2007 budget wouldapply; and

• for eligible property acquired in 2010 and 2011,less generous CCA rates would apply.4

The 2009 budget would extend to eligible propertyacquired in 2010 or 2011 the more generous 50 percentstraight-line CCA rate applicable to eligible propertyacquired in 2009 (the half-year rule would still apply).

Another budget proposal would offer faster CCA oneligible computers and software acquired after January27, 2009, and before February 2011. Instead of the 55percent declining balance rate currently applicable, theCCA rate would be 100 percent and the half-year rulewould not apply, meaning that the cost of the propertywould be written off entirely in the year it is acquiredby the business. The property eligible for this fasterwrite-off would be most general purpose electronicdata processing equipment (and related systems soft-ware) that:

• is located in Canada;

• is acquired by the taxpayer for use in a Canadianbusiness or to earn income from property locatedin Canada (or to lease to someone so using it);and

• was not previously used (or acquired for use) be-fore being acquired by the taxpayer for use inCanada.

Canadian-Controlled Private Corporations

A corporation that is a Canadian-controlled privatecorporation (CCPC) enjoys a number of advantageswithin the Canadian tax system. In particular, a CCPCmay benefit from a low 11 percent tax rate on the firstC $400,000 of qualifying active business income that itearns via a mechanism called the small-business deduc-tion.5 The budget would increase the maximum in-

come eligible for the deduction from C $400,000 to C$500,000 effective January 1, 2009.6

CCPCs are also eligible to earn investment taxcredits at an enhanced 35 percent rate on up to C $3million of qualifying scientific research and experimen-tal development. The C $3 million threshold is reducedonce the CCPC’s taxable income for the previous yearreaches C $400,000 and eliminated entirely onceprevious-year taxable income reaches C $700,000. Thebudget would increase the C $400,000 and C $700,000amounts to C $500,000 and C $800,000, respectively,expanding the availability of the enhanced ITCs.

Finally, the budget would correct a technical prob-lem arising from a court decision in 2006, which af-fects the precise time at which control of a CCPC isacquired on the relevant day. The ruling had createdanomalous results arising from determining exactlywhen control of the corporation had been acquired,and the CCPC had thereby lost its status as a CCPC.

Administrative MattersThe budget proposes to require that some taxpayers

file their tax returns electronically, effective for taxyears ending after 2009. Corporations with annualgross revenue over C $1 million would be required tofile electronically except in situations (to be announcedlater) when the Canada Revenue Agency believes elec-tronic filing would be inefficient.7 Some minor amend-ments to related penalty provisions have also been pro-posed. The budget also proposes that in 2010 andthereafter a taxpayer that files 50 or more of any par-ticular type of information return would be required todo so electronically. This would occur most frequentlyin the case of T4 reporting returns for employmentincome.

Previously Announced MeasuresWhen Parliament was prorogued in December 2008,

a number of tax measures had not yet been enactedinto law and were automatically terminated. The bud-get confirms the government’s intention to reintroducemany of these previously announced proposals, includ-ing:

• changes to the taxation of financial institutions tobetter align income tax laws with accountingrules; and

• draft amendments relating to the rules allowingsome taxpayers to report their Canadian incometax in a foreign (‘‘functional’’) currency.

4In both cases the deduction in the first year was limited bythe half-year rule.

5When two or more corporations are associated, they mustshare the limit. To limit this tax preference to smaller businesses,the deduction begins to phase out when the CCPC has taxablecapital employed in Canada of C $10 million, and is eliminatedcompletely when the CCPC has C $15 million of taxable capitalemployed in Canada.

6This increase in the small-business limit would also: result insome CCPCs earning between C $400,000 and C $500,000 intaxable income having an additional month to pay any balanceof tax owed; and entitle some CCPCs to be eligible to pay theirtaxes in quarterly installments rather than monthly.

7Examples provided of such exceptions include nonresidentsand insurance companies.

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Personal Tax MeasuresThe budget also contains a number of relatively mi-

nor personal income tax amendments, largely directedat low- and middle-income earners. These include:

• the basic personal amount (the amount of incomethat can be earned before any tax is payable)would increase from C $9,600 for 2009 to C$10,320 for 2010 and would thereafter be indexedto inflation;

• the upper limit of the two lowest tax bracketswould be increased for 2009, with the 15 percenttax bracket ending at C $40,726 instead of C$37,885 and the 22 percent tax bracket ending atC $81,452 instead of C $75,769 — both bracketswould be indexed to inflation thereafter; and

• the tax credit for persons 65 and older would in-crease by C $1,000 to C $6,408.

A new home renovation tax credit of up to C$1,350 would be introduced for qualifying home reno-vation expenditures (excluding routine repairs and fur-niture) of up to C $10,000 incurred between January28, 2009, and February 1, 2010. This tax credit maynot cost the government much in forgone tax revenuebecause much home renovation activity occurs underthe table as part of the underground economy. Thatactivity would have to come into the tax system for thecredit to be claimed. The budget would also introducea small first-time home buyer’s tax credit on qualifyinghomes acquired after January 27, 2009. Also, the

amount of money that a first-time home buyer couldwithdraw from his registered retirement savings plan(RRSP, a tax-sheltered individual retirement fundanalogous to a U.S. 401(k)) would increase from C$20,000 to C $25,000. The budget also proposes reliefprovisions to compensate for the decrease in the valueof investments in an RRSP (or some similarretirement-related vehicles) following the death of theannuitant to prevent undue hardship when investmentsdecline in value postmortem before the deceased’sproperty is distributed.

Finally, the 15 percent mineral exploration tax creditavailable to individuals who invest in flow-throughshares of mining exploration companies would be ex-tended another year for flow-through share agreementsentered into by March 31, 2010.

♦ Steve Suarez is a partner with Osler, Hoskin &Harcourt LLP in Toronto.

Full Text Citations• Finance Minister Jim Flaherty describes Canada’s 2009

budget economic action plan. Doc 2009-1816; 2009 WTD17-9

• Summary of 2009 budget tax relief measures. Doc 2009-1817; 2009 WTD 17-10

• Prime Minister Stephen Harper notes home renovationtax credit. Doc 2009-1819; 2009 WTD 17-11

• Flaherty’s budget speech. Doc 2009-1823; 2009 WTD17-12

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Argentina

Buenos Aires’ New Stamp TaxTriggered by Two Core Events

Buenos Aires’ official gazette on January 19 pub-lished Resolution 10/09, the first set of implementingrules for the city’s stamp tax, which was reenacted onJanuary 9 by Law 2997. (For prior coverage, see TaxNotes Int’l, Jan. 26, 2009, p. 294, Doc 2009-822, or 2009WTD 9-2.)

The stamp tax, which was limited to real estatetransactions until December 2008, was absent fromBuenos Aires for more than five years. The stamp taxis a local levy, so each jurisdiction provides its ownlegislation. Accordingly, the taxable events, exemptions,taxable amounts, tax rates, terms for payment, penal-ties, and interest vary by jurisdiction. However, thegeneral aspects of the stamp tax are shared by mostjurisdictions.

Buenos Aires’ stamp tax can be triggered by twocore events resulting in the assessment of an instru-mentality tax or a financial transaction stamp tax.

Instrumentality TaxThis tax is triggered by written legal contracts either

executed or having effects within the city of BuenosAires. In general, the term ‘‘effects’’ refers to the execu-tion of the contractual obligations. The fact that thecontract is executed outside Argentina does not relievethe parties thereto from their obligation to satisfy thestamp tax because the agreement — though executedabroad — could still have effects in Buenos Aires.

The taxable amount is equal to the contractual valueduring its whole term. However, there are specific rulesfor contracts subject to automatic renewal or extensionterms beyond five years. The new rules provide that inthe absence of a fixed taxable amount set forth in thecontract, it should be reasonably estimated — with theevidence and data available to the taxpayer when thetaxable event is triggered — using, for example, any ofthe following guidelines: similar past agreements; theforecasted revenue in the relevant jurisdiction; or the

figures of the developing business. If the local tax au-thority challenges the taxable amount assessed andproves that the estimation procedure was wrong, finesand interest will be applied.

The new legislation provides rules aimed at avoidingdouble taxation within Argentina. If a contract is ex-ecuted in one jurisdiction and the assets are located ina different one, taxing powers are granted with priorityto the jurisdiction where the assets are located.

Tax rates vary depending on the taxable events. Thestandard tax rate is 0.8 percent, while a higher rate upto 2.5 percent applies to real estate transactions. A re-duced rate of 0.5 percent applies to leasing agreements,and a higher rate of 1 percent applies to set contractsinvolving trading of rights of soccer players. All partiesto the agreement are jointly and severally liable beforethe State Revenue Service for the payment of the fullamount of the stamp tax triggered by a given agree-ment.

Like the stamp tax in most provinces, the BuenosAires stamp tax is governed by the ‘‘instrumentalityprinciple,’’ according to which the taxable event is onlytriggered when a contract or document is prepared inwriting by the parties or the party to the agreement;and such written document sufficiently prove the rightsand obligations of the parties — namely when it repro-duces the main elements of the contract, disregardingthe facts and actions taken by the taxpayers. This in-strumentality principle is also stated in the federal co-participation of taxes law, a law passed by the NationalCongress that provides for the allocation of tax rev-enues between the federal government and the prov-inces. This law imposes a restriction on the taxingpowers of the provinces.

Some tax planning devices have been used country-wide to avoid payment of the stamp tax. They havemainly consisted of agreements implemented in such amanner that they do not fit within the instrumentalityprinciple. These options are available under the newBuenos Aires legislation, but taxpayers must carefullyimplement them to ensure that the Supreme Court pre-cedents governing these matters can be reasonably re-lied upon.

There are a number of exemptions available, whichshould be scrutinized on a case-by-case basis. Some of

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the most significant exemptions relate to contracts forthe incorporation of companies in Buenos Aires, aswell as their capital increases and liquidations; all con-tracts aimed at papering public listing of securities; andguarantee agreements that secure other taxable instru-ments, life insurance agreements, labor agreements,export related agreements, and so on.

Financial Transaction Stamp TaxThis tax is triggered on all loans or credits that a

financial institution is party to that imply a delivery orreceipt of principal (or funds in general) that triggersinterest over time and that are registered and recordedby such financial entities. The taxable amount isdeemed to be the figures used to calculate the interesttimes the tax rate, which is the standard one of 0.8percent per year. So the tax burden is proportional tothe term the taxable transaction remains in place: Thelarger the term, the higher the tax burden.

The persons contracting with the financial entitiesare deemed to be the taxpayers and such entities aredeemed to be the collecting agents. Accordingly, theyare subject to joint and several liability.

Specific exemptions apply to this taxable event, themost significant being that related to transactions sub-ject to the instrumentality tax: To the extent such bur-den is triggered, even in a different jurisdiction, therewill be no financial transaction tax on the same trans-action. Also, bank deposits in savings accounts, timedeposits, and checking accounts are exempt, as well asmortgage deeds and other security agreements used tosecure taxable transactions.

As of the enactment of Law 2997, taxpayers arerequired to monitor the stamp tax legislation in the cityof Buenos Aires in conjunction with the one applicablein other provinces to ensure they take advantage of taxplanning options or at least avoid double taxationwhen transactions that are executed in one locationhave effects in a different one.

♦ Cristian Rosso Alba, Rosso Alba,Francia & Ruiz Moreno, Buenos Aires

Bangladesh

Government Revokes Import Tax onRenewable Energy Imports

Bangladeshi Prime Minister Sheikh Hasina Wajedon January 15 announced that all taxes and duties as-sessed on imports of solar power generating equipmenthave been revoked to encourage the use of renewableenergy as the country continues to struggle with powershortages.

Previously, imports of renewable energy equipmentwere subject to a 3 percent import duty and a 15 per-cent VAT.

The withdrawal of the import taxes is part of thecountry’s new renewable energy policy, which was ap-proved in December 2008. The policy also provides fora five-year corporate tax holiday for income from re-newable energy projects. The government’s goal is forthe country to derive 5 percent of its electricity fromrenewable sources by 2015 and 10 percent of its overallelectric supply by 2020.

In addition to commercial-scale solar energy plants,the government also seeks to promote the use of micro-level solar energy for domestic use. More than 300,000households are using solar energy equivalent to 15megawatts, accounting for less than 1 percent of thecountry’s total electricity generation of around 3,500megawatts.

Hasina also heads the Ministry of Electricity, Oil,and Mineral Resources.

♦ Aziz Nishtar, Nishtar & Zafar Advocates, Karachi

Cambodia

Tax Breaks Targeted to CriticalGarment Industry

The Cambodian government has announced that itwill offer tax breaks targeted to the clothing industry(accounting for 320,000 jobs in a country of 14.2 mil-lion) as a way to address the global financial crisis’simpact on Cambodia, according to media reports.

Because the Phnom Penh government lacks cash, itreportedly cannot undertake the kind of stimulus pack-ages seen in neighboring countries like Thailand, Ma-laysia, and Singapore.

In addition to the tax breaks, the government plansto invest in infrastructure such as power plants, ruralroads, irrigation systems, and telecommunications in anattempt to establish the kinds of structures the countrywill need when growth returns. According to the Eco-nomic Institute of Cambodia (a Phnom Penh thinktank), up to 66 percent of the workforce works in therural sector at some point during the year.

The projects are to be funded through donor contri-butions, according to a January 26 article onBloomberg.com. Contributor countries in December2008 pledged $950 million in aid for fiscal 2009, a 40percent increase over fiscal 2008. The money will gotoward Cambodia’s $1.8 billion 2009 budget, whichincludes the infrastructure expenditures. Cambodia’sfiscal year runs January 1 to December 31.

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‘‘We cannot distribute cash to the people. What wecan do is give targeted tax cuts to garment factoriesand spend more on infrastructure so we can preparefor economic developments in the future,’’ HangChuon Naron, secretary-general of the Ministry ofEconomy and Finance, said in a January 23 interviewwith Bloomberg.com.

Despite its problems, Cambodia has experiencedfour straight years of growth above 10 percent. Thisgrowth has stemmed largely from special deals for for-eign firms, such as tax holidays and greatly reducedimport tariffs.

Furthermore, 60 percent of that growth has arisenfrom just three sectors: tourism, construction, and gar-ment manufacturing, with the latter accounting for 12percent of GDP in 2007. However, weakening demandin crucial retail markets like the United States, whichreceives 70 percent of Cambodia’s textile exports, hasforced Cambodia to close 10 percent of its garmentfactories, triggering the loss of 20,000 jobs, accordingto Roger Tan of the Garment Manufacturer’s Associa-tion of Cambodia.

Hang Chuon Naron anticipates a drop in garmentexports of 2 percent. He also foresees a 20 percentdrop in the number of tourists visiting Cambodia andthe virtual collapse of the construction sector. Hehopes the tax breaks will keep businesses afloatthrough the difficult times.

The IMF has predicted that Cambodia will grow ata rate of 4.75 percent in 2009, the slowest pace since1998.

♦ Randall Jackson, Tax Analysts.E-mail: [email protected]

Chile

Stimulus Package Wins UnanimousApproval

The Chilean Senate on January 14 unanimously ap-proved a $4 billion economic stimulus plan presentedby President Michelle Bachelet on January 5. (Forprior coverage, see Tax Notes Int’l, Jan. 19, 2009, p. 212,Doc 2009-349, or 2009 WTD 5-3.)

The plan, which was unanimously approved by theChamber of Deputies on January 8, still must besigned by Bachelet, a formality that Finance MinisterAndrés Velasco said would soon be addressed.

Tax measures in the plan include the temporaryelimination of the stamp tax, a reduction in themonthly advance tax payments made by businesses(expected to take effect as early as this month), and

provisions to accelerate income tax refunds for the2010 tax year and to accelerate the tax credit availablefor some training costs.

Velasco called the package ‘‘important and urgent’’and expressed gratitude for the political consensus thatled to the approval of the package in a unanimous andexpedited manner.

♦ Lisa M. Nadal, Tax Analysts.E-mail: [email protected]

China (P.R.C.)

U.S. Companies Facing ComplianceBurdens in China

U.S. companies with operations in the People’s Re-public of China now face much more significant taxcompliance obligations, according to panelists on aJanuary 15 PricewaterhouseCoopers International TaxServices webcast.

The P.R.C. government last year introduced a newannual enterprise income tax return package, newrelated-party transaction (RPT) forms, and new con-temporaneous transfer pricing documentation require-ments.

The new EIT return package and the new transferpricing disclosure rules are very complex, PwC taxpartner Todd Landau said. ‘‘It is always a commonexperience with respect to China that there’s only someof what we need to know that is known today, withadditional information that will clearly need to beknown as time progresses throughout the period priorto deadlines’’ for the filing of returns and the submis-sion of contemporaneous transfer pricing documenta-tion, he said.

For example, the State Administration of Taxation(SAT) released guidance on the EIT return, plus 45pages of explanatory notes, late in 2008, PwC tax part-ner Michael Ho said. But those notes are no longervalid because a new set of notes (Guo Shui Han [2008]No. 1081) released on January 7 has superseded them.This has left many companies struggling to keep up.

BackgroundThe SAT on October 30, 2008, issued a new annual

EIT return package (Guo Shui Fa [2008] No. 101) foruse by taxpayers that must file returns under the EITlaw that took effect on January 1, 2008. The returnpackage includes a main return and 15 schedules, all ofwhich must be filed by May 31. (For prior coverage,see Tax Notes Int’l, Dec. 22, 2008, p. 945, Doc 2008-24993, or 2008 WTD 247-14.)

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On December 16, 2008, the SAT released nine RPTdisclosure forms (Guo Shui Fa [2008] No. 114) to re-place forms required under China’s previous annualincome tax return filing system for foreign investmententerprises. The new RPT forms ask companies to dis-close whether they have prepared contemporaneoustransfer pricing documentation when filing the annualCIT return. (For prior coverage, see Doc 2008-26922 or2008 WTD 247-18.) The RPT forms must be filed to-gether with the annual EIT return package.

The SAT on January 9 published the Implementa-tion Regulations for Special Tax Adjustments (GuoShui Fa [2009] No. 2, or Circular 2), which define thescope of China’s transfer pricing rules and set out thecontemporaneous transfer pricing documentation rulesthat both foreign and domestic enterprises must followunder China’s new EIT law. (For prior coverage, seeTax Notes Int’l, Jan. 19, 2009, p. 205, Doc 2009-521, or2009 WTD 7-1.)

Circular 2 provides for some exemptions from thecontemporaneous documentation rules. For example,companies may be exempt if the value of their inter-company tangible goods transactions is below CNY200 million (about $30 million) and if the value oftheir intercompany nontangible goods transactions isbelow CNY 40 million (about $6 million), not countingsales and purchases that are covered by cost-sharingagreements or advance pricing agreements.

An exemption is also available if the foreign share-holding in the enterprise is less than 50 percent and theenterprise traded only with domestic related parties.Finally, an exemption is available for transactions cov-ered by an APA.

DetailsHo outlined the company filing requirements for

calendar year 2008, saying companies must file thenew annual EIT return package and the new RPTforms by May 31, and prepare the contemporaneoustransfer pricing documentation by December 31, whichis an extended deadline for calendar year 2008. Nor-mally, the due date for contemporaneous documenta-tion will be May 31 of the year following the tax year,he said.

The new EIT return asks for information taxpayerspreviously did not have to provide. For example, Hosaid, the new return now has lines for:

• a tax adjustment of assets measured at fair value;

• an analysis of income or loss from long-term in-vestments;

• a tax adjustment of advertising and promotionexpenses;

• a tax adjustment of depreciation or amortization;and

• a tax incentive statement for both grandfatheredand new tax incentives.

Ho also urged taxpayers to act swiftly to completethe nine new RPT forms by May 31 for tax year 2008— even though they only came out in December 2008.‘‘While it seems like we still have a few more monthsto go, given the uncertainty and the difficulties in han-dling some of the taxation treatment, there may not bea lot of time in preparing the returns for filing,’’ Hosaid. He said the new RPT forms are much more com-plex than the old filing regime that was in place forcalendar year 2007.

After the webcast, Ho told Tax Analysts that thenew EIT return forms contain many items and adjust-ments that will be subject to subsequent regulationsand further SAT guidance. ‘‘As a result, there will bemany cases of uncertain tax treatment, which willlikely increase taxpayer compliance burdens,’’ he said.

The obligation to provide more detailed informationon intercompany transactions and other new filingrules ‘‘may be too great a responsibility to delegate en-tirely to the tax and accounting staff of the Chinesesubsidiaries’’ of U.S. parents, Ho said. ‘‘Therefore, amuch more coordinated effort to work with the localChinese entity will likely be necessary to satisfy thegreater Chinese compliance responsibilities.’’

Landau predicted the expanded information avail-able to Chinese tax examiners could make future taxexaminations ‘‘a very bumpy ride.’’ He said U.S. com-panies with Chinese operations may need to undertake‘‘new information gathering processes and protocols’’to meet the new compliance requirements.

Finally, the panelists cautioned that companies mustcorrelate the EIT return package, RPT forms, and anycontemporaneous transfer pricing documentation. Eventhough the forms and filings are all separate, taxpayersmust ensure a consistent position for all of them, ac-cording to PwC.

♦ Charles Gnaedinger, Tax Analysts.E-mail: [email protected]

Ecuador

Congress Approves Tax PackageEcuador’s recently inaugurated National Congress

has approved a new tax package designed to combatthe effects of the global financial crisis, includingamendments to the income and capital flight taxes anda new tax on deposits held abroad. The amendmentsentered into full force and effect on January 1.

The amendments, published in Official Gazette 497on December 30, 2008, are in response to a package ofmeasures prepared by President Rafael Correa Del-gado. Ecuador’s economy is largely dependent on oil

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exports, and the recent drop in oil prices has created adifficult economic scenario that will affect governmentfunding and the cash flow of private enterprises. (Forprior coverage of the Tax Fairness Bill, see Doc 2008-472 or 2008 WTD 7-5.)

The new law extends a 10 percentage point reduc-tion in the 25 percent corporate income tax rate to fi-nancial entities and cooperatives that reinvest theirprofits by increasing their capital and purchasing assetsthat would help their operations.

The amendments provide for the reduction or dis-missal of the advance income tax payment when thereare economic effects for a given industry or economicsector. To be approved by the president, the Ministry ofEconomy and Finance and the tax administration mustissue technical reports of an income reduction in theindustry or economic sector. The reduction or dismissalof the payment must be evaluated on a yearly basis.

The new law establishes 2009 as a transition yearregarding withholding tax on interest paid on foreigncredits. The normal 25 percent withholding rate overinterest, which does not exceed the Ecuadorian CentralBank’s rate, has been reduced to 5 percent until De-cember 31, 2009. Payments made by financial entitiesare free from withholding during the entire year.

The capital flight tax rate has been increased from0.5 percent to 1 percent, and all but one exclusion havebeen eliminated. Therefore, all payments (includingthose made for imports) are charged with the 1 percentcapital flight tax. Individuals can leave the countrywith up to US $8,570 in cash free of tax.

All imports whose payment is made with funds lo-cated abroad are deemed to be made with local moneyand therefore will be taxed.

To encourage financial entities and those entitiesparticipating in the stock market to bring billions ofEcuador dollars of their clients’ deposits into the coun-try, the National Congress has created a new tax. Thistax will be charged on all deposits held abroad by theabove-mentioned companies at a monthly rate of 0.084percent of the amount of their assets held abroad.

♦ Roberto M. Silva Legarda, professor of tax law,Pontificia Universidad Católica del Ecuador, Quito, and

partner, Tributum Consultans

European Union

Austrian Leasing Rules IncompatibleWith EC Treaty, ECJ Says

Austrian rules that denied an investment-premiumtax advantage to lessors of goods used by lessees inother EU member states violated article 49 of the ECTreaty (the freedom to provide services), the EuropeanCourt of Justice said in its December 4, 2008, judg-ment in Jobra Vermögensverwaltungs-Gesellschaft mbH v.Finanzamt Amstetten Melk Scheibbs (C-330/07). (For thejudgment, see Doc 2008-25509 or 2008 WTD 235-10.)

BackgroundJobra was an Austrian company with a wholly

owned subsidiary, Braunshofer, also an Austrian resi-dent company. Jobra purchased some trucks and leasedthem to Braunshofer, which used the trucks in EUmember states other than Austria. Consequently, Jobrawas denied an investment-premium tax advantage be-cause the leased assets were used ‘‘primarily abroad’’and not in Austria.

The Austrian tax rules at issue made the tax advan-tage available only if the assets had been used at anAustrian place of business for at least half the timethey had been in use. Jobra argued that the rules wereincompatible with its rights under EC Treaty articles43 (freedom of establishment) and 49 (freedom to pro-vide services).

ConsiderationsThe ECJ noted that the leasing of vehicles is a serv-

ice under article 50 of the EC Treaty.

The Court went on to determine that the Austriantax regime at issue — ‘‘which applies a less favourabletax regime to investments in assets which, once theyhave been hired out for remuneration, are used in otherMember States, than to investments in such assets thatare used domestically — is likely to discourage under-takings that would be eligible for that tax advantagefrom providing rental services to economic operatorsthat carry out their activities in other Member States.’’

JustificationsThe ECJ examined and rejected three possible justi-

fications: the need to ensure balance in the allocationof taxing rights, the need to safeguard the coherence ofthe national tax system, and the need to prevent abuse.

Allocation of Taxing Rights

The Austrian and German governments argued thatthe investment-premium rules at issue were consistentwith the allocation of taxing rights between the mem-ber states. They pointed out that the conditional grant-ing of the investment-premium tax advantage ‘‘aims to

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ensure that there is a connection between, on the onehand, the granting of that tax advantage and, on theother hand, the taxation of profits generated throughthe use of those assets.’’

The ECJ replied that the rental income at issue istaxable in Austria; therefore, Austria’s right ‘‘to exer-cise its taxing powers in relation to activities carried onin its territory’’ was not jeopardized.

Coherence of the Tax System

In response to arguments about the need to safe-guard the coherence of the tax system, the ECJ notedthat there was no direct link between the investment-premium tax advantage granted to the lessor and thesubsequent taxation of the lessee’s income generatedthrough the use of the leased assets.

Need to Prevent Abuse

The Austrian government argued that the tax rulesat issue were aimed at preventing ‘‘wholly artificial ar-rangements involving transfers for remuneration.’’ Oneconcern mentioned by the government was that ‘‘thelessor could hand over all or part of the premium tothe lessee which, for its part, could use that asset togenerate profits in other Member States. Thus, it wouldbe possible to circumvent the fact that the advantage islimited to Austria.’’ Without the tax rules at issue, ‘‘itwould be possible, merely by setting up the leasingcompany for a corporate group in Austria, to claim theinvestment premium for all the acquisitions made bythat group, irrespective of where those assets areused,’’ it said.

The ECJ agreed that the member states can havenational tax rules that restrict the freedom to provideservices, provided that those rules specifically target‘‘wholly artificial arrangements which do not reflecteconomic reality and whose only purpose is to obtain atax advantage.’’ However, it said the leasing of assetsto another undertaking for use in other member states‘‘cannot be the basis of a general presumption of abu-sive practice and justify a measure which compromisesthe exercise of a fundamental freedom guaranteed bythe Treaty.’’

The ECJ observed that the Austrian tax rules af-fected every lessor eligible for the investment-premiumtax advantage that hired out assets for remuneration toundertakings operating cross-border activities, ‘‘anddoes so even where nothing points towards the exist-ence of such an artificial arrangement. Furthermore,the legislation does not allow lessors to adduce evi-dence that no abuse is taking place.’’

The JudgmentAccordingly, the ECJ held that because the Austrian

tax rules did not make it possible to limit the denial ofthe investment-premium tax advantage to cases involv-ing wholly artificial arrangements, the rules could not

be justified by overriding reasons of public interest and,consequently, were precluded by article 49 of the ECTreaty.

The ECJ further stated that there was no need toexamine whether the EC Treaty provisions on freedomof establishment might also preclude the rules.

AnalysisThis case is particularly interesting because of the

ECJ’s comments on justifications — particularly theneed to prevent tax abuse. The judgment appears totake the ECJ’s previous reasoning in this context onestep further. The judgment also represents the latest ina line of cases concerning the taxation of leasing serv-ices and how the tax rules interact with the fundamen-tal freedoms.

Balancing the Allocation of Taxing RightsIn Jobra, that justification of the Austrian rules was

unsuccessful because Austria failed to take into accountthe rental income received by Jobra from its subsidiaryin relation to the leased assets. That income remainedtaxable in Austria. Thus, even though the leased assetsmight be used outside Austria, the income receivedfrom the leased assets remained within Austria’s taxjurisdiction. Consequently, the argument that there wasan impact on the allocation of taxing rights was re-jected, because although Austria granted aninvestment-premium tax advantage for the leased as-sets, which in this case were not used mainly in Aus-tria, that did not impinge on Austria’s right to tax theincome from those assets.

Preventing Tax AbuseThe ECJ acknowledged that the member states re-

tain the right to prevent abuse in situations when thenational rules specifically target ‘‘wholly artificial ar-rangements which do not reflect economic reality andwhose only purpose is to obtain a tax advantage.’’ Thiswas, in many respects, a repeat of its mantra from ear-lier cases such as Marks & Spencer (C-446/03), in whichthe ECJ noted that the member states were ‘‘free toadopt or to maintain in force rules having the specificpurpose of precluding from a tax benefit wholly artifi-cial arrangements whose purpose is to circumvent orescape national tax law.’’1 (For the ECJ judgment inMarks & Spencer, see Doc 2005-25015 or 2005 WTD 239-16.)

The word ‘‘specific’’ should be emphasized because,as the ECJ explained once again in Jobra, problems

1This harks back to the much earlier ECJ judgment in ICI v.Colmer (C-264/96), in which the ECJ held that the U.K. ruleswere precluded by the freedom of establishment because theyapplied generally to all situations in which most of the group’ssubsidiaries were established for whatever reason outside theUnited Kingdom.

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occur when the national antiabuse rules are general innature. The ECJ stated that it could not be claimedthat there was such abuse when an undertaking hiredassets out for remuneration to another undertaking thatused them primarily in other member states, highlight-ing, in particular, that that hiring out ‘‘cannot be thebasis of a general presumption of abusive practice andjustify a measure which compromises the exercise of afundamental freedom guaranteed by the Treaty.’’ Thiskey flaw in the design of many member states’ taxantiabuse rules is apparent from the ECJ’s jurispru-dence, including the Austrian rules in this case.

Burden of ProofClearly, the burden of proof in the area of tax abuse

should remain on the tax authorities, at least until theymake a prima facie case that the abuse exists. However,this is rarely the case when the antiabuse rules aredrafted in a general way to include situations like thoseseen in Jobra, where no apparent abuse was happening.The ECJ dealt with this issue for the first time in Jobrawhen it commented that ‘‘the legislation at issue affectsevery lessor eligible for the investment premium whichhires out assets for remuneration to undertakings carry-ing out cross-border activities, and does so even wherenothing points towards the existence of such an artifi-cial arrangement.’’

The requirement that some evidence pointing to-ward the existence of wholly artificial arrangements orabuse should exist may be helpful to taxpayers facingantiabuse rules in the future as, clearly, they can ad-vance the argument to the tax authorities that theECJ’s ruling in Jobra specifically mentioned that thereis an onus on the tax authorities to at least demon-strate that something abusive is occurring. This is anadditional part of the tax authorities’ burden of proofbefore the burden gets transferred over to the taxpayerto show that no abuse is taking or has taken place.

The ECJ, following the reasoning of its earlier taxavoidance case law, goes on to make it clear that in thecircumstances of this case, the Austrian rules do notallow lessors ‘‘to adduce evidence that no abuse is tak-ing place.’’ The consequences of this are significantbecause the taxpayer is never given the opportunity torebut the allegation of abuse. Perhaps more impor-tantly, as a result, the ECJ found that the Austrian taxrules at issue do not make it possible to limit the re-fusal to grant the investment-premium tax advantage tocases involving wholly artificial arrangements, whichindicates that the rules go too far and are a dispropor-tionate restriction on the fundamental freedom to pro-vide services.

Protective Nature of the Austrian RulesFinally, it is useful to highlight the protective nature

of the Austrian tax rules at issue in Jobra. Article 49 ofthe EC Treaty precludes such rules because their aimwas to provide tax advantages mainly for Austrian resi-dents who leased assets to other Austrian residents

who used the leased assets mainly in Austria. In aninternal market, it is clear that such rules seriouslyhamper cross-border trade and economic activity, andthe provision of leasing services in particular, becausethe tax advantage is limited to Austrian lessors andlessees who lease assets for mainly Austrian domesticuse purposes.

With many leasing companies providing servicescross-border, Jobra may be one of the ECJ’s most sig-nificant preliminary rulings in the area of cross-borderleasing, on a par with its earlier judgment in Eurowings(C-294/97), in which German tax rules that penalizeda German company for obtaining its leasing servicesfrom an Irish company came under scrutiny and werefound to be incompatible with the freedom to provide(and to receive) services as set forth in EC Treaty ar-ticle 49.

In the eyes of the ECJ, protectionist rules of thisnature have no place in an ‘‘area without internal fron-tiers.’’ Although direct taxation remains within thecompetence of the member states, the exercise of thatcompetence when the member states design their taxsystems must take place in full compliance with EUlaw. In this case, the protectionist Austrian tax ruleswill have to be either amended (to ensure compliance)or repealed.

♦ Tom O’Shea, Queen Mary University of London, Centrefor Commercial Law Studies

Germany

Former Deutsche Post CEO ConvictedOf Tax Evasion

A German court on January 26 convicted KlausZumwinkel, former CEO of Deutsche Post and themost prominent German taxpayer to be caught up inthe Liechtenstein tax scandal, of tax evasion, accordingto media reports.

The Bochum court reportedly handed down a two-year suspended sentence and fined Zumwinkel €1 mil-lion (about $1.3 million).

The fine and two-year suspended sentence was whatprosecutor Gerrit Gabriel called for in his closing re-marks, according to a January 26 Associated Press re-port. ‘‘He knew exactly what he was doing,’’ Gabrielwas quoted as saying.

Gabriel requested a relatively light sentence (convic-tion of tax evasion can lead to up to 10 years in prisonunder German law) given that Zumwinkel has paid€3.9 million (about $5.1 million) in back taxes and

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confessed to his wrongdoing on January 22 at the startof his trial. (For prior coverage, see Doc 2009-1382 or2009 WTD 13-3.)

Since news of the Liechtenstein scandal broke inFebruary 2008, German prosecutors have reportedlyrecovered over €150 million from German taxpayersseeking to avoid a trial. German authorities claim thatup to €4 billion was hidden in Liechtenstein.


Haiti

Mobile Phone Service ProvidersOppose Tax Hike

Mobile phone service providers in Haiti are protest-ing a 2008-2009 budget measure that would increasethe tax on mobile phone users.

Radio Kiskeya, a Port-au-Prince news radio stationreported on January 16 that the new proposal wouldamend the taxation component of the Telecommunica-tions Act of 2002.

Mobile service providers have joined together to op-pose the tax increase, claiming it would hurt theeconomy. Digicel, Voila, and Haitel insist that raisingthe tax on cell phone use would actually reduce taxrevenue by discouraging cell phone use and in turnreducing general business activity.

The three companies say they have invested morethan $600 million in the nation’s networks and servicesover the past 10 years, and that they directly employmore than 2,000 Haitians. They claim that as many as55,000 jobs indirectly rely on the smooth functioningof the telecommunications sector.

Haiti’s General Tax Directorate acknowledged thatthe telecom sector has been the greatest source of gov-ernment tax income since 1999, producing 28 percentof Haitian revenues in fiscal 2007-2008, which endedSeptember 30, 2008.

The proposed changes reportedly include a newcharge of HTG 3.60 per minute (about $0.09) for localcalls and HTG 4 per minute for international calls. Thenew charges would come on top of the current chargeof HTG 4.70 per minute that subscribers must pay; thecurrent charge includes a 10 percent revenue tax.


Hungary

Employer Tax Cut, VAT IncreaseUnder Consideration

The Hungarian government has proposed cuttingthe payroll tax employers must contribute to the na-tion’s social security system by 5 percentage points toaugment employment as Hungarian businesses strugglewith liquidity and credit issues arising from the worldfinancial crisis.

In announcing the proposed payroll tax cut, PrimeMinister Ferenc Gyurcsany was careful to emphasizethat overall government revenue cannot be allowed toplummet as a result of tax breaks, according to mediareports. He therefore also proposed increasing the VATrate by 2 to 3 percentage points — to 22 percent or 23percent — to offset the revenue loss from the payrolltax reduction.

The government estimates that the proposed payrolltax reduction would cost an estimated HUF 300 billion(about $1.4 billion).

The tax proposals follow a January 25 meeting atwhich Gyurcsany told economists that a reduction inHungary’s tax and contribution rates is necessary tomaintain the nation’s competitiveness.

The economists suggested that Budapest put in placean overall economic and social reform plan that wouldcover the next three to four years, extending beyondthe next parliamentary elections in 2010.

Hungarian industrialists offered their own suggestionat the January 25 gathering. Peter Furo, head of theConfederation of Hungarian Employers and Industrial-ists, told the Hungarian press that his organization sug-gested that Budapest suspend the capital gains tax for ayear or two to spur savings and the purchase of gov-ernment securities.

While Gyurcsany was receptive to the economists’suggestion, he remained noncommittal toward theCGT proposal.

The government expects the economy to contract by2 percent to 3 percent in 2009, forcing an adjustmentin the budget that was approved in December 2008.But while Gyurcsany pointed to the need to lessen thetax burden on businesses, he also spoke of the need tomaintain the budget’s deficit target of less than 3 per-cent of GDP, as required by the European Union.

The government therefore hopes it can redistributethe tax burden, freeing up corporate money while pre-serving the income needed to hold down borrowingand the potential of an inflated deficit.

Unnamed government sources were quoted as say-ing that Budapest wants to rearrange about HUF 1 tril-lion of spending and revenue items in the 2009 budget,

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but will insist on offsetting tax cuts in one area withincreases in another, such as with the VAT increase tooffset the payroll tax reduction.

Peter Szijjarto, spokesman for the right-wing opposi-tion Hungarian Civic Union, labeled Gyurcsany’sJanuary 25 meeting a failure, according to a January26 report in The Budapest Times.

The Alliance of Free Democrats, a fellow left-wingparty to Gyurcsany’s Hungarian Socialist Party, said ina statement that while it applauds Gyurcsany’s desireto reduce taxes and contributions, it questions his ear-nestness in light of a December 2008 statement inwhich he said that tax cuts in 2009 or 2010 would beimpossible. The Alliance of Free Democrats calledGyurcsany’s inconsistency ‘‘harmful’’ to the Hungarianeconomy.

The parties were scheduled to meet in an extraordi-nary session of parliament on January 29 to discussthe worsening economy and the government’s pro-posed legislation. The government plans to submit themost pressing bills to the parliament by mid-March tofacilitate an effective date of July 1, Gyurcsany said ina statement.


India

Indian PE Not Responsible forWithholding, Tax Tribunal Says

The Mumbai Income Tax Appellate Tribunal onDecember 5 issued its ruling in DCIT v. Stock Engineerand Contractors BV, clarifying the withholding tax obli-gation on payments made to nonresidents by an Indianpermanent establishment of a Dutch company, as wellas the deductibility of some expenses for such a PE.

In the case at issue, which related to assessmentyear 2000-2001, Stock Engineer and Contractors (theassessee), a company incorporated in and resident ofthe Netherlands, was engaged in the design and con-struction of oil, gas, and petrochemical plants. Itsigned a contract with an Indian oil company for theengineering, procurement, and construction of a facil-ity in India on a turnkey basis. For that purpose, theassessee set up project and site offices in India (an In-dian PE) after obtaining the due regulatory approval.The assessee in turn subcontracted a part of the workto its Malaysian subsidiary.

Under that agreement, the Malaysian subsidiary wasto supply personnel to the assessee for the purpose of

executing the Indian project. Those personnel stayed inIndia for a period of more than six months during theyear under consideration.

Separately, the assessee also engaged a U.K. com-pany to deploy employees for supervision of the Indianproject, and another Dutch company to provide engi-neering services. Both of those companies were unre-lated to the assessee.

The personnel of the U.K. company were deployedin India for 135 days. The assessee did not withholdany Indian income tax when paying the Malaysian,U.K., and Dutch suppliers. (The assessee also hadsome employees at its head office who dedicated partof their time providing technical support to the IndianPE; however, none of those employees visited India forthe project work.)

During the 2000-2001 assessment year, the assesseededucted the payments it made to the Malaysian sub-sidiary and the unrelated U.K. and Dutch companiesin computing the Indian PE’s taxable income. The as-sessee also deducted part of the salary cost incurred bythe head office for its employees based on the numberof hours the employees spent on the Indian project.

In the course of assessment proceedings, the taxofficer concluded that the assessee was subject to awithholding tax obligation on the payments it made tothe various service suppliers. Because no tax was with-held, those payments were not deductible in computingthe taxable profits of the Indian PE,1 the tax officersaid.

In particular, the tax officer took the position thatthe Malaysian subsidiary had a PE in India under ar-ticle 5(4)(a) of the India-Malaysia income tax treaty,which states that a PE is created if supervisory activi-ties are carried out in India for more than six monthsin connection with a construction, installation, or as-sembly project in India.

The tax officer also held that the U.K. company hada PE in India under article 5(2)(k) of the India-U.K.income tax treaty, which states that a services PE iscreated if the aggregate stay of the personnel in Indiaexceeds 90 days.

Regarding the payment to the Dutch company, thetax officer held that it constituted a payment for techni-cal services, which is subject to tax under the India-Netherlands income tax treaty.

1Failure to meet the withholding tax obligation leads to,among other things, the denial of a tax deduction for the pay-ment in question (ITA section 40(a)(i)). The withholding tax ob-ligation in the case of payment to a nonresident is triggered un-der ITA section 195 if the payment is subject to Indian incometax in the hands of the recipient.

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Addressing the assessee’s deduction of the salarycosts of some employees in its head office, the tax of-ficer said those costs were in the nature of head officeexpenses, which are subject to a deductibility cap undersection 44C of the Indian Income Tax Act.2 Subjectingit to that limit, the tax officer denied the deduction.

The assessee successfully argued its case before thecommissioner of income tax (appeals). The RevenueDepartment then appealed to the tribunal.

Tribunal’s RulingThe tribunal held that the Malaysian company did

not have a PE in India under article 5(4)(a) of theIndia-Malaysia tax treaty. It noted that the personnelsupplied by the Malaysian company were under thedirect control of the assessee, that the Malaysian com-pany had no further role after the personnel were sup-plied to the assessee, and that the Malaysian companydid not carry out any direct supervisory activities inIndia.

Also, the tribunal noted that there is no article inthe India-Malaysia tax treaty that deals specificallywith fees for technical services. Consequently, therewas no obligation on the assessee to withhold Indiantax from the payments it made to the Malaysian com-pany and the payments were therefore tax deductible.

The tribunal also noted that article 5(2)(j) of its taxtreaties, which provides for a threshold of six monthsin India, specifically refers to a building site, installa-tion, or assembly project, or supervisory activities inconnection therewith.

Turning to the assessee’s payments to the U.K. com-pany, the tribunal noted that, in contrast to article5(2)(j), a PE is triggered under article 5(2)(k) when serv-ices, including managerial services, are performed inIndia for an unrelated party for a period of more than90 days in any 12-month period.

The tribunal therefore applied the settled legal prin-ciple that if two provisions are equally applicable to asituation, the one that is most beneficial to the tax-payer should be adopted. Because the personnel of theU.K. company were deployed in India for no morethan 135 days, there was no PE for the U.K. companyunder article 5(2)(j) of the India-U.K. tax treaty. Conse-quently, the assessee was not required to withhold anyIndian tax from its payments to the U.K. company andthe payments were therefore tax deductible.

Regarding the services supplied by the Dutch com-pany, the tribunal held that those services, while tech-

nical, did not make any technical knowledge or experi-ence available to the assessee. As such, the assessee’spayments to the Dutch company could not be classi-fied as fees for technical services within the meaning ofarticle 12 of the India-Netherlands tax treaty, the tribu-nal said. The assessee therefore was not required towithhold any Indian tax from the payments, and thepayments were tax deductible, the tribunal ruled.

On the final question, the tribunal held that the de-ductibility cap on head office expenses is limited toexecutive and general administrative expenses incurredby the head office for a common purpose — for ex-ample, for purposes of managing the head office aswell as all branches and PEs in general. In the case atissue, the payment was made to employees whoworked in the head office and did not work exclusivelyon the Indian project (that is, they also worked for thehead office, as shown by the allocation of part of thesalary costs based on the hours spent on the Indianproject). Therefore, there was a common purpose forthose expenses as envisaged in ITA section 44C, thetribunal said.

However, because the employees were providing spe-cific technical services to the Indian project, their costscould not be classified as executive and general admin-istrative expenditures, which refer to managerial andadministrative services alone and do not include tech-nical services, the tribunal said. Therefore, those costswere not subject to the deductibility cap imposed byITA section 44C and were fully deductible in comput-ing the taxable profits of the Indian PE.

For nonresidents with a PE in India, this ruling maymake it easier to fully claim a deduction for costs relat-ing to services other than managerial and administra-tive services, subject of course to the arm’s-length prin-ciple under the transfer pricing code.

♦ Shrikant S. Kamath, tax consultant, Hong Kong

Subsidiaries in India Do NotConstitute a PE, Tribunal Rules

A German company’s Indian subsidiaries do notconstitute a permanent establishment in India; there-fore, the company is not subject to taxation in India,according to the Pune Income Tax Appellate Tribunal.

The tribunal’s ruling in ACIT v. Epcos AG — issuedon June 30, 2008, and made public on January 21 —involves the 2003-2004 assessment year and deals withissues relating to the Germany-India income tax treatyand the Indian Income Tax Act, 1961. (For the ruling,see Doc 2009-1333 or 2009 WTD 14-21.)

BackgroundEpcos AG is a multinational company that designs,

manufactures, and markets electronic components. It

2ITA section 44C limits the deduction for head office ex-penses to 5 percent of taxable income, computed as specified.Head office expenses have been defined to mean executive andgeneral administrative expenditures incurred by the assessee out-side of India, including salaries, rent, travel expenses, and so on.

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has operations in Germany and subsidiaries across theworld, including two in India. During the year underconsideration, the German arm of Epcos AG suppliedservices such as marketing, sales support, and technol-ogy support to the Indian subsidiaries in return for roy-alty payments.

In its Indian tax return, the German arm of EpcosAG classified the payments it received from the Indiansubsidiaries as royalties and fees for technical services,which were subject to Indian income tax at a rate of10 percent under article 12 of the Germany-India in-come tax treaty.

The Indian tax officer requested details about theservices supplied to the Indian subsidiaries by the as-sessee, and the company submitted that sales arehandled by Epcos AG’s regional sales offices, whereasmarketing efforts are centralized at the German head-quarters in Munich.

The company said it is organized by product divi-sions, and each division has a central marketing teamthat works for all the manufacturing subsidiaries in thatdivision. Epcos AG charges an arm’s-length fee for theservices that the central marketing team renders for thebenefit of the various manufacturing subsidiaries.

The transfer pricing officer (TPO) agreed that theservices provided by the assessee were supplied to theIndian subsidiaries on an arm’s-length basis, as re-quired by the transfer pricing provisions of the ITA.

The tax officer, however, thought that the assesseehad a PE in India in the form of the two subsidiariesbecause the assessee was conducting its business in In-dia through those subsidiaries and more specifically,through the employees of the subsidiaries. He classifiedthe payments at issue as business profits under article 7of the Germany-India tax treaty and assessed tax on agross basis at the 20 percent rate provided under theITA. (For the year in question, the ITA did not allow adeduction for any expenses related to royalties and feesfor technical services earned by a foreign company.)

The commissioner of income tax (appeals) subse-quently overturned the assessment, holding that theservices supplied by Epcos AG were routine in natureand were provided to enable the Indian subsidiaries tocarry on their own business activities, and not the busi-ness of the assessee. The Revenue Department thenappealed to the tribunal.

The Tribunal’s DecisionIn the tribunal’s own words, the commissioner of

income tax (appeals) properly rejected the tax officer’s‘‘overzealous approach.’’

The tribunal held that a tax treaty generally providesfor an alternate tax regime and not an exemption re-gime. Therefore, the burden is first on the Revenue De-partment to show that the assessee has taxable incomeunder the treaty, and then the burden is on the assessee

to show that its income is exempt under the treaty. Un-less a tax jurisdiction has a right to tax an income, it isirrelevant whether, under the domestic tax legislationof that tax jurisdiction, the income in question is tax-able. In a situation in which India has no right to tax aparticular income in the hands of the nonresident cov-ered by a tax treaty, the provisions of ITA do notcome into play at all.

The tribunal confirmed that when an economic ac-tivity is carried out in a fixed place of business avail-able to a foreign enterprise, that place will be a PE ofthe foreign enterprise regardless of whether the activi-ties at issue are core activities or peripheral activities.However, if the PE carries on an activity that does notserve the overall purpose of the foreign enterprise ordoes not contribute to the profits of the foreign enter-prise, the existence of such a PE is wholly academicand does not have any tax implications in the sourcejurisdiction (in this case, India).

While Epcos AG’s business is to supply certaintypes of services to its Indian subsidiaries, the businessof the Indian subsidiaries is to manufacture and selltheir own products, the tribunal said. The fact that theemployees of the Indian subsidiaries were also engagedin marketing and information technology support ac-tivities does not mean that those employees were doingthe business of the assessee, it said.

Further, the TPO had agreed that the paymentsmade by the Indian subsidiaries to Epcos AG were atarm’s length, and the assessee had not reimbursed thesubsidiaries for any costs incurred in connection withtheir employees in India, and as such, there could notbe any payment for, or in connection with, the servicesrendered by those employees.

The tribunal therefore held that the Indian subsidiar-ies did not constitute a PE of Epcos AG in India, andthat the assesssee was not subject to taxation in Indiaon royalties or technical service fees paid by the Indiansubsidiaries.

♦ Shrikant S. Kamath, tax consultant, Hong Kong

Indonesia

Exit Tax Rules Revised

Indonesia’s Directorate General of Taxation on De-cember 21, 2008, issued Regulation PER-53/PJ/2008(later amended by PER-1/PJ/2009 of January 9,2009), regarding the procedures for payment, exemp-tion, and administration of the fiscal (exit) tax for resi-dent individuals traveling overseas.

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As of January 1 and continuing through December31, 2010, the new rates for the fiscal tax are IDR 2.5million for travel by air and IDR 1 million for travel bysea.

Indonesian tax residents who are 21 years and olderand who have not registered and received a tax identifi-cation number (NPWP) are required to pay the fiscaltax, which is creditable against the individual’s incometax payable at the end of the year (once the taxpayerhas obtained an NPWP). The new regulation does notaddress the mechanism for crediting fiscal tax againstan employer’s income tax payable at year-end.

In contrast, taxpayers who have registered and re-ceived an NPWP are no longer required to pay the fis-cal tax. The taxpayer’s spouse and dependent familymembers also will be exempt from the tax, providedthat they are listed on the family card (Kartu Keluarga)of the NPWP holder. For families of foreign citizenswith an NPWP, the taxpayer must attach a photocopyof a Certificate of Expatriate’s Family Structure orother official document equivalent to the certificate,indicating the family relationship status.

Exemptions from the fiscal tax are granted to for-eign taxpayers who do not reside in Indonesia or whostay in Indonesia for no more than 183 days in a 12-month period. Diplomats and representatives of inter-national organizations and their families, Indonesiancitizens permanently residing abroad, hajj pilgrims, in-dividuals crossing land borders, Indonesian studentsstudying abroad, Indonesian workers with migrantworker cards, and individual tax residents with annualincome below the nontaxable income threshold alsoare exempt from the fiscal tax.

♦ Firdaus Asikin and Connie Chu,Deloitte Touche Tohmatsu, Jakarta. Copyright © 2009

Deloitte Touche Tohmatsu. All rights reserved.

Regulation Amends CFC Rules,Clarifies Export Duty

Indonesia’s Ministry of Finance recently issuedRegulation 256/PMK.03/2008 (dated December 31,2008) revising the previous controlled foreign corpora-tion rules under Ministry of Finance Decree 650/KMK.04/1994.

The new rules, which entered into force on January1, no longer contain blacklisted countries; thus, Indone-sia no longer distinguishes between the jurisdictions offoreign subsidiaries. Any undistributed profits of un-listed companies with Indonesian control of 50 percentor more that are incorporated in foreign countries willbe deemed to be distributed if they are not distributedwithin four months of the most recent submission ofan annual tax return in that foreign country.

If there is no obligation to file an annual tax returnin that foreign country, the undistributed profits will bedeemed distributed if they are not distributed withinseven months after the tax year ends.

Distributed dividends received from foreign subsidi-aries are taxed in the normal manner. The ordinaryforeign tax credit with a per-country limitation doesnot extend to the underlying corporate tax.

Like the old CFC regulations, the new rules applyonly to foreign subsidiaries that are directly held byIndonesian tax residents and do not have grandfather-ing provisions that extend to foreign subsidiaries indi-rectly owned by Indonesian tax residents through theirdirect foreign subsidiaries acting as mixer companies.

It is unclear whether the CFC rules are still appli-cable if the Indonesian shareholder does not haverights to receive dividends under the relevant laws inthe jurisdiction of the foreign subsidiary.

Export DutyThe Ministry of Finance also issued Regulation

214/PMK.04/2008 (dated December 16, 2008), whichclarifies Export Duty Regulation 214. Regulation 214,which entered into force on January 1, implementedCustoms Law 17 of 2006 and articles 2(5), 14, and 18of Regulation 55 of 2008 concerning the application ofexport duty.

Generally, exported goods are subject to export duty,with the exception of:

• goods owned by foreign missions or their officialswho are posted in Indonesia, based on the prin-ciple of reciprocity;

• goods that are owned and used by museums,zoos, and similar public places, as well as goodsused for nature conservation;

• goods used in scientific research and development;• goods that are used as samples and are not for

commercial use;• belongings of individual passengers and carrier

crew members traveling cross-border, and ship-ments up to a certain value of export duty or inspecified amounts;

• goods that were imported and reexported; and

• exported goods that will later be imported.

To be eligible for the export tax exemption, an ex-porter must file a written declaration with the head ofthe customs office reporting goods that fall into thefirst four categories mentioned above, and must file anapplication with the head of the customs office for thelast two categories of goods mentioned above.

The export duty rate is based on a percentage of theexport value (ad valorum) or the specific amount ofthe export value. The rate is based on the export valuestipulated on the date the export declaration is filedwith the customs office.

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The exporter or its customs proxy generally mustpay the export duty by the time the export declarationis filed with the customs office. For some exports, thedeadline is 60 days after the departure of the carrier ofthose goods.

As with other customs and tax disputes, any disputeover export duty shall begin with the filing of an objec-tion application to the Directorate General of Customsand Excise. If the directorate’s decision is not satisfac-tory, the exporter may appeal to the tax court.

♦ Freddy Karyadi, senior lecturer,Trisakti University, Jakarta

Jamaica

World Bank Backs Jamaican TaxReform Effort

The World Bank has issued a $100 million develop-ment policy loan to Jamaica that is intended to assistthe Caribbean nation as it seeks to improve its financesand reform its tax system.

The World Bank on January 15 announced it hadapproved the fiscal and debt sustainability developmentpolicy loan to aid Jamaica in containing public spend-ing, improving financial management and budgetingprocesses, and ‘‘enhancing the efficiency and fairnessof the tax system.’’ The loan will have a 30-year termand will defer payments for the first five years.

The Jamaican government laid out its proposal toreform both tax policy and tax administration in itsDecember 2008 loan request. The proposal calls forreporting the costs of tax exemptions and special ratesto lawmakers, eliminating general consumption tax ex-emptions for nonfood categories and certain purchasercategories, taking steps to ensure that corporate profitsare taxed at either the corporate or individual level,and increasing the income tax threshold.

To improve tax system administration, the proposalcalls for reducing filing requirements through payrolltax consolidation, increasing enforcement efforts, andimproving the tax authorities’ ability to collect and useinformation to detect fraud and evasion.

In his April 2008 budget speech, Prime MinisterBruce Golding had outlined the challenges faced by thegovernment as it seeks to reform taxation. Goldingcalled the current system ‘‘inequitable, inefficient andleaky.’’ According to Golding, the government is col-lecting only 20 percent of applicable corporate taxesand only half of applicable property taxes. He alsosaid that outside the country’s pay as you earn (PAYE)system, only 4,000 individuals pay income tax. Gold-

ing estimated that 250,000 self-employed individualswho are liable to pay income tax are not doing so.

‘‘We could significantly reduce taxes and collect sig-nificantly more taxes, if everybody paid and this willbe the aim of the comprehensive tax reform program,which we intend to introduce next year,’’ Golding said.

The Jamaica Confederation of Trade Unions(JCTU) has criticized the current income tax system ascreating an ‘‘unfair and unjust tax burden’’ on PAYEworkers. In a January 4 opinion article published inThe Gleaner, JCTU General Secretary Lloyd Goodleighcalled on Parliament to ‘‘implement a tax reform pack-age that is efficient and equitable.’’

‘‘Parliament can correct an economic inefficiencyand transform the society by putting in place anefficient/equitable tax system and seeking to securenational consensus on a social covenant between thegovernment of Jamaica and its citizens,’’ Goodleighwrote.

On January 17 the Jamaican government announcedthe Domestic Tax Administration Project, which tar-gets the same tax administration goals included in theWorld Bank proposal. Under the plan, the governmentwill consolidate three collection departments to fallwithin the authority of the commissioner general.

‘‘The new regime is expected to achieve increasedrevenue through significant improvements in the effi-ciency and effectiveness of the organization of domes-tic tax; contribute directly to macroeconomic stability,stimulate greater voluntary compliance and collectmore of the revenues due; reduce dependence on bor-rowing by making additional financial resources avail-able on a sustainable basis to finance budgetary needsand be able to reduce tax rates through widening ofthe tax base,’’ the government said in a January 17 re-lease.

♦ David D. Stewart, Tax Analysts.E-mail: [email protected]

Japan

Consumption Tax Measure AdvancesJapanese Prime Minister Taro Aso’s Cabinet on

January 23 approved a supplementary clause in theimplementation legislation for the proposed 2009budget proposal that paves the way for an increase inthe current 5 percent consumption tax rate in or afterfiscal 2011. (For related coverage, see Doc 2008-26445 or2008 WTD 243-2.)

The final wording of the supplementary clause re-flects a compromise between members of the rulingLiberal Democratic Party (LDP) who opposed Aso’s

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insistence that the bill include a hard and fast commit-ment to raise the consumption tax in fiscal 2011, andthose who supported Aso’s position. The clause alsostresses the need for Tokyo to promote administrativereform and to deal with wasteful expenditures — im-portant points for many LDP members who opposedthe initial 2011-specific wording. With an electionlooming later this year, Aso reportedly wants to avoidcreating tension within his party.

The LDP needs to receive a two-thirds majority inthe powerful lower house of the Diet to have anyhopes of passing budget-related bills that may be re-jected by the opposition Democratic Party of Japan(DPJ), the majority party in the upper house.

The revised clause states that the actual date for in-creasing the tax rate will be specified in a separate bill,but that all necessary legal preparations will be put inplace by fiscal 2011, which would enable the govern-ment to implement the tax increase and other relatedtax reforms as soon as a date is agreed upon.

By revising the supplementary clause the Cabinethas aligned itself with the LDP’s Treasury and FinanceDivision and its Policy Deliberation Committee, bothof which reportedly gave their approval a day earlier.The party’s General Council also signaled its backingof the implementation legislation, including the supple-mentary clause, on January 23. The 2009 budget pro-posal was presented to the Diet on January 19.

Some LDP lawmakers continue to harbor concerns.‘‘The wording is still ambiguous. Prime Minister Asohas a responsibility to give a full account of the plan,’’said Kenichi Mizuno, an LDP member of the Houseof Representatives (lower house), according to a Janu-ary 22 Kyodo News report.

‘‘I find it acceptable if the government wouldspecify the rate increase and the specific date in sepa-rate legislation,’’ added Ichita Yamamoto, an LDPmember of the House of Councillors (upper house)who had previously opposed the clause. However,Yamamoto told reporters that ‘‘it is impossible to raisethe consumption tax in fiscal 2011.’’ The Japanese fis-cal year runs April 1 to March 30.

Not surprisingly, the opposition DPJ was quick tocondemn the consumption tax clause. At a January 23press conference in Tokyo, DPJ acting President NaotoKan said the clause ‘‘has highlighted Prime MinisterAso’s flip-flop on another important issue.’’ Kan appar-ently was alluding to Aso’s indecision about whetherhigh-income individuals should accept cash paymentsfrom Tokyo as part of the government’s overall stimu-lus plan. Aso initially suggested that high-income indi-viduals should not accept any of the ¥2 trillion (about$22.5 billion) dispersal, but he reportedly changed hismind, later saying that everyone should use the moneyto stimulate the economy.

LDP supporters defended Aso at various Tokyopress conferences on January 23. In one conference,

Chief Cabinet Secretary Takeo Kawamura downplayedthe possibility that LDP members will still oppose thebill when it comes up for vote in the Diet and deniedthat the wording indicates a retreat from Aso’s originalposition. ‘‘The policy presented remains the same,’’ hetold reporters.

Aso now hopes to build support among the Japa-nese public for an eventual consumption tax increase.He reportedly has assigned Akira Amati, state ministerin charge of administrative reform, to draw up a planthat will address needed administrative reforms, spot-light wasteful spending, and suggest ways to make thepublic servant system more efficient. All of those stepsare reflected in the supplementary clause as steps to betaken before resorting to a consumption tax increase.

Aso’s approval rating has plummeted recently tobelow 20 percent, partly as a result of rising unemploy-ment and falling wages. His decreasing popularityraises the threat of an LDP defeat in the general elec-tions, which are to be held by September.


Multinational

IASB Rejects Proposal to AllowDiscounting of Current Tax in IAS 12

The International Accounting Standards BoardJanuary 23 voted against a proposal included in a bal-lot draft of an exposure document of amendments toInternational Accounting Standard No. 12, ‘‘IncomeTaxes,’’ that would broadly allow for the discounting ofa company’s current tax assets and liabilities.

At its board meeting in London, the IASB also de-cided to ‘‘stay silent’’ and not include any discussionon the discounting of current tax in the forthcomingexposure draft. The board members agreed there is noneed to mention a specific requirement in IAS 12 be-cause a company can use existing accounting literatureduring rare circumstances when a discount could applybecause of a government agreement.

IASB member James Leisenring objected to the bal-lot draft’s proposal, but noted that discounting of cur-rent tax can depend on circumstances, such as whenthere are taxes that are owed but for which a settle-ment can be reached with a revenue service. He addedthat he had no problem with a company discountingthat tax amount.

IASB member Robert Garnett added that in practicelarge accounting firms discount current taxes whenthere has been an agreement with a government thatfalls outside the normal tax code for deferred payment.

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He added that he doesn’t believe firms routinely dis-count current taxes across the board.

Leisenring also said the proposal created a ‘‘funda-mental difference’’ from U.S. generally accepted ac-counting principles during the ongoing convergenceproject with the U.S. Financial Accounting StandardsBoard.

An agenda paper prepared for the meeting notesthat FASB’s Financial Accounting Standard No. 109,‘‘Accounting for Income Taxes,’’ does not include aspecific requirement or prohibition regarding the dis-counting of current tax.

Leisenring took issue with the proposal’s also failingto note the differences between U.S. GAAP and whatthe IASB was considering. ‘‘It’s just so frustrating towork on convergence projects and have these last-minute 180s come up, and it’s no wonder we don’t getthings done,’’ he said.

‘‘I do not think this is worth it during a project thatis complicated enough,’’ Leisenring said. The IASB hassaid its current project to reduce the differences be-tween IAS 12 and FAS 109 will lead to an exposuredraft of an international financial reporting standard toreplace IAS 12 by early 2009 and to a final standard in2010.

♦ Thomas Jaworski, Tax Analysts.E-mail: [email protected]

Norway

Government Proposes Carryback RuleFor Losses

The Norwegian government on January 26 pre-sented a NOK 20 billion (about $2.93 billion) ‘‘crisispackage’’ that includes tax proposals that would allowcompanies to carry back losses in 2008 and 2009 andwould expand the research and development credit.

Norway has not been hit hard by the global finan-cial crisis, but the government is concerned about ris-ing unemployment levels. Unemployment is expectedto reach 4 percent this year, a small number by interna-tional standards but high by Norwegian standards.Business and opposition politicians are disappointedthat the package does not contain more tax reductions,but the government has concluded that most tax reduc-tion proposals are expensive compared with the num-ber of jobs they create. Therefore, most of the pack-age’s money would go to municipalities, public works,and environmental investments.

The most important tax proposal would grant com-panies a carryback for losses in 2008 and 2009. Under

the ordinary rules, such a carryback is granted onlywhen the taxpayer’s business is terminated. Under theproposal, companies with profits in previous years,back to 2006, but losses in 2008 and/or 2009 would begranted the deduction earlier — perhaps much earlier— than under the ordinary carryforward rules, imme-diately increasing cash flow. However, the proposedrules would apply only to losses up to NOK 5 millionfor each of the income years 2008 and 2009. There isno rule regarding consolidated companies belonging tothe same group, so presumably, one cap of NOK 5million would apply to each company of a group. Therules would also apply to a nonresident company doingbusiness in Norway through a branch.

To avoid complicated recalculations of taxable in-come and taxes for earlier years, the rule is technicallyframed as a cashing out in 2009 and/or 2010 of 28percent of the losses sustained in 2008 and/or 2009, tothe extent that these losses do not exceed the taxableprofits of 2006 to 2008. The 28 percent reflects thecompany tax rate for all the relevant years. As a conse-quence, the right to carry forward losses from 2006 to2008 is reduced by the same amount as the losses in2008 and 2009, the tax value of which has been cashedout.

The revenue loss, and the corresponding cash flowfor the companies, is estimated to amount to NOK3.25 billion in 2008 and a similar amount in 2009.However, because the rules imply that losses to be car-ried forward to later years are correspondingly reduced,future taxes would increase.

The other tax proposal would raise the cap on theR&D tax credit. Currently, taxpayers can claim an in-come tax credit of 20 percent of costs for R&D (andhave the difference cashed out if the credit exceeds thecalculated taxes) if the project is accepted by the Nor-wegian Research Council. The cap would be raisedfrom NOK 4 million to NOK 5.5 million for the com-pany’s own research and from NOK 8 million to NOK11 million for a project carried out by a research insti-tution. This proposal would reduce tax revenue, andincrease the relevant companies’ cash flow, by NOK180 million in 2009. Unlike the loss carryback pro-posal, this proposal is not limited to 2009 and 2010.

♦ Frederik Zimmer, Department of Public andInternational Law, University of Oslo

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OECD

OECD Group Addresses CIVs,Cross-Border Investors

An informal consultative group (ICG) organized bythe OECD has released two reports that address theapplication of treaty benefits to collective investmentvehicles and cross-border investors

Issued on January 12, the reports — ‘‘Granting ofTreaty Benefits With Respect to the Income of Collec-tive Investment Vehicles’’ (the CIV report) and ‘‘Pos-sible Improvements to Procedures for Tax Relief forCross-Border Investor’’ (the procedures report) — werecommissioned by the OECD in December 2006 whenthe informal consultative group was established.

The CIV report deals with conceptual and practicalissues relating to income tax treaty benefits when inves-tors in one country invest, through a fund organized ina second country, in investments in a third country.

The procedures report deals more generally with thepractical problems of making claims for treaty reliefwhen investors hold investments through intermediaryinstitutions, such as banks and brokerages, and are notthe owners of record of the investments.

Fund managers with cross-border investments orinvestors, banks, and brokerages should be aware ofthis development, since it might be a harbinger of fu-ture developments in international tax treaty practice.

It must be emphasized that at this stage, the reportscontain only the views of the ICG. The OECD’s Com-mittee for Fiscal Affairs has not adopted the ICG’sconclusions as a statement of the OECD’s officialviews, although it may do so in the future.

The CIV ReportIt is very common for an investment fund organized

in one country (the fund country) owned by investorsin a second country (the investor country) to invest insecurities issued by residents of a third country (thesource country). Most source countries impose with-holding taxes on payments of interest, dividends, orboth to foreign investors, and some (such as Canada,Spain, and Australia) impose tax on some capital gainsrealized by foreign investors.

Thus, investors are often very interested in whetherrelief from source-country tax is available under anapplicable income tax treaty. There may be a treatybetween the source country and the fund country, atreaty between the source country and the investorcountry, or both. Unfortunately, even if the sourcecountry has tax treaties with both the fund country andthe investor country, it is often very difficult for invest-ments made by such a fund to qualify for benefits un-

der either treaty. There are conceptual and practicalreasons for this. (The practical reasons are discussed inthe procedures report.)

Source-Country/Fund-Country TreatyA fund typically will be able to claim treaty benefits

in its own right under the source-country/fund-countrytreaty only if it is a resident of the treaty country. Ar-ticle 4(1) of the 2008 OECD model income tax treatydefines a resident of a treaty country as ‘‘any personwho, under the laws of that State, is liable to taxtherein by reason of his domicile, residence, place ofmanagement or any other criterion of a similar na-ture.’’ There are three common reasons why a sourcecountry might not treat a fund as a resident of thefund country for treaty purposes, thereby denyingtreaty benefits.

First, the source country might not view the fund asa ‘‘person’’ for treaty purposes. Some types of vehiclescommonly used for investment funds are treated ascontractual relationships, and not legal entities, as amatter of domestic law. One very common example isthe Luxembourg fond commun de placement (mutualfund). Also, funds organized as trusts create problemsbecause the concept of a trust frequently does not existunder the laws of non-English-speaking countries.

Second, a fund most likely is not subject to tax inthe fund country at the full statutory rate. It might beexempt from tax or taxable at a special low rate, itmight be fiscally transparent, or it might get a deduc-tion for dividends paid (like U.S. mutual funds of theusual type). The source country might not view such afund as subject to tax in the fund country.

The view of the United States is that an entity issubject to tax in the fund country if the fund countryhas taxing jurisdiction over the entity, so under generalprinciples of fund-country law, the entity could be sub-ject to fund-country tax, even if the entity is subject toa special tax exemption. Other countries are not as le-nient.

Third, although limitation on benefits clauses his-torically were unique to U.S. income tax treaties, some-times a source country will want some assurance thatthe fund is not being misused by investors resident incountries that do not have an income tax treaty withthe source country. There are several situations inwhich a source country will not grant treaty relief to afund without knowing something about who owns thefund.

Source-Country/Investor-Country TreatyThe problem with a claim by an investor for relief

under the source-country/investor-country treaty is thatthe fund is in the middle. Treaties based on the OECDmodel provide relief to a beneficial owner of income.But the OECD model treaty does not purport to definewhat a beneficial owner is, and this issue is the subjectof much debate.

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Internal Revenue Code section 894(c) and Treas.reg. section 1.894-1(d) deal with this issue in caseswhen the United States is the source country. An inves-tor can claim benefits of the U.S./investor-countrytreaty on the investor’s share of the fund’s income ifthe fund is fiscally transparent in the investor countryand the investor is not fiscally transparent in the inves-tor country. The analysis in other countries can be dif-ferent, or unclear.

The CIV report is limited in scope to funds that areboth widely held and subject to investor protectionregulations, that is, are under the Investment CompanyAct of 1940 in the United States, or the UCITS Direc-tive in the EU. It does not address the usual type ofhedge fund or private equity fund.

The report concludes that under existing treaties, afund that does not have legal personality under domes-tic law, such as a fond commun de placement, most likelyis not a person for treaty purposes and therefore cannotclaim benefits under the source-country/fund-countrytreaty in its own right. On the other hand, a fund or-ganized as a corporation or a trust should be regardedas a person for treaty purposes, the report says.

It concludes that a fund that receives an exemptionfor specific types of income should be viewed as sub-ject to tax for treaty purposes, as should a fund thatreceives a deduction for dividends paid (as is the casewith U.S. mutual funds). But a fund that is fiscallytransparent (treated like a partnership) in the fundcountry or is exempt from fund-country tax on all ofits income should not be subject to tax in the fundcountry.

The majority view in the report, though not withoutdissent, is that a fund that is a resident should beviewed as the beneficial owner of its income for treatypurposes. In any event, it is important that sourcecountries clarify their views as to whether CIVs areentitled to benefits under current treaties.

The ICG also considered situations under existingtreaties in which a fund cannot claim benefits underthe source-country/fund-country treaty in its own right.In those cases, the report concludes that in principle,investors should be able to claim treaty benefits ontheir share of the fund’s income under the source-country/investor-country treaties.

This approach — investor-level benefits under thesource-country/investor-country treaties — was viewedas less desirable than fund-level benefits because of thedifficulty of allocating the fund’s income among theinvestors in a widely held fund with investors comingand going daily. It was also recognized that many in-vestors would not bother to file requests for relief un-der the source-country/investor-country treaties forsmall amounts of money. Thus, it was argued in thesecases that the fund should be able to file claims forrelief under the source-country/investor-country trea-ties on behalf of the investors. However, a minority of

the ICG did not believe that investors resident outsideof the fund country should be able to claim treaty ben-efits under the applicable source-country/investor-country treaty. This view would allow investor-levelclaims only to residents of the fund country.

The CIV report suggests that future treaties shouldaddress the issues raised by CIVs directly, and containsdraft language for revisions to the commentary to theOECD model income tax treaty. The preferred ap-proach is that a fund should always be a treaty benefi-ciary in its own right, although perhaps with relief cutback proportionately to the extent that the investors arenot themselves entitled to benefits under a source-country/investor-country treaty with benefits compa-rable to the source-country/fund-country treaty.

For example, if the fund was 80 percent owned bytreaty-protected investors and 20 percent owned bynon-treaty-protected investors, one might limit benefitsunder the source-country/fund-country treaty to 80percent of the fund’s income. (The issues regardinghow such a fund is to ascertain who owns it are dis-cussed in the procedures report.)

The ICG felt that allowing funds to claim treatybenefits under the source-country/fund-country treatyfor the future is preferable to allowing an investor toclaim treaty benefits under the source-country/investor-country treaty on the investor’s share of the fund’s in-come. But the latter alternative might be preferable if,for example, a substantial number of investors in theinvestor country are pension funds that are entitled tospecial treaty benefits not available to ordinary inves-tors. This would allow pension funds to claim theirspecial treaty rates on their share of the fund’s income,albeit at the cost of more complexity.

The Procedures ReportUnder modern securities processing, interests in a

fund or any widely held or publicly traded securitymight be owned through multiple levels of brokers,banks, and other financial intermediaries. For example,the investor of record might be a central securities de-pository such as the Depository Trust Company in theUnited States or Clearstream or Euroclear in Europe.

The depository holds investments for the account ofits participants, which typically are banks and broker-ages. The banks and brokerages in turn hold invest-ments on account of their customers, typically throughomnibus accounts that combine securities held on be-half of multiple customers.

This system exists for reasons that have nothing todo with tax. But as a result, the payers in the sourcecountry might have no idea who the ultimate ownersof the income that they are paying are, and a fundmight not know who owns it. Obtaining this informa-tion can be very difficult. This can be even moretroublesome if some of the intermediaries are subjectto bank secrecy rules.

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Furthermore, a source country frequently will wantsome documentary proof that someone claiming treatybenefits is in fact entitled to them. Can the payers inthe source country deal with a mountain of paperworkfrom all of the ultimate customers and investors, espe-cially given that the fund or financial intermediarylooks like one investor on the books of the source-country payers?

If some of the investors can benefit under an in-come tax treaty with the source country and otherscannot, will the source country allow withholding ononly a proportion of the payments?

If relief at source is impossible, the investors mightbe able to request refunds from the source country. Butwhat documentation will they need from the fund orfinancial intermediary that will be acceptable to thesource country?

Can the fund or financial intermediary generate thenecessary documentation without undue burden? Willthe investors bother to file claims for refunds of smallamounts?

These problems may not be too troublesome forfunds with a small number of sophisticated investors,such as the pension pooling vehicles that are cominginto use in Europe. But these issues are daunting forfinancial intermediaries with a large number of cus-tomers and for retail funds with a large number ofsmall investors.

The goal of the procedures report is to set forth bestpractices for how countries should handle claims fortreaty relief when an investor that is entitled to treatyrelief in its own right does not own the investment di-rectly, but owns it through a CIV or through one ormore levels of intermediaries.

The ICG considered how to reduce costs and ensurethat tax administrators’ rules were being followed. Itsconclusions are as follows:

• As much as possible, source countries should al-low treaty relief at source, rather than requiringinvestors to file claims for refunds afterward.

• Intermediaries that have been authorized by thesource country should be allowed to make claimsfor treaty relief on behalf of their customers on apooled basis, without having to provide detailedinformation on customers for each payment.1

• Authorized intermediaries should be required topass along detailed information about customersthat have claimed treaty benefits to the sourcecountry after the fact so that the source countrycan verify that the treaty claims are proper. Thesource country would share this information with

the investor countries so that they can confirmthat the income is being reported properly.2

• Countries that do not use unique taxpayer identifi-cation numbers should do so, to allow informa-tion to be properly matched.3

• Investors should be permitted to claim treaty ben-efits based on their own self-certification, ratherthan being required to obtain residence certifi-cates, at least for small accounts.4

ImplicationsAs stated earlier, the conclusions of these reports

have not been accepted by the OECD, and the OECDdoes not make tax laws. But the OECD’s recommen-dations have been very influential on the treaty policiesof developed countries. Thus, if these reports areadopted by the OECD, international treaty practicemight move in the direction outlined in the reports.

The Committee for Fiscal Affairs now is consideringthe reports, and has invited public comments on them.Comments are due by March 6.

♦ Matthew Blum, Ernst & Young LLP, Boston.

The author appreciates the assistance of Alastair Campbell,a senior in Ernst & Young’s International Tax Services

Group in Boston.

1This suggestion clearly bears a resemblance to the U.S. quali-fied intermediary system and the Irish qualifying intermediarysystem.

2This is not like the U.S. qualified intermediary system be-cause the U.S. system is designed to respect bank secrecy fornon-U.S. investors.

3Note that the United States does not require foreign personsclaiming treaty benefits relating to publicly traded investments(and some other types of investments) to obtain U.S. taxpayeridentification numbers.

4As is the practice in the United States.

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Portugal

Government Submits BudgetSupplement

The Portuguese government on January 19 submit-ted to the parliament a budget supplement proposalcontaining several tax measures, including a new in-vestment tax credit for 2009, an expansion of the re-search and development tax credit, and the extensionof the Portuguese holding regime to EU-incorporatedentities moving their seat or place of effective manage-ment into Portugal. (For prior coverage of the recentlypassed 2009 Budget Law, see Tax Notes Int’l, Jan. 12,2009, p. 137, Doc 2009-232, or 2009 WTD 4-1.)

The supplementary budget bill, titled ‘‘Initiative forEmployment and Investment,’’ is the government’s re-action to the worsening economic conditions in Portu-gal. If approved, the bill’s measures would be effectivefrom January 1, 2009.

New Investment Tax Credit

The bill includes a new tax incentive designed tostimulate investment. The Regime Fiscal de Apoio aoInvestimento (RFAI 2009) would provide several taxbenefits for qualified investments made in some busi-ness sectors.

The RFAI 2009 includes the following tax benefits:

• an ITC that operates as a deduction against cor-porate income tax otherwise payable (up to a limitof 25 percent of the tax due) equal to 20 percent(for qualified investments lower than €5,000,000)or 10 percent (for qualified investments higherthan €5,000,000) of the qualified investment; anyunused credit may be carried forward for fouryears; and

• an exemption on real estate transfer tax (IMT),property tax (IMI), and stamp tax on the acquisi-tion of real estate for investment purposes; thereal estate tax exemptions are subject to the ap-proval of the municipality where the investment ismade.

The following investments are eligible for the taxincentive:

• new tangible assets; however, the following newassets are excluded: land (except when used forresource extraction), buildings (except when usedfor factories or administrative offices), noncom-mercial vehicles, furniture (except when used fortourism purposes), social equipment (except if ac-quired under legal obligation), and other assetsthat are not directly connected with the activitydeveloped; and

• intangible assets that qualify as expenses withtransfer of technology through the acquisition ofpatent rights, licenses, know-how, or unpatentedtechnical knowledge; for large companies (that is,those not qualifying as small and medium-sizeenterprises under the EU definition), the invest-ments in intangible fixed assets may not exceed 50percent of the qualified investment.

Under the RFAI 2009, qualifying investments mustbe maintained for a five-year period subject to a recap-ture rule and the qualifying investment must be de-signed to promote the creation of employment during2009.

The RFAI 2009 is limited to taxpayers engaged inthe following business sectors: agriculture, forestry,agro industries, energy, tourism, and manufacturing orextraction industries (except steelwork industries, ship-building, and synthetic fibers as defined in article 2 ofCommission Regulation 800/2008). The tax incentiveis also extended to companies that realize investmentsin next-generation broadband equipment. The RFAI2009 is not applicable to companies that fall within themeaning of ‘‘company in difficulty’’ as defined by theEU guidelines on state aid for rescuing and restructur-ing firms in difficulty.

This ITC may not be used concurrently with anyother similar tax incentive, and the total tax incentivecannot exceed the maximum amount of aid for a givenregion as stipulated by the guidelines on national re-gional aid for 2007 to 2013.1

R&D Tax Incentive

The bill would also amend the Portuguese R&Dinvestment tax credit. The Sistema de IncentivosFiscais em Investigação e Desenvolvimento Empre-sarial (SIFIDE) would ultimately increase the amountof tax credit available for qualifying R&D investments.Under the proposal, credits against corporate tax liabil-ity would be available for qualifying R&D expenses upto the following amounts:

• a basic credit equal to 32.5 percent of the qualify-ing expenses for the relevant year; and

• an additional credit equal to 50 percent of theamount by which the qualifying expenses for therelevant year exceed the average R&D expensesincurred over the two preceding years, with a ceil-ing of €1.5 million. This deduction would only beapplicable to costs that have not been subsidizedby the state. Any unused credit would remain tobe carried forward for six years.

1Guidelines on national regional aid for 2007-2013 (2006/C54/08).

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Extension of Portuguese Holding Regime

The proposal would extend the tax regime appli-cable to Portuguese incorporated holding companies(Sociedade Gestora de Participações Sociais, or SGPS)to foreign EU-incorporated entities that move theirstatutory seat or place of effective management intoPortugal. The objective of this amendment is twofold.First, the measure is designed to eliminate a potentialincompatibility with EU law regarding the nonapplica-tion of this beneficial regime to foreign EU holdingcompanies effectively managed in Portugal. Second,the measure aims to stimulate investment and to createan incentive to transfer capital into the Portuguese ter-ritory.

Under the proposal, the more favorable regime forparticipation exemption on dividends received andcapital gains realized that is applicable to SGPSswould apply equally to companies incorporated underthe law of another EU member state that have theirstatutory seat or place of effective management locatedwithin Portuguese territory and that have as their solecorporate purpose the management of participations inother companies provided the conditions establishedfor SGPSs under the Portuguese legal framework aremet.2

Under the current applicable legal framework, theactivities defined as holding activities include only:mere holding of investments in which at least 70 per-cent of the total investments must be in companies inwhich the holding company owns directly or indirectlya minimum of 10 percent of the share capital with vot-ing rights for more than one year3; rendering of techni-cal services and/or management services to companiesin which the holding company holds directly or indi-rectly a qualified participation; and lending of fundsand providing cash management to subsidiaries andother qualifying holdings (that is, minimum direct orindirect holding of 10 percent). Also, the holding com-pany is restricted to acquiring or holding real estateunless the real estate is used for the premises of itshead office or of its subsidiaries.

Other AmendmentsThe proposal would reduce the minimum amount of

special advance corporate tax payments, which is es-sentially meant to function as a minimum tax, to€1,000. The amount of the advance corporate tax pay-ment is basically equal to 1 percent of annual turnovercapped with a limit of €70,000 and payable in two orthree installments.

When VAT return shows a credit balance, the excessinput tax may be carried forward or a refund may berequested if the credit balance during a period of 12calendar months exceeded €250. The bill proposes areduction to €3,000 (from the previous €11,250) of theminimum excess input VAT necessary to request a re-fund before the 12-month period elapses.

The bill would allow the government to establish areverse charge rule for VAT payers covering the supplyof goods and services within public procurement con-tracts of a value equal to or greater than €5,000 whenthe acquirer of the goods or services is the Portuguesestate or other public entities.

The bill would extend the tax credit availableagainst personal income tax for acquisition of personalcomputers and related equipment to cover expensesfrom the acquisition of next-generation broadbandequipment. The tax credit would remain equal to 50percent of the acquisition costs of the taxpayer with alimit of €250.

♦ Paulo Núncio and Tiago Cassiano Neves,Garrigues, Lisbon

Russia

Court Dismisses Claim for Back TaxesAgainst Ernst & Young

The Moscow Arbitration Court on January 27quashed a RUB 390 million claim for back taxesagainst Ernst & Young’s Russian subsidiary, Ernst &Young Vneshaudit, according to a January 27 report byRIA Novosti, the state news agency.

Further details on the court’s decision were notavailable.

The company had challenged a December 29, 2007,decision of the Moscow Tax Inspectorate ordering it topay RUB 390 million in profits taxes, VAT, and finesand penalties for 2004. The tax authorities accused thecompany of underreporting its 2004 profits of RUB10.5 million by RUB 630.3 million.

Ernst & Young Vneshaudit had deducted that sumas expenses for consulting services performed by itsparent company in Cyprus. The authorities said those

2The legal framework of SGPSs is contained in Decree Law495/88 as amended by Decree Law 318/94, Decree Law 378/98, and Law 109-B/2001. Article 32 of the Tax Benefits Statuteincorporates the tax regime applicable to SGPSs.

3The holding company may nonetheless invest in mere pas-sive holdings (that is, less than 10 percent of the voting rights) if:the amount does not exceed 30 percent of the investments madein other holdings; the value of each passive holding is not lessthan €5 million; the purchase results from the target company’smerger or demerger; and the holding company has formalized amanagerial subordination agreement with the target company,under which the management of the subordinated company’sbusiness activities is entrusted to the holding company.

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expenses were unjustified and that the services wereactually performed by the Russian office.

In a similar case, Russia’s Higher Arbitration Courton January 20 quashed a RUB 260 million claim forback taxes against the Moscow branch of Price-waterhouseCoopers, according to media reports. Thetax authorities had accused PwC of illegally deductingconsulting service payments made to PwC’s Dutchbranch, saying those services were actually performedby the Russian office. (For prior coverage, see Tax NotesInt’l, Apr. 21, 2008, p. 230, Doc 2008-8429, or 2008WTD 75-1.)

♦ Kristen A. Parillo, Tax Analysts.E-mail: [email protected]

Spain

Directors’ Remuneration NotDeductible, Supreme Court Says

Spain’s Supreme Court recently issued two judg-ments denying corporate income tax deductions for theremuneration of directors of a public limited company(PLC). The November 13, 2008, judgments (2578/2004and 3991/2004), which were only recently made pub-lic, have caused quite a debate.

The Tax Inspectorate had initiated two separate pro-ceedings against a PLC, claiming that the directors’remuneration it had included as a deductible expensedid not qualify.

After exhausting all appeal procedures, the companybrought its case to the Supreme Court, which also con-cluded that the directors’ remuneration was nondeduct-ible. The company’s bylaws described the directors’remuneration as ‘‘a fixed amount that could be re-viewed annually, in addition to a share of the com-pany’s profits in line with the limits laid down by legis-lation.’’

In its interpretation of the current Public LimitedCompanies Act and of section 13(ñ) of the CorporateIncome Tax Act 1978 (now abrogated), the Court con-cluded that for the remuneration of the directors of aPLC to be tax deductible, the company bylaws mustspecify the directors’ remuneration ‘‘with certainty.’’The remuneration will be considered certain if it meetsthe following conditions:

(a) the bylaws must specify a definite earningssystem and not contemplate several systems fromwhich the board of directors can choose;

(b) for variable earnings based on profit sharing,the bylaws must establish a definite percentage,and not a maximum percentage; and

(c) for fixed earnings, the bylaws must establish adefinite amount, or alternatively, must establishcriteria to calculate the exact amount withoutleaving scope for discretion.

The Court’s conclusions, which appear to divergefrom the current corporate income tax regulation,could have significant practical repercussions.

The finding on fixed remuneration in point (c) isparticularly controversial because the bylaws of manycompanies define directors’ remuneration as a fixedamount to be established every year by the generalshareholders meeting.

Points (a) and (b), on the other hand, reflect existingcommon practice: The bylaws must specify the earn-ings system, and, in the case of variable earnings, theymust specify a definite percentage of profit sharing.

Under the previous regulation on corporate incometax (section 13(ñ) of the Corporate Income Tax Act1978) applicable to the fiscal years subject to the Su-preme Court’s analysis, for an expense to qualify as taxdeductible, it must be a mandatory expense and, there-fore, necessary for the company to engage in its activity.

The current regulation does not refer to those re-quirements. It states that an expense is considered taxdeductible if the company enters it into its books andmeets the conditions of the commercial regulation ondirectors’ remuneration. Thus, controversy may arise ifthe tax authorities rely on the Supreme Court’s judg-ments and not on the criteria of the Directorate Gen-eral of Registries and Notarial Affairs (Dirección Gen-eral de los Registros y del Notariado), concluding thatcompanies that do not specify the remunerationamount in their bylaws are in breach of the commer-cial regulation. This would result in the remunerationof the directors not being tax deductible.

This risk is limited to PLCs and does not extend tolimited liability companies (the most common type ofcompany in Spain). Under section 66.3 of the LimitedLiability Companies Act, fixed remuneration ‘‘will beset every fiscal year by agreement of the shareholdersgeneral meeting.’’ The act itself thus prevents LLCsfrom establishing a definite amount in their bylaws,stating that the shareholders general meeting must setthe amount annually.

The Court’s judgments of November 2008 are espe-cially relevant for listed PLCs. The Spanish tax authori-ties may consider that the remuneration those com-panies pay to their directors is nondeductible if theirbylaws do not specify a definite remuneration amount,or alternatively, the criteria needed to calculate the ex-act amount without leaving scope for discretion. There-fore, it is important to pay close attention to how the

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tax authorities interpret the judgments in the context ofthe current wording of the Corporate Income Tax Act.

♦ Ana Martinez, senior tax associate,Cuatrecasas, Barcelona office, and

Sonia Velasco, tax partner,Cuatrecasas, New York office

Sweden

Government Proposes to DeferEmployee Tax Payments

In the face of growing liquidity problems experi-enced by Swedish companies, the Swedish governmenton January 22 proposed allowing employers to deferpaying employee taxes (arbetsgivaravgifter) for twomonths, according to a statement posted on the Swed-ish government’s website.

Finance Minister Anders Borg and Enterprise Minis-ter Maud Olofsson focused on corporate liquidity dur-ing a press conference in Stockholm, pointing out thatcurrent turmoil in global financial markets has made itincreasingly difficult to arrange borrowing. Without theproposed tax deferral measure, they said, companieswill soon find themselves short of cash needed to meeteven minimal operating needs.

The government has estimated that the proposal willcost about SEK 500 million (approximately $61 mil-lion).

The employee tax deferral proposal follows a 1.7percentage point corporate tax rate cut, from 28 per-cent to 26.3 percent, that took effect on January 1. Thegovernment announced the corporate tax cut in Sep-tember. (For prior coverage, see Tax Notes Int’l, Sept.22, 2008, p. 984, Doc 2008-19804, or 2008 WTD 181-1.)

The government is now referring the tax deferralplan to the Council on Legislation (Lagrådet), whichwill decide whether the proposal is legally valid.


United States

Drafters of Temporary Branch RegsDefend Rules’ Complexity

Drafters of the recently issued section 954(d)(2) tem-porary branch rules on January 23 defended the com-plexity of the foreign base company sales income regu-lations issued a month earlier. (For the final andtemporary contract manufacturing regulations (T.D.9438), see Doc 2008-27115 or 2008 WTD 249-34; for ac-companying proposed regulations (REG-150066-08),see Doc 2008-27116 or 2008 WTD 249-35.)

‘‘Complexity of business necessitates a complexrule,’’ Michael DiFronzo, IRS deputy associate chiefcounsel (international), said during a BNA Tax Man-agement International Tax luncheon in Washingtonsponsored by Buchanan Ingersoll & Rooney.

Itai Grinberg of Treasury’s Office of the Interna-tional Tax Counsel said the most important evolutionbetween proposed regulations (REG-124590-07) issuedin February 2008 and the temporary regulations wasthe creation of a uniform rule on the location ofmanufacturing. (For REG-124590-07, see Doc 2008-4147or 2008 WTD 40-31.) He told the group that the draftersmade the change in response to commenter recommen-dations that suggested that the rules should not treatCFCs satisfying the physical manufacturing test differ-ently from CFCs that satisfy the substantial contribu-tion test. (For prior coverage, see Tax Notes Int’l, Jan.26, 2009, p. 274, Doc 2009-756, or 2009 WTD 9-1.)

‘‘The temporary regulations are concerned with thedeflection of income to jurisdictions that fail the taxrate disparity test, not with the mere dispersion of ac-tivities,’’ Grinberg said.

Asked about the complexity of the branch rules,Grinberg explained that while developing the rules offi-cials decided to work from the preexisting branch rulesand to address more complicated fact patterns to arriveat the temporary regulations.

Herman Bouma, a tax attorney with BuchananIngersoll & Rooney, questioned the rules’ complexity,arguing that they could achieve the same outcome bycomparing a CFC’s effective foreign tax rate for salesincome and its effective foreign tax rate for manufac-turing income to determine if there is a tax rate dispar-ity.

‘‘We made a determination early on in the projectnot to open the tax rate disparity test question,’’ Di-Fronzo said. He also noted that current statutory provi-sions may prevent such a regulatory solution.

During an earlier discussion of the final contractmanufacturing rules, Jeffrey Mitchell, branch chief, IRS

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Office of Associate Chief Counsel (Income Tax andAccounting) discussed proposals that had been rejectedin the course of developing the rules. He said thedrafters considered and received comments on includ-ing a substantial contribution safe harbor, but decidednot to adopt the safe harbor because of the ‘‘broadrange of activities covered by the regulations’’ prevent-ing the creation of an appropriate rule.

Mitchell added that the IRS rejected including anantiabuse provision that would have precluded CFCsfrom meeting the substantial contribution test if a re-lated person had significant involvement in the produc-tion process.

‘‘We decided that the CFC’s contribution reallyshould be evaluated on its own and we ultimately de-cided that even more than one person could make asubstantial contribution,’’ Mitchell said. ‘‘If another

party makes a contribution to the manufacturing proc-ess, it doesn’t preclude the CFC from having a substan-tial contribution.’’

♦ David D. Stewart, Tax Analysts.E-mail: [email protected]

CORRECTION

An article in the January 26, 2009, issue of TaxNotes International (‘‘U.S. Tax Returns for Foreign Na-tionals,’’ p. 337) contained an error. On p. 340, in thesection titled ‘‘Disclosure Requirements,’’ references toSchedule A should be to Schedule B.

Tax Analysts regrets the error.

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U.K. Tax Update

Buddy, Can You Spare a Dime?by Trevor Johnson

In the words of Private Frazer of the popular Britishsitcom Dad’s Army, ‘‘We’re all doooomed!’’ So-

called experts are queuing up to outdo each other withprophesies of gloom and despondency. The Bank ofEngland base rate, which stood at 5 percent last Sep-tember, is now at 1.5 percent. This is the lowest ratesince the bank was formed in 1694, the year in whichSir Isaac Newton discovered gravity and about 80 yearsbefore the United States came into existence.

The Bank’s Monetary Policy Committee meetsagain on February 5, when some commentators expecta further cut and predict that at some point this year itwill end up at, or very close to, zero. These dramaticreductions conjure up an image of desperation; thebank is at the wheel of the British economy careeringdown the mountain toward the abyss, and is pumpingthe foot brake harder and harder because that’s all itcan do.

And yet as far as businesses are concerned, the baserate is meaningless as the banks are neither passing onthe reductions to existing borrowers nor advancing newloans. Their point is that the London Interbank OfferedRate, the rate at which banks borrow in the LondonInterbank Market, is 2.7 percent for 12-month sterling.They also have become more defensive since thesubprime fiasco and are trying to rebuild their capitaland profitability, which is why they are incurring thewrath of the government and the public at large. We,the public, see the government giving our money to thebanks so that they can lend it back to us — a crazysituation, but one that isn’t working as the money issticking in the bank’s coffers.

After handing out £37 billion to the banks, the gov-ernment has introduced two sets of measures to in-crease the banks’ liquidity and get them lending again.These include:

• Guaranteeing up to 50 percent of borrowings tobusinesses with turnovers below £500 million andtaking as security some of the banks’ ‘‘toxic’’ in-vestments and loans.

• An extension of the Small Business FinanceScheme outlined in last autumn’s prebudget re-port, available to businesses with a turnover of upto £25 million. This scheme will guarantee 75 per-cent of loans of up to £1 million over 10 years.

• The establishment of a fund to allow businessesto sell debt to the government in exchange forequity. In other words, they will swap some oftheir debt for a slice of their business. Companieswith a turnover of up to £50 million will be ableto gain equity of between £250,000 and £2 mil-lion.

• Allowing banks to take up government insuranceagainst their expected bad debts, but only up to 90percent of those loans.

• The Bank of England buying high-quality assetsfrom companies in all sectors in return for cash.

• Restructuring last October’s bailout by allowingNorthern Rock more time to repay its governmentloan and allowing Royal Bank of Scotland to is-sue ordinary shares to the government in ex-change for the preference shares to reduce thedividend burden on the bank.

Trevor Johnson, FTII, AITI, ATT, is a chartered tax adviser and a past president of the Association ofTaxation Technicians. However, the views expressed are entirely his own.


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We, the taxpayers, are now in a situation in whichnot only are we giving the banks money to lend tobusinesses, we are also going to relieve the banks ofmost of the risk of lending. I can’t help but ask whywe now need the banks at all. The government couldjust cut out the middlemen and take over the bankingsector, lock, stock, and barrel.

Of course there is one sector that is immediatelyaffected by the reduction in base rate — those withsavings. The banks and building societies have takenthe opportunity to reduce interest rates paid to inves-tors, though some have not passed on the full reduc-tion. Nevertheless, it was recently reported that some40 percent of savings accounts were paying less than 1percent and 26 percent were paying less than 0.5 per-cent. If rates on the majority of accounts get muchlower, investors may well consider withdrawing all theirsavings and keeping them under the floorboards. Atleast there the money will not be at the mercy of thebank and they can derive pleasure from taking it outand counting it every once in a while. If we ever ex-perience deflation, as the more pessimistic haveclaimed, the investors will find their savings’ purchas-ing power increased and there would be no tax to pay!

As savings income is dropping, there is clearly goingto be a drop in the income tax receipts on that income,which is why the Conservatives’ latest tax policy seemsan empty gesture. The proposal was to exempt savingsincome from income tax for all but those who pay taxat the highest rate of 40 percent (currently those whohave a total taxable income, after the deduction of al-lowances, of £36,000 and above). This, coupled with alarge increase in the personal allowance for those over65, was stated to be to help the ‘‘innocent victims ofthe downturn.’’ All very laudable, but would it reallybe of any help at a time when there is little or no in-come to be exempted? The cynic in me thinks this isjust posturing before an expected spring general elec-tion.

The real practical help for these times has taken theform not of rate cuts, which are unlikely to stimulatethe economy and in any event would have a delayedimpact, but of allowing businesses to spread their taxpayments over an agreed period. This was a measureannounced in the prebudget report with the setting upof the HM Revenue & Customs’ Business PaymentSupport Service (BPSS). The objective at the time wasto enable ‘‘businesses in temporary financial difficulty



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and unable to pay their tax bills to spread payment oftheir bills over a timetable they can afford.’’ All taxespaid by businesses are covered: corporation tax, in-come tax, value added tax on sales, income tax de-ducted from the wages and salaries of employees, andnational insurance contributions. This is a nonstatutorymeasure and therefore will not feature in the forthcom-ing Finance Bill. It also means that if the Revenue donot agree to a postponement, there is no right of ap-peal.

When it was first announced, some business propri-etors thought that it meant they were free to pay theirtaxes when they wanted. Instead, it is a matter of ne-gotiating with someone in the BPSS a planned pro-gram of payments for liabilities becoming due. It is notan option open to all — only trading companies, soletraders, and partnerships. The Revenue have set outthree conditions: The business must be in genuine diffi-culty, unable to pay the tax on time, and likely to beable to pay if it was allowed more time.

The real practical help forthese times has taken theform not of rate cuts, butof allowing businesses tospread their tax paymentsover an agreed period.

I have no experience of, nor have I heard of, anyanecdotal evidence of how this facility is working. Ac-cording to a January 14 press release, the Revenue statethat over 20,000 businesses had been allowed to defermore than £350 million of taxes, which sounds impres-sive, but averages out at only £1,750 each. The pressstatement also claims that, in the majority of cases, itcan take the Revenue as little as 10 minutes to reach adecision, although we are not told what that decisionis.

For sole traders and partners, any income tax thatremains unpaid 28 days after the due date attracts a 5percent late payment surcharge and a further 5 percentif it is still unpaid six months later. If a deferment planis agreed on, there is no surcharge imposed for latepayment. However, there is, of course, a price to pay,and that is in the form of interest, currently 4.5 percent(in other words, 3 percentage points above base rate).

When I had a real job and was running my ownpractice on overdraft, I was being charged 2.5 percent-age points above my bank’s own base rate. This wouldcurrently mean a rate of 4 percent; so the rate chargedby the Revenue is not too bad, at least at first sight. Itis easy to overlook the fact that interest charged on late

payment of tax is not itself tax deductible. Dependingon the rate and type of tax being paid, it is an effectivegross rate of between 5.62 percent to 7.5 percent. So abusiness with cash flow problems would be better usingits existing overdraft facilities if possible.

The problem is, of course, that many will probablybe at the limits of their permitted borrowings, andtherefore agreeing on a deferral plan with the Revenuemay be the only way out. Certainly it is much moreadvisable than for the business proprietor to seek a per-sonal unsecured loan, which can carry interest of atleast 8 percent, which again would not be tax deduct-ible (or, for that matter, to stick his head in the sandand hope the problem goes away).

Although 200,000 businesses were said to havemade use of this deferral option, I expect there will bemany more applications in the next couple of weeks.Most companies in the U.K. tend to have a March 31or December 31 year-end, and as the corporation taxof small and medium-size companies is due ninemonths after the year-end, many will have had to paythe tax on October 1, 2008, for the year to March 31,2008, or on January 1, 2009, for the year to March 31,2008. Possibly the majority of the 200,000 businessesreferred to in the Revenue’s press release are in thatcategory. The next category to apply for deferment willbe the sole traders and partnerships. Their tax liabilitiesare not as straightforward as companies.

To begin with, they are charged tax for a tax year,not for the period for which they prepare their ac-counts. The amount charged for an ongoing businessfor the tax year 2007-2008, for example, will be thetax-adjusted profits of its accounting period ending inthat tax year. As sole traders and partnerships are freeto choose whatever accounting date they wish, thoseprofits may have been earned as long ago as the yearto April 30, 2007, in the days when the word‘‘subprime’’ had not entered into common parlanceand most people thought Northern Rock was a populardance. Income tax for 2007-2008 is payable by twoamounts, each being half of the final liability for thetax year 2006-2007, due on January 31, 2008, and July31, 2008, and a final ‘‘catch-up’’ payment on January31, 2009, if the actual liability for the year turns out tobe more than that for the previous year, as it should doif the business is growing.

Although a prudent small-business proprietor whohad made good profits in the year to April 30, 2007,will make sure he has the cash available to pay the taxwhen it comes due, life is not like that. Most businessproprietors pay last year’s tax out of this year’s in-come. The problem is that there may not be any in-come this year. On January 31, 2009, the proprietor istherefore faced with having to pay a large tax bill onincome earned in the year ended April 30, 2007, whichhas been spent when there’s nothing in the kitty thisyear to pay it. But that’s not all — on that same date



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he has to pay the first installment of his 2008-2009 li-ability, which is half of the large 2007-2008 liabilitybased on his profits for the year to April 30, 2008, ayear when we had heard of subprime and NorthernRock, but before the recession hit. Those profits mayhave been equally as high as the previous years, so areal problem exists.

The reality is that instead of the business having togo to its bank to ask for a loan to pay the tax (which itprobably will not get), the government is taking overthe role of banker and lending the business the moneyinstead. Once more, we have to ask, ‘‘Do we reallyneed the banks?’’ ◆



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The Global Tax Revolution: The Rise of TaxCompetition and the Battle to Defend It

S imply because it’s published by Cato, this bookmight be dismissed by the tax engineers of the

Obama administrations — people like Chief EconomistLawrence Summers, Treasury Secretary TimothyGeithner, House Ways and Means Committee ChairCharles B. Rangel, D-N.Y., and Senate Finance Com-mittee Chair Max Baucus, D-Mont. That would be amistake.

In response to globalization, many countries haveadopted simpler tax systems with lower rates, seekingto improve their competitive position in the worldeconomy. By and large, these efforts have succeeded.Critics may deplore the outbreak of tax competition,but Chris Edwards and Daniel Mitchell come to cel-ebrate the revolution, not reverse it. It’s hard to arguewith success; yet three criticisms are often voiced: Taxcompetition undermines the ability of government tocollect revenue; with the result that public goods andsocial programs are underfunded; and as collateraldamage, progressivity is eroded because tax cuts favorcapital income and highly paid personnel.

Where others see vice, Edwards and Mitchell findvirtue. Small government is their goal. America’s prob-lem is not the starvation of public programs, it’s too

much money thrown at social entitlements and bridgesto nowhere. Progressive taxation loads the heaviest bur-dens on human and physical capital, and therebycripples economic performance.

Surveying reforms around the world, the authorsconclude that tax competition spurs investment andpromotes growth. Not only does tax competition un-leash entrepreneurial energy at home, it also attractsforeign investment and skilled labor. The authors awardspecial merit to countries that join the ‘‘flat tax club’’— in its ideal form (who can forget the famous Hall-Rabushka postcard return?), a single low-rate taxacross all forms of income. On this prescription, Ed-wards and Mitchell would especially like the Obamaadministration to take notice. A simple flat tax systemis the path the United States must follow, in their view,to meet rising competition from the likes of Brazil,Russia, India, China, and Korea — the BRICKs. Asthe first step, the authors recommend sharp cuts inboth individual and corporate tax rates: slashing indi-vidual tax rates to a range between 15 percent and 25percent, and corporate tax rates to 15 percent.

The rationale behind a ‘‘starve the beast’’ strategyfor reaching smaller and more efficient government isstraightforward: Reduced revenues will restrain publicspending and eventually force government to curtailexcessive promises. On this proposition, I must notetwo ironies. First, in recent years, an absence of rev-enue has persuaded neither Italy nor the United Statesto curb expenditure, despite the ‘‘conservative’’ leader-ship of Berlusconi and Bush. Second, as the authorsrecognize, tax competition has yet to reduce public rev-enues as a share of GDP. Laffer-curve effects — basebroadening and less tax avoidance — are sufficientlystrong that tax revenues typically remain stable or evenrise in the wake of rate cuts.

Recent experience not only contradicts critics whofear a race to the bottom in terms of public expendi-ture, but also disappoints advocates who devoutly urge

The Global Tax Revolution: The Rise of TaxCompetition and the Battle to Defend It

by Chris Edwards and Daniel J. Mitchell

Published by the Cato Institute: Washington(2008).

255 pagesPrice: $21.95

Reviewed by Gary Clyde Hufbauer, Reginald Jonessenior fellow, Peterson Institute for InternationalEconomics.


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smaller government. But the authors are more optimis-tic than the critics: They keep their fingers crossed thatfuture installments of tax competition will eventually‘‘starve the beast.’’ Count me a skeptic. Given demo-graphic aging in all OECD countries and sharp incomeinequalities among the elderly, it seems doubtful thattax competition will curtail entitlement spending. In-deed, entitlement spending could easily double over thenext generation, with medical care accounting for mostof the expansion. In the contest between tax cuts andgrandmother’s heart surgery, guess who wins.

For me, the compelling argument for tax competi-tion is that it serves to align fiscal charges with publicbenefits — just as that hero of public finance, CharlesTiebout, described a half century ago. Tiebout, ofcourse, was talking about local governments. But in theface of rising tax competition, many national govern-ments have not only reformed their tax systems butalso have enhanced the business environment by im-proving transportation, power grids, telecommunica-tions, schools, hospitals, and museums.

Given the virtues of tax competition, Edwards andMitchell condemn attempts to harmonize national taxsystems, led by the OECD and the European Union.In fact, the anti-tax-competition crowd has graduallylost its voice in recent debates. However, it seemswrong to dismiss wholesale the arguments advancedfor tax harmonization.

One subject where I agree with the tax harmoniza-tion school is the need to share information on invest-ments by nonresidents between the host country and

the home country. In the Cato view, the creation ofefficient reporting networks will suppress tax competi-tion. That’s true, if the term ‘‘tax competition’’ isstretched to encompass means of furthering tax eva-sion. But my belief is that the country of citizenship orresidence of natural persons has the right to tax theirworldwide income if it chooses; accordingly, capitalincome earned abroad should be reported by the hostcountry as a matter of comity between nations.

This issue is closely related to an important but of-ten overlooked question: Do the virtues of tax competi-tion apply with equal force to personal income taxationas to corporate income taxation? That’s where Tieboutentered the debate, with the metaphor of disaffectedcitizens ‘‘voting with their feet.’’ But citizens cannotchange nationality as easily as residence; and in somecountries, the rights and privileges associated with citi-zenship are extremely valuable. Against this factualbackground, I think it’s an open question whether un-fettered tax competition is appropriate in the realm ofpersonal taxation.

Edwards and Mitchell have written a most entertain-ing book — not an easy feat when the subject is taxa-tion. Casual readers will enjoy stories about celebrities— Ringo Starr of Beatles fame, Irish rock band U2,Swedish pop group ABBA, and others — who havechanneled their wealth and royalties to tax haven juris-dictions. Policy wonks will appreciate the comprehen-sive surveys of tax reform. There’s something foreveryone — even the Obama team and its congres-sional allies. ◆

BOOK REVIEW


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New Rules for Valuing Intangible Assets in Spainby Sonia Velasco and Ana Colldefors

The tax treatment of some intangible assets inSpain has been modified and presents substantial

advantages. (See Tax Notes Int’l, Feb. 18, 2008, p. 597,Doc 2008-2042, or 2008 WTD 35-11.)

Under Act 16/2007 of July 4, 2007, Spain grants a50 percent corporate tax credit for income derived fromthe rights to use and exploit patents and other intan-gible assets.

On February 13, 2008, the European Commissionannounced that this Spanish corporate tax credit de-signed to promote research and development is com-patible with EU rules on state aid, as the tax creditapplies to all companies, regardless of their size or sec-tor.

In relation to the application of this 50 percent taxcredit, the Spanish tax authorities issued a binding taxruling (V1299-08) on June 19, 2008, to clarify whichexpenses must be taken into account when determiningthe value of intangible assets. The value of intangibleassets is relevant because this tax credit may only beapplied until the tax period following the year in whichthe value of the income was more than six timesgreater than the cost of the intangible assets. The in-tangible assets must be created by the entity applyingthe exemption or by a group company in a tax group.

As a general rule, the value of an asset for tax pur-poses is its book value with modifications mentioned in

the Spanish Corporate Tax Act. The expenses incurredin the development of an intangible asset constitute itsbook value. The year’s expenses can only be registeredas the asset’s book value if the expenses are clearlyindividualized and allocated to one particular projector intangible asset, and there are sufficient reasons tobelieve in the technical and economic success of theintangible asset. Therefore, only some expenses in-curred in creating an intangible asset can be registeredas an increase in the value of the intangible asset beingdeveloped.

With this ruling, the Spanish tax authorities took ataxpayer-friendly position because they considered thatthe cost basis for tax purposes of the intangible asset,in particular when calculating the limit on the 50 per-cent tax credit, should take into account the intangibleasset’s book value (following the rules above) but alsoexpenses incurred that may not be registered as an in-crease of the book value of the assets (for example,R&D expenses of the year).

The Spanish tax authorities’ interpretation reducessubstantially the effect of the limit to six times thevalue of the intangible asset, given that this value cansometimes be much higher than the intangible asset’sbook value. This makes the tax regime for patents andother intangible assets, in effect in Spain since January2008, more attractive. ◆

Sonia Velasco is a partner with Cuatrecasas in New York, and Ana Colldefors is an associate with Cuatre-casas in Barcelona.


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Deduction of School Fees Under German Lawby Marko Wohlfahrt and Katrin Köhler

German tax law allows a tax deduction for schoolfees paid during the German tax year (the calen-

dar year) for some accredited private German schools.Fees paid to foreign private schools, however, generallycannot be deducted from the German income tax base.This limit on the deductibility of school fees has givenrise to issues as to whether the rules are compatiblewith EC law, specifically the freedom to provide serv-ices in another EU member state.

German Domestic Law

According to article 10 of the German Income TaxCode (Einkommensteuergesetz, or EStG), 30 percent offees paid for private German schools can be treated asspecial expenses on a taxpayer’s German income taxreturn if the following requirements are met:

1) the taxpayer is entitled to receive Germanchild benefit payments or the child allowance forthe child attending the private school;

2) the expenses relate to education costs (that is,expenses for accommodation, meals, and generalmentoring are excluded); and

3) the school is recognized as an approved substi-tute or supplementary school to the German pub-lic school system.

In late 2004 the Federal Finance Court (Bundes-finanzhof) decided that some private German and Eu-ropean schools also are within the scope of require-ment 3 above, even if the schools are located outside ofGermany but are within the European Economic Area.

Fees for other private schools are not considered de-ductible as special expenses, even though the schoolsare located in Germany.

The CaseThe case involved German resident spouses who

were jointly assessed German income tax and whosechildren attended a private school in Scotland in theyears at issue, 1998 and 1999. The German tax au-thorities denied a deduction for the school fees paid tothe Scottish private school as special expenses for in-come tax purposes.

The case was appealed to the local Finance Court ofCologne (Finanzgericht Köln), which in 2005 had todecide whether fees paid by German tax residents to aprivate non-German school in Scotland could be con-sidered special expenses. The court had concerns aboutthe compatibility of the German legal position with thefreedom of services provision of the EC Treaty, be-cause restricting the deduction for school fees to Ger-man schools could discriminate against foreign indi-viduals who move to work in Germany but whosechildren attend schools in their home countries, as wellas German individuals who move to work abroad (butremain subject to worldwide German tax liability) andwhose children attend schools abroad. Therefore, theFinance Court of Cologne referred the issue to the Eu-ropean Court of Justice.

The ECJ issued its decision on September 11, 2007,concluding that while German law allows the deduc-tion for some accredited schools within Germany and

Marko Wohlfahrt is a consultant and Katrin Köhler is a senior manager with Deloitte Touche Tohmatsu inDüsseldorf.

Copyright © 2009 Deloitte Touche Tohmatsu. All rights reserved.


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for German schools within the EEA, the practice ofthe German tax authorities disallowing a tax deductionfor school fees for private schools located outside Ger-many but within the EEA is not compatible with EClaw, in particular with the freedom of services and free-dom of movement principles in articles 49 and 18 ofthe EC Treaty (Schwarz/Gootjes-Schwarz (Case C-76/05)).

The ECJ concluded that the German rule consti-tutes an obstacle to the freedom to provide servicesbecause it dissuades German residents from sendingtheir children to private schools established in anothermember state and impedes private schools establishedin other member states from offering education to thechildren of German residents. The German rule gener-ally results in a higher tax burden for taxpayers whosent their children to a private school located in an-other EU member state because the school fees wouldnot be deductible. Finally, the ECJ ruled that the Ger-man provision violates the free movement of citizensbecause it places the taxpayers who have children at-tending schools in another member state at an unjusti-fiable disadvantage compared with persons who havenot exercised that right.

Consequences of the ECJ DecisionBased on the ECJ decision, the Finance Court of

Cologne ruled on February 14, 2008, that the fees paidby the taxpayers to the school in Scotland had to betreated as special expenses on the taxpayer’s Germanincome tax return. However, the fiscal court grantedleave to the German tax authorities to appeal to theGerman Federal Finance Court to obtain further clari-fication on the impact on domestic tax law if EU lawis violated (for example, because of proof required bythe tax authorities related to requirement 3 above). Thetax authorities filed an appeal in April 2008, and theoutcome is still pending.

Following the ECJ’s decision, the German tax au-thorities generally intend to consider fees paid toschools within the EU/EEA as special expenses forGerman income tax purposes. The tax authorities re-quire, however, that the foreign school leads to agraduation approved by the Conference of CulturalMinisters of the German Federal States or the Ministryof Culture of a German federal state. Also, the Ger-man tax resident claiming the tax deduction must pro-vide the tax authorities with confirmation from the for-eign school that access to the school is not limited tostudents who can afford to pay the school fees (that is,for purposes of meeting requirement 3 above), but thatstudents with limited financial funds also can attendthe school (for example, through scholarships).

Should the school fees not be taken into account ina German income tax assessment notice (for example,the taxpayer could not provide the requested proof be-cause the school had not forwarded necessary docu-ments), the taxpayer should file an objection and re-quest a postponement of the final assessment until theFederal Finance Court issues its decision in the case.

2009 Tax Act

The lower house of the German Parliament (Bundes-tag) on November 28, 2008, approved the 2009 annualTax Act (Jahressteuergesetz 2009), and the upper house(Bundesrat) approved it on December 19, 2008. TheTax Act provides that school fees for private non-German schools in the EU/EEA whose graduation isapproved by the German authorities will be treated asspecial expenses. While the act maintains the 30 per-cent deduction level for school fees, the deduction willbe capped at €5,000. The new rule is retroactive fromJanuary 1, 2008, and for all prior-year cases for whicha relevant income tax assessment notice has not be-come final. ◆

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Different Methods of Attributing Profits to AgencyPEsby Carlos Eduardo Costa M.A. Toro

I. Introduction

I t has been said that article 7 is the heart of theOECD model convention.1 Indeed, article 7 of the

OECD model2 deals with the most important categoryof income — business profits, which comprise most ofthe income that arises in international transactions.3 Ittherefore covers a wide extent of activities carried outby an enterprise, either by forbidding the host state totax when the permanent establishment threshold is notmet or by allowing taxation when such requirement isfulfilled.

Its acknowledged importance aside, article 7 stillpresents some debatable issues regarding its interpreta-tion, such as the attribution of profits to agency PEs.This issue becomes even more controversial when thePE is a separate enterprise associated with its principal,in most cases a subsidiary constituting a PE of its for-eign parent company. In this context, despite being oneof the most important concepts of international taxa-tion and being extensively dealt with in the OECDmodel convention and its commentary, PE characteri-zation is still a controversial issue around the world,

since it involves a factual analysis that can only bemade on a case-by-case basis.4

As pointed out by the OECD in the introduction toits model convention, member countries have long rec-ognized the need to ‘‘clarify, standardize, and confirmthe fiscal situation of taxpayers who are engaged ineconomic activities in other countries through the ap-plication by all countries of common solutions to iden-tical cases of double taxation.’’5 However, this aim ofthe OECD is not always met in practice, as the inter-pretation of relevant provisions of the OECD modelconvention often diverges between states. The OECDitself recognizes that the practices of the countriesaround the world regarding the attribution of profits toPEs and the interpretation of article 7 differ signifi-cantly.6

The OECD’s findings were confirmed by a studycarried out by the International Fiscal Association onthe occasion of its 60th Congress held in Amsterdamin 2006. The general report of this congress indicated awide divergence among the branch reporters regardingthe interpretation of article 7. According to the generalreport, the only point on which most of the branch

1Alberto Xavier, Direito Tributário Internacional do Brasil, 6th ed.(Rio de Janeiro: Forense, 2004), p. 695.

2Unless otherwise indicated, all references are to the 2005OECD model convention.

3Klaus Vogel, Klaus Vogel on Double Taxation Conventions, 3rded. (London: Kluwer Law International, 1997), p. 399.

4Massimiliano Gazzo, ‘‘Permanent Establishment ThroughRelated Corporations: New Case Law in Italy and Its Impact onMultinational Flows,’’ Bulletin (June 2003), pp. 257-264.

5Para. 2 of the introduction to the 2005 OECD model.6Para. 1 of the update of the status of the OECD project on

the attribution of profits to PEs (2006), available at http://www.oecd.org/dataoecd/55/14/37861293.pdf.

Carlos Eduardo Costa M.A. Toro is a partner with Zilveti e Sanden Advogados in São Paulo.

This article is based on the advanced LL.M. paper the author submitted in fulfillment of the requirementsof the advanced LL.M. in international tax law at the International Tax Center Leiden (Leiden University).


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reports were of the same view is that there is little orno guidance from the tax authorities on the issue ofattribution of profits to PEs. Moreover, most jurisdic-tions have little, if any, case law on this issue.7

The existence of different interpretations on thescope of article 7 is therefore against the purpose of atax convention for the avoidance of double taxation,giving rise to harmful consequences on the exchange ofgoods and services between states. The lack of consis-tency in applying a treaty provision is a major contra-diction to the purpose of that treaty in providing a har-monized sharing of taxing rights between thecontracting states.8

In this context, this article discusses the applicationof the provisions of article 7 of the OECD model con-vention regarding the situation when an agency PE isfound to exist, especially in the case when a subsidiaryconstitutes an agency PE of its foreign parent com-pany. In other words, it is intended to analyze throughthe existing case law the main features of this particu-lar type of PE.

Furthermore, the different approaches to attributeprofits to agency PEs will be addressed, namely thefunctionally separate entity approach, also known asthe authorized OECD approach or dual taxpayer ap-proach; and the single taxpayer approach, also referredto as the zero-sum approach. It is intended to providean answer to the question of whether there may be aprofit attributable to an agency PE in excess of thearm’s-length remuneration paid to the dependent agent.Phrased differently, the issue at stake is whether it ispossible to attribute a separate profit to an agency PEonce the agent had an arm’s-length reward for the serv-ice provided for the nonresident enterprise. This is avery controversial issue, as there is much disagreementin the international tax community with the OECDpreferred approach.

It is a very sensitive issue in practice as it directlyaffects the supply chain management of multinationalenterprises, when the characterization of an agency PEmay have a significant impact on the overall costs.9Through their supply chain management, multinationalenterprises will often seek to structure their activities ina foreign country in a manner that either avoids the

characterization of an agency PE10 or provides for themost advantageous allocation of functions, assets, andrisks. Generally, multinational enterprises will seek toallocate functions, assets, and risks in a low-tax juris-diction to achieve a lower worldwide effective tax rate.In this context, the lack of clear guidance on the ap-propriate atribution of profits to agency PEs is a sig-nificant obstacle to the structuring of an optimal sup-ply chain from a multinational enterprise’s perspective.

Indeed, it is widely recognized that in the field oftaxation the lack of certainty is harmful to both tax-payers and states as it may hinder cross-border trade.11

The importance of this subject can also be deducedfrom the decision of the International Fiscal Associa-tion to dedicate a plenary session to the attribution ofprofits to PEs at its 60th Congress. Among the issuesdiscussed in the plenary session was the attribution ofprofits to agency PEs when there is a supplementaryprofit attributable to such PE in addition to the arm’s-length reward paid to the agent. The lack of consensusamong the panel members indicates the extent of thecontroversy on this issue.

Therefore, it is hoped that the analysis of the rel-evant case law, especially Morgan Stanley and SET Satel-lite, and the opinions of prominent tax scholars mightpoint towards a predominant direction on the interpre-tation of the issue at stake that could avoid the uncer-tainty on the tax consequences of setting up a businessinvolving an agency PE.

II. The Agency PE

The main rule of article 7 of the OECD model taxconvention basically states that the profits of an enter-prise must only be taxed in its state of residence (homestate) unless the enterprise carries on business in theother contracting state through a PE situated therein(host state). In this latter case, the profits of the enter-prise may be taxed in the other state, but only so muchof them as are attributable to that PE.

It derives from the wording of the provisions of ar-ticle 7 that the existence of a PE is the decisive factorfor the allocation of taxing rights regarding the busi-ness profits of an enterprise. As stated by Brian J. Ar-nold, the PE requirement ‘‘is a minimum threshold

7Philip Baker and Richard S. Collier, General Report, ‘‘TheAttribution of Profits to Permanent Establishments,’’ Cahiers deDroit Fiscal International, Vol. 91b, Subject II (Amersfoort: SduFiscale & Financiële Uitgevers, 2006), pp. 34-35.

8In some situations, the existence of different interpretationsmay derive from the domestic legislation of a particular state,giving rise to the issue of treaty override.

9Hans Pijl, ‘‘The Zero-Sum Game, the Emperor’s Beard andthe Authorized OECD Approach,’’ Eur. Tax’n (Jan. 2006), pp.29-35.

10Avoiding the characterization of a PE is not only a matterof achieving a lower worldwide effective tax rate, but also avoid-ing a high burden of compliance costs.

11As early as 1776, Adam Smith outlined certainty as one ofthe four principles of an ideal tax system, along with equity, con-venience, and economy. Adam Smith, An Inquiry Into the Natureand Causes of the Wealth of Nations (London: Methuen and Co.,Ltd., ed. Edwin Cannan, 1904), available at http://www.econlib.org/library/Smith/smWN21.html.

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that must be satisfied before a country can tax resi-dents of other treaty countries on their profits derivedfrom the other country.’’12

At this stage, it is worthwhile to remember whatKees van Raad cited as one of the fundamental rulesin applying tax treaties, that ‘‘tax treaties restrict theapplication of internal tax law.’’13 Stated differently, atax treaty might restrict taxation, but not impose a taxthat does not otherwise exist under domestic law. Themain purpose of tax treaties is to establish a mecha-nism to avoid double taxation by restricting tax claimsin areas where overlapping tax claims are expected tooccur.14

In this sense, the PE threshold must be met to allowthe host state to tax the items of income arising withinits territory, if its domestic law so provides. Broadlyspeaking, the rationale behind the PE provision is thatas the enterprise is deriving profits in the host state byhaving a presence thereof, that is, by being economi-cally connected with that state and using its infrastruc-ture, the host state should be entitled to tax suchprofits.

The characterization of a PE is governed by article5, provided that the relevant states concluded anOECD-patterned treaty. For the present analysis, whatis relevant is the characterization of an agency PE,which is governed by the provisions of article 5, para-graph 5 of the OECD model tax convention.

The first use of article 5, paragraph 5 in a modeldates back to the 1935 League of Nations draft.15 Theunderlying principle of this provision is that a personacting on behalf of the enterprise in the host stateleads to a taxable presence thereof, that is, a PE, eventhough the enterprise may not have a fixed place ofbusiness in that state in the sense of paragraphs 1 and2 of article 5.16 This particular feature of the agencyPE — irrelevance of a fixed place of business — illus-trates the difficulty in characterizing such a PE in prac-tice, as opposed to the physical PE set forth in article5, paragraphs 1 and 2. While the characterization ofthe latter type is rather obvious, tax authorities face amore difficult task in identifying agency PEs because of

the need to focus on the activities of the enterprise ascarried out by the dependent agent.17

Under article 5, paragraph 5 of the OECD modeltax convention, an agency PE is found to exist whenthe following characteristics are met: (i) a person (indi-vidual or company) is acting on behalf of the enter-prise, (ii) other than an agent of independent status,(iii) with authority to conclude contracts, (iv) in thename of the enterprise, (v) on a regular basis. In theOECD language, as long as these requirements aremet, the agency PE is characterized a dependent agent(DA) and a dependent agent PE (DAPE). There arecountless debatable questions in connection with eachof these requirements, all of which, however, fall out-side the scope of this article.18 For the purposes of thisarticle, it is assumed that every time an agency PE ismentioned, the requirements at stake were met.

In this context, though this is not the core issue ofthis article, the scope of article 5, paragraphs 5 and 6of the OECD model convention is quite disputableamong scholars, especially when it comes to the differ-ence between common-law and civil-law practitioners.From a common-law perspective, it is often argued thatarticle 5, paragraphs 5 and 6 cover only agents con-cluding contracts binding on their principal.19 However,a different view based on civil law is that article 5(5) ofthe OECD model convention refers to direct repre-sentatives, while article 5(6) relates to indirect represen-tatives.20 These diverse views reflect the essential differ-ence between common and civil law:

When an agent makes a contract in his ownname, but on behalf of an undisclosed principal,as a general rule under common law, the princi-pal is bound by the contract, whereas under civillaw, again as a general rule, only the agent, andnot the principal, is bound by such a contract.21

This difference between common and civil law isoften viewed as a tax planning opportunity. Multina-tional enterprises will take into account all the above-mentioned factors that characterize an agency PEwhen setting up a business abroad. Under their supplychain management and international tax planning strat-egy, multinational enterprises will often seek to struc-ture their activities in a foreign country in a manner

12Brian J. Arnold, ‘‘Threshold Requirements for Taxing Busi-ness Profits Under Tax Treaties,’’ Bulletin — Tax Treaty Monitor(Oct. 2003), pp. 476-492.

13Kees van Raad, ‘‘Five Fundamental Rules in Applying TaxTreaties,’’ Liber Amicorum Luc Hinnekens (Bruxelles: Bruylant,2002), pp. 587-597.

14Vogel, supra note 3, at 27.15John F. Avery Jones et al., ‘‘The Origins of Concepts and

Expressions Used in the OECD Model and Their Adoption byStates,’’ Bulletin — Tax Treaty Monitor (June 2006), p. 237.

16Vogel, supra note 3, at 329.

17Arnold, supra note 12, at 479.18For reference to the controversial issues involving the

agency PE notion, see Giuseppe Persico, ‘‘Agency PermanentEstablishment Under Article 5 of the OECD Model Conven-tion,’’ Intertax, Vol. 28, No. 2 (2000), pp. 66-82.

19John F. Avery Jones and David A. Ward, ‘‘Agents as Per-manent Establishments Under the OECD Model Tax Conven-tion,’’ Eur. Tax’n (May 1993), pp. 154-181.

20Sidney I. Roberts, ‘‘The Agency Element of Permanent Es-tablishment: The OECD Commentaries From the Civil LawView,’’ Eur. Tax’n (Mar. 2008), pp. 107-113.

21Avery Jones and Ward, supra note 19, at 156.

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that either avoids the characterization of an agencyPE22 or provides for an optimal allocation of functions,assets, and risks to shift income to a low-tax jurisdic-tion.

Taking into account a particular company willing todistribute its goods in a foreign country, there are basi-cally two distribution models that may be adopted toaccomplish this goal: (i) the buy-sell model, involving alocal distributor that may be related to the company,and (ii) the agency model. Both models have their vari-ances, triggering different tax consequences, and oftenmultinational enterprises play around with the featuresof each model to shift income to a low-tax jurisdiction(for example, by using a limited risk distributionmodel, under which part of the risk is shifted from thedistributor to the principal, so the former is entitled toa lower profit). Essentially, the allocation of functions,assets, and risks will determine the arm’s-length remu-neration of a distributor in a buy-sell model. However,one of the main tax consequences of the agency modelis the possibility of the constitution of an agency PE inthe host state once the requirements of article 5, para-graph 5 of the OECD model tax convention are met.

Because of the extensive use of the OECD modelconvention and its commentary and the developmentof case law and doctrine, it can be said that nowadaysthe characterization of an agency PE is not as compli-cated as it was in the past, although it still requires acase-by-case analysis. Nonetheless, an open question,both to tax authorities and taxpayers, is how muchprofits must be attributed to that PE.

III. Subsidiary Constituting an Agency PEBefore addressing the core issue of the different ap-

proaches to attribute profits to agency PEs, attentionshould be given to the particular phenomenon of asubsidiary constituting an agency PE of its foreign par-ent company, as this might lead to different conse-quences regarding the attribution of profits to that PE.

The provisions of article 5, paragraph 7 of theOECD model tax convention set forth that:

the fact that a company which is a resident of acontracting state controls or is controlled by acompany which is a resident of the other con-tracting state, or which carries on business in thatother state (whether through a PE or otherwise),shall not of itself constitute either company a PEof the other.

This ‘‘anti-single-entity’’ clause makes clear that asubsidiary should not be considered a PE of its parentcompany for the mere fact of their corporate relation-ship (that is, that they belong to the same group ofcompanies).

The commentaries on article 5, paragraph 7 of theOECD model tax convention reaffirm this rule andstress that the fact that the trade or business carried onby the subsidiary company is managed by the parentcompany is not sufficient to consider the former a PEof the latter.

However, it is also generally accepted that the sub-sidiary cannot hide behind its independent legal statusto avoid an agency PE characterization because ‘‘thereis no reason why a subsidiary company acting as anagent of its parent company should be treated differ-ently than a third party acting as an agent.’’23 In thesame way, the commentaries on article 5, paragraph 7provide for this possibility.

As will be demonstrated below, several decisionswere issued recently recognizing the existence of a sub-sidiary constituting a PE of its parent company. Thedecisions were not always received by the internationaltax community free of criticism.

A. Interhome

The Interhome case24 involves a decision of the Con-seil d’Etat (Supreme Administrative Court of France)ruling that a French subsidiary (Interhome Gestion)may constitute an agency PE of its Swiss parent com-pany (Interhome AG), but only if the former:

• cannot be regarded as an independent agent of itsparent company; and

• habitually exercises an authority to bind the Swissparent in commercial activities that are related tothose of the parent.

Interhome AG is a group of companies headquar-tered in Switzerland engaged in the business of rentingholiday accommodations. In this context, InterhomeAG concluded mandate contracts with owners in sev-eral European countries and promoted the houses in acatalogue, while its subsidiary in France — InterhomeGestion — was responsible for the proper execution ofthese contracts within the French territory.25 (See Fig-ure 1.)

Under this scenario, French tax authorities arguedthat Interhome Gestion should be considered anagency PE of Interhome AG and therefore the incomereceived by the latter, comprised of commission on therents, should be taxed in France as profits attributableto that PE.26

22Arnold, supra note 12, at 483.

23Arthur Pleijseir, ‘‘The Agency Permanent Establishment,Practical Applications. Part Two,’’ Intertax, Vol. 29, Nos. 6-7,(2001), pp. 223-224.

24Conseil d’Etat (Supreme Administrative Court of France),June 20, 2003, decision 224407.

25Id.26Id.

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The French tax authorities’ arguments were over-ruled by the Court of Appeals of Paris because theactivities carried out by Interhome Gestion were legallydifferent from those of Interhome AG and the formerdid not have legal authority to bind the latter.27

Later on, the case was brought before the SupremeAdministrative Court, which held that Interhome Ges-tion would only constitute a PE of its parent companyif the requirements of article 5 of the France-Switzerland treaty, equivalent to article 5(5) of theOECD model, were met. In other words, such charac-terization would only occur if Interhome Gestioncould not be considered an independent agent and if ithabitually exercised in France an authority, legal orfactual, to conclude contracts in the name of Inter-home AG that relate to ordinary business activities ofthat company.28 Therefore, the Supreme AdministrativeCourt maintained the core part of the decision of theCourt of Appeals of Paris, rejecting the characteriza-tion of Interhome Gestion as a PE of its parent com-pany.

Despite this outcome (that is, no characterization ofthe subsidiary as being a PE of its parent company),the relevance of this case to the present analysis is thatthe Supreme Administrative Court of France clearlydescribed the requirements by which a subsidiarymight constitute a PE of its parent company, empha-sizing the possibility of a subsidiary binding de factoits parent company and not only legally. According to

the Conseil d’Etat, the exercise of the authority to bindthe Swiss parent should be determined not only by ref-erence to a legal mandate, but also by reference to theactual circumstances.

This factual approach adopted by the Conseil d’Etatwould prove to be decisive in a later case — Zimmer —analyzed below, that was heavily criticized by somescholars.

B. Philip Morris

The importance of the Philip Morris case29 to thepresent work resides not only in that it involves a de-pendent agent that is a subsidiary of its principal, butalso, and most important, because of the particularfeatures envisaged by the Italian Supreme Court for thecharacterization of what it called a ‘‘multiple PE’’ — aPE within a group of companies.

Philip Morris involves an audit carried out by theItalian tax authorities regarding the character of theactivities performed by Intertaba SpA, the Italian com-pany of the Philip Morris group, which was structuredat the time of the facts as shown in Figure 2.

The decision of the Supreme Court of Italy statedthat because of the activities carried out by IntertabaSpA in supervising the performance of the licensingand distribution contracts concluded among the othercompanies of the Philip Morris group and its participa-tion in negotiating such contracts, the company couldbe deemed to be a ‘‘place of management’’ at the dis-posal of the entire group. Intertaba SpA was then con-sidered to constitute a ‘‘multiple subsidiary’’ PE in

27Court of Appeals of Paris, decision 96-859 2e (releasedJune 13, 2000).

28Klaus Vogel in cooperation with the IBFD’s Tax TreatyUnit, ‘‘1. Subsidiaries as Permanent Establishments?’’ Bulletin —Tax Treaty Monitor, Tax Treaty News (Oct. 2003), p. 474.

29Italian Supreme Court, Dec. 20, 2001, decisions 3367 and3368; Italian Supreme Court, Dec. 20, 2001, decision 7682; andItalian Supreme Court, Dec. 20, 2001, decision 10925.

Switzerland

France

Interhome AG

InterhomeGestion

Execution ofcontracts

Mandate contracts withhouse owners

Payment of commission onthe rents

Other European States

Figure 1. Interhome

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Italy under the notion provided in article 5(1) of theOECD model convention, as well as an agency PE asprovided in article 5(3).30

The reasoning of the Supreme Court of Italy is thatthe incorporation of Intertaba SpA was intended todisguise the existence of a PE in Italy to avoid fulltaxation of the royalties derived from the licensing con-tracts concluded with the Italian state monopoly forthe sale of tobacco products.31

In addition to the introduction of the concept of amultiple PE, the Supreme Court of Italy identified thefollowing principles to determine the existence of aPE:32

• an Italian company may be a multiple PE of for-eign companies belonging to the same group andpursuing a common strategy;

• the supervision or control of the performance of acontract cannot, in principle, be considered an

auxiliary activity within the meaning of article5(4) of the OECD model convention and the cor-responding article of the Germany-Italy tax treaty;

• the participation of representatives or employeesin a phase of the conclusion of a contract may beregarded as an authority to conclude contracts;

• the entrusting of the management of businesstransactions to a resident company by a corpora-tion that is not resident in Italy makes the residentcompany a PE of the foreign corporation; and

• the existence of a PE should be verified by adopt-ing a substantial rather than formalistic approach.

The line of reasoning of the Supreme Court of Italyhas been extensively criticized. The criticism focusedon the characteristics that the Italian Supreme Courttook into account to determine the existence of a PE,which somewhat deviates from what is provided inarticle 5 of the OECD model convention and thetreaty applicable to the case. Indeed, the reasoning ofthe decision and especially the statement that the par-ticipation in the negotiation of contracts was sufficientto create an agency PE caused great concern and re-percussions in the international tax community.

Apparently, that was not the intention of the Court.Justice Enrico Altieri from the Tax Division of the Ital-ian Supreme Court later stated that the Court did not

30Gazzo, supra note 4, at 259.31Id. at 258.32Caterina Innamorato, ‘‘The Concept of a Permanent Estab-

lishment Within a Group of Multinational Enterprises,’’ Eur.Tax’n (Feb. 2008), p. 81.

Figure 2. Philip Morris

U.S.

Germany Switzerland

Italy

Philip Morris

FTR

Sale of filters

Philip MorrisEurope

Intertaba SpAItalian StateMonopoly Co.

Royalties

98% 2%

U.S.

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intend to create a new notion of permanent establish-ment (the multiple PE of a group), but that it simplyidentified a common structure for the pursuit of agroup strategy.33

Intentional or not, the repercussions of this case andthe concern that other courts could follow the SupremeCourt of Italy’s reasoning and adopt such principles indeviation from what is stated in the OECD model con-vention and its commentary led the OECD to amendthe commentary on article 5 for clarification pur-poses.34

Apart from the criticism that it may have been sub-jected to, the importance of this decision to this articleis that the factual analysis of the activities performedby a company, as provided for by the audit carried outby the Italian tax authorities, might well lead to theconstitution, by that company, of a PE of its affiliatedcompanies.

C. Zimmer

As mentioned above, the main purpose of tax plan-ning in an international setting is to achieve a lowerworldwide effective tax rate. Therefore, the location ofthe key business functions of a company (for example,manufacturing, distribution, sales, and research anddevelopment) should be, as much as possible, in a low-tax jurisdiction. Significant functions and risk, andtherefore the associated profit, should be allocated in alow-tax jurisdiction to provide for a lower worldwideeffective tax rate. Establishing core business functionsin low-tax jurisdictions or shifting such functions or therisk associated with such functions to low-tax jurisdic-tions is likely to result in the migration of income tosuch locations. As a consequence, a reduction in theworldwide effective tax rate is achieved, provided the

shift in income and risk is supported by operationalsubstance and arm’s-length transfer pricing principles.35

In this context, a typical example of functions andrisk shifting that occurred in the past few years is theconversion of fully fledged distributors into commis-sionaires.36 This phenomenon is well illustrated in Zim-mer, a recent decision of the Court of Appeals of Parisinvolving a U.K. company, Zimmer Ltd., and theFrench tax authorities.37 Zimmer commercialized itsorthopedic products in France until 1995 through aFrench distributor, Zimmer SAS. However, from March27, 1995, Zimmer SAS commercialized Zimmer Ltd.’sproducts in a commissionaire capacity under a com-missionaire agreement. The French tax administrationassessed corporate income tax (plus 10 percent sur-charge) for the years 1995 and 1996 on the groundsthat it had a PE. Zimmer Ltd. objected to the assess-ment and brought the case before the court.38

33Id. at 83.34Most of the changes, first released as a public discussion

draft (available at http://www.oecd.org/dataoecd/34/9/31483903.pdf), were later adopted in the 2005 commentary tothe OECD model tax convention to avoid the repetition of theinterpretation of the Supreme Court of Italy.

35Raffaele Russo et al., Fundamentals of International Tax Plan-ning (Amsterdam: IBFD Publications BV, 2007), p. 75.

36As pointed out by Giuseppe Persico, ‘‘the commissionairestructure is particularly attractive and widely used since it pro-vides the opportunity to centralize the entrepreneurial risks in thehands of the principal’’ (emphasis added); Persico, supra note 18,at 76.

37Court of Appeals of Paris, Feb. 2, 2007, decision05PA02361.

38Id.

Figure 3. Zimmer

Until 1995

U.K.

France

ZimmerLtd.

Zimmer Ltd.Main Functions/Risks

Manufacturing function

Zimmer SASMain Functions/Risks

Distribution functionMarketing functionMarket riskInventory riskCredit risk

ZimmerSAS

Distributioncapacity

•

•••

••

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The operations carried out by the Zimmer group aredescribed in figures 3 and 4.

The main issue was whether Zimmer SAS consti-tuted an agency PE of Zimmer Ltd. and as a conse-quence a part of the latter’s company profits were at-tributable to that PE and subject to tax in France. Thecourt concluded that Zimmer SAS constituted a PE ofZimmer Ltd., and the profits realized in France byZimmer Ltd. were taxable in France.39

There was a lengthy discussion on the characteriza-tion of an agency PE because the parties concluded acommissionaire arrangement, a particular feature ofcivil-law jurisdictions. A commissionaire can be definedas an intermediary that acts on behalf of its principal,in its agency capacity, but in its own name. The com-missionaire performs an indirect representation; it as-sumes personally the rights and obligations arisingfrom the contracts concluded with a third party andthe latter does not have a legal relationship with theprincipal. This particular feature of the commissionairearrangement gives rise to two separately legal relation-ships:

• a principal and commissionaire relationship; and

• a commissionaire and third-party relationship.40

Thus, the two main differences of the commission-aire under French law and the agent described in theOECD model convention and its commentary are:

• the commissionaire is legally responsible beforethe client, while the typical agent described in theOECD model convention and its commentary is aperson acting on behalf of the enterprise and noton its own capacity; and

• the commissionaire concludes contracts in its ownname, whereas the agent has authority to con-clude contracts in the name of the enterprise. Thisnotion is strange to common law, in which a con-tract concluded by an agent always binds the prin-cipal, irrespective of whether the principal wasdisclosed.41

In the taxpayer’s view, these features of the commis-sionaire arrangement would be sufficient to avoid thecharacterization of a PE in France. Indeed, unlike aconventional distribution carried out through a typicalagent, a commissionaire should not be considered toconstitute an agency PE in the sense of article 5(5) ofthe OECD model convention because it does not havepower to bind the principal and because it concludessale contracts in its own name, rather than in the nameof the principal. In practice customers may not beaware that they are dealing with an agent because theyonly have a contractual relationship with the commis-sionaire. Of course, one should not rely on an extremeformalistic approach to limit the application of article5(5) of the OECD model convention to agents thatenter into contracts literally in the name of the enter-prise, as such provisions equally apply to agents thatconclude binding contracts that are not actually in thename of the enterprise.42 However, under a commis-sionaire arrangement the issue is not only the name ofwhom the contract is entered into with, but also, andmore important, the lack of binding effects regardingthe principal.

I believe that as a result, in a typical commissionairearrangement the requirements of article 5(5) of the

39Id.40Persico, supra note 18, at 76.

41See Avery Jones et al., supra note 15, at 236; Persico, supranote 18, at 68.

42Vogel, supra note 3, at 329. The same view is expressed inpara. 32.1 of the OECD commentary on article 5.

Figure 4. Zimmer

After 1995

U.K.

France

ZimmerLtd.

Zimmer Ltd.Main Functions/Risks

Manufacturing functionMarketing functionMarket riskInventory riskCredit risk

Zimmer SASMain Functions/Risks

Sales functionZimmer

SAS

Commissionairearrangement

•••••

•

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OECD model convention are not met and therefore noagency PE is found to exist.43 It is up to disputeamong scholars whether commissionaires fall under thescope of article 5(5) of the OECD model convention,especially because of the diverse views arising from thecommon-law and civil-law notions of agents.

One might argue that economically the commission-aire performs basically the same activities as a conven-tional agent under article 5(5) of the OECD modelconvention, but legally there is no contractual relation-ship between the customer and the principal. The cus-tomers only have a contractual relationship and there-fore can only sue the commissionaire, not theprincipal, which is why the characterization of a typi-cal commissionaire as an agent within the meaning ofarticle 5(5) of the OECD model convention is, in myview, unreasonable.

That was not the interpretation of the Court of Ap-peals of Paris in concluding that Zimmer SAS couldde facto bind its parent company, Zimmer Ltd. Phraseddifferently, the court clearly adopted an economic sub-stance approach to conclude that the principal was ac-tually bound by the commissionaire.

This should not be considered a good decision be-cause it ignored the particular features of a commis-sionaire arrangement, a typical concept of civil-lawjurisdictions. It is therefore expected that tax authori-ties, especially in France, will feel encouraged to chal-lenge commissionaire structures on the basis of an eco-nomic approach.

Despite this controversial issue of the substance-over-form approach adopted by the Court of Appealsof Paris, the question of what portion of profits shouldbe attributed to that PE remained unanswered. Thisquestion is addressed in the following section.

IV. Different Approaches

A. Introduction

The origins of article 7 of the current OECD modelconvention dates back to the 1920s and to the work ofthe League of Nations, predecessor of the OECD. Atthat time, under the 1927 League of Nations draft con-vention, article 5 governed the taxation of what wasthen called ‘‘income from a trade or profession’’; therewas little guidance on how to determine the incometaxable in each contracting state.44

The current wording of article 7(2) establishing theseparate enterprise concept — that the profits of a PEwill be ‘‘the profits which it might be expected to makeif it were a distinct and separate enterprise engaged inthe same or similar activities under the same or similarconditions and dealing wholly independently with theenterprise of which it is a PE’’ — has its origins inarticle 3 of the 1933 League of Nations draft conven-tion and was generally followed by the subsequentMexico and London model conventions of 1943 and1946, respectively.45

There are two maininterpretations of article 7regarding the attribution ofprofits to PEs.

Since then, the study of the issue of attribution ofprofits to PEs has evolved greatly, but despite the ef-forts of the OECD no consensus has been achievedamong states until the recent adoption of the revisedcommentary on the current article 7 to be included inthe 2008 update to the model tax convention. This re-vised commentary is a great achievement and will pro-vide more guidance on this issue.

There are two main interpretations of article 7 re-garding the attribution of profits to PEs: the function-ally separate entity approach, also known as the au-thorized OECD approach; and the relevant businessactivity approach.

Generally, the authorized OECD approach providesthat the profits to be attributed to a PE must be theprofits that it ‘‘would have earned at arm’s length if itwere a legally distinct and separate enterprise perform-ing the same or similar functions under the same orsimilar conditions.’’46 The relevant business activityapproach provides that the expression ‘‘profits of anenterprise’’ in article 7(1) of the OECD model conven-tion refers to the profits of business activities in whichthe PE has participated. The main feature of this ap-proach is that ‘‘profits are earned only from transac-tions with third parties (or with associated enterprises):no profit is earned from a transaction between the PEand the enterprise of which it is part.’’47 Under therelevant business activity approach, article 7(1) limits

43See Stéphane Gelin and David Sorel, ‘‘French Commission-naire: A PE for Its Foreign Principal?’’ Tax Notes Int’l, Aug. 6,2007, p. 581, Doc 2007-16318, or 2007 WTD 154-6.

44Raffaele Russo, ‘‘Tax Treatment of ‘Dealings’ Between Dif-ferent Parts of the Same Enterprise Under Article 7 of theOECD Model: Almost a Century of Uncertainty,’’ Bulletin — TaxTreaty Monitor (Oct. 2004), pp. 472-485.

45Id. at 474; see also para. 81 of the OECD ‘‘Report on theAttribution of Profits to Permanent Establishments,’’ Part I(General Considerations), (2006).

46Para. 10 of the ‘‘Report on the Attribution of Profits to Per-manent Establishments,’’ Part I (General Considerations), (2006).

47Baker and Collier, supra note 7, at 30.

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the profits that may be attributable to a PE, on the ba-sis of article 7(2), to the overall profits of the wholeenterprise. One major consequence of this is the im-possibility of attributing profits to a particular PE ifthe enterprise, considered as whole, makes a loss.

When it comes to the attribution of profits toagency PEs, the controversial issue is determiningwhether there may be a profit attributable to theagency PE in excess of the arm’s-length remunerationpaid to the dependent agent. The issue is whether it ispossible to attribute a separate profit to an agency PEonce the agent had an arm’s-length reward for the serv-ice provided.

The two different approaches provide for completelydifferent answers: The application of the authorizedOECD approach to agency PEs leads to the possibilityof a separate profit and loss attribution to that PE,while the single taxpayer approach provides that oncethe dependent agent received an arm’s-length reward,no profit or loss can be attributed by the host state.The authorized OECD approach leads to the treatmentof the dependent agent and the agency PE as two dif-ferent taxable entities (also known as the dual taxpayerapproach). Conversely, the single taxpayer approachprovides that an arm’s-length remuneration paid onlyto the dependent agent is in compliance with the PEtreshhold.

B. OECD Project on Attribution of Profits to PEs

Before analyzing the authorized OECD approach indetail, it is important to present an overview of theOECD project on attribution of profits to permanentestablishments to examine what is the legal status ofsuch approach as well as its role in interpreting currenttreaties. This analysis is necessary since one of themain controversies regarding the authorized OECDapproach refers to its applicability regarding treatiescurrently in force. While some argue that the approachis the most proper interpretation of article 7 of the cur-rent version of the OECD model convention, othersargue that the application of the authorized OECDapproach is dependent on changes to be made in thewording of tax treaties and therefore cannot be appliedto the treaties currently in force.

The starting point of this project was the OECD’sattempt to analyze how the principles developed in the1995 OECD transfer pricing guidelines, which dealswith the application of the arm’s-length principle totransactions between associated enterprises, should ap-ply in the context of the relationship between a PE andits general enterprise.48 The aim of this effort was toachieve a greater consensus on the attribution of profits

to PEs and the interpretation of article 7 of the OECDmodel tax convention, avoiding the risk of double taxa-tion.

In this context, the OECD released in 2001 parts I(General Considerations) and II (Banks)49 and in 2003Part III (Global Trading)50 of a discussion draft on theattribution of profits to PEs. In 2004 a revised discus-sion draft of parts I,51 II, and III was released for pub-lic comment. Finally, in December 2006, the Commit-tee on Fiscal Affairs released new versions of parts I,II, and III of its ‘‘Report on the Attribution of Profitsto Permanent Establishments.’’52

Moreover, in December 2006 the OECD Committeeon Fiscal Affairs decided that to provide ‘‘improvedcertainty for the interpretation of existing treaties basedon the current text of article 7, a revised Commentaryshould be prepared taking into account those aspects ofthe Report that do not conflict with the existing Com-mentary’’ (aspects that constitute a mere clarificationof the proper interpretation of article 7).53 Therefore,on April 10, 2007, as a first part of the implementationpackage, a discussion draft of the revised commentaryon article 7 was released for public comment takinginto account many of the conclusions included in partsI, II, and III of the ‘‘Report on the Attribution ofProfits to Permanent Establishments.’’54

The revised commentary on the current article 7 ofthe OECD model tax convention was then included inthe 2008 update to the model tax convention, whichwas adopted by the committee at its meeting of June24-25, 2008, when the committee also adopted the‘‘Report on Attribution of Profits to Permanent Estab-lishments.’’ The revised commentary will be includedin the new version of the OECD model tax conventionthat will soon be published; the report will also be pub-lished separately.55

Furthermore, the OECD Committee on Fiscal Af-fairs intends to implement the conclusions of the re-port not only through a new version of the commen-tary on the current text of article 7, but also through anew version of article 7 itself with accompanying new

48Para. 2 of the update of the status of the OECD project onthe attribution of profits to PEs (2006).

49See http://www.oecd.org/LongAbstract/0,3425,en_2649_201185_1923011_1_1_1_1,00.html.





54See http://www.oecd.org/document/52/0,3343,en_2649_201185_38376628_1_1_1_1,00.html.

55See http://www.oecd.org/document/52/0,3343,en_2649_33747_38376628_1_1_1_1,00.html.

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commentary to be used in the negotiation of futuretreaties and of amendments to existing treaties. Thus,the OECD Committee on Fiscal Affairs recently re-leased as a discussion draft what it called the secondpart of the implementation package — a new versionof article 7 and related commentary changes. The com-mittee will be receiving comments on this discussiondraft until December 31, 2008, and it is expected thatthe new article and the commentary changes will beincluded in the next update to the OECD model taxconvention, which is tentatively scheduled for 2010.56

Considering that this article is focused on case lawon the attribution of profits to agency PEs, and thedecisions were held before the release of the discussiondraft of the new version of article 7 and related com-mentary changes, all comments made refer to the cur-rent wording of the OECD model convention and the‘‘Report on the Attribution of Profits to PermanentEstablishments.’’ One first important issue that arises iswhat weight should be given to this report in applyingtax treaties currently in force. The specialized doctrinehas already discussed at length the legal status of thecommentary to the OECD model convention, and itcan be said that there is no generally accepted view onthis controversial issue.57 If the legal status of the com-mentary is unclear and subject to a variety of differentinterpretations, more obscure is the role of a reportthat was, at the time the decisions being analyzed wereheld, not implemented yet.

The OECD recognizes in paragraph 7 of the revisedcommentary on article 7 that there are differences be-tween some of the conclusions of the report and theinterpretation of article 7 previously given in the com-mentary in a way that the report should only provideguidelines for the application of the arm’s-length prin-ciple incorporated in the article to the extent that itdoes not conflict with the commentary. In case of con-flict between the two, the commentary should alwaysprevail over the report.58

This is not mere academic debate; rather, it is a veryimportant issue in practice as the conclusions of thereport lead to major consequences on the attribution ofprofits to PEs in general and particularly to agencyPEs. The Indian Income Tax Appellate Tribunal had to

face this dilemma in the SET Satellite case; the taxpayerreferred to the report as ‘‘what the law should be andnot what the law is.’’59

To address the different interpretations, I will firstpresent a summary of the authorized OECD approachto attribute profits to PEs in general, followed by ananalysis of its specific features regarding agency PEs,and finally the particularities of the single taxpayer ap-proach.

C. The Authorized OECD ApproachBetween the two main interpretations of the provi-

sions of article 7 of the OECD model convention re-garding the attribution of profits to PEs, the OECDopted for the functionally separate entity approach,rather than the relevant business activity approach.Now one can see that the reason why the first is alsocalled the authorized OECD approach is because itprovides for the OECD preferred interpretation of ar-ticle 7.60

The authorized OECD approach provides that theprofits to be attributed to a PE must be the profits thatit ‘‘would have earned at arm’s length if it were a le-gally distinct and separate enterprise performing thesame or similar functions under the same or similarconditions.’’61 Conversely, the functionally separate en-tity approach does not limit the profits of the PE byreference to the profits of the enterprise as a whole. Asa consequence, it is perfectly possible under this ap-proach to attribute profits to a PE even if the enter-prise, considered as whole, incurs a loss.

The OECD report reaffirms the primacy of thearm’s-length principle in attributing profits to PEs bydetermining the adoption of the functionally separateentity approach. As shown below, the application ofthis approach requires a stretch: The PE is supposed tobe treated as a functionally separate entity of its headoffice, though it is part of the same enterprise. Oncethe PE cannot enter into actual transactions with otherparts of the enterprise of which it is part, it is neces-sary to provide for the recognition of the dealings be-tween the PE and its head office, which goes againstthe axiom that an enterprise cannot make a profit fromdealing with itself.

1. The Authorized OECD Approach to PEs

The application of the functionally separate entityapproach under the report requires a two-step analysis:

• the functional and factual analysis; and

• the comparability analysis.56See id.57See, e.g., Vogel, supra note 3, at 43; David A. Ward, ‘‘The

Role of the Commentaries on the OECD Model in the TaxTreaty Interpretation Process,’’ Bulletin — Tax Treaty Monitor(Mar. 2006), p. 98; and John F. Avery Jones, ‘‘The Effect ofChanges in the OECD Commentaries After a Treaty Is Con-cluded,’’ Bulletin — Tax Treaty Monitor (Mar. 2002), pp. 102-109.

58Mary Bennett and Raffaele Russo, ‘‘OECD Project on At-tribution of Profits to Permanent Establishments: An Update,’’Int’l Transfer Pricing J. (Sept./Oct. 2007), p. 283.

59Indian Income Tax Appellate Tribunal, Apr. 20, 2007, deci-sion 535/Mum/04 and 205/Mum/04.

60Para. 78 of the ‘‘Report on the Attribution of Profits to Per-manent Establishments,’’ Part I (General Considerations), (2006).

61Id. at para. 10.

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In essence, the first step involves the application, byanalogy, of the principles described in the 1995 OECDtransfer pricing guidelines to identify the economicallysignificant activities and responsibilities undertaken bythe PE, while the second step is the comparabilityanalysis and the application of the transfer pricingmethods to determine an arm’s-length profit of the PE.

The two-step analysis is summarized as follows inthe OECD ‘‘Report on the Attribution of Profits toPermanent Establishments’’:

Step OneA functional and factual analysis, leading to:• The attribution to the PE as appropriate of the

rights and obligations arising out of transactionsbetween the enterprise of which the PE is a partand separate enterprises;

• The identification of significant people functionsrelevant to the attribution of economic ownershipof assets, and the attribution of economic owner-ship of assets to the PE;

• The identification of significant people functionsrelevant to the assumption of risks, and the attri-bution of risks to the PE;

• The identification of other functions of the PE;

• The recognition and determination of the natureof those dealings between the PE and other partsof the same enterprise that can appropriately berecognised, having passed the threshold test; and

• The attribution of capital based on the assets andrisks attributed to the PE.

Step Two

The pricing on an arm’s length basis of recog-nised dealings through:

• The determination of comparability between thedealings and uncontrolled transactions, establishedby applying the Guidelines’ comparability factorsdirectly (characteristics of property or services,economic circumstances and business strategies)or by analogy (functional analysis, contractualterms) in light of the particular factual circum-stances of the PE; and

• Applying by analogy one of the Guidelines’ tradi-tional transaction methods or, where such meth-ods cannot be applied reliably, one of the transac-tional profit methods to arrive at an arm’s lengthcompensation for the dealings between the PEand the rest of the enterprise, taking into accountthe functions performed by and the assets andrisks attributed to the PE.

The functional and factual analysis described in stepone of the report resembles the analysis provided inthe 1995 OECD transfer pricing guidelines. The diffi-culty in replicating the principles developed in theguidelines in a PE setting is that, differently from whathappens when applying article 9 to associated enter-

prises dealings, a PE is not legally a separate enterprisebut is part of the same enterprise of its head office.

The solution found by the OECD Committee onFiscal Affairs to cope with this difficulty was to look atthe functions of the people working for the enterpriseto attribute the assets, risks, capital, rights, and obliga-tions belonging to the PE.62 As a result, under the au-thorized OECD approach, economic ownership of as-sets should be attributed to the PE in accordance withthe significant people functions as well as the risks re-lated to the functions performed by people in that PE.Also, the authorized OECD approach establishesmechanisms to attribute capital to the PE in line withthe assets and risks attributed to it and criteria for therecognition and determination of the dealings betweenthe PE and its general enterprise.

The second step involves the determination of re-muneration of any dealings between the hypothesizedenterprises on the basis of the functions performed,assets used, and risks assumed, as provided for in the1995 OECD transfer pricing guidelines.63

2. The Authorized OECD Approach to Agency PEs

Regarding the attribution of profits to agency PEs,the OECD believes that the same principles adoptedfor other types of PEs should apply. As a matter ofconsistency, the OECD believes there is no reason toapply a different mechanism of profits attribution whenit comes to agency PEs.

Consequently, profits should be attributed to theagency PE on the basis of the assets and risks of thenonresident enterprise relating to the functions per-formed by the former on behalf of the latter.

The authorized OECDapproach leads to thetreatment of thedependent agent and theagency PE as two differenttaxable entities.

As pointed out by Hans Pijl, the authorized OECDapproach takes the functions performed in the hoststate as the starting point for the attribution of profits.Moreover, under the notion that assets and risks followfunctions, the functional and factual analysis will deter-mine the assets and risks that must be attributed to the

62Id. at para. 18.63Id. at para. 13.

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agency PE.64 Considering, for example, the situationwhen the credit risk on accounts receivable is notborne by the dependent agent itself but directly by theprincipal, a reward for such risk will have to be attrib-uted to the agency PE.65

One major aspect of the authorized OECD ap-proach is that it leads to the treatment of the depend-ent agent and the agency PE as two different taxableentities. This means that the agency PE is not the de-pendent agent per se; its hypothetical existence is apartfrom the dependent agent and is derived because thegeneral enterprise in the home state has a dependentagent in the host state. As a consequence, the author-ized OECD approach challenges the widespread ideathat the profit of an agency PE is zero by definition.

Under the authorized OECD approach, it is notonly the income earned by the dependent agent itselfthat matters but also the income the general enterpriseearns through its agency PE in the host country. What-ever is paid to the dependent agent (for example, sal-ary, fixed amount, or percentage of sales) should beconsidered as an expense in ascertaining the agency PEprofits.

This is precisely when the authorized OECD ap-proach differs from the single taxpayer approach. Thepayment of the dependent agent remuneration and itsdeduction on the computation of the agency PE profitsdoes not mean that there will be no profits left. Thoseprofits will be determined on the basis of the functionsperformed by the agency PE.

In this context, it is possible that no profit be attrib-utable to the agency PE depending on the functionsperformed by that PE.66 Indeed, under the OECD re-port, there is no presumption that the agency PE willalways generate profits, as it may well happen that littleor no profit is attributed to it if only routine functions

are performed. Nothing prevents the general enterprisefrom organizing its business in the host state in a man-ner in which little or no functions are performed by theagency PE and, as a consequence, little or no tax mustbe attributable to it under the authorized OECD ap-proach.

The authorized OECD approach determines that thedependent agent be rewarded for the service providedto the nonresident enterprise on an arm’s-length basis;that is, taking into account its assets and risks, whilethe profits of the agency PE should be determined onthe basis of the assets and risks of the nonresident en-terprise in relation to the functions performed by thedependent agent on behalf of the enterprise, added bysufficient capital to support those assets and risks.67

By definition, the overall taxable income of the de-pendent agent plus the income of the agency PE(deemed to be independent) must be equal to the tax-able income a company would earn in an arm’s-lengthtransaction. In a simplistic fashion, the authorizedOECD approach can be described on the basis of theexample illustrated in Figure 5.68

Under the authorized OECD approach, there is aprofit attributable to the agency PE in excess of the

64Pijl, supra note 9, at 30-31.65Raffaele Russo, ‘‘Application of Arm’s Length Principle to

Intra-Company Dealings: Back to the Origins,’’ Int’l Transfer Pric-ing J. (Jan./Feb. 2005), p. 14.

66Pijl, supra note 9, at 32.67Bennett and Russo, supra note 58, at 282.68This example was drafted based on a similar diagram pro-

vided by Hans Pijl in ‘‘The Zero-Sum Game, the Emperor’sBeard and the Authorized OECD Approach,’’ supra note 9, at32.

Figure 5. Authorized OECD Approach to Agency PEs

Home State

Host State

General Enterprise

Permanent Establishment

Agent

Agent P&LGross income 200Cost of services (150)Profit 50

GE P&LGross income 2,000Cost of goods (500)Agent fee (200)Profit 1,300

PE P&LGross income 2,000Cost of goods (1,000)Agent fee (200)Profit 800

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arm’s-length remuneration paid to the dependent agent.In other words, the $200 ‘‘paid’’ by the general enter-prise to its dependent agent, which is assumed to be anarm’s-length reward, does not eliminate the need toattribute a separate profit to the agency PE in accord-ance with the assets, risks, capital, and rights and obli-gations referring to that PE.

As shown below (referring to the single taxpayerapproach), the arm’s-length remuneration of $200 issufficient to comply with the tax liabilities that arose inthe host state.

D. The Single Taxpayer Approach to Agency PEs

The single taxpayer approach is based on the axiomthat the agency PE profit is zero by definition. Underthis approach, an arm’s-length remuneration paid tothe dependent agent extinguishes any PE tax liabilityin the host state. The rationale behind this approach isthat if the dependent agent is fully rewarded at arm’slength for all functions performed, assets used, andrisks assumed, then there can be no additional profit tobe attributed to the agency PE.69

Differently from the authorized OECD approach(which leads to the treatment of the dependent agentand the agency PE as two different taxable entities),under the single taxpayer approach the ‘‘individual orentity whose activities create the PE is considered to bethe PE himself/itself,’’70 that is, one single taxpayer.

This particular feature of the single taxpayer ap-proach — that the agent is the PE — can be describedon the basis of the example illustrated in Figure 6.71

By comparing the two hypothetical figures, it isclear that the single taxpayer approach leads to a lesserportion of profit to be attributable to the host state,that is, $50 instead of $850. This is an inherent conse-quence of the assumption that the dependent agentand the agency PE are one and the same thing.

Now that the main features of both the authorizedOECD approach and the single taxpayer approachhave been outlined, it is time to analyze the interpreta-tion of this controversial issue by the courts. Sadly,there are only a few decisions dealing with the attribu-tion of profits to agency PEs. The lack of a significantamount of case law highlights the importance of theMorgan Stanley and SET Satellite cases. Both cases werejudged in Indian courts, but many scholars felt thecases had opposite outcomes, demonstrating that thecontroversy of this issue remains, even within theboundaries of a single state.

E. Morgan Stanley

The Morgan Stanley case involves the taxation onactivities carried out between entities of the MorganStanley group.72 Morgan Stanley and Co. (MSCo), aninvestment bank located in the United States, enteredinto a services agreement with Morgan Stanley Advan-tages Services Pvt. Ltd. (MSAS), a service company

69Baker and Collier, supra note 7, at 33.70Annika Deitmer, Ingmar Dörr, and Alexander Rust, ‘‘Invi-

tational Seminar on Tax Treaty Rules Applicable to PermanentEstablishments — in Memoriam of Prof. Dr. Berndt Runge,’’Bulletin — Tax Treaty Monitor (May 2004), p. 187.

71See supra note 68.72Supreme Court of India, July 9, 2007, decision 2114/07

and 2415/07.

Figure 6. Single Taxpayer Approach to Agency PEs — Agent Is PE

Home State

Host State

General Enterprise P&L

Permanent Establishment

Agent

Agent P&LGross income 200Cost of services (150)Profit 50

GE P&LGross income 2,000Cost of goods (500)Agent fee (200)Profit 1,300

PE P&LGross income 200Agent fee (200)Profit 0

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established in India, by which the latter provided sup-port services to the former. The services were charac-terized as back-office activities and comprised:

• equity and fixed income research;• account reconciliation; and• information technology services (for example,

back-office operation, data processing, and sup-port centers).73

In connection with the services agreement con-cluded by the parties, MSCo staff was seconded toMSAS, although continued to be legally employed andreceiving salary from MSCo.

The transactions entered into by MSCo and MSASare summarized in Figure 7.

Of great importance to this case is that MSCo filedwith the Indian tax authorities a request for an advanceruling to determine whether the services provided byMSAS, under the services agreement entered into be-tween the two, could lead to the constitution of a PEin India of MSCo within the meaning of article 5(1) ofthe treaty concluded between India and the UnitedStates, and if so, the amount of profit attributable tothat PE.74

The Authority for Advanced Ruling (AAR) in Indiadecided:

• MSCo cannot be regarded as having a fixed PEwithin the meaning of article 5(1) of the India-U.S. treaty;

• MSAS cannot be regarded as being an agency PEin the sense of article 5(4) of the India-U.S.treaty;

• MSCo would be regarded as having a PE in Indiawithin the meaning of article 5(2)(l) of the India-U.S. treaty ‘‘if it were to send some of its em-

ployees to India as stewards or as deputationistsin the employment of MSAS’’; and

• the transactional net margin method was the mostappropriate transfer pricing method to determinethe arm’s-length price of the services provided byMSAS.75

Both the Indian Department of Revenue and MSCofiled an appeal before the Supreme Court of India. Thearguments of both appellants can be summarized asfollows:76

• The Department of Revenue argued that MSCoshould be considered to have a fixed PE in Indiain the sense of article 5(1) of the India-U.S. treatyas it proposes to carry on its business in Indiathrough MSAS and there was a fixed place ofbusiness in Mumbai; and MSAS should be con-sidered to constitute an agency PE of MSCo inIndia under article 5(4) of the India-U.S. treaty, asthe former was legally and financially dependenton the latter.

• MSCo argued that the activities carried out byMSAS did not constitute a PE under article 5(2)(l)of the India-U.S. treaty.

Because of its importance to the analysis of thiscase and the fact that the provisions of article 5(2)(l) ofthe India-U.S. treaty are not standard provisions underthe OECD model convention, a full look at the rel-evant provisions of the India-U.S. treaty is necessary.(See Table 1.)

Regarding the existence of a fixed PE within themeaning of article 5(1) of the India-U.S. treaty, theSupreme Court of India recognized the existence of afixed place of business, but held that the second re-quirement of article 5(1) of the treaty — through

73Id. at 2-3.74Id. at 3.

75Id. at 4-5.76Id.

Figure 7. Morgan Stanley

U.S.

India

Morgan Stanleyand Company

Support ServicesEquity and fixed income researchAccount reconciliationIT services

Arm’s-lengthremuneration forsupport services

Morgan StanleyAS Pvt. Ltd.

•••

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Table 1. Comparison of OECD Model Convention and India-U.S. TreatyOECD Model Convention Convention Between the Government of the United States of America and the

Government of the Republic of India for the Avoidance of Double Taxationand the Prevention of Fiscal Evasion with respect to Taxes on Income, signed

in New Delhi on September 12, 1989Article 5 — Permanent Establishment Article 5 —Permanent Establishment

1. For the purposes of this Convention, the term‘‘permanent establishment’’ means a fixed place of businessthrough which the business of an enterprise is wholly orpartly carried on.

2. The term ‘‘permanent establishment’’ includes especially:a) a place of management;b) a branch;c) an office;d) a factory;e) a workshop, andf) a mine, an oil or gas well, a quarry or any other placeof extraction of natural resources.

( . . . )

4. Notwithstanding the preceding provisions of this Article,the term ‘‘permanent establishment’’ shall be deemed not toinclude:

a) the use of facilities solely for the purpose of storage,display or delivery of goods or merchandise belonging tothe enterprise;b) the maintenance of a stock of goods or merchandisebelonging to the enterprise solely for the purpose ofstorage, display or delivery;c) the maintenance of a stock of goods or merchandisebelonging to the enterprise solely for the purpose ofprocessing by another enterprise;d) the maintenance of a fixed place of business solely forthe purpose of purchasing goods or merchandise or ofcollecting information, for the enterprise;e) the maintenance of a fixed place of business solely forthe purpose of carrying on, for the enterprise, any otheractivity of a preparatory or auxiliary character;f) the maintenance of a fixed place of business solely forany combination of activities mentioned in subparagraphsa) to e), provided that the overall activity of the fixedplace of business resulting from this combination is of apreparatory or auxiliary character.

5. Notwithstanding the provisions of paragraphs 1 and 2,where a person — other than an agent of an independentstatus to whom paragraph 6 applies — is acting on behalf ofan enterprise and has, and habitually exercises, in aContracting State an authority to conclude contracts in thename of the enterprise, that enterprise shall be deemed tohave a permanent establishment in that State in respect ofany activities which that person undertakes for theenterprise, unless the activities of such person are limited tothose mentioned in paragraph 4 which, if exercised througha fixed place of business, would not make this fixed place ofbusiness a permanent establishment under the provisions ofthat paragraph.

1. For the purposes of this Convention, the term ‘‘permanent establishment’’means a fixed place of business through which the business of an enterprise iswholly or partly carried on.

2. The term ‘‘permanent establishment’’ includes especially:(a) a place of management;(b) a branch;(c) an office;(d) a factory;(e) a workshop;(f) a mine, an oil or gas well, a quarry, or any other place of extraction ofnatural resources;( . . . )(l) the furnishing of services, other than included services as defined inArticle 12 (Royalties and Fees for Included Services), within a ContractingState by an enterprise through employees or other personnel, but only if:

(i) activities of that nature continue within that State for a period or periodsaggregating more than 90 days within any twelve month period; or(ii) the services are performed within that State for a related enterprise(within the meaning of paragraph 1 of Article 9 (Associated Enterprises)).

( . . . )

3. Notwithstanding the preceding provisions of this Article, the term‘‘permanent establishment’’ shall be deemed not to include any one or more ofthe following:

(a) the use of facilities solely for the purpose of storage, display, or occasionaldelivery of goods or merchandise belonging to the enterprise;(b) the maintenance of a stock of goods or merchandise belonging to theenterprise solely for the purpose of storage, display, or occasional delivery;(c) the maintenance of a stock of goods or merchandise belonging to theenterprise solely for the purpose of processing by another enterprise;(d) the maintenance of a fixed place of business solely for the purpose ofpurchasing goods or merchandise, or of collecting information, for theenterprise;(e) the maintenance of a fixed place of business solely for the purpose ofadvertising, for the supply of information, for scientific research or for otheractivities which have a preparatory or auxiliary character, for the enterprise.

4. Notwithstanding the provisions of paragraphs 1 and 2, where a person —other than an agent of an independent status to whom paragraph 5 applies —is acting in a Contracting State on behalf of an enterprise of the otherContracting State, that enterprise shall be deemed to have a permanentestablishment in the first-mentioned State if:

(a) he has and habitually exercises in the first-mentioned State an authority toconclude contracts on behalf of the enterprise, unless his activities are limitedto those mentioned in paragraph 3 which, if exercised through a fixed placeof business, would not make that fixed place of business a permanentestablishment under the provisions of that paragraph;(b) he has no such authority but habitually maintains in the first-mentionedState a stock of goods or merchandise from which he regularly delivers goodsor merchandise on behalf of the enterprise, and some additional activitiesconducted in that State on behalf of the enterprise have contributed to thesale of the goods or merchandise; or(c) he habitually secures orders in the first-mentioned State, wholly or almostwholly for the enterprise.

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which the business of an enterprise is wholly or partlycarried on — was not satisfied regarding the back-office activities.

Moreover, the Court considered that the back-officeservices to be provided by MSAS fall under article5(3)(e) of the India-U.S. treaty, which excludes thecharacterization of a PE regarding ‘‘the maintenanceof a fixed place of business solely for the purpose ofadvertising, for the supply of information, for scientificresearch or for other activities which have a prepara-tory or auxiliary character, for the enterprise.’’77

Concerning the existence of an agency PE, the Su-preme Court of India concluded that there was no PEbecause MSAS did not have authority to enter into orconclude contracts (which were entered and concludedin the United States).78

Moreover, regarding the stewards seconded byMSCo to work in India as employees of MSAS, theSupreme Court of India disagreed with the ruling pro-vided by the AAR and held that their activity did notlead to the constitution of a PE within the meaning ofarticle 5(2)(l) of the India-U.S. treaty. According to theCourt, the stewardship activities did not constitute aservice provided by MSCo to MSAS, rather, ‘‘MSCo ismerely protecting its own interests in the competitiveworld by ensuring the quality and confidentiality ofMSAS services.’’79 The underlying idea is that the en-terprise must provide a service to a third party toqualify as a PE — a PE does not arise when the enter-prise is providing a service to itself. Under the Court’sview, as no service was being provided to a third partyby the stewards, no PE was found to exist.

However, regarding the deputationists deployed byMSCo to work in India as employees of MSAS, theSupreme Court of India held that they did not becomeemployee of MSAS; they retained their employmentlien with MSCo and therefore constituted a service PEin the sense of article 5(2)(l) of the India-U.S. treaty.The Court found that MSAS was therefore a servicePE in India regarding the services performed by thedeputationists deployed by MSCo.80

Once the Supreme Court of India concluded thatMSCo had a service PE in India, the question washow much profit could be attributed to that PE. TheCourt first made reference to the ruling provided in theAAR that when the nonresident compensates a PE atarm’s length no further profits could be attributable toIndia. Then the judges presented their agreement withthis ruling:

The impugned ruling is correct in principle inso-far as an associated enterprise, that also consti-tutes a PE, has been remunerated on an arm’slength basis taking into account all the risk-takingfunctions of the enterprise. In such cases nothingfurther would be left to be attributed to the PE.The situation would be different if the transferpricing analysis does not adequately reflect thefunctions performed and the risks assumed by theenterprise. In such a situation, there would be aneed to attribute profits to the PE for thosefunctions/risks that have not been considered.81

The widespread interpretation of this case law sup-ports that it is in line with the single taxpayer approachsince it provides that no further profit is left to be at-tributed to the PE once the dependent agent has re-ceived an arm’s-length reward for the service provided.

Nevertheless, there is a dissenting view headed byHans Pijl (and shared by me) that considers this deci-sion as favoring the authorized OECD approach.82

Indeed, a careful reading of the decision’s reasoningreveals that the Supreme Court of India left open thepossibility of a further profit attribution to the PE aslong as there are other functions performed or risksassumed by the enterprise that are not reflected in thedependent agent remuneration. This conclusion resultsfrom the final part of the decision: ‘‘The situationwould be different if the transfer pricing analysis doesnot adequately reflect the functions performed and therisks assumed by the enterprise. In such a situation,there would be a need to attribute profits to the PE for thosefunctions/risks that have not been considered.’’83 (Emphasisadded.) This is clearly in line with, if not a definitionof, the authorized OECD approach.

It can be derived from the decision that no furtherprofit was attributed to the PE in India precisely be-cause no other functions or risks were identified in theframework of the activities carried out by that PE, notbecause the Supreme Court of India opted as a matterof principle for the single taxpayer approach.

It is interesting that this decision is always promotedas being one of the most important precedents in favorof the single taxpayer approach when it really invali-dates it.

All the conflicting views presented above result fromthe confusing wording of the decision in its concludingsection. Although the wording of the decision is some-what ambiguous, I feel it safe to conclude that this is a

77Id. at 15, 16, and 18.78Id. at 16.79Id. at 20-21.80Id. at 21-22.

81Id. at 46.82Hans Pijl, ‘‘Morgan Stanley: Issues Regarding Permanent

Establishments and Profit Attribution in Light of the OECDView,’’ Bull. for Int’l Tax’n (May 2008), pp. 174-182.

83Supreme Court of India, July 9, 2007, decision 2114/07and 2415/07, p. 46.

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precedent in favor of the authorized OECD approach,rather than the single taxpayer approach as it mightlook at first sight.

F. SET Satellite

SET Satellite involves a Singaporean broadcastingcompany named SET Satellite (Singapore) Pte. Ltd.that was engaged in the business of marketing and dis-tributing satellite television channels in India.84 SETSatellite appointed SET India Pvt as its agent in India,whose activity mainly comprised marketing airtimeslots to various advertisers in India on behalf of SETSatellite, as illustrated in Figure 8.

When filing its tax returns, SET Satellite assumedthe position that it was not subject to tax in India be-cause it did not have a PE within the meaning of ar-ticle 5(8) of the India-Singapore tax treaty. For the sakeof clarity, the provisions of article 5(8) of the treatydeviate from the wording of the OECD model conven-tion by enlarging the notion of agency PE to other ac-tivities, such as:

• maintenance of stock of goods or merchandise tobe delivered on behalf of the enterprise; or

• habitually securing orders wholly or almostwholly for the enterprise itself or for the enter-prise and other enterprises controlling, controlledby, or subject to the same common control as thatenterprise.

However, the India-Singapore treaty provides for theessential features of the typical concept of agency PEsas established in the OECD model: (i) a person (indi-viduals or companies) acting on behalf of the enter-prise, (ii) other than an agent of independent status,

(iii) with authority to conclude contracts, (iv) in thename of the enterprise, (v) on a regular basis. Differentfrom the OECD model, the India-Singapore treatydoes not require that the dependent agent concludescontracts ‘‘in the name of the enterprise,’’ but ‘‘on be-half of the enterprise.’’ In my opinion, however, thisdifference does not lead to major consequences be-cause, as explained above regarding the Zimmer case,one should not rely on an extreme formalistic approachto limit the application of article 5(5) of the OECDmodel convention to agents that enter into contractsliterally in the name of the enterprise, as such provi-sions apply equally to agents that conclude bindingcontracts that are not actually in the name of the enter-prise.

For the sake of clarity, a full look at the relevantprovisions of the India-Singapore treaty is necessary.(See Table 2.)

According to the court, there was no dispute aboutwhether SET Satellite had a dependent agent in India.The issue was whether once the dependent agent (SETIndia) was paid an arm’s-length remuneration for theservices rendered to its principal (SET Satellite), anyfurther income, other than the income earned by thedependent agent, can be said to be attributed to thedependent agent PE and therefore subject to tax in In-dia.85

Indian tax authorities argued that:• though the purchase and sale of airtime are ef-

fected in Singapore, the receipt regarding broad-casting advertisement is in the territory of India;

• the income regarding, or in connection with therelay of, advertisements, accrues in India; and

• SET Satellite has a PE in India in the form ofSET India, and therefore, advertisement revenuefrom AXN channel is taxable in India as businessincome.

84Indian Income Tax Appellate Tribunal, Apr. 20, 2007, deci-sion 535/Mum/04 and 205/Mum/04. As both appeals pertainedto the same person, involved interconnected issues, and wereheard together, the tribunal disposed of both appeals in a con-solidated order. 85Id. at paras. 6 and 31.

Figure 8. SET Satellite

Singapore

India

SET SatelliteMarketing services in

the Indian market

Arm’s-lengthremuneration for

marketing services SET India

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To support its arguments, Indian tax authorities re-lied mainly on the OECD ‘‘Report on the Attributionof Profits to Permanent Establishments.’’ SET Satelliteargued that, according to the provisions of article 7(2)of the India-Singapore treaty, since SET India was re-munerated on an arm’s-length basis there was no addi-tional profit to be taxed in India regarding the adver-tisement revenues. The arguments raised by SETSatellite were supported by the writings of Philip Bakerand Richard S. Collier, guidance previously issued bythe Indian tax authorities, and the decision of theAAR in Morgan Stanley, in which an arm’s-length re-ward paid by a foreign enterprise to its dependent

agent for the service provided extinguishes the taxliability of the foreign enterprise in India.

The court clearly adopted an interpretation in linewith the authorized OECD approach or dual taxpayerapproach by treating the dependent agent and theagency PE as two different taxable units:

A dependent agent cannot, strictly speaking, betermed as PE because neither the DependentAgent belongs to the PE, nor can one have some-thing as a result of having the same thing, i.e. ifa dependent agent is itself a PE, one cannot havea PE as a result of having a dependent agent. In

Table 2. Comparison of OECD Model Convention and India-Singapore Treaty

OECD Model Convention Agreement Between the Government of the Republic of Singaporeand the Government of the Republic of India for the Avoidance ofDouble Taxation and the Prevention of Fiscal Evasion with respect

to Taxes on Income concluded January 24, 1994

Article 5 — Permanent Establishment Article 5 — Permanent Establishment

1. For the purposes of this Convention, the term ‘‘permanentestablishment’’ means a fixed place of business through which thebusiness of an enterprise is wholly or partly carried on.

2. The term ‘‘permanent establishment’’ includes especially:a) a place of management;b) a branch;c) an office;d) a factory;e) a workshop, andf) a mine, an oil or gas well, a quarry or any other place ofextraction of natural resources.

( . . . )

5. Notwithstanding the provisions of paragraphs 1 and 2, where aperson — other than an agent of an independent status to whomparagraph 6 applies — is acting on behalf of an enterprise and has,and habitually exercises, in a Contracting State an authority toconclude contracts in the name of the enterprise, that enterprise shallbe deemed to have a permanent establishment in that State in respectof any activities which that person undertakes for the enterprise,unless the activities of such person are limited to those mentioned inparagraph 4 which, if exercised through a fixed place of business,would not make this fixed place of business a permanentestablishment under the provisions of that paragraph.

1. For the purposes of this Agreement, the term ‘‘permanentestablishment’’ means a fixed place of business through which thebusiness of the enterprise is wholly or partly carried on.

2. The term ‘‘permanent establishment’’ includes especially:(a) a place of management;(b) a branch;(c) an office;(d) a factory;(e) a workshop;(f) a mine, an oil or gas well, a quarry or any other place ofextraction of natural resources;(g) a warehouse in relation to a person providing storage facilitiesfor others;(h) a farm, plantation or other place where agriculture, forestry,plantation or related activities are carried on;(i) premises used as a sales outlet or for soliciting and receivingorders;(j) an installation or structure used for the exploration orexploitation of natural resources but only if so used for a periodof more than 120 days in any fiscal year.

( . . . )

8. Notwithstanding the provisions of paragraphs 1 and 2, where aperson — other than an agent of an independent status to whomparagraph 9 applies — is acting in a Contracting State on behalf ofan enterprise of the other Contracting State that enterprise shall bedeemed to have a permanent establishment in the first-mentionedState, if:

(a) he has and habitually exercises in that State an authority toconclude contracts on behalf of the enterprise, unless his activitiesare limited to the purchase of goods or merchandise for theenterprise;(b) he has no such authority, but habitually maintains in thefirst-mentioned State a stock of goods or merchandise from whichhe regularly delivers goods or merchandise on behalf of theenterprise; or(c) he habitually secures orders in the first-mentioned State, whollyor almost wholly for the enterprise itself or for the enterprise andother enterprises controlling, controlled by, or subject to the samecommon control, as that enterprise.

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such a case, the treaty could have simply statedthat a dependent agent or agency shall be deemedto be PE of the enterprise; there was no need tosay, as has actually been said, that an enterpriseshall be deemed to have a PE by the virtue ofhaving a dependent agent and meeting one oftests set out in the relevant sub article. DependentAgent and the Dependent Agent PE, therefore,cannot be one and the same thing.86

Regarding the determination of the profits of theagency PE, the court relied on the OECD ‘‘Report onthe Attribution of Profits to Permanent Establish-ments’’ and followed the functionally separate entityapproach by stating that:

the profit computations of the PE have to pro-ceed on the basis that the PE is wholly independ-ent of its GE [General Enterprise], which from apurely accounting and commercial point of view,generally means nothing more than the hypoth-esis that intra organization transactions are to betaken into account at arm’s length price.87

According to the court:

the DAPE and DA88 has to be, therefore, treatedas two distinct taxable units. The former is a hypo-thetical establishment, taxability of which is onthe basis of revenues of the activities of the GEattributable to the PE, in turn based on theFAR89 analysis of the DAPE, minus the pay-ments attributable in respect of such activities, insimple words, whatever are the revenues gener-ated on account of functional analysis of theDAPE are to be taken into account as hypotheti-cal income of the said DAPE, and deduction isto be provided in respect of all the expenses in-curred by the GE to earn such revenues, includ-ing, of course, the remuneration paid to the DA.The second taxable unit in this transaction is theDA itself, but this taxability is in respect of theremuneration of the DA.90

Regarding the AAR’s ruling in Morgan Stanley, thecourt stated that this argument was not persuasive as itis ‘‘well settled in law that these rulings have bindingvalue only on the assessee and on the Commissionerwith reference to that particular transaction.’’91

The court went on to conclude:

We are of the considered view that in addition ofthe taxability of the DA in respect of remunera-tion earned by him, which is in accordance withthe domestic law and which has nothing to dowith the taxability of the foreign enterprise ofwhich he is dependent agent, the foreign enter-prise is also taxable in India, in terms of the pro-visions of Article 7 of the tax treaty, in respect ofthe profits attributable to the dependent agentPE.92

SET Satellite is an important case because it involvesthe effective application of the conclusions of the ‘‘Re-port on the Attribution of Profits to Permanent Estab-lishments,’’ despite the arguments raised by the tax-payer against its legal status and applicability while nochange in the wording of the OECD model conventionor its commentary has been put in place. The judgeshad to reconcile the interpretation that seemed to bemore appropriate with the relevant arguments raised bythe taxpayer, especially the legal status of the report,which, at the time of the judgment, was not part ofthe commentary to the current OECD model conven-tion. The report was not part of the commentary inplace at the time of the conclusion of the India-Singapore treaty, which creates an additional argumentfor those that defend a static, rather than an ambula-tory, interpretation of the commentary to the OECDmodel convention.

As shown below, I believe this decision is correctand provides for the most appropriate interpretation ofarticle 7 regarding the attribution of profits to PEs.

However, this decision was made by the Indian In-come Tax Appellate Tribunal, so it is unclear whetherthe Supreme Court of India will uphold the decision orwhether it will clarify its earlier ruling in Morgan Stan-ley and rule in favor of the taxpayer.

V. The Most Suitable ApproachIt seems safe to conclude that the authorized OECD

approach is indeed the most appropriate approach toattribute profits to PEs.

A. Adequate Allocation of RisksThe single taxpayer approach is quite attractive at

first sight, as it provides for an outcome that is appar-ently quite logical: As the dependent agent is remuner-ated on an arm’s-length basis, both home and hoststates seem to get their fair share of the income thatarises in a particular transaction.93 The home statetaxes the profits of the enterprise, while the host stateis entitled to tax the income paid to the dependent

86Id. at para. 8.87Id. at para. 10.88DAPE stands for ‘‘dependent agent permanent establish-

ment,’’ and DA means ‘‘dependent agent.’’89The court uses this acronym to refer to functions per-

formed, assets used, and risks assumed.90Indian Income Tax Appellate Tribunal, Apr. 20, 2007, deci-

sion 535/Mum/04 and 205/Mum/04, para. 11.91Id. at para. 17.

92Id. at para. 11.93Para. 272 of the ‘‘Report on the Attribution of Profits to

Permanent Establishment,’’ Part I (General Considerations),(2006).

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agent in accordance with the functions it performs —an arm’s-length remuneration.

This apparently logical reasoning hides the possibil-ity of other functions being performed in the host stateas risks are allocated to the agency PE in the frame-work of its dealings with its head office.

Indeed, the single taxpayer approach is firmly re-jected by the OECD in its report precisely because:

it ignores assets and risks that relate to the activ-ity being carried on in the source jurisdiction sim-ply because those assets and risks legally belongto the non-resident enterprise. . . . The single tax-payer approach simply does not consider that ifthe risks (and reward) legally belong to the non-resident enterprise it is nonetheless possible toattribute those risks (and reward) to a PE of thenonresident enterprise created by the activity ofits dependent agent in the host country.94

Undeniably, the single taxpayer approach ignores thepossibility of other risks being assumed in the hoststate, which may not reflect the entire activities of theenterprise in that state. This is what Raffaele Russocalled a misallocation of the risks within the enterprise:‘‘that the risk is legally borne by the nonresident enter-prise should not impede the allocation of it to the PEfor purposes of profit attribution.’’95

If, for example, the credit risk on accounts receiv-able is not borne by the dependent agent itself but di-rectly by the principal, a reward for such risk must beattributed to the agency PE.96

In my view, the strange outcome of ignoring suchfunctions and risks is a direct consequence of theaxiom that involves the notion of the single taxpayerapproach, that the individual or entity whose activitiescreate the PE is considered to be the PE himself/itself.97

As, under the single taxpayer approach, the figuresof the dependent agent and the agency PE are mixedinto one, the eventual other functions performed andrisks assumed in the framework of the agency PE areblurred into this single taxable unit and remain unre-vealed.

Therefore, it can be said that the single taxpayer ap-proach might lead to a hidden profit escaping taxationof the host state depending on the facts and circum-stances.

It is only the authorized OECD approach that al-lows the host state to ‘‘see’’ and be able to tax eventualother functions that are being performed or risks beingassumed within its territory. Considering the exampleof a typical agency PE, only a functional and factualanalysis as provided by the authorized OECD ap-proach will reveal to the host state a profit that other-wise would be completely hidden.

The single taxpayerapproach might lead toa hidden profit escapingtaxation of the host statedepending on the facts andcircumstances.

With the characterization of two clear separate tax-able units — the dependent agent and the agency PE— the precise amount of income is attributed to eachone of them in accordance with the functions per-formed, assets used, and risks assumed by each taxableunit.

The Supreme Court of India, though ruling in Mor-gan Stanley that there was no further profit to be attrib-uted to the PE in excess of an arm’s-length remunera-tion, was able to see the possibility that other functionsmight be performed and risks assumed in the hoststate, different from those relating to the dependentagent:

The impugned ruling is correct in principle inso-far as an associated enterprise, that also consti-tutes a PE, has been remunerated on an arm’slength basis taking into account all the risk-takingfunctions of the enterprise. In such cases nothingfurther would be left to be attributed to the PE.The situation would be different if the transfer pricinganalysis does not adequately reflect the functions per-formed and the risks assumed by the enterprise. In such asituation, there would be a need to attribute profits to thePE for those functions/risks that have not been con-sidered.98 [Emphasis added.]

A careful reading of the decision’s reasoning revealsthat the Supreme Court of India left open the possibil-ity of a further profit attribution to the PE as long asthere are other functions performed or risks assumedby the enterprise that are not reflected in the dependentagent remuneration.94Id.

95Raffaele Russo, The Attribution of Profits to Permanent Estab-lishments: The Taxation of Intra-Company Dealings (Amsterdam:IBFD Publications BV, 2005), p. 30.

96Russo, supra note 65, at 14.97Deitmer, Dörr, and Rust, supra note 70, at 187.

98Supreme Court of India, July 9, 2007, decision 2114/07and 2415/07, p. 46.

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If the single taxpayer approach is adopted, theseeventual additional functions or risks of the enterprisein the host state will never be remunerated, which isclearly against the wording of article 7, and which isintended to provide for tax sharing between home andhost states weighted on the basis of the functions per-formed, assets used, and risks assumed.

This interpretation is shared by Richard Vann;though he believes that the existing theories regardingthe allocation of profits to PEs are not convincing, heexpresses his preference for what he called the ‘‘rowingor relay theory,’’ under which:

every transaction within the boundaries of thefirm is intended to produce a profit over andabove the market price of any intra-firm transac-tion or dealing that operates as an input into thatprofit and that profit is allocated to all parts ofthe firm which participate in the realisation ofthe ultimate profit on the sale to the third party.99

The name of this theory refers to the idea that eachmember of the team contributes to the overall profit asthey all work together towards the same goal, whichresembles a rowing race.

Therefore, it is clear that the authorized OECD ap-proach is the only method that entails an adequate al-location of risks within the enterprise, avoiding an un-due limitation of the host state taxing rights. If theresulting increase in host state taxation is undesirable,this is an issue of tax policy that does not overcomethe conclusion that the authorized OECD approachprovides for a proper allocation of risks within the en-terprise, as opposed to its contrary single taxpayer ap-proach.

B. The Rationale Behind Article 7In my view, it is undisputable that the rationale of

the OECD report is in line with the underlying prin-ciple codified in article 7.

Article 7 upholds primacy of the arm’s-length prin-ciple in attributing profits to PEs as a natural conse-quence of the adoption of the separate entity fiction.100

The OECD report reaffirms the primacy of thearm’s-length principle in attributing profits to PEs bydetermining the adoption of the functionally separateentity approach. In the framework of an agency PE,the host state is therefore entitled to tax the profits that

the agency PE might be expected to make if it were aseparate enterprise engaged in the same or similar ac-tivities under the same or similar conditions and deal-ing wholly independently with the enterprise of whichit is a PE.

Some authors expressed concern about the require-ment, under the authorized OECD approach, of thePE recognizing notional payments as a deduction or asbasis for attributing profits, based on the notion that‘‘an enterprise cannot make a profit from dealing withitself.’’101

However, by adopting the transfer pricing guidelinesto a general enterprise and PE relationship, the onlyresult that is harmonious is that the PE profits must bedetermined in accordance with the assets and risks ofthe nonresident enterprise relating to the functions per-formed by the dependent agent on behalf of the non-resident enterprise, together with sufficient capital tosupport those assets and risks. As a matter of principle,the authorized OECD approach is the only one thatleads to an outcome that is coherent with the fiction ofindependence provided in article 7(2). It is undeniablethat the single taxpayer approach does not fully accom-plish the fiction of independence of article 7(2), whichis the same as saying that it results in a partial applica-tion of its provisions. This outcome cannot be ac-cepted, as it is against the rationale and wording ofarticle 7.

In this sense, as noted by Hans Pijl, the authorizedOECD approach is correct from the perspective of taxtreaty interpretation because the result ‘‘coincides withthe source principle . . . that the state in which the ac-tivities are carried on has the right to levy tax.’’102

Moreover, it is clear that, under the OECD report,there is no presumption that the agency PE will alwaysgenerate profits. Sometimes little or no profit is attrib-utable to it if only routine functions are performed. Asthe profits will be allocated among the relevant statesin accordance with the functions performed and therisks assumed by the enterprise, each state will alwaysbe entitled to tax the profits that arise from activitiescarried out within its territory.

Other criticism to the authorized OECD approachraised by Philip Baker and Richard Collier is that it‘‘represents a significant departure from the interpreta-tion of article 7 as set out in the current commen-tary.’’103 In other words, they argue that the currentwording of article 7 of the OECD model conventionand its commentary does not leave room for the appli-cation of the authorized OECD approach and there-fore amendments must be made at least in the com-mentary. Further, they conclude that considering the

99Richard J. Vann, ‘‘Tax Treaties: The Secret Agent’s Se-crets,’’ Brit. Tax Rev. (50th Anniversary Edition), no. 3 (2006), p.345.

100In 1933 the League of Nations draft already provided forthe arm’s-length principle as the guidance for the allocation ofprofits to intracompany dealings; see Russo, supra note 65, at 7.In this sense, the convention determined that a PE must betreated in the same manner as independent enterprises operatingunder the same or similar conditions.

101Baker and Collier, supra note 7, at 57.102Pijl, supra note 9, at 32.103Baker and Collier, supra note 7, at 31.

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existing case law and guidance, the adoption of theauthorized OECD approach will be very hard in sev-eral jurisdictions without an explicit change in thewording of article 7.104

In this sense, it is argued that the current wording ofarticle 7(3) only allows actual expenses to be taken intoaccount and not notional expenses, in a way that thefiction of independence of the PE, on the basis of thecurrent wording of article 7(2), is not complete.

An analysis of the history of article 7 demonstratesthat the underlying rationale of this provision has al-ways been the separate entity fiction. In this sense, theoutcome resulting from the adoption of the single tax-payer approach is clearly against this rationale, leadingto an unreasonable reduction of the host state taxingrights.

Despite this, it is worth remembering that theOECD Committee on Fiscal Affairs recently adoptedthe revised commentary on the current article 7 of theOECD model tax convention and included it in the2008 update to the model tax convention, which willbe soon published.105

Also, as mentioned above, the OECD Committee onFiscal Affairs intends to implement the conclusions ofthe report not only through a new version of the com-mentary on the current text of article 7, but alsothrough a new version of article 7 itself with accompa-nying commentary to be used in the negotiation of fu-ture treaties and amendments to existing treaties.

Therefore, although it seems that the most properinterpretation of article 7, on the basis of the currentOECD model convention and commentary, requiresthe adoption of the authorized OECD approach irre-spective of any modification in its wording, the neces-sary changes to improve certainty on this interpretationare being made by the OECD.

C. The Need for Consistency

Another argument against the single taxpayer ap-proach is that its acceptance would result in applyingthe OECD approach in different manners dependingon what type of PE is involved.

In this sense, regarding other types of PEs, assetsand risks would be attributed to the PE in accordancewith the functions carried on by it, with the conse-quent attribution of profits. No one would dispute thatthese assets and risks legally belong to the nonresidententerprise, but are attributable to the PE under theOECD approach because of the functions performedby that PE. However, once the single taxpayer ap-proach is adopted, no profits would be attributed to an

agency PE regarding the risks and assets of the non-resident enterprise, even if they arise from activitiescarried out through the agency PE.106

There is no relevant difference between the fixed PEand the agency PE to justify a different methodologyin attributing profits to them.

As analyzed above, the single taxpayer approach isbased on the axiom that the agency PE profit is zeroby definition. However, there is no empirical, theoreti-cal, or legal basis for achieving this conclusion. First,there is no significant difference between the character-istics of a fixed PE and an agency PE that may justifya difference in treatment regarding the attribution ofprofits. Second, no convincing theoretical support hasbeen provided in favor of the single taxpayer ap-proach.107 Third, nothing in the wording of articles 5and 7 of the OECD model seems to support a differ-ence in treatment. Quite the opposite, the basis for at-tributing profits to all types of PEs is precisely thesame provision of article 7 and the arm’s-length prin-ciple.

Therefore, there is no reason why the attribution ofprofits to an agency PE should be treated differentlyfrom the attribution of profits to other types of PE.

D. Do Not Assume the Law Is Redundant

One of the principles that guides the legal interpre-tation process is that the law does not have uselesswords.

Adopting the single taxpayer approach would makearticle 5(5) of the OECD model superfluous and thisoutcome is against the principle of the effective inter-pretation of conventions incorporated into the conceptof good faith in article 31(1) of the Vienna Conventionon the Law of Treaties.108

Indeed, it must be recognized that the adoption ofthe single taxpayer approach leads to the concept ofagency PE becoming meaningless, because the profitsof the agency PE will be taxed anyway by its state ofresidence. Therefore, if there is no additional profit tobe attributed to the agency PE over and above thearm’s-length reward of the dependent agent, there is noneed to have article 5(5).

The characterization of an agency PE would havethe sole consequence of ensuring that the dependentagent receives an arm’s-length remuneration. Basically,once an agency PE is found to exist, the considerationpaid by the nonresident enterprise to its dependent

104Id. at 57.105See http://www.oecd.org/document/52/

0,3343,en_2649_33747_38376628_1_1_1_1,00.html.

106Para. 273 of the ‘‘Report on the Attribution of Profits toPermanent Establishment,’’ Part I (General Considerations),(2006).

107Pijl, supra note 9, at 35.108Id. at 32.

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agent would be as if the parties were associated enter-prises, an outcome similar to subjecting them to theprovisions of article 9.

However, no attribution of profits would be made tothe agency PE, which is a major contradiction to thesole purpose of article 7.

There is no doubt that when dealing with the trans-actions between associated enterprises (that is, the re-muneration of the dependent agent regarding the serv-ices provided to the nonresident enterprise), article 9 isthe relevant article in determining whether the transac-tions were carried out on an arm’s-length basis.109

However, regarding the attribution of profits to theagency PE in the host state, article 7 is clearly the rel-evant provision.110 In this context, as discussed above,‘‘the assets and risks of the nonresident enterprise re-lating to the functions performer on its behalf by thedependent agent enterprise, together with sufficient freecapital to support those assets and risks,’’ should firstbe attributed to the agency PE.111 Under the author-ized OECD approach, this factor will be the measureof the profits to be attributed to the agency PE. In thisscenario, the arm’s-length remuneration of the depend-ent agent mentioned in the previous paragraph shouldbe deducted in the determination of the agency PEprofits.

As a consequence, a legal reasoning that has theconsequence of not attributing profits to a PE, as it isthe single taxpayer approach, should be rejected be-cause it does not comply with the traditional standardsof legal interpretations, which should not assume thatthe law, for articles 5 and 7 of OECD model, is redun-dant.

E. Practical Difficulties Should Not PreventAdoption

Philip Baker and Richard S. Collier raise argumentsof a practical nature against the authorized OECD ap-proach. According to Baker and Collier, it is particu-larly difficult to determine the profit, if any, to be at-tributed to the agency PE in excess of the arm’s-lengthreward to the dependent agent because there are manyimplementation difficulties, namely the need to providedocumentation of an agency PE when the nonresidententerprise is not aware of its existence.112

Some tax authorities, especially in common-lawcountries, adopt the single taxpayer approach becauseof practical considerations and try to charge, to theextent possible, the profit left from the dependent

agent.113 It would be much easier for the tax authori-ties of the host state to challenge the arm’s-length re-muneration paid to the dependent agent, rather thanseek to tax the agency PE.114

A higher difficulty in determining the profit to beattributed to an agency PE in excess of the arm’s-length reward paid to the dependent agent should notbe an obstacle to the implementation of the authorizedOECD approach. Simplicity in the field of taxation isalways welcome, but not if the price to pay is ignoringone of the basics of the taxation of business profits.

Although recognizing the positive aspects of thesingle taxpayer approach as being a simple system froman administrative perspective, there is no need for com-plicated functional and factual analysis, and this ap-proach has no theoretical support.115

Therefore, an interpretation that entails an adequateallocation of the risks within the enterprise and that isin line with the rationale underlying article 7 precedesany considerations of a practical nature. The need forsimplicity in the field of taxation should never over-come a legal interpretation that is harmonious with thewording of the legal text.

VI. ConclusionIt seems safe to conclude that the authorized OECD

approach is indeed the most appropriate approach toattribute profits to PEs.

The authorized OECD approach is the only onethat entails an adequate allocation of the risks withinthe enterprise because the single taxpayer approachignores the possibility of other functions being per-formed or risks being assumed in the host state, whichmay not reflect the entire activities of the enterprise inthat state. Therefore, the single taxpayer approachmight lead to a hidden profit escaping from taxation ofthe host state, while the authorized OECD approachallows the host state to ‘‘see’’ and be able to tax even-tual other functions or risks that are being performedor assumed within its territory.

Moreover, it is undisputable that the rationale of theauthorized OECD approach is in line with the underly-ing principle codified in article 7. This provision up-holds the primacy of the arm’s-length principle in at-tributing profits to PEs as a natural consequence of theadoption of the separate entity fiction. By adopting thearm’s-length principle to dealings between the generalenterprise and its PE, the only result that is harmoni-ous is that the PE profits must be determined in accord-ance with the assets and risks of the nonresident enter-prise relating to the functions performed by the

109Para. 276 of the ‘‘Report on the Attribution of Profits toPermanent Establishments,’’ Part I (General Considerations),(2006).

110Id. at para. 277.111Id. at para. 278.112Baker and Collier, supra note 7, at 33.

113Pijl, supra note 9, at 33.114Baker and Collier, supra note 7, at 33.115Pijl, supra note 9, at 33.

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dependent agent on behalf of the nonresident enter-prise, together with sufficient capital to support thoseassets and risks. Therefore, the authorized OECD ap-proach is the only one that leads to an outcome that iscoherent with the fiction of independence provided inarticle 7(2).

Furthermore, there is no reason why the attributionof profits to an agency PE should be treated differentlythan the attribution of profits to other types of PEs.The adoption of the single taxpayer approach results inapplying the OECD approach in different manners de-pending on what type of PE is involved, which isclearly unreasonable.

Also, the adoption of the single taxpayer approachwould make article 5(5) of the OECD model superflu-ous, which is against one of the main principles thatguides the legal interpretation process — that the lawdoes not have useless words.

Finally, considerations of a practical nature shouldnot overcome a legal interpretation that is harmoniouswith the wording of the legal text, and is the reasonwhy the authorized OECD approach should prevailover the single taxpayer approach, even if the formermay be a more difficult application in practice.

The analysis of the relevant case law shows that at-tribution of profits to PEs is still a controversial issue,although a trend towards the adoption of the author-ized OECD approach can be seen.

Moreover, the criticisms of the application of theauthorized OECD approach to treaties currently inforce are somehow weakened as the OECD Committeeon Fiscal Affairs adopted, at its meeting of June 24-25,2008, the revised commentary on the current article 7of the OECD model and included it in the 2008 up-date to the model.

Tax practice shows that there will always be roomto discuss the legal status of the OECD commentaryas well as the historical debate between the static andambulatory interpretation of the commentary.

Therefore, the states that concluded OECD-patterned treaties should put all their efforts into imple-menting the necessary changes to adopt the authorizedOECD approach because only a uniform interpretationof article 7 of the OECD model among the states canensure that no double taxation will arise, greatly ben-efiting cross-border trade. ◆

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U.S. Tax Reviewby James P. Fuller

Contract Manufacturing: Final Regulations

The IRS and Treasury issued final contract manu-facturing regulations that will apply to tax years of

controlled foreign corporations beginning after June 30,2009. (For the final regulations, see Doc 2008-27115 or2008 WTD 249-34.) New branch rule regulations werealso issued, albeit in temporary form. Those are dis-cussed separately below. A taxpayer may choose to ap-ply the new contract manufacturing regulations and thetemporary branch rule regulations retroactively for itsopen tax years. A taxpayer may so choose only if thetaxpayer and all members of its affiliated group applyboth the contract manufacturing regulations and thetemporary branch rule regulations in their entirety tothe earliest tax year of each CFC that ends with orwithin an open tax year of the taxpayer and to all sub-sequent tax years of the taxpayer.

Substantial Contribution Test: Employees

The proposed regulations provided that a CFC willsatisfy the substantial important contribution test re-garding personal property only if all the facts and cir-cumstances show that the CFC made a substantial con-tribution through the activities of its employees to themanufacture of the property. The proposed regulationsprovided a nonexclusive list of activities to be consid-ered in determining whether the CFC satisfies the sub-stantial contribution test.

The final regulation defines employees by referenceto Treas. reg. section 31.3121(d)-1(c). That provision,entitled ‘‘Common-Law Employees,’’ states that everyindividual is an employee if, under the usual common-law rules, the relationship between him and the personfor whom he performs services is the legal relationshipof employer and employee. It continues by stating thatgenerally, such a relationship exists when the personfor whom services are performed has the right to con-

trol and direct the individual who performs the serv-ices, not only as to the result to be accomplished bythe work but also as to the details and means by whichthat result is accomplished. That is, the regulationstates, an employee is subject to the will and control ofthe employer and not only as to what will be done buthow it will be done.

It is not necessary under that provision that the em-ployer direct or control the manner in which the serv-ices are performed; it is sufficient if he has the right todo so.

The right to discharge is also an important factorindicating that the person possessing that right is anemployer. Other factors characteristic of an employer,but not necessarily present in every case, are the fur-nishing of tools, and the furnishing of a place to work,to the individual who performs the services.

If an individual is subject to the control and direc-tion of another merely as to the result to be accom-plished by the work and not as to the means andmethods for accomplishing the result, he generally isan independent contractor. An individual performingservices as an independent contractor is not as to thoseservices an employee under the usual common-lawrules. Whether the relationship of an employer andemployee exists will be determined upon an examina-tion of the facts of each case.

The IRS and Treasury state that this clarification ofthe term ‘‘employee’’ will promote more effective appli-cation of the contract manufacturing regulations. TheIRS and Treasury believe that the activities performedby certain nonpayroll workers should be considered indetermining whether a CFC provides a substantial con-tribution through its employees. The IRS and Treasuryconcluded that it would be inappropriate to broadenthe definition of employee to include anyone in anagency relationship with the CFC, because it could

James P. Fuller is an attorney and a partner at Fenwick & West in Mountain View, Calif.


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create unintended branch rule issues for taxpayers (forexample, as a result of employees of a contract manu-facturer being treated as employees of the CFC undersuch a definition).1

Thus, the final regulations, the preamble states, pro-vide that employee means any individual who underTreas. reg. section 31.3121(d)-1(c) has the status of anemployee for U.S. federal income tax purposes. Thisdefinition of the term ‘‘employee’’ may encompasssome seconded workers, part-time workers, workers onthe payroll of a related employment company whoseactivities are directed and controlled by CFC em-ployees, and contractors, so long as those individualsare deemed to be employees of the CFC under Treas.reg. section 31.3121(d)-1(c).

The preamble notes that this definition may result inan individual being treated as an employee of two ormore entities simultaneously.

Substantial Contribution Activities

The substantial contribution activities, that is, thenonexclusive list of activities that will be considered indetermining whether manufacturing takes place, are atthe heart of the new regulation. They were rewordedsomewhat and are set forth below:

1. Oversight and direction of the activities orprocesses pursuant to which the property ismanufactured, produced, or constructed (underthe ‘‘physical manufacturing’’ rules).

2. Activities that are considered in, but that areinsufficient to satisfy, the tests for ‘‘physicalmanufacturing.’’

3. Material selection, vendor selection, or controlof the raw materials, work-in-process, or finishedgoods.

4. Management of manufacturing costs or capa-bilities (for example, managing the risk of loss,cost reduction, or efficiency initiatives associatedwith the manufacturing process, demand plan-ning, production scheduling, or hedging raw ma-terial costs).

5. Control of manufacturing-related logistics.

6. Quality control (for example, sample testing orestablishment of quality control standards).

7. Developing, or directing the use or develop-ment of, product design and design specifications,as well as trade secrets, technology, or other intel-lectual property for the purpose of manufactur-ing, producing, or constructing the personal prop-erty.

Under Treas. reg. section 1.954-3(a)(4)(iv)(c), allCFC employee functions contributing to the manufac-ture of the personal property will be considered in theaggregate when determining whether a substantial con-tribution is made to the manufacture of the personalproperty through the activities of the CFC’s employees.There is no single activity that will be accorded moreweight than any other activity in every case or that willbe required to be performed in all cases. There is nominimum threshold for functions performed by em-ployees of a CFC before the functions regarding agiven activity may be taken into account as part of thesubstantial contribution test. Therefore, all functionsperformed by a CFC’s employees are considered (andgiven appropriate weight) under the substantial contri-bution test, even if the CFC’s employees perform onlysome of the functions in connection with any one ac-tivity (for example, some of the vendor selection) con-sidered under that test.

The weight given to any functions performed by em-ployees of the CFC regarding any activity will bebased on the economic significance of those functionsto the manufacture, production, or construction of therelevant personal property and will vary with the factsand circumstances. Only activities of the CFC’s em-ployees are considered in the substantial contributionanalysis, and, consequently, purely contractual assump-tions of risk are not considered in the substantial con-tribution analysis. A CFC will not be precluded frommaking a substantial contribution simply because otherpersons make a substantial contribution to the manu-facture, production, or construction of that property.

The importance of oversight and direction of theactivities or processes under which personal property ismanufactured, produced, or constructed will varybased on the facts and circumstances associated withthe manufacture, production, or construction at issue.The preamble states that oversight and direction of theactivities or process under which personal property ismanufactured are likely to be important elements inmany substantial contribution analyses. In some indus-tries, a substantial contribution could be made by aCFC without its employees engaging in oversight anddirection of the activities or process under which per-sonal property is manufactured.

Since the regulations provide that only activities ofthe CFC’s employees are considered in the analysis,mere contractual rights, legal title, tax ownership, orassumption of economic risk are not considered in thesubstantial contribution analysis. The CFC does notneed to own the raw materials that are used in themanufacturing process.

The proposed regulations used the term ‘‘manage-ment of the manufacturing profits.’’ The IRS and Treas-ury intend that the substantial contribution test recog-nize contributions made by a CFC’s employees to themanufacturing process through functions that help en-sure a plant is run in an economically efficient manner,

1See below for a discussion of the possible effects of this newrule under the temporary branch rule regulations.

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such as optimization of plan capacity and reduction ofwaste (for example, waste of raw materials). However,not all corporate managerial decisions are intended tobe considered in the substantial contribution test, be-cause they may not be directly related to the manufac-ture of the personal property. For example, the IRSand Treasury do not intend that corporate finance deci-sions be considered in the substantial contribution test.Similarly, the IRS and Treasury do not intend that thegeneral management of enterprise risk be considered inthe substantial contribution test.

In considering logistics, the activity is intended toinclude, for example, arranging for delivery of raw ma-terials to a contract manufacturer, but to exclude deliv-ery of finished goods to a customer. Thus, the finalregulations revised the activities’ description to read‘‘control of manufacturing related logistics.’’

Changes were made in the ‘‘use of trade secrets’’provision (number 7 above) to clarify that developing,or directing the use or development of, trade secrets,technology, or other intellectual property are consid-ered under the substantial contribution test, but onlywhen activities of this nature are undertaken for thepurpose of the manufacture of the personal property.

The term ‘‘protection’’ regarding trade secrets wasdeleted. The IRS and Treasury were concerned thatabsent this clarification, the final regulations could readto provide that legal work performed by a CFC’s in-house legal staff was considered under the substantialcontribution test, including in cases in which, for ex-ample, litigation success could be heavily correlated toprofitability or business failure regarding a product.

The activity as described in both the proposed andfinal regulations concerns intellectual property used inthe manufacture of the personal property. Thus, devel-oping, or directing the use or development of, market-ing intangibles is not intended to be considered in thesubstantial contribution test.

Other Matters

The IRS and Treasury had requested comments onwhether the substantial contribution test should includean antiabuse rule and safe harbor. In particular, com-ments were requested as to whether it would be appro-priate to add an antiabuse rule to prevent a CFC fromsatisfying the substantial contribution test when a sig-nificant part of the direct or indirect contributions tothe manufacture of personal property provided collec-tively by the CFC and any related U.S. persons are pro-vided by one or more related U.S. persons. Commenta-tors recommended that in determining whether a CFCmakes a substantial contribution, it should not be rel-evant whether other persons (whether U.S. or foreign,related or unrelated) contribute to the manufacturingprocess. The IRS and Treasury agreed with those com-mentators. Thus, the final regulations do not adopt anantiabuse rule.

The IRS and Treasury also concluded that no safeharbor could fairly apply across the range of industriespotentially subject to these contract manufacturingrules, and therefore no safe harbor was provided in thefinal regulations.

A CFC may provide asubstantial contribution toa largely automatedmanufacturing processthrough its employees.

Commentators requested that the regulations adoptprinciples to determine when the employees of a part-nership should be treated as employees of the CFC forpurposes of determining whether the CFC’s relativeeconomic interest in the partnership should be relevantto determining whether the CFC satisfies the substan-tial contribution test. The IRS and Treasury concludedthat this issue was beyond the scope of the regulatoryproject, but they continue to study the issue and wel-come comments. Thus, the final regulation providesonly that a CFC’s distributive share of income of apartnership will be considered earned from productsmanufactured, produced, or constructed by the CFConly if the manufacturing exception would have ap-plied to exclude the income from subpart F income ifthe CFC had earned the income directly, determinedby taking into account only the activities of the em-ployees of, and the property owned by, the partnership.

The proposed regulations contained a rebuttable pre-sumption that a CFC does not satisfy the substantialcontribution test when the activities of a branch of theCFC satisfy the physical manufacturing test. In re-sponse to comments, the IRS and Treasury concludedthat the substantial contribution test can be adminis-tered without the benefit of a rebuttable presumption,and the final regulations do not contain this rebuttablepresumption.

Automated manufacturing (Example 4 in the pro-posed regulations) was the subject of significant com-ment. A number of examples were added to clarifythat a CFC may provide a substantial contribution to alargely automated manufacturing process through itsemployees. The examples are discussed below.

The IRS and Treasury generally agreed with com-mentators that if the substantial contribution test issufficient to constitute the manufacture of the personalproperty where a CFC substantially contributes to themanufacture, production, or construction of that prop-erty, then it should be equally sufficient if those activi-ties are performed by a related person in the CFC’s

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country of organization. Therefore, the final regula-tions provide that the same-country manufacturing ex-ception is available to taxpayers in cases when a relatedperson provides a substantial contribution to the manu-facture of the personal property in the CFC’s countryof organization. The final regulations also retain therule provided in the proposed regulations to reflect thatpersonal property manufactured, produced, or con-structed in the country of organization of the sellingcorporation will qualify for the same country exceptionregardless of whose employees engage in the qualifyingmanufacturing activities in that country.

The IRS and Treasury continue to believe, as de-scribed in the preamble to the proposed regulations,that the so-called ‘‘its’’ argument is contrary to existinglaw and represents an incorrect reading of section954(d)(1). Thus, despite some criticism by commenta-tors and at the hearings on the proposed regulations,the final regulations maintain the rules provided in theproposed regulations regarding when personal propertysold by a CFC will be considered to be other than theproperty purchased by the CFC: ‘‘A controlled foreigncorporation will not be treated as having manufactured,produced, or constructed personal property which thecorporation sells merely because the property is sold ina different form than the form in which it was pur-chased.’’

Examples

Example 1

FS, the CFC in question, does not exercise, throughits employees, its powers to control the raw materials,work in process, or finished goods, and FS also doesnot exercise its powers of oversight and direction. Like-wise, FS does not through its employees, develop, ordirect the use or development of the intellectual prop-erty for the purpose of manufacturing Product X. FSdoes not satisfy the substantial contribution test.

Example 2

The facts are the same as in Example 1, except thatFS, through its employees, engages in product designand quality control and controls manufacturing-relatedlogistics. FS’s employees exercise the right to overseeand direct the activities of the third-party contractmanufacturer in the production of Product X. FS satis-fies the substantial contribution test.

Example 3

FS, a CFC, enters into a contract with an unrelatedcontract manufacturer to produce Product X. Employ-ees of FS select the materials that will be used tomanufacture the product. FS does not own the materi-als or work-in-process during the manufacturing pro-cess. FS, through its employees, exercises oversight anddirection of the manufacturing process and providesquality control. FS manages the manufacturing costsand capabilities of the product by managing the risk of

loss and engaging in demand planning and productionscheduling. FS satisfies the substantial contributiontest.

Example 4

FS purchases raw materials from a related person.They are manufactured into Product X by an unrelatedcontract manufacturer under an agreement. The con-tract manufacturer contracts with another corporationfor its employees to operate the contract manufacturer’splant and transform, assemble, or convert the raw ma-terials into Product X. Apart from physical perform-ance of the substantial transformation, assembly, orconversion of the raw materials into Product X, em-ployees of FS perform all of the other manufacturingactivities required in connection with the manufactureof Product X (for example, oversight and direction ofthe manufacturing process; vendor selection; control ofraw materials, work-in-process and finished goods; con-trol of manufacturing-related logistics; and qualify con-trol). FS satisfies the substantial contribution test.

Example 5

FS purchases raw materials from a related person.The raw materials are manufactured into Product X byan unrelated contract manufacturer selected by FS. Atall times, FS retains ownership of the raw materials,work-in-process, and finished goods. FS retains theright to oversee and direct the activities or process ac-cording to which the product is manufactured, but doesnot exercise, through its employees, its powers of over-sight and direction. FS is the owner of sophisticatedsoftware and network systems that remotely and auto-matically (without human involvement) take orders,route them to the contract manufacturer, order raw ma-terials, and perform quality control. FS has a smallnumber of computer technicians who monitor the soft-ware and network systems to ensure that they are run-ning smoothly and apply any necessary patches orfixes. The software and systems were developed by em-ployees of the U.S. parent company. The parent com-pany’s employees supervise the computer technicians,evaluate the results of the automated manufacturingbusiness, and make operational and manufacturing de-cisions. The parent’s employees develop and provide toFS all of the upgrades to the software and networksystems. The parent’s employees also direct and controlother aspects of the manufacturing process such asvendor material selection, management of the manu-facturing costs and capabilities, and the selection of thecontract manufacturer. FS does not satisfy the substan-tial contribution test.

Example 6

Assume the same facts as in Example 5, except thatFS, through its employees, engages in the activities under-taken by the parent’s employees in Example 5. Theparent’s employees also contribute to product andmanufacturing process design and provide support and

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oversight to FS in connection with the functions per-formed by FS through its employees. FS satisfies thesubstantial contribution test. Selection of the contractmanufacturer, even though not specifically identified onthe nonexclusive factors list, is considered in determin-ing whether FS makes a substantial contribution to themanufacture of Product X through its employees.

Example 7Assume the same facts as in Example 6, except that

the software and network systems, and the upgrades tothose systems, were purchased by FS rather than devel-oped by employees of FS. FS satisfies the substantialcontribution test. The lack of performance of softwareand network system development activities is not deter-minative under the facts and circumstances of the busi-ness. Further, this determination does not require acomparison between the activities of FS and the activi-ties of the domestic parent.

Example 8FS has raw materials manufactured into Product X

by an unrelated contract manufacturer. FS controls theraw materials, work-in-process, and finished goods. FScontrols the manufacturing-related logistics, managesthe manufacturing costs and capabilities, and providesquality control for the contract manufacturer’s manu-facturing process and product. No intellectual propertyof significant value is required to manufacture theproduct. FS does not own any intellectual property orhold an exclusive or nonexclusive right to manufactureProduct X. FS satisfies the substantial contribution test.

Example 9FS1 and FS2, unrelated CFCs, contract with an un-

related contract manufacturer to manufacture ProductX. Neither FS1 nor FS2 owns the materials or work-in-process during the manufacturing. FS1, through its em-ployees, designs Product X. FS1 directs the use of theproduct design and design specifications and other in-tellectual property for the purpose of manufacturingProduct X. Employees of FS1 also select the materialsthat will be used in the manufacture of the productand the vendors to provide those materials. FS2,through its employees, designs the process for manufac-turing Product X. FS2, through its employees, managesthe manufacturing costs and capabilities for Product X.FS1 and FS2 each provide quality control and over-sight and direction of the contract manufacturer’smanufacturing activities for different aspects of themanufacture of Product X. Both FS1 and FS2 satisfythe substantial contribution test. Each independentlymakes a substantial contribution through the activitiesof its employees for the manufacture of the product.

Example 10

FS purchases raw materials and has them manufac-tured into Product X by an unrelated contract manu-facturer. Products in the X industry are distinguished(and vary widely in value) based on the raw materialsused to make the product and the product design. FS

designs the product and selects the materials that thecontract manufacturer will use to manufacture theproduct. FS also manages the manufacturing costs andcapabilities. Product X can be manufactured from theraw materials to FS’s design and specifications withoutsignificant oversight and direction, quality control, orcontrol of manufacturing-related logistics. The activitiesmost relevant to the substantial contribution analysisunder these facts are material selection, product design,and management of the manufacturing costs and capa-bilities. FS makes a substantial contribution throughthe activities of its employees to the manufacture ofthe product.

Example 11

FS purchases raw materials and has them manufac-tured into Product X by an unrelated contract manu-facturer. FS controls the raw material, work-in-process,and finished goods; manages the manufacturing costsand capabilities; and provides oversight and directionof the manufacture of Product X. Employees of FSvisit the manufacturer’s facility for one week eachquarter and perform quality control tests on a randomsample of the units of Product X produced during theweek. In the industry, quarterly visits to a manufactur-ing facility by qualified persons are sufficient to controlthe quality of manufacturing. FS satisfies the substan-tial contribution test.

Manufacturing Branch RulesThe manufacturing branch rule regulations that were

proposed with the contract manufacturing regulationswere adopted as temporary regulations. (For the pro-posed regulations, see Doc 2008-27116 or 2008 WTD 249-35.) Treasury and the IRS presumably concluded thatthere were sufficient changes in these regulations suchthat they should be issued in temporary form and alsoreproposed. A public hearing has been scheduled forthe proposed version of these regulations on April 20,2009. The temporary regulations apply to tax years ofCFCs beginning after June 30, 2009, and for tax yearsof U.S. shareholders in which these tax years of CFCsend. As discussed above, the temporary regulationsunder some conditions may be applied retroactively bya taxpayer for its open tax years.

Branch Definition: Important IssuesThe proposed regulations did not define the term

‘‘branch.’’ Some commentators suggested that the regu-lations define the term. These commentators suggestedvarious definitions for the IRS and Treasury to con-sider. Some commentators suggested, for example, thata branch be defined as a permanent establishment, as abusiness activity in a jurisdiction outside a CFC’scountry of organization that has separate books andrecords, or as a trade or business outside a CFC’scountry of organization. Commentators pointed to pre-cedents in the section 367 and section 987 regulations.Alternatively, some commentators requested that the

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regulations make clear that a de minimis amount ofactivity outside a CFC’s country of organization (forexample, traveling employees) does not constitute abranch.

Other commentators warned that requiring too higha level of activity outside a CFC’s country of organi-zation before a CFC is treated as having a branchwould make it possible for a CFC organized in alower-taxed jurisdiction to contribute substantially tomanufacturing activities in a higher-tier jurisdictionwithout causing the CFC to operate through a branch.Still other commentators suggested that courts haveconcluded that the IRS and Treasury lack the regula-tory authority to determine what constitutes a branch,and that they may address only the consequences flow-ing from the existence of a branch.

The IRS and Treasury determined that defining abranch was beyond the scope of this regulatory project.However, the temporary regulations retain an examplesimilar to an example in the proposed regulations thatillustrates that employees of a CFC that travel to acontract manufacturer’s location outside the CFC’scountry of organization do not necessarily give rise toa branch in that location.

An important issue in this regard, however, was leftunstated and unaddressed in both the branch rule regu-lations and the preamble to those regulations. The con-tract manufacturing regulations define ‘‘employee’’ byreference to section 3121. The branch rule regulationsare silent on this point.2

If employees of one corporate entity (Corp B) canbe treated as a branch of another corporate entity,Corp A, so that Corp A has a branch in Country Bsimply because an IRS examining agent contends thatCorp A’s employees have section 3121 control overCorp B’s employees, then the new branch rule is muchdifferent from the old branch rule.

Ashland Oil and Vetco may have been overruled, or atleast placed in question. There is no reason this look-through, if it is the rule, couldn’t apply to unrelatedpersons, as well as related persons. It also has nothingnecessarily to do with contract manufacturing; this rulealso presumably could apply in other branch rule con-texts, for example, under the sales branch rule.

Should it make a difference whether it is the tax-payer who asserts that certain persons are employeesfor purposes of the contract manufacturing rules, orcan IRS examining agents on their own make that as-sertion? Could one such ‘‘employee’’ constitute abranch, or does it require many ‘‘employees’’?

The court in Ashland Oil considered the dictionarydefinition of branch (‘‘division, office or other unit ofbusiness located at a different location from the main

office or headquarters’’; a business dictionary similarlystated an ‘‘office’’ in a different location from the ‘‘par-ent company.’’)

The court in Ashland stated that regardless of theprecise ordinary meaning of branch, the court wasconfident that it didn’t encompass Tensia, an unrelatedcorporation operating under an arm’s-length contrac-tual arrangement with the taxpayer’s CFC.

Until this treatment of ‘‘employees’’ is made clearerunder the branch rule regulations, it might be a reasonnot to apply the contract manufacturing regulationsretroactively. To do so, the branch rule regulations alsomust be applied retroactively.

Also, a recent statement by an IRS spokespersonraises more questions. It was to the effect that a salesbranch might exist even in the absence of selling activi-ties: ‘‘If a branch is booking sales income, the IRS willargue that it is a sales branch.’’ I certainly do not seesuch a rule anywhere in the regulations, where sellingactivity is necessary to have a sales branch. It seems atodds with the court’s discussion in Ashland Oil as wellas the statutory language. To be consistent with Ash-land Oil and section 954(d), a branch would need to bepresent before this could arise. But that was not thequestion being addressed. The statement was in re-sponse to a question about whether the existence of asales branch is based on earning income or sales activi-ties. We may have some new rules.

Hypothetical Effective Tax RateThe tax rate disparity tests take into account the

actual tax rate paid on the sales income by the sellingbranch or remainder and the hypothetical effective taxrate that would be paid by the manufacturing branch(or remainder) on that sales income under the rules ofthe country in which the manufacturing branch is lo-cated (or, in the case of a remainder, the country oforganization of the CFC) if it were derived from thesources within that country. The IRS and Treasuryagreed with commentators that uniformly available taxincentives are to be considered in determining the hy-pothetical effective tax rate to be used in applying thetax rate disparity tests.

On the other hand, if a sales affiliate in the countryof manufacturing can theoretically receive certain taxrelief by taking certain actions, for example, by apply-ing for special treatment under a ruling process, but thetaxpayer has not affirmatively obtained that tax relieffor the manufacturing branch (or a remainder), thenthe hypothetical effective tax rate that would be paidby the manufacturing branch (or remainder) were it toderive the sales income should be the effective tax ratethat would be applicable in that jurisdiction withoutsuch relief.

The IRS and Treasury state that no change to thetext of the existing regulation is necessary to addressthese points. However, a new Example 8 is included inthe temporary regulations to illustrate that uniformly2See, however, note 1, supra.

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applicable incentive tax rates are taken into account indetermining the hypothetical effective tax rate.

Location of ManufacturingUnder the proposed regulations, the relevant tax rate

disparity test was applied by giving satisfaction of thephysical manufacturing test precedence over satisfac-tion of the substantial contribution test when multiplebranches, or one or more branches and the remainderof the CFC, perform manufacturing activities for thesame item of personal property.

If more than one branch (or one or more branchesand the remainder of the CFC) each independentlysatisfies the physical manufacturing test, then thebranch or the remainder of the CFC located or organ-ized in the jurisdiction that would impose the lowesteffective rate of tax is treated as the location of manu-facturing, producing, or constructing the personal prop-erty for purposes of applying the tax rate disparitytests.

If none of the branches or the remainder of theCFC independently satisfies the physical manufacturingtest, but the CFC as a whole satisfies the substantialcontribution test, then under the proposed regulations,the location of manufacturing was the location of thebranch or the remainder of the CFC that provides thepredominant amount of the CFC’s substantial contri-bution to the manufacturing of the personal property.If a predominant amount of the CFC’s contribution isnot provided by any one location, then under the pro-posed regulations, the location of manufacturing forpurposes of applying the manufacturing branch taxrate disparity test was that place (either the remainderof the CFC or one of its branches) where the manufac-turing activity for that property is performed and thatwould impose the highest effective tax rate.

Commentators suggested that the same rule shouldapply consistently when a branch (or remainder) inde-pendently satisfies the manufacturing test, regardless ofwhether it satisfies the physical manufacturing test orthe substantial contribution test. The IRS and Treasuryagree. Therefore, the rules in the proposed regulationswere modified. The temporary regulations provide thatthe lowest-of-all-rates rule will apply whenever abranch (or remainder) independently satisfies themanufacturing test.

The IRS and Treasury also believe, however, thatproviding for parity of treatment for satisfaction of thephysical manufacturing test and the substantial contri-bution test regarding the lowest-of-all-rates rule is notsufficient to determine the location of manufacturingin cases in which a CFC satisfies the substantial contri-bution test, yet no branch (or remainder) independentlysatisfies the substantial contribution test.

The temporary regulations thus revise the rules fordetermining the location of manufacture of the per-sonal property when more than one branch (or one ormore branches and the remainder) contributes to the

manufacture of the personal property, but no branch(or remainder) independently satisfies the physicalmanufacturing test or the substantial contribution test.

If a demonstrably greater amount of manufacturingactivity regarding personal property occurs in jurisdic-tions without tax rate disparity relative to the sales orpurchase branch, the location of the sales or purchasebranch will be deemed to be the location of manufac-ture of the personal property. Otherwise, the locationof manufacture of the personal property will bedeemed to be the location of a manufacturing branch(or remainder) that has tax rate disparity relative to thesales or purchase branch.

The location of any activitywith respect to themanufacture of thepersonal property is wherethe CFC’s employeesengage in that activity.

The location of any activity for the manufacture ofthe personal property is where the CFC’s employeesengage in that activity. When an employee travels toperform his or her activities, those activities arecredited to the location in which the activities are con-ducted if there is a branch or remainder of the CFC inthat jurisdiction. The activities of employees while trav-eling to a country with a CFC that does not maintaina branch or remainder are not credited to the branch orremainder where the traveling employees are regularlyemployed for purposes of determining the location ofmanufacturing under the branch rule. Those activities,however, can be taken into account for purposes ofsatisfying the manufacturing exception and the substan-tial contribution test.

Multiple Manufacturing Branch Rules Summary

In summary, the rules for multiple locations per-forming activities that contribute to the manufacture ofthe product are as follows:

1. If one or more branches or the remainder ofthe CFC independently satisfies the manufactur-ing test, the location of manufacturing is thebranch with the lowest effective rate of tax on theincome allocated to the remainder for branch ruletesting purposes.

2. If no location independently satisfies themanufacturing test, but the CFC as a wholemakes a substantial contribution to the manufac-ture of personal property, then the location of

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manufacturing is the tested manufacturing loca-tion unless the tested sales location provides ademonstrably greater contribution to the manu-facture of the property.

3. The tested manufacturing location is the loca-tion of any branch or remainder that contributesto the manufacture of the property and thatwould be treated as a separate corporation underthe tax rate disparity test and that would have thelowest effective rate of tax under the tax rate dis-parity test.

4. The tested sales location is where the CFCpurchases or sells the personal property. Thetested sales location includes the activities of anybranch or remainder that would not be treated asa separate corporation under the tax rate dispar-ity test.

5. The tested manufacturing location will bedeemed to include the activities of any branch orremainder that would be treated as a separatecorporation from the tested sales location underthe tax rate disparity test.

6. If the tested sales location provides a demon-strably greater contribution to the manufacturing,or if there is no tested manufacturing location,then the tested sales location is the location ofmanufacturing.

Coordination of Branch RulesThe current manufacturing branch rule contemplates

the existence of a sales or purchase branch and amanufacturing branch. The rules provide that in someinstances, the sales or purchase branch is treated as theremainder of the CFC for purposes of applying the taxrate disparity test. However, the sales or purchasebranch rules of the existing regulations do not indicatethat those rules do not apply in cases in which themanufacturing branch rules are applied. Treasury andthe IRS believe that if one or more sales or purchasebranches are used in addition to a manufacturingbranch, and the manufacturing branch rule’s multiplebranch rule test is applied for income from the sale ofan item of personal property, then the sales or purchas-ing branch rules should not apply to determinewhether that income is foreign base company sales in-come (FBCSI). The temporary regulations reflect thisnew clarifying coordination rule.

Unrelated to Unrelated TransactionsCommentators suggested that there was uncertainty

as to whether a substantial contribution to the manu-facture, production, or construction of personal prop-erty by a CFC could cause the CFC to earn FBCSI incases when, in the absence of the substantial contribu-tion test, some taxpayers had taken the position thatthey were outside the scope of the FBCSI rules. Forexample, the CFC might purchase property from unre-lated persons and sell that property to unrelated per-

sons. Some commentators expressed concern thattransactions that are not currently subject to the exist-ing regulations may become subject to the regulationsas a result of the interaction of the substantial contri-bution test and the manufacturing branch rule. Othercommentators suggested more generally that it was un-clear if the substantial contribution test might create abranch through which a CFC carries on activities in acontract manufacturer’s jurisdiction.

The IRS and Treasury agree that taxpayers may besubject to the FBCSI rules as a result of CFC em-ployees performing indicia of manufacturing activitiesthrough a branch outside the country of organizationof the CFC. The IRS and Treasury believe this result isclear in the proposed regulations, and therefore nomodifications are made to the text of the temporaryregulations to further clarify this result.

The IRS and Treasury note in the preamble that inresponse to comments, physical manufacturing andactivities satisfying the substantial contribution test aretreated with equal importance. Thus, the IRS and Treas-ury did not incorporate in the temporary regulationsan exception for activities performed through a branchlocated outside the country of organization of a CFCfor cases in which, in the absence of the substantialcontribution test, some taxpayers have taken the posi-tion that they were outside the scope of the FBCSIrules.

One commenter recommended that the IRS andTreasury consider a special delayed effective date toallow taxpayers with unrelated to unrelated transac-tions that may now become subject to the FBCSI rulestime to restructure their operations in light of the regu-lations. The commenter argued that these taxpayerswere outside the scope of the FBCSI rules before adop-tion of these regulations and should be providedenough time to restructure. A special effective date wasnot provided, but the temporary regulations generallyhave a delayed effective date.

Examples

I will describe the regulation’s examples in the orderin which they appear in the temporary regulation, andI will not renumber them. This hopefully will helpreaders match up the examples with the text in theregulation. Unless stated otherwise, FS is a CFC organ-ized under the laws of Country M.

1. Example — Figure 1

FS operates three branches. Branch A in Country Amanufactures Product X. Branch B located in CountryB sells Product X manufactured by Branch A to cus-tomers for use outside Country B. Branch C located inCountry C sells Product X manufactured by Branch Ato customers for use outside Country C. FS conductsno manufacturing or selling activities of its own. Coun-try M imposes an effective tax rate on sales income of0 percent. Country A imposes an effective tax rate on

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sales income of 20 percent. Country B imposes an ef-fective tax rate on sales income of 20 percent. CountryC imposes an effective tax rate on sales income of 18percent. The manufacturing branch rule is applied tothe sales income derived by Branch B by treatingBranch B as though it alone were the remainder of theCFC. The use of Branch B does not have the same taxeffect as if Branch B were a wholly owned subsidiary,because the tax rate applicable to income allocated toBranch B (20 percent) is not less than 90 percent of,and at least 5 percentage points less than, the effectiverate of tax that would apply to that income under thelaws of Country A (20 percent). The rules are appliedseparately to the sales income derived by Branch C bytreating Branch C as though it alone were the remain-der of the CFC. The use of Branch C also does nothave the tainted tax effect under the rate disparity test.Under the temporary regulation’s new coordinationrule, the sales branch rules do not apply. (See Figure1.)

2. Example — Figure 2

FS purchases raw materials and sells finished prod-ucts. FS is subject to a 10 percent tax rate on its salesincome. It has two branches, A, which makes ProductX, and B, which makes Product Y. A’s country taxessales at 20 percent, and B’s country taxes sales at 12percent. As to Branch A, the branch rule applies, andA is treated as a separate corporation. As to B, thebranch rule does not cause B to be treated as a sepa-rate corporation. (See Figure 2.)

3. Example 1 — Figure 3

FS has three branches. Branch A located in CountryA designs Product X. Branch B located in Country Bprovides quality control and oversight and direction.Branch C physically manufactures Product X. Theactivities of Branch A and Branch B do not inde-pendently satisfy the manufacturing rules. Employees

of FS in Country M purchase the raw materials usedin the manufacture of Product X from a related personand control the work-in-process and finished goodsthroughout the manufacturing process. Employees ofFS in Country M also manage the manufacturing costand capabilities and oversee the coordination betweenthe branches. Employees of FS in Country M sellProduct X to unrelated persons for use outside Coun-try M. The sales income from the sale of Product X istaxed in Country M at an effective rate of 10 percent.Country C imposes an effective rate of tax of 20 per-cent on sales income.

Country C is the location of manufacture for pur-poses of applying the branch rule tests, because onlythe activities of Branch C independently satisfy themanufacturing rules. Under the branch rule tax ratedisparity test, Branch C is treated as a separate corpo-ration. Therefore, sales of Product X by the remainderof FS are treated as sales on behalf of Branch C. Indetermining whether the remainder of FS will qualifyfor the manufacturing exception, the activities of FSwill include the activities of Branch A and Branch B,respectively, if each of those branches would not betreated as a separate corporation under the tax ratedisparity test. (See Figure 3.)

4. Example 2 — See Figure 3.

Assume the same facts in Example 1 (3. above), ex-cept that in addition to the design of Product X,Branch A also performs in Country A other manufac-turing activities, including those ascribed to FS in Ex-ample 1 that are sufficient to satisfy the substantialcontribution test. Country A imposes a 12 percent taxon sales income. Branch A and Branch C through theiractivities each independently satisfy the manufacturingtest. Therefore, the branch rule is applied using the

FS

A B C

Does not Mfg or Sell

20%

Mfgs

20% 18%

Sells Sells

Figure 1

FS

A B

Sells X and Y

20%

Product

X

12%

Product

Y

10%

Figure 2

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lowest effective tax rate that would apply to sales in-come in either Country A or Country C. Therefore,Branch A is treated as the location of manufacture.Neither Branch A nor Branch C is treated as a separatecorporation. Sales of Product X by the remainder ofFS are not treated as made on behalf of any branch.

5. Example 3 — Figure 5FS purchases from a related person raw materials

that are manufactured into Product X by an unrelatedcorporation under a contract manufacturing agreement.FS has two branches. Branch A located in Country Adesigns Product X. Branch B in Country B controlsmanufacturing-related logistics, provides oversight anddirection during the manufacturing process, and con-trols the raw materials and work-in-process. FS man-ages the manufacturing costs and capabilities related tothe manufacture of Product X through employees lo-cated in Country M. Employees of FS located inCountry M oversee the coordination between thebranches. Employees of FS located in Country M alsosell Product X to unrelated persons for use outsideCountry M. Country M imposes an effective tax rateon sales income of 10 percent. Country A imposes aneffective rate of tax on sales income of 20 percent, andCountry B imposes an effective rate of tax on salesincome of 24 percent. Neither the remainder of FS norany branch of FS independently satisfies the manufac-turing test. As a whole, FS provides a substantial con-tribution to the manufacture of Product X.

The tested sales location is Country M. The locationof Branch A is the tested manufacturing location, be-cause the effective rate of tax (10 percent) is less than90 percent of, and at least five percentage points less

than, the effective rate of tax that would apply to thisincome in Country A (20 percent), and Country A hasthe lowest effective rate of tax among the manufactur-ing branches that would be treated as separate corpora-tions. The activities of Branch B will be included in thecontribution of Branch A for purposes of determiningthe location of manufacture, because Branch B wouldalso be treated as a corporation separate from FS un-der the tax rate disparity test. The activities of the re-mainder of FS would not provide a demonstrablygreater contribution to the manufacture of Product Xthan the activities of Branch A and Branch B consid-ered together. Therefore, the location of manufacture isCountry A, the location of Branch A. (See Figure 5.)


The facts are the same as in Example 3 (5. above),except that the effective rate of tax on sales income inCountry B is 12 percent. Also, the activities of employ-ees of FS located in Country B and Country M, ifconsidered together, provide a demonstrably greatercontribution to the manufacture of Product X than theactivities of employees of FS located in Country A.The tested sales location is Country M. The location ofBranch A is the tested manufacturing location becauseof the tax rate disparity and the fact that Branch A isthe only branch that would be treated as a separatecorporation. The activities of Branch B will be consid-ered in the contribution of the remainder of FS forpurposes of determining the location of manufactureof Product X, because there is no tax rate disparity.Since the activities of Branch X and the remainder ofFS provide a demonstrably greater contribution to themanufacture of Product X than the activities of Branch

FS

A B C

Purchases RM

Controls inventories

Manages cost/capabilities

Oversees

10% tax

Designs X

20% tax

Location

of Mfg

QC

OversightPhysical

Mfg X

Sells

Figure 3

manufacturing

FS

A B

10% tax

manages

oversees

design

20%

Location

of MFG

oversight

24%

CM

Figure 5

ManagesOversees

OversightDesign

of Mfg

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B, neither Branch A nor Branch B will be treated as aseparate corporation. (See Figure 6.)


The facts are the same as in Example 3 (5. above),except that selling activities are also performed byBranch D in Country D, where Country D imposes a16 percent effective rate of tax on sales income. Also,the activities of FS located in Country A and CountryM, considered together, provide a demonstrably greatercontribution to the manufacture of Product X than theactivities of employees of FS located in Country B.

The results for the remainder of FS are the same asin Example 3: A is treated as a separate corporation.

These rules also must be applied regarding BranchD because it performs selling activities for Product X.

Thus, for purposes of that sales income, the location ofBranch D is the tested sales location. The location ofBranch B is the tested manufacturing location becausethere is a tax rate disparity between Country D andCountry B, and Branch B is the only branch thatwould be treated as a separate corporation. The manu-facturing activities performed in Country M by the re-mainder of FS and the manufacturing activities per-formed in Country A by Branch A will be included inBranch D’s contribution to the manufacture of ProductX for purposes of determining the location of manu-facture of Product X regarding Branch D’s sales in-come. Branch D, Branch A, and the remainder of FS,considered together, provide a demonstrably greatercontribution to the manufacture of Product X than theactivities of Branch B. Therefore, the branch rules willnot apply to Branch D, and neither Branch A norBranch D will be treated as a separate corporation.(See Figure 7.)


FS purchases from a related person raw materialsthat are manufactured into Product X by an unrelatedcontract manufacturer (CM). CM physically manufac-tures the goods in Country C. Employees of FS lo-cated in Country M sell Product X to unrelated per-sons for use outside Country M.

Employees of FS located in Country M engage inproduct design, manage the manufacturing costs andcapabilities for Product X, and direct the use of intel-lectual property for purposes of manufacturing ProductX. Quality control and oversight and direction of themanufacturing process are conducted in Country C byemployees of FS who are located in Country M butwho regularly travel to Country X. Branch A is theonly branch of FS. Product design for Product X con-ducted by employees of FS located in Country A aresupplemental to the bulk of the design work, which isdone by employees of FS located in Country M. At alltimes, employees of Branch A control the raw materi-als, work-in-process, and finished goods. Employees ofFS located in Country A also control manufacturing-related logistics for Product X. Country M imposes aneffective rate of tax on sales income of 10 percent.Country A imposes an effective rate of tax on salesincome of 20 percent. Neither the remainder of FS norBranch A independently satisfies the manufacturingtest, although FS as a whole provides a substantialcontribution to the manufactured Product X.

The tested sales location is Country M because theremainder of FS performs the selling activities regard-ing Product X. The tested manufacturing location isthe location of Branch A because there is a tax ratedisparity, and Branch A is the only branch that wouldbe treated as a separate corporation. Although the ac-tivities of traveling employees are considered in deter-mining whether FS as a whole makes a substantialcontribution, the activities of the employees of FS that

FS

A B

10%

20%

Tested Mfg

Location

12%

No branch is a

separate corp.

Same as in Example 3 (Figure 5 above), except B is 12%

tax. In addition, B and FS in country M together provide

demonstrably greater contribution than A.

Figure 6

Country

FS

A B D

10% Sells

20% 24% Sells

16%

Same as in Example 3 (Figure 5 above) except

Branch D sells.

Figure 7

Sells

Sells

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are performed in Country C are not taken into consid-eration in determining whether Country M, the juris-diction under the laws of which FS is organized, is thelocation of manufacture. The activities of employees ofFS performed in Country M do not provide a demon-strably greater contribution to the manufacture ofProduct X than the activities of employees of FS lo-cated in Country A. Therefore, the location of manu-facture is Country A. (See Figure 8.)

9. Example 3 — Figure 9This is an example in the current regulations that is

modified in the temporary regulations. CFC E, incor-porated under the laws of Country X, is a whollyowned subsidiary of CFC D, also incorporated underthe laws of Country X. E maintains Branch B inCountry Y. E’s sole activity, carried on through BranchB, consists of the purchase of articles manufactured inCountry X by Corporation D and the sale of thosearticles through Branch B to unrelated persons. BranchB is treated as a wholly owned subsidiary corporationof E because of a tax rate disparity. Income derived byBranch B, treated as a separate corporation, constitutesFBCSI.

If instead D were unrelated to E, none of the in-come would be FBCSI because E’s branch would bepurchasing from and selling to unrelated persons, andif Branch B were treated as a separate corporation, itlikewise would be purchasing from and selling to unre-lated persons. Alternatively, if D were related to E, but

Branch B manufactured the articles before sale, the in-come would not be FBCSI because Branch B, treatedas a separate corporation, would qualify for the manu-facturing exception. (See Figure 9.)


FS operates one branch, Branch A, that physicallymanufactures Product X. Raw materials used in themanufacture of Product X are purchased by FS froman unrelated person. FS engages in activities in Coun-try M to sell Product X to a related person for use out-side Country M. Employees of FS located in CountryM perform only sales functions. The effective rate im-posed in Country M on the income from the sale ofProduct X is 10 percent. Country A generally imposesan effective rate of tax on income of 20 percent, butimposes a uniformly applicably incentive rate of tax of10 percent on manufacturing income and related salesincome. The use of Branch A to manufacture ProductX does not have substantially the same tax effect as ifBranch A were a wholly owned subsidiary corporationof FS, because the effective rate of tax on FS’s salesincome from the sale of Product X in Country M (10percent) is not less than 90 percent of, and at least 5percentage points less than, the effective rate of taxthat would apply to that income in the country inwhich Branch A is located (10 percent). Branch A isnot treated as a separate corporation. (See Figure 10.)

FS

A

Product design, etc.

20%

Location

of MFG

employees

travel for QC

and oversight

CM

10%

Some design

controls materials

Employees travel

Country C

Figure 8

Employees

of Mfg

Employee travel

Dx

Ex

By

Figure 9

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FS has two branches, Branch A and Branch B, lo-cated in Country A and Country B, respectively. FSpurchases from a related person raw materials that arephysically manufactured into Product X by an unre-lated corporation (CM). CM manufactures the productoutside FS’s country of organization. FS managesmanufacturing costs and capacities for the manufactureof Product X through employees located in CountryM. Employees of FS located in Country M oversee thecoordination between the branches.

Branch A, through the activities of employees of FSlocated in Country A, designs Product X, controlsmanufacturing-related logistics, and controls the rawmaterials and work-in-process during manufacturing.Branch B, through activities of employees of FS lo-cated in Country B, provides quality control and over-sight and direction during the manufacturing process.Employees of FS located in Country M sell Product Xto unrelated persons for use outside Country M. Coun-try M imposes an effective rate of tax on sales incomeof 10 percent, Country A imposes an effective rate oftax on sales income of 12 percent, and Country B im-poses an effective rate of tax on sales income of 24percent. None of the remainder, Branch A or BranchB, independently satisfies the manufacturing tests, al-though FS as a whole provides a substantial contribu-tion to the manufacture of Product X. The activities ofthe remainder of FS and Branch A, if considered to-gether, would not provide a demonstrably greater con-tribution to the manufacture of Product X than theactivities of Branch B.

The tested sales location is Country M. The locationof Branch B is the tested manufacturing location be-cause there is a tax rate disparity and Branch B is theonly manufacturing branch that would be treated as aseparate corporation. The manufacturing activities per-formed in Country A will be included in the contribu-tion of the remainder of FS for purposes of determin-

ing the location of the manufactured Product X,because there is not a tax rate disparity. The location ofmanufacture is Country B. Branch B is treated as aseparate corporation. To determine whether incomefrom the sale of Product X is FBCSI, the remainder ofFS takes into account the activities of Branch A be-cause there is no tax rate disparity. The remainder ofFS is considered to have manufactured Product X be-cause the manufacturing activities of the remainderand Branch A, considered together, make a substantialcontribution to the manufacture of Product X. There-fore, income from the sale of Product X by the remain-der of FS does not constitute FBCSI. (See Figure 11.)

Cost Sharing: Temporary Regulations

The IRS and Treasury issued temporary and pro-posed regulations that cover cost-sharing arrangements(CSAs) beginning on January 5, 2009, but with impor-tant grandfather rules for existing CSAs. (For the tem-porary regs, see Doc 2008-27341 or 2009 WTD 1-24.) Thetemporary regulations apply to buy-in transactions(now called platform contribution transactions, orPCTs) that occur on or after the date of a materialchange in the scope of a grandfathered CSA. Whethera material change in scope has occurred is determinedon a cumulative basis, and a series of expansions, anyone of which is not a material expansion by itself, maycollectively constitute a material expansion.

While the temporary regulations represent an im-provement over the proposed regulations, the tempo-rary regulations still rely heavily on the controversial‘‘investor model’’ and the special pricing methods forPCTs. At the inception of a CSA, all participants inthe CSA should expect to earn a return on their totalinvestment that is appropriate given the risk associatedwith each participant’s activities under the CSA. Theinvestor model treats each participant in the CSA ashaving made an investment composed of its share of

FS

AMfg

20%

10% incentive rate

Figure 10

FS

A B

Activities

10%

Activities 12% Activities 24%

Location of

MFG

Figure 11

Mfg

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the intangible development costs incurred on an on-going basis and any contribution of existing resourcesand capabilities. The alternatives realistically availableto the participants must be considered. Most commen-tators criticized the model on the grounds that its valu-ation principles are too restrictive.

Taxpayers may need to amend their written agree-ments, as described in temp. Treas. reg. section 1.482-7T(k)(1), for CSAs existing before the effective date ofthe new regulations. If the taxpayer has no agreementin place that complies with these requirements by July6, 2009, the taxpayer’s CSA may not be grandfathered.A CSA statement will also need to be filed by Septem-ber 2, 2009.

One final introductory note: The Ninth Circuit hasyet to make a decision in Xilinx. That decision couldultimately have an important effect on these regula-tions.

GeneralSeveral commentators questioned whether and how

the proposed regulations conformed to the arm’s-lengthstandard and the commensurate with income rules. Inresponse, the preamble states that the temporary regu-lations provide further guidance on the evaluation ofthe arm’s-length results of cost-sharing transactions(CSTs) and PCTs. The regulations address the materialfunctional and risk allocations in the context of a CSA,including the reasonably anticipated duration of thecommitments, the intended scope of the intangible de-velopment, the degree and uncertainty of profit poten-tial of the intangibles to be developed, and the extentof platform and other contributions of resources, capa-bilities, and rights to the development and exploitationof cost-shared intangibles (CSA activity).

If available data concerning uncontrolled transac-tions reflect, or may be reasonably adjusted to reflect,similar facts and circumstances concerning a CSA,they may be the basis for application of the compa-rable uncontrolled transaction method to value theCST and PCT results. Because of the difficulty of find-ing data that reliably reflect these facts and circum-stances, the preamble states, the temporary regulationsalso provide for other methods. Those include the in-come, acquisition price, market capitalization, and re-sidual profit-split methods.

The temporary regulations also provide taxpayerswith more flexibility in designing some aspects ofCSAs.

R&D Cost Sharing That Is Not a CSAThe proposed regulations defined the contractual

terms, risk allocations, and other material provisions ofa CSA covered by the cost-sharing rules. While otherintangible development arrangements might in generalbe referred to as cost-sharing arrangements, they werenot treated as CSAs by the proposed regulations unlesseither: (1) the taxpayer substantially complied with the

CSA administrative requirements and reasonably con-cluded that its arrangement was a CSA; or (2) the tax-payer substantially complied with the CSA administra-tive requirements and the IRS determined that theCSA rules should be applied to the arrangement.

The IRS and Treasury continue to believe that theserules, provided for CSAs, should apply only to the in-tended transactions. The rules are to be applied only tothe defined scope of intangible development arrange-ments and to apply no more broadly or narrowly thanintended. Thus, this portion of the proposed regula-tions was adopted.

Nonconforming arrangements are governed by otherprovisions of the section 482 regulations. Intangibledevelopment arrangements, including partnerships, out-side the scope of the cost-sharing rules are governed bythe transfers of intangible rules or the controlled serv-ices provisions, as appropriate. Nevertheless, the pre-amble states that the methods and best method consid-erations under the cost-sharing rules may be adaptedfor purposes of evaluating nonconforming intangibledevelopment arrangements.

Four examples illustrate these rules. In Example 1,P and S execute an agreement that purports to be aCSA, but they fail to enter into a PCT for some rel-evant software. P and S substantially complied with thecontractual requirements and the documentation, ac-counting, and reporting requirements and thus havemet the administrative requirements. However, becausethey did not enter into a PCT for software that wasreasonably anticipated to contribute to the developmentof the cost-shared product, they cannot reasonably con-clude that their arrangement is a CSA. Nevertheless,the arrangement between P and S closely resembles aCSA. If the Service concludes that the CSA rules pro-vide the most reliable measure of an arm’s-length re-sult, the Service may apply the CSA rules and treat Pand S as entering into a PCT for the software. Or theService may conclude that other provisions in the sec-tion 482 rules apply.

In Example 2, the facts are the same as in Example1, except that P and S enter into and implement a PCTfor the software. The Service determines that the PCTpayments for the software were not arm’s length. How-ever, P and S reasonably concluded that their arrange-ment is a CSA. The Service must apply the CSA rulesand make an adjustment to the PCT payments as ap-propriate.

In Example 3, the facts are the same as in Example1, except that P and S enter into a PCT for the soft-ware. The agreement provides for a fixed considerationof $50 million per year for four years, payable at theend of each year. The agreement satisfies the arm’s-length standard; however, S actually pays P consid-eration at the end of each year in the form of four an-nual royalties equal to 2 percent of sales. P and Sfailed to implement the terms of their agreement and

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could not reasonably conclude that their agreementwas a CSA. Nevertheless, the arrangement closely re-sembles a CSA, and the Service may apply the CSArules and make appropriate adjustments.

In Example 4, the facts are the same as in Example1, except that P does not own proprietary software andP and S determine that the arm’s-length amount forPCT payments is $10 million. The IRS determines thatthe PCT payments should be $100 million. To deter-mine the $10 million present value, P and S assumed auseful life of eight years for the platform contribution,because that is when the relevant patent expires. How-ever, use of the PCT patent rights in research is ex-pected to lead to benefits attributable to exploitation ofthe cost-shared intangibles extending many years be-yond expiration of the PCT patent. P and S expect toapply for additional patents.

The method used by P and S also uses a decliningroyalty based on an application of the CUT method inwhich the purported CUTs all involve licenses tomanufacture and sell the current generation of theproduct. These make or sell rights are fundamentallydifferent from use of the PCT patent rights to generatea new product. This further reduces the reliability ofthe method used by P and S.

The example concludes that the method used by Pand S is so unreliable and so contrary to the provisionsof the CSA rules that P and S could not reasonablyconclude that they had contracted to enter into a CSA.Accordingly, the Service is not required to apply theCSA rules. Nevertheless, if the Service concludes thatthe CSA rules provide the most reliable measure of anarm’s-length result, it may apply the CSA rules andmake appropriate adjustments.

Territorial InterestsThe proposed regulations required the controlled

participants in a CSA to receive nonoverlapping territo-rial interests that entitled each controlled participant tothe perpetual and exclusive right to the profits in itsterritory attributable to cost-shared intangibles. Com-mentators said this was overly restrictive and did notalign with common business models.

The temporary regulations thus permit use of a newbasis — a field of use division of interests — in addi-tion to the territorial division of interests. The regula-tions also authorize other nonoverlapping divisionalinterest, provided that the basis used meets criteria:(1) the basis must clearly and unambiguously divide allinterests in cost-shared intangibles among the con-trolled participants; (2) the consistent use of this basiscan be dependably verified from the participant’srecords; (3) the rights of the controlled participants toexploit cost-shared intangibles are nonoverlapping, ex-clusive, and perpetual; and (4) the resulting benefitsassociated with each controlled participant’s interest incost-shared intangibles are predictable with reasonablereliability.

If the CSA divides all interests in cost-shared intan-gibles on a territorial basis (territorial divisional inter-ests), the entire world must be divided into two ormore nonoverlapping geographic territories. Each con-trolled participant must receive at least one such terri-tory, and in the aggregate all the participants must re-ceive all of the territories. Each controlled participantmust be assigned the perpetual and exclusive right toexploit the cost-shared intangibles through the use, con-sumption, or disposition of property or services in itsterritories. Thus, compensation will be required if othermembers of the controlled group exploit the cost-shared intangibles in that territory.

If the CSA divides all interests in the cost-sharedintangibles on the basis of all uses (whether or notknown at the time of the division) to which the cost-shared intangibles are to be put (field of use divisionsinterests), all anticipated uses of the cost-shared intan-gibles must be identified. Each controlled participantmust be assigned at least one such anticipated use, andin the aggregate all the participants must be assignedall of the anticipated uses. Each controlled participantwill be assigned a perpetual and exclusive right to ex-ploit the cost-shared intangible through the use or usesassigned to it, and one controlled participant must beassigned the exclusive and perpetual right to exploit thecost-shared intangibles through any unanticipated uses.

Three examples illustrate these rules. In Example 1,P receives the interest in Product Z in the U.S., and Sreceives the interest in the product in the rest of theworld. Both P and S have plants for manufacturingProduct Z located in their respective geographic territo-ries. For commercial reasons, Product Z is neverthelessmanufactured by P in the U.S. for sale to customers incertain jurisdictions just outside the U.S. in close prox-imity to P’s U.S. manufacturing plant. Because S ownsthe territorial rights outside the U.S., P must compen-sate S to ensure that S realizes all the cost-shared in-tangible profits from P’s sale of products in S’s terri-tory. Benefits projected for these sales will be includedfor purposes of estimating S’s reasonably anticipatedbenefits (RAB) share.

In Example 2, the facts are the same in Example 1,except that P and S agree to divide their interests inProduct Z based on site of manufacturing. P will haveexclusive and perpetual rights in Product Z manufac-tured in facilities owned by P. S will have exclusive andperpetual rights to Product Z manufactured in facilitiesowned by S. Both facilities that will manufacture Prod-uct Z, and the relative capacities of these sites, areknown. All facilities are operating at near capacity andare expected to continue to operate at near capacitywhen Product Z enters production, so it will not befeasible to shift product between P’s and S’s facilities.P and S also have no plans to build new facilities. Thebasis for the division of interest is unambiguous andclearly defined and can be dependably verified.

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In Example 3, the facts are the same as in Example2, except that P’s and S’s manufacturing facilities arenot expected to operate at full capacity when ProductZ enters production. Production of Product Z can beshifted at any time between sites owned by P and sitesowned by S, although neither P nor S intends to shiftproduction as a result of the agreement. In this case,the production of interests based on manufacturingsites is not a division that is satisfactory because theparties’ relative shares of benefits are not predictablewith reasonable reliability.

Platform and Other Contributions

The proposed regulations described external contri-butions for which compensation was due from othercontrolled participants. Under the proposed regulations,an external contribution (buy-in) generally consisted ofthe rights in a ‘‘reference transaction’’ in any resourceor capability reasonably anticipated to contribute todeveloping cost-shared intangibles. The reference trans-action, a concept that is not in the temporary regula-tions, essentially was a non-arm’s-length hypotheticalcomparable.

A platform contribution isany resource, capability, orright that is reasonablyanticipated to contributeto developing cost-sharedintangibles.

The temporary regulations replace the term ‘‘exter-nal contribution’’ with the term ‘‘platform contribu-tion’’ and use the term ‘‘platform contribution transac-tion.’’ The temporary regulations define a platformcontribution as any resource, capability, or right that acontrolled participant has developed, maintained, oracquired externally to the intangible development activ-ity (whether before or during the course of the CSA)that is reasonably anticipated to contribute to develop-ing cost-shared intangibles. A resource, capability, orright reasonably determined earlier not to be a platformintangible may be reasonably determined later to be aplatform intangible. The PCT obligation regarding aresource or capability or right once determined to be aplatform contribution does not terminate merely be-cause it may later be determined that the resource orcapability or right has not contributed, and is notlonger reasonably anticipated to contribute, to develop-ing cost-shared intangibles.

For purposes of a PCT, the PCT payee’s provisionof a platform contribution is presumed to be exclusive.It also is presumed that the platform resource, capabil-

ity, or right is not reasonably anticipated to be commit-ted to any business activities other than the CSA activ-ity. The controlled participants may rebut thepresumption. For example, if the platform resource is aresearch tool, the controlled participants could rebutthe presumption by establishing to the Service’s satis-faction that as of the date of the PCT, the tool is rea-sonably anticipated not only to contribute to CSA ac-tivity but also to be licensed to an uncontrolledtaxpayer.

To the extent a controlled participant contributes theservices of its research team for purposes of developingcost-shared intangibles under the CSA, the other con-trolled participant would owe compensation for theservices of the team under temp. Treas. reg. section1.482-9T, just as would be the case in a contract serv-ice arrangement.3 When there is a combined contribu-tion of research services, intangibles in process, orother resources, capabilities, or rights, the temporaryregulations provide for an aggregate valuation wherethat would provide the most reliable measure of anarm’s-length result.

Any right to exploit an existing intangible withoutfurther development, such as the right to make, repli-cate, license, or sell existing products, does not consti-tute a platform contribution to a CSA, and the arm’s-length consideration for such rights (make or sellrights) does not satisfy the compensation obligationunder a PCT.

In an example, P and S enter into a CSA to developthe second generation of ABC, a computer softwareprogram. Before that arrangement, P had incurred sub-stantial costs and risks to develop ABC. P executed alicense with S as the licensee by which S may makeand sell copies of the existing ABC. This make or sellright does not constitute a platform contribution.

In another example, P and S enter into a CSA inaccordance with which P will commit to the project itsresearch team that has developed a number of othervaccines. The expertise and existing integration of theresearch team is a unique resource or capability of Pthat is reasonably anticipated to contribute to the devel-opment of the cost-shared product. Therefore, P’s pro-vision of the capabilities of the research team consti-tutes a platform contribution for which compensationis due from S as a part of the PCT. The controlled par-ties designate the platform contribution as a provisionof services that would otherwise be governed by temp.

3Interestingly, the treatment available under the cost-sharingrules for the contribution of the services of a research team ascontrolled services is stated to be ‘‘without any inference’’ con-cerning the potential status of workforce-in-place as an intangibleunder section 936(h)(3)(B). The status of workforce-in-place asan intangible, of course, has arisen as an issue in the context ofsection 936 exits.

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Treas. reg. section 1.482-9T if entered into by con-trolled parties. The applicable method for determiningthe arm’s-length value of the compensation obligationunder the PCT will be governed by those regulations assupplemented by the CSA rules.

The platform contribution is presumed to be the ex-clusive provision of the benefits by Company P of itsresearch team to the development of Vaccine Z. Be-cause the intangible development costs (IDCs) includethe ongoing compensation of the researchers, the com-pensation obligation under the PCT is only for thevalue of the commitment of the research team by P tothe CSA’s development efforts net of the researchercompensation. The value of the compensation obliga-tion of S for the PCT will reflect the full value of theprovision of services as limited by S’s RAB share.

Intangible Development Activity and CostsThe scope of the intangible development activity

(IDA) includes all activities that could reasonably beanticipated to contribute to developing the reasonablyanticipated cost-shared intangibles. The IDA cannot bedescribed merely by a list of particular resources, ca-pabilities, or rights that will be used in the CSA, sincethe IDA is a function of what are the reasonably an-ticipated cost-shared intangibles.

The scope of the IDA may change as the nature oridentity of the reasonably anticipated cost-shared intan-gibles or the nature of the activities necessary for theirdevelopment becomes clearer. For example, the rel-evance of certain ongoing work to developing reason-ably anticipated cost-shared intangibles or the need foradditional work may become clear only over time.

Regarding stock options and other stock-based com-pensation, the IRS and Treasury continue to considerthe technical changes and issues described in Notice2005-99, 2005-22 C.B. 1214, and comments they havereceived and intend to address the issue in a subse-quent regulations project.

Changes in ParticipationA change in participation under a CSA occurs when

there is either a controlled transfer of interests or a ca-pability variation. A controlled transfer occurs when aparticipant in a CSA transfers all or part of its interestin cost-shared intangibles under the CSA in a con-trolled transaction, and the transferee assumes the asso-ciated obligations under the CSA. In that case, thetransferee will be treated as succeeding to the trans-feror’s prior history under the CSA as it relates to thetransferred interest, including the transferor’s cost con-tributions, benefits received, and PCT payments attrib-utable to such rights or obligations.

A capability variation occurs when, in a CSA inwhich interests in cost-shared intangibles were dividedon a basis such as plant capacity, the controlled partici-pants’ division of interests, or their relative capabilitiesor capabilities to benefit from the cost-shared intan-

gibles are materially altered. The capability variation isconsidered to be a controlled transfer of interests.

If there is a change in participation, the arm’s-length amount of consideration must be determinedconsistent with the reasonably anticipated incrementalchange in returns to the transferee or transferor result-ing from the change in participation.

In one of the examples, P and S agree to dividetheir interests based on the site of manufacturing. Twoyears after formation of the CSA, because of a changein plans not reasonably foreseeable at the time theCSA was entered into, S acquires additional facilitiesfor the manufacture of the product. The acquisition isa capability variation. Accordingly, there was a com-pensable change in participation.

RABsRAB shares must be updated to account for changes

in economic conditions, the business operations andpractices of the participants, and the ongoing develop-ment of intangibles under the CSA. For purposes ofdetermining RAB shares at any given time, reasonablyanticipated benefits must be estimated over the entireperiod, past and future, of exploitation of the cost-shared intangibles, and must reflect appropriate up-dates. Indirect bases for measuring anticipated benefitsinclude units used, produced, or sold; sales; operatingprofits; and other bases.

Other bases for measuring anticipated benefits mayin some circumstances be appropriate, but only to theextent that there is expected to be a reasonably identifi-able relationship between the basis of measurementused and additional income generated or costs saved byuse of the cost-shared intangibles.

In one example, operating profit is determined to beappropriately used to determine RABs because thepharmaceutical product will be sold by USP at ahigher profit than FS will be able to sell the product inforeign countries. In another example, sales are inap-propriate for determining RABs because FP distributesthe product directly to customers while the U.S. sub-sidiary sells to independent distributors. Sales could beused only if adjustments were made to account for dif-ferences in market levels at which the sales occur.

General Principles and Best Method ConsiderationsThe proposed regulations articulated ‘‘general prin-

ciples’’ — such as the realistic alternatives principle —applicable to any method to determine the arm’s-lengthcharge in a PCT. These provisions were intended toprovide supplementary guidance on the application ofthe best method rule to determine which method, orapplication of a method, provides the most reliablemeasure of an arm’s-length result in a CSA context.That is, these principles provide best method con-siderations to aid in the competitive evaluation ofmethods or applications, and they were not intendedthemselves to be methods or trumping rules.

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The investor model was a core principle of the pro-posed regulations. A PCT payer, through cost sharingand payments made in accordance with the PCT, isinvesting for the term of the CSA activity and shouldexpect returns over time consistent with the riskiness ofthat investment. Commentators, however, criticized theinvestor model for stripping away risk returns from thePCT payer.

The temporary regulations retain the investor model,including the requirement to analyze the alternativesrealistically available to the taxpayer, but provide addi-tional guidance to explain that when the PCT payerassumes risks, it accordingly enjoys the returns (or suf-fers the detriments) that may result from those risks.

In doing a best method analysis, the relative reliabil-ity of the application of a method depends on the de-gree of consistency of the analysis with the assumptionthat, as of the date of the PCT, each controlled partici-pant’s aggregate net investment in the CSA activity(attributable to platform contributions, operating contri-butions, and operating cost contributions) is reasonablyanticipated to earn a rate of return equal to the appro-priate discount rate for the controlled participant’sCSA activity over the entire period of the CSA activity.

The regulation states that if the cost-shared intan-gibles themselves are reasonably anticipated to contrib-ute to developing other intangibles, then the period thatis used includes the period, reasonably anticipated as ofthe date of the PCT, of developing and exploiting theindirectly benefited intangibles. The example in temp.Treas. reg. section 1.482-7T(g)(2)(ii)(B) indicates that,based on industry experience, the period does not needto be infinite.

The relative reliability of a method also depends onthe degree of consistency of the analysis with the as-sumption that uncontrolled taxpayers dealing at arm’slength would have evaluated the terms of the transac-tion, and entered into the transaction, only if no alter-native is preferable. This condition is not met, the regu-lation states, when for any controlled participant thetotal anticipated present value of its income attribut-able to its entering into the CSA, as of the date of thePCT, is less than the total anticipated present value ofits income that could be achieved through an alterna-tive arrangement realistically available to that con-trolled participant.

The regulation states that realistic alternatives mayinvolve varying risk exposure and thus may be morereliably evaluated using different discount rates. Deter-mination of the applicable discount rates obviously willbe important under these rules. In some circumstances,the regulation states, a party may have less risk as alicensee of intangibles needed in its operations, and sorequire a lower discount rate than it would have byentering into a CSA to develop the intangibles, whichmay involve the party’s assumption of additional riskin funding its cost contributions to the IDA. Similarly,

self-development of intangibles and licensing out maybe riskier for the licensor, and so require a higher dis-count rate than entering into a CSA to develop the in-tangibles, which would relieve the licensor of the obli-gation to fund a portion of the IDCs of the IDA.

A discount rate should be used that most reliablyreflects the risk of the set of activities or transactionsbased on all the information potentially available at thetime for which the present value calculation is to beperformed. The discount rate may differ among a com-pany’s various activities and transactions. The pro-posed regulations indicated that the weighted averagecost of capital (WACC) of the taxpayer, or an uncon-trolled taxpayer, could provide the most reliable basisfor a discount rate if the CSA activity involves thesame risk as projects undertaken by the taxpayer, oruncontrolled taxpayer, as a whole. In appropriate situa-tions, a company’s internal hurdle rate for projects ofcomparable risk might provide a reliable basis for adiscount rate in the cost-sharing analysis.

Commentators criticized the proposed regulationsdiscount rate guidance. Some concluded that the pro-posed regulations inappropriately emphasized the tax-payer’s WACC as a basis for analysis. The specific ref-erences to WACC and hurdle rates are eliminated, butwithout any inference as to a WACC or a hurdle ratebeing an appropriate discount rate, or an appropriatestarting rate in ascertaining a discount rate, dependingon the facts.

While the regulation discusses the possibility of us-ing different discount rates to reflect varying risk levels— and that is important — there is little additionalguidance in the regulation in this regard. The tax-payer’s or other taxpayers’ WACC and hurdle ratesseem to be lurking in the background, perhaps as de-fault rates. Taxpayers will need to carefully analyzeand document their discount rates. If the new regula-tion is to work, this is the place where it will need towork.

In an example, P and S form a CSA to develop in-tangible X, which will be used in Product Y. P has aplatform contribution for which S commits to make aPCT payment of 5 percent of its sales of Product Y. Indetermining whether P had a more favorable realisticalternative, the Service compares P’s anticipated post-tax discounted present value of the financial projec-tions under the CSA with P’s anticipated posttax dis-counted present value of the financial projectionsunder a reasonably available alternative licensing ar-rangement. In undertaking the analysis in the example,the Service determines that because it would be fund-ing the entire development of the intangible, P takesgreater risk in the licensing scenario than in the cost-sharing scenario. The Service concludes that because

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there are differences in market-correlated risks betweenthe two scenarios, different discount rates should beused for the two scenarios.4

Arm’s-Length RangeThe temporary regulations provide guidance on the

use of arm’s-length ranges for some methods in com-puting PCT payments. Some of the methods specifiedin the temporary regulations (for example, the incomemethod) have a structure in which an arm’s-length re-sult is estimated by performing calculations that de-pend on two or more impute parameters such as therelevant discount rate, certain financial projections, anda return for routine activities. The temporary regula-tions address the arm’s-length range in the context ofthese methods.

CUT MethodThe proposed regulations provided for possible use

of the CUT method to determine the arm’s-lengthcharge in the PCT when appropriate in accordancewith the standards of the intangibles transfer and con-trolled services provisions of the section 482 regula-tions. Some commentators suggested that any arrange-ments that uncontrolled parties may call a cost-sharingarrangement should serve as a CUT, even though thearrangement may involve materially different risk allo-cations and provisions than addressed in the cost-sharing rules.

The temporary regulations, in response, describe therelevant considerations for purposes of evaluatingwhether a potential CUT may reflect the most reliablemeasure of an arm’s-length result. Although all of thefactors entering into a best method analysis must beconsidered, comparability and reliability under theCUT method in the CSA context are particularly de-pendent on: similarity of contractual terms; degree towhich allocation of risks is proportional to reasonablyanticipated benefits from exploiting the results of in-tangible development; similar period of commitment asto the sharing of intangible development risks; andsimilar scope, uncertainty, and profit potential of thesubject intangible development.

This includes a similar allocation of the risks of anyexisting resources, capabilities, or rights, as well as ofthe risks of developing other resources, capabilities, orrights that would be reasonably anticipated to contrib-

ute to exploitation within the parties’ divisions that areconsistent with the actual allocation of risks betweenthe controlled participants.

Income Method

The proposed regulations made the income methoda specified method for purposes of evaluating thearm’s-length charge in a PCT. The arm’s-length chargewas an amount that equated to a controlled partici-pant’s present value of entering into a CSA with thepresent value of the controlled participant’s best realis-tic alternative.

In one application, based on a CUT analysis, thePCT payee’s best realistic alternative was assumed tobe to develop the cost-shared intangible on its own,bearing all the intangible development costs (IDCs)itself, and then to license the cost-shared intangibles. Inthe second application, based on a comparable profitsmethod analysis, it was assumed that the PCT payer’sbest realistic alternative would be to acquire the rightsto external contributions (renamed platform contribu-tions under the temporary regulations) for paymentswith a present value equal to the PCT payer’s antici-pated profit, after reward for its routine contributionsto its operations, from the CSA activity in its territory.

Both income method applications provided for acost contribution adjustment in order to allocate to thePCT payer the return for its additional risk, as com-pared to its realistic alternative, of bearing its RABshare of the IDCs.

Commentators criticized the income method be-cause it strips away risk returns from the PCT payer.Commentators pointed to the potential risk differentialsbetween cost sharing and the alternative arrangements.Cost sharing would generally be more risky for thePCT payer than licensing as a result of its sharing withthe PCT payee the risks of the IDA. Cost sharing, onthe other hand, would generally be less risky for thePCT payee than licensing. Those comments observedthat these risk differentials would ordinarily be re-flected in different discount rates being appropriate un-der the cost-sharing and licensing alternatives.

The temporary regulations in any event adopt theincome method but provide more guidance. In general,they provide that the best realistic alternative of thePCT payer to entering into the CSA would be to li-cense intangibles to be developed by an uncontrolledlicensor that undertakes the commitment to bear theentire risk of intangible development that would other-wise have been shared under the CSA. Similarly, thebest realistic alternative of the PCT payee to enteringinto the CSA would be to undertake the commitmentto bear the entire risk of intangible development thatwould otherwise have been shared under the CSA andlicense the resulting intangibles to an uncontrolled li-censee.

4At least, I think this is the conclusion in the example. Theconcluding sentence of the analysis states that ‘‘the Commis-sioner concludes that the differences in market-correlated risksbetween the two scenarios, and therefore the differences in dis-count rates between the two scenarios, relate to the differences inthese components of the financial projections.’’ Temp. Treas. reg.section 1.482-7T(g)(2)(v), Example. Examples illustrating the in-come method rules are clearer in illustrating the use of differentdiscount rates. Temp. Treas. reg. section 1.482-7T(g)(4)(vii), Ex-amples 1-3.

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The licensing alternative is derived on the basis of afunctional and risk analysis of the cost-sharing alterna-tive, but with a shift of the risk of cost contributions tothe licensor. The licensing alternative also should as-sume contractual provisions regarding nonoverlappingdivisional intangible interests, and regarding allocationsof other risks, that are consistent with the actual CSAin accordance with the cost-sharing rules.

The temporary regulations describe both CUT-basedapplications and CPM-based applications of the in-come method. However, they differ from applicationsdescribed in the proposed regulations by equating thecost-sharing and licensing alternatives of the PCTpayer using discount rates appropriate to those alterna-tives.

If the market-correlated risks as between the cost-sharing and licensing alternatives are not materiallydifferent, a reliable analysis may be possible by usingthe same discount rates for both alternatives. Other-wise, as recognized in the best method considerationsconcerning discount rates, realistic alternatives havingthe same reasonably anticipated present value may never-theless involve varying risk exposure and thus generallyare more reliably evaluated using different discountrates. The discount rate for the cost-sharing alternativewill also depend on the form of the PCT paymentsassumed (for example, lump sum, royalty on sales, androyalty on divisional profit).

The temporary regulations clarify the opportunities,depending on the facts and circumstances, for the PCTpayer to assume risks and accordingly to enjoy the re-turns (or suffer the detriments) that may result fromthose risks. For example, in addition to its cost contri-butions to developing cost-shared intangibles, a PCTpayer may also make significant operating contribu-tions, such as existing marketing or manufacturing proc-ess intangibles, as well as make significant operatingcost contributions toward further developing the intan-gibles. To the extent parties to comparable transactionsundertake risks of similar scope and duration, the PCTpayer will be appropriately rewarded based on amethod that relies in whole or part on returns in thecomparable transactions under an application of theincome method whether based on a CUT or CPM.

Some commentators criticized the income methodas positing an unrealistic perpetual life. The incomemethod, the preamble states, is premised on the as-sumption that, at arm’s length, an investor will make arisky investment (for example, in a platform for devel-oping additional technology) only if the investor rea-sonably anticipates that the present value of its reason-ably anticipated operational results will be increased atleast by a present value equal to the platform invest-ment. It may be that the technology is reasonably ex-pected to achieve an incremental improvement and re-sults for only a finite period. The period of enhanced

results that justifies the platform investment in thosecircumstances effectively would correspond to a finite,not a perpetual, life.

This is helpful. There is not an automatic assump-tion of an infinite period. As noted in the best methoddiscussion, an example states that, based on industryexperience, the period may be limited to a finite pe-riod. P and S in the example are confident that thecost-shared product will be replaced by a new type ofgenetic testing based on an unrelated technology after10 years and that then, the cost-shared product willhave no further value. See temp. Treas. reg. section1.482-7T(g)(2)(ii)(B), Example. In temp. Treas. reg. sec-tion 1.482-7T(g)(4)(vii), Example 3, one of the incomemethod examples, some cost-shared software will havea five-year life. Thereafter it will be rendered obsoleteand unmarketable by obsolescence of the storage me-dia to which it relates.

Acquisition Price and Market CapitalizationMethods

The proposed regulations included guidance on theacquisition price and market capitalization methods forevaluating the arm’s-length charge in a PCT. Under theacquisition price method, the arm’s-length charge for aPCT is the adjusted acquisition price, that is, the acqui-sition price increased by the value of the target’s liabili-ties on the date of the acquisition, and decreased bythe value on that date of the target’s tangible propertyand other resources and capabilities not covered by thePCT.

Under the market capitalization method, the arm’s-length charge for a PCT is the adjusted average marketcapitalization, that is, the average daily market capitali-zation over the 60 days ending with the date of thePCT, increased by the value of the PCT payee’s liabili-ties on that date, and decreased on account of tangibleproperty and any other resources and capabilities ofthe PCT payee not covered by the PCT.

Commentators questioned the reliability of thesemethods in light of volatility of stock prices and lackof correlation between stock prices and underlying as-sets, for example, owing to control premiums or eco-nomics of integration.

The IRS and Treasury recognize that these com-ments point to considerations that, depending on thefacts and circumstances, will need to be taken into ac-count in a best method analysis that compares the reli-ability of the results under application of thesemethods as against the results under application ofother methods.

The temporary regulations retain the best methodconsiderations stated in the proposed regulations thatobserved that reliability is reduced under these methodsif a substantial portion of the target’s nonroutine con-tributions to business activities is not required to be

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covered by a PCT and, in the case of the market capi-talization method, if the facts and circumstances dem-onstrate the likelihood of a material divergence be-tween the PCT payee’s average market capitalizationand the value of its underlying resources, capabilities,and rights for which reliable adjustments cannot bemade.

Residual Profit-Split and Other MethodsThe temporary regulations conform the modified

residual profit-split method from the proposed regula-tions to the changes made to the income method.Other unspecified methods also may be used, but theymust be acceptable under general and cost-sharing bestmethod considerations. They also must consider therealistic alternatives to the transaction.

Form of PaymentThe proposed regulations provided that the form of

payment selected for any PCT had to be specified nolater than the date of the PCT. In the case of a postfor-mation acquisition, the consideration under the PCThad to be paid in the same form as the considerationin the uncontrolled transaction in which the postforma-tion acquisition was made. An example indicated thatacquisitions for stock were considered to be for a fixedform of payment. The temporary regulations do notretain the special rule for postformation acquisitions.Subsequent acquisitions remain an important source ofplatform contributions that occasion the requirement ofPCT compensation. Controlled participants maychoose the form of payment for these PCTs.

The temporary regulations incorporate rules to en-sure that a contingent form for PCT payments is ap-plied properly by both taxpayers and the IRS. A CSAcontractual provision that provides for payments for aPCT to be contingent on the exploitation of cost-shared intangibles will be respected as consistent witheconomic substance only if the allocation between thecontrolled participants of the risks attendant on thisform of payment is determinable before the outcomesof the allocation that would have materially affectedthe PCT pricing are known or reasonably knowable.The contingent payment provision must clearly andunambiguously specify the basis on which the obliga-tions are to be determined.

Periodic Adjustments

The proposed regulations used the commensuratewith income provisions so that the Service can makeperiodic adjustments for an open tax year and all sub-sequent years of the CSA activity in the event of a pe-riodic trigger. A periodic trigger arose if the PCT payerrealized, over the period beginning with the earliestdate on which the intangible development occurredthrough the end of the adjustment year, an actuallyexperienced return ratio (AERR) of the present valueof its total territorial operating profits divided by thepresent value of its investment consisting of the sum of

its cost contributions plus PCT payments, outside theperiodic return ratio range (PRRR) of between 0.5 and2. The Service would use an applicable discount rate,which in the case of some publicly traded entitieswould be their WACC, unless the Service determined,or the controlled participants established, that anotherdiscount rate better reflected the degree of risk of theCSA activity.

Commentators offered several criticisms of the peri-odic adjustment rules. Some considered the periodicadjustment rules to be inconsistent with the arm’s-length standard and, through hindsight, to strip awayreturns for risk. Other commentators said taxpayersshould have the same ability as the Service to makeperiodic adjustments.

The IRS and Treasury reaffirm that the commensu-rate with income principle is consistent, and periodicadjustments are to be administered consistently, withthe arm’s-length standard. Accordingly, the temporaryregulations continue to provide for periodic adjust-ments along lines similar to those in the intangibletransfers portion of the section 482 regulations, asadapted for the cost-sharing context.

In an important narrowing, the temporary regula-tions provide that a periodic trigger occurs if theAERR falls outside the PRRR of between 0.667 and1.5 (or between 0.8 and 1.25 if the taxpayer has notsubstantially complied with the documentation require-ments). The preamble states that this is intended toisolate situations in which the actual results suggest thepotential of an absence of arm’s-length pricing as ofthe date of the PCT.

The IRS and Treasury believe that the periodic trig-ger under the temporary regulations more realisticallytargets the threshold at which periodic adjustment scru-tiny is appropriate. In determining whether to makeany periodic adjustments, the Service will considerwhether the outcome as adjusted more reliably reflectsan arm’s-length result under all relevant facts and cir-cumstances.

Periodic adjustments will not be made if the con-trolled participants establish to the satisfaction of theService that all the conditions described in one of theexceptions below will apply regarding a trigger PCT.

The first exception is that the same platform contri-bution was furnished to an uncontrolled taxpayer un-der substantially the same circumstances as those ofthe relevant trigger PCT and with a similar form ofpayment as the trigger PCT. This applies only if thetransaction served as the basis for the application ofthe CUT method in the first year and all subsequentyears in which substantial PCT payments relating tothe trigger PCT were required to be paid. The amountof the PCT payments in the first year must have beenat arm’s length.

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The second exception is that the differential is dueto extraordinary events beyond the control of the con-trolled participants that could not reasonably have beenanticipated as of the date of the trigger PCT.

The third exception is that the periodic triggerwould not have occurred had the PCT payer’s divi-sional profits or losses used to calculate its presentvalue of total profits (PVTP) excluded those profits orlosses attributable to the PCT payer’s routine contribu-tions to its exploitation of the cost-shared intangibles,attributable to its operating cost contributions, and at-tributable to its nonroutine contributions to the CSAactivity.

In an important narrowing,the temporary regulationsprovide that a periodictrigger occurs if the AERRfalls outside the PRRR ofbetween 0.667 and 1.5.

The fourth exception is that the periodic triggerwould not have occurred had the divisional profits orlosses of the PCT payer used to calculate its PVTPincluded its reasonably anticipated divisional profits orlosses after the adjustment year from the CSA activity,including its routine contributions, its operating costcontributions, and its nonroutine contributions to thatactivity, and had the cost contributions and PCT pay-ments of the PCT payer used to calculate its PVI(present value of the PCT payer’s investment at thestart date) included its reasonably anticipated cost con-tributions and PCT payments after the adjustment year.

Also, a periodic trigger will not be deemed to haveoccurred in any year subsequent to the 10-year periodbeginning with the first tax year in which there is sub-stantial exploitation of the cost-shared intangibles re-sulting from the CSA, if the AERR is within thePRRR for each year of the 10-year period. It also willnot be deemed to have occurred in any year of thefive-year period beginning with the first tax year inwhich there is exploitation of the cost-shared intan-gibles resulting from the CSA if the AERR falls belowthe lower bound of the PRRR.

The IRS and Treasury intend to issue by revenueprocedure separate published guidance that provides anexception to periodic adjustments in the context of anadvance pricing agreement. The guidance would pro-vide that no periodic adjustments will be made in anyyear based on a trigger PCT that is a covered transac-tion under the APA. An APA process generally is con-temporaneous with the taxpayer’s original transactions

and involves transparency concerning a taxpayer’s up-front efforts to conform to the arm’s-length standard.

Treatment of PaymentsCST payments generally will be considered the

payer’s cost of developing intangibles at the locationwhere the development is conducted. For these pur-poses, IDCs borne directly by a controlled participantthat are deductible are deemed to be reduced to theextent of any CST payments owed to it by other con-trolled participants under the CSA.

The PCT payer’s payment is deemed to be reducedto the extent of any payments owed to it from othercontrolled participants. PCT payments will be charac-terized consistently with the taxpayer’s designation ofthe type of transaction. Depending on the designation,the payments will be treated as either consideration fora transfer of an interest in intangible property or forservices.

Administrative RequirementsTemp. Treas. reg. section 1.482-7T(k) contains the

CSA administrative requirements. There are four mainsections: contractual; documentation; accounting; andreporting requirements. This section of the temporaryregulations is lengthy.

The contractual rules are important. CSA agree-ments already in effect will need to be modified byJuly 6, 2009, by integrating those rules with the transi-tion rules in temp. Treas. reg. section 1.482-7T(m). ACSA statement also will need to be filed by September2, 2009.

Documentation is especially important under thetemporary regulations. For example, careful analysisand documentation of discount rate choices could bevery important. Also, the periodic adjustment triggerrange is narrower for taxpayers that fail to maintainadequate documentation.

New Best Method ExamplesExample 13. USP and FS enter into a CSA to de-

velop a new drug. Immediately before entering into theCSA, USP acquires Company X. X is engaged in re-search relevant to the product area, and its only signifi-cant resources and capabilities are its workforce andsole patent. The patent is associated with a compoundthat USP reasonably anticipates will contribute to de-veloping the CSA product. The acquisition pricemethod, based on the lump sum price paid by USP forCompany X, is likely to provide a more reliable meas-ure of an arm’s-length result than any other method.

Example 14. Company X is a publicly traded U.S.company engaged in pharmaceutical research. Its onlysignificant resources and capabilities are workforce andits sole patent. Company X has no marketable prod-ucts. Company X enters into a CSA with FS, its newlyformed foreign subsidiary, to develop a new drug. Thenew drug will be derived from the compound covered

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by USP’s patent. All of Company X’s researchers willbe engaged solely in research that is related to develop-ing that product. Given that Company X’s platformcontributions covered by PCTs relate to its entire eco-nomic value, application of the market capitalizationmethod provides a reliable measure of an arm’s-lengthresult.

Example 15 describes a U.S. company (MDI) thatdeveloped a new dental surgical microscope that drasti-cally shortens many surgical procedures. MDI enteredinto a CSA with a wholly owned foreign subsidiary todevelop the next generation of the product. The inter-ests are divided on a territorial basis. The rights associ-ated with the current product, as well as MDI’s re-search capabilities, are reasonably expected tocontribute to the development of the next generationproduct and are therefore platform contributions. Atthe time of the PCT, MDI’s only product is the micro-scope, although MDI was developing the next genera-tion microscope. Concurrent with the CSA, MDI sepa-rately transfers exclusive and perpetual exploitationrights associated with the existing product to FS in thesame territory as assigned to FS in the CSA. The ex-ample states that it is likely to be more reliable toevaluate the combined effect of the transactions than toevaluate them in isolation. This is because the com-bined transactions relate to all of the economic valueof MDI. The market capitalization method is likely toproduce a reliable measure of an arm’s-length paymentfor the aggregated transactions.

Example 16 states the same facts as in Example 13,except that the acquisition occurred significantly in ad-vance of the CSA and reliable adjustments cannot bemade for this time difference. Also, Company X hasother valuable molecular patents and associated re-search capabilities, apart from Compound X, that arenot reasonably anticipated to contribute to the develop-ment of the CSA product and that cannot be reliablyvalued. The CSA divides divisional interests on a terri-torial basis. Under the terms of the CSA, USP willundertake all R&D and manufacturing as well as thedistribution activities for its territory (the UnitedStates). FS will distribute the product in its territory(the rest of the world). FS’s distribution activities areroutine in nature, and the profitability from its activi-ties may be reliably determined from third-party com-parables. FS does not furnish any platform intangibles.At the time of the PCT, reliable financial projectionsassociated with development of the CSA product andits separate exploitation in each of the markets are under-taken. Application of the income method using CPMis likely to provide a more reliable measure of anarm’s-length result than application of the acquisitionprice method.

Example 17 states the same facts as in Example 13,except that the acquisition occurred some time beforethe CSA, and Company X had some areas of promis-ing research that are not reasonably anticipated to con-

tribute to developing the CSA product. The CSA di-vides divisional interests on a territorial basis. TheService determines that the acquisition price stated isuseful in forming the arm’s-length price, but not neces-sarily determinative. Under the terms of the CSA, USPwill undertake all R&D and manufacturing associatedwith the product as well as distribution activity for itsterritory (the United States). FS will distribute the CSAproduct in its territory (the rest of the world). FS’s ac-tivities are routine in nature, and the profitability fromits activities may be reliably determined from third-party comparables. It is possible that the acquisitionprice method or the income method using CPM mightreasonably be applied. Whether the acquisition pricemethod or the income method provides the most reli-able evidence of an arm’s-length price for USP’s con-tributions depends on a number of factors, includingthe reliability of the financial projections, the reliabilityof the discount rate chosen, and the extent to whichthe acquisition price of Company X could be reliablyadjusted to account for changes in value over the pe-riod between the acquisition and the formation of theCSA and to account for the value of the in-processresearch work done by Company X that does not con-stitute platform contributions to the CSA.

Example 18 states that the facts are the same in Ex-ample 17, except that FS has a patent on CompoundY, which the parties reasonably anticipate will be use-ful in mitigating potential side effects associated withCompound X and could thereby contribute to the de-velopment of the product. The rights in Compound Yconstitute a platform contribution for which compensa-tion is due from USP as a part of the PCT. The valueof FS’s platform contribution cannot be reliably meas-ured by market benchmarks. Under the facts, it is pos-sible that either the acquisition price or the incomemethod together or the residual profit-split methodmight reasonably be applied to determine the arm’s-length PCT payment due between USP and FS. Underthe first option, the PCT payment for the platform con-tributions related to Company X’s workforce, andCompound X would be determined using the acquisi-tion price referring to the lump sum price paid by USPfor Company X. Because the value of these platformcontributions can be determined by reference to a mar-ket benchmark, they are considered routine platformcontributions. Accordingly, the platform contributionrelated to Compound Y would be the only nonroutineplatform contribution, and the relevant PCT paymentis determined using the income method. Alternatively,rather than looking to the acquisition price for Com-pany X, all the platform contributions are considerednonroutine and the residual profit-split method is ap-plied to determine the PCT payments for each platformcontribution. Under either option, the PCT paymentswill be netted against each other.

Whether the acquisition price method together withthe income method or the residual profit-split method

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provides the most reliable evidence of the arm’s-lengthprice of the platform contributions depends on a num-ber of factors, including the reliability of the determi-nation of the relative values of the platform contribu-tions for purposes of the residual profit-split method,and the extent to which the acquisition price of thecompany can be reliably adjusted to account forchanges in value over the period between the acquisi-tion and the formation of the CSA and to account forthe value of the rights and in-process research done byCompany X that does not constitute platform contribu-tions to the CSA. It is also relevant to considerwhether the results of each method are consistent witheach other, or whether one or both methods are consis-tent with other potential methods that could be ap-plied.

Transition Rules

The proposed regulations included transition rulesfor existing qualified cost-sharing arrangements. Grand-father treatment would have been terminated in someevents, including the occasion of a periodic trigger as aresult of a subsequent PCT, a material change in thescope of the arrangement, such as a material expan-sion of the activities undertaken beyond the scope ofthe intangible development area, or a 50 percent orgreater change in the ownership of interests in cost-shared intangibles. Commentators objected to thegrandfather termination events.

The temporary regulations do not terminate thegrandfather treatment upon a 50 percent change ofownership or on account of a subsequent periodic trig-ger or a material change in the scope of the arrange-ment.

The temporary regulations instead adopt a targetedprovision that applies the temporary regulations’ peri-odic adjustment rules to PCTs that occur on or afterthe date of a material change in the scope of a grand-fathered CSA. A material change in scope would in-clude a material expansion of the activities undertakenbeyond the scope of the IDA. For this purpose, a con-traction of the scope of the CSA, absent the materialexpansion into one or more lines of research and de-velopment beyond the scope of the IDA, does not con-stitute a material change in the scope of the CSA.Whether a material change in scope has occurred isdetermined on a cumulative basis. Therefore, a seriesof expansions, any one of which is not a material ex-pansion by itself, may collectively constitute a materialexpansion.

An arrangement in existence on January 5, 2009,will be considered a CSA if before that date it was aqualified cost-sharing arrangement under Treas. reg.section 1.482-7, but only if the written agreement isamended if necessary to conform with, and only if theactivities of the controlled participants substantiallycomply with, the provisions of the new rules by July 6,

2009. Temp. Treas. reg. section 1.482-7T(m) sets forthspecific rules for how the temporary regulations applyto existing CSAs.

Other Regulations

Entity ClassificationThe IRS finalized regulations to make the federal

tax classification of the Bulgarian public limited liabil-ity company (aktsionerno druzhestevo) consistent with thefederal tax classification of public limited liability com-panies organized in other countries of the Europeaneconomic area: a per se corporation. (For the finalregs, see Doc 2008-25013 or 2008 WTD 230-26.)

Conduit Financing ArrangementsThe IRS and Treasury proposed regulations under

sections 881 and 7701(l) dealing with conduit financingstructures. (For the proposed regs, see Doc 2008-26696or 2008 WTD 246-27.) Treas. reg. section 1.881-3 allowsthe IRS to disregard the participation of one or moreintermediate entities in a financing arrangement inwhich the entities are acting as conduit entities, and torecharacterize the financing arrangement as a transac-tion directly between the remaining parties to the fi-nancing arrangement for purposes of imposing tax un-der sections 871, 881, 1441, and 1442.

Since the publication of Treas. reg. section 1.881-3,the IRS and Treasury issued the so-called check-the-box regulations. The preamble to the newly proposedregulations states that Treasury and the IRS are awarethat issues have arisen regarding the proper treatmentof disregarded entities under Treas. reg. section1.881-3. These proposed regulations clarify that a disre-garded entity is a person under Treas. reg. section1.881-3. Thus, transactions that a disregarded entityenters into will be taken into account for purposes ofdetermining whether a financing arrangement exists.

The preamble also states that the IRS and Treasuryare continuing to study conduit financing arrangementsand may issue separate guidance to address the treat-ment under those regulations of some hybrid instru-ments. Specifically, the IRS and Treasury are studyingtransactions in which a financing entity advances cashor other property to an intermediate entity in exchangefor a hybrid instrument that is treated as debt underthe laws of the foreign jurisdiction in which the inter-mediate entity is resident and is not treated as debt forU.S. federal tax purposes.

The issue is whether these instruments should con-stitute a financing transaction under the section 881regulations. One possible approach, the preamblestates, is to treat all transactions involving these hybridinstruments between a financing entity and an inter-mediate entity as financing transactions. Comments arerequested. Another possible approach is to add addi-tional factors to consider in determining when stock ina corporation (or other similar interest in a partnership

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or trust) may constitute a financing transaction. Theadditional factors would focus on whether, based onthe facts and circumstances surrounding the stock, thefinancing entity has sufficient legal rights to, or otherpractical assurances regarding, the payment received bythe intermediate entity to treat the stock as a financingtransaction. Comments are requested.

Consolidated Return Regs: Intercompany DebtThe IRS and Treasury finalized a new version of

Treas. reg. section 1.1502-13(g), which deals with inter-company debt obligations in the context of a U.S. con-solidated tax return. The regulation involves mostlydomestic issues, which I will not cover here. However,it also addresses two potential international issues.

The new regulations allow the transfer of intercom-pany debt obligations in a tax-free manner in somesituations. It also contains antiavoidance rules to pre-serve a proper matching within the consolidated return.In one case, the assignment of an intercompany obliga-tion by a creditor member under section 351 can be atriggering transaction, which means the intercompanydebt obligation is deemed paid and reissued, withwhatever consequences that brings.

One of the situations in which the intercompanydebt obligation is triggered by the creditor’s transferunder section 351 is when the transferor or transfereemember has a loss subject to a limitation (for example,a loss from a separate return limitation or a dual con-solidated loss that is subject to limitation under Treas.reg. section 1.1503(d)-4), but only if the other memberis not subject to a comparable limitation.

When debt becomes an intercompany obligation,the deemed satisfaction and deemed reissuance aretreated as transactions separate and apart from thetransaction in which the debt becomes an intercom-pany obligation, and the tax consequences of the trans-action in which the debt becomes an intercompanyobligation must be determined before the deemed satis-faction and reissuance occurs. The regulation statesthat ‘‘for example, if the debt became an intercompanyobligation in a transaction in which section 351 ap-plies, any limitation imposed by section 362(e) on thebasis of the intercompany obligation in the hands ofthe transferee member is determined before the deemedsatisfaction and reissuance.’’ Section 362(e)(1) providesfor a limitation on the importation of built-in losses,and section 361(e)(2) provides for a limitation on thetransfer of built-in losses in section 351 transactions.The example might involve a foreign parent companycontributing to its U.S. subsidiary (the parent of theU.S. consolidated group) an obligation that thereafterbecomes an intercompany obligation.

IRS Rulings and Notices

Withholding TaxThe Internal Revenue Service announced that it is

adding withholding taxes to the tier 1 list of issues.

Dual Capacity TaxpayersLTRs 200850023, 200850024, and 200850025

granted permission to taxpayers to revoke their previ-ous elections to use the dual capacity taxpayer safeharbor method described in Treas. reg. section 1.901-2A(c)(3) in determining the amount of their foreignincome taxes paid or accrued to a foreign country. Thesafe harbor method election may not be revoked with-out the consent of the Service. Consent is normallygiven, provided the conditions in the regulations aresatisfied. The three rulings appear to have been issuedto the same U.S. consolidated group.

Subpart F and PartnershipsIn Notice 2009-7, 2009-3 IRB 312, the IRS identi-

fied as transactions of interest transactions in which aCFC owns an interest in a domestic partnership that inturn owns interests in lower-tier CFCs. (For Notice2009-7, see Doc 2008-27221 or 2008 WTD 250-22.) Thestated concern is that the lower-tier CFC’s subpart Fincome may not be included in income by the U.S. par-ent company. This would seem to be in accord withthe statute, in which a domestic partnership is classi-fied as a U.S. person. Most interesting, however, is thatthe Service approved just such a structure in a recentletter ruling. LTR 200838003, discussed in a previouscolumn, approved such a structure in the context ofthe PFIC rules. (For prior coverage, see Tax Notes Int’l,Oct. 27, 2008, p. 343, Doc 2008-22362, or 2008 WTD211-9.) It is curious that the Service was willing to fa-vorably rule on just such a structure, yet a couple ofmonths later described it as a transaction of interest.

Restructured TransactionCCA 200849012 describes a U.S. parent company

that in concert with a Country Y bank adopted a taxstrategy developed and marketed by a promoter. A spe-cial purpose vehicle was incorporated in Country Y.The SPV was formed with funds of the parent and thebank. The parent received an equal number of sharesof preferred stock and common stock. Each share ofpreferred stock was stapled to each share of commonstock, making a combined unit (referred to as the ClassB securities). The value of the preferred shares vis-à-visthat of the common shares was highly disproportionate(1,000-1 ratio). The bank received an equal number ofClass A securities, which were similarly stapled units.

SPV purchased accounts receivable at a discountfrom the parent’s subsidiaries and transferred/assignedmost of the remaining funds to the parent as a loan.According to the transactional documents, SPV was topurchase monthly accounts receivable from the parent’sgroup with monies repaid to it by the parent on theloan. SPV was to simultaneously relend the excess ofthe monthly loan repayments over the monthly pur-chase amounts to the parent’s group. In reality, theCCA states, the purchase of accounts receivable, collec-tion of loan repayments, and relending to the parentnever took place other than perhaps as book entries.

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The taxpayer asserts that SPV’s two business activi-ties were factoring accounts receivable and lendingmoney. The simultaneous lending and alleged purchaseactivities essentially operated with monies contributedby the parent to SPV as a circular cash flow, becausethose funds were immediately retransferred to the par-ent’s group as loan proceeds and/or purchase monies.The simultaneous lending and alleged purchase activi-ties also operated with respect to monies contributedby the bank to SPV as loan proceeds (some amount ofwhich was purchase money to buy the parent’s ac-counts receivable). SPV (the purported factor) hadhired the parent’s group to service and collect on theaccounts receivable that the parent’s group allegedlysold to SPV.

The CCA concludes that SPV did not in effect or insubstance factor the parent’s accounts receivable. SPVnever owned the accounts receivable. At no time didSPV ever physically possess the accounts receivablesfiles or any of the funds collected on the accounts re-ceivable. The funds essentially stayed with the parentgroup, and SPV appears to have received only a secu-rity interest in the accounts receivable and the collec-tions thereon. SPV was not given a present possessoryinterest on either the accounts receivable or the fundscollected on those accounts receivable.

The steps involved in the transactions, when takentogether, the CCA states, closely resemble, and havemany of the same characteristics as a revolving line ofcredit from the bank to the parent, with the parent’saccounts receivable being used as collateral for theloan. The parent and its subsidiaries maintained lock-boxes in their own names into which they put themonies collected in servicing the accounts receivablethey allegedly sold to SPV. SPV would acquire domin-ion and control over the contents of those boxes onlyon the occurrence of a termination event.

The purported factoring transactions permitted theparent to deduct on its consolidated federal income taxreturns both the losses in the aggregate amount of thediscounts arising from the sale of the accounts receiv-able and the interest payment by the parent’s groupmade on the loans received from SPV. No U.S. incometax was paid on the interest or discount income earnedby SPV. SPV did not treat its discount and interest in-come as attributable to a U.S. permanent establish-ment, nor did the parent withhold 30 percent U.S. taxon the interest and discount paid to SPV. Further, theparent did not treat SPV as a controlled foreign corpo-ration.

The Service held that when viewed in substance, theseries of transactions constituted solely lending activi-ties, that is, monies loaned by the bank to SPV for thepurpose of having SPV relend those same funds to theparent. SPV’s main role in the series of transactionswas merely that of a lender of monies to the parent, ora conduit through which the bank passed the loan pro-ceeds to the parent. The Service may alternatively ar-

gue that either the loans were between SPV and theparent or that they were between the bank and the par-ent, with SPV acting merely as a conduit throughwhich the loan proceeds passed. Either way, the parentis not entitled to deduct the purported losses arisingfrom the factoring transactions, but should be allowedadditional interest deductions resulting from the newrecharacterization of these items.

As an alternative position to recasting the transac-tion as a direct loan from the bank to SPV, the CCArecommends that the Service assert that the bank’s in-terest in SPV is strictly a debt interest with an equitykicker, rather than a stock interest in SPV. In that case,the parent would be the sole shareholder of SPV,which would be a CFC. The CCA states that recharac-terizing the Class A securities as debt instrumentswould effectively deny the parent’s deduction for thefactoring discount through the use of section 267.

The CCA states that recasting the transaction asmerely a loan between the bank and the parent withSPV’s role as that of a conduit provides the correctand most satisfactory resolution of the matter. Rechar-acterizing the transaction in this manner more accu-rately captures the true substance of the transaction. Italso would serve to eliminate any section 267 issue,because under this recast, no sale of accounts receiv-able between the parent and SPV would be consideredto have taken place, and, therefore, the parent wouldnot have realized any loss on a purported sale of thereceivables.

Publicly Traded PartnershipsLTR 200852005 described X, which was originally

organized as a foreign entity that constitutes a per secorporation for U.S. tax purposes. (For LTR200852005, see Doc 2008-27159 or 2008 WTD 251-17.)

A acquired all of the outstanding ordinary shares ofX. X then reregistered as an eligible entity under thelaws of that foreign country and filed a check-the-boxelection to be treated as a partnership for U.S. tax pur-poses.

In addition to its ordinary shares, X has outstandingB shares that are nonvoting, noncumulative preferenceshares that are widely held. The B shares previouslywere listed and traded on a stock exchange, althoughthey since have been delisted. Holders of B shares havethe right to sell their shares to X on a certain date eachyear. Also, X implemented an off-market repurchaseprogram under which the owners of the B shares maysell their shares to X twice per month. X has the rightto repurchase all outstanding B shares without the con-sent of the B shareholders at a certain time for a speci-fied price. X intends to exercise its right to redeem allof the B shares at that time.

The taxpayer sought and obtained a ruling that X isnot a publicly traded partnership under section 7704(b).Section 7704(b) provides that the term ‘‘publicly tradedpartnership’’ means any partnership if: (1) interests in

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the partnership are traded on an established securitiesmarket; or (2) interests of the partnership are readilytradable on a secondary market (or the substantialequivalent thereof). The section 7704 regulations pro-vide that transfers under a closed end redemption planare disregarded in determining whether interests in apartnership are readily tradable on a secondary marketor the substantial equivalent thereof.

Interests in X are not traded on an established secu-rities market. The repurchase program and the rights ofB shareholders to sell their B shares to X each yearqualify as closed end redemption plans under section7704 regulations. Therefore, the redemptions underthose plans are disregarded in determining whether theinterests in X are readily tradable on a secondary mar-ket or the substantial equivalent thereof.

FIRPTA

LTR 200851023 describes the taxpayers as four for-eign corporations that raise funds from non-U.S. inves-tors to invest in real estate and real-estate-related in-vestments located in the United States. (For LTR200851023, see Doc 2008-26742 or 2008 WTD 247-32.) X,a U.S. partnership, was created at the same time thatthe foreign corporations were created to raise fundsfrom U.S. investors to invest in the same real estate andreal-estate-related investments. The foreign corporationsand X are collectively referred to as ‘‘feeder funds.’’ Asfunds were periodically raised by one or more of thefeeder funds, a new domestic corporation was created,and those funds were contributed to the new domesticcorporation. Each of these newly created domestic cor-porations constituted a U.S. real property holding com-pany under section 897. The corporations used thecontributed funds to purchase assets that constitutedU.S. real property interests. One of these corporationsis A. A owns interests in a U.S. limited partnership,which owns interests in some U.S. real property.

The taxpayers have proposed to form a new foreignpartnership (FP) and to contribute all of their equityinterests in the corporations, including A (transferredproperty), to FP in a transaction qualifying under sec-tion 721. Each of the taxpayers represents that, for pur-poses of section 897(g), the interests in FP that the tax-payers receive in exchange for the transferred propertywill be a U.S. real property interest to the extent attrib-utable to U.S. real property interests of FP.

Shortly after the taxpayer’s contribution, the U.S.limited partnership will dispose of all of its assets in afully taxable transaction. The partnership will use theproceeds to settle any outstanding liabilities and thendistribute its remaining assets to its partners, includingA, in a complete liquidation. A will use the proceedsreceived in the liquidation to settle its outstandingliabilities and then distribute its remaining assets to itsshareholders, which will include FP and X, in a com-plete liquidation under section 331.

Provided that FP adopts the remedial allocationmethod under the section 704 regulations and complieswith the filing requirements of temp. Treas. reg. section1.897-5T(d)(1)(iii), the Service ruled that the taxpayers’transfer of the transferred property in exchange forpartnership interests in FP will constitute a nonrecogni-tion transaction under section 721 and section 897(e).

The Service also ruled that any gain that FP realizesin connection with the liquidation of A is not gain re-alized in connection with the disposition of a U.S. realproperty interest under section 897, provided that Asatisfies the exclusion described in section 897(c)(1)(B).Section 897(c)(1)(B) provides that a taxpayer can estab-lish that a corporation was not a USRPHC during thefive-year period ending on the date of the dispositionof the interest by showing that the corporation did nothold any USRPIs on the date of the disposition of thatinterest and all of the USRPIs held by that corporationduring the five-year period were disposed of in a trans-action in which the full amount of gain was recog-nized.

Treaties

CCA 200848032 states that the U.S. competent au-thority has interpreted the mutual agreement procedurelanguage in most U.S. treaties to mean that if the for-eign country raises an adjustment, the U.S. can grantrelief (a refund) even if it is for a tax year for whichthe statute of limitations has closed. The U.S. wouldnot be able to increase a taxpayer’s income under thetreaty unless the IRS examiners had already assessedadditional tax.

Treaties

Canada, Iceland, and Bulgaria

Treasury announced on December 15, 2008, that theprotocol to the Canada-U.S. treaty and the new treatieswith Iceland and Bulgaria entered into force. (For theTreasury announcement, see Doc 2008-26353 or 2008WTD 242-30.)

New Zealand

Treasury also announced that the U.S. and NewZealand agreed to enter into a treaty protocol. (For thetreaty protocol, see Doc 2008-25303 or 2008 WTD 232-15.) The new agreement provides for the elimination ofsource country taxation on some direct dividends andon interest paid to banks and other financial enterpriseswhen the payer of the interest is not a related party. Italso reduces the limit of taxation on cross-border pay-ments of royalties from 10 percent to 5 percent.

France

Treasury announced that the U.S. and France signeda treaty protocol providing for the elimination ofsource country taxation of some direct dividends and

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the elimination of source country taxation of cross-border royalty payments. (For the protocol and memo-randum of understanding (MOU), see Doc 2009-670 or2009 WTD 8-30; for a U.S. Treasury news release, seeDoc 2009-671 or 2009 WTD 8-31.) It also provides formandatory arbitration in cases that cannot be resolvedby the competent authorities within a specified periodof time.

GermanyThe U.S. and German competent authorities agreed

on an MOU to a set of operating guidelines that detailhow the mandatory binding arbitration provisions ofthe U.S.-German tax treaty will operate. (For the MOUon the arbitration process, see Doc 2008-27070 or 2008WTD 249-32. For the operating guidelines, see Doc 2008-27071 or 2008 WTD 249-33.)

The MOU was signed on December 8, 2008. It pro-vides detailed guidance on several procedural issuesrelating to the arbitration process, including when thecommencement date of a case is established; when ar-bitration proceedings must begin; how arbitrationboard members are appointed; what information toinclude in position papers; what to do when a caseinvolves a permanent establishment issue or was ini-tially submitted as a bilateral advance pricing agree-ment request; how to compensate the arbitration boardmembers; and how to terminate arbitration proceed-ings.

The MOU states that the competent authorities maynot appoint as an arbitration board member currentgovernment employees or those who have left the gov-ernment less than two years ago. Board members musthave significant international tax experience.

The MOU provides that each competent authoritywill be permitted to submit a proposed resolution paper(not to exceed 5 pages) and a supporting position paper(not to exceed 30 pages) within 90 days of the appoint-ment of the arbitration board’s chair. In a PE case, thecompetent authorities may submit a paper that takes al-ternative positions. That is, the competent authority maytake the position that no PE exists, but may also proposewhat amount of income should be allocated to the PEshould the board determine that a PE does exist.

Future Tax Policy

In a previous column, I suggested that it might behelpful to reinstate section 965 for reasons discussedthere. (For prior coverage, see Tax Notes Int’l, Nov. 24,2008, p. 675, Doc 2008-24320, or 2008 WTD 229-10.) Sec-tion 965 encouraged repatriation of a huge amount oflow-taxed foreign earnings and injected the cash intothe U.S. economy.

I noted that the American Shipping ReinvestmentAct of 2008, introduced as H.R. 6374 and S. 3359,would provide an incentive to reinvest foreign shippingearnings in the U.S. in accordance with a modified sec-tion 965. I also noted that an article in The New YorkTimes on December 9, 2008, discussed the benefits ofreinstating section 965. The U.K. government has an-nounced that it is considering such a provision.

One alternative to section 965 that some taxpayershave suggested involves allowing foreign subsidiaries tolend funds to their U.S. parent company for up to twoyears without triggering section 965. Reinstating sec-tion 965 seems cleaner, but this is an alternative. ◆

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February 9

U.S. International Tax Reporting andCompliance — Fort Lauderdale, Fla.The Council for International Tax Edu-cation will sponsor a two-day seminarfocusing on the latest IRS tax reportingrequirements for U.S. companies withforeign operations.

• Tel: (914) 328-5656

• E-mail: [email protected]

International Tax — New York. Net-working Seminars will sponsor a one-day introduction to international taxwith topics including expense apportion-ment, earnings and profits, the foreigntax credit, and Subpart F income.

• Tel: (914) 874-5395

• E-mail:[email protected]

February 10

International Tax — New York. Net-working Seminars will sponsor a one-day international tax update with topicsincluding new contract manufacturingregulations, recent changes to the foreigntax credit, new service rules under sec-tion 482, and treaty developments.

• Tel: (914) 874-5395


February 11

International Tax — New York. Net-working Seminars will sponsor a one-day advanced international tax seminarwith topics including inbound and out-bound transactions, transfers of intan-gible assets, permanent establishmentsunder tax treaties, foreign exchange, andfinancing foreign subsidiaries.

• Tel: (914) 874-5395


February 16U.S. International Tax — Houston.ATLAS will sponsor a two-day introduc-tion to U.S. international tax with topicsincluding key issues involving theAmerican Jobs Creation Act and theU.S. tax effects of generating income orlosses from operations overseas.

• Tel: (800) 206-4432

• Web site: http://www.atlas-sfi.com

February 18U.S. International Tax — Houston.ATLAS will sponsor a two-and-a-half-day intermediate-level seminar on U.S.international taxation.

• Tel: (800) 206-4432


February 23U.S. Transfer Pricing — New York. TheCouncil for International Tax Educationwill sponsor a two-day intermediate- toadvanced-level seminar focusing on U.S.transfer pricing issues.

• Tel: (914) 328-5656


Tax Accounting for U.S. Multinationals— New York. The Council for Interna-tional Tax Education will sponsor atwo-day conference on topics includingcomputing taxes in assembling the cor-porate tax provision under FAS 109, taxaccounting requirements for reportingdomestic production benefits, and howFIN 48 rules apply to uncertain tax po-sitions for public and nonpublic compa-nies.

• Tel: (914) 328-5656


February 25Cross-Border Tax Controversies —Washington. The Tax Council Policy

Institute will hold a two-day symposiumfocusing on topics including disputeresolution, transfer pricing, indirect taxa-tion, and permanent establishment andnexus. The keynote speaker will be IRSCommissioner Douglas Shulman.Contact: Donna Cox-Davies or RogerLeMaster.

• Tel: (914) 686-5599 or(202) 822-8062

• E-mail: [email protected] [email protected]

• Web site: http://www.tcpi.org

Global Transfer Pricing — Frankfurt.The C5 business information group willsponsor a two-day conference on mini-mizing corporate transfer pricing risks,with a special focus on regulatory re-quirements in France, Germany, India,Russia, the U.K., and the U.S.Contact: Susan Jacques.

• Tel: +44 (0) 20 7878 6888


• Web site: http://www.C5-Online.com/transferpricing

February 26

Cyprus Double Tax Treaties —Moscow. The Moscow Times and Euro-fast Global Ltd. will sponsor a seminaron confidentiality agreements, tax trea-ties, and exchange of information.

• Tel: +7 495 232 4774, 232 1769

International Tax — Washington. TheU.S. branch of the International FiscalAssociation will sponsor a two-day con-ference on tax treaties, transfer pricing,

The calendar is available online asDoc 2009-1789.

Submissions to the TaxCalendar may be sent by fax to(703) 533-4646 or by e-mail [email protected].


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financially distressed companies from aCanadian perspective, and tax-effectivesupply chain management.

• Tel: (866) 298-9464


March 2International Tax — Miami. Network-ing Seminars Inc. will sponsor a one-dayintroductory course on internationaltaxation and taxation of foreign earn-ings of U.S. corporations.

• Tel: (914) 874-5395


• Web site: http://www.networkingseminars.net

March 3International Tax — Miami. Network-ing Seminars Inc. will sponsor a one-dayintermediate course on internationaltaxation focusing on recent U.S. rulingsand changes to the international taxregulations.

• Tel: (914) 874-5395



March 4International Tax — Miami. Network-ing Seminars Inc. will sponsor a one-dayadvanced course on international taxa-tion focusing on recent court decisionsand U.S. and foreign tax rulings.

• Tel: (914) 874-5395



March 9U.S. International Tax Reporting andCompliance — Dallas. The Council forInternational Tax Education will spon-sor a two-day seminar focusing on thelatest IRS tax reporting requirements forU.S. companies with foreign operations.

• Tel: (914) 328-5656


U.S. Infrastructure Investments — NewYork. ATLAS will sponsor a two-dayseminar of the tax advantages of U.S.infrastructure investments, including

information regarding public-privatepartnerships transactions.

• Tel: (800) 206-4432


March 16International Tax Forum — San Fran-cisco. ATLAS will sponsor a two-dayforum on topics including new transferpricing regulations, strategies for repatri-ating foreign earnings, and FAS 48 re-porting.

• Tel: (800) 206-4432


March 23U.S. Transfer Pricing — San Francisco.The Council for International Tax Edu-cation will sponsor a two-day introduc-tory seminar on the U.S. transfer pricingrules.

• Tel: (914) 328-5656


China Tax Update — San Francisco.The Council for International Tax Edu-cation will sponsor a two-day technicalupdate on the latest legal, tax, and ac-counting issues facing companies withoperations or business opportunities inChina.

• Tel: (914) 328-5656


U.S. International Tax — Seattle.ATLAS will sponsor a two-day introduc-tion to U.S. international tax with topicsincluding key issues involving theAmerican Jobs Creation Act and theU.S. tax effects of generating income orlosses from operations overseas.

• Tel: (800) 206-4432


European and U.S. Cross-Border Finan-cial Products — London. ATLAS andStructured Finance Institute will sponsora two-day conference on the technicaldetails of European and U.S. cross-border financial products.

• Tel: (800) 206-4432


March 25U.S. International Tax — Seattle.ATLAS will sponsor an intermediate-level three-day seminar on U.S. interna-tional tax provisions using examples andcase studies.

• Tel: (800) 206-4432


March 30

U.S. Tax Planning — Chicago. ATLASwill sponsor a two-day seminar on taxplanning in the current economic envi-ronment.

• Tel: (800) 206-4432


April 2

Corporate Taxation — Washington andWebcast. ALI-ABA and the ABA Sec-tion of Taxation will cosponsor a two-day course on topics including taxablemerger and acquisition structures, cross-border issues, treatment of contingentliabilities, executive compensation andcompensatory interests, and structures toaccommodate private equity investors.

• Tel: (800) 253-6397

April 20

Taxation of Financial Products —Chicago. ATLAS will sponsor a two-day introduction to tax and accountingissues regarding financial products andderivatives.

• Tel: (800) 206-4432


U.S. International Tax Reporting andCompliance — Atlanta. The Councilfor International Tax Education willsponsor a two-day course on IRS taxreporting requirements for U.S. compa-nies with foreign operations.

• Tel: (914) 328-5656


April 26

Offshore Companies — Miami.Offshore Alert will sponsor a three-dayconference on topics including defenseagainst IRS administrative and criminalinvestigations, the limits of Chapter 15,Ponzi schemes, anti-money laundering,offshore insurance products, and flagshiptax investigations. Contact: NaomiComerford.

• Tel: (305) 372-6296

• Web site: http://www.offshorealertconference.com

TAX CALENDAR


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April 27

U.S. International Tax — New York.ATLAS will sponsor a two-day introduc-tion to U.S. international tax with topicsincluding key issues involving theAmerican Jobs Creation Act and theU.S. tax effects of generating income orlosses from operations overseas.

• Tel: (800) 206-4432


April 29

U.S. International Tax — New York.ATLAS will sponsor an intermediate-level three-day seminar on U.S. interna-tional tax provisions using examples andcase studies.

• Tel: (800) 206-4432


May 4

International Tax — Chicago. Network-ing Seminars Inc. will sponsor a one-dayintroductory course on internationaltaxation and taxation of foreign earn-ings of U.S. corporations.

• Tel: (914) 874-5395



Foreign Tax Credit — Chicago. ATLASwill sponsor a two-day overview courseon U.S. foreign tax credit mechanicsunder various code sections.

• Tel: (800) 206-4432


May 5

International Tax — Chicago. Network-ing Seminars Inc. will sponsor a one-dayintermediate course on internationaltaxation focusing on recent U.S. rulingsand changes to the international taxregulations.

• Tel: (914) 874-5395



May 6International Tax — Chicago. Network-ing Seminars Inc. will sponsor a one-dayadvanced course on international taxa-tion focusing on recent court decisionsand U.S. and foreign tax rulings.

• Tel: (914) 874-5395



May 7U.S. International Tax — Philadelphia.ATLAS will sponsor a two-day forumon topics including cross-border taxplanning for corporations and U.S. regu-latory guidance.

• Tel: (800) 206-4432


May 13Partnerships, LLCs, and Joint Ventures— Chicago. The Practising Law Insti-tute will sponsor a three-day seminar onpartnership tax rules.

• Tel: (800) 260-4754

• Web site: http://www.pli.edu

May 18Earnings and Profits of Foreign Subsid-iaries — Philadelphia. ATLAS willsponsor a two-day seminar focusing onnew regulations for earnings and profits,subpart F income, and foreign tax cred-its.

• Tel: (800) 206-4432


Latin America Tax Update — Miami.The Council for International Tax Edu-cation will sponsor a two-day conferencethat examines tax issues in doing busi-ness in Latin America.

• Tel: (914) 328-5656


U.S. International Transfer Pricing —Miami. The Council for InternationalTax Education will sponsor a two-daycourse on U.S. transfer pricing rulesunder IRC section 482.

• Tel: (914) 328-5656


Tax Aspects of International Acquisi-tions — Philadelphia. ATLAS willsponsor a two-day seminar on cross-border business mergers and acquisi-tions.

• Tel: (800) 206-4432


May 27Partnerships, LLCs, and Joint Ventures— New York. The Practising Law Insti-tute will sponsor a three-day seminar onpartnership tax rules.

• Tel: (800) 260-4754


June 4International Transfer Pricing —Chicago. ATLAS will sponsor a two-dayseminar on pricing documentation, au-dits, competent authority procedures,and advanced pricing agreements.

• Tel: (800) 206-4432


June 10Partnerships, LLCs, and Joint Ventures— San Francisco. The Practising LawInstitute will sponsor a three-day semi-nar on partnership tax rules.

• Tel: (800) 260-4754


June 15U.S. International Tax — Boston.ATLAS will sponsor a two-day introduc-tion to U.S. international tax with topicsincluding key issues involving theAmerican Jobs Creation Act and theU.S. tax effects of generating income orlosses from operations overseas.

• Tel: (800) 206-4432


June 17U.S. International Tax — Boston.ATLAS will sponsor an intermediate-level three-day seminar on U.S. interna-tional tax provisions using examples andcase studies.

• Tel: (800) 206-4432


TAX CALENDAR


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CORRESPONDENTS

Africa: Zein KebonangAlbania: Adriana CiviciAngola: Trevor WoodAnguilla: Alex RichardsonAntigua: Donald B. WardArgentina: Cristian E. Rosso Alba; Sebastian Lopez-SansonArmenia: Suren AdamyanAsia: Laurence E. LipsherAustralia: Graeme S. Cooper; Richard Krever; Philip BurgessAustria: Markus Stefaner; Clemens Philipp SchindlerBahamas: Hywel JonesBangladesh: M. Mushtaque AhmedBarbados: Patrick B. ToppinBelgium: Werner Heyvaert; Marc QuaghebeurBermuda: Wendell HollisBotswana: I.O. SennanyanaBrazil: David Roberto R. Soares da SilvaBulgaria: Todor Tabakov; Lubka TzenovaCameroon: Edwin N. ForlemuCanada: Brian J. Arnold; Jack Bernstein; Steve SuarezCaribbean: Bruce ZagarisCayman Islands: Timothy RidleyChile: Macarena NavarreteChina (P.R.C.): Laurence E. Lipsher; Peng Tao; Huiyan QiuCook Islands: David R. McNairCosta Rica: Alvaro Castro MendezCroatia: Hrvoje ŠimovicCuba: Cristian Óliver Lucas-MasCyprus: Theodoros PhilippouCzech Republic: Niko HärigDenmark: Nikolaj Bjørnholm; Jens WittendorffDominican Republic: Dr. Fernándo Ravelo AlvarezEastern Europe: Iurie LunguEcuador: Roberto Silva LegardaEgypt: Abdallah El AdlyEstonia: Viktor Trasberg; Inga KlausonEuropean Union: Marco Rossi; Clemens Philipp SchindlerFiji: Bruce SuttonFinland: Marjaana HelminenFrance: Olivier Delattre; Michel Collet; Hervé BidaudGambia: Samba Ebrima SayeGermany: Jörg-Dietrich Kramer; Thomas Eckhardt; Clemens PhilippSchindler; Wolfgang Kessler; Rolf EickeGhana: Seth TerkperGibraltar: Charles D. SerruyaGreece: Alexandra GavrielidesGuam: Stephen A. CohenGuernsey: Neil CrockerGuyana: Lancelot A. AtherlyHong Kong: Laurence E. LipsherHungary: Farkas BársonyIceland: Indridi H. ThorlakssonIndia: Nishith M. Desai; Shrikant S. Kamath; Vaishali Mane; MundachalilPadmakshanIndonesia: Freddy KaryadiIran: Mohammad TavakkolIreland: Kevin McLoughlinIsle of Man: Richard VanderplankIsrael: Joel Lubell; Guy KatzItaly: Alessandro-Adelchi Rossi; Gianluca Queiroli; Marco Rossi; FedericoPacelliJapan: Paul PreviteraJersey: J. Paul Frith

Kenya: Glenday GrahamKorea: Sangmoon ChangKuwait: Abdullah Kh. Al-AyoubLatvia: Andrejs Birums; Valters GencsLebanon: Fuad S. KawarLibya: Ibrahim BaruniLithuania: Nora VitkunieneLuxembourg: Jean-Baptiste BrekelmansMalawi: Clement L. MonongaMalaysia: Jeyapalan KasipillaiMalta: Dr. Antoine FiottMauritius: Ram L. RoyMexico: Jaime Gonzalez-Bendiksen; Koen van ’t HekMiddle East: Aziz NishtarMonaco: Eamon McGregorMongolia: Baldangiin GanhulegMorocco: Mohamed MarzakMyanmar: Timothy J. HolzerNauru: Peter H. MacSporranNepal: Prem KarkiNetherlands: Eric van der Stoel; Michaela Vrouwenvelder; Jan Ter WischNetherlands Antilles: Dennis Cijntje; Koen LozieNew Zealand: Adrian SawyerNigeria: Elias Aderemi SuluNorthern Mariana Islands: John A. ManglonaNorway: Frederik ZimmerOman: Fudli R. TalyarkhanPanama: Leroy WatsonPapua New Guinea: Lutz K. HeimPhilippines: Benedicta Du BaladadPoland: Dr. Janusz Fiszer; Michal TarkaPortugal: Francisco de Sousa da Câmara; Manuel Anselmo TorresQatar: Finbarr SextonRussia: Scott C. AntelSaint Kitts-Nevis: Mario M. NovelloSaudi Arabia: Fauzi AwadSerbia and Montenegro: Danijel PanticSierra Leone: Shakib N.K. Basma; Berthan MacaulaySingapore: Linda NgSlovakia: Niko HärigSouth Africa: Peter SurteesSpain: Florentino Carreño; Sonia VelascoSri Lanka: D.D.M. WaidyasekeraSweden: Leif Mutén; Mattias DahlbergSwitzerland: Thierry BoitelleTaiwan: Yu Ming-iTrinidad & Tobago: Rolston NelsonTunisia: Lassaad M. BediriTurkey: Mustafa ÇamlicaTurks & Caicos Islands, British West Indies: Ariel MisickUganda: Frederick SsekandiUnited Arab Emirates: Nicholas J. LoveUnited Kingdom: Trevor Johnson; Nikhil Mehta; Tom O’SheaUnited States: James FullerU.S. Virgin Islands: Marjorie Rawls RobertsUruguay: Dr. James A. Whitelaw; Alberto VarelaVAT Issues: Richard AinsworthVanuatu: Bill L. HawkesVenezuela: Ronald Evans; Pedro Palacios Rhode

Vietnam: Frederick Burke

Zambia: W Z Mwanza

Zimbabwe: Prof. Ben Hlatshwayo


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no job name - dartmouth college...vodafone’s appeal in the case, which stemmed from vodafone’s...

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