Down the BRIC Road

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By James J. Tobin, Esq.  

Ernst & Young LLP, New York, NY   * 

U.S. tax practitioners take an almost perverse pride in the complexity of the U.S. tax system, particularly the international tax area. U.S. leadership in anti-avoidance regimes — from the controlled foreign corporation (CFC) rules to the foreign tax credit rules to limitation on benefits (LOB) provisions in tax treaties, etc. — is unmatched and arguably may be our most successful export after fast food. Although we clearly remain the leaders in tax complexity, many of the world's major economies have been adopting and adapting various of our complex avoidance-type processes for years.  Take, for example, the CFC area where U.S.-style rules were enacted first in Germany in 1972, followed by Canada in 1976, Japan in 1978, France in 1980, and the United Kingdom in 1984. (Another 14 countries adopted CFC regimes in the 1990s, with more added to the roster since 2000.)

In recent years I have been encouraged that CFC regimes and foreign tax credit systems seem to be moderating somewhat as governments recognize both the importance of international business to their local multi-national corporations (MNCs) and the need for rules that reflect modern global business processes. Foreign tax credit rules have been replaced with exemption systems in the United Kingdom and Japan, while CFC rules have been relaxed a bit in many countries, including New Zealand, Australia, and some EU countries.  Indeed, this is a trend where the United States would be well-served to follow the lead of some of our major trading partners. On the other hand, I'm also surprised to see an unfortunate trend of new CFC rules and foreign tax credit restrictions proliferating in some emerging market countries.

An extreme example is Brazil, which got into the game almost 10 years ago when it completely eliminated deferral by requiring Brazilian-based MNCs to include in income the profits of their foreign subsidiaries on an annual basis, regardless of whether such earnings were repatriated to Brazil. China took the plunge effective in 2008, introducing a CFC regime, and now India is proposing something similar in the new Direct Tax Code. Russia, which is playing economic catch-up with its BRIC (Brazil, Russia, India, China) counterparts, has not announced any plans for a CFC regime, but I worry that Russia could join the club at some point.

I am somewhat perplexed that the governments of emerging economies would follow this particular path of complexity and burden while the trend in developed countries (other than the United States, so far) seems to be the reverse. It seems counter-intuitive for countries that are in the early stages of their global economic development to adopt tax rules that impede the foreign activities of their own new MNCs. I would have expected instead these governments to encourage their MNCs to go global and not to adversely affect these companies' global investments with anti-MNC tax rules. Even more remarkable to me, some of the rules in the emerging countries may be even more potentially onerous than those in the United States, the acknowledged leader in tax complexity.

Brazil has a worldwide tax system with no deferral.  India's proposed Direct Tax Code would establish a CFC regime seemingly with no deemed-paid foreign tax credits, thereby ensuring full double taxation on a current basis. China also has new rules in the foreign tax credit area which they are adopting from scratch — no mean feat in and of itself. The Chinese model involves a three-tier foreign tax credit system with a modified "per-country" limitation approach. I submit that given the trend we observe of Chinese companies buying and expanding sophisticated global businesses, this three-tier approach will severely limit their ability to obtain double tax relief.  Moreover, a per-country limitation is completely outdated and very difficult to apply in today's global economy. So this is going to cause serious angst among Chinese MNCs and their tax advisors. Or perhaps this should be viewed as an economic stimulus program for tax professionals? I probably shouldn't complain given the Chinese competitive advantage from the standpoint of access to capital, human resources, and natural resources. Their adoption of some U.S.-style uncompetitive tax rules may help level the playing field a tad.

While these changes in the BRIC countries' tax systems are unwelcome developments for their outbound MNCs, of even greater interest to a wider audience is the direction things are taking with regard to the tax treatment of inbound investment. There is a definite trend evolving across the tax landscape in emerging economies: tax benefits are increasingly being conditioned on the satisfaction of vague substance requirements and holding company structures are coming under increasing scrutiny. Business purpose, tax residence, beneficial ownership, substance and operational alignment are all also becoming increasingly important. Fair enough. However, these very subjective standards are all prone to differing interpretations in the eye of the beholder, i.e., the countries that are seeking to impose these standards in a way that will raise tax revenue at the expense of foreign investors.

Take, for instance, the most recent example of tax overreach: the Vodafonecase in India. In Vodafone, a Dutch holding company indirectly acquired a controlling interest in an Indian company through the purchase of shares in a Cayman entity that indirectly owned shares of the Indian company through a chain of Mauritius companies that ran from three tiers to six tiers deep. Thus, the Cayman company being sold stood quite far removed in the corporate structure chain from the Indian subsidiary in question. The Indian tax authorities took the position that the offshore transaction was taxable in the hands of the seller under Indian law, ignoring the intervening foreign holding companies and, even more incredibly, ignoring the fact that a direct sale of the Indian shares by the Mauritius holding company should have been tax-free under the India-Mauritius Income Tax Treaty. According to the Indian tax authorities, the Dutch holding company had a withholding tax obligation with respect to gain arising from the transaction.

The Bombay High Court validated the idea that there could be an Indian tax element to the sale, ruling that the Indian tax authorities had jurisdiction to tax the transaction to the extent the gains related to that part of the transaction that had a nexus with India. The High Court's ruling does not appear to propose a general principle of taxing all offshore share transactions that indirectly involve Indian assets. But it does set forth a nebulous concept of apportionment of the gain from an underlying Indian element of profit despite seemingly recognizing that a purely foreign capital gain would be exempt.

China, the largest economy of the BRIC states, has also shown a determination both to question treaty eligibility and to tax the capital gains derived by nonresident investors from indirect share transfers. China's State Administration of Taxation (SAT) issued Guoshuihan [2009] No. 601 (Circular 601) in October 2009 on treaty eligibility and Guoshuihan [2009] No. 698 (Circular 698) in December 2009 targeting capital gains from equity sales. Circular 601 contains guidelines on the interpretation and determination of beneficial ownership to maintain tax treaty eligibility. Circular 698 basically extends the substance-over-form approach to capital gains derived indirectly by nonresidents on share or equity transactions and authorizes the SAT to disregard certain intermediary entities under the general anti-avoidance rule if they are considered to be established for tax avoidance purposes and to lack a business purpose. 

And indeed, in several recently reported cases in China, the SAT has taken an approach similar to Vodafone in India and has disregarded an intermediary holding company to assert jurisdiction over an indirect sale of a Chinese entity. Both circulars and the reported cases address factors for determining whether adequate economic substance or business purpose exists. The criteria include factors such as number of employees, their functions and activities, office space, etc. If indeed the Circulars are applied in a way that requires the satisfaction of most of these criteria, it will be hard for any typical holding company to qualify, which in my view goes well beyond the usual standard for beneficial ownership in developed countries.

No doubt my point of view on these issues is heavily influenced by my U.S. tax upbringing. Under U.S. rules, it is rare that we entirely disregard an entity (absent electively doing so under our check-the-box rules). Most of the MNC clients I deal with have scores or hundreds of legal entities in their structures, often for legal liability protection, intellectual property protection, access to capital or debt funding, or other commercial reasons. Many of these legal entities, while having purpose and function, will not have their own dedicated employees or premises; rather, they are managed by employees of other group companies. Absent blatant conduit arrangements or other unusual factors, the clear expectation under U.S. rules and — in my experience — the rules of most developed countries is that such entities would be fully respected for tax and other regulatory purposes.

Based on this perspective, I would expect that the sale of a foreign holding company would not produce a taxable result with respect to local subsidiaries held by that foreign holding company, unless there were clear rules that explicitly provided for some form of extraterritorial tax treatment. Two examples of such rules that come to mind are the Taxable Canadian Property regime in Canada where shares in a nonresident holding company are considered to be taxable property in Canada if too high a percentage of value relates to Canadian real property or resource assets and the German transfer tax rules for real estate where an indirect sale causes a transfer tax to apply in certain instances. More examples exist.  But a significant difference in my view is that these rules, while perhaps also somewhat troubling from a global policy standpoint, are relatively clear, objective rules, can be understood by taxpayers, and don't disregard intervening entities but rather deal with the character of a particular entity or the transfer event itself.

Likewise, in the treaty eligibility area, I am used to our LOB approach. As above, the LOB regime does not disregard the foreign treaty entity but looks to whether and the extent to which the treaty entity is eligible for the benefits of an income tax treaty.  The identity of the shareholders of the treaty entity is a factor in determining treaty eligibility, as is the business activity of the entity (or very importantly, any related entities) in its country of residence. But whether or not the entity is able to satisfy the treaty eligibility tests, any income it receives from the United States (absent conduit arrangements) will be taxed by the United States as its income. And these LOB criteria are relatively clear, objective standards, explicitly set forth in the bilaterally negotiated treaty terms.

Of course, I don't want to sound like a fan of U.S. LOB rules, Taxable Canadian Property rules, or other similar taxpayer-unfriendly extraterritorial provisions. There are definitely some themes to whine about with respect to these provisions, not the least of which is the real potential for double taxation. But I am even more concerned about vague and subjective abuse standards and unilateral disregard of corporate form which can be inconsistent from country to country. The MNCs I deal with rank certainty/no surprises as their highest priority in dealing with their tax affairs, particularly driven by the need to accurately reflect their tax position in their financial statements and not to have unexpected spikes or dips in their reported tax rate. The capital markets also need certainty, particularly for M&A transactions, IPOs, reporting of results to fund investors, etc.

It seems to me that emerging market government policy objectives should be in line with this. Inbound investment is critical to these economies and the resources committed to tax administration are limited. So objective rules consistent with global standards are what is needed. They help MNCs understand and satisfy their compliance obligations and they enable more consistent administration of the law and less potential for disputes which both delay collection of tax and absorb scarce tax authority and judicial human resources.  And while I'm giving advice, how about scaling back some of the anti-abuse rules applicable to outbound investors from emerging market countries so that the uncertainty and complexity associated with those rules intrude less on business activity occurring as local MNCs expand and compete globally? It seems to me that would better align with an outbound growth policy. Come to think of it, maybe the United States could lead the way here and eliminate most of our, in my view, outdated foreign base company Subpart F rules in order to help our MNCs expand and compete globally as well! I suspect that may not happen for a while but one can always hope.

This commentary also will appear in the January 2011 issue of the Tax Management International Journal.  For more information, in BNA's Tax Management Portfolios, see Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, and Yoder, Lyon, and Noren, 926 T.M., CFCs — General Overview, and Levine and Miller, 936 T.M., U.S. Income Tax Treaties — The Limitation on Benefits Article, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation, and ¶7160, U.S. Income Tax Treaties.

The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.