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On November 28, 2007, as mandated by the American Jobs Creation Act of 2004 (the “2004 Act”), the Treasury Department submitted a report to Congress on earnings stripping, transfer pricing, and U.S. income tax treaties, emphasizing intangible property in the case of transfer pricing.¹ While the 2004 Act added Code provisions intended to deter the “inversion” or expatriation of U.S. corporations, it did not change the earnings stripping, transfer pricing, or tax treaty abuse rules that are arguably relevant to the “dynamics” of inversion transactions. The Treasury was instead directed to issue a report on the effectiveness of each of the rules. These were due in 2005. A study of the effect of the 2004 Act's inversion provisions was also mandated for 2005, but the report says that more time is needed to assess their impact and also that the study should wait on the issuance of further regulations under §7874.

In summary, the report concludes that: (1) while there is no “conclusive evidence” of earnings stripping--defined generally as the payment of “excessive deductible interest” to foreign-related parties--by foreign-controlled domestic corporations in general, there is “strong evidence” of earnings stripping by so-called “inverted” corporations (i.e., U.S. corporations that inverted into, or became, foreign corporations prior to the effective date of the 2004 Act); (2) the way forward on transfer pricing is for the Treasury to finalize regulations relating to cost sharing, related-party services, and global securities dealing; and (3) the limitation on benefits articles in U.S. income tax treaties are central to preventing the abuse of those treaties. In the absence of sufficient information about earnings stripping, a new tax form intended to collect information on potential earnings stripping was released for comment at the same time the Report was issued.² While deferring a report on the inversion provisions of the 2004 Act, the report does conclude that the enactment of those provisions “appears to have been successful in curtailing inversion transactions by large, publicly traded corporations.”

What are we to make of this? The earnings stripping rules, in §163(j), were enacted in 1989 and expanded in 1993 to cover guaranteed debt, and there have since been then a number of proposals, including proposals by the Treasury, to change §163(j).³ Given these proposals and the time that has elapsed since §163(j) was enacted, it is surprising the report concludes that: (1) more information is needed to determine whether there is earnings stripping and how foreign-controlled domestic corporations would be affected by the proposals for change; (2) the “overall effect of income stripping on U.S. employment is unclear”; and (3) “existing studies do not address the question of how income shifting affects cross-border investment.”

In the case of inverted corporations, the report says the data “strongly suggest that these corporations are shifting substantially all of their income out of the United States, primarily through interest payments.” But the source for this seems to be limited to one private-sector study,⁴ and, as noted above, the Treasury at this time is not ready to report comprehensively on the expatriation rules of the 2004 Act, notwithstanding the Congressional direction to do so by the end of 2005.

Turning to income tax treaties, the report focuses on treaty-based “abuses” of the U.S. withholding tax rules, particularly in the case of interest and dividends, and also on the U.S. treaty policy with respect to the elimination by treaty of the excise tax on premiums paid to foreign insurance companies to insure or reinsure U.S. risks.

After reviewing the history and evolution of “limitation on benefits” articles in U.S. tax treaties through the “model” income tax convention released by the Treasury at the end of 2006, the report says that these articles are “critical” and that they provide “significant deterrence against “treaty “abuse.” It goes on to say that there is empirical evidence that, in the absence of a “limitation on benefits” article, withholding tax reductions or eliminations in older treaties, such as those with Iceland, Hungary,⁵ and Poland (and Barbados prior to the 2004 protocol), have been abused, and limitation on benefits articles in treaties appear to provide a “significant deterrence” against abuse.

This is interesting, but is it news? The use of Hungarian and Icelandic companies to avoid U.S. withholding taxes on interest has been around for some time, and is essentially part of the 1995 decision that the anti-conduit regulations would not deal with common-equity-financed foreign conduits but rather would wait on the extension to all treaty partners of limitation on benefits articles.

Some U.S. treaties eliminate the excise tax imposed on premiums paid to foreign insurers, but others do not,⁶ and the report says that, when asked to do so in treaty negotiations, Treasury conducts a “thorough review” of the taxation of the other country's insurance industry and accedes to the request only if satisfied that an insurance company resident in the other state will “face a level of taxation that is substantial relative to the level” of tax faced by U.S. insurers. This is more informative than the Technical Explanation of the 2006 Model Treaty, which was silent on U.S. treaty policy with respect to the excise tax. The report, however, makes no mention of the other current issues involved in offshore insurance and whether there is a transfer pricing problem that needs to be addressed.⁷

The part of the report dealing with transfer pricing is more satisfying, although it includes no real surprises. The report says that the fundamental components of the IRS’s five-part strategy to improve the administration of §482 that were described in the report issued in 1999⁸ remain unchanged. In addition, Treasury needs to finalize and modernize transfer pricing guidance on: (1) cost sharing rules with respect to the type and valuation of external contributions (i.e., buy-in payments);⁹ (2) related party (or “controlled”) services transactions, including coordination with the rules that apply to transfers of intangible property generally;¹⁰ and (3) the determination of income from global securities dealing (i.e., the income of a dealer in securities that operates in more than one country).¹¹ The cost sharing rules were proposed in 2005, and the report states that the Treasury Department is working to finalize these. Temporary and proposed regulations have been issued with respect to related party services and new proposed regulations with respect to global dealing operations are “to be issued shortly.”

This commentary also will appear in the February 8, 2008, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Isenbergh, 900 T.M., Foundations of U.S. International Taxation, and Levine and Miller, 936 T.M., U.S. Income Tax Treaties -- The Limitation on Benefits Article, and in Tax Practice Series, see ¶7110, Foreign Income Taxation -- General Principles, and ¶7140, U.S. Income Tax Treaties.