By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The Italian Supreme Court (Corte Suprema di Cassazione) continues to astonish observers in its interpretation of the Permanent Establishment (PE) article of Italian income tax treaties. In the most recent case, Voith Paper S.r.l.,1 the court has come to a conclusion that also raises questions about who the technical taxpayer would be for purposes of applying the U.S. foreign tax credit rules.2
In the Voith Paper case, the Italian tax authorities had audited the wholly owned Italian subsidiary of a German entity. The tax authorities on audit asserted that the German entity had a PE in Italy. The opinion is not clear as to the technical basis for finding a PE, but that conclusion probably was based on a determination that the Italian entity acted as a dependent agent which habitually exercised the authority to conclude contracts in the name of the German parent. The tax authorities then attributed to the PE the royalties the Italian subsidiary paid to other group companies controlled by the German entity. Since the German entity was the party which was determined to have an Italian PE to which profits were attributed, it seems clear under traditional PE concepts that the German entity should have been liable for the Italian corporate income tax. Instead, the Italian authorities assessed the tax liability against the Italian company and not against the German parent (or against any of the other group companies that actually received the royalties). The assessment was achieved by disallowing a deduction for the royalties paid, to create the effect of reintegrating those amounts into the taxable income of the Italian entity. Indeed, the effect was to include the gross amount in taxable income, thus denying to the taxpayer the ability to reduce the income by allocable expense, which should have been allowed under a normal application of PE principles. The Supreme Court upheld this assessment.
Assessing a resident entity for a tax liability imposed on profits attributable to a PE of a nonresident certainly is a surprising interpretation of the PE and profit attribution provisions of the treaty. If a nonresident maintains a PE in a source state, and profits are attributable to that PE which then are liable to source-country net income tax, it seems clear that the normal conclusion would be that the entity which maintains the PE, i.e., the nonresident, is the entity that is liable for the tax. The OECD has suggested that tax administrations might find administratively convenient approaches for collecting taxes owed by nonresidents,3 but the suggestion that administrative procedures be established to facilitate compliance is an entirely different proposition than determining that a local entity is liable for a tax purportedly arising from the business activities of another. There is no suggestion in the opinion that the tax is being levied on the Italian entity in its capacity as an agent for the German parent, and there is no reference to any other special circumstance (like a partner being held liable for taxes owed on partnership income) that could explain the result.
Italian practitioners have noted that this case is not the first time that the Italian tax authorities have assessed a resident entity as the result of an audit of a nonresident affiliate. In various cases, the authorities have asserted that a nonresident maintained a PE in Italy, but then proceeded to assess the tax against an Italian affiliate without making any effort to assess tax against the nonresident entity. In the Voith Paper decision, the Italian Supreme Court has endorsed that practice, and apparently considers this approach proper under the Italy-Germany Income Tax Treaty as well as domestic regulations.
Had this case involved a U.S. group, the U.S. tax director then would need to address the U.S. foreign tax credit consequences of this decision. For U.S. groups that maintain a low-tax principal company structure in Europe, the risk of a PE assertion against the principal company can be doubly damaging; not only could the assertion give rise to an additional tax liability, but frequently such an assessment carries the double whammy that the additional tax will not be creditable any time soon. In most cases, earnings generated by a low-tax principal company will be retained by the controlled foreign corporation (CFC), rather than being distributed to the United States as dividends. As a consequence, any foreign taxes for which the CFC is liable would not become available as foreign tax credits as long as the earnings are retained offshore, making the tax in essence an unrecoverable cost of the structure.
The judgment of the court in Voith Paper, however, raises the possibility that if a similar case arose with respect to a U.S. group, and subject to the application of §909 as discussed below, the U.S. parent could claim the taxes assessed against and paid by the Italian sales and marketing affiliate as indirect foreign tax credits upon a distribution of earnings from the Italian entity, at least if the affiliate is not checked into the low-tax principal company and the entity is not held below the low-tax principal in a way that would cause any dividends distributed by that entity to become blended for foreign tax credit purposes into the low-tax earnings and profits (E&P) pool of the principal.
While many U.S. groups for various reasons have structured their sales entities as members of a check-the-box group with their low-tax principal, a major downside of that structure is the dilution of the foreign taxes paid in the sales entities in the low-tax E&P pool of the principal. As a result, some groups have structured their sales entities as sister entities to the low-tax principal, for the precise purpose of making sure that the sales entity taxes would remain available as foreign tax credits without dilution. For those groups, Voith Paper raises interesting issues.
The technical issue raised by the Voith Paper decision is the question of whether the Italian sales entity or the nonresident principal is the "taxpayer" under the principles of Regs. §1.901-2(f)(1). The current regulations provide that "[t]he person by whom tax is considered paid for purposes of §§901 and 903 is the person on whom foreign law imposes legal liability for such tax even if another person (e.g., a withholding agent) remits such tax" (usually referred to as the "technical taxpayer" rule). The rule is illustrated by a couple of examples, one of which includes a source-country withholding agent that pays interest to a nominee, for the benefit of a third-party beneficial owner. The example concludes that the third-party beneficial owner is the "taxpayer" and thus entitled to claim the credit for the withholding tax, on the basis that legal liability for the tax is imposed on the third party, not on the nominee (or on the withholding agent).4 A further rule states that if foreign tax is imposed on the combined income of two or more related persons (such as corporate affiliates) "and they are jointly and severally liable for the income tax under foreign law, foreign law is considered to impose legal liability on each such person for the amount of foreign tax that is attributable to its portion of the basis of the tax, regardless of which person actually pays the tax."5
Under these rules, it appears that the Voith Italian affiliate would be the technical taxpayer for §§901 and 902 purposes for the tax assessment upheld by the Italian Supreme Court. While the judgment of the court is not clear in this respect either, the court seems to have held that only the Italian entity was liable for the additional corporate income tax, despite the fact that the audit proceeded on the basis of attributing royalty income earned by other entities to an Italian PE of the German parent. Furthermore, the court seems to have concluded that the Italian entity was directly liable for the tax, and not merely required to remit the tax on behalf of another entity (such as the German parent) as an agent or other form of representative of some other entity. There is no mention of joint and several liability for the tax.
U.S. groups have commonly sought to manage PE exposures relating to transactions between a low-tax principal and a local sales and marketing entity by endeavoring to position the issue as a transfer pricing matter between those two entities. If an audit is resolved by means of a transfer pricing adjustment that allocates additional income to the local sales entity, the resulting additional tax is clearly one for which the sales entity is the technical taxpayer. Such taxes then may be made available to the U.S. parent as credits by means of a dividend distribution in the same way as all other corporate-level taxes of that entity. The theory of the Voith Paper case would seem to equalize the effect of a transfer pricing and a PE adjustment from the perspective of identifying the "technical taxpayer" of the additional tax assessment.
The conclusion might be different, however, under regulations proposed in 2006 in response to the decision in Guardian Industries v. U.S., 65 Fed. Cl. 50 (2005), aff'd, 477 F.3d 1368 (Fed. Cir. 2007), but not yet finalized. In Guardian Industries, the court agreed that the U.S. parent could claim a current foreign tax credit for the Luxembourg tax paid by a disregarded parent of a Luxembourg consolidated group, where the other operating entities in the group were separately regarded entities, on the basis that under Luxembourg law only the parent was liable to pay the tax on the consolidated income. The effect of that case was that the U.S. parent obtained a credit for the entire Luxembourg tax imposed on consolidated income, without currently including in U.S. taxable income the income of the other members of the Luxembourg consolidated group.
The Treasury intended to prevent this separation of income from tax for foreign tax credit purposes in regulations proposed after the Court of Federal Claims decision in Guardian Industries. The proposed regulations restate the definition of "taxpayer" to provide as follows:6
Income tax … is considered paid for U.S. income tax purposes by the person on whom foreign law imposes legal liability for such tax. In general, foreign law is considered to impose legal liability for tax on income on the person who is required to take the income into account for foreign income tax purposes …. This rule applies even if under foreign law another person is obligated to remit the tax, another person (e.g., a withholding agent) actually remits the tax, or foreign law permits the foreign country to proceed against another person to collect the tax in the event the tax is not paid.
The proposed regulations also include an example of taxes imposed on an entity that is taxable by virtue of maintaining a PE in the source state. The example stated as a fact that the taxpayer had taxable income attributable to a PE in another country.7 The example comes to the expected conclusion that the nonresident entity is considered to be legally liable for the source-country tax imposed on the income from its PE.
It is not clear how the proposed regulation would apply in a case similar to that of Voith Paper. One of the unclear aspects of the Voith Paper case is that the court did not identify with precision the entity to which income should be attributed; it simply upheld an assessment of tax against the Italian entity, claiming that the latter, representing the Italian permanent establishment, should qualify as an autonomous center to which relationships related to the nonresident entity should be attributed. The second sentence in the proposed regulation as quoted above does refer to cases where a person other than the entity principally liable for the tax may be compelled under local law to collect or remit the tax. In each case described, however, it seems that the regulation assumed that an entity other than the remitting entity had legal liability for the tax. In the Voith Paper case, however, there was never any conclusion that the nonresident was liable for the tax even on a joint and several liability basis, or that the assessment against the Italian entity was only for purposes of collecting the liability of another party.
For taxable years beginning after December 31, 2010, Congress has stepped in and the U.S. tax director also must consider §909. Section 909 does not address the technical taxpayer rule directly, but instead suspends the ability of a U.S. parent to take certain foreign tax credits, including a §902 credit on distributions from a CFC, where there has been a "foreign tax credit splitting event." Section 909 generally provides that the foreign tax credits are suspended until "the related income is taken into account" by the CFC, which then may provide the §902 foreign tax credits. The legislative history to §909 is particularly sparse.8 How can a taxpayer that wishes to avoid the §909 quarantine cause the income to be "taken into account" by the CFC in a case like Voith Paper? The usual U.S. rules regarding conforming adjustments after §482 allocations apply to cases where the §482 allocation has been made by the IRS, or a taxpayer self-initiated adjustment has been made on an original return.9 Pursuing Competent Authority relief in the two jurisdictions directly affected (Italy and Germany here) might be an approach to try to balance the books through an agreement by both sides that the taxable income is that of the entity on which the liability was assessed. One would hope that the fact that the tax administration action was to disallow a deduction would not preclude Competent Authority relief, since the effect was to create double taxation as the royalty income presumably was included in the taxable income of the recipients. Once a case has made it all the way to a national Supreme Court, however, the opportunities for Competent Authority relief generally are long gone.
The message for taxpayers facing a case like Voith Paper should be that endeavoring to resolve cases on a transfer pricing basis remains the most effective way to ensure that an entity other than the low-tax principal remains the technical taxpayer for any additional assessments. Competent Authority proceedings may then be useful to not only relieve double taxation in the residence state, but also to support recognizing the earnings in the source-country entity for §909 purposes. In the Italian context in particular, it will be interesting to see whether the Voith Paper decision will encourage more assessments against Italian entities on income they did not realize.
This commentary also will appear in the November 2011 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes — General Issues, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
1 Decision of the Supreme Court n. 16106/11 (7/22/11).
2 I am grateful for the assistance of Giuliana Polacco of the Baker & McKenzie Milan office in interpreting the Voith Paper decision.
3 OECD Report on the Attribution of Profits to Permanent Establishments, July 17, 2008, ¶282.
4 Regs. §1.901-2(f)(2)(ii), Example 2.
5 Regs. §1.901-2(f)(3).
6 Prop. Regs. §1.901-2(f)(1)(i).
7 Prop. Regs. §1.901-2(f)(6), Example 7.
8 See Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586 (JCX-46-10), Aug. 10, 2010.
9 Rev. Proc. 99-32, 1999-2 C.B. 296; Regs. §1.482-1(a)(3).
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