Internal Revenue Service Notice on Bitcoins and Other Virtual Currencies

27 Mar

Internal Revenue Service Notice 2014-21, March 25, 2014, describes how existing general tax principles apply to transactions using virtual currency. Virtual currency is described as a digital representation of value that functions as a medium of exchange, a unit of account, and/or a store of value. It operates like “real” currency but does not have legal tender status in any jurisdiction.

The Service answers frequently-asked questions on bitcoin status and solicits comments.  The Notice is uncontroversial, trendy and answering idiotic theories.

For federal tax purposes, virtual currency is treated as property. General tax principles are applicable. A taxpayer who receives virtual currency as payment for goods or services must, in computing gross income, include the fair market value of the virtual currency, measured in U.S. dollars, as of the date that the virtual currency was received. The basis of the currency in the recipient’s hands is determined the same way.

If a virtual currency is listed on an exchange, and the exchange rate is established by market supply and demand, the fair market value of the virtual currency is determined by converting the virtual currency into U.S. dollars (or into another real currency which can be converted into U.S. dollars) at the exchange rate, in a reasonable manner that is consistently applied.

If the fair market value of property received in exchange for virtual currency exceeds the taxpayer’s adjusted basis of the virtual currency, the taxpayer has taxable gain. The taxpayer has a loss if the fair market value of the property received is less. A taxpayer generally realizes capital gain or loss on the sale or exchange of virtual currency that is a capital asset in the hands of the taxpayer, and ordinary gain or loss if the virtual currency is not a capital asset, e.g., inventory and other property held mainly for sale to trade customers.

Virtual currency is not treated as currency that could generate foreign currency gain or loss for U.S. federal tax purposes.

When a taxpayer successfully mines virtual currency, the fair market value of the virtual currency as of the date of receipt is includible in gross income. If a taxpayer’s mining constitutes a business, and the mining activity is not undertaken as an employee, the net earnings are subject to the self-employment tax. The fair market value of virtual currency paid as wages is subject to federal withholdings. A payment made using virtual currency is subject to information reporting to the
same extent as any other payment made in property.

A person who in the course of a trade makes a payment of $600 or more in a taxable year to an independent contractor for the performance of services is required to report that payment on Form 1099-MISC. A third party that contracts with a substantial number of unrelated merchants to settle payments between the merchants and their customers is a third party settlement organization (TPSO), required to report payments made to a merchant on a Form 1099-K, Payment Card and Third Party Network Transactions, if certain thresholds are met.

No clear answer was provided to the question whether taxpayers would be subject to penalties for having treated a virtual currency transaction in a manner that is inconsistent with the Notice, prior to March 25, 2014.


Capitalized interest on defaulted policy loans includible in taxable amount

21 Mar

In Black v. Commissioner of Internal Revenue, Docket No. 6406-12. Feb. 12, 2014, the U.S. Tax Court has determined that capitalized interest accrued on taxpayer’s loans against his life insurance policy, is includible in determining the gross distribution and the taxable amount arising from the termination of the policy. The taxpayer borrowed against a life insurance policy but failed to repay the loans. The policy was terminated, and the loans were satisfied by policy proceeds and extinguished.

In June 1989, the husband of the taxpayer couple acquired an insurance policy on his life from Northwestern Mutual Life Insurance Co. (Northwestern). The policy was a whole life policy, having both cash value and loan features.

Taxpayer was permitted to borrow against the policy. “Policy debt” consisted of outstanding loans and accrued interest. Unpaid interest was added to loan principal. Taxpayer could surrender the policy and receive as a distribution the cash value of the policy, minus any outstanding policy debt. The policy terminated, if policy debt exceeded the cash value.

Over time, taxpayer borrowed $103,548 against the policy, which he did not repay. In 2009, the policy was terminated. The combined balance of the loans, including principal and interest, was $196,230, and taxpayer’s investment in the contract (aggregate premiums paid) was $86,663.

Northwestern issued to taxpayer a Form 1099-R, Distributions From Pensions, Annuities, etc. reflecting a gross distribution of $196,230 and a taxable amount of $109,567. The latter represented the difference between the combined balance of the loans, and taxpayer’s investment in the contract, i.e., $86,663.

Taxpayers did not report any part of the taxable income on Form 1099-R, nor did they acknowledge the policy on their return.

In 2011, taxpayers nervously amended their 2009 return, to reflect an increase in income of $16,885, attributable to the difference between the principal of the policy loans less premiums paid. The amended return was not accepted. The Service issued a notice of deficiency of $30,571 and assessed an accuracy-related penalty.

The parties agreed that the taxable amount of the gross distribution that arose on termination of the policy did not include taxpayer’s investment in the contract of $86,663, and that the taxable amount takes into account the outstanding loans totaling $103,548. The Service contended that the taxable amount also takes into account capitalized interest.

Internal Revenue Code section 61 specifically includes in gross income, income from life insurance contracts and from discharge of indebtedness.

The Court regarded taxpayer’s policy loans as true loans. Taxpayers would not have had to recognize these loan proceeds as taxable income upon receipt. When an insurance policy is terminated and the proceeds are used to satisfy a policy loan, the transaction is treated as if the taxpayers received the proceeds and applied them against the outstanding loan.

Under Code section 72, an amount received in connection with a life insurance contract, which is not received as an annuity, generally constitutes gross income to the extent that the amount exceeds the investment in the insurance contract. The investment in the contract is defined generally as the premiums or other consideration paid, less amounts received under the contract, to the extent excludable from gross income.

The Court held that the capitalized interest was properly treated as part of the principal of the indebtedness. Capitalized interest is includible in determining the amount of a taxpayer’s gross distribution when an insurance policy is terminated. The policy loans, including capitalized interest, were charged against the available proceeds at that time. This satisfaction of the loans had the effect of a pro tanto payment of the policy proceeds to taxpayers, and constituted income to them. A contrary result would permit policy proceeds, including previously untaxed investment returns, to escape tax altogether and found no basis in the law.

Taxpayers argued that the termination of the life insurance policy gave rise to a discharge of indebtedness. The Court could not so characterize the source of taxpayers’ income. The loans to taxpayer were not discharged; rather, they were extinguished after Northwestern applied the cash value of the insurance policy toward the debt owed. Even if the income were discharge of indebtedness income, taxpayers did not allege that any exception under Code section 108 applied to exclude the amount from gross income.

Code section 6662(a) imposes an accuracy-related penalty equal to 20% of the amount of any underpayment of tax that is attributable to a substantial understatement of income tax. An understatement of income tax is “substantial”, if it exceeds the greater of $5,000 or 10% of the tax required to be shown on the return. There is an exception to the accuracy-related penalty with respect to any portion of an underpayment, if the taxpayer establishes that there was reasonable cause for such portion, and the taxpayer acted in good faith with respect to such portion. Taxpayers self-prepared their 2009 Federal income tax return, and nothing in the record suggests that they consulted with a professional adviser in connection therewith. Taxpayer is an attorney, yet failed to cite any case holding that interest on loans made against an insurance policy is not includible in the gross distribution when the policy is terminated for nonpayment. The only authorities taxpayers cited were Code sections and Treasury regulations that were inapposite. The Court held therefore that taxpayers failed the reasonable cause exception, nor could they invoke the “substantial authority” provision to reduce the amount of the understatement for penalty computation purposes.

Canada – Budget 2014 – International Tax Measures

12 Mar

Captive Insurance

Certain passive or Canadian-source income earned by a controlled foreign affiliate of a Canadian resident taxpayer is considered foreign accrual property income (FAPI) and is taxable in the hands of the Canadian taxpayer on an accrual basis.

Canadian risks are risks in respect of Canadian resident persons, property situated in Canada, or businesses carried on in Canada. Income from the insurance of Canadian risks is FAPI, where 10 per cent or more of the gross premium income (net of reinsurance ceded) of a foreign affiliate is premium income from Canadian risks.

Enlightened taxpayers engage in “insurance swaps”, feebly and shabbily designed to circumvent this rule, by purporting to transfer Canadian risks, originally insured in Canada, to a wholly-owned foreign affiliate of the taxpayer. The Canadian risks are then exchanged with a third party for foreign risks that were originally insured outside of Canada, while ensuring that the affiliate’s overall risk profile and economic returns are essentially unchanged.

Budget 2014 proposes to amend the existing anti-avoidance rule in the FAPI regime relating to the insurance of Canadian risks. The revised rule will apply where:

- taking into consideration any arrangements entered into by the foreign affiliate (or a person not dealing at arm’s length with the affiliate), the affiliate’s risk of loss or opportunity for gain in respect of foreign risks can reasonably be considered to be determined by reference to the returns from other risks (the tracked risks) that are insured by other parties; and

- at least 10 per cent of the tracked risks are Canadian risks.

Where the new rule applies, the affiliate’s income from the insurance of the foreign risks and any income from a connected arrangement will be included in computing its FAPI. This measure will apply to taxation years that begin on or after February 11, 2014.
Offshore Regulated Banks

Income from an investment business carried on by a foreign affiliate is included in the affiliate’s FAPI. An investment business is generally a business the principal purpose of which is to derive income from property. There is a regulated foreign financial institution exception, for a business carried on by a foreign affiliate as a foreign bank, a trust company, a credit union, an insurance corporation or a trader or dealer in securities or commodities. These activities must be regulated in the country in which the business is principally carried on, or another relevant foreign jurisdiction.

Certain clever Canadian taxpayers that are not financial institutions purport to qualify for the regulated foreign financial institution exception by establishing foreign affiliates and electing to subject those affiliates to foreign regulation. The main purpose of these affiliates is often to engage in proprietary activities, i.e., to invest or trade in securities on their own account (or those of group members, presumably), and not to facilitate financial transactions for customers.

Budget 2014 adds new conditions, making the regulated foreign financial institution available only where the following conditions are satisfied:

- The relevant taxpayer (i.e., the Canadian taxpayer of which the foreign corporation is a foreign affiliate) is (i) a Schedule I bank, a trust company, a credit union, an insurance corporation or a resident trader or dealer in securities or commodities, and supervised by the Superintendent of Financial Institutions or a similar provincial regulator, (ii) a wholly-owned subsidiary of such an institution, or (iii) a corporation that wholly owns such an institution (and is also subject to regulation).

- More than 50 per cent of the total taxable capital employed in Canada of the taxpayer and all related Canadian corporations is attributable to taxable capital employed in Canada of regulated Canadian financial institutions. Certain regulated Canadian financial institutions that have with equity of at least $2 billion, and certain affiliates, will be deemed to satisfy this second condition.

Satisfying these new conditions will not guarantee that income of a foreign affiliate from proprietary activities will be considered active business income. The affiliate also must carry on a regulated foreign financial services business, as required under the existing law, and the proprietary activities must comprise part of that business.

Stakeholders are invited to submit comments concerning the scope of this measure by early April 2014.
Back-to-Back Loans

The thin capitalization rules in the Income Tax Act limit the deductibility of interest expense of a corporation or a trust, where debt owed by the debtor to specified non-residents exceeds a 1.5-to-1 debt-to-equity ratio. In the case of a corporation, the rules apply to debts owing to a specified shareholder, i.e., a non-resident person who, together with persons with whom the specified shareholder is not dealing at arm’s length, owns shares representing at least 25 per cent of the votes or value of the corporation. The rules also apply to debts owing to any other non-resident who does not deal at arm’s length with a specified shareholder.

In the case of a trust, the rules apply to debts owing to a specified non-resident beneficiary, and to debts owing to any other non-resident who does not deal at arm’s length with a specified beneficiary.

Part XIII of the Income tax Act also generally applies a 25-per-cent withholding tax (unless reduced by tax treaty), on interest paid or credited by a Canadian resident to a non-arm’s length non-resident. Withholding tax also applies to payments and credits by a non-resident, if the interest is deductible in computing taxable income earned in Canada.

Taxpayers trying to be clever have sought to avoid these rules, through “back-to-back loan” arrangements, interposing a third party (e.g., a foreign bank) between two related taxpayers (such as a foreign parent corporation and its Canadian subsidiary). Budget 2014 adds a specific anti-avoidance rule in respect of withholding tax on interest payments, and amends the existing anti-avoidance provision in the thin capitalization rules. Under the proposed rule, a back-to-back loan arrangement will exist where, as a result of a series of transactions, the following conditions are met:

• a taxpayer has an outstanding interest-bearing obligation owing to a lender (the intermediary); and
• the intermediary or any person who does not deal at arm’s length with the intermediary
- is pledged a property by a non-resident person as security in respect of the obligation (a guarantee, in and of itself, will not be considered a pledge of property),
- is indebted to a non-resident person under a non-recourse debt, or
- receives a loan from a non-resident person on condition that a loan be made to the taxpayer.

Where a back-to-back loan arrangement exists, appropriate amounts in respect of the obligation and interest will be deemed owing to the non-resident person for purposes of the thin capitalization rules, generally in an amount equal to the lesser of:

- the outstanding obligation owing to the intermediary; and
- the fair market value of the pledged property or the outstanding amount of the debt for which recourse is limited or the loan made on condition.

The taxpayer will also be deemed to have an amount of interest payable to the non-resident person equal to the proportion of the interest on the obligation owing to the intermediary that the deemed amount owing is of that obligation.

Withholding tax will generally apply in respect of a back-to-back loan arrangement to the extent that it would otherwise be avoided by virtue of the arrangement.

The new rules will apply (i) in respect of the thin capitalization rules, to taxation years that begin after 2014, and (ii) in respect of withholding tax, to amounts paid or credited after 2014.
Consultation on tax planning by multinational enterprises

The Organisation for Economic Co-operation and Development has launched a bright new project aimed at addressing “base erosion and profit shifting” (BEPS) strategies used by multinational enterprises (MNEs). The OECD and the G-20 are working together on the issues identified in the BEPS Action Plan, released July 2013.

The enlightened Department of Finance invites input on the following, often-excessively general and conceptual questions:

• What are the impacts of international tax planning by MNEs on other participants in the Canadian economy? How to ensure fairness among different categories of taxpayers ? (e.g., MNEs, small businesses and individuals)
• Which of the international corporate income tax and sales tax issues identified in the BEPS Action Plan should be considered the highest priorities for examination and potential action by the Department? The Department pointedly notes that in some countries (e.g., South Africa and the European Union), foreign-based vendors must register and charge sales taxes if they make e-commerce sales to local residents.
• Are there other corporate income tax or sales tax issues related to improving international tax integrity that should be of concern to the Department?
• What considerations should guide the Department in determining the appropriate approach to take in responding to the issues identified – either in general or with respect to particular issues?
• Would concerns about maintaining Canada’s competitive tax system be alleviated by coordinated multilateral implementation of base protection measures?
Consultation on Treaty Shopping

Related to the above general international tax consultations, Budget 2013 set out the government’s concerns over “treaty shopping”, i.e. clever arrangements under which a person not entitled to the benefits of a particular tax treaty with Canada uses an entity resident in a state with which Canada has a tax treaty, to obtain Canadian tax benefits. Budget 2013 announced consultations regarding possible approaches to address treaty shopping. A consultation paper was released in August 2013, with request for comments.

Treaty shopping was also targeted in the above OECD Action plan of July 2013. The Action Plan calls for the development of “model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances”. The OECD is expected to issue its recommendations in September 2014.

Most countries that have addressed the issue in their tax treaties have used a general rule that denies a tax treaty benefit if one of the main purposes for entering into a transaction is to obtain the benefit. Some countries (e.g., the United States and Japan) have more detailed and specific rules.

Canada has included a main purpose rule in several of its tax treaties, as have several other countries. Stakeholders expressed concerns that a general approach might produce less certain outcomes in some cases (compared to a more specific approach). The Department responds that the U.S. limitation on benefits provision does not capture all forms of treaty shopping, e.g., arrangements that use certain entities, such as publicly-traded corporations or trusts.

Several stakeholders expressed a preference for a solution to treaty shopping that would require the re-negotiation of Canada’s tax treaties: a domestic law response to treaty shopping would alter the balance of compromises reached in the negotiation. The Department tartly responds that domestic law provisions to prevent tax treaty abuse are not considered by the OECD or the United Nations to be in conflict with tax treaty obligations, and that other countries have enacted legislation.

Some stakeholders asserted that only a few of Canada’s tax treaties would need to be re-negotiated in order to significantly curtail treaty shopping. Ah, but then other conduit countries would emerge, responds the Department.

Not minding to short-circuit the future public comments requested, the Department announces that the main elements it wants to see in the treaty-shopping rule are the following.

• A main purpose provision: subject to the relieving provision, a benefit would not be provided under a tax treaty, if it is reasonable to conclude that one of the main purposes for undertaking a transaction (which can be part of a series of transactions or events) that results in the benefit, was for the person to obtain the benefit.
• Conduit presumption: it would be presumed that one of the main purposes for undertaking a transaction that results in a treaty benefit, was to obtain that benefit, if the relevant treaty income is primarily used to transfer an amount to another person who would not have been entitled to an equivalent or more favourable benefit, had the other person received the relevant treaty income directly.
• Safe harbour presumption: subject to the conduit presumption, it would be presumed that none of the main purposes for undertaking a transaction was to obtain a treaty benefit, if:
- the person (or a related person) carries on an active business (other than managing investments) in the treaty state and, where the relevant treaty income is derived from a related person in Canada, the active business is substantial compared to the activity carried on in Canada giving rise to the relevant treaty income;
- the person is not controlled by another person who would not have been entitled to an equivalent or more favourable benefit had she received the relevant treaty income directly; or
- the person is a corporation or a trust the shares or units of which are regularly traded on a recognized stock exchange.

• Relieving provision: if the main purpose provision applies in respect of a treaty benefit, the benefit is to be provided, in whole or in part, to the extent that it is reasonable having regard to all the circumstances.

Even if a transaction results in a tax treaty benefit, the Department generously opines that it does not necessarily follow that one of the main purposes for undertaking the transaction was to obtain the benefit. The proposed rule would not apply in respect of an ordinary commercial transaction solely because obtaining a tax treaty benefit was one of the considerations for making an investment.

The rule would apply to taxation years that commence after enactment of the rule. The Department finds rather unreassuringly that transitional relief “may” be appropriate.

The Department invites comment on five specific examples. The first example involves assignment of income. Aco, resident in State A, owns intellectual property used by subsidiary Canco, resident in Canada. State A does not have a tax treaty with Canada. Aco incorporates Bco in State B, a state with which Canada has a tax treaty that provides for a nil rate of withholding tax on royalties. Aco assigns to Bco the right to receive royalty payments from Canco. Bco agrees to remit 80 per cent of the royalties received to Aco within 30 days. Bco pays tax in State B on its net amount of royalty income. State B does not impose withholding tax on royalties.

Under the conduit presumption, in the absence of proof to the contrary, one of the main purposes for the assignment of the royalties would be for Bco to obtain the withholding tax reduction. By virtue of the relieving provision, Bco may be allowed the benefits of the treaty in respect of the portion of the royalty payments not used by Bco to pay Aco.

If, instead, only 45 per cent of the royalties received by Bco were used to pay Aco, the conduit presumption would not apply as to the main purpose of the transaction, and it would be a question of fact whether the main purpose provision applied.

The second example involves payment of dividends. Canco is owned by Bco, resident in State B. The sole investment of Bco consists of the shares of Canco. Bco was established by its two corporate shareholders, Aco and Cco, residents of State A and State C respectively. Canada has a tax treaty with State B. Canada also has tax treaties with States A and C, which provide a higher rate of withholding tax on dividends than the State B treaty rate. Bco is required to distribute the entire dividend received from Canco to Aco and Cco almost immediately. Under the domestic laws of State A and State C, dividends received from foreign corporations are subject to tax.

Under the conduit presumption, one of the main purposes for the establishment of Bco would be to obtain the withholding tax reduction under the treaty between Canada and State B. Subject to the relieving provision, the benefit would be denied. The benefits that would have applied if Bco had not been established may be provided under the relief provision, to the extent it is reasonable having regard to all the circumstances, i.e., the benefits under the tax treaty between Canada and States A and C, had the dividend been paid directly from Canco. The Department would also require in this instance that Aco and Cco be taxable on the dividends.

Example 3 involves change of residence. Aco, resident in State A, owns shares of a Canadian-resident corporation and is contemplating their sale. The sale would trigger a capital gain taxable in Canada. Canada does not have a tax treaty with State A. Shortly before the sale, Aco is continued into, and becomes a resident of, State B, a state that does not impose tax on capital gains. The tax treaty between Canada and State B provides an exemption for capital gains on shares of a Canadian corporation disposed of by residents of State B. Aco sells the shares and retains the proceeds of disposition.

Since the proceeds of disposition remain with Aco, the conduit presumption would not apply. However, the main purpose provision would still apply.

If Aco were already a resident of State B at the time of the initial acquisition of the shares, it would need to be determined whether one of the main purposes for the establishment of Aco as a resident of State B was to obtain the capital gains exemption. All the relevant circumstances would need to be considered, including, for example, the lapse of time between the establishment of Aco in State B and the realization of the capital gains, and any other intervening events.

Example 4 involves “bona fide” investments. B-trust is a widely held trust that is a resident of State B, a state with which Canada has a tax treaty. B-trust holds 10 per cent of its portfolio in shares of Canadian corporations. Under the tax treaty between Canada and State B, the withholding tax rate on dividends is reduced to 15 per cent. A majority of investors in B-trust are residents of states with which Canada does not have a tax treaty. B-trust annually distributes all of its income to its investors.

Because dividends received by B-trust from Canadian corporations are primarily used to distribute income to persons not entitled to tax treaty benefits, under the conduit presumption one of the main purposes for the structure is to obtain the benefit under the tax treaty between Canada and State B. It would have to be clearly established that none of the main purposes for undertaking these investments, either alone or as part of a series of transactions, was to obtain the benefit of the tax treaty. This could be the case here, since investors’ decisions to invest in B-trust are not driven by any particular investments made by B-trust, and B-trust’s investment strategy is not driven by the tax position of its investors.

Example 5 addresses the safe harbours for foreign active business operations. Aco is resident in State A, with which Canada does not have a tax treaty. Aco owns all the shares of Finco, resident in State B, which has a tax treaty with Canada. Finco acts as a financing corporation for Aco’s wholly owned subsidiaries, including Canco and Bco (also resident State B). Bco carries on an active business in State B, which is substantial in comparison to the activities carried on by Canco. Aco’s other subsidiaries are residents of other states with which Canada has tax treaties with benefits on payments of interest equivalent to those in the Canada-State B tax treaty. Finco receives payments of interest from Aco subsidiaries and reinvests its profits.

Since the interest payments received by Finco from Canco are primarily used to pay persons who would have been entitled to an equivalent benefit had they received the interest payment directly from Canco, the conduit presumption would not apply. The safe harbour presumption describes categories of persons who, unless they are used in conduit arrangements, are generally considered not to be engaged in treaty shopping in the course of their normal operations.

FATCA Flexes and Frightens: Highly-Superficial Canada-U.S. Agreement on Foreign Account Compliance

7 Feb

The Canadian Finance and National Revenue ministers announced smugly on Wednesday that, after lengthy negotiations, Canada and the United States have signed an agreement under the Canada-U.S. tax treaty, deferring the application of the dreaded U.S. Foreign Account Tax Compliance Act. Enacted in 2010, FATCA requires non-U.S. financial institutions to report to the Internal Revenue Service the bank accounts held by non-resident U.S. taxpayers. Failure to comply subjects a financial institution or its account holders to an array of sanctions, including special withholding taxes on payments to them from the United States.

Without an inter-governmental agreement in place, this unprecedented invasion of privacy would have been imposed on Canadian financial institutions and their clients as of July 1, 2014.

Under the new agreement, financial institutions in Canada will not report any information directly to the Service. Rather, relevant information on accounts held by U.S. residents and U.S. citizens will be reported to the Canada Revenue Agency. Big difference !! Revenue Canada will then exchange the information with the Service, under the very limited and vague safeguards in the tax treaty. This rather cosmetic change is believed to bring the process within Canadian privacy laws.

This so-called protection of privacy is in fact a type of furtive and illegal adoption of a Canadian FATCA by administrative decree. The Service is only too happy, under the agreement, to provide Revenue Canada “with enhanced and increased” information on bank accounts of Canadian residents at U.S. banks.

Revenue Canada vainly tries to reassure the public that significant exemptions and relief have been obtained. Certain accounts are exempt from FATCA and will not be reportable: Registered Retirement Savings Plans, Registered Retirement Income Funds, Registered Disability Savings Plans, Tax-Free Savings Accounts, and others. This is insulting nonsense, since Revenue Canada already has all that information !

More bizarrely, smaller deposit-taking institutions, such as credit unions, with assets of less than $175 million, will be exempt. These are presumably the plumbers’ credit union-type organizations, that U.S. citizens abroad wouldn’t even be eligible to join, anyway.

The 30 percent FATCA withholding tax will not apply to clients of Canadian financial institutions, and can apply to a Canadian financial institution only if it is in significant and long-term non-compliance with its obligations under the agreement.

More tellingly, in September 2013, our fearless G-20 “leaders” committed already to automatic exchange of tax information as the new global standard, and endorsed an OECD proposal to develop a global model for the automatic exchange of tax information. They also signaled an intention to begin exchanging information automatically on tax matters among G-20 members by the end of 2015.

So at least we know now how efficiently our taxes are applied, to the inflated salaries of the drafters of these highly-superficially protective agreements, and to their related travel and deliciously-catered negotiation sessions.

Revised Guidance on Dividend-Equivalent Payments

1 Feb

In the last hours before Christmas Eve, the Internal Revenue Service issued a titillating 16-page regulation project, providing revised guidance to nonresidents and foreign corporations that hold financial products with payments contingent upon U.S.-source dividend payments. Internal Revenue Code, sec. 871(m). The preceding January 2012 regulation project (77 FR 3202) is withdrawn.

The 2013 proposed regulations better identify (1) when a notional principal contract (NPC) “is of a type which does not have the potential for tax avoidance”, and (2) other payments that are dividend equivalents, because they are substantially similar to specified NPC payments and substitute dividend payments.

Congress enacted Code section 871(m) in 2010, in the Hiring Incentives to Restore Employment Act (HIRE Act). Section 871(m) treats a dividend equivalent as a dividend from sources within the United States for withholding tax and other purposes. Payments for this purpose include any gross amount that is used in computing any net payment transferred to or from the taxpayer.

A dividend equivalent is

(1) any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction that (directly or indirectly) is contingent upon or determined by reference to the payment of a U.S.-source dividend,

(2) any payment made pursuant to a specified NPC that is contingent upon or determined by reference to such payments, or

(3) any other payment that the Treasury determines is “substantially similar” to a specified NPC payment or substitute dividend payment.

The 2012 proposed regulations provided that a dividend equivalent included any gross amount used to compute any net amount transferred to or from the taxpayer, even if the taxpayer made a net payment or no payment was made because the net amount was zero. A dividend equivalent, however, did not include any amount determined by reference to an estimate of an expected (but not yet announced) dividend. This exception did not apply if the estimate adjusted to reflect the amount of the actual dividend.

For payments before March 18, 2012, a specified NPC was any NPC if (1) the long party transferred the underlying security to the short party in connection with entering into the NPC, (2) the short party transferred the underlying security to the long party in connection with the termination of the NPC, (3) the underlying security is not readily tradable on an established securities market, (4) the short party posted the underlying security as collateral with the long party, or (5) the NPC is identified by Treasury as a specified NPC. The long party is the counterparty that holds a long position with respect to an underlying security, such as the purchaser of a call option or the writer of a put option.

For payments made after March 18, 2012, any NPC is (much more drastically) a specified NPC, unless the Service determines that the NPC is of a type that does not have the potential for tax avoidance.

For payments made prior to January 1, 2014, the 2012 regulations defined a specified NPC using substantially the same definition as provided in the Code. For payments made on or after January 1, 2014, the 2012 proposed regulations defined a specified NPC as an NPC that meets one or more of the following factors: (1) the long party is “in the market” on the same day that the parties priced or terminated the NPC; (2) the underlying security is not regularly traded on a qualified exchange; (3) the short party posts the underlying security as collateral and the underlying security represents more than ten percent of the collateral posted by the short party; (4) the actual term of the NPC is fewer than 90 days; (5) the long party controls the short party’s hedge; (6) the notional principal amount is greater than five percent of the total public float of the underlying security or greater than 20 percent of the 30-day daily average trading volume; or (7) the NPC is entered into on or after the announcement of a special dividend and prior to the ex-dividend date.

The 2012 proposed regulations described payments that are substantially similar to substitute dividends made pursuant to securities lending and sale-repurchase transactions and to payments made pursuant to specified NPCs. A substantially similar payment was any (1) gross-up amount paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent, or (2) payment made pursuant to an equity-linked instrument (ELI) that was calculated by reference to a U.S-source dividend if the ELI satisfied one or more of the specified NPC factors.

The 2012 proposed regulations provided that certain indices referenced by an NPC or ELI would not be underlying securities, and therefore, would not be subject to section 871(m). Each component security of a customized index would be treated as an underlying security in a separate NPC. A customized index was defined as (1) a “narrow-based index,” generally based on a definition in the Securities Exchange Act of 1934, or (2) any other index, unless futures contracts or options contracts referencing the index trade on a qualified board or exchange.

The 2012 regulations also provided rules to require a withholding agent to withhold tax owed with respect to a dividend equivalent, and explained the procedures when an NPC became a specified NPC after the date that the parties entered into the NPC. The proposed regulations provided that the term dividend equivalent included any payment that was made prior to the date the NPC became a specified NPC and that was (directly or indirectly) contingent upon or determined by reference to the payment of a U.S.-source dividend.

Several comments on the 2012 proposed regulations stated that the seven-factor approach to defining a specified NPC would not accurately identify tax avoidance transactions. The factors could treat a contract as a specified NPC even when the contract was not entered into primarily to avoid withholding. Similarly, some tax-motivated transactions would not be subject to tax under section 871(m), because the transaction would not meet any of the seven factors.

Comments on the 2012 proposed regulations also stated that the term of a contract does not indicate the potential for tax avoidance, and the term rule could result in retroactive withholding obligations. 90 days was not the appropriate threshold for a minimum term. Another comment acknowledged that the length of the term may indicate that a contract has a tax avoidance motive, but recommended adding an exception for termination events that are beyond the parties’ control. Withholding agents and taxpayers would have difficulty applying the “in the market” factor. A long party should be treated as being “in the market” only when the long party sold or purchased the underlying security “in connection with” entering into or terminating an NPC.

Comments also stated that the definition of a specified ELI was overly broad, because numerous types of ELIs do not give rise to the policy concerns underlying section 871(m). The comments requested that the final regulations limit the scope of the term ELI to contracts that provide delta-one or near delta-one exposure to the underlying equity. The delta of an instrument reflects the change in the value of the instrument relative to a change in the value of the underlying security. Non-delta-one derivatives do not provide investors with a substitute for physical ownership of the underlying security. One comment disagreed, stating that a delta-based standard would provide non-delta-one financial instruments with a competitive advantage over delta-one products because non-delta-one financial instruments would be subject to more favorable tax treatment.

Another comment suggested that the term ELI not include single stock futures contracts (SSFs) unless the SSF is an “exchange future for physical” (EFP). EFP is a transaction in which an investor (1) sold stock and purchased an SSF for future delivery of the same stock or (2) purchased stock and sold an SSF to deliver the same stock in the future. An SSF, other than an EFP, should not be treated as an ELI because SSFs trade on a regulated exchange, unlike bilateral over-the-counter contracts. An adjustment to the settlement price of an SSF is not a payment upon which withholding may be applied.

Several comments also recommended an exception to the term ELI for exchange-traded options, because many of these options do not provide close economic substitutes for owning stock. Two of the seven specified NPC factors will apply to many standard exchange-traded options, i.e., initial term of less than 90 days, and, when an investor exercises an exchange-traded call option, the investor acquires the underlying securities. The final regulations should account for the differences between over-the-counter and exchange-traded options.

Comments requested clarification on how the 2012 proposed regulations would interact with the regular withholding rules. The 2012 regulations did not clearly address whether intermediaries, custodians, clearing organizations, and members of clearing organizations are withholding agents. Due to the large volume of transactions cleared by exchanges on a daily basis, it would be impractical to treat an exchange as a withholding agent. The 2012 regulations would impose an undue burden on broker-dealers with non-U.S. customers, because the broker-dealers would have to develop complicated systems to determine whether an instrument is an ELI and the amount of any dividend equivalent. Other comments stated that a withholding agent should not be liable for U.S. tax when the withholding agent lacks the information necessary to determine whether a transaction constitutes a specified NPC.

Comments also questioned the proposed rule treating all payments as dividend equivalents if a contract became a specified NPC only as a result of the long party acquiring physical shares upon termination (“crossing out”). The 2012 regulations unfairly would have required a withholding agent to withhold for U.S. tax on all payments made pursuant to a contract that would be treated as dividend equivalents when the contract only became a specified NPC because of a “cross out”. Other comments recommended that this rule should apply only to NPCs that are specified NPCs because they meet the “in the market” or the 90-day factor.

Several comments stated that a chain of equity derivatives could result in the collection of cascading U.S. tax, and recommended that the final regulations incorporate specified NPCs into the qualified securities lender and credit-forward regimes described in Notice 2010–46, 2010–24 I.R.B. 757, which limits U.S. tax withheld in a chain of securities lending or sale-repurchase transactions.

Other comments recommended that certain transactions be exempt from section 871(m), such as transactions entered into by a non-U.S. dealer as a long party in the ordinary course of business. The non-U.S. dealer does not enter into the transaction to avoid U.S. tax, and U.S. tax would be paid on any dividend equivalent paid to the customers of the non-U.S. dealer.

One comment questioned the definition of narrow-based index, and suggested that the final regulations incorporate the exceptions provided in the Securities Exchange Act. Comments suggested that the term customized index be revised to apply only to a narrow-based index or any index offered by a publisher that is not a “recognized independent index publisher.” The definition of a customized index should exclude an index if an exchange-traded derivative tracked that index. A customized index should not include any index with respect to which U.S. equity securities comprise less than 20 percent of the notional value. The definition of customized index should be broadened, because the 2012 definition may have permitted certain transactions designed to avoid U.S. tax.

The 2012 proposed regulations provided that the rules would apply to payments made on or after the date the rules are adopted. Comments expressed concern about the potentially retroactive effect of the regulations. With respect to ELIs, the final regulations should apply only to those transactions entered into after the effective date, because taxpayers and withholding agents did not foresee that these contracts would be subject to U.S. tax. The effective date of the final regulations should be delayed, because market participants will be required to make systems modifications and operational adjustments.

Treasury and the Service agree that the proposed seven-factor approach to identify a specified NPC does not provide the best framework for evaluating whether an NPC “is of a type which does not have the potential for tax avoidance” and that the seven-factor approach would be difficult to administer. Accordingly, the new regulations are based on the objective measurement of a derivative’s delta. A transaction has the “potential for tax avoidance” if it approximates the economics of owning an underlying security without incurring the tax liability associated with owning that security. For both equity swaps and other equity derivatives, the determination of whether a transaction may give rise to a dividend equivalent will generally depend only on the determination of a single objective measurement at the time the transaction is acquired. Treasury’s proposal should not be used as a basis for applying the delta standard to interpret other Code sections.

The 2013 proposed regulations define a section 871(m) transaction as any securities lending or sale-repurchase transaction, specified NPC, or specified ELI. With respect to payments made on or after January 1, 2016, a specified NPC is any NPC that has a delta of 0.70 or greater when the long party acquires the transaction. A specified ELI is any ELI that has a delta of 0.70 or greater when the long party acquires the transaction.

If a transaction references more than one underlying security, the taxpayer must determine whether the transaction is a section 871(m) transaction with respect to each underlying security.

The delta of an NPC or an ELI is the ratio of the change in the fair market value of the NPC or ELI to the change in the fair market value of the property referenced. The delta of a transaction must be determined in a commercially reasonable manner. If the delta of an NPC or ELI is not reasonably expected to vary during the term of the transaction, the NPC or ELI has a constant delta and the delta is treated as 1.0. If a transaction would not have a delta of 1.0 but for this rule, the number of shares of the underlying security is adjusted to reflect the constant delta of 1.0. This prevents taxpayers from avoiding the 2013 proposed regulations by using transactions that reduce delta while retaining the economics of owning a set amount of shares.

The 2013 proposed regulations also treat multiple transactions as a single transaction for purposes of determining if the transactions are a section 871(m) transaction, when a long party (or a related person) enters into two or more transactions that reference the same underlying security and the transactions were entered into in connection with each other. These rules do not combine transactions when a taxpayer is the long party with respect to an underlying security in one transaction and the short party with respect to the same underlying security in another transaction.

Transactions that are combined in this manner are treated as separate transactions for all other purposes. A withholding agent is not required to withhold on a dividend equivalent paid pursuant to a transaction that has been combined with other transactions unless the agent knows that the long party (or a related person) entered into the potential section 871(m) transactions in connection with each other.

Treasury requests comments regarding whether (and, if applicable, how) the rules for combining separate transactions should apply in other situations, such as when a taxpayer holds both long and short positions with respect to the same underlying security.

The 2013 proposed regulations provide that a dividend equivalent is (1) any payment of a substitute dividend made pursuant to a securities lending or sale-repurchase transaction that references a U.S. source dividend payment, (2) any payment made pursuant to a specified NPC that references a U.S. source dividend payment, (3) any payment made pursuant to a specified ELI that references a U.S. source dividend payment, or (4) any other substantially similar payment. A payment references a U.S. source dividend payment, if the payment is directly or indirectly contingent upon or determined by reference to the payment of a U.S.-source dividend.

Certain transactions typically provide for dividend equivalents to be paid at the time a dividend is paid on a referenced stock, e.g., stock loans, equity sale-repurchase transactions, and total return swaps. Treasury believes that an ELI that has economic terms substantially similar to a securities lending or sale-repurchase transaction, or a specified NPC, creates the same potential for avoidance of U.S. withholding tax. An ELI is any financial transaction (other than a securities lending or sale-repurchase transaction or an NPC) that references the value of one or more underlying securities, e.g., forward contracts, futures contracts, options, debt instruments convertible into underlying securities, and debt instruments with payments linked to underlying securities. The 2013 proposed regulations provide that another substantially similar payment is a gross-up amount paid by a short party in satisfaction of the long party’s tax liability with respect to a dividend equivalent. Treasury requests comments regarding whether other payments should be treated as substantially similar payments, such as a payment made by a seller of stock to the purchaser pursuant to an agreement to deliver a pending U.S. source dividend after the record date (for example, a due bill).

The definition of an underlying security has also been revised, as any interest in an entity taxable as a corporation for Federal tax purposes if a payment with respect to that interest may give rise to a U.S. source dividend. If a transaction references more than one such entity (including a reference to an index that is not a qualified index), each interest is treated as a separate underlying security. If a transaction references a qualified index, the qualified index is treated as a single security that is not an underlying security.

The 2013 proposed regulations also revise the rules pertaining to indices. In general, a qualified index is any index that (1) references 25 or more underlying securities; (2) references only long positions in underlying securities; (3) contains no underlying security that represents more than 10 percent of the index’s weighting; (4) rebalances based on objective rules at set intervals; (5) does not provide for a high dividend yield; and (6) is referenced by futures or option contracts that trade on a national securities exchange or a domestic board of trade.

The 2013 proposed regulations provide rules for identifying a payment of a dividend equivalent. A payment includes any gross amount that references a U.S. source dividend and that is used to compute any net amount transferred to or from the long party, even if the long party makes a net payment to the short party or the net payment is zero. A payment is treated as made on the date the amount of the dividend equivalent is fixed, even if it is paid or otherwise taken into account on a later date.

The 2013 proposed regulations eliminate an earlier exception, and explicitly treat estimated dividend payments as dividend equivalents, because the economic benefit of a dividend is present.

A dividend equivalent also includes any amount that references the payment of a U.S. source dividend, and any contractual term of a potential section 871(m) transaction that is calculated based on an actual or estimated dividend. For example, when a long party enters into an NPC that provides for payments based on the appreciation in the value of an underlying security but does not explicitly entitle the long party to receive payments based on regular dividends (a price return swap), the 2013 proposed regulations treat the price return swap as a transaction that provides for the payment of a dividend equivalent, because the anticipated dividend payments are presumed to be taken into account in determining other terms of the NPC, such as in the payments that the long party is required to make to the short party or in setting the price of the underlying securities.

The 2013 proposed regulations also provide rules for calculating the amount of a dividend equivalent. For a securities lending or sale-repurchase transaction, the amount of a dividend equivalent for each underlying security equals the actual per share dividend amount paid on the underlying security, multiplied by the number of shares of the underlying security transferred. For a specified NPC or specified ELI, the amount of a dividend equivalent equals the per share dividend amount with respect to the underlying security multiplied by the number of shares of the underlying security (subject to adjustment), multiplied by the delta with respect to the underlying security at the time that the dividend equivalent is determined. If a transaction provides for a payment based on an estimated dividend, the 2013 proposed regulations require that the actual amount of the dividend payment is used to calculate the amount of the dividend equivalent, unless the short party identifies a reasonable estimated dividend amount in writing at the inception of the transaction. Then the per share dividend amount used to compute the amount of a dividend equivalent is the lesser of the amount of the estimated dividend and the amount of the actual dividend paid.

The delta of a transaction at the time the long party acquires a potential section 871(m) transaction is used to determine whether the transaction is a section 871(m) transaction. The delta of the section 871(m) transaction at the time that the amount of the dividend equivalent is determined is used to calculate the amount of the dividend equivalent. Because the delta of a transaction may vary over time, the delta used to calculate the amount of a dividend equivalent is not used to re-test whether a transaction is a section 871(m) transaction. A long party’s section 871(m) transaction continues to be subject to tax, even if the delta of the section 871(m) transaction is below 0.70 at the time the dividend equivalent is determined. Similarly, a long party that acquires a potential section 871(m) transaction that has a delta below 0.70 at the time of acquisition, will not have a section 871(m) transaction even if the delta increases above 0.70 during the time the long party holds the transaction.

The amount of the dividend equivalent generally is determined on the earlier of the ex-dividend date or the record date for the dividend. However, if a section 871(m) transaction has a term of one year or less, the amount of the dividend equivalent is determined when the long party disposes of the transaction. Therefore, a long party that acquires an option with a term of one year or less that is a specified ELI will not incur a withholding tax if the option lapses.

The 2013 proposed regulations provide exceptions to the definition of a section 871(m) transaction for two transactions that have little potential for tax avoidance. The first exception applies when a qualified dealer (i.e., subject to regulatory supervision) enters into a transaction as the long party in its capacity as a dealer. The dealer must certify that it is a qualified dealer, and withhold and deposit any tax imposed by section 871(m). The second exception applies when a taxpayer enters into a transaction as part of a plan pursuant to which one or more persons are obligated to acquire 50 percent or more of the entity issuing the underlying securities.

An NPC may reference a partnership interest, and the partnership could be formed to hold a basket of U.S. equity securities. A comment recommended that regulations treat an NPC that references a partnership interest as a separate NPC with respect to each underlying security held by the partnership. The 2013 proposed regulations treat a transaction that references an interest in an entity that is not a C corporation as referencing the allocable portion of any underlying securities and potential section 871(m) contracts held directly or indirectly by that entity. There is an exception if underlying securities and potential section 871(m) transactions represent 10 percent or less of the value of the interest in the referenced entity at the time the transaction is entered into.

The Service may also treat any payment made with respect to a transaction as a dividend equivalent, if the taxpayer acquires a transaction with a principal purpose of avoiding the application of these rules. The Service will continue to closely scrutinize other transactions that are not covered by section 871(m), and that may be used to avoid U.S. taxation. In addition, the IRS may challenge the U.S. tax results using all available statutory provisions and judicial doctrines (e.g., substance over form doctrine, the economic substance doctrine, etc.) as appropriate.

When a broker or dealer is a party to a potential section 871(m) transaction, the broker or dealer is required to determine whether the transaction is a section 871(m) transaction, and if so, the amounts of the dividend equivalents. If a broker or dealer is not a party to the transaction or both parties are brokers or dealers, the short party must make these determinations.

The 2013 proposed regulations also describe the exception to withholding where no money or property is paid. A withholding agent is not obligated to withhold on a dividend equivalent until the later of: (1) the time that the amount of the dividend equivalent is determined and (2) the time at which any of the following has occurred: (a) money or other property is paid pursuant to a section 871(m) transaction, (b) the withholding agent has custody or control of money or other property of the long party after the amount of the dividend equivalent is determined, or (c) there is an upfront payment or a prepayment of the purchase price. A withholding agent is relieved of liability when the agent does not have control of money or other property of the long party, but the long party remains liable for U.S. tax on the dividend equivalent.

U.S. source portfolio interest received by a nonresident alien individual is not subject to withholding tax. Certain contingent interest payments are excluded from the definition of portfolio interest. Treasury has authority to impose tax on contingent interest when necessary to prevent tax avoidance. Most contingent debt instruments are either referenced to a qualified index, have an embedded option with a delta below 0.70, or both. A debt obligation that is a specified ELI and provides for a contingent interest payment determined by reference to a U.S. source dividend payment has the potential to be used by a nonresident alien individual or foreign corporation to avoid section 871(m). Therefore, any contingent interest will not qualify for the portfolio interest exemption to the extent that the contingent interest payment is a dividend equivalent.

The 2013 proposed regulations generally will apply to payments made on or after the date of publication of the Treasury decision adopting final regulations. Certain provisions in the 2013 proposed regulations apply at different dates. Consideration will be given to any written comments, and a public hearing has been scheduled for April 11, 2014.

Proposed Revenue Procedure on Tax Treaty Competent Authority Assistance

26 Jan

Proposed Revenue Procedure on Tax Treaty Competent Authority Assistance

The Internal Revenue Service has proposed a revenue procedure, I.R.B. No. 2013–50, Dec 9, 2013, that would update and supersede Rev. Proc. 2006–54, 2006–2 C.B. 1035, providing guidance on requesting assistance from the U.S. competent authority, acting through the Advance Pricing and Mutual Agreement program and the Treaty Assistance and Interpretation Team, under the provisions of U.S. tax treaties. U.S. tax treaties permit taxpayers to request the assistance of the U.S. competent authority in alleviating taxation not in accordance with the treaty. The proposed revenue procedure would substantially restate Rev. Proc. 2006–54 in the faint hopes of improving clarity, readability, and organization; and to reflect structural changes undertaken by the Service since 2006, including the establishment of the Large Business & International Division (U.S. competent authority).

This grand document, of succulent multi-national interest:

- clarifies that competent authority issues may arise as a result of taxpayer-initiated positions, as opposed to being a strict instrument of public international law;
- clarifies that the U.S. competent authority is available, whether or not in the course of the mutual agreement process, for informal consultations, including foreign tax credit issues;
- recognizes that the U.S. competent authority can expand the scope of a mutual agreement case to include additional treaty countries, competent authority issues, or taxable years;
- elaborates on interactions of requests for competent authority assistance and advance pricing agreements;
- provides new pre-filing procedures applicable to mutual agreement cases, including mandatory submission of a pre-filing memorandum in cases raising certain issues;
- specifies that the U.S. competent authority accepts requests for assistance with respect to certain foreign pension plan determinations;
- provides new streamlined procedures for invoking the accelerated competent authority procedure without consent of an office conducting examinations;
- generally subjects small case requests to the same requirements as other requests, subject to case-by-case minimization of administrative burdens;
- increases thresholds for small case qualification to $5,000,000 for a corporation or partnership and $1,000,000 for other persons;
- specifies an example of an unreasonable taxpayer condition to acceptance of a competent authority resolution, resulting in denial of assistance, and states additional bases for denying U.S. competent authority assistance: More particularly, the U.S. competent authority may deny assistance, in whole or in part, at any point in the MAP process, and will generally take such action if any of the following circumstances are present:
(1) providing assistance to the taxpayer would be inconsistent with the tax treaty;
(2) the taxpayer has expressed that it is willing to accept a MAP resolution only under conditions that are unreasonable or prejudicial to the interests of the U.S. government;
(3) The issue on which competent authority assistance is sought is the same as or similar to an issue considered in evaluating a prior MAP or bilateral or multilateral APA request;
(4) The taxpayer agreed to or acquiesced in a foreign-initiated adjustment involving significant legal or factual issues without previously having consulted the U.S. competent authority;
(5) The taxpayer’s conduct before filing its MAP request or after the MAP process has been initiated has significantly impeded the ability of the IRS to adequately examine and address the MAP issues for which assistance has been requested or the ability of the U.S. competent authority to resolve the MAP case;
(6) The subject matter of the MAP request includes certain issues pending in litigation;
(7) The taxpayer rejected a request to extend the period of limitations for the taxable periods covered by the MAP request;
(8) The MAP issue was included in a protest to IRS Appeals and was not properly severed from such protest;
(9) The MAP issues covered by the MAP request cannot be adequately resolved without the involvement of one or more additional foreign competent authorities and either the taxpayer fails to cooperate in seeking the involvement of such additional foreign competent authorities or such competent authorities refuse to participate in multilateral consultations on the MAP case;
(10) An adequate resolution of the MAP case would require consideration of issues involving the taxpayer and members of the controlled group located in non-treaty jurisdictions and the taxpayer fails to disclose such issues in the MAP process; or
(11) In MAP cases involving taxpayer-initiated positions, the request evinces after-the-fact tax planning or fiscal evasion or is otherwise inconsistent with sound tax administration.

The Service haughtily claims that the U.S. competent authority’s decision as to whether a MAP request is complete or to deny, suspend, or terminate assistance is not subject to administrative review.

The proposed revenue procedure also:
- describes consultation requirements in treaty limitation-on-benefits provisions, the possibility of requiring withdrawal of a U.S.-initiated adjustment, and taxpayer requests to make a joint presentation to the U.S. and foreign competent authorities;
- regulates the Simultaneous Appeals Procedure;
- provides, subject to a limited exception, that the U.S. competent authority will not accept a request for assistance if the taxpayer seeks IRS Appeals review of a competent authority issue;
- clarifies the procedures applicable a request for U.S. competent authority assistance when a matter is pending in litigation;
- restates and revises U.S. competent authority procedures with respect to repatriation payments made in the mutual agreement context;
- describes basic procedures applicable where a tax treaty contains a provision for mandatory arbitration; and
- the user fee for requests for relief with respect to limitation on benefits has been increased to $27,500.


Indignant Tax Court of Canada reduces Discount Rate between McKesson Units by Half

15 Jan

Tax Court of Canada reduces Discount Rate between Related Parties by Half

The Tax Court issued in late December an exhausting 105-page transfer pricing decision, reducing by half the discount at which McKesson Canada sold its receivables to its Luxembourg parent starting in 2003. McKesson Canada Corporation v. The Queen, Dec. 13 2013, 2008-2949(IT)G. The complex receivables transaction was designed solely in an attempt to reduce the taxes on the Canadian unit of this pharmaceutical supplier. The excess discount was treated as a taxable shareholder benefit subject to withholding tax, for which McKesson Canada was made liable outside of the treaty limitations period for transfer pricing assessments. The poor taxpayer also has to pay the Crown’s appeal costs.

It isn’t until the postscript in the 82d footnote that the true meaning of the case comes to light, in the honorable Court’s apology: “I can do no better than quote from a 2013 address by Lord Neuberger of Abbotsbury, President of the UK Supreme Court (entitled ironically Justice in an Age of Austerity): “We seem to feel the need to deal with every aspect of every point that is argued, and that makes the judgment often difficult and unrewarding to follow. Reading some judgments one rather loses the will to live – and that is particularly disconcerting when it’s your own judgment that you are reading.””

McKesson U.S. is the 15th ranking largest public company in the Fortune 20 list of companies, with annual revenues in excess of US$100 billion. In Canada, the core business of the McKesson group is the wholesale distribution of pharmaceutical medicine products. The McKesson Group delivers one-third of all medicare to the public in the US. McKesson Canada had about one-third of the Canadian market. In 2002, McKesson Canada had sales of $3 billion, profits of $40 million, 2,400 employees and the largest share of the Canadian market.

In 2003, McKesson Canada entered into an agreement to sell its current receivables at a discount to its Luxembourg immediate parent company (“MIH”). MIH purchased all eligible receivables as at that date (about $460,000,000), and committed to purchase eligible receivables daily as they arose for the next five years, subject to a $900,000,000 cap.

The discount rate selected greatly exceeded an arm’s length rate, resulting in a large shortfall in what would have been taxable income. Under absurd prevailing Canadian tax tendencies, this entirely-tax-motivated transaction is in itself valid, unless affected by specific anti-avoidance provisions in the Income Tax Act, such as the requirement in section 249 that related parties deal on arm’s length terms.

A secondary issue was McKesson Canada’s liability for failure to withhold Part XIII non-resident tax from the disallowed amounts paid to its non-resident parent. Assessment of the Part XIII liability would have been outside of time limitations, if it had been treated as a transfer pricing adjustment, rather than a secondary effect of an adjustment.

In 2003, 99.96% of McKesson Canada’s receivables proved to be good and collected when managed by McKesson Canada’s credit department. McKesson Canada had no identified business need for a cash infusion or borrowing, nor did McKesson Group need McKesson Canada to raise funds for another member of the group.

The McKesson Group had amassed large amounts of cash in Ireland. MIH used this money to finance the purchases of McKesson Canada’s receivables under the facility. MIH had the right to put non-performing receivables back to McKesson Canada for 75% of the face amount, readjusted to the amount actually collected by McKesson Canada.

MIH borrowed all the money needed from the Irish entity, directly or indirectly. MIH’s obligations were guaranteed by another non-Canadian McKesson Group entity. MIH paid McKesson Canada to continue to have its credit and collections department manage the receivables.

Most of the proceeds of the initial $460,000,000 receivables sale were returned by McKesson Canada to MIH. A portion was loaned to another Canadian corporation to permit its tax losses to be used.

The Revenue Agency challenged these related party transactions on the basis that the amounts paid to the non-Canadian McKesson entity differed from those that would have been paid between arm’s length persons transacting on arm’s length terms and conditions. The discount upon the purchase of the receivables in accordance with this revolting revolving facility was a 2.206% discount from the face amount. This discount rate for receivables expected to be paid within 30 days could be restated as an annual financing cost of 27%.

As a direct result of these pernicious discounts, McKesson Canada ceased to be profitable for its 2003 taxation year and reported a tax loss. McKesson Canada’s profits in later years were similarly significantly reduced.

The predominant purpose of McKesson Canada entering into the transactions was the reduction of its Canadian tax on its profits. None of the raising or freeing up of capital, reducing credit risk from its customers, nor improving its balance sheet was the company’s predominant purpose; they were results of the transactions. There were “belts and braces” inserted to ensure that the receivables facility did not leave the purchasing entity holding any financial or credit risk associated with McKesson Canada or its receivables.

The Court noted sarcastically that, in the weeks before the signing of the receivables agreements, Toronto Dominion Securities Inc. (“TDSI”) was retained by taxpayer’s tax law firm Blake Cassels, to provide advice on certain so-called arm’s length aspects of the receivables agreements. By the time that TDSI was consulted, the structure and pricing approach and formulae were largely settled. It is not clear that any significant changes were made to reflect any advice or information given by TDSI.

The Income Tax Act provides for contemporaneous arm’s length transfer pricing documentation/analysis requirements to defend the Act’s transfer pricing penalty provisions. The Court noted that last minute, rushed, not fully informed, paid advocacy that was not made available to the Canadian taxpayer and not read by its parent, could not easily satisfy the contemporaneous documentation requirements.

McKesson Canada had a pre-existing business relationship with the TD Bank group. Several years earlier, McKesson Canada had done a receivables factoring transaction with TD Factors to avoid Canadian federal capital tax. The Court found it entirely unreasonable to suggest that this was a comparable transaction for arm’s length pricing purposes to the one in issue.

TDSI’s bizarre approach in the current agreement was to use instead a 16-day discount period for the initial purchase, averaging the “missing” 16 days across the entire five years of the RSA term. The bank set a discount period of 31.73 days for all discount rate calculations for receivables purchases under the RSA. The effect of these strange and unnatural practices was double this portion of the discount rate for the December 2002 purchase, thereby providing a significant timing benefit to the McKesson Group in respect of McKesson Canada’s tax reduction for the 2003 year.

TDSI made numerous other design decisions in its structured monstrosity, with which the Court took issue. TDSI identified a concentration risk issue associated with the larger obligors, that losses on their receivables had an increased likelihood of deviating from historical levels. TDSI did not attempt to quantify that increased likelihood or validate the increased risk.

TDSI noted that the multi-year data it has been provided did not cover a full economic cycle of Canadian trough-to-peak-to-trough. The report does not say that more historic data was asked for, nor that it was unavailable. Thus, three standard deviations from mean that TDSI suggested adding, seemed unreasonable. TDSI’s bright suggestions, combined with the selection of monthly numbers, had the result of driving the .03% actual monthly average loss to 0.24% – an eight-fold increase.

TDSI tied the “very possible” need for a replacement servicer, and the associated risk factoring, to the fact that McKesson Canada was not a highly-rated credit on a stand-alone basis. The connection was not obvious. This component of the discount rate was also unreasonable.

It was not self-evident why prompt payment discounts were not treated in the same manner as other dilutions such as volume rebates to customers. The prompt payment discount risk was appallingly estimated at the outset, fixed throughout at historic levels, plus an unexplained buffer, instead of being reflected in its rolling average actual performance throughout the agreement’s term. The TDSI Report overlooked other obvious related risks. No explanation was offered for accepting a fixed approach.

The determination of interest discount was flawed. Because MIH was exceptionally thinly-capitalized, TDSI found it appropriate to use non-investment grade bond market credit spreads as a proxy. This was correct from a profitable business transaction point of view, but TDSI failed to address the possibility that the transaction exactly as structured could not be done profitably on arm’s lengths terms and conditions, and failed to address other basic considerations. TDSI was unaware (hello?) that MIH enjoyed a full guarantee and indemnity from its parent company. This lack of balance in favour of MIH was not identified or discussed.

TDSI’s report on the grossly excessive servicing fees admitted that it did “not have ready knowledge of comparable situations”.

Under section 247 of the Income Tax Act, where a taxpayer and a non-resident person with whom the taxpayer does not deal at arm’s length are participants in a series of transactions, and either

(a) the terms imposed between the participants differ from those that would have been made between persons dealing at arm’s length, or

(b) the series would not have been entered into between persons dealing at arm’s length, and can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit,

any tax-relevant amounts are adjusted to the quantum or nature that would have been determined, if the terms imposed had been those that would have been made between persons dealing at arm’s length, or, where paragraph (b) applies, the series of transactions entered into had been the series that would have been entered into between persons dealing at arm’s length.

The Tax Court noted that there may be a point at which the extent of changes to the agreed non-arm’s length terms and conditions can constitute an effective recharacterization of the transaction only permitted under paragraph (b) above. It was unnecessary to resolve this issue in disposing of the appeal.

The Court emphasized that, in disposing of a transfer pricing appeal, it should consider “notional continued control type rights” when looking at term or executory contract rights. This refers to implicit unwritten, unenforceable guarantees of the parent company in the group.

The appropriate transfer pricing analysis methodology would not be any of the four methodologies named in the OECD Guidelines and, therefore, an “other method” should be used.

An “other method” that would be appropriate was that followed by TD Bank, taking the receivables transaction as the parties structured it, and not introducing any recharacterization or additions, but accurately identifying the risks transferred to MIH, unlike what TD naughtily actually did. Another expert’s report did not follow the parties’ chosen structure, but rather relied on a comparability and adjustment approach which began by looking at the public bond market discount rates on a five-year non-investment grade Canadian bond fund index and then making a number of significant adjustments to reflect issues peculiar to the receivables transaction. That methodology was inappropriate.

While some experts suggested that arm’s length parties did non-recourse receivables purchase transactions on comparable terms, absent any supporting evidence, the Court was unable to give any weight or relevant consideration to the suggestion.

The Court noted in despair that one of the largest and most significant benefits to McKesson Canada was the transfer of the risk of loss on the receivables. There is credit default insurance available in the market from arm’s length commercial players in the financial markets, both direct insurance and synthetic or derivative structured products. The Court lamented that it was given no evidence of the practical availability (or non-availability) or effectiveness, or pricing/costs for such. Such evidence might have provided the poor Court with other helpful information with which to try to price the risk transference, beyond McKesson Canada’s available historic loss and performance and projections for its receivables portfolio, and risk spreads in the public bond market.

The adjustment of a formula or criterion (e.g., yearly versus monthly) may not clearly be permitted under the language of ITA section 247. The Court held that the OECD Guidelines’ commentary on “realistically available options/alternatives” would support a broader reading of which amounts’ quantum can be adjusted to reflect arm’s length terms and conditions. This bold approach contradicts some of the Court’s earlier comments giving priority to the Act over the Guidelines and other international soft law, but is otherwise a reassuring tendency.

In her testimony, the TDSI officer identified the material transaction risks as (i) dilutions, including prompt payment discounts (ii) losses – primarily credit losses and (iii) servicing risk, i.e., that the servicer collects but does not remit to the buyer, however unthinkable on the present facts.

While the TDSI Report said that it looked at pricing of comparable risks in the market, the expert acknowledged glumly that TDSI did no more than obtain credit spread numbers from their bond traders. The expert had difficulty, even in direct examination, in giving a satisfactory, responsive, logical or complete explanation of the interest discount portion of the discount spread. She couldn’t even provide a very thorough or satisfactory answer as to why the TDSI Report, when assessing the accrued rebates dilution risk, assumed that 100% of McKesson Canada’s customers would set off their full accrued rebates. She could not explain how this was reasonable.

Another taxpayer expert report (PwC) had insufficient grounds for notching all of the others obligors’ credit risk down two grades below the public debt rating that PwC had assigned to taxpayer’s largest customers. This picking and choosing, mix and match as it suits approach, to the relevance of the actual performance of the receivables pool made for “transparently poor advocacy, and even more questionable valuation opinions.”

A credit rating downgrade of McKesson U.S. would not necessarily involve any change to McKesson Canada’s ability to service its receivables. The related probability numbers were inadequately explained, questionable and, to the Court’s mind, unreliable advocacy or posturing.

One of the taxpayer experts inexplicably never considered the cost of insuring the receivables in his pricing approach, nor to test the results of his approach. That hapless expert came across as a partisan advocate quick to point out the specks in the poor Crown’s expert reports, and downplaying, if not refusing to acknowledge, the weak points in his own.

The beleaguered Court was troubled by the introduction of a general reserve as enhanced credit protection to MIH on purchased receivables which MIH does not enjoy directly, or even indirectly, in the receivables sale. There may be significant reserves in securitizations, in secured loans, and in other asset backed loans, but this agreement gave no such security or protection to MIH once it purchased any particular receivables. The Court thus did not rely upon the results of two related expert reports. The Court emphasized that this was not a securitization transaction, but its definition is far too vague to be useful: “an off-balance sheet debt financing, via a thinly capitalized special purpose entity, that accesses low rate investment grade financing via a structured finance product that incorporates risk minimization features including support from the seller of the existing cash flow stream.”

There was no McKesson Canada covenant or assets supporting the collectibility of any receivable after it was transferred to MIH. This was viewed as fundamentally different from either a securitization or a secured loan. No mention was made at that point of the valuable putback of non-performing debt enjoyed by MIH for 75% of the face amount.

The Court dismissed comparables based on the maximum receivables pool of $900,000,000, since exposure was never expected to reach that amount.

The 30-day Canadian dollar bankers’ acceptance rate, or CDOR, as of December 16, 2002 was 2.79% per annum. The Court did not accept that using a fixed “days sales outstanding” (DSO) of 31.73 days throughout the term without regard to changes to actual DSO, was an arm’s length term. Arm’s length parties would incorporate a floating approach to DSO averaged over some period, say three to four months, and would not accept the risk of fixing the DSO for the entire term.

The Court also did not accept the special loss discount computed for taxpayer’s largest clients, and which was based on rated companies’ bond ratings, with various offensive or illogical assumptions. Under the receivables agreement, the loss discount for more-than-2% customers could very suspiciously be recalculated at any time, if the buyer MIH thought that the mix of large customers to other customers had changed, but not if McKesson Canada thought that the mix had changed in its favour, for lands’ sakes.

The Court disagreed that the loss discount attributable to the smaller customers would be fixed by arm’s length parties in the manner it was, or fixed at that same number for a five-year term. The loss discount was almost 600% of what would be expected from taxpayer’s historic receivables write-offs, without any significant projected, planned or reasonably anticipated material risk of deterioration of its business, its customers, or the economy generally. The loss discount did not even directly take into account the historical or actual ongoing performance of the receivables pool.

The discount spread in the receivable agreement was calculated as the sum of four components: a servicing discount, a prompt payment dilutions discount, an accrued rebate dilutions discount, and an interest discount.

The appalling issue with the prompt payment dilutions was whether the risk had been accounted for in the discount spread on arm’s length terms. The Court held that arm’s length parties would remove the risk of change during the term of the agreement in the levels of prompt payment discounts, by adopting a floating dynamic prompt payment component.

The Court did not accept that the accrued rebate dilutions risk warranted any material discount. The taxpayer would not agree with a notional arm’s length purchaser to a discount that either assumed that all of the taxpayer’s customers would exercise a claim to set off their accrued rebate entitlements, or that assigned a credit risk spread to the taxpayer equivalent to junk bond issuer status.

The interest discount was intended to provide MIH with a return from the discounted purchase of receivables, in addition to all of the above amounts, equal to an assumed cost of funds (that it did not in fact bear) equal to the cost to a below-investment grade borrower that borrowed 100% of the receivables purchase price by issuing its junk bonds in the market. The Court found this element completely unacceptable, unreasonable, unsupported on the evidence, and a term that would not be agreed to by with an arm’s length party.

Overall, the horrified Court could only say that it had never “seen so much time and effort by an appellant to put forward such an untenable position so strongly and seriously. This had all the appearances of alchemy in reverse.”

The total of these adjustments resulted in a discount range of 0.959% to 1.17%, compared to the 2.206% agreed to by the parties. This adjusted rate was comparable to the 1.013% reassessed by the Minister of National Revenue.

It was not necessary to fix a particular point within the determined range, as the taxpayer’s evidence did not rise to the level of a prima facie case that “demolishes” the key assumptions of fact made by the Minister that support the reassessments.

The Court felt obliged to try and translate the bizarre new direction shown by the Supreme Court in recent years, protecting the corporate tax shelter industry: “The Supreme Court of Canada reminds us regularly that the Duke of Westminster is alive and well and living in Canada.”, a reference to the outdated, foreign IRC v Duke of Westminster, (1936) AC 1. The Court noted that there was certainly nothing wrong with taxpayers doing tax-oriented transactions, tax planning, and making decisions based entirely upon tax consequences, subject only to the general anti-avoidance rule in section 245 of the Act. GAAR was not inexplicably relevant to this appeal, presumably because the Crown thought it safer to rely on more narrowly-worded anti-avoidance provisions. The Crown could have done both, but is presumably subservient to the errant recent Supreme Court doctrine.

The Part XIII withholding tax issue was whether the Revenue could charge McKesson Canada for failure to withhold on the deemed benefit transfer to parent. The Revenue assessed McKesson Canada just outside of the 5-year limitation for transfer pricing adjustments under the Canada-Luxembourg treaty. The Court held that the derivative liability of McKesson Canada was not protected by the treaty limitation clause.

The Court viewed a benefit as paid by McKesson Canada to its parent MIH via the transfer of receivables at an overstated discount rate, which resulted in giving away some of its assets to its parent corporation. All shareholders are broadly taxable under a general provision in section 15 of the Act. The amount of this benefit is deemed by the Act to be a dividend paid by McKesson Canada to MIH, subject to 5% withholding under the Canada-Luxembourg Treaty.

In in its 2003 short year the Canadian tax avoided by McKesson Group was US$4,500,000, and some form of Luxembourg tax was expected to be payable in the amount of US$29,000.

Article 9 of the Canada-Luxembourg Treaty provides that, any income which would, but for (bizarre and unnatural) conditions existing between associated enterprises that would not have existed between the independent, have accrued to one of the enterprises, but, by reason of those conditions, has not so accrued, may be included in the income of that enterprise and taxed accordingly. A Contracting State may not change the income of an enterprise in these circumstances, after the expiry of the time limits in national law and, in any case, after five years from the end of the year in which the income which would be subject to such change would, but for the (bizarre and unnatural) conditions above, have accrued to that enterprise.

The Revenue properly asserted that the standalone obligation of McKesson Canada under the Income Tax Act as a Canadian payor who fails to remit is distinct for Article 9 purposes from a change in the income of MIH for tax purposes.

Both the Vienna Convention and the Supreme Court of Canada in The Queen v. Crown Forest Industries Limited et al., 95 DTC 5389 (SCC), confirm that “literalism has no role to play in the interpretation of treaties”, Coblentz v. The Queen, 96 DTC 6531 (FCA, 1996). In Crown Forest, the Supreme Court also held that, in ascertaining the purposes of a treaty article, a court may refer to extrinsic materials which form part of the legal context, including model conventions and official commentaries thereon, without the need to first find an ambiguity before turning to such materials.

The Tax Court in McKesson held that an ITA subsection 215(6) vicarious assessment of a Canadian payor for failure to remit and withhold tax is not a change by Canada of MIH’s income, and does not constitute Canada seeking to add a transfer pricing adjustment amount to MIH’s income and to tax that increased amount. The Court was understandably more inclined to see it as an enforcement and collection provision than a tax charging provision.

The Court also found that the requirements are more clearly not met because the only transfer pricing adjustment in Article 9(1) is income which, but for the related party conditions, would have accrued to MIH under the receivables transactions. While the amount of MIH’s taxable benefit and deemed dividend may be the same as this transfer pricing adjustment, it is not an amount of income that, had the discount rate been an arm’s length discount rate, would have accrued to MIH. On the contrary, the transfer pricing adjustment is income that but for the non-arm’s length terms and conditions would have accrued to McKesson Canada. This reasoning is superficially correct but not in keeping with the broad interpretative approach mandated by the OECD Guidelines. The honorable Court should not have been so thrilled to have happened upon the argument.

The Court noted that this same problem arose equally clearly in respect of the requirement that a five-year limitation period can only begin to run from the end of the year in which the income of MIH sought to be changed would, but for the non-arm’s length discount rate used, have accrued to MIH. Again, had an arm’s length discount rate been used in the receivables agreement, the additional income would have accrued to McKesson Canada, not MIH.


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