Tax News and Developments North American Tax Practice Group

2014 IRS APA Annual Report: Achievements and Challenges Ahead On March 27, 2015, the IRS issued its Annual Report Concerning Advance Pricing Agreements (Announcement 2015-11, I.R.B. 2015-15) (“2014 APA Report”), which presents the key results of the Advance Pricing and Mutual Agreement Office (“APMA”) for the calendar year ended December 31, 2014. The 2014 APA Report provides general information regarding the operation of the office, including staffing, and statistical information regarding the numbers of APA applications received and resolved during the year, including countries involved, demographics of taxpayers involved, industries covered and transfer pricing methods (“TPMs”) employed. The following summarizes the highlights of the report and provides observations of APMA and APAs.

APMA Operations

APMA staffing in 2014 remained consistent with the prior year, with 81 team leaders and economists and 10 senior managers, but the composition of staff saw a shift, with a reduction in the number of economists and a corresponding increase in team leaders. Given the important role that economists play in the development of an APA position, even a slight decrease in the number of economists in the program could have a disproportionate effect on the program’s ability to advance cases to discussion with treaty partners (or in the case of unilateral requests, with taxpayers). The IRS previously stated that it intended to increase APMA’s staffing to approximately 65 team leaders (up from 59 for CY 2014) and 30 economists (up from 22 for CY 2014) to improve its case processing times, but recent reductions to the IRS budget have resulted in an overall hiring freeze at the agency that puts those planned increases at risk. Further, there were significant changes in leadership during 2014, with the Deputy Commissioner (International), the APMA Director and the Transfer Pricing Operations Director departing the IRS within a six-week period. While all of those positions are now filled (some with personnel in an acting capacity), the disruption caused by those rapid departures (and staff turnover that occurred during the year) had an impact on internal operations, APA negotiations with taxpayers, and bilateral APA negotiations involving other countries’ tax authorities, with active cases changing hands and thereby requiring additional time to process, as discussed below.

Newsletter April 2015 | Volume XV-2

In This Issue:

2014 IRS APA Annual Report: Achievements and Challenges Ahead

Final Foreign Tax Credit Splitter Rules Largely Track Temporary Rules

A Tough Undertaking: The IRS Provides Guidance on the Tax Rate Disparity Test

IRS Addresses Effect of Subpart F Inclusion on US Shareholder Earnings & Profits

IRS Releases Proposed Regulations on More Narrowly Tailored "Next Day Rule"

Like-Kind Exchange Treatment Denied in North Central Rental Case Involving Related Party Transfers

Taxpayer Victory: Fifth Circuit Reverses Tax Court in BMC Software, Inc. v. Commissioner

US Supreme Court Issues Decision in Two State Tax Cases

Constitutional Challenge to Delaware's Unclaimed Property Estimations Proceeds

Canadian Tax Update

Asia Pacific Tax Update: Bulletin 16: China Makes a Pre-Emptive Strike on BEPS!

European Tax Update: Infringement Procedure Launched Against French 3% Tax on Dividends' Distribution: An Opportunity to Obtain a Refund?

Getting Better All the Time…Baker & McKenzie Expands Transfer Pricing Capabilities in Nation's Capital

Upcoming Spring Conferences Focus on Tax Controversy and Transfer Pricing

Baker & McKenzie

2 Tax News and Developments April 2015

APA Intake and Output

New applications: The 2014 APA filings were down slightly from 2013, with 108 full applications and 33 user fees in 2014, as opposed to 111 full applications and 42 user fees the prior year. In terms of the countries for which bilateral requests are filed, the 2014 APA Report shows that, as in prior years, bilateral requests involving Japan and Canada predominate (53% of the total submissions), although this percentage is a significant drop from the 73% that those two countries represented in 2013. Rather, in 2014, five other countries (UK, Korea, Denmark, Mexico and Netherlands) each represented at least 5% of the bilateral submissions, with 14% coming from all other countries combined.

This diversification of participation is an encouraging sign for multinational companies doing business around the globe. As bilateral APA relationships between countries increase and improve, the potential for companies to resolve transfer pricing issues expands. With the recent announcement that the United States has changed its previous position and is now accepting bilateral APA requests for transactions with India, yet another country with an aggressive audit program has agreed to work towards prospective certainty. Reports out of India so far suggest that the APA program has been well received, with 146 APA applications filed in the first year of the program (2012) and another 232 the following year. India has reached one bilateral APA agreement, with Japan. It remains to be seen how many bilateral APA requests involving India will be filed with the IRS, but adding such an important treaty partner to the APA program is likely to increase inventory in 2015.

Another notable statistic regarding applications involves unilateral submissions. The percentage of unilateral submissions increased to 29% of the total, as compared with 18% in 2013 (and 19% in 2012). This increase could indicate more cross-border activity with countries with which the United States does not have a treaty, e.g., Brazil and Singapore, or could be a response to the heightened focus on transfer pricing by all of the US treaty partners, including those that do not have an APA program.

Processing times: For APAs executed in 2014, APMA generally did not improve on the processing times that were reported for 2013. For all unilateral APAs, its case processing times increased, although there was a significant decrease in the average processing times for new unilateral requests, from almost three years (35.9 months) to slightly more than two years (26.7 months). With regard to bilateral renewal APAs, the IRS decreased its average processing times from 36.2 months to 35.7 months, but the median processing times increased from 31.9 months to 33.9 months.

The new APMA Director, Hareesh Dhawale, indicated that some of the longer processing times relate to APAs with years that cover the 2008-2009 downturn period, which are typically more difficult cases to resolve. Further, as noted above, staff turnover in the program and a reduced number of economists available to handle cases have a direct impact on processing times. Each transfer of a case to a new team leader or economist creates a learning curve that can and usually does add to the overall processing time. It is important, then, for taxpayers in the program to be proactive when informed of a staffing change, for example by offering to meet with the new team and brief them regarding the case.

Upcoming Tax Events:

Doing Business in Singapore - An International Business Hub New York, New York April 28, 2015 Global Tax Planning and Transactions Workshop New York, New York April 29-30, 2015 TEI Software Day Santa Clara, California May 5, 2015 Global Tax Planning Half-day Workshop for Multinationals Focus on Colombia and Tax-Free Business Separations Miami, Florida May 6, 2015 VAT for the Financial Services Sector Webinar May 12, 2015 TEI IRS Audits & Appeals Seminar Chicago, Illinois May 19-21, 2015 Revised BEPS Discussion Draft on Preventing the Artificial Avoidance of PE Status (Action 7) Webinar May 21, 2015 EMEA Tax Conference Paris, France June 3-6, 2015 Baker & McKenzie/Bloomberg BNA Global Transfer Pricing Conference Washington, DC June 11-12, 2015 Baker & McKenzie/Bloomberg BNA International Tax Conference Toronto, Ontario October 14, 2015 Baker & McKenzie/Bloomberg BNA Global Transfer Pricing Conference Toronto, Ontario October 15-16, 2015 TEI International Tax Day Santa Clara, California October 27, 2015 North America Tax Workshop Miami, Florida January 29, 2016

Baker & McKenzie

3 Tax News and Developments April 2015

Executed APAs: With the decline in staffing and change in APMA management (as well as senior management changes in other areas of the IRS’s Transfer Pricing Operation), the IRS executed many fewer APAs in 2014 as compared with 2013: In 2014, APMA executed 101 APAs (81 bilateral and 20 unilateral), as compared with 145 APAs in 2013 (105 bilateral and 39 unilateral). The IRS appears to continue to have difficulty addressing complex APAs and moving bilateral renewal APAs through the pipeline: 80% of pending renewal APAs during 2014 were bilateral, compared with 86% during 2013.

As in prior years, the 2014 APA Report indicates that US-Japan bilateral APAs continue to constitute a large percentage of the overall APAs that the program processes, but the number of US-Japan bilateral APAs executed is down relatively significantly compared with 2013. That is, 47% of the 81 executed bilateral APAs during 2014 were US-Japan bilateral APAs (i.e., 38 executed APAs), as compared with 53% of the 105 bilateral APAs executed during CY 2013 (i.e., 56 executed APAs). The heavy caseload involving US-Japan APAs is reflected in the number of APA teams that have responsibility for the US-Japan APAs. Specifically, three of the team leader groups have responsibility for APAs involving Japan (as well as other jurisdictions). Similarly, three of the team leader groups have responsibility for APAs involving Canada (as well as other jurisdictions).

It appears that the IRS is still devoting a substantial portion of its resources to APAs involving Japan and Canada, but there continues to be a backlog for such APAs, particularly with Japan. The reasons for the backlog are varied, but the Japan case status can be contrasted with APAs submitted under the US-Canada treaty, where the treaty authorizes APAs that are unagreed for two years after the positions have been exchanged to be subject to arbitration. In contrast, the current US treaty with Japan does not include an arbitration provision, although the countries in 2013 signed a protocol, which is awaiting US Senate ratification, that would amend the treaty to include arbitration. Until the protocol is ratified, however, there will not be any effective mechanism to accelerate agreements between the United States and Japan. In addition, it appears that new levels of review of APA requests and draft APA agreements may be lengthening processing times; the impact of such review will probably be observed more clearly in the statistics for 2015.

US vs. Non-US parent companies: With respect to the percentage of APAs involving US parent companies and non-US parent companies, 55% of the executed APAs for 2014 involved non-US parent companies and their US subsidiaries, which is the same percentage as 2013; this predominance of non—US parent companies accessing the program has been consistent throughout the years for which such information has been reported. These statistics show that the IRS APMA program continues to appeal particularly to non-US parent companies. Such appeal can be due to, among other things, the IRS’s continued focus on transfer pricing involving non-US parent companies, non-US parent companies’ desire for transfer pricing certainty, or an increase in audit activity in other countries that a bilateral APA with the United States could mitigate.

Industries represented: In contrast to the results in 2013, where wholesale/retail trade was the predominant industry represented in the executed agreements (41%), the 2014 agreements involved predominantly manufacturing (47% of the total, as compared with 35% in 2013). Within the manufacturing segment, computer and electronic equipment represented more than a quarter of those agreements in 2014; this also contrasted with the prior year, when the

Baker & McKenzie

4 Tax News and Developments April 2015

transportation equipment industry represented nearly 30% of the total and computer and electronics only 18%. To some extent, the year-over-year industry breakdown is random, in that it provides a snapshot of a particular twelve-month period, and many factors can impact which specific cases reach resolution at what time. For 2012, for example, computer and electronics represented 30% of the total, and transportation equipment (a category that includes both automotive companies and suppliers) was only 14% of the total. The other industry classification that is prominent in the APA program is wholesale/retail trade, and wholesalers of durable goods dominate that class year over year, with more than 50% of the total APAs in that category for all three years for which data is available.

TPMs applied: Consistent with prior years, the Comparable Profits Method/ Transactional Net Margin Method ("CPM/TNMM") is the most commonly applied TPM for tangible and intangible property transactions, being applied to 78% of such transactions (approximately the same as in 2013). One notable change was a relatively significant increase in the application of the Comparable Uncontrolled Transaction ("CUT") method (13% of transactions in 2014, compared with less than 5% in 2013). Here again, the CUT method and Comparable Uncontrolled Price ("CUP") method represented 9% of the agreements in 2012, suggesting that, as with the industry profile for a given year, the specific methods employed can vary based on factors independent of the method itself. Regarding the profit level indicator used when the CPM/TNMM is employed, the Operating Margin (defined as operating profit divided by net sales) was applied in 88% of the cases in which the CPM/TNMM was selected (an increase from 78% in CY 2013), and the Berry Ratio and Return on Assets ("ROA") (or Return on Capital Employed) were applied in approximately the same percentage of transactions as in 2013.

Asset intensity adjustments: It is the policy of the APA office to make the asset-intensity adjustments identified in the US regulations, i.e., receivables, inventory and payables, in all cases where such adjustments can be made. Where appropriate, property, plant and equipment (“PP&E”) adjustments are made, but the percentage of cases where such an adjustment is made in any given year is a function of the specific facts of the cases that were resolved in that year.

APA terms: APA term lengths, including rollback years, decreased from an average of seven years in 2013 to an average of six years in 2014, with the largest number of APAs having five-year terms (41% of APAs executed, which is the same as 2013). This trend should continue as APMA works through the older cases that had built up in inventory before the merger in 2012 and have skewed both the average and the absolute term lengths of executed APAs. Looking at the statistics over the past three years, both 2012 and 2013 included at least one agreement with a 20-year term, and multiple agreements with terms that exceeded 10 years. In contrast, the longest term for an executed APA in 2014 was 11 years, and there were only one or two such cases. This is not to say that the program has worked through all the contentious and difficult cases that lead to outlier term lengths, but it suggests a trend towards more expeditious settlements in most cases. When a difficult or contentious case reaches conclusion, often at the end or beyond the end of the requested term, both taxpayers and governments often seek to extend the term of an APA and provide some prospectivity.

Baker & McKenzie

5 Tax News and Developments April 2015

FX adjustments: The APA program has no set policy regarding adjustments to taxpayer financials to account for currency fluctuations. The 2014 APA Report notes that, “In appropriate cases, APAs may provide specific approaches for dealing with currency risk, such as adjustment mechanisms and/or critical assumptions.” The 2012 APA Report included the following additional language: “In 2012, very few executed APAs included either adjustment mechanisms or critical assumptions regarding currency or other, similar risks, and most of the cases that did so involved bilateral agreements with Japan, which has experienced significant, extreme currency fluctuations over the last several years.” Over the years of the APA program, Foreign Exchange ("FX")-adjustment mechanisms have been proposed by taxpayers and by governments, and where the fluctuations are extreme, or where a currency has weakened significantly, this can be taken into account when shaping a bilateral agreement.

Observations and Conclusions

Overall, the 2014 APA Report appears to reflect both positive developments and areas requiring attention for companies in the APA program and those considering entering the program. In terms of positive developments, the number of executed agreements remains strong as compared with pre-merger results, and staffing remains high. The diversification of countries with which the United States has an active APA program is also a positive development. It takes time to develop a relationship with a treaty partner that will result in a prospective agreement on transfer pricing matters; given the subjectivity inherent in the arm’s length standard, there must be trust between the parties before either one will agree prospectively to forego the right to re-evaluate the most appropriate TPM. As the IRS gains more experience with other treaty partners, particularly India, this expands the opportunity for US-based taxpayers to manage their transfer pricing risk through multiple, bilateral agreements. It is also a positive development that, despite the continued prominence of the CPM/TNMM and the Operating Margin profit level indicator,, the IRS appears willing to agree to apply a variety of transfer pricing methods in its agreements, showing flexibility to select the “best method” for the covered transactions.

On the other hand, the reduction in the number of economists and the budget restrictions that at present have resulted in a hiring freeze across the IRS could result in a slowdown of case processing because APMA policy requires some level of economist involvement in every case. It also remains to be seen how the changes in leadership that occurred in 2014 will impact the future operation of the APMA office, particularly given the establishment of additional levels of review of both initial submissions and tentative agreements.

By Barbara J. Mantegani Washington, DC and Richard L. Slowinski Washington, DC

Baker & McKenzie

6 Tax News and Developments April 2015

Final Foreign Tax Credit Splitter Rules Largely Track Temporary Rules On February 10, 2015, the Treasury Department and IRS released final regulations under Code Section 909 (the "Final Regulations") addressing situations in which foreign income taxes have been separated from the income to which they relate (T.D. 9710). The Final Regulations do not materially alter the foreign tax credit splitter framework previously adopted pursuant to section 909 as described in the proposed and temporary regulations issued in 2012 (the "Temporary Regulations"). The Final Regulations generally apply to taxable years ending after February 9, 2015, although there are many exceptions and transition rules scattered throughout the Final Regulations.

Section 909, enacted in 2010 and effective for foreign income taxes paid or accrued in tax years beginning after December 31, 2010, provides that, "[i]f there is a foreign tax credit splitting event with respect to a foreign income tax paid or accrued by the taxpayer, such tax shall not be taken into account for purposes of this title before the taxable year in which the related income is taken into account under this chapter by the taxpayer." As in the Temporary Regulations, the foreign tax credit splitter arrangements identified in Treas. Reg. § 1.909-2 as giving rise to split foreign income taxes are: 1) reverse hybrid splitter arrangements; 2) loss sharing splitter arrangements; 3) hybrid instrument splitter arrangements; and 4) partnership inter-branch payment splitter arrangements. An additional splitter arrangement identified in Treas. Reg. § 1.909-5, a foreign consolidated group splitter arrangement in which the taxpayer failed to allocate foreign consolidated tax liability based on each member's share of the foreign consolidated taxable income, continues to constitute a pre-2011 splitter arrangement. For subsequent tax years, Treas. Reg. § 1.901-2(f)(3), adopted in 2012, requires such allocation in all instances. The good news is that the Treasury Department and IRS did not identify any additional arrangements that will be considered foreign tax credit splitter arrangements under the Final Regulations, though they continue to be concerned with any arrangement that inappropriately separates foreign income taxes from the related income.

The Temporary Regulations described a reverse hybrid splitter arrangement as an arrangement whereby the owner of an entity that is treated as a corporation for US tax purposes but is fiscally transparent for foreign tax purposes is required to pay the foreign income taxes (referred to as "split taxes") due with respect to foreign taxable income of such entity even though the related income or earnings and profits (referred to as "related income") remain in the reverse hybrid entity (a "covered person") for US tax purposes. Treas. Reg. § 1.909-2(b)(1) of the Final Regulations does not materially alter this description. However, in response to a comment that it was not clear how to calculate the income of a reverse hybrid related to foreign income taxes where the entity subsequently incurs losses and its earnings and profits fluctuate over time, the Final Regulations include a clarifying example.

Example 2 of Treas. Reg. § 1.909-2(1)(v) contemplates a situation in which a US parent corporation ("USP") owns all of the shares of a disregarded entity ("DE") which owns all of the shares of a reverse hybrid ("RH"). In year 1, RH generates 200u of foreign taxable income and DE pays 60u of country A income tax with respect thereto. The 60u of country A income taxes are split taxes and will not be taken into account by USP in year 1 absent any distribution by RH of its earnings and profits to DE in year 1. In year 2, RH has a loss of 100u for country

Baker & McKenzie

7 Tax News and Developments April 2015

A and for US income tax purposes and RH makes a 100u distribution to DE at the end of year 2. Example 2 concludes that USP may take into account all 60u of country A taxes in year 2. Presumably the same conclusion would apply if RH itself remained profitable but it was merged with a foreign corporation in year 2 that is producing current losses (the use of prior year losses may be subject to restrictions under the hovering deficit rules of Treas. Reg. § 1.367(b)-7(d)).

Treas. Reg. § 1.909-2(b)(2) of the Final Regulations provides that, "[a] foreign group relief or other loss-sharing regime is a loss-sharing splitter arrangement to the extent that a shared loss of a US combined income group could have been used to offset income of that group in the current or in a prior foreign taxable year [(a "usable shared loss")] but is used instead to offset income of another US combined income group." [Emphasis Supplied.] The Temporary Regulations defined a loss-sharing splitter arrangement in much the same way, except that such regulations did not indicate when a loss must usable to constitute a usable shared loss. The change in the Final Regulations reflected in the language emphasized above was in response to a comment requesting that the definition of a usable shared loss be clarified to exclude any loss that could not be used in the current year even though such loss could be carried backward or forward and used by the US combined income group that generated such loss in a different foreign taxable year. The Treasury Department and IRS accepted this proposal with respect to loss carryforwards due to the unpredictability of knowing whether the loss could be used by the US combined income group that generated it in some future foreign tax year. However, they rejected the proposal with respect to losses that could be carried back and used by the US combined income group that generated such loss - such losses are considered usable and will give rise to a loss-sharing splitter arrangement if used by another US combined income group.

The IRS and Treasury Department rejected other requests to amend the regulations to: 1) allow a US combined income group to reduce the amount of usable shared losses giving rise to split taxes by the amount of losses that were shared by other US combined income groups with such group (i.e., a netting of losses shared among US combined income groups); and 2) treat as a distribution of related income (presumably allowing any foreign income taxes associated with such related income to be utilized) to the US combined income group (that shared a usable loss in a prior year) any shared loss received by it from another US combined income group. Both changes were rejected as too burdensome even though the current rules result in a largely one-way street that is unfavorable to taxpayers. The Final Regulations do clarify that the reference to "income" in Treas. Reg. § 1.909-2(b)(2)(v) refers to income for purposes of foreign tax law rather than US tax law.

Under the Final Regulations, a US equity hybrid instrument is a splitter arrangement if: 1) under the foreign tax law to which the instrument owner is subject, the instrument gives rise to includible income and such inclusion results in the owner paying or accruing foreign taxes; 2) under the foreign tax law to which the issuer is subject, the instrument gives rise to deductions that are incurred or otherwise taken into account by the issuer; and 3) the events that give rise to income and deductions under foreign tax law do not result in an income inclusion for the instrument owner for US federal income tax purposes. The Final Regulations eliminated the phrase "payment or accruals" in the foregoing definition because it created confusion where an accrual might not give rise to income for US federal income tax purposes but a payment would. Instead, the Final Regulations make clear that, if an accrual gives rise to a

Baker & McKenzie

8 Tax News and Developments April 2015

deduction for the issuer and income for the owner for foreign tax purposes without giving rise to income for US federal income tax purposes, then the arrangement is a US equity hybrid splitter arrangement regardless of whether a payment is later made on the instrument that does give rise to income for US federal income tax purposes. As illustrated by the example in Treas. Reg. § 1.909-2(3)(E), any such payment with respect to the US hybrid equity instrument would be treated as a dividend and be treated as a distribution of income related to the split taxes of the owner only to the extent provided by Treas. Reg. § 1.909-3 and Treas. Reg. § 1.909-6.

Another comment to the Temporary Regulations recommended that the regulations provide additional mechanical rules for tracking related income. However, the Treasury Department and IRS, while acknowledging that a number of mechanical issues in tracking split taxes and related income are not fully addressed in Treas. Reg. § 1.909-6, promised to consider such issues only in future guidance. The Treasury Department and IRS also declined to expand the scope of Treas. Reg. § 1.909-6 to provide that split taxes carry over to a domestic corporation in the case of a foreign-to-US liquidation or other inbound transaction described in Code Section 381. Nor did they adopt a taxpayer-friendly proposal that would have, in effect, allowed the payor of split taxes (in certain situations) a deduction for such split taxes where a covered person with income related to such split taxes ceases to be a covered person (e.g., as a result of the disposition of such person) before the payor takes into account the related income of such covered person. Instead, according to the Treasury Department and IRS, such split taxes remain permanently suspended and, therefore, taxpayers may wish to consider whether such related income should be transferred by the covered person to the payor (e.g., through a distribution) prior to the cessation of the covered person relationship.

In summary, although containing a number of adjustments, the Final Regulations issued with respect to foreign tax credit splitter arrangements largely track the Temporary Regulations and do not significantly expand their scope. That should generally be a good thing for taxpayers.

By Thomas R. May, New York

Baker & McKenzie

9 Tax News and Developments April 2015

A Tough Undertaking: The IRS Provides Guidance on the Tax Rate Disparity Test Code Section 954(d)(2) is commonly known as the “branch rule.” The branch rule, enacted in 1962 with the original Subpart F provisions, was intended to prevent controlled foreign corporations (“CFC”) from using foreign branches to effectively avoid the foreign base company sales income ("FBCSI") rules. The branch rule is designed to apply to situations where a company's sales activities are separated from its manufacturing activities through a branch. Specifically, when the sales activities through the CFC's branch are taxed at a lower rate than the rate that would be imposed on the manufacturing income and a sufficient tax rate disparity (“TRD”) results, the branch rule causes such branch to be treated as though it were a wholly-owned subsidiary corporation of the CFC and, as a result of such construct, FBCSI of the CFC may result.

Although regulations exist and some rulings have been issued over the years, many questions remain regarding the application of the TRD test. In a recent legal advice memorandum dated February 9, 2015 ("AM 2015-002"), the IRS Chief Counsel's office provided some guidance regarding the TRD test in the case of property manufactured by a CFC, specifically, (i) whether a common base should be used to calculate the actual rate of tax and the hypothetical rate of tax when applying the TRD test and (ii) whether the relevant tax laws to be taken into account when determining the common base should be those of the manufacturing jurisdiction.

By way of background, the regulations promulgated under section 954(d)(2) provide, with respect to a sales branch, that the TRD test applies to determine whether or not the branch rule is triggered. The branch rule is triggered if, under the TRD test, the income allocated to the sales branch is taxed at an effective rate of tax ("ERT") that is less than 90 percent of, and at least five percentage points below, the ERT which would apply to such income under the laws of the CFC's country of organization. Therefore, the TRD test requires a determination of the actual ERT paid in the sales jurisdiction, which requires knowing the actual tax imposed and on what base the actual tax was paid. In addition, the TRD test requires a determination of the hypothetical ERT, which requires knowing what tax would have been paid in the manufacturing jurisdiction and the hypothetical base upon which such tax would have been paid.

To assist in discussing the TRD test, the IRS provided the following example (the “Example”):

In Year 1, CFC, a controlled foreign corporation (“CFC”) incorporated in Country B, purchases raw materials from an unrelated supplier and uses them to manufacture (under the principles of Treas. Reg. § 1.954-3(a)(4)) Product X in Country B. DE is the wholly owned subsidiary of CFC and has elected to be treated as a disregarded entity of CFC pursuant to Treas. Reg. § 301.7701-3(c). DE is located in Country A and does not engage in any manufacturing activities. DE derives €100x of commission income in connection with the sale of Product X by CFC to unrelated customers located outside of Country A and Country B. DE incurs €30x of sales expenses related to the sale of Product X. CFC has no other income that would constitute foreign base company income under section 954. Country A and

Baker & McKenzie

10 Tax News and Developments April 2015

Country B both impose a 20% statutory rate of tax on sales income. Country A allows DE to exclude half of its income from the sale of products manufactured and sold for use outside of Country A. Country B does not tax DE’s sales income until it is remitted to CFC as a dividend. Both Country A and Country B would allow a €30x deduction for the sales expenses. DE paid €4x of income tax in Country A in Year 1.

In a footnote related to the Example, the IRS further provided that:

For federal income tax purposes, DE is treated as a branch or division of CFC, rather than as a separate entity. Under the laws of Country A and Country B, however, DE and CFC are treated as separate entities, and DE could either purchase Product X from CFC and sell to unrelated customers at a mark-up or receive commissions from CFC, ostensibly for facilitating sales from CFC to unrelated customers, without taking title to Product X. In this memorandum, the facts are such that DE receives sales commissions from CFC.

For purposes of applying the TRD test to the Example, the IRS set forth a five-step analysis. The first step included a determination of the income upon which the test would be based. Second, the actual tax on that income was determined. Third, the hypothetical tax base was determined. Fourth, a determination of the hypothetical tax that would have been imposed on that income was made. And, finally, the IRS’s five-step analysis divided the actual tax and hypothetical tax by the hypothetical tax base to compare the resulting ERTs. Each of these steps and the IRS’ analysis are described in more detail below.

Applying the first step to the Example, the IRS determined that the relevant income was the DE's gross income derived in connection with the sale of property sold on behalf of the CFC i.e., €100x. This step was fairly straightforward given the only income of the branch was its sales commission earned. In applying the second step, the IRS determined the actual tax incurred in Country A equaled €4x ((100x-50x-30x)*20%). Here, the IRS at least vaguely referenced the complexity that may arise in the event the sales branch had earned income other than income connected with the sales activity by stating that such income and tax must be separated for purposes of applying these first two steps.

In the third step of the five-step analysis, the IRS determined the hypothetical tax base equaled €70x (100x-30x). In discussing this step, the IRS, citing to Treas. Reg. § 1.954-3(b)(2)(i)(e), stated that "[t]he relevant tax laws to be taken into account in determining the hypothetical tax base are those of the CFC's country of incorporation (i.e., the manufacturing jurisdiction)." The IRS further clarified that when determining the TRD gross income, such amounts should be reduced by the exclusions and deductions that would be permitted under the laws of the manufacturing country regardless of whether those exclusions and deductions would be allowed under US tax laws.

The IRS, in the fourth step, performed the mathematical computation of multiplying the statutory rate of tax in the manufacturing jurisdiction to the hypothetical tax base i.e., 14x (70x*20%). Finally, in the fifth step, the actual tax and the hypothetical tax were each divided by the hypothetical tax base to arrive at the ERTs to then conduct a comparison. Thus, the actual ERT of 5.71% (€4x/€70x) was compared to the resulting hypothetical ERT of 20% (€14x/€70x).

Baker & McKenzie

11 Tax News and Developments April 2015

In analyzing this step, the IRS reiterated that a common base should be used in the TRD test. Because the actual ERT was both less than 90 percent of and at least five percentage points less than the hypothetical ERT, there was sufficient TRD to trigger the branch rule in the Example.

Interestingly, the IRS indicated that using the hypothetical base from the manufacturing location (as opposed to the sales location) should be more taxpayer favorable (i.e., less likely to result in a branch being treated as a separate subsidiary corporation under the TRD test). The IRS reasoned that this should be the case because "the taxable income in the sales jurisdiction is often less than the hypothetical taxable income in the manufacturing jurisdiction and when used as the common tax base will produce ERTs in both jurisdictions that are higher, but not proportionally higher, such that it is more likely the ERTs will differ by more than 5 percentage points." However, applying this approach to the Example, a different result would have been reached. In other words, using the taxable income in Country A as the common denominator would not have resulted in a TRD at all.

In AM 2015-002, the IRS sought to provide guidance in what is undoubtedly a complex area of US tax law. Although an attempt at a tough undertaking was made, many questions remain unanswered and controversy in this area will likely continue.

By Rodney W. Read, Houston

IRS Addresses Effect of Subpart F Inclusion on US Shareholder Earnings & Profits On February 13, 2015, the Associate Chief Counsel (International) released General Legal Advice Memorandum 2015-001 ("GLAM") addressing the consequences of income inclusions under Code Section 951(a)(1) on a US shareholder's earnings and profits ("E&P"). The GLAM considers a fact pattern in which a controlled foreign corporation ("FS") is wholly owned by a domestic corporation ("USP") that qualifies as a US shareholder under section 951(b). In Year 1, FS earns Subpart F income and holds US property (as defined in section 956(c)). As a result, USP has income inclusions under sections 951(a)(1)(A) and (B) with respect to FS in Year 1. On the basis of the Treasury Regulations and case law, the GLAM concludes that USP must increase its E&P in Year 1―the year of the section 951(a)(1) inclusion―regardless of whether FS makes any actual distributions to USP in Year 1. This article examines the IRS's reasoning, as well as its dismissal of possible counterarguments, for the abovementioned approach.

The Basic Mechanics of Subpart F

A controlled foreign corporation ("CFC") is a foreign corporation that is owned more than 50% (measured by vote or value) by US shareholders. A US shareholder, as defined in section 951(b), is a United States person owning at least 10% voting power in a foreign corporation. Section 951(a), in turn, requires a US shareholder to include its pro rata share of Subpart F income (as defined in section 952), as well as the amount determined under section 956 (relating to investments in US property), in gross income in the year in which the Subpart F income or section 956 amounts arise. The Subpart F provisions generally

Baker & McKenzie

12 Tax News and Developments April 2015

ensure that US shareholders are taxed immediately on certain income earned by CFCs.

While the Subpart F provisions constitute an anti-deferral regime, they do not intend to subject the same item of CFC income to tax more than once. Accordingly, once earnings have been taxed as Subpart F income, those earnings should not be included again in the US shareholder's income when such amounts are actually distributed or subsequently invested in US property. To prevent the double-counting of CFC earnings, the Subpart F rules provide for stock basis adjustments and the creation of an account for previously taxed income ("PTI") to account for income inclusions under section 951(a)(1). Specifically, section 961(a) requires a US shareholder to increase the basis in its CFC stock to the extent it includes in gross income amounts under section 951(a)(1) with respect to the stock. Likewise, a US shareholder increases its PTI account balance by the same amount under section 959. Upon an actual distribution of CFC earnings, the US shareholder does not include such amounts in gross income. Rather, the US shareholder reduces its basis in the CFC stock and decreases the PTI account, ensuring that Subpart F income is included in income only once, even if the section 951(a)(1) inclusion and an actual distribution of CFC earnings occur at separate times. In the event the US shareholder disposes of its interest in the CFC prior to any distributions, the US shareholder's increased tax basis in the CFC stock should likewise prevent a double income inclusion.

The IRS's Rationale For an Adjustment to Earnings & Profits

In the GLAM, the IRS acknowledges that E&P is not specifically defined in the Code, and therefore looks to Treas. Reg. § 1.312-6, which provides that E&P for a particular period includes "all items includible in gross income under section 61." Section 61 broadly defines gross income to include "all income from whatever source derived" and is not limited to the items enumerated in the statute. As discussed above, section 951(a)(1) requires a US shareholder to include in gross income its pro rata share of a CFC's Subpart F income and amounts determined under section 956. The IRS also cites Treas. Reg. § 1.312-6(a) for the general proposition that "a domestic corporation's E&P is increased when it takes the corresponding item of income into account in computing taxable income." Absent an express rule to the contrary, the IRS reasons that statutory provisions affecting the timing of income (i.e., deferral or acceleration) should have a corresponding effect on timing for E&P purposes. Because no statutory or regulatory provisions contain express timing rules regarding the timing of E&P adjustments related to section 951(a)(1) inclusions, the IRS concludes that section 951(a)(1) inclusions are subject to Treas. Reg. § 1.312-6(a) and should therefore increase E&P in the year in which they are included in the US shareholder's gross income.

In support of its position, the IRS relies on authorities that establish the relationship between the deferral of income inclusions, basis adjustments that preserve income for future taxation, and E&P adjustments. First, the IRS cites Commissioner v. Wheeler, 324 US 542 (1945), in which the taxpayer contributed appreciated stock to a corporation in a nonrecognition transaction. As such, the corporation took a carryover basis in the stock. For purposes of calculating E&P upon the corporation's subsequent disposition of the stock, the taxpayer sought to calculate the resulting gain by taking a higher fair market value (as of the time

Baker & McKenzie

13 Tax News and Developments April 2015

of the contribution) basis in the stock. The Supreme Court rejected this argument and held that carryover basis applied for purposes of determining the corporation's E&P. As such, the use of carryover basis effectively deferred the gain for purposes of computing both taxable income and E&P. The IRS also cites Bangor & Aroostok Railroad Co. v. Commissioner, 16 T.C. 578 (1951), in which the taxpayer elected to reduce the basis in its bonds rather than recognize "bond profit" realized on the repurchase of its bonds at a discount. The taxpayer nonetheless argued that the bond profit should increase E&P for purposes of determining its excess profits credit. The Tax Court disagreed and held that bond profit should only increase E&P at the time it is actually includible in income.

The GLAM asserts that Wheeler and Bangor & Aroostok demonstrate that an E&P inclusion should generally occur at the time that income is taken into account. Where income recognition is deferred through basis carryover or reduction, an E&P adjustment should not be made at the time of the initial transaction, but should instead be made at the time the income is actually included in taxable income. The IRS draws a parallel between this proposition and the PTI and basis provisions under the Subpart F regime. As discussed above, the Subpart F rules provide for a current income inclusion under section 951(a)(1), but preclude any subsequent income inclusion through stock basis adjustments and the creation of a PTI account. The IRS acknowledges that Wheeler and Bangor & Aroostok address income deferral, rather than the income acceleration that results under the Subpart F rules. Nonetheless, the IRS states that the cases support the proposition that when income is taken into account and basis is increased to prevent such income from being subsequently taxed again, E&P must be increased. In short, the IRS concludes that the stock basis adjustments and PTI account under sections 961(a) and 959, respectively, serve the same function as the basis adjustments in Wheeler and Bangor & Aroostok ‒- to ensure that the income is included once, and only once, in taxable income.

In addition to the abovementioned cases, the IRS further notes that while section 961(b) provides for a basis decrease with respect to a distribution that is not included in a US shareholder's income under section 959, it does not explicitly address the E&P consequences of the distribution. Section 312(f)(2), however, expressly states that a nontaxable distribution in which stock basis is decreased does not increase the E&P of the recipient. As such, the GLAM concludes that the E&P of a US shareholder should be increased at the time of the section 951(a)(1) inclusion and not at the time of the subsequent distribution.

Possible Counterarguments Dismissed

The IRS addresses two possible counterarguments with respect to its conclusion. First, the IRS addresses the argument that section 951(a)(1) inclusions should not increase E&P because such inclusions do not increase the US shareholder's ability to make a dividend distribution (on account that no cash or property is distributed). The IRS flatly rejects this argument by stating that E&P is not simply a measure of cash flow and that other statutory and regulatory guidance likewise requires an increase in E&P even where no cash or property is distributed. Second, the IRS considers the argument that E&P cannot be in two places at once, as a result of the CFC maintaining its E&P balance until an actual distribution is made, while the US shareholder increases its E&P at the time of the section 951(a)(1) inclusion. The IRS acknowledges that a corporate shareholder generally only recognizes income, and makes a corresponding

Baker & McKenzie

14 Tax News and Developments April 2015

increase to E&P, upon an actual distribution from a subsidiary corporation, but the IRS states that the general rule does not always apply. As an example of an exception to the general rule, the IRS references the consolidated return regulations.

The GLAM establishes the IRS's position that a US shareholder should increase its E&P in the year of a section 951(a)(1) inclusion, regardless of when the CFC makes an actual distribution. Taxpayers should confirm that they take a consistent approach to ensure that distributions the US shareholder makes are properly characterized for US tax purposes as a dividend, return of basis, or capital gain under section 301, as the case may be.

By Erin Tyler Brewster, Houston

IRS Releases Proposed Regulations on More Narrowly Tailored "Next Day Rule" On March 5, 2015, the Treasury Department and the IRS published long-awaited proposed regulations under Treasury Regulation § 1.1502-76 (the "2015 Proposed Regulations") providing rules governing the allocation of a corporation's items of income, gain, deduction, loss and credit when the corporation leaves or joins a consolidated group. The most recent guidance in this area was a memorandum, GLAM 2012-010 (the "GLAM"), issued by the IRS on January 31, 2013. (For a detailed discussion of the issues addressed in the GLAM, see prior Tax News and Developments article Deducting Stock Options Cashed Out on a Change in Control: The IRS Announces Its View (Volume XIII, Issue 3, June 2013) located under publications at www.bakermckenzie.com). The allocation of a target corporation's (the "Target's") tax items, and specifically whether the acquiring corporation (the "Acquirer") or the selling corporation (the "Seller") receives the benefit of the tax items, is often a negotiated point in the M&A context. If the 2015 Proposed Regulations are finalized in current form, these parties will be limited in their ability to agree to allocate closing day items to the Target's pre-closing short year return or the Target's post-closing short year return. The 2015 Proposed Regulations will not become effective until they are published as final regulations in the Final Register, but coupled with the GLAM issued two years ago, they serve to confirm the government's position regarding the allocation of the Target's closing day items.

In general, when a corporation leaves or joins a consolidated group, the taxable year of the Target closes at the end of the day on the date the transaction closes (the "Closing Date"), and a new taxable year begins on the day following the Closing Date. In the M&A context, the taxable period ending on the Closing Date is often referred to as "Target's Pre-Closing Tax Period," and the taxable period beginning after the Closing Date is referred to as "Target's Post-Closing Tax Period." Prior regulations issued by the Treasury Department and the IRS on September 8, 1966, did not address the treatment of the Target's tax items that accrued on the Closing Date. As a consequence, these regulations were not clear regarding whether the Target's tax items accrued on the Closing Date should have been reflected on the tax return for Target's Pre-Closing Tax Period or the return for Target's Post-Closing Tax period. As a result, many followed what they called the "lunch rule" for Closing Date items; namely, if the item was taken into account after noon on the Closing Date, then it was allocated to the Target's Post-Closing Tax Period.

Baker & McKenzie

15 Tax News and Developments April 2015

On August 15, 1994, the Treasury Department and the IRS published final regulations that were intended to eliminate ambiguity surrounding the treatment of Target's Closing Date tax items (the "Current Regulations"). Under the general rule of the Current Regulations, the Target is treated as ceasing to become a member of a consolidated group at the end of the Closing Date (the "End of Day Rule"), and the Target's items are typically included on the return for Target's Pre-Closing Tax Period. The Current Regulations provide two exceptions to the End of Day Rule: an exception referred to as the next day rule (the "Next Day Rule") and an exception regarding S corporations, each discussed below.

The Next Day Rule

Under the Next Day Rule, if on the Closing Date a transaction occurs that is properly allocable to the portion of the Closing Date after the sale of the Target closes, the Target must treat the transaction for all federal income tax purposes as occurring at the beginning of the following day. (Treas. Reg. §1.338-1(d) also contains a next day rule for cases in which a Code Section 338 election is made for the target.) The preamble to the 2015 Proposed Regulations indicates that the Next Day Rule was drafted to address the "seller beware" fact pattern (aka the "unscrupulous buyer" case). For example, if the Acquirer causes the Target to sell an entire business unit on the Closing Date, but after the closing of the sale of the Target, gain related to that sale would be reported on the Acquirer's consolidated tax return. It would be inappropriate to allocate the gain to the return related to Target's Pre-Closing Tax Period because Seller had no control over the sale of the business unit after the sale of the Target closed.

The Next Day Rule provides that the Acquirer, the Seller and the Target must treat the transaction as occurring on the beginning of the day following the Closing Date if the transaction occurs on the Closing Date and is "properly allocable" to the portion of the Closing Date following the Closing. Under the Current Regulations, whether a transaction is properly allocable to the portion of the Closing Date after the sale of the Target depends on whether the allocation is reasonable and consistently applied by all parties. Whether an allocation is reasonable hinges on several factors, including whether the items of income, gain, deduction, loss and credit are allocated inconsistently and whether the allocation is inconsistent with other provisions of the Internal Revenue Code. Whether the allocation is consistently applied simply means that each of the Seller, the Target and the Acquirer (and persons related to each) must report the item consistently. For example, if the Target accrues an expense related to the sale of the Target, the Acquirer and the Seller cannot both take a deduction for the same expense in the Pre-Closing Tax Period and the Post-Closing Tax Period.

The Next Day Rule has afforded planning opportunities for both the Seller, the Target and the Acquirer, particularly when the Target is a loss company that would be further limited under Code Section 382 if deductions for expenses related to the closing of the sale of the Target must be taken in the tax return related to the Target's Pre-Closing Tax Period. Many taxpayers have interpreted the Next Day Rule as providing the parties with flexibility in allocating Closing Date items to the next day, provided the allocation is reasonable and consistently applied.

Baker & McKenzie

16 Tax News and Developments April 2015

The preamble to the 2015 Proposed Regulations explains that the Treasury Department and the IRS believe that the interpretation of the Next Day Rule as described above is inappropriate because it allows taxpayers to elect the income tax return on which the tax items are reported and accordingly may not result in an allocation that clearly reflects taxable income. From the Treasury Department's and the IRS' perspective, the ability to shift tax items between tax periods is inconsistent with the purpose of Treasury Regulation § 1.1502-76(b) to clearly reflect income of the Target and the consolidated group, and the Current Regulations create controversy between taxpayers and the IRS regarding the proper allocation of the Target's Closing Date tax items.

The Proposed Next Day Rule

In an effort to reduce the controversy and uncertainty under the Next Day Rule, the Treasury Department and the IRS issued the 2015 Proposed Regulations to clarify the period in which the Target must report certain tax items by replacing the current rule with a revised, more narrowly tailored version of the next day rule (the "Proposed Next Day Rule"). The application of the Proposed Next Day Rule is mandatory, not elective. Thus, if the Acquirer causes the Target to enter into a transaction on the Closing Date but after the sale of the Target closes (that is, the "seller beware" scenario), the transaction giving rise to the extraordinary item is treated as occurring at the beginning of the next day for purposes of when the Target must report the item.

The Proposed Next Day Rule only applies to "extraordinary items" that occur on the Closing Date, and it is not applicable to any extraordinary item that arises simultaneously with the event that caused the Target's change in status (e.g., the closing of the transaction). Thus, fees generated in connection with the sale of the Target are "compensation-related deductions" for purposes of the 2015 Proposed Regulations, and, to the extent the fees arise simultaneously with the Closing, such items must be reported on the tax return for Target's Pre-Closing Tax Period. This is consistent with the position the IRS expressed in the GLAM, where the IRS determined that the deduction for compensatory nonqualified stock options and stock appreciation rights vesting on a change in control of Target, as well as banking and financial advisory fees contingent upon the closing of the acquisition, became fixed and determinable upon the closing and accordingly belonged on the return for Target's Pre-Closing Tax Period.

The S Corporation Exception

Under the Current Regulations, if the Target is an S corporation immediately before joining a consolidated group, the Target becomes a member of the consolidated group at the beginning of the day the termination of S corporation election is effective, and the Target's S corporation taxable year closes for federal income tax purposes at the end of the preceding day. Before the S corporation exception was added on November 10, 1999, the Target S corporation was required to file a one-day standalone C corporation return for the Closing Date. The S corporation exception solved this hardship. However, this created the risk of the "unscrupulous seller" (S corporation shareholders causing the Target to complete sales of assets on the Closing Date but prior to, or simultaneous with, the closing of the transaction).

Baker & McKenzie

17 Tax News and Developments April 2015

The Previous Day Rule

The 2015 Proposed Regulations retain the S corporation exception to the End of Day Rule and add a new rule that is essentially a corollary to the Next Day Rule. The preamble explains that where, on the one hand, the Proposed Next Day Rule requires extraordinary items resulting from transactions that occur on the Closing Date (but after the closing of the sale of the Target) to be allocated to Target's Post-Closing Tax Period, the previous day rule, on the other hand, requires extraordinary items resulting from transactions that occur on the Closing Date (but before or simultaneously with the closing of the sale of the Target) to be allocated to the Target's tax return for the short period that ends on the previous day (the day preceding the termination date).

Anti-avoidance Rule and Other Proposals

The 2015 Proposed Regulations would also modify the current anti-avoidance rule. Under the Current Regulations, adjustments are made when a corporation acts with a principal purpose to substantially reduce the liability of any person. The 2015 Proposed Regulations clarify that the anti-avoidance rule can apply when a corporation modifies an existing contract in anticipation of the sale of the Target to shift a tax item, if the modification is undertaken with a prohibited purpose.

In addition to the above, the 2015 Proposed Regulations contain, among other things, a proposal that would provide relief to taxpayers that may inadvertently miss a deadline for filing a return when the Target joins a new consolidated group after the Closing Date and ceases to exist through, for example, an intergroup restructuring in Acquirer's consolidated group. The 2015 Proposed Regulations also provide a coordination rule for section 382(h) and section 1374 regarding a corporation's net unrealized built-in loss and net unrealized built-in gain that would otherwise be changed on the Closing Date due to certain recognition events.

In conclusion, taxpayers involved in M&A transactions should consider the rules set forth in the 2015 Proposed Regulations, particularly before allocating the Target's tax items that accrue on the Closing Date to the tax return relating to Target's Pre-Closing Tax Period or Target's Post-Closing Tax Period.

By Kai R. Kramer, Houston

Baker & McKenzie

18 Tax News and Developments April 2015

Like-Kind Exchange Treatment Denied in North Central Rental Case Involving Related Party Transfers In North Central Rental & Leasing, LLC vs. US, the US Court of Appeals for the Eighth Circuit held that North Central Rental & Leasing, LLC (the "Taxpayer") did not qualify for like-kind exchange deferral in a transaction in which the Taxpayer was selling used equipment and purchasing replacement inventory because it was a prohibited, related party transaction.

Background on Like-Kind Exchanges Between Related Parties

Code Section 1031 provides that no gain or loss is recognized if property used in a trade or business or held for investment is exchanged for like-kind property. The policy behind the rule is to prevent the imposition of income tax on a taxpayer who essentially continues his or her original investment via the like-kind property as opposed to liquidating or "cashing in" on his or her original investment. However, related parties soon began to implement complex and sophisticated transactions to exploit the like-kind exception in a manner inconsistent with its purpose.

To prevent potentially abusive basis-shifting transactions between related parties, Congress enacted section 1031(f). Section 1031(f) provides that if an exchange occurs between related parties (as defined under section 267(b) or section 707(b)(1)), then gain or loss on the exchange must be recognized if either party disposes the replacement property within two years. In addition, section 1031(f)(4) broadly precludes nonrecognition treatment to any exchange that is part of a transaction or series of transactions structured to avoid the purposes of the related party exchange rule.

Facts and Holding of North Central Case

Butler Machinery Company (the "Parent") was in the business of leasing heavy mining and construction equipment for manufacturers of such equipment. For valid business purposes, Parent formed Taxpayer to take over its leasing operations.

To facilitate its business, one of the equipment suppliers (the "Supplier") encouraged its dealers, including Parent, to participate in a like-kind exchange program using a qualified intermediary. The Supplier advised Parent that participation in its like-kind exchange program would enable Parent to take advantage of the Supplier's favorable financing program that would allow Parent up to six months to pay for the purchase of new equipment (the "replacement property"). However, the Supplier made it clear that the favorable terms of its financing program would only be available if Parent, and not its subsidiary, the Taxpayer, purchased the replacement property from the Supplier. Consequently, to take advantage of the Supplier's financing program, Parent had to purchase equipment from the Supplier and then resell the equipment to the Taxpayer. Specifically, from 2004-2007, Taxpayer and Parent engaged in 398 transactions that can be summarized as follows:

Baker & McKenzie

19 Tax News and Developments April 2015

• Taxpayer sold used equipment (the "relinquished property") to a third party through a qualified intermediary.

• Simultaneous to the sale, Parent purchased replacement property from the Supplier.

• Parent then sold the replacement property to the qualified intermediary and the qualified intermediary, in turn, paid Parent using the sale proceeds from the sale of the relinquished property.

• The qualified intermediary then transferred the replacement property to the Taxpayer.

As a result of the foregoing transactions, Taxpayer acquired its replacement property and claimed Section 1031 like-kind exchange treatment to defer the gain otherwise recognizable upon the sale of the relinquished property. In turn, Parent possessed the proceeds from the sale of the relinquished property and due to the favorable terms of the Supplier's financing program, had up to six months before it was obligated to pay the Supplier for the replacement property.

The IRS argued that Taxpayer and Parent collectively cashed in their investments and as a result, Taxpayer was not entitled to nonrecognition treatment on the transactions. Specifically, the IRS noted that although Taxpayer continued to hold investment property similar to the property it sold during the transactions, Parent held only cash for up to six months after the exchange, until it had pay the Supplier. Taxpayer rebutted by arguing that Parent was required to pay the Supplier within six months for the replacement property and as such, the like-kind exchange transactions did not involve any cashing out.

The court ruled in favor of the IRS and held that Parent's receipt of cash in exchange for the equipment and its subsequent unrestricted access to that cash for six months thereafter disqualified Taxpayer from nonrecognition treatment pursuant to section 1031(f)(4). Specifically, the court held that Parent's sole purpose of being involved in the exchanges was to receive interest-free cash for six months. In this regard, the court pointed out that Parent used the cash it was receiving from the transaction for day-to-day business activities, including paying the electric bill and making payroll.

Takeaway from Case

It is worth noting that this was a unique case in which there was a conflict of business and tax interests. Taxpayer was in the leasing business and was engaging in the like-kind transactions. However, the Supplier made it clear that only Parent would qualify for its favorable financing program, not Taxpayer. As a result, Parent had to buy the replacement property directly from the Supplier and then resell it to Taxpayer, which created the related party issue.

Although the court in this case ruled against Taxpayer, it is important to remember that related parties can engage in tax-free like-kind exchanges if the requirements of section 1031(f) are satisfied. In the North Central case, the court was highly influenced by the fact that the qualified intermediary paid Parent with cash that was not earmarked for payment to the Supplier. Hence, it viewed Parent's unfettered access to the cash as similar to the cashing in of an investment rather than a tax-free like-kind exchange. The court's reasoning here

Baker & McKenzie

20 Tax News and Developments April 2015

raises the question of whether a restriction on the use of the cash received by Parent would have resulted in a qualifying like-kind exchange transaction under section 1031.

By Pratiksha Patel, Miami

Taxpayer Victory: Fifth Circuit Reverses Tax Court in BMC Software, Inc. v. Commissioner On March 13, 2015, the Court of Appeals for the Fifth Circuit in BMC Software, Inc. v. Commissioner, No. 13-60684 (5th Cir. 2015) unanimously reversed the Tax Court's decision, 141 T.C. No. 5 (2013) and sided with the taxpayer. The Fifth Circuit opinion is directly pertinent to taxpayers that took advantage of the Code Section 965 dividends received deduction (DRD) during 2004, 2005, or 2006 (the "testing period") and made or seek to make conforming adjustments under Rev. Proc. 99-32, 199-2 C.B. C.B. 296 (“Rev. Proc. 99-32” or "99-32") in the wake of resolving a transfer pricing controversy. The case also provides guidance regarding more general principles of statutory interpretation and deference to agency publications.

The case involved the treatment of BMC's accounts receivable created after 2006, the year in which the dividend was paid pursuant to a 99-32 closing agreement for purposes of section 965(b)(3). The Tax Court had held the receivable was deemed to arise as of the 2006 year end and constituted related party indebtedness for purposes of section 965(b)(3). Reversing the Tax Court, the Fifth Circuit found that the account receivable created after the testing period was not indebtedness within the meaning of section 965(b)(3) and that the boilerplate language of the closing agreement did not create retroactive indebtedness for all federal tax purposes.

It is premature to conclude that the Fifth Circuit opinion ends the IRS's attempt to reduce DRDs as a correlative adjustment in granting 99-32 relief. The IRS may move for the Fifth Circuit to reconsider its opinion and continue to litigate the issue in other circuits. For example, the Tax Court currently has a fully stipulated case under advisement in Analog Devices v. Commissioner, T.C. No. 017380-12 (appealable to the First Circuit). For other taxpayers with section 482 controversies in the 2004 through 2006 tax years, the IRS may insist on including express closing agreement language addressing section 965(b)(3) as a condition to granting 99-32 relief.

Repatriation Holiday Homeland Investment Act

The Homeland Investment Act, part of the American Jobs Creation Act of 2004 (P.L. 108-357), allowed corporations an elective one-time DRD equal to 85% of the "qualifying dividends" received from their controlled foreign corporations (CFCs) during either 2004, 2005, or 2006 (also known as an "HIA Dividend"). The purpose of the repatriation provision, codified in section 965, was to encourage US corporations to repatriate foreign income and use the funds for domestic investment.

To prevent the use of "round trip" or circular cash flows to finance the dividend repatriation, section 965(b)(3) required taxpayers show that their related party

Baker & McKenzie

21 Tax News and Developments April 2015

debt had not increased between October 2004 and the end of the year in which the dividend was paid.

BMC Software Repatriation in 2006

BMC took advantage of the repatriation in 2006, claiming $709 million in "qualifying dividends" from its Irish affiliate ("BSEH") eligible for the 85% section 965 DRD. The IRS subsequently audited BMC and asserted that royalties that BMC US paid to BSEH in 2006 and for four years prior failed to comply with the arm's-length standard under section 482. In 2007, BMC entered into a closing agreement with the IRS, increasing BMC US's income under section 482 for each of the years at issue, including 2006. To account for BSEH having overpaid royalties to BMC, a secondary adjustment was required to conform the cash accounts on the entities' balance sheets. BMC entered into a second closing agreement in September 2007, pursuant to Rev. Proc. 99-32, which allowed BMC to repatriate cash corresponding to the amount allocated in the primary section 482 adjustment through a deemed account receivable due to BMC from BSEH.

Because BMC's 99-32 closing agreement made certain of those receivables retroactive to 2006 (part of the testing period), the IRS took the position that the subsequently created accounts receivable increased BSEH's related party "indebtedness" under section 965(b)(3) and therefore reduced BMC's eligibility for the repatriated DRD under section 965. BMC proceeded to Tax Court to litigate the issue, filing its petition in 2011. See prior Tax News and Developments article BMC Software v. Commissioner. A "Catch-22" For Taxpayers Litigating Section 482 Controversies Arising From Years Also Including a Section 965 Repatriation (Volume 13, Issue 5, October 2013), which covered the Tax Court decision, located under publications at www.bakermckenzie.com.

Tax Court Decision and Appeal to Fifth Circuit

After losing in Tax Court, BMC appealed to the Fifth Circuit. The Fifth Circuit rejected the Tax Court's reasoning, finding in favor of BMC and holding that (1) the plain text of section 965 did not support the IRS interpretation, and (2) BMC never agreed to treat the relevant accounts receivable as indebtedness. Because BMC did not create the receivables until 2007, the court concluded that those receivables did not exist as of the close of the 2006 tax year when BMC claimed the DRD. The fact that BMC agreed to backdate the receivables to the testing period, "does nothing to alter the reality that [the receivables] did not exist during the testing period."

The case has implications for taxpayers facing similar challenges from the IRS, and provides important guidance for taxpayers considering closing agreements with the IRS. BMC's 99-32 closing agreement made no reference to section 965, but IRS internal guidance, including Industry Directive #2 on Section 965 Foreign Earnings Repatriation, LMSB- 4-0408-021 (April 21, 2008), now requires closing agreements in transfer pricing cases contain language regarding section 965(b)(3). For taxpayers who took advantage of the repatriation holiday and are now facing transfer pricing adjustments that may result in 99-32 closing agreements, these cases will present different facts than those addressed by the Fifth Circuit. There is also a risk the IRS will revise Rev. Proc. 99-32 to modify

Baker & McKenzie

22 Tax News and Developments April 2015

the classification of accounts receivable to directly address the treatment for purposes of section 965, which could have negative implications for taxpayers.

The court addressed how to interpret closing agreements, choosing to apply general contract principles. The plain language of the 99-32 closing agreement controlled, and therefore, BMC never agreed to treat the deemed receivable as indebtedness. The court pointed to the fact that (1) the closing agreement did not reference section 965; (2) the boiler plate provision "for federal income tax purposes…" failed to bind the taxpayer with respect to section 965; and (3) the closing agreement covers only those tax consequences it expressly listed (i.e., not section 965 since it was not addressed). Extrinsic evidence indicated BMC did not agree to the treatment the IRS advocated.

More generally, the Fifth Circuit decision addresses issues of deference and statutory interpretation. The court's opinion offers insight into the limits on the deference owed to IRS notices. The Fifth Circuit did not give any weight to a contemporaneous IRS Notice 2005-64, which specifically classified accounts receivable created under Rev. Proc. 99-32 as related party debt for purposes of section 965(b)(3). The notice contained only a single sentence regarding the treatment of accounts receivables as indebtedness; its treatment was entirely conclusory, and it provided no analysis or explanation. Therefore, the court found the notice completely unpersuasive and unworthy of deference under Skidmore v. Swift & Co., 323 U.S. 134 (1944). As a result, BMC Software offers insight into the limits on the deference owed to IRS notices or other agency guidance issued without following the notice and comment rulemaking requirements.

Taxpayers in other circuits facing similar transfer pricing adjustments should keep in mind the potential implications of entering a 99-32 closing agreement. The Fifth Circuit decision is not binding on other circuits, and the Analog Devices case that is currently pending in the Tax Court could have potential implications since it could result in a circuit split. It remains unclear whether the IRS will appeal the Fifth Circuit decision, or nonacquiesce in an Action on Decision. The BMC Software opinion highlights what is likely the next battleground in this area - negotiating 99-32 closing agreements and specifically the language around section 965(b)(3). For taxpayers who do not have transfer pricing issues, or who never made an HIA dividend, the case remains relevant since it provides guidance on how courts interpret IRS guidance and directives as well as the application of general contract principles to closing agreements.

By Amanda T. Kottke, Palo Alto

Baker & McKenzie

23 Tax News and Developments April 2015

US Supreme Court Issues Decision in Two State Tax Cases The United States Supreme Court issued decisions in the state tax cases of Direct Marketing Association v. Brohl and Ala. Dep’t of Revenue v. CSX Transportation on March 3, 2015 and March 4, 2015, respectively. (For previous discussion on each case see Tax News and Developments articles US Supreme Court to Hear Three State Tax Cases (Volume IV, Issue 5, October 2014) and US Supreme Court Grants Certiorari in "Direct Marketing Association" (Volume IV, Issue 4, August 2014), located under publications at www.bakermckenzie.com.)

Direct Marketing Ass’n v. Brohl In Direct Marketing Ass’n v. Brohl, Docket No. 13-1032 (March 3, 2015), the Court considered whether a state regulation imposing a sales tax notice and reporting obligation is procedurally barred from review in federal court pursuant to the federal Tax Injunction Act (“TIA”), which prevents federal district courts from deciding certain state tax cases. The Court held that the TIA does not bar federal jurisdiction in determining whether Colorado’s notice and reporting requirement violates the US Commerce Clause. The Court did not, however, address the issue of whether such a lawsuit would be barred under the “comity doctrine,” which prohibits federal courts from interfering with the fiscal operations of state governments. The Court remanded the case to the Tenth Circuit for a determination on that issue.

Direct Marketing Association (“DMA”), a trade association of businesses/organizations that market products directly to consumers, challenged a Colorado regulation that requires out-of-state retailers who are not required to collect or remit sales/use tax, but have more than $100,000 in gross Colorado sales, to (1) notify their Colorado customers that they must self-report use tax on their purchases, (2) provide their Colorado customers with an annual purchase summary, and (3) provide a report to the Colorado Department of Revenue (“Department”) that details each of their Colorado customers and the amount of their purchases. See Colo. Code Regs. 39-21-112.3.5. This reporting requirement is separate and distinct from a Colorado customer’s requirement to remit use tax to the state (i.e., the reporting requirement puts Colorado customers on notice that they have a tax obligation).

DMA first brought its challenge in the US District Court for the District of Colorado, arguing that Colorado’s notice and reporting requirements violate the Commerce Clause by discriminating against out-of-state retailers. The district court agreed with DMA and permanently enjoined the enforcement of Colorado’s regulation. On appeal, the Tenth Circuit held that the TIA deprived the district court of jurisdiction to enjoin the Department from enforcing its regulation. The TIA provides that “district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under State law where a plain, speedy and efficient remedy may be had in the Courts of such State.” 28 U.S.C. § 1341. The Tenth Circuit reasoned that the TIA applied because the law at issue concerned, at least indirectly, the levy or collection of a state tax and DMA could have sought a “plain, speedy, and efficient remedy” at the state level.

Baker & McKenzie

24 Tax News and Developments April 2015

The Court disagreed. In reversing the Tenth Circuit, the Court held that Colorado’s regulation was merely a reporting requirement for out-of-state sellers, not an “assessment, levy, or collection” of tax, so the TIA did not apply. The Court reasoned that the notice and reporting requirement did not involve any “levy” and preceded the process of assessment and collection. The Court explained that when the notice and reporting requirements are filed, “the State still needs to take further action to assess the taxpayer’s use-tax liability and to collect payment from him.” The Court further stated that “[e]nforcment of the notice and reporting requirements may improve Colorado’s ability to assess and ultimately collect its sales and use tax from consumers, but the TIA is not keyed to all activities that may improve a State’s ability to assess and collect taxes.”

Although the Court unanimously determined that the TIA did not bar DMA's suit from federal court, Justice Kennedy’s noteworthy concurring opinion suggests that the Court should revisit its decisions in Quill and National Bellas Hess (i.e., US Supreme Court cases holding that, for sales or use tax purposes, physical presence is required to support a finding of “substantial nexus” – the prerequisite for a state’s jurisdiction to tax). Specifically, Justice Kennedy indicated that those cases were decided before the advent of the Internet and that “[t]here is a powerful case to be made that a retailer doing extensive business within a State has a sufficiently ‘substantial nexus’ to justify imposing some minor tax-collection duty, even if that business is done through mail or the Internet.” Justice Kennedy further stated that “the instant case does not raise this [nexus] issue in a manner appropriate for the Court to address it. It does provide, however, the means to note the importance of reconsidering doubtful authority,” referencing Quill and National Bellas Hess.

The Court’s remand to the Tenth Circuit regarding the comity issue leaves the procedural aspect of this case far from complete. However, Justice Kennedy’s concurring opinion is telling of his view of how sales tax nexus should evolve. Congress has also considered the current sales tax collection environment and has proposed legislation (i.e., the Marketplace Fairness Act) which would allow states to require out-of-state retailers to collect sales and use tax on sales made to in-state customers under certain conditions. If the Court were to reverse Quill/National Bellas Hess or if the Marketplace Fairness Act were enacted, the US sales and use tax landscape would change significantly.

Ala. Dep’t of Revenue v. CSX Transp., Inc.

The Court’s decision in Ala. Dep't of Revenue v. CSX Transp., Docket No. 13-553 (Mar. 4, 2015) addressed whether Alabama’s sales tax regime discriminated against interstate rail carriers in violation of the federal Railroad Revitalization and Regulatory Reform Act of 1976 (“4-R Act”). Specifically, the Court determined the appropriate "comparison class" for discrimination claims under the 4-R Act and remanded the case to the Eleventh Circuit to determine whether Alabama’s sales tax regime was discriminatory against rail carriers when compared to other similar taxes imposed on the comparison class.

Alabama taxes the purchase of diesel fuel differently among transportation businesses. For example, rail carriers pay a 4% sales tax on purchases of diesel fuel; motor carriers pay a diesel fuel excise tax of 19¢ per gallon, and water carriers are completely exempt from tax on diesel fuel purchases. The 4-R Act precludes states from imposing “another tax that discriminates against a rail carrier.” 49 U.S.C. § 11501(b)(4). CSX Transportation, Inc. (“CSX”), an interstate

Baker & McKenzie

25 Tax News and Developments April 2015

rail carrier that is subject to Alabama’s 4% sales tax, challenged Alabama’s taxing scheme on the grounds that exempting its competitors (i.e., motor carriers and water carriers) from sales tax on their purchase of diesel fuel discriminates against rail carriers in violation of the 4-R Act.

The Court affirmed the Eleventh Circuit’s holding that the appropriate “comparison class” for purposes of determining whether a tax discriminated against railroads in violation of the 4-R Act is the class identified by the allegedly injured taxpayer. Here, the comparison class was CSX’s direct competitors: motor carriers and water carriers. The Court arrived at this "comparison class" by first noting that nothing in the ordinary meaning of the word "discrimination" suggests that it is always measured in relation to the population at large. Next, the Court determined that the default "comparison class," when the "comparison class" is not statutorily defined, is the comparison class defined in the taxpayer's theory of discrimination, so long as it consists of similarly-situated taxpayers. In this case, CSX's theory of discrimination defined the "comparison class" as motor carriers and water carriers. Thus, in the Court's opinion, the discrimination claim must be analyzed only in relation to motor carriers and water carriers.

After defining the “comparison class”, the Court considered whether the discrimination analysis should be limited to the 4% Alabama sales tax on purchases of diesel fuel, as suggested by CSX. Alternatively, the state argued that the Court should take a holistic view and consider all of the Alabama taxes and related laws regarding the purchases of diesel fuel (e.g., the 19¢ per gallon Alabama excise tax that motor carriers must pay on purchases of diesel fuel and whether federal law compels a fuel tax exemption for water carriers). The Eleventh Circuit refused to consider the state's argument, finding that weighing the different taxes was too complex for the courts. The United States Supreme Court reversed, reasoning that complexity cannot be a bar to adjudication, and finding that a holistic view of similar taxes and related laws may render a singular tax disparity nondiscriminatory. Accordingly, the Court remanded the case to be reheard with all similar tax types being considered in the discrimination analysis.

Although the CSX opinion may be read narrowly as an interpretation of an esoteric statute with few implications for most taxpayers, the Court has hinted at how it will treat ambiguous tax discrimination statutes generally: the allegedly injured taxpayer will enjoy broad discretion in defining the comparison class based on its theory of discrimination, but the state's tax structure will be viewed holistically, with all similar tax types being weighed in the discrimination analysis.

By David Pope, New York and Trevor R. Mauck, New York

Baker & McKenzie

26 Tax News and Developments April 2015

Constitutional Challenge to Delaware's Unclaimed Property Estimations Proceeds A federal District Court has allowed a challenge to the constitutionality of Delaware's use of estimations to establish unclaimed property liability to go forward over the state’s objections. See Temple-Inland, Inc. v. Cook, et al., Civ. No. 14-654-SLR (U.S. Dist. Ct. Del. 3/11/2015). As previously reported in this newsletter, the plaintiff in this case brought the action after Delaware asserted a significant amount of estimated unclaimed property liability was due based on an insignificant amount of property actually found to be owed to the state. (See Tax News and Developments article A Real Game Changer?: Temple Inland v. Cook and the Future of Unclaimed Property in Delaware (Volume IV, Issue 6, December 2014), located under publications at www.bakermckenzie.com.) Delaware moved to dismiss, but the court denied the state's motion on counts brought by the plaintiff under the Due Process, Ex Post Facto, Takings, Commerce, and the Full Faith and Credit clauses of the US Constitution.

While the court also denied the plaintiff's motion for summary judgment, there is little doubt the judge has concerns with the constitutionality of Delaware's aggressive estimation technique. For several years Delaware has avoided fully litigating these issues. It remains to be seen if this case is the exception, finally giving the business community a decision on an administrative practice that has come to epitomize "states behaving badly" in the pursuit of revenue. For now, Delaware audits and voluntary disclosures will proceed with these estimations in play, although the corporations subjected to them may be less inclined to acquiesce. The odds of success in opposing such excessive estimations appear to be increasing.

For additional information, please see Tax Analysts: State Tax Notes article Federal Court Questions Delaware's Practice of Extrapolating Unclaimed Property Liability (Matthew S. Mock, March 30, 2015), also available under publications at www.bakermckenzie.com.

By Matthew S. Mock, Chicago

Baker & McKenzie

27 Tax News and Developments April 2015

Canadian Tax Update Multinationals with Canadian activities should take note of the following recent developments:

Canadian Federal Budget Delivered on April 21st: BEPS; Relief for Foreign Employers; Automatic Exchanges of Information

Canadian Finance Minister Joe Oliver delivered the federal budget on Tuesday, April 21st (the "Budget"), containing a few measures of interest to multinationals.

The Budget provides an update on tax planning by multinational enterprises. The Budget indicates that Canada looks forward to the conclusion of the OECD/G-20 BEPS project and to discussions with the international community on the implementation of its recommendations. According to the Budget, Canada “will proceed in this area in a manner that balances tax integrity and fairness with the competitiveness of Canada’s tax system ” noting that “[t]axes are one of the main factors that drive investment decisions and the Government is committed to maintaining Canada’s advantage as an attractive destination for business investment.”

The Budget proposes relief for US and foreign companies whose employees perform services in Canada on a temporary basis. Under existing rules, foreign employers are required to withhold and remit income tax in respect of foreign employees performing services in Canada notwithstanding the fact that the employees may be exempt from tax on their employment income under a tax treaty. While waivers may be obtained from the Canada Revenue Agency ("CRA"), the process can often create an administrative burden. To reduce this burden, the Budget proposes to provide an exception to the withholding requirements for payments made after 2015 by qualifying non-resident employers to qualifying non-resident employees. An employee will be a qualifying non-resident employee in respect of a payment if the employee is exempt from Canadian income tax in respect of the payment because of a tax treaty and is not in Canada for 90 or more days in any 12-month period that includes the time of the payment. In order to be a qualifying non-resident employer, an employer must be resident in a country with which Canada has a tax treaty. Partnerships may also qualify in certain circumstances. In all cases, the employer must not carry on business through a Canadian permanent establishment in its fiscal period that includes the time of the payment and the employer must be certified by the CRA at the time of the payment. Foreign employers will continue to be responsible for its reporting obligations with respect to amounts paid to its employees. No penalty will apply to a qualifying non-resident employer for failing to withhold in respect of a payment if, after reasonable inquiry, the employer had no reason to believe at the time of the payment that the employee did not meet the conditions set out above.

The Budget references the new common reporting standard endorsed by Canada and the other G-20 countries in November 2014 for automatic information exchange developed by the OECD, and the necessary legislative procedures which the G-20 Finance Ministers committed to in February 2015. The Budget indicates that Canada proposes to implement the common reporting standard starting on July 1, 2017, allowing a first exchange of information in 2018. As of the implementation date, financial institutions will be expected to have procedures in place to identify accounts held by a resident of any country

Baker & McKenzie

28 Tax News and Developments April 2015

other than Canada and to report the required information to the CRA. As the CRA formalizes exchange arrangements with other jurisdictions (having been satisfied that each jurisdiction has appropriate capacity and safeguards in place), the information will begin to be exchanged on a reciprocal, bilateral basis. Draft legislative proposals will be released for comments in the coming months.

The CRA Releases a Transfer Pricing Memorandum on Intra-group Services: Is the CRA Moving Further Away from the Arm's Length Principle in Canada?

The Canada Revenue Agency (the "CRA") recently released Transfer Pricing Memorandum TPM-15 -- Intra-group Services and Section 247 of the Income Tax Act ("TPM-15"). Taxpayers are unlikely to be surprised by many of the points highlighted by the CRA in TPM-15. TPM-15 highlights the importance of establishing the relevant facts, including identifying the service provider, providing a rationale for the provision of the services from both the provider and recipient's perspectives, determining whether services were rendered, and identifying the benefits of the services to the recipient. Additionally, TPM-15 outlines computational considerations, including separating services in respect of which a direct charge is possible from those where indirect charges are necessary, identifying and discussing the cost base, selecting and providing a rationale for the choice of an allocation key and justifying any mark-ups. TPM-15 also provides a better sense of the high level of detail that the CRA expects in support of cross-border service charges.

Where taxpayers may be surprised is in the CRA's view that it can look through a fee for service to the underlying component costs of the provider and effectively evaluate the deductibility of the fee to the service recipient based on what the deductibility of the component costs would have been had they been incurred directly by the service recipient. In making this point, the CRA notes that the payment of a fee that includes non-deductible items as underlying components would not be prohibited if the amount is arm's length, but a portion of the amount may nevertheless not be deductible to the recipient under domestic income tax rules. Furthermore, the CRA's position is that affected taxpayers would have no recourse to competent authority assistance under a relevant treaty: "[w]hile taxpayers may argue that they will be subject to double taxation on those amounts if they are not deductible in Canada, the taxpayer has no recourse under Article 9 of a tax treaty [Related Persons or Associated Enterprises] because the amounts are arm's length amounts."

This position begs the question: Where does one draw the line? For example, what about a situation in which an entity pays for manufacturing services and part of the fee covers depreciation, pension expenses or equity based compensation paid by the manufacturer that would not have been deductible if incurred by the recipient in Canada? Would some material portion of the service recipient's cost of goods sold become non-deductible?

While the CRA states that it is following the arm's length principle, one cannot help but question why an entity paying a related party for services should be faced with evaluating the underlying costs incurred by the service provider in assessing deductibility of the fee in Canada. This approach is not used where the parties to the transaction are not related to each other.

Baker & McKenzie

29 Tax News and Developments April 2015

Federal Court of Appeal Decides Intercompany Shared Research and Development Costs Form Part of the Value for Duty on Imported Goods: Importers May Need to Look Beyond the Transfer Price of Goods Imported into Canada to Determine Value for Duty

The Federal Court of Appeal ("FCA") recently released its decision in Skechers USA Canada Inc. v. President of the Canada Border Services Agency, 2015 FCA 58 (“Skechers”). Certain research and development ("R&D") payments have always been dutiable and therefore included in the value for duty of goods imported into Canada. The Skechers decision is important for Canadian importers as the FCA upheld the determination by the Canadian International Trade Tribunal (“CITT”) that certain payments made by a Canadian subsidiary to its parent company for research, development and design expenses under a cost-sharing arrangement must be included in determining the value for duty even if those payments are attributable to products that are not imported into Canada or product designs that never come to fruition, provided that there is a “sufficient link” between such payments and the goods actually imported into Canada.

Subsection 47(1) of the Customs Act (the "Act") provides that the primary method for determining value for duty is the "transaction value" of the goods. The transaction value of goods is determined by ascertaining "the price paid or payable" for the goods when the goods are sold for export to Canada and subsection 45(1) of the Act defines "price paid or payable" to mean "the aggregate of all payments made or to be made, directly or indirectly, in respect of the goods by the purchaser to or for the benefit of the vendor." While certain R&D payments that can be directly related to the imported goods have always been dutiable, the Skechers decision arguably broadens the scope of what R&D costs must be included in the transaction value of imported goods. In Skechers, the FCA affirmed the CITT’s conclusion that as the research, design, and development process was “a seamless, interrelated process, the whole of which is required to produce the goods at issue”, R&D costs for the product designs that never came to fruition or for goods that were never imported into Canada were nonetheless incurred to ultimately bring about the products that were imported into Canada. As a result, these additional R&D costs should have been included in the value for duty of the goods imported into Canada.

Importers need to review their R&D costs to determine whether they are dutiable in light of the Skechers decision. The Toronto Customs and Trade group has issued a Customs Alert on April 14, 2015 containing a more detailed analysis of the Skechers decision and its impact on importers (see R&D Expenses Paid to the Vendor of Imported Goods May Need to be Included in their Entirety in the Customs Value for Duty Determination, also available at www.internationaltradecomplianceupdate.com).

The CRA Releases an Income Tax Folio on Interest Deductibility: Additional Administrative Guidance Provided

Interest expense is generally considered to be a capital expenditure for purposes of the Canadian Income Tax Act and therefore not deductible, unless specific requirements are met. In determining whether interest is deductible in a particular situation, taxpayers must often rely on the administrative positions of the CRA, as articulated in Interpretation Bulletin IT-533, "Interest Deductibility and Related Issues", and elsewhere.

Baker & McKenzie

30 Tax News and Developments April 2015

On March 6, 2015, the CRA replaced Interpretation Bulletin IT-533 with Income Tax Folio S3-F6-C1, "Interest Deductibility". The Folio, which generally is consistent with the administrative positions taken by the CRA in Interpretation Bulletin IT-533, provides updated references to significant jurisprudence and legislative developments. The Folio also provides expanded commentary, as compared to Interpretation Bulletin IT-533, on "participating interest", contingent liabilities (including contingent interest), the linking of borrowed money to its current use, the deductibility of interest on borrowed money used to acquire investments and loss consolidation arrangements within a corporate group.

Suggestions concerning the structure or content of the Folio may be submitted to the CRA on or before June 6, 2015.

Self-Assessment of GST/HST by Canadian Insurers: Department of Finance to Recommend Legislative Amendments in respect of the "Loading" Element of Reinsurance Contracts.

A financial institution may be required to self-assess goods and services tax / harmonized sales tax ("GST/HST") on certain income tax deductible payments that it makes in respect of its Canadian business to its foreign branches or affiliates. The self-assessment of GST/HST by a financial institution on these payments is meant to ensure that GST/HST is not avoided by importing goods or services from a foreign branch or affiliate that is not required to charge GST/HST. GST/HST incurred by a financial institution is significant because a financial institution generally is not entitled to recover the GST/HST that it pays.

A Canadian insurer that cedes insurance risks to a related foreign reinsurer (an arrangement that is very common), is required to self-assess GST/HST in respect of deductible reinsurance premiums that it pays to the related foreign reinsurer to the extent that the reinsurance premiums are attributable to "loading". "Loading" is meant to include the non-financial components of a reinsurance premium, such as a reinsurer's administrative expenses and employee compensation costs. However, the definition of "loading" in the GST/HST self-assessment rules is much broader. Indeed, the Canadian insurance industry and the Canadian tax community have expressed concern over the breadth of this definition with both the Canadian Department of Finance ("Finance Canada") and the CRA since the announcement of these GST/HST self-assessment rules in 2005.

In October, 2014, Finance Canada responded to these concerns with a statement clarifying its policy intent with respect to the scope of the concept of "loading". The statement provided a narrower interpretation of the concept of "loading" than implied by the definition of "loading" in the GST/HST self-assessment rules. In response to Finance Canada's clarifications, the CRA issued GST/HST Notice 287 in January, 2015 to provide its administrative positions of the concept of "loading". These administrative positions are consistent with the policy intent expressed by Finance Canada.

Notwithstanding Finance Canada's clarifications and the CRA's Notice, members of the Canadian insurance industry and the Canadian tax community sought assurances that clarifying amendments would be made to the GST/HST self-assessment rules. Finance Canada has now issued a letter (dated February 26, 2015) to the Insurance Bureau of Canada and the Canadian Life and Health Insurance Association indicating that it intends to recommend such clarifying amendments.

Baker & McKenzie

31 Tax News and Developments April 2015

In light of these developments, an insurer that has paid reinsurance premiums in respect of its Canadian business to a foreign branch or affiliate should consider whether GST/HST previously self-assessed may be recoverable. Consideration should also be given to whether its current arrangements should be altered to minimize the impact of the GST/HST self-assessment rules going forward.

New Canadian Tax Controversy Guide

Jacques Bernier and Mark Tonkovich of our Toronto office recently published the annual update to their chapter on resolving Canadian tax controversies in The Tax Disputes and Litigation Review, 3rd ed. (London, UK: Law Business Research Ltd., 2015). The chapter, available for download at http://www.bakermckenzie.com/bktorontotaxdisputeslitigationfeb15/, provides an overview of the intricacies of the Canadian tax dispute resolution system.

By Brian Segal, Toronto, Alex Pankratz, Toronto, Christopher Raybould, Toronto and Randall Schwartz, Toronto

Asia Pacific Tax Update: Bulletin 16: China Makes a Pre-Emptive Strike on BEPS! On March 18, 2015, the State Administration of Taxation of China introduced measures to deny income tax deductions for certain service fees and royalties paid by Chinese companies to their overseas affiliates. These highly controversial measures were published in Bulletin 16 and appear to stem from China’s initiatives to implement rules that it views as related to the OECD Base Erosion and Profit Shifting (“ BEPS ”) Project. Bulletin 16 targets service fee and royalty payments made to affiliated companies outside China that do not undertake functions and risks and/or lack economic substance. In the case of royalties, the focus is also on payments to companies that have legal ownership of the underlying intangible assets, such as intellectual property, but have not contributed sufficiently to the creation of value in the intangibles.

For additional details, see China Tax Alert Bulletin 16: China Makes a Pre-Emptive Strike on BEPS!, distributed April 1, 2015 and available under publications at www.bakermckenzie.com.

European Tax Update: Infringement Procedure Launched Against French 3% Tax on Dividends’ Distributions: An Opportunity to Obtain a Refund? Since 2012, a 3% tax applies on dividends paid by French entities, notably to shareholders established or domiciled outside of France.

Following the filing of a complaint, the EU Commission investigated this 3% tax on dividends’ distributions and recently sent a letter of formal notice to the French Government. France has now to answer this letter so as to convince the EU Commission that this tax is in compliance with EU regulations.

Though the infringement procedure is still at an early stage, taxpayers should consider filing claims with French tax authorities as soon as possible, so as to protect their interests and avoid dismissals based on statutes of limitations (for instance, any refund claim regarding the 3% tax paid in 2013 will have to be filed

Baker & McKenzie

32 Tax News and Developments April 2015

before December 2015). Indeed, the EU Commission did regard the arguments of the claimant as being grounded enough to launch this procedure against France.

This article first appeared as a Paris Tax Practice Group Alert, distributed on March 27, 2015, also available under publications at www.bakermckenzie.com.

Getting Better All the Time…Baker & McKenzie Expands Transfer Pricing Capabilities in Nation's Capital Baker & McKenzie recently welcomed Barbara J. Mantegani as Counsel to the Washington, DC office. An experienced transfer pricing lawyer, Barb is a twenty-year transfer pricing veteran, having previously worked in both private practice and at the IRS as a Competent Authority Analyst in the Office of US Competent Authority and as a Senior Manager in the IRS Advance Pricing and Mutual Agreement Office. She is highly respected and well-known within the transfer pricing community, with particular expertise in complex transfer pricing matters, including Advance Pricing Agreements ("APAs") and Mutual Agreement Procedures ("MAP") cases. Barb’s significant experience with double tax and APA cases involves a number of key US treaty partners including Japan, Denmark, Canada and India.

Working in various industries such as pharmaceuticals, automotive, consumer electronics, manufacturing, e-commerce and high-tech, Barb's practice will focus on international transfer pricing planning and dispute resolution, including APAs, Competent Authority requests and Appeals petitions. In her role as Counsel, her practice will also include advising multinationals in the development of global transfer pricing policy documents.

Barb joins Baker & McKenzie from a global accounting firm, where she led the Southeast Region Transfer Pricing Practice. She has published several journal articles and is a frequent speaker on international transfer pricing topics. Barb received her Masters of Law from Georgetown University Law Center, her Juris Doctor from the University of Maine School of Law and her Bachelor of Arts from Boston College.

Please join us in welcoming Barb to the North American Tax Practice!

Baker & McKenzie

33 Tax News and Developments April 2015

Upcoming Spring Conferences Focus on Tax Controversy and Transfer Pricing

Join Baker & McKenzie at TEI's IRS Audits & Appeals Seminar, May 19-21, 2015

You are invited to learn the nuts, bolts and nuances of tax controversy at the 2015 Tax Executives Institute ("TEI") IRS Audits & Appeals Seminar: Insights and Skills for Tax Controversy Success. This three day event takes place May 19-21, 2015 simultaneously in the Chicago and San Francisco Bay areas.

This year's program will offer insight into the tax controversy lifecycle, technical, strategic and practical controversy issues, including for state, local and foreign audits. For the seventh consecutive year, Baker & McKenzie is pleased to present the foreign audits track.

In Managing Foreign Audit Controversies, held the final day of the Chicago seminar, Baker & McKenzie attorneys will present on a broad range of foreign audit topics. Panel sessions will provide insight on managing audits and controlling privileged information amidst calls for increased transparency, VAT and indirect tax audits and strategies for handling foreign tax raids, plus a review of hot topics in Asia, Europe and the Americas. The sessions will feature the perspectives of panelists from countries including Australia, Brazil, Canada, China, France, Germany, India, Mexico and others.

To learn more about the 2015 TEI IRS Audits & Appeals Seminar, including a complete conference agenda and registration options, visit http://www.tei.org/events/Pages/2015-IRS-Audits--Appeals-Seminar.aspx.

Global Transfer Pricing Conference Returns to DC for Fifth Consecutive Year, June 11-12

Baker & McKenzie and Bloomberg BNA join forces once again to present the Fifth Annual Global Transfer Pricing Conference in Washington, DC on Thursday, June 11 and Friday, June 12, directly following the joint OECD and USCIB Conference. OECD and government officials, along with corporate and private transfer pricing practitioners, will gather to discuss the highly debatable topics that surround the BEPS Action Plan and the steps tax authorities are taking when considering companies' international transactions.

This year the conference begins Thursday evening with a Networking Reception at Baker & McKenzie's Washington, DC office followed by a Town Hall Panel on BEPS and dinner at the Army Navy Club. Town Hall panelists will include Marlies de Ruiter, Head of the Tax Treaty, Transfer Pricing and Financial Transactions Division, OECD, Paris and Andrew Hickman, Head of the Transfer Pricing Unit, OECD, Paris, along with Baker & McKenzie partners Mary Bennett (former head of Tax Treaty, Transfer Pricing & Financial Transactions Division of the OECD's Centre for Tax Policy & Administration) and Caroline Silberztein (former head of the OECD Transfer Pricing Unit). Sessions on Friday will focus on persistent transfer pricing issues including hard-to-value intangibles, recent APA and MAP developments in China and India, the moral hazard concept as it pertains to the OECD's recent draft on risk, Large Business & International Division developments and its impact on transfer pricing litigation and country-by-country reporting.

Baker & McKenzie North America Tax

Chicago +1 312 861 8000

Dallas +1 214 978 3000

Houston +1 713 427 5000

Miami +1 305 789 8900

New York +1 212 626 4100

Palo Alto +1 650 856 2400

San Francisco +1 415 576 3000

Toronto +1 416 863 1221

Washington, DC +1 202 452 7000

Baker & McKenzie

34 Tax News and Developments April 2015

Full conference details, including the agenda and registration information, is accessible by visiting Bloomberg BNA online at www.bna.com/washington-transfer-pricing. We hope to see you in Washington, DC, at what promises to be an interesting and informative conference!

New Webinar Event: In advance of the conference, we are hosting a complimentary webinar covering the Revised BEPS Discussion Draft on Preventing the Artificial Avoidance of Permanent Establishment Status (Action 7). The webinar will be held on Tuesday, May 21 at 12:00 – 1:30 pm EST. Presented by Gary Sprague (Palo Alto), Rafic Barrage (Washington, DC), Chris Brodersen (Frankfurt), Dominika Korytek (San Francisco), and Patrick O'Gara (London), this webinar provides advisors with the latest techniques and opportunities, new practical ideas, and useful explanation charts, sample clauses, and checklists. For more information and to register, visiting Bloomberg BNA online at www.bna.com/revised-beps-discussion-m17179925461.

Tax News and Developments is a periodic publication of Baker & McKenzie’s North American Tax Practice Group. The articles and comments contained herein do not constitute legal advice or formal opinion, and should not be regarded as a substitute for detailed advice in individual cases. Past performance is not an indication of future results. Tax News and Developments is edited by Senior Editors, James H. Barrett (Miami) and David G. Glickman (Dallas), and an editorial committee consisting of Glenn G. Fox (New York), Kirsten R. Malm (Palo Alto), Robert H. Moore (Miami), John Paek (Palo Alto ), Alex Pankratz (Toronto), Patricia Anne Rexford (Chicago), Caryn L. Smith (Houston), and Angela J. Walitt (Washington, DC). For further information regarding the North American Tax Practice Group or any of the items or Upcoming Events appearing in this Newsletter, please contact Carol Alexander at 312-861-8323 or carol.alexander@bakermckenzie.com.

Your Trusted Tax Counsel ® www.bakermckenzie.com/tax

©2015 Baker & McKenzie. All rights reserved. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm.

This may qualify as "Attorney Advertising" requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome.

www.bakermckenzie.com

Baker & McKenzie Global Services LLC 300 East Randolph Drive Chicago, Illinois 60601, USA Tel: +1 312 861 8000 Fax: +1 312 861 2899