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March 31, 2012Volume 16, Number 6

Articles

International Tax PlanningIs the Economic Substance Doctrine a Kind of Tax Porn? The IRS Adopts a “Don’t Ask, Won’t Tell” PolicyBy Joseph B. Darby III ........................................................... p. 3

U.S.--Acquisitions of U.S. S Corporations: Opportunities for the Foreign InvestorBy Stephen F. Jackson and Katherine Loda (Ernst & Young LLP) ............................................................. p. 4

New Foreign Financial Asset Reporting Requirement with Deadline of April 17, 2012By Ira B. Mirsky, Adrienne Walker Porter, Karen A. Simonsen, and Todd A. Solomon (McDermott Will & Emery) .................. p. 5

Analysis of FATCA Proposed RegulationsBy Douglas S. Stransky and Martha F. Coultrap (Sullivan & Worcester LLP) ...................................................................... p. 7

Brazil--Brazil Tax Cuts, Credits Throw Lifeline to IndustryBy Alonso Soto and Luciana Otoni (Reuters) ........................ p. 20

France--The French Financial Transaction Tax: A Sign of Things to Come?By Iain Scoon, Simon Letherman, James Leslie, Anne-Sophie Maes, and Niels Dejean (Shearman & Sterling LLP) ............. p. 22

UK--UK Lawmakers Reject “Flawed” EU Transaction TaxBy Huw Jones (Reuters) ........................................................ p. 23

A Twice-MonThly RepoRT on inTeRnATionAl TAx plAnning

Advisory Board page 6

All You Wanted to Know About the Economic Substance Doctrine, but Were Afraid to AskIs the IRS applying the Economic Substance Doctrine too broadly? This article notes the legislative intent, and provides examples of how the doctrine was meant to be used, and how the doctrine has morphed into something quite different. Page 3

Strategies when Foreign Investors Target an S CorporationS corporations provide some clear tax advantages, but the benefits are confined to U.S. owners. Some strategies, such as conversion to an LLC, are analyzed for foreign investors that want to acquire an S company. Page 4

FATCA Woes for Employers with Interests in Foreign Pension PlansThe Foreign Account Tax Compliance Act (FATCA) requires persons with interests in a foreign pension, deferred compensation plans, and equity awards of foreign stock, to report such interests for tax year 2011. Employers should consider notifying U.S. employees or other U.S. taxpayers that participate in the company’s foreign pension plans or deferred compensation plans, among others. Page 5

France's New Tax on Stock Trades, CDSs, and High Frequency TradingFrance's financial transaction tax exempts intra-group transactions and derivatives. The French FTT may serve as a model for EU member states that might impose their own version with the likely demise of the proposed EU financial transaction tax. Page 22

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International Tax Planning

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(Economic Substance, continued on page 10)

One of the most famous lines ever to appear in a United States Supreme Court opinion was penned by Justice Potter Stewart, who wrote, “I know it when I see it.”

The “it” that Potter Stewart felt certain he knew when he saw was hard-core pornography. Stewart’s full quote, from the case Jacobellis v. Ohio, 378 U.S. 184 (1964), is as follows:

“I shall not today attempt further to define the kinds of materials that I understand to be embraced within that shorthand description [i.e., the term “hard-core pornography”]; and perhaps I could never succeed in intelligibly doing so. But I know it when I see it, and the motion picture involved in this case is not that.”

Now comes the Internal Revenue Service, here to explain the meaning and import of the so-called “Economic Substance Doctrine.” This is a long-standing common-law (judge-made) doctrine that was formally enacted and codified in 2010 by the U.S. Congress, and that presently resides in the Internal Revenue Code, with an address located at Section 7701(o)1 Bear in mind that the codification of the Economic Substance Doctrine has caused massive consternation among tax practitioners and taxpayers alike: It is the greatest source of caterwauling and gloomy predictions since the U.S. invaded Iraq or the Kardashians first appeared on TV.

The problem is that the Economic Substance Doctrine shares one dominant trait with hard-core pornography: Both are exceedingly difficult to define. Indeed, in Notice

2010-62, issued shortly after the codification was enacted, the IRS ostentatiously announced that it had absolutely nothing to announce—that it was going to take a page from Potter Stewart and not make any effort whatsoever to try and define one of the most important—not to mention prurient—subjects in tax law today.

In Notice 2010-62, the IRS conspicuously declined to identify transactions that it considered safe from challenge under the Economic Substance Doctrine. It also declined to identify transactions that it felt came

Joseph B. Darby III ([email protected]) is a Shareholder at the Boston office of Greenberg Traurig LLP, concentrating his practice in the areas of tax law, corporate transactions and intellectual property. He is a lecturer at law in the Graduate Tax Program at Boston University Law School and an adjunct professor at Bentley University in the Masters in Taxation Program, teaching courses at both schools that include Taxation of Intellectual Property and Tax Aspects of Buying and Selling a Business. He is a member of the Tax Strategies’ Advisory Board, and winner of the “Tax Writer of the Year—2007” Award.

Is the Economic Substance Doctrine a Kind of Tax Porn? The IRS Adopts a “Don’t Ask, Won’t Tell” PolicyBy Joseph B. Darby III

The problem is that the economic substance Doctrine shares one

dominant trait with hard-core pornography: Both are exceedingly

difficult to define.

within the Economic Substance Doctrine. Then, to top it all off, the IRS also announced that it would not issue private letter rulings with respect to the “relevance” or application of the doctrine.

What the IRS was announcing—between the lines, but very clearly—was that the IRS itself is having a difficult time defining what the Economic Substance Doctrine really means, but, rest assured: When it comes to economic substance, the IRS knows it when it sees it.

The purpose of this article is to take a close look at the Economic Substance Doctrine (hereafter the ESD), peek behind the curtains and under the covers to get a glimpse at the IRS’s thinking on this new statutory provision, and ultimately provide a full-frontal view of this new and revealing body of law as it may apply to a host of currently common international tax and business transaction structures.

Section 7701 (oh!) After a long and quixotic history as a well-intentioned

but unevenly applied common law doctrine, the ESD was formally embraced by Congress in March 20102 and is now embodied in new Section 7701(o). (Section


(Acquiring S Corp, continued on page 18)

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I. IntroductionThe S corporation can be a beneficial method of

structuring a business in the United States. Although originally developed to facilitate operations for small businesses, S corporations are used even by large businesses today. In 2005, the Commissioner of the Internal Revenue Service stated, “The use of S corporations has exploded.” As of 2002, 59 percent of all U.S. corporate returns were filed by S corporations.1

The business and tax advantages of S corporations explain their frequent use. An S corporation, unlike a C corporation, passes through profit or net losses to its shareholders. The pass-through nature of the income

an existing S corporation from its U.S. owners. In this case, planning should be done. However, these planning opportunities need to be considered at the time of, or even before, the acquisition.

II. Planning OpportunitiesA. IRC Section 338(h)(10) Election

The first planning opportunity that foreign investors should consider when acquiring an S corporation is an election under Section 338(h)(10) of the Internal Revenue Code.2 This election treats a U.S. stock acquisition as an asset acquisition for U.S. Federal Income tax purposes. The election is available when the acquirer purchases, within a 12-month period, 80 percent or more of the stock of an unrelated target (Target). Mechanically, a Section 338(h)(10) election creates a sale transaction where the Target is deemed to have sold its assets to a new corporation (NewCo) at the close of the acquisition date, with the sales proceeds deemed to have been distributed in liquidation of Target to its shareholder(s). As a result, the election generally allows the acquiring corporation to step up the basis in the acquired company’s assets to fair market value, resulting in greater tax depreciation deductions. Any residual purchase price is allocated to goodwill, which may generally be amortized over 15 years for tax purposes.3

The primary advantage of the election to the foreign purchaser is that the purchase price is allocated among the assets (including goodwill) of Target. Without an election, the basis of the acquired assets would not be affected by the sale and would continue to be depreciated utilizing their existing depreciation methods and lives. The portion of the sale price representing goodwill could not be amortized or otherwise recovered prior to the ultimate disposition of the Target stock. By making the election, the entire purchase price can be allocated among the Target assets and recovered through depreciation and amortization over the appropriate periods.

Target generally recognizes gain or loss on the transaction as if it sold assets rather than stock. The gain on the sale of the assets passes through to the Target shareholders, thereby increasing their basis in the Target stock before the liquidation of their shares. As a result, if the gain on the deemed asset sale increases the basis of the Target stock to an amount that equals or exceeds the amount paid for that stock, then the Target Corporation shareholders will only recognize gain in connection with the “deemed asset sale” and not recognize gain in

Acquisitions of U.S. S Corporations: Opportunities for the Foreign InvestorBy Stephen F. Jackson and Katherine Loda (Ernst & Young LLP)

Stephen F. Jackson is a Partner, and Katherine Loda is a Senior Manager, with Ernst & Young’s International Tax Services Practice. The authors are based in the New York city office of Ernst & Young. The views expressed in this article are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member of Ernst & Young Global Limited.

When a foreign investor is considering the acquisition of a

portion of an existing s corporation, converting the s corporation to a

U.S. LLC may be beneficial.

means that the corporation’s profits are only taxed at the shareholder level, thus, avoiding the double taxation of C corporation income. However, an S corporation is similar to a C corporation in that it provides limited liability to its shareholders.

Unfortunately, the tax and legal benefits of S corporations are unavailable to foreign investors in the U.S. S corporations have specific formation requirements the purpose of which was to maintain simplicity. Only U.S. individuals, estates, certain trusts and tax-exempt entities can be shareholders in an S corporation. Foreign persons, corporations and partnerships are not permitted S corporation shareholders. If an S corporation is acquired by a non-U.S. person, S corporation status is lost.

Due to the prevalence of S corporations, foreign investors often are faced with the opportunity to buy


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(FATCA Reporting, continued on page 6)

The Foreign Account Tax Compliance Act (FATCA) requires certain U.S. taxpayers holding foreign financial assets, including an interest under a foreign pension or deferred compensation plan and foreign equity awards, to report those interests beginning with this tax filing season (the 2011 Form 1040). FATCA, enacted in 2010 as part of the Hiring Incentives to Restore Employment Act, is aimed at U.S. persons holding investments in offshore accounts and imposes steep penalties for failure to comply. Although it is the employee’s responsibility to meet any reporting requirements, employers with a multinational and mobile workforce should understand the possible filing obligations and may wish to consider alerting individuals of this new filing requirement. Note that FATCA reporting requirements are separate from FBAR reporting of foreign financial accounts.

Individuals with a Reporting Obligation under FATCA

U.S. taxpayers holding certain foreign financial assets with an aggregate value exceeding $50,000 are generally required to report certain information about those assets on new Form 8938 (Statement of Specified Foreign Financial Assets) that must be attached to the taxpayer’s annual Form 1040 tax return. Reporting applies for assets held in taxable years beginning after March 18, 2010 (generally starting with the 2011 tax return). Higher asset thresholds apply to U.S. taxpayers who file a joint tax return or who reside abroad. U.S.

citizens, resident aliens and nonresident aliens holding an interest in certain foreign assets may be required to file Form 8938. An individual who is not required to file a U.S. income tax return for a year is not required to file a Form 8938 for that year.

Employee Benefits Required to be Reported as Foreign Financial Assets on Form 8938

Guidance and instructions issued by the Internal Revenue Service (IRS) list several types of “specified foreign financial assets” that should be reported on Form 8938, including interests in a foreign pension or deferred compensation plan generally exceeding an aggregate value of $50,000. Limited relief from the reporting requirement may apply, including where an account has been reported on a Form 8891 (U.S.

New Foreign Financial Asset Reporting Requirement with Deadline of April 17, 2012By Ira B. Mirsky, Adrienne Walker Porter, Karen A. Simonsen, and Todd A. Solomon (McDermott Will & Emery)

Ira B. Mirsky ([email protected]), Karen A. Simonsen ([email protected]), and Todd A. Solomon ([email protected]) are Partners, and Adrienne Walker Porter ([email protected]) is an Associate, with McDermott Will & Emery. Mr. Mirsky’s practice is concentrated in tax controversy matters related to employee compensation, fringe and welfare benefits, and deferred compensation arrangements. Ms. Porter’s practice is focused on employee benefits, 401(k) plans, and executive compensation. Ms. Simonsen specializes in design and compliance issues related to qualified retirement plans, non-qualified deferred and equity compensation programs, and fiduciary issues. Mr. Solomon’s practice is focused on designing, amending, and administering pension plans, profit sharing plans, and 401(k) plans. Mr. Mirsky is resident in the Washington D.C. office of McDermott Will & Emery. Ms. Porter, Ms. Simonsen, and Mr. Solomon are in the Chicago office.

Taxpayers who fail to meet their obligation to file Form 8938 are subject

to significant penalties.

Information Return for Beneficiaries of Certain Canadian Registered Retirement Plans) and for an interest in foreign governmental retirement schemes, such as social insurance. Additionally, no reporting under FATCA is required for a financial account that is maintained by a U.S. payer, including a retirement account at a U.S. branch of a foreign financial institution or a foreign branch of a U.S. financial institution. However, in most cases, a U.S. taxpayer’s interest in a foreign pension plan must be reported on Form 8938, even if the individual is no longer actively accruing benefits under the plan. Pension industry groups are lobbying for additional relief from this requirement, but with filings due shortly, employers need to address this issue now.

For example, consider an executive of a multinational company who performed services in the United Kingdom and participated in the company’s UK pension plan for several years. In 2010 the individual transfers to the United States and became a U.S. taxpayer. This individual will most likely need to report the UK pension plan interest on Form 8938, even if the individual has no way to value the pension plan interest to determine whether it exceeds the applicable filing thresholds. Also included in the list of specified foreign financial assets are compensatory stock options and equity awards. This


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FATCA Reporting (from page 5)

Richard E. AndersenWilmer Cutler Pickering Hale and Dorr LLP (New York)

Joan C. ArnoldPepper Hamilton LLP (Boston)

Sunghak BaikErnst & Young (Singapore)

William C. BenjaminWilmer Cutler Pickering Hale and Dorr LLP

(Boston)

Steven D. BortnickPepper Hamilton (New York)

Joseph B. Darby IIIGreenberg Traurig LLP (Boston)

Rémi DhonneurKramer Levin Naftalis & Frankel LLP

(Paris)

Hans-Martin EcksteinPricewaterhouseCoopers

(Frankfurt am Main)

Jaime González-BéndiksenBéndiksenLaw

(Mexico)

Alan Winston GranwellDLA Piper (Washington)

Jamal Hejazi, Ph.D.Gowlings, Ottawa

Lawrence M. HillDewey & LeBoeuf LLP (New York)

Advisory BoardMarc Lewis

Sony USA (New York)

Keith MartinChadbourne & Parke LLP

(Washington)

William F. RothBDO USA, LLP

Kevin RoweReed Smith (New York)

John A. SalernoPricewaterhouseCoopers LLP

(New York)

Michael J. SemesBlank Rome LLP (Philadelphia)

Douglas S. StranskySullivan & Worcester LLP (Boston)

Michael F. SwanickPricewaterhouseCoopers LLP

(Philadelphia)

Edward TanenbaumAlston & Bird LLP (New York)

Guillermo O. TeijeiroNegri & Teijeiro Abogados

(Buenos Aires)

David R. TillinghastBaker & McKenzie LLP (New York)

Eric TomsettDeloitte & Touche LLP (London)

means U.S. taxpayers who have equity awards of foreign stock must report these interests on Form 8938.

Determining whether a particular type of interest must be reported requires a case-by-case analysis. Issues to consider include whether to report non-vested interests in an employee benefit program, the determination of whether the investments, assets or stock are held in a U.S. or foreign account and whether the amounts meet reporting thresholds. In determining the value of a foreign pension or deferred compensation plan for purposes of compiling Form 8938, the IRS instructs that the value of such interest is the fair market value in the plan on the last day of the year. If the fair market value is not readily accessible to the individual, the value can be reported as the value of cash and/or other property distributed during the year. The same value is to be used in determining whether a reporting threshold has been triggered. If an individual does not have access to the fair market value and did not receive a distribution from the plan during the year, the value of the interest in the plan is zero for reporting purposes. If an individual meets the reporting requirements, a Form 8938 must be filed, even if the value of the foreign financial asset cannot be determined.

Penalties for Non-ComplianceTaxpayers who fail to meet their obligation to file

Form 8938 are subject to significant penalties, including $10,000 for failure to file, with a maximum penalty of up to $50,000 for continued failure to file and a 40 percent penalty on the understatement of any tax attributed to non-disclosed assets.

Next StepsEmployers should examine whether any U.S.

employees of the company or other U.S. taxpayers participate in any of the company’s foreign pension plans or deferred compensation plans, or have received foreign equity awards. Because it may be difficult for the company to determine which employees have a filing obligation under FATCA, it may be advisable to provide a general notice to all participants in the company’s foreign plans to alert them of the possible filing requirements and applicable penalties, and to encourage them to contact their personal tax adviser to determine whether they have a filing obligation.

© 2012 McDermott Will & Emery q


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(FATCA Analysis, continued on page 8)

On February 8, 2012, the Treasury Department and the Internal Revenue Service issued proposed regulations for the next major phase of implementing the Foreign Account Tax Compliance Act (FATCA). The regulations lay out a step-by-step process for U.S. account identification, information reporting, and withholding requirements for foreign financial institutions (FFIs), certain non-financial foreign entities (NFFEs) and U.S. withholding agents.

FATCA was enacted in 2010 by Congress as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA generally requires FFIs to report to the IRS information about financial accounts held by U.S. taxpayers or by NFFEs in which U.S. taxpayers hold a substantial ownership interest.

FATCA imposes a 30 percent withholding tax on certain U.S. source payments to FFIs and NFFEs that fail to comply with their information reporting obligations. To avoid having tax withheld on such payments under FATCA, an FFI will have to become a participating FFI by entering into an agreement with the IRS prior to June 30, 2013 that the FFI will:

• Identify U.S. accounts or interest holders;• Report certain information to the IRS regarding such

U.S. accounts or interest holders;• Verify its compliance with its obligations under the

agreement; and • Ensure that a 30 percent tax on certain payments of

U.S. source income is withheld when paid to non-participating FFIs and account holders who are unwilling to provide the required information. Since FATCA’s enactment and prior to the issuance of

the proposed regulations, the IRS has issued preliminary guidance on the implementation of FATCA. See Notice 2010-60, 2010-37 I.R.B. 329, Notice 2011-34, 2011-19 I.R.B. 765, and Notice 2011-53, 2011-32 I.R.B. 124 (FATCA Notices).

This article highlights the significant modifications and additions to the guidance in the FATCA Notices that

is provided by the proposed regulations. The proposed regulations are expected to become final during the summer of 2012.

FATCA Overview and FATCA Notices FATCA requires any withholding agent to withhold

30 percent on the following payments to an FFI:• any payment of U.S. source interest, dividends, rents,

salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income (FDAP income); and

• any gross proceeds from the sale or other disposition of any property of a type that can produce interest or dividends from sources within the United States.

FFI RequirementsAn FFI can avoid the withholding tax, if the FFI either

(a) enters into an agreement (FFI Agreement) with the IRS

An offshore private equity fund having U.S. investors will be an FFI.

to perform certain obligations or (b) meets requirements prescribed by the IRS to be deemed to comply with the requirements of FATCA. An FFI is defined as a financial institution that (i) accepts deposits in the ordinary course of a banking or similar business; (ii) as a substantial portion of its business, holds financial assets for the account of others; or (iii) is engaged primarily in the business of investing, reinvesting, or trading in securities, partnership interests, commodities, or any interest in such securities, partnership interests, or commodities. Thus, in addition to banks and traditional financial institutions, an offshore private equity fund having U.S. investors will be an FFI.

FATCA requires an FFI that enters into an FFI Agreement (participating FFI) to identify any depository account, any custodial account, and any equity or debt interest in it held by U.S. persons (U.S. account) or U.S.-owned foreign entities and comply with certain verification and due diligence procedures.

A participating FFI is required to report certain information on an annual basis to the IRS with respect to each U.S. account and to comply with requests for additional information with respect to any U.S. account.

Douglas S. Stransky ([email protected]) is an International Tax Partner in Sullivan & Worcester LLP’s Boston office and a lecturer at law with the Boston University Law School Graduate Tax Program. He is a member of the Advisory Board of Practical Tax Strategies. Martha F. Coultrap ([email protected]) is a Corporate Partner in Sullivan & Worcester New York Office and head of the Private Investment Funds and Institutional Investors Practice Group.

Analysis of FATCA Proposed RegulationsBy Douglas S. Stransky and Martha F. Coultrap (Sullivan & Worcester LLP)


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(FATCA Analysis, continued on page 9)

FATCA Analysis (from page 7)

The information that must be reported includes: (i) the name, address, and taxpayer identifying number (TIN) of each account holder who is a U.S. person (or, in the case of an account holder that is a U.S.-owned foreign entity, the name, address, and TIN of each U.S. person that is a substantial U.S. owner of such entity); (ii) the account number; (iii) the account balance or value as of the last day of the reporting period; and (iv) the gross receipts and gross withdrawals or payments from the account for the reporting period.

If foreign law would prevent the FFI from reporting the required information, absent a waiver from the account holder or failure of the account holder to provide a waiver within a reasonable period of time, the FFI is required to “close” the account. The implications for an FFI that is a private equity fund are not clear, and whether such an

withholding agent does not know or have reason to know that any information provided by the beneficial owner or payee is incorrect; and (iii) the withholding agent reports the information which has been provided by the beneficial owner or payee to the IRS.

Withholding Agents Liable for TaxFATCA provides that every person required to

withhold and deduct any tax under FATCA is made liable for such tax and is indemnified against the claims and demands of any person for the amount of any payments made in accordance with FATCA. In general, the beneficial owner of a payment is entitled to a refund for any overpayment of tax actually due under other provisions of the Code. However, with respect to any tax properly deducted and withheld under FATCA from a payment beneficially owned by an FFI, FATCA provides that the FFI is not entitled to a credit or refund, except to the extent required by a treaty obligation of the United States. In addition, no credit or refund shall be allowed or paid with respect to any tax properly deducted and withheld unless the beneficial owner of the payment provides the IRS with information to determine whether such beneficial owner is a U.S.-owned foreign entity and the identity of any substantial U.S. owners of such entity.

The Proposed Regulations The proposed regulations seek to implement the

FATCA reporting and withholding regime efficiently and effectively by establishing adequate lead times to allow system development and by minimizing the overall compliance burdens. The proposed regulations also provide guidance on topics that were not addressed in the FATCA Notices.

Modifications and Additions to FATCA Notices Significant modifications and additions to the

guidance in the FATCA Notices include the following:

Refinement of the Definition of Financial Account FATCA defines a financial account to mean, any

depository account, any custodial account, and any equity or debt interest in an FFI, other than interests that are regularly traded on an established securities market. The proposed regulations refine the definition of financial accounts to focus on traditional bank, brokerage, money market accounts, and interests in investment vehicles, and to exclude most debt and equity securities issued by banks and brokerage firms, subject to an anti-abuse rule.

Expanded Scope of “Grandfathered Obligations”FATCA provides that no amount shall be required

to be deducted or withheld from any payment under any obligation outstanding on March 18, 2012, or from

If an FFI complies with the obligations in its FFI Agreement, it will not be held strictly liable for inadvertent failure to

identify a U.S. account.

FFI can fulfill its obligations under the FFI Agreement to close an account by withholding all distributions to the non-compliant account holder, has yet to be determined.

FATCA requires a participating FFI to withhold 30 percent of any passthru payment to a “recalcitrant” account holder who will not provide the required information or to an FFI that does not meet certain requirements (nonparticipating FFI). A recalcitrant account holder is any account holder that fails to provide the information required to determine whether the account is a U.S. account, or the information required to be reported by the FFI, or that fails to provide a waiver of a foreign law that would prevent reporting. A participating FFI may elect to withhold on passthru payments, and instead be subject to withholding on payments it receives, to the extent those payments are allocable to recalcitrant account holders or nonparticipating equity or debt holders FFIs.

NFFE RequirementsFATCA requires a withholding agent to withhold

30 percent of any withholdable payment to any NFFE, a foreign entity that is not a financial institution, if the payment is beneficially owned by the NFFE or another NFFE.

An NFFE can meet FATCA’s requirements if: (i) The beneficial owner or payee provides the withholding agent with either a certification that such beneficial owner does not have any substantial U.S. owners, or the name, address, and TIN of each substantial U.S. owner; (ii) the


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FATCA Analysis (from page 8)

the gross proceeds from any disposition of such an obligation. The proposed regulations extend that deadline to any payment made under an obligation outstanding on January 1, 2013, and any gross proceeds from the disposition of such an obligation.

Transitional Rules for Affiliates with Legal Prohibitions on Compliance

FATCA provides that the requirements of the FFI Agreement shall apply to the U.S. accounts of the participating FFI and to the U.S. accounts of each other FFI that is a member of the same expanded affiliated group. Recognizing that some jurisdictions have laws that prohibit an FFI’s compliance with certain of FATCA’s requirements, the proposed regulations provide until January 1, 2016 for the full implementation of FATCA.

Additional Categories of Deemed-Compliant FFIsFATCA provides that an FFI may be deemed to comply

with the law’s requirements under certain circumstances. Notice 2011-34 provides initial guidance regarding certain categories of FFIs that will be deemed to comply with the FATCA requirements. The proposed regulations provide additional categories of deemed-compliant institutions to include: certain local banks, collective investment funds (under very limited circumstances) and affiliates of participating FFIs that register with the IRS and satisfy various requirements.

Modification of Due Diligence Procedures for the Identification of Accounts

FATCA requires participating FFIs to identify their U.S. accounts. Notices 2010-60 and 2011-34 provide guidance regarding the due diligence procedures that participating FFIs will be required to undertake to identify their U.S. accounts. To reduce the administrative burden on FFIs, the proposed regulations provide that FFIs may rely primarily on electronic reviews of pre-existing accounts. For preexisting individual accounts, manual review of paper records is limited to accounts with a balance or value that generally exceeds $1,000,000. Additionally, preexisting, individual accounts with a balance or value of $50,000 or less, and certain cash value insurance contracts with a value of $250,000 or less, are excluded from the due diligence requirement.

With respect to pre-existing entity accounts, the proposed regulations exclude accounts of $250,000 or less and extend reliance on information gathered in the context of the due diligence required to comply with anti-money laundering/“know your customer” (AML/KYC) rules, and simplified procedures to identify the status of preexisting entity accounts. With respect to new accounts,

the proposed due diligence rules permit reliance by an FFI on its existing customer intake procedures.

Guidance on Procedures Required to Verify Compliance

FATCA requires a participating FFI to comply with certain verification procedures to identify U.S. accounts. The proposed regulations modify and supplement the prior guidance by providing that responsible FFI officers will be expected to certify that the FFI has complied with the terms of the FFI Agreement. Verification of such compliance through third-party audits is not mandated. If an FFI complies with the obligations set forth in its FFI Agreement, it will not be held strictly liable for inadvertent failure to identify a U.S. account.

Extension of the Transition Period for the Scope of Information Reporting

Notice 2011-53 provides for phased implementation of the reporting required under FATCA. Pursuant to Notice 2011-53, only identifying information (name, address, TIN, and account number) and account balance or value of U.S. accounts would be required to be reported in 2014 (with respect to the 2013 year). The proposed regulations provide that reporting on income will be phased in beginning in 2016 (with respect to the 2015 year), and reporting on gross proceeds will begin in 2017 (with respect to the 2016 year).

Passthru PaymentsFATCA requires participating FFIs to withhold on

passthru payments made to nonparticipating FFIs and recalcitrant account holders. Notice 2011-53 states that participating FFIs will not be obligated to withhold on passthru payments that are not withholdable payments (foreign passthru payments) made before January 1, 2015. The proposed regulations provide that withholding will not be required with respect to foreign passthru payments before January 1, 2017; instead, the proposed regulations require participating FFIs to report annually to the IRS the aggregate amount of certain payments made to each nonparticipating FFI.

In the case of jurisdictions that enter into agreements to facilitate FATCA implementation, the IRS will work with the governments of such jurisdictions to develop practical alternative approaches to achieving the policy objectives of passthru payment withholding. In addition, where such an agreement provides for the foreign government to report to the IRS information regarding U.S. accounts and recalcitrant account holders, FFIs in such jurisdictions may not be required to withhold on any foreign passthru payments to recalcitrant account holders.

© 2012 Sullivan & Worcester LLP q


Economic Substance (from page 3)

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7701(o) created such an immediate sensation among tax practitioners that it was promptly dubbed “Section 7701 (oh!).”) As described by Congress (with more or less a straight face), the new provision was not supposed to represent a substantive change in the law, but rather was intended merely as a codification of the existing common law doctrine, together with a “clarification” that, on the surface, is merely supposed to resolve and reconcile conflicting interpretations of certain technical aspects of the doctrine.3 However, the fact that Congress went to the conspicuous trouble of codifying the ESD, coupled with some attention-grabbing penalty provisions (a 40

be treated as having economic substance only if— (A) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (B) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into such transaction.6

If the language of Section 7701(o) is generally vague, there is one prominent exception: the penalties. The ESD is accompanied by a clearly written and truly scary new penalty provision, set forth in Section 6662(b)(6), which applies “strict liability” (meaning that there is no good faith exception) to any transaction that lacks economic substance under Section 7701(o) or under “any similar rule of law.” The penalty is 40 percent if the transaction is undisclosed, and is 20 percent even if the transaction is adequately disclosed, with further disclosure requirements for a reportable transaction.

An obvious and immediate short-coming of the ESD statute is that it does not make any effort to identify the transactions to which it will be applied. Rather, it merely provides that, if the ESD is “relevant,” then the conjunctive test applies. The erstwhile legislative history (technically the Joint Committee Report7 or “Bluebook”) to Section 7701(o) gives at least some guidance on the intended scope, but most of this is in the form of platitudes, together with a few examples, most of which fall into the “no brainer” category.

The Bluebook explanation of the provision starts with the broad homily that “the provision does not change present law standards in determining when to utilize an economic substance analysis,”8 followed by the bromide in the related footnote that “[i]f the realization of the tax benefits of a transaction is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate, it is not intended that such tax benefits be disallowed.”9 (This astonishingly casual and off-hand comment will be taken at face value by this article—indeed, will be given more concrete importance than it may in fact deserve—and will hereinafter be referred to as the “Congressional Plan” exception.)

The Bluebook then tosses out a second platitude, which is that the ESD is “not intended to alter the tax treatment of certain basic business transactions that, under longstanding judicial and administrative practice are respected, merely because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages.”10 (This similarly flip and after-hours standard will be referred to hereinafter as the “Basic Business Transaction” exception.) The Bluebook then provides four “safe” examples of an exempt Basic

The penalty is 40 percent if the transaction is undisclosed, and

20 percent even if the transaction is adequately disclosed.

percent penalty if a transaction is found to lack economic substance, which is reduced to a 20 percent penalty even if all relevant facts are disclosed), meant that the ESD was suddenly being paraded around in the tax-equivalent of a head-snapping string bikini.

The ESD came naked into this world as just one of many synonymous-sounding anti-abuse doctrines4 developed by the courts over the years to deny tax benefits in situations that courts found to be abusive, tax-motivated transactions. The ESD was most famously articulated in a U.S. Supreme Court case, Frank Lyon v. Commissioner,5 and after Lyon the lower courts developed the ESD further, but disagreed over its specific technical applications. Most courts agreed that there was a two-prong test, comprised of 1) whether the transaction had economic substance (the “objective” test) and 2) whether there was a non-tax business purpose (the “subjective” test). However, the courts split into three camps over how to apply the test, with some courts requiring that both prongs be met (a conjunctive test), some courts requiring that either prong be met (a disjunctive test), and some courts taking both tests into account in reaching an ultimate determination (a combined test).

The Congress, in codifying the ESD, opted to apply the conjunctive test, with a huge dollop of enforcement penalties ladled on top. New Section 7701(o) reads in relevant part as follows:

(o) Clarification of economic substance doctrine(1) Application of doctrineIn the case of any transaction to which the economic substance doctrine is relevant, such transaction shall


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Business Transaction (herein referred to collectively as the “Angel Transactions”), comprised of the following11:

1. the choice between capitalizing a business enterprise with debt or equity (“First Angel Transaction”);

2. a U.S. person’s choice between using a foreign corporation or domestic corporation to make a foreign investment (“Second Angel Transaction”);

3. the choice to enter into a transaction or series of transactions that constitute a corporate organization or reorganization under Subchapter C (“Third Angel Transaction”); and

4. the choice to utilize a related-party entity in a transaction, provided that the parties act consistently with the arms-length standards contained in Section 482 (“Forth Angel Transaction”).

Don’t Ask, Won’t TellThe IRS soon followed up the codification of the ESD

with what can properly be characterized as a comedy of non-guidance. First, the IRS issued Notice 2010-62, announcing its intention neither to provide a black list nor an angel list of transactions, while notifying taxpayers that the subject was also outside the scope of private letter ruling requests. In other words, a “Don’t Ask, Won’t Tell” policy. However, the ESD inspired far too much interest, fascination and fear to slip quietly into the night, and so, when the IRS subsequently issued two relatively boring and technical documents known as “field directives,” on September 14, 201012 (2010 Directive) and July 15, 201113 (2011 Directive), these two documents were eagerly seized upon for guidance with the enthusiasm of paparazzi studying a sensational new Paris Hilton naked video tape. (You’re kidding! The IRS did WHAT?!!)

The IRS apparently forgot that it is the most closely watched and enthusiastically scrutinized branch of the entire federal government—the Lindsay Lohan of bureaucracies. In any event, the IRS was so disconcerted by the tabloid, National Enquirer-like response to the 2011 Directive that, on October 6, 2011, an IRS official speaking on the record at a tax luncheon made it clear that the 2011 Directive was “just that” (i.e., a field directive and nothing more), and thus did not create any new substantive law or otherwise provide any precedent that could be relied on by taxpayers.14 In other words, the IRS basically announced, “We didn’t tell you what we just told you, so please ignore everything you just read.” And just how logical and successful a response was that to the IRS’s own self-inflicted controversy?

Don’t ask.

What’s It All About, Alfie?So, after all that, what kind of international tax

transactions are most likely to fall under the Economic

Substance Doctrine? Traditionally—meaning based on the types of litigated tax-controversy cases that created the ESD doctrine in the first place—the “classic” targets should be technically complex, often multi-tiered financial transactions, usually undertaken by very large companies and for relatively blatant tax-avoidance motivations. If we take Congress at its word, the ESD ought not impact the common, traditional forms of tax structuring, including international tax structuring.

However, a nagging concern among tax advisors is that international tax structuring, even more so than domestic tax planning, is often driven entirely by tax-planning considerations. For example, the use of Dutch CVs, or Bermuda holding companies, or “double Irish” structures, or Cyprus holding companies, or any number of other common international business arrangements, are implemented precisely (and, in many cases, entirely) because they produce favorable international tax consequences.

On the other hand, these international transactional structures are implemented precisely because they comport with the letter of the tax law, and arguably with its spirit as well. The Bluebook states that the ESD is not intended to disrupt the tax benefits of a transaction that “is consistent with the Congressional purpose or plan that the tax benefits were designed by Congress to effectuate,” i.e., the “Congressional Plan” exception. Likewise, the Bluebook states that the ESD is not intended to apply to “basic business transactions that, under longstanding judicial and administrative practice are respected…” i.e., the “Basic Business Transactions” exception. With these basic principles in mind, and having read and NOT ignored the 2010 and 2011 Directives, let’s look at a few relatively common international transactions and consider how the ECD might be—and, dare we suggest, ought to be—applied under Section 7701(o). Hypothetical #1: Sale of Non-U.S. Software Rights to a Foreign SubsidiaryA. Structure of the Transaction(s)

1. USCo has developed a new and valuable software program (Software) that it wishes to exploit both within and outside the U.S. To conduct its non-U.S. activities, USCo creates a wholly-owned subsidiary under the laws of Ireland, managed and controlled in Bermuda (IPSub).

2. USCo sells the non-U.S. rights in the Software (the Non-U.S. Rights) to IPSub for an arms-length purchase price that meets the requirements of Section 482 and the applicable regulations. USCo and IPSub then enter into a cost-sharing agreement, pursuant to which the two parties will continue to develop and upgrade the


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Software, and will share the costs in a manner that complies with the applicable regulations under Reg. Section 1482-7.

3. IPSub, in turn, creates a wholly owned subsidiary, which is an “eligible entity” formed under the laws of Ireland, and managed, controlled and operating in Ireland (Licensing Sub).

4. IPSub licenses the Non-U.S. Rights to Licensing Sub, which in turn uses the Software to conduct a bona fide licensing business in Ireland that is intended to meet the requirements of Section 954(c)(2)(A).15

5. Licensing Sub, in turn, creates a substantial number of wholly owned subsidiaries, each an “eligible entity” formed under the laws of, and operating solely in, each jurisdiction where such Licensing Sub intents to exploit the Software (collectively, the Country Subs).

6. IP Sub elects16 to “check-the-box” with respect to Licensing Sub and thereby causes Licensing Sub to be treated as a “disregarded entity” for U.S. federal income tax purposes. Licensing Sub, in turn, elects to “check-

turn, forming a foreign subsidiary to receive investment funds, acquire the software, enter into the cost-sharing agreement, and then conduct foreign business activities is inherently condoned and approved in the Second Angel Transaction.

2. Sale of the Non-U.S. Rights to the IP Sub is inherently approved by the Fourth Angel Transaction, and further supported by the Second Angel Transaction. Furthermore, one can divine a Congressional Plan approving this element of the transaction from Sections 367 and 482 and the regulations thereunder, which expressly indicate that Section 367(d) does not apply in the case of an actual sale or license of intangible property by a U.S. person to a foreign corporation.18 In turn, the cost-sharing agreement between the USCo and its IP Sub should be viewed as a Basic Business Transaction exempted by a history of acceptance and use over may years by the IRS, and also exempted by the Congressional Plan exception in light of the extensive regulations issued by the IRS over the years governing cost-sharing arrangements.19

3. Formation of a second-tier foreign subsidiary by a first-tier foreign subsidiary should be accepted under the Basic Business Transaction rule, and also under the Second Angel Transaction. The Subpart F rules, for example, provide a specific exception under the definition of foreign base company sales income for purchases and sales of tangible property to related controlled foreign corporations formed under the laws of the country in which the tangible property is sold for use, consumption, or disposition,20 and this statutory structure inherently assumes that bona fide foreign subsidiary business arrangements are respected, both under Subpart F in particular and under the Code in general.

4. A licensing arrangement at arms-length between IP Sub and Licensing Sub should come within the Fourth Angel Transaction and also, more generally, within the Basic Business Transaction exception.21 Such arrangements have been around forever and there is no inherent tax abuse so long as the pricing meets the requirements of Section 482.22

5. The sub-licensing of the Non-U.S. Rights to Country Subs should be respected for the same reasons that are discussed in connection with Step 4 (Fourth Angel Transaction) and, more generally, Basic Business Transaction exception.

6. The election23 to “check-the-box” for the entire foreign group should come within what I will describe (dare I use the term “invent”) as a corollary of the Congressional Plan exception, which is that any regulatory scheme approved by the IRS in regulations or similar authoritative pronouncements that constitute “authority” for federal income tax purposes should be treated as a

If we take Congress at its word, the esD ought not impact the common, traditional forms of tax structuring,

including international tax structuring.

the-box” with respect to each Country Sub, and thereby causes each Country Sub to be treated as a disregarded entity for U.S. federal income tax purposes. The net effect of this check-the-box structure is that the IP Sub is treated for U.S. federal income-tax purposes as an Irish corporation carrying on business in Ireland and other jurisdictions, and engaged in a licensing business that meets the requirements of Section 954(c)(2)(A) and the applicable regulations.17

B. Discussion and Analysis under ESD1. Migration of intellectual property to a foreign

subsidiary is a historically common transaction for U.S.-based holding companies, and should easily come within the Basic Business Transaction exception in principle. For example, Section 367(d) addresses and provides a special rule for contributions of intangible property to a foreign subsidiary that overrides the general rule of Section 351, and such rule clearly anticipates that a transfer of IP to a foreign subsidiary is a generically permissible transaction. Literally thousands (a very conservative number) of U.S. corporations have transferred assets to a wholly owned foreign subsidiary over the years, often in connection with a cost-sharing agreement. In

March 31, 2012 Practical International Tax Strategies® 13(Economic Substance, continued on page 14)

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de facto safe harbor, so long as the structure is consistent with the regulatory intent. Here, the transaction involves the use of the “check-the-box” rules, which were issued by the IRS in 1997 as a resolution to the endless litigation under the Kintner Regulations.24 The check-the-box regime has been used widely and repeatedly by U.S. holding companies in international business structures, and such use is well known by the IRS and is inherently approved by virtue of IRS silence on the matter. Indeed, the use of a check-the-box regime in connection with Subpart F issues is substantively consistent with the congressional policy contained in Section 954(c)(6), and thus has consistency with both regulatory and legislative policies directly pertaining to the structure and tax issues at hand. Ultimately, the Basic Business Transaction rule recognizes that there is an inherent “stare decisis” element to the codification of the ESD, which must necessarily accept and respect common and long-standing business transactional structures, and must look to the Congress for a change in the tax treatment of such structures.25 In all events, such long-standing tolerance should not be subject to abrupt reversal, especially with an application of “strict liability” penalties, through a mere change in IRS enforcement policies.

Hypothetical #2: Decision to Form a New Irish Corporation to Act as a Holding Company for all Foreign (Non-US) OperationsA. Transaction

1. USCo is a U.S. corporation, taxable as an S corporation, that in turn owns numerous first-tier foreign (non-U.S.) subsidiaries, each of which is formed under the laws of the applicable foreign jurisdiction in which it operates. Each foreign subsidiary carries on the business of acting as a sales agent for the USCo parent in the foreign subsidiary’s jurisdiction of formation. USCo has historically engaged in the business of purchasing manufactured products from unrelated third-party manufacturers generally located in Asia, and then distributing these products in the United States and, through its subsidiaries, around the world. Under the current structure, USCo purchases all of the manufactured products directly in bulk, and then resells products in the U.S. and in each applicable foreign jurisdiction. The current structured is based on an “agency” model rather than a “distribution” model, meaning that each foreign subsidiary acts as a sales agent in its jurisdiction of formation, and earns a commission on such sales. This model was originally implemented as a tax-efficient “repatriation” structure, because almost all the income is taxed in the U.S. a single time at individual

income tax rates of the USCo shareholders, and almost all of the money is brought back to the U.S. for use by USCo in its business operations. USCo does not currently check-the-box with respect to its foreign subsidiaries, but, as a practical matter, the foreign subsidiaries do not generate significant net income at this time, because the commissions paid on sales are largely offset by operating expenses in each applicable jurisdiction. USCo does not have meaningful use of its trademark or other intangibles in its foreign operations. A reasonably compelling argument can be made that any and all foreign customers are those generated by and belonging to the foreign subsidiaries. 26

2. USCo has decided that the U.S. market is maturing, that U.S. income tax rates are excessive compared to those of other jurisdictions, and that it would be better off it if “trapped” its foreign-source income offshore, subject to

The IRS followed up the codification of the esD with what can properly be

characterized as a comedy of non-guidance.

lower tax rates, and then reinvested its offshore profits to develop its non-U.S. operations. USCo has therefore decided to form a new first-tier foreign holding company based in Ireland. USCo picked Ireland over Switzerland and Singapore (each of which has similarly low tax rates and favorable tax treaty networks) because its key administrative and management employees involved in international distribution activities were most willing to move to Ireland. The new Irish entity, IrishCo, will purchase and distribute products directly from the Asian manufacturers going forward, and will act as the foreign holding company for all non-U.S. business operations.

3. The USCo then contributes the stock of all of its existing first-tier foreign subsidiaries to IrishCo (thereby creating a controlled foreign corporation group or CFC Group). As part of the contribution transaction, USCo enters into a Gain Recognition Agreement, and takes all other steps to comply with the requirements of Section 367 and the related regulations. As a result, no income or gain is recognized on these contribution transactions.

4. IrishCo is a regarded entity for U.S. federal income tax purposes, actively engaged in business operations in Ireland. Meanwhile, a check-the-box election is made for all of the new second-tier foreign subsidiaries (i.e., the foreign corporations contributed by USCo to IrishCo) and these second-tier foreign subsidiaries are thereafter disregarded entities for U.S. federal income tax purposes.27



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5. IrishCo thereafter purchases manufactured products from the unrelated Asian manufacturers, and sells these (through its disregarded subsidiaries) to unrelated parties throughout the world. Income is taxed throughout the CFC Group, but is primarily taxed to IrishCo at the moderate Irish tax rate of 12.5 percent. USCo continues to purchase products from the unrelated Asian manufacturers for distribution in the U.S., and pays U.S. income taxes on the income from the U.S. activities.

B. Discussion and Analysis under ESD1. The pre-existing corporate structure is presumably

“safe” because it is a relatively standard arrangement for a U.S. S corporation distributing products in Europe and throughout the world. Basic Business Transactions exception should apply. In all events, the IRS should

by U.S. taxpayers since 1997. Thus, as I noted above at footnote 23, it should be viewed as a corollary to the Congressional Plan exception.

5. The net tax effect of the USCo restructuring is that the income from non-U.S. sources that was largely subject to tax in the U.S. is instead subject to tax largely in Ireland, at much lower tax rates. There is nothing improper with this change in the tax consequences because the relevant business activities have actually been shifted to Ireland and are now substantively conducted through the Irish subsidiary (and its disregarded lower-tier subsidiaries) in non-U.S. jurisdictions. The business activity itself is not subject to the reach of Subpart F (it involves buying products from an unrelated party and selling them to an unrelated party, and thus does not generate Subpart F income29) and there is no reason why foreign source income from an active trade of business conducted entirely outside the U.S. should be subject to current U.S. tax. The fact that the U.S. corporation chose intentionally to make its foreign-source income immediately subject to U.S. taxation under the prior structure (i.e., arguably as a result of “dumb” tax planning) does not make the revised structure unfair or abusive in any way, and certainly would not merit an application of the ESD. Among other arguments one can advance—a little tongue-in-cheek, but nonetheless a factor in this relevant case—is that the ESD was designed to address and disallow aggressive tax-planning that is “too clever by half,” and is specifically NOT intended to address a taxpayer whose business and tax structure is modified from “dumb” to “appropriate,” and thereby merely results in a reduction of U.S. taxes.

A Naked Appeal for Common SenseA fair question to ask is whether, even if each step in

an international tax transactional structure is defensible under the ESD analysis set forth above, the transaction in the aggregate might nonetheless still be subject to IRS challenge, based on the argument that the overall transaction lacks economic substance. In particular, the IRS might argue that no one step is necessarily provocative or unseemly, but all the steps, taken together, cross the invisible line. In the movie business, after all, a bare breast here, a bare buttocks there, and pretty soon you have a film that even Potter Stewart would be interested in watching.

This article argues that a series of permissible transactional steps should add up to a permissible transaction in the whole under the ESD (and the tax equivalent of a “PG” rating), especially if the transaction involves international tax structuring, the goal is to create a rational business arrangement in light of complex international tax rules, and the transaction complies

such long-standing tolerance by the IRs should not be subject to abrupt reversal, especially with an application of “strict

liability” penalties.

have no beef because the starting structure is expressly designed to tax worldwide income right away in the U.S., and so the U.S. is getting far more tax revenue than is warranted by the actual operations. The Proposed Transaction, of course, is expressly designed to address and “fix” that problem!

2. The IrishCo is being formed because it has substantial business28 and tax benefits. Tax benefits include low income tax rates compared to the U.S., and an extensive treaty network with countries in Europe and throughout the world. Forming a foreign subsidiary to conduct foreign business activities should be viewed as consistent with the Congressional Plan under Section 367, also should also be viewed as a Basic Business Transaction since it is within the scope—or at least the spirit—of the Second Angel Transaction.

3. The contribution of existing first-tier foreign subsidiaries to IrishCo to form the CFC Group is a transaction clearly anticipated by Section 367(a)(2), and thus part of the Congressional Plan, as well as a form of corporate reorganization that would be both a Basic Business Transaction and a Third Angel Transaction.

4. The election to “check-the-box” and treat as disregarded entities the members of the CFC Group below the IrishCo is merely a basic exercise of the regulatory scheme enacted by the IRS under Reg. § 301.7701-3 and widely used in international structures


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with the practical guidelines provided by the Joint Committee.

To be sure, if a tax transaction looks and feels like a bare effort at tax avoidance, a seductive scheme dressed up in a flimsy tax nothing, the IRS can and should give it the “X” rating it deserves. But those kinds of schemes, in the end, are as easy to spot as Lady Godiva on horse back: We all know them when we seen them.

On the other hand, this article believes strongly—indeed, passionately—that there is an inherent admonishment to the IRS from Congress, embodied in the legislative history discussed above, that the ESD is not a racy and exotic new audit position for the IRS to assume. Rather, the IRS should invoke the ESD only discreetly and circumspectly, and always through a process governed by balance, respect for established practices, and above all common sense.

1 Unless otherwise noted, all “Section” references are to the Internal Revenue Code of 1986, as amended.2 The Health Care and Education Reconciliation Act of 2010, Public Law 111-50, Act Section 1409.3 The ESD provides a conjunctive two-part test at Section 7701(o)(1)(A) and (B), both of which must be met in order to establish the existence of economic substance. Prior to this codification, federal courts were divided on whether a taxpayer needed to meet both prongs of the test or merely had to satisfy either prong of the test. Congress chose to stick taxpayers with a two-pronged fork. 4 The various court-invented doctrines include “business purpose,” “sham transaction,” “substance over form,” “step transaction,” and similar phraseology, all suggesting essentially the same problem and the same cure, which was to deny the tax benefits in cases where the transaction (or parts of the transaction) had no independent logic or purpose other than the generation of favorable tax benefits.5 435 U.S. 561 (1978).6 The Rest of Section 7701(o) reads as follows:

(2) Special rule where taxpayer relies on profit potential. (A) In general. The potential for profit of a transaction shall be taken into account in determining whether the requirements of subparagraphs (A) and (B) of paragraph (1) are met with respect to the transaction only if the present value of the reasonably expected pre-tax profit from the transaction is substantial in relation to the present value of the expected net tax benefits that would be allowed if the transaction were respected. (B) Treatment of fees and foreign taxes. Fees and other transaction expenses shall be taken into account as expenses in determining pre-tax profit under subparagraph (A). The Secretary shall issue regulations requiring foreign taxes to be treated as expenses in determining pre-tax profit in appropriate cases. (3) State and local tax benefits. For purposes of paragraph (1), any State or local income tax effect which is related to a Federal income tax effect shall be treated in the same manner as a Federal income tax effect. (4) Financial accounting benefits. For purposes of paragraph (1)(B), achieving a financial accounting benefit shall not be taken into account as a purpose for entering into a transaction if the origin of such financial accounting benefit is a reduction of Federal income tax. (5) Definitions and special rules. For purposes of this subsection— (A) Economic substance doctrine. The term “economic substance doctrine” means the common law doctrine under which tax benefits under subtitle A with respect to a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose. (B) Exception for personal transactions of individuals. In the case of an individual, paragraph (1) shall apply only to transactions entered into in connection with a trade or business or an activity engaged in for the production of income. (C) Determination of application of doctrine not affected. The determination of whether the economic substance

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doctrine is relevant to a transaction shall be made in the same manner as if this subsection had never been enacted. (D) Transaction. The term “transaction” includes a series of transactions.

7 Staff of the Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010” as Amended, in Combination with the “Patient Protection and Affordable Care Act.” A mouthful, to say the least. However, for citation purposes, this article uses the cumulative Blue Book, General Explanation of Tax Legislation Enacted in the 111th Congress, prepared by the staff of the Joint Committee on Taxation.8 Bluebook, at 378.9 Bluebook, at 378-9, fn. 103410 Bluebook, at 379.11 Bluebook, at 379.12 September 14, 2010, an LB&I Directive, LMSB-20-0910-024.13 LB&I-4-0711-015.14 Allison Bennett, “IRS Field Directive on Economic Substance Doctrine Not Legal Precedent, Official Says,” BNA Daily Tax Report, October 7, 2011 15 The activities in the second-tier Irish entity are intended to qualify as active business income for purposes of Subpart F, Section 951 et. seq., and this could be accomplished in several ways, but for purposes of this hypothetical (and to extract the complexity of Subpart F from this already complicated fact pattern), this hypothetical assumes that the business in question qualifies as a bona fide licensing business and therefore the licensing income is not “subpart F income.”16 Technically, on Form 8832, the foreign entity that is to become a disregarded entity makes the “election,” and its parent corporation then “consents” to the election. However, since the foreign entity is controlled by its parent, this article uses the not-inaccurate shorthand description that the parent “elects” to treat the subsidiary as a disregarded entity.17 This is a classic “Double Irish” structure, and eliminates payments that could create issues or problems under Subpart F for U.S. income tax purposes, while also allowing the IP Sub to pay tax on a large portion of the licensing income from non-U.S. activities in Bermuda at zero or minimal tax rates. See Darby, Joseph B. III, “Double Irish More than Doubles the Tax Saving: Hybrid Structure Reduces Irish, U.S. and Worldwide Taxation,” Practical International Tax Strategies, May 15, 07 p.2, V. 11, No. 9.18 Reg. § 1.367(d)-1T(g)(4)(i) (first sentence). Instead, the sale of the intangible property in this transaction is governed by Section 482 and the related regulations, which in fact authorize a sale transaction but then seek to protect the interests of the federal government by providing special valuation rules to ensure that the transfer price is appropriate by applying a “commensurate with income” standard. The rationale is stated in the Section 482 White Paper: “Sales and licenses of intangibles are … not transactions described in Section 351 or 361.” 19 Currently, there are two sets of cost-sharing regulations, Reg. § 1.482-7A, applicable for periods before January 4, 2009, and Reg. § 1.482-7, finalized in December 2011. The sheer complexity and detail of these regulations should provide ample protection under the Congressional Plan exception (as interpreted and implemented by the IRS) to any taxpayer that makes a reasonable, good-faith effort to comply with these regulations. Note that while the scary penalty provisions enacted in conjunction with the ESD purport to provide no “good faith”

exception, the reality is that both the Basic Business Transaction exception and the Congressional Plan exception have always been read broadly in practice (remember, this is not a change in the law!) and so a good-faith effort to comply with the cost-sharing regulations means that the IRS’s remedy is to audit and exercise the Commissioner’s powers to adjust under Section 482, and not a right to attack the transaction itself under the ESD. 20 This is an attempt to condense the much more verbose language of Section 954(d)(1), which states in relevant part as follows:

For purposes of subsection (a)(2), the term “foreign base company sales income” means income (whether in the form of profits, commissions, fees, or otherwise) derived in connection with the purchase of personal property from a related person and its sale to any person, the sale of personal property to any person on behalf of a related person, the purchase of personal property from any person and its sale to a related person, or the purchase of personal property from any person on behalf of a related person where— (A) the property which is purchased (or in the case of property sold on behalf of a related person, the property which is sold) is manufactured, produced, grown, or extracted outside the country under the laws of which the controlled foreign corporation is created or organized, and (B) the property is sold for use, consumption, or disposition outside such foreign country, or, in the case of property purchased on behalf of a related person, is purchased for use, consumption, or disposition outside such foreign country.

21 Since one of the steps in the transaction structure is to use the “check-the-box” election to treat the Licensing Sub as a disregarded entity, the licensing transaction technically ceases to exist (i.e., Licensing Sub is disregarded and is subsumed into IP Sub). However, it does seem appropriate to examine each step or element in the overall transaction and evaluate whether and why each step should fall outside the scope of the ESD.22 Moreover, even if there is non-arms-length pricing (or otherwise inadequate pricing under Section 482) in this licensing transaction, that abuse is properly covered and addressed under the statutory scheme contained in Section 482, and the authority of the Commissioner to re-characterize transactions, and should not be awkwardly shoe-horned into a disallowance based on a violation of the ESD. The ESD should be used solely to address the substantively thin and chimerical arrangements that the courts have long found to lack “economic substance” under the common law, and not transactions that are economically substantive but where the choice of structural path is influenced—or even wholly governed—by tax considerations. 23 The check-the-box election is pursuant to Reg. §§ 301.7701-2 and -3.24 The case of United States v. Kintner, 216 U.S. 418 (9th Cir. 1954), and a prior U.S. Supreme Court case, Morrissey v. Commissioner, 296 US 344 (1935), spawned regulations under Section 7701 based on two primary and four secondary characteristics that distinguished corporations from partnerships. These regulations were replaced by the check-the-box regime in 1997. 25 For example, the Obama Administration has at various times proposed a law change that would eliminate check-the-box for non-U.S. subsidiaries of a U.S. corporate group. This suggests both that the current statutory scheme permits such elections, and that a legislative change is the appropriate remedy.



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Congress, after all, both makes and changes tax laws under the Constitution, and the IRS merely enforces those laws. It is also worth noting in passing that most if not all “check-the-box” decisions involving foreign subsidiaries result in a reduction of foreign taxes rather than U.S. taxes, e.g., by allowing the Licensing Sub to pay royalties the to IP Sub that reduce Irish income taxes, while allowing IP Sub to avoid creating Subpart F income. Absent the check-the-box decision, IP Sub would simply be located in Ireland, pay more in Irish taxes, and still avoid U.S. Subpart F taxation on the non-U.S. income. 26 Arguably, customer relationships would even more clearly belong to the foreign subsidiaries under a distribution model rather than an agency model, and in fact the IRS might argue that under the agency model the foreign customers actually “belong” to the USCo. Query whether, in the present situation, the IRS might argue that valuable “customer intangibles” are being “transferred” by USCo to the foreign subsidiaries, with attendant consequences under Section 367. A defensive planning strategy to address this issue—certainly awkward but possibly effective—would be to have the USCo continue to service “existing” customer relationships, while IrishCo and its subsidiaries service only new customers. However, that bifurcated arrangement would undermine the intended efficiencies of the new structure, so the more practical answer would probably be to address and manage the risk. Note that “customer intangibles” have been proposed by the Obama Administration to be included in the categories of property subject to Section 367(d), but the proposal has not been enacted into law.27 The “check-the-box” election needs to be made timely and needs to take effect after the transfer of the foreign subsidiaries to the IrishCo, because a premature election would cause a deemed liquidation of the foreign subsidiaries to occur prior to the transfer to IrishCo, which would require USCo to report

as income the “all earnings and profits amount” of the foreign subsidiaries, and the transfer of the foreign subsidiaries to IrishCo then would be recast as an outbound transfer of assets rather than foreign stock, with very considerably different tax consequences under Section 367, especially with respect to any intangible property potentially governed by Section 367(d). Assuming the check-the-box election is made after the transfer for IrishCo, the election is treated for US federal income tax purposes as a liquidation of each second-tier foreign subsidiary into IrishCo, and should generally be “tax free” under Section 332, since a liquidation of a foreign subsidiary into another foreign subsidiary is generally eligible for non-recognition under that Code Section. However, be aware that there are circumstances where a subsidiary liquidation can be a taxable event (e.g., if the subsidiary is insolvent) and it is further possible that a taxable liquidation could generate Subpart F income, although it is probably unlikely in the present case.28 Arguably, the Basic Business Transaction exception should recognize that forming or restructuring a corporate group is inherently a “business” purpose, even if the restructuring itself is guided and motivated solely by tax strategies. The point is that a business has to have some operating structure (inherently the “business purpose”) and it is entirely normal for that structure to be created (and later modified, e.g., through tax-free “reorganizations”) for reasons based entirely on tax consequences. In the present case, however, it seems in all events clear that a business purpose is present, based on forming a corporation (thereby providing limited liability) in Ireland (and therefore availing the entity of the benefits and protections of Irish law, including access to the Irish court system, the Irish treaty network and the related advantages of participation in the European Union). 29 See Section 954(d)(1), the text of which is found in footnote 20, above. q

U.S. IRS to Hire 300 New Agents for International Tax Focus

The U.S. Internal Revenue Service hopes to hire 300 more agents to scrutinize multinational corporations’ tax returns, shifting scarce resources into the international arena. To help shift resources to international work, the IRS is offering buy-outs to agents doing domestic work, said Steven Miller, a deputy IRS commissioner, speaking at a tax conference.

The IRS in recent years has been boosting its focus on international tax filings, increasing the number of agents to 856 last year from 13 in 2001.

Facing a 2.5 percent budget cut for fiscal 2012, the IRS cannot increase the size of its work force, tax professionals have said. Some employees are being reassigned to international work while private-sector recruits have also been brought aboard.

The agency will increase its audits of businesses with assets between $10 million and $250 million, Miller said.

Special scrutiny will also be extended to partnership businesses, where earnings are taxed on the individual side of the code. These pass-through companies account for more than half of all U.S. business income, and the number of such filing is increasing, Miller said. The IRS is also analyzing new data on businesses filing “uncertain tax positions.”

There were 133 businesses, or 3 percent of all UTP filings, that did not meet IRS requirements. Those businesses that erred will not need to refile for 2010, but will be examined by the IRS in future years. By Patrick Temple-West (Reuters) q

18 www.wtexec.com/tax.html (Acquiring S Corp, continued on page 19)

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Acquiring S Corp (from page 4)

connection with the deemed liquidation of the Target corporation.4

However, even though the amounts of income recognized at the shareholder level are most often relatively equal in a stock sale with and without a Section 338(h)(10) election, the character (i.e., capital vs. ordinary) may be different. Without the election, the shareholders would generally recognize capital gain on the difference between their portion of the sale proceeds and their basis in the Target corporation stock. If the parties make a Section 338(h)(10) election, the character of the income or loss will depend in large part on the character of the income or loss recognized by Target upon the deemed sale of its assets. As a consequence, if the S corporation realizes ordinary income (e.g., depreciation recapture or gain from the sale of inventory) this income will flow through to the shareholders as ordinary income. Ordinary income is most likely taxed at a higher rate (i.e., 35 percent) than the long-term capital gain rate (i.e., 15 percent). As such, depending upon the other income of the S corporation shareholders, the shareholders may owe additional taxes due to the election. Therefore, depending upon the overall benefit of the election, the acquirer and the selling shareholders must discuss methods for compensating the shareholders for any additional tax or administrative burden caused by the election.

It should be noted that Internal Revenue Code Section 1374 imposes a corporate-level tax (BIG tax) on gains accruing in a corporation’s assets prior to the conversion to S corporation status, to the extent such gains are recognized in the ten-year period following conversion to an S corporation. The BIG tax generally applies to C corporations electing S corporation status after December 31, 1986. The BIG tax is avoided in a stock sale where no Section 338(h)(10) election is made.

Applicability of the BIG tax to a potential Target corporation, and the degree of exposure, should be investigated during the due diligence phase of the acquisition process. If a corporation has been an S corporation since its inception, and has not acquired assets from other corporations in tax-free transactions, the BIG tax should be inapplicable.

B. Conversion to U.S. LLC1. Alternative A: U.S. Acquirer

When a foreign investor is considering the acquisition of a portion of an existing S corporation, converting the S corporation to a U.S. LLC may be beneficial. This planning strategy can be particularly useful when the foreign investor acquires less than 80 percent of the S corporation.5 Like the Section 338(h)(10) election, conversion to a U.S. LLC may allow the foreign acquirer to step up the basis in its portion of the S corporation assets

in order to increase its depreciation and amortization deductions.

Consider the following fact pattern:i. Shareholder owns an existing S corporation

(Target).ii. Shareholder forms a new U.S. Corporation that

elects to be treated as an S Corporation from its inception (New S Co).

Shareholder

Target New S Co

iii. Shareholder contributes the shares in Target to New S Co in exchange for an additional ownership interest.

iv. Target is converted to a U.S. LLC (Target/LLC).

Shareholder

New S Co

Target/LLC

v. Foreign Acquirer forms a U.S. corporation (U.S. New Co) and finances it with a combination of debt and equity.

vi. U.S. NewCo acquires a 70 percent interest in Target/LLC in exchange for cash.

Shareholder Foreign Acquiror

Loan

US NewCoNew S Co

Target/LLC



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(Acquiring S Corp, continued on page 20)

In this transaction, the conversion of Target from an S corporation to an LLC should be considered a tax-free Type F reorganization.6 Under the check-the-box regulations, a single member LLC should be treated as a disregarded entity for U.S. tax purposes unless the Shareholder makes an election to treat it as a corporation. Thus, any Target income or losses would flow through to New S Co and subsequently flow through to Shareholder.

Once New S Co sells 70 percent of its Target/LLC interest to U.S. NewCo, Target/LLC will become a partnership absent an election to treat it as a corporation. The partnership formation is deemed to be preceded by a sale of a pro rata portion of each of Target/LLC’s assets to U.S. New Co. New S Co and U.S. New Co then are deemed to contribute the assets to a new partnership.7

Target/LLC recognizes gain or loss on the deemed asset sale under Section 1001, which passes through to the Shareholder. The character of the gain is determined by reference to the assets in the hands of New S Co. As explained above, the BIG tax may also be applicable to the deemed asset sale on gains accruing in a corporation’s assets prior to the conversion to S corporation status, to the extent such gains are recognized in the 10-year period following conversion to an S corporation.

Both New S Co and U.S. New Co should have an outside basis in the new partnership equal to their adjusted basis in the contributed assets.8 Thus, New S Co would have a basis in its partnership interest equal to the carryover basis in its remaining assets that are not sold to U.S. NewCo. U.S. NewCo, on the other hand, gets a stepped-up basis in its partnership interest. The outside basis of U.S. NewCo’s partnership interest would equal the purchase price for the interest in Target/LLC.

Each party’s inside basis in the partnership assets would be equal to their adjusted basis in the contributed assets immediately following the deemed asset sale.9

Thus, New S Co would have a carryover basis in the contributed assets. U.S. New Co would have a stepped up basis in the assets equal to the purchase price. The stepped-up basis is allocated among the partnership assets including goodwill and going concern value.

Because U.S. New Co’s inside basis in the Target/LLC assets is stepped up to the purchase price for the Target/LLC interest, the entire purchase price can be allocated among U.S. NewCo’s portion of the Target/LLC assets and recovered through depreciation and amortization over the appropriate periods. This allows recovery of the portion of the sales price representing goodwill prior to the U.S. NewCo’s potential future disposition of the Target/LLC stock.

In addition to the stepped up basis in the acquired assets, this planning idea also enables the foreign parent to leverage its U.S. operations. Because the income and

losses of Target/LLC will flow-up to U.S. NewCo, U.S. NewCo may be able to offset its interest expense to Foreign Parent with Target/LLC income.10

2. Alternative B: Foreign AcquirerAn alternative to the fact pattern described above

would be for a foreign corporation (Foreign Sub) to acquire Target/LLC. In this case, the Shareholder’s tax results would be the same and the acquirer would still get a step-up in the acquired assets. However, there are additional considerations that need to be assessed.

Shareholder Foreign Acquiror

Loan

Foreign SubNew S Co

Target/LLC

First, Foreign Sub will be operating in the U.S. through its partnership interest in Target/LLC. As a result, Foreign Sub will be subject to U.S. tax on income that is effectively connected with a U.S. trade or business (ECI).11 ECI is taxed on a net basis at graduated rates comparable to the tax imposed on U.S. corporations. A foreign corporation is generally considered to be engaged in a business that generates ECI if the U.S. activity is considerable, continuous, and regular. Isolated and occasional activities are insufficient to create ECI. Moreover, passive investment activity is, likewise, insufficient to create ECI.

In addition to the net tax imposed on ECI, branches and partnerships that have ECI are subject to the branch profits tax and branch interest tax. The tax base for the branch profits tax is the dividend equivalent amount that is essentially the branch earnings for the year less the amounts reinvested in the United States. The tax base for the branch interest tax is actual interest paid, or deemed paid.12 These taxes, designed to simulate corporate tax treatment, impose a 30 percent tax on deemed withdrawals from the branch or partnership. In some cases, the 30 percent branch taxes can be reduced or eliminated by treaty provided that the applicable treaty addresses the branch taxes and certain residency requirements are met.

A portion of the interest expense incurred by the foreign acquirer may be eligible for a deduction against Target/LLC ECI pursuant to Reg. Section 1.882-5. The


basic approach to determine the amount of interest expense allocated to a U.S. branch of a foreign corporation is to apportion the interest expense between ECI and non-ECI. This method creates a hypothetical U.S. debt amount and then determines the interest expense on that hypothetical debt.

III. ConclusionThe U.S. economic crisis has made U.S. businesses

an attractive investment option for foreign multinational corporations. Although, foreign investors in the U.S. are unable to be shareholders in S corporations, there are still attractive investment strategies that can be used to structure foreign investments in the U.S. Foreign investors should be sure to consider these strategies as part of their due diligence prior to acquiring a U.S. S corporation.

1 IRS News Release, 2005-76 (July 25, 2005).2 All section (Section) references in this article are to the Internal Revenue Code of 1986 and the Treasury Regulations thereunder, as amended to date.3 Some States follow the Federal tax treatment of acquisitions for which a Section 338(h)(10) election has been made. Therefore, the basis of the assets of Target would be increased for state tax purposes in a similar manner as for Federal tax purposes in these States. However, a few States do not follow Federal treatment. As with any acquisition, State and local tax consequences need to be identified and carefully weighed.

4 If the shareholders’ basis in the Target stock, after the flow through of income and losses and the adjustment to basis, is less than the share proceeds received, then one or more Target stockholders will recognize additional gain on the deemed liquidation of Target caused by the Section 338(h)(10) election. This situation often arises where the conversion to S status occurred recently. 5 If the acquirer purchases 80 percent or more of the S corporation, the Section 338(h)(10) election is available.6 Sections 361 and 368(a)(1)(F).7 Rev. Rul. 99-5; 1991-1 C.B. 434; 1999 IRB Lexis 9, February 8, 1999. The contribution of assets to the new partnership should be tax free both to U.S. NewCo and New S Co under Section 721.8 Section 722.9 Section 723.10 Subject to the rules under Sections 163(j), 267(a), and 385 that can impact the deductibility of interest expense, as well as the conduit regulations under Reg. Sections 1.881-3 and conduit case law in the fact pattern where Foreign Acquirer itself borrowed in order to make the Loan to U.S. NewCo.11 If a U.S. or foreign partnership is engaged in a U.S. trade or business, any foreign corporate partner in the partnership is also deemed engaged in the U.S. trade or business pursuant to Section 875. 12 Branch interest tax is imposed on excess interest payments that are “deemed paid” as well as actual interest payments. Excess interest is the excess of interest deemed paid on liabilities allocated to the branch under Reg. Section 1.882-5 (so-called ‘allocable interest’ (Section 884(f)(2)) and interest on liabilities actually paid by the branch. q

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Brazil’s government unveiled a new package of tax cuts, low-cost credits and other relief for ailing industries on April 3, seeking to resurrect a once-booming economy struggling to regain momentum.

In a speech to business leaders in the capital, Brasilia, President Dilma Rousseff said the measures are necessary to revive Latin America’s biggest economy and help Brazil defend itself against what she called “predatory competition” from low-cost rivals in the global marketplace.

The measures were announced the same day that fresh data showed signs of life in Brazilian industry after a prolonged slump. Analysts, however, cautioned that the latest policies fail to tackle the overall tax burdens, heavy bureaucracy and lack of investment that have long held back Brazil.

Since the global slowdown brought Brazil’s economy to a near-standstill late last year, policymakers have been taking incremental steps to revive it. But after five consecutive interest-rate cuts, a rise in import taxes on cars, and a series of measures designed to curb the appreciation of Brazil’s currency, a recovery is far from clear.

Critics in recent months have blasted the Rousseff administration for policies increasingly seen as protectionist.But Rousseff put the blame at the feet of developed countries, where the financial crisis originated, and big exporters like China and the United States, whose currencies she has long argued remain artificially weak and unfairly competitive against the Brazilian real.

BRAzIL

Brazil Tax Cuts, Credits Throw Lifeline to IndustryBy Alonso Soto and Luciana Otoni(Reuters)

(Tax Cuts, continued on page 21)


Tax Cuts (from page 20)

BRAzIL

“We will not hesitate,” she said, “to do what we must to defend our jobs, our industry and our growth.”

Payroll Tax CutsThe government said it will cut payroll taxes to spur

hiring in sectors as varied as textiles and plastics to the automotive industry. Together, the tax cuts represent about 10 billion reais ($5.5 billion) annually in forgone public revenue, part of which the government will seek to recover with tax increases on products such as alcohol and tobacco.

More FinancingThe government will also stimulate domestic

industry through government purchases and inject 45 billion reais ($24.6 billion) into the coffers of state development bank BNDES, which provides subsidized loans for Brazilian companies and is the main source of long-term financing in Brazil, especially for much-needed infrastructure projects.

The moves are the second such stimulus package for ailing Brazilian industries since the country’s previously red-hot economy began to cool in mid-2011, hit by fallout from Europe’s sovereign debt crisis and slower growth in China, Brazil’s biggest trade partner.

Finance Minister Guido Mantega, who unveiled the measures before Rousseff and other government officials, said Brazil would also continue to enforce recent measures aimed at preventing the real from strengthening further. While the moves to raise taxes on certain financial transactions and speculative capital have curtailed the currency’s rally in recent months, the real is still about 30 percent stronger than at the depths of the 2008 financial crisis.

The currency firmed after Mantega’s comments, in which he said the recent retreat by the currency had put the real back at a “reasonable” level.

After growth of 7.5 percent in 2010, Brazil’s economy nearly screeched to a halt late last year, posting a full-year gain of just 2.7 percent—far less than originally predicted. The government hopes the new measures will help it reach its projection for growth of as much as 4.5 percent in 2012.

Tax ReformWhile welcomed by Brazilian industry as helpful,

the package was criticized by economists and business leaders as falling far short of the true reforms necessary to help unburden Brazil’s economy from high taxes and red tape.

“This doesn’t solve the problem,” said Mauricio Rosal, chief economist at Raymond James in Sao Paulo. Long-term, he added, “this does nothing to address the problems of competitiveness.” Fernando Marques, owner of a local pharmaceutical company, União Quimica, urged the government to do more. “The government still needs to tackle the real problems hurting industry,” he said. “We need tax reform.”

Long-pending tax, judicial and pension reforms are among the many big overhauls economists say Brazil

The package was criticized as falling short of the necessary measures to

unburden Brazil’s economy from high taxes and red tape.

needs to free up investment and make the economy more efficient.

In a study released April 3, Fitch Ratings said the country remains more attractive to investment than it did in decades past but that further progress remains elusive without “a reduction in cost of doing business.”

Mixed Views on RecoveryGovernment figures on April 3 showed that industrial

output in February recovered most of its lost ground from a sharp drop in January, when Brazil’s overvalued currency and economic ills abroad continued to erode the competitiveness of manufacturers.

Industrial production rose a better-than-expected 1.3 percent in February, the best monthly growth rate in a year. In January, industrial output contracted a revised 1.5 percent, less than a previous estimate of a 2.1 percent decline.

Despite the snap back in February, analysts cautioned it is too early to say that a genuine recovery is underway. A weak industrial sector was one of the main culprits for disappointing economic growth in 2011.

“We can’t say industry is recovering.,” said Thiago Carlos, an economist at Link Investimentos in Sao Paulo. “It’s still weak and it keeps suffering from problems of competitiveness, and there is no real improvement on the horizon.” q


In anticipation of the implementation of the draft directive published by the EU Commission on September 28, 2011 for a tax on financial transactions, on February 8, 2012 the French government submitted for parliamentary approval proposed legislation to introduce a unilateral financial transaction tax (French FTT) in France. The French FTT is included in the Amended Finance Law for 2012 of March 14, 2012 adopted by the French Assemblée Nationale and will come into effect on August 1, 2012. The new tax is projected to raise €1.1 billion per year. Though narrower in scope than its proposed EU counterpart, the French FTT is likely to have an impact not only in France but also globally.

How the French FTT Works The French FTT is not a single tax, but is composed of three separate taxes. The first element (and the element that seems likely to have the widest impact) is a 0.1 percent tax on the acquisition of “equity instruments” of French companies:

• with a registered office in France; • with a market capitalization of over €1 billion; and • whose shares are listed.

For these purposes “equity instruments” is widely defined to include shares and other equity instruments that give or can give access to capital or voting rights (but not bonds even if such bonds are convertible into or exchangeable for shares or carry a coupon linked to the profits of the issuer). Exemptions are available for activities such as those carried out by clearing houses or

depositary receipt systems, market-making activities and intra-group transactions. There is also an exemption for the primary issue of equity instruments and temporary transfers of securities such as stock loans and repos. The tax will be due on the first day of the calendar month after that in which the acquisition of the relevant equity instruments takes place and will be payable by the financial intermediary that executed the purchase order or negotiated the purchase order for its own account, regardless of where the relevant financial intermediary is located. In the event that a particular transaction does not involve a financial intermediary, the tax would instead be due from the relevant custodian. It is worth noting that from August 1, 2012 transfers of the listed shares of French companies with a market capitalization of less than €1 billion (and which would therefore fall outside the French FTT regime) will instead be subject to 0.1 percent transfer tax if a transfer deed is executed (currently, the rates of the French transfer tax range from 0.25 percent to 3 percent). The second element of the French FTT is a tax on certain credit default swaps (CDSs) on sovereign bonds purchased by individuals domiciled in France, companies incorporated in France and French establishments of non-French companies. This tax is levied at the rate of 0.01 percent on the notional value of the CDS. However, it only applies to “bare” CDSs, where the beneficiary of the CDS does not hold a corresponding long position on the related sovereign bonds (or an asset/instrument the value of which is linked to such bonds). Market makers are exempt from this tax on bare CDSs; however, none of the other exemptions which are available for the “equity investment” tax are available for the CDS tax. The third element of the French FTT is a 0.01 percent tax on high frequency trading (HFT). The tax applies to a French company, or the French branch of a non-French company, engaging in HFT for its own account. HFT is defined as the use of an automated system to transmit, change or cancel a series of orders for a given security, with these orders separated by a time period that has yet to be determined, but in any case will not exceed one second. As soon as the company modifies or cancels a certain percentage of orders within a trading day, the tax is triggered, and applies to the value of the cancelled or modified transactions that exceed the threshold. The exact threshold at which the tax will be triggered is yet to be decided, but it will not be less than two-thirds of the daily orders.

FRAnCe

Iain Scoon ([email protected]) is a Partner, Simon Letherman ([email protected]) is Counsel, and James Leslie ([email protected]) is an Associate, with the London office of Shearman & Sterling LLP. Anne-Sophie Maes ([email protected]) is an Associate, and Niels Dejean ([email protected]) is a Partner, with the Paris office of Shearman & Sterling. Mr. Scoon’s practice is concentrated in international and UK corporate taxation, including mergers and acquisitions, corporate reorganizations, and structured finance. Mr. Letherman specializes in tax aspects of domestic and international banking, corporate reorganizations, private equity and capital markets. Mr. Leslie and Ms. Maes specialize in tax matters. Mr. Dejean’s practice is focused on structured finance, mergers and acquisitions, and investment funds.

The French Financial Transaction Tax: A Sign of Things to Come?By Iain Scoon, Simon Letherman, James Leslie, Anne-Sophie Maes, and Niels Dejean (Shearman & Sterling LLP)

(Financial Transaction Tax, continued on page 23)


Rationale Behind the French FTT Ostensibly, both the (some might say, somewhat simplistic) belief that financial transactions are exempt from taxation and current sentiment across Europe have encouraged France to look to the financial sector to contribute further to public finances. With the primary aim of the tax on equity instrument transfers seemingly revenue raising, the proposal is couched in terms of producing a tax yield and minimizing the risk of driving away financial activity. This can be contrasted with the taxes on CDS and HFT activities that would appear to be directed at discouraging transactions that the French government regards as speculative in nature.

The Impact It was noted in the proposal for the French FTT that there may be a decrease in trading volume of the affected instruments, which could lead to less revenue for Euronext and multilateral trading systems (most of which are established outside France) that capture a portion of the flow of orders on French securities. There is also likely to be a negative impact on the price of securities within the “equity investments” definition, though this is unlikely to be as large as the 10 percent drop predicted by analysts

with regard to the EU proposal, as the French proposal includes an exception for market making (which would prevent a cascade of cumulative tax charges inherent in the current form of the EU proposal). In general, the

Financial Transaction Tax (from page 22)

FRAnCe

The French FTT is likely to have an impact not only in France but also

globally.

UK Lawmakers Reject “Flawed” EU Transaction Tax

Britain must veto the European Union proposal to tax financial transactions because the plan would likely prompt banks to relocate, according to a report by the House of Lords.

The European Commission has proposed a tax on derivative, stock and bond trades to raise up to 57 billion euros ($75.7 billion) from 2014 to make banks pay for economic damage from the financial crisis.

Much of the money would be collected in London, the EU’s biggest financial centre, but the report from the House of Lords said such a tax would not meet its stated objectives. “There is a significant likelihood that financial institutions will relocate outside the EU in order to avoid the tax,” the report said.

The UK has already said it won’t approve the EC proposal, effectively killing a pan-EU tax, since unanimity is needed among the 27 member states to bring into law.

Germany and France hoped for a transaction tax in the 17-nation euro zone, but this also looks unlikely after the Netherlands came out against the EC proposal.

German Finance Minister Wolfgang Schaeuble conceded for the first time that even a euro zone tax was doomed.

Stamp DutyThe focus is already switching to the possible introduction of national stamp duties on share transactions,

which Britain already has and which France is set to follow in August. The UK House of Lords report said the government should still seek to influence this development because stamp duties in different countries may have consequences for Britain. Sony Kapoor of think tank Re-Define told the lawmakers that if other EU states introduced stamp duties, Britain could lose its relative “first-mover advantage.” Brussels has said that if the EU set an example with a “Tobin Tax” or “Robin Hood Tax,” as it is also referred to by advocates, other countries would follow. By Huw Jones (Reuters) q

French government seems confident that the French FTT will not have a materially negative impact, and that the low rate of tax, in conjunction with the complexity and costs associated with changing a company’s registered office, mean that the risk of flight of taxed activities is limited. This may well be the case, although there have been some suggestions that in some cases the tax, together with other tax measures announced by the candidates to the French Presidency, may in fact lead to French groups reconsidering the location of their headquarters. As discussed above, bare sovereign CDS trading and HFT appear to be regarded by the French government as

(Financial Transaction Tax, continued on page 24)


FRAnCe

Financial Transaction Tax (from page 23)

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particularly speculative activities that do not contribute stability or useful liquidity to the market. It is argued that a decrease in these transactions will help make the operation of the market more transparent for long term investors and regulators, which in turn reinforces stability. Thus, it seems that the tax on these activities is actually aimed at discouraging their use.

French FTT and the Proposed EU Financial Transaction Tax

Although the provenance of the French FTT is very much rooted in the proposed EU tax on financial transactions, and the French government has stated its anticipation and support for an EU directive, the two differ significantly. Many of these differences stem from the unilateral nature of the French proposal. For example, corporate and sovereign bonds are excluded from the French FTT, because the French government believes that to do otherwise may impact France’s long term financing in relation to other EU member states. A possible consequence of France unilaterally introducing a financial transactions tax is the risk of driving financial activities out of France to competing countries. Therefore, derivatives in general are not included in the French FTT as the derivatives market is particularly competitive, so that a tax on this sector could lead to a rapid flight of the exchange of listed derivatives. In relation to the tax on equity instruments, the risk of evasion also led to the French FTT not using the EU

principle of territoriality based on the residence of the parties to determine whether a transaction is in scope, but instead looking at the status of the issuing company. In this way, the “equity instrument” element of the French FTT bears more similarity to UK stamp duty than the EU draft, a fact that the French Finance Minister, François Baroin, has used to defend the French FTT from criticism that France is “going it alone.” Another significant difference between the French FTT and the EU proposal is the presence of several important exemptions from the French FTT, such as for market-making activities, intra-group transfers and hedging in the context of CDSs. The absence of such exemptions in the EU proposal has been heavily criticized, and so the French FTT may indicate a potential path forward on this front. It will be interesting to see whether the EU follows the French lead in abandoning the territoriality principle in favor of a “stamp duty” covering securities issued by entities within the territories covered by the EU FTT.

A Sign of Things to Come? While the French FTT may not immediately alter the financial landscape, it is clear that the French government considers the French FTT a preliminary step towards an EU-wide financial transaction tax. At present, though, it seems likely that the required unanimity of member states for an EU tax directive will present a significant stumbling block. The United Kingdom remains

opposed to such a tax and it may be that other EU member states (for example, Ireland) would also object to its introduction or to any form of tax harmonization. EU finance ministers have arranged to discuss the Commission’s proposal at the end of March and to explore “possible alternative routes” forward. With these political complications still yet to be resolved, it seems likely that, for now, the French FTT may serve more as a blueprint for those EU member states that are prepared to “go it alone” in the future. In this way, even if an FTT is not introduced across the EU, the form that the French FTT has taken, how wide an impact it has and how successful it is in achieving its objectives may be an interesting taste of things to come.

© 2012 Shearman & Sterling LLP q

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