H. Jacob Lager

Archive for June, 2012|Monthly archive page

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Debt or equity? HP case sheds new light on old issue

In Court decisions, Debt v. equity on June 28, 2012 at 10:46 am

Hewlett-Packard was handed a recent loss in Tax Court when its preferred equity in a foreign corporate special purpose vehicle (SPV) was recast as debt.  Consequently, HP was denied an indirect foreign tax credit as well as a capital loss on the equity when sold.

So, what exactly happened here?

Historically speaking, HP fell into a classic tax question: was the subject investment debt or equity?  The answer is not always so easy to discern.  Believe it or not, The Internal Revenue Code itself does not contain a general definition of the term “indebtedness” or “equity.”  Instead, courts that have considered the debt versus equity issue have repeatedly stated that the question whether an advance of funds is debt or equity is a question of fact to be decided on the basis of all the facts and circumstances.  Courts typically consider a list of factors that are to be taken into account in resolving this issue.

Here, the court held that HP’s preferred equity of a foreign corporation was debt because there was a high level of economic and legal certainty that HP would receive a prescribed dividend and that HP’s investment would be as safe as a bank deposit.  The court also noted that HP held a right to put the stock to its fellow shareholder in the seventh year of the investment, which the court treated as a put to the issuer.

The alarming thing about this case is that the court’s ruling relied so very much on the very aspects that typically make SVPs attractive to investors: namely, the investment’s safety and security.  SPVs are often specifically designed to constrict both their investment options and their ability to incur debt.  But according to the court’s ruling the fact that “HP was essentially assured of the return on its investment” took its SPV interest out of the world of equity.

Going forward, international issuers and investors will need to particularly mind the economic security and exit certainty elements of a planned SPV.  When combined, these two aspects, meant to cater to conservative investors, may in fact prove too good to be true.

 

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New technologies, meet old tax rules

In Technology and taxes on June 20, 2012 at 9:06 am

Does online affiliate marketing create a taxable nexus?  Are MMORPG currency swaps taxable realization events?  Is downloadable software an item of taxable property for sales tax purposes?  I see these questions with increasing regularity and the answers are rarely consistent.

So I love it when somebody makes my job easier.

Enter KPMG’s new online “Country Perspectives on Taxing the Cloud” tool.  The online resource describes how 18 different countries are approaching the taxability of cloud-based transactions.

Any company shifting to a new cloud-based business model will want to examine how its local country treats the character and source of the cloud income and whether the cloud operations create new income, withholding or indirect taxes.

The tool provides a great launching pad for users and cloud providers who are looking to virtually cross borders into a new market.   It also describes how to best approach local incentives when situating physical servers and other infrastructure items.

KPMG expects to add more countries in the coming months.

Thanks for making me look smart, guys.  Keep it up!


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Circuit Split Alert! – Fifth Circuit Diverges from Third in Holding UK Windfall Tax Creditable

In Court decisions, Foreign taxes on June 12, 2012 at 8:59 am

It’s a tax blogger’s dream.  In Entergy Corp. v. Commissioner, The Fifth Circuit just held on June 5 that a US company’s UK windfall tax payment qualifies as a creditable foreign tax and creates a circuit split after the Third Circuit recently held otherwise.

What’s a Windfall Tax?

In 1997 the United Kingdom enacted a windfall tax on the excess profits of certain recently privatized utility companies.  The tax was meant to address public backlash against what was perceived as bargain sales of the utilities.

The tax imposed on each of the utilities a 23 percent assessment on the difference between: (1) a company’s “profit-making value” (its average annual per day profit multiplied by nine) and (2) its “flotation value” (the price for which it was acquired).

Here, the US taxpayer who owned a UK subsidiary that operated a privatized utility paid the windfall tax and sought a US income tax credit based on that payment.  The IRS disallowed the credit.  As the Eighth Circuit noted, the parties “essentially disagreed on whether the Windfall Tax . . . constituted a tax on excess profits, creditable under I.R.C. § 901, or a tax on unrealized value” for which no credit would be allowed.

What this Means – Foreign Tax Credit Defined

In general, regulation 1.901-2(a) allows a credit only for foreign taxes the “predominant character” of which is an income tax in the US sense. To have that character, the tax must:  (1) reach only realized income, (2) be imposed on the basis of gross receipts, and (3) target only net income.

Third Circuit/IRS Position

In a previous case, the Third Circuit held that the windfall tax did not meet the second requirement – that it be imposed on gross receipts, or an amount not greater than gross receipts. According to this argument, the windfall tax statute focuses on “profit-making value,” an average profits calculation based on a particular time period, not “gross receipts,” even though gross receipts may impact the tax indirectly.

Fifth Circuit/Taxpayer Position

The Fifth Circuit court rejected the Third Circuit’s approach and, more pointedly, the notion that it must only examine the windfall statute’s text in reaching its conclusion.  Instead the panel examined the tax’s history and actual effect of the foreign tax on taxpayers.  Noting that “both the design and effect of the windfall tax was to tax an amount that, under US tax principles, may be considered excess profits realized by the vast majority of the windfall tax companies,” the panel ruled that the tax was designed to reach net gain under normal circumstances.  In practice, the taxpayer demonstrated that the windfall tax’s application would be based on “either actual income or an imputed value not intended to reach more than actual gross receipts.”  Consequently, the tax’s “predominant character” was that of the US income tax and that it was a creditable foreign tax under section 901.

At the moment, it’s unclear whether the split will reach the Supreme Court for final determination.  The essence of the clash lies in how an unconventional foreign tax might satisfy the three-prong test for US credit-worthiness.  While the issue may not be headline-grabbing like a civil rights or due process dispute, the US tax response to more exotic foreign taxes that are not easily categorized represents a real cost to US-based multinationals (this case involved a credit of $243 million).  I would guess we’ll see this up for certiorari sooner than later.

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Same-Sex Marriage Tax Ramifications: A Look at Mass v. Dept. of Health and Human Services

In U.S. Tax policies on June 4, 2012 at 11:08 am

In a case where civil rights, election-year politics, and (yes!) tax policy meet, the First Circuit last week affirmed a district court’s holding that section 3 of the Defense of Marriage Act violates the equal protection clause by denying federal tax and other benefits to same-sex couples and surviving same-sex spouses who were lawfully married in Massachusetts.

At issue are basically all federal benefits available to spouses, including federal employee health insurance, Social Security benefits, and (wait for it) the right to file “joint federal tax returns, which can lessen tax burdens.” Although not mentioned in this decision, federal recognition of same-sex marriages will also touch on the following issues:

  • Eligibility for the unlimited estate tax exclusion for assets passing to a surviving spouse;
  • Ability to pass on assets to a foreign spouse via  Qualified Domestic Trust (QDOT);
  • A host of other immigration and naturalization issues for those multinational same-sex spouses.

Read more about the decision.

Updates!

Remember our entry a few weeks ago about the administrative Microsoft decision that absolutely savaged the District of Columbia’s reliance on a specious third-party transfer pricing analysis?

The District is appealing.   Not sure how you appeal from a finding that the subject analysis was “useless in determining whether Microsoft’s controlled transactions were conducted in accordance with the arm’s-length standard” and its findings were “arbitrary, capricious, and unreasonable.” DC Office of Tax and Revenue Chief Counsel Alan Levine is quoted as noting that the “transfer pricing program, at issue in this case, and others, is important to the District of Columbia.” OTR has not yet revealed the substantive grounds for this appeal.

In other news, the Indian retroactivity saga continues.  While Indian Finance Minister, Mr Pranab Mukherjee has sought to reassure investors that “in cases where assessment proceedings have become final before the first day of April 2012, such cases shall not be reopened,” Vodafone remains a target.  According to the  Finance Ministry, the retroactive Vodafone assessment remains active because it involves an alleged default in fulfilling the withholding tax obligation.  More here.

Photo by Cynthia.Ess.