Tax Break

John Fisher, international tax consultant

Archive for the month “February, 2019”

Nexus, shmexus

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What tax advisers think they look like

In my halcyon days as a tax adviser, a client conference meant lots of numbers thrown at a stark white screen via an overhead projector, the small audience looking pale and bored under the harsh fluorescent lighting. We, the professionals, were geeks that nobody wanted to talk to unless we were saving their cash, or saving their hides.

It transpires that  a quarter of a century is a long time in tax, and in recent years we have found ourselves in  conference centers bathed in blue light, no numbers in sight, talking (and talking) about ‘paradoxes’ and ‘paradigm shifts’, and other intelligent concepts that have as much to do with tax as that other famous three-letter word ending in ‘x’. It isn’t that much has really changed. It is just that we have learned to talk-the-talk and walk-the-walk in our designer suits. The meaning of the words – or their dubious relevance – doesn’t really matter. Conferences are all about the sound bytes and the press coverage. The public face of tax has had a makeover.  Meanwhile, real tax consulting – exactly as in the good old days – continues to be undertaken by consenting adults behind closed doors.

It is, therefore, with some trepidation and a shaking pen, that I find myself writing about – what might actually be – both a ‘paradox’ and ‘paradigm shift’  in international taxation.

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When physical nexus made sense

I refer, of course, to the OECD’s invitation for public input on the possible solutions to the tax challenges of digitization. The topic is not new (see Tax Break October 5th 2018), and is, indeed, Action 1 (of 15)  of the Base Earnings and Profit Shifting (BEPS) initiative that has been monopolizing the attention of tax practitioners for the last five years. However, it has for some time been looking like it would be sacrificed on the altar of disagreement and procrastination, as it requires a complete rethink of two of the pillars of the existing century-old system – nexus (connection to a country) and profit allocation (between countries).

On February 13th, the Inclusive Framework on BEPS (comprised of just about every self-respecting nation in the world – not to mention a few others) came up with a Public Consultation Document, the member countries having previously been divided on any way of moving forward. To be clear, it is stressed that the comments are ‘without prejudice’ (which I think means countries are not committed). Different countries have different interests – in the rawest of terms developing countries that are not hi-tech originators have a major interest in attracting tax from digital companies interacting with their populations, while the United States would ideally like to keep as much of Google and friends’ taxable income as possible for itself. The indisputable paradox here is that – in a world veering more and more towards trade wars and protectionism –  they  were able to come up with a series of alternative proposals, any one of which  – if adopted – will represent a paradigm shift in international taxation affecting everybody.

There are three proposals for tampering with profit allocation and nexus, with the aim of ensuring that taxable profit is allocated according to where value is created.

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No comment

The first proposal focuses on ‘user participation’. This is fairly specific to the ‘highly’ digitalized economy –  social networks, search engines and on-line marketplaces, where the activities and participation of these users contribute to the creation of the brand, the generation of valuable data, and the development of a critical mass of users, which helps to establish market power. For this purpose, nexus would no longer be only to where the company physically undertakes its business. but also to  where the users build part of its profits, with suitable allocation of those profits.

The second proposal is based on ‘marketing intangibles’ such as brand and trade name which are reflected in  favourable attitudes in the minds of customers and so can be seen to have been created in the market jurisdiction. There are also other marketing intangibles, such as customer data, customer relationships and customer lists  derived from activities targeted at customers and users in the market jurisdiction, supporting the treatment of such intangibles as being created in the market jurisdiction. Once again the definition of nexus would need to be expanded beyond the physical and profit allocated accordingly.

The third proposal relates to ‘substantial economic presence’ via digital technology and other automated means. Such presence could be evidenced by:  the existence of a user base and the associated data input;  the volume of digital content derived from the jurisdiction;  billing and collection in local currency or with a local form of payment;  the maintenance of a website in a local language;  responsibility for the final delivery of goods to customers or the provision by the enterprise of other support services such as after-sales service or repairs and maintenance; or  sustained marketing and sales
promotion activities, either online or otherwise, to attract customers. Same again, in terms of revolutionary forces in international tax.

As already mentioned, each of the proposed methods requires an overhauling of ‘nexus’, until now based on a level of  physical presence in a jurisdiction, and ‘profit allocation’ which – even in the BEPS world – suffers from the vagaries of the Old World Order.

Pending public comment – the deadline for which has been extended to March 6 – the bets are on  ‘Marketing Intangibles’ over ‘User Participation’, the former catching a wider cross-section of the digital industry in its net. ‘Substantial Economic Presence’ was a late arrival at the ball, and  – if the digital tax revolution is consummated – will likely be confined to the role of chaperone.

Will anything happen? There is no question that the BEPS project has achieved a momentum that could not have been predicted five years ago. The Americans are said to favour ‘marketing intangibles’ – although when they calm down from the sound bytes, soft blue light and dark suits, they might start to run the boring numbers and discover it (and any other change) is not in their best interests.

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‘I am just the greatest ever paradox and paradigm shift!’

So, it looks like ultimate success in achieving the paradigm shift rests on the continued goodwill of the United States, which in the current political climate would be a paradox par excellence. But, we are living in interesting times.

Embrace the Model Treaty

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A real heavyweight of the small screen

When wheelchair bound ‘Ironside’ star Raymond Burr walked confidently down the aircraft steps at Lod Airport in 1974, the reaction of the Israeli public was something akin to the second coming. Still caught in the long shadow of the Yom Kippur War, Israelis were far closer to Tom Brokaw’s ‘Greatest Generation’ than  consumerist 1970s Western Society.  But, that didn’t stop them going bananas over an American TV personality.

Nearly half a century later, Israelis have taken their dubious place in western culture, and they can now fawn and slobber over their own lesser stars. Bar Refaeli – whose completely unearned claim to fame emanates from a combination of heaven-endowed gifts and an unearthly attachment to  silicone – has the nation goggle-eyed over her tax affairs. Based on tabloid rumors, she appears to be in a civil disagreement with the Income Tax Authority over whether she was justified in claiming not to be resident in either Israel or the United States while she shacked up with an Italian-American actor, and in a criminal disagreement over whether she – and her parents – hid critical facts from that same, august authority.

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Tax inspectors are only human after all

More worryingly, the tax authorities themselves seem to have jumped on the media bandwagon with the announcement last week that a committee has been set up to review the criteria for tax residence with a view to establishing greater certainty. Oh dear.

Starting with  the last major tax reform in 2003, Israel has moved forward steadily with the removal of ambiguity about Israel tax residency in domestic law. There was a useful addition to the law in 2007, a requirement to report the basis for an aggressive non-residence position from 2016, and several landmark court cases in recent years. Furthermore, Israel now has double taxation treaties with substantially all the countries Israelis are likely to clear off to (Australia is taking up the rear), which take precedence over domestic law where there is a dispute.

What appears to have put up the Tax Authority’s blood pressure in the Refaeli case (and, in fairness, those of a few other mega-rich individuals) is the claim not to be resident anywhere. That was ably dealt with in a court case back in 2016 concerning a poker player, when the judge made clear that such cases would be rare in the extreme (he even quoted the classic case of a person living on a yacht in the middle of the ocean).

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Sometimes it needs more than the instructions

The problem, if there is one, does not arise  from Israel’s lack of certainty in defining residence. In fact, Israel – in broadly paralleling the OECD Model Treaty guidelines – has a very healthy approach, combining qualitative tests (a person’s center of life), and secondary quantitive tests (number of days present). The problem is that the United States, going it alone as always, relies – at the first level – on a purely quantitative approach. So, in theory at least, an individual like Ms Refaeli could make sure they did not hit the quantitative test in either country, while claiming ‘center of life’ in the United States, where they don’t really care. Hey presto! Not resident anywhere. Any effort to achieve more certainty – like in the United States pure quantitive approach – is probably doomed to abject failure.

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His judgment is not to be trusted…

In cases like Ms Refaeli’s, it is surely far safer to have an Israeli judge look qualitatively at the situation in the light of the facts, and then – as Her Ladyship dons her black cap – stare the  defendant coolly in the eye while pronouncing sentence.

 

 

GILTI until proven simple

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What a joke

Appearing on Johnny Carson’s Tonight show in 1975, the ex-governor of California quipped: ‘We live in the only country in the world where it takes more brains to figure out your income tax than it does to earn the income.’ A little over a decade later, the same gentleman put his pen where his mouth was, and signed into law the Tax Reform Act of 1986, ostensibly simplifying the US Tax Code.

Well, I have to admit that I didn’t take much interest in the Code before Reagan’s reform, but – if that was simplification – I dread to think what it was like in the good old days. Fast forward thirty-odd years and Donald Trump was playing the same game. Or was he?

As US taxpayers start to consider their first  filings under the latest reform, one example should show just how complex the damned thing is.

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He also borrowed the line

As of  2018 the US corporate tax system went over to a territorial basis. That broadly meant that dividends received from abroad by US corporations would be exempt from tax. Nothing is ever that simple. America had invented, back in 1962, the concept of Controlled Foreign Corporation  (today the internationally ubiquitous CFC) which essentially taxed passive and certain other profits parked in tax-advantaged jurisdictions on a current basis, irrespective of whether the income was repatriated. But, if they were to transition to a territorial basis, that wasn’t enough. To paraphrase Mr Carson: ‘Wheeeeeere’s Google/Amazon/Apple?’ What about active income being cleverly sheltered in the Islands and Irelands of the world? And so was born Global Intangible Low Taxed Income (GILTI). After certain adjustments, foreign income (‘intangible’ was evidently thrown in to make a good acronym) would be taxed at half the federal tax rate (10.5% in the New World Order) with a foreign tax credit for 80% of the foreign tax paid on the income. That meant that a foreign tax rate of over 13.125% cancelled out the US tax (which is the same effective rate on Foreign Derived Intangible Income – the export incentive offered to US corporations under the reform – meaning there is ostensibly no tax advantage to going through loops to carry on the business offshore).

So far – if a little complicated –  bearable. The fun starts, however, when considering the effect of GILTI on individual or transparent entities (LLCs, S Corps, Partnerships) investing directly in foreign companies. Once caught within the CFC rules, their position becomes untenable. As it seems right now, they get no 50% deduction for GILTI and no foreign tax credit. That means they have to pay up to 37% tax on the gross income abroad, in addition to the local tax paid.  Given that the foreign jurisdiction may impose withholding tax on distribution of an actual dividend (albeit that such tax may be credited – if there is other income – in a general basket separate from GILTI), and given the exposure to State taxes and Obamacare, it is time to consider buying a one-way ticket  up the Empire State Building.

Now, straight-thinking people  might have thought this was a mistake, calling for suitable regulations to correct the situation. Evidently not. In this (once again) newly simplified world of US tax the solution being screamed from the rooftops is for the individuals to make a S962 election for their income to be treated as corporate  for tax purposes. That way they (probably) become eligible for the foreign tax credit – although the 50% deduction still looks doubtful. Because they have elected to be treated as a corporation, there is tax to pay on the ‘dividend’ when received. This ‘might’ be eligible as a qualified dividend (23.8% tax) and there ‘may’ be a credit to be had on the foreign withholding tax. But, nobody seems very sure.

This is simplification?

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Don’t try this at home, kids. It’s just for movie stars

I recall an interview with the conservative intellectual guru William F Buckley Jr. on the night of Reagan’s 1980 victory. Asked why he wholeheartedly supported the former actor, he told a story (much as the newly elected president might). He had been one of a group, including Reagan,  attending a meeting in a room on a high floor of a luxury hotel. The door became jammed, and they couldn’t get out. Reagan proceeded to climb out of the window, feel his way  along the perilous ledge to the next room, where the window happened to be open, climb in and come around to open the door from the outside. To the genuinely brilliant Buckley, that showed decisiveness, and made Reagan eligible to rule the world. When I heard this, my immediate reaction was: ‘Wouldn’t it have been simpler to just call reception?’

Perhaps the Americans just have a different concept of  ‘simple’? After all, as George Bernard Shaw is reputed to have said: ‘The English and Americans are two peoples divided by a common language’.

Watch this space

The Fast Show Special

The Rolls Royce (alright, Bentley) of tax havens

The proud boast of the John Lewis Partnership Department Store chain, ‘Never knowingly undersold since 1925’, is less than impressive when compared with Switzerland’s record on international tax. It has never been knowlingly undersold since at least 1872 when one of its cantons signed the world’s first every double taxation treaty. I thought of Switzerland when enquiring about a new car last week. As the model that interests me is sold in two local showrooms, I tried both. One was highly professional and even told me the ‘real’ statistics for fuel consumption, as well as which model would best suit my needs. The other went through the usual car salesman’s pitch and, before signing off, blatantly declared they would undercut anything the other guys were offering. The search goes on.

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Anything you need..

Throughout my career, Switzerland has been enormously useful. Holding companies, domicile companies, principal companies, mixed companies and finance branches have provided solutions for international groups looking to park some of their profits offshore without the need for sailing out to some God-forsaken island in the Atlantic of Pacific where, once upon a time, the local representative might have been cooked for lunch. However, as international competition for corporate tax tourism picked up in recent decades, the Swiss had to up their game. There were even international visits from  respectable firms of Swiss tax advisors offering private rulings involving somersaults of tax logic. Nothing particularly strange about that. It was the fact that they were accompanied by  representatives of their local cantons’ tax authorities, smiling benignly.

And then came the world’s Damascene Conversion to fairness and transparency in the international tax sphere. For Switzerland it was more a case of the Spanish Inquisition. With nowhere to turn, where would they would they go from here?

Well, the response has been sometime in coming, and thanks to 50,000 troublemakers forcing a referendum on the issue a couple of weeks back, it will still be coming until at least May. But, the proposal approved by the legislature late last year does away with all those different types of special company and says goodbye to private tax rulings. In their place come ‘reduced’ combined federal and cantonal tax rates centred around 13% to 14% and a string of other provisions.

It is the string of other provisions that has left me checking the internet for booby-trapped timing devices.  Switzerland just has to stay ahead of the pack. Call it Swiss DNA. In the modern world 13% to 14% just ain’t going to swing it. (They couldn’t go any lower – as a nation that doesn’t sport beaches and not much else, they do have to worry about funding their welfare schemes. As it is, employee/employer taxes have had to be upped to cover the loss of corporate revenue). There is provision for step-up of assets for companies migrating to Switzerland (some nice planning available there) and the write-off of hidden reserves for companies coming out of the old regimes. But, the latter only lasts five years and Switzerland presumably hopes to live a bit longer than that. Notional Interest Deductions on capital are thought to only apply to one canton. Beyond that, patent box and R&D treatment are pretty standard.

quote-in-italy-for-thirty-years-under-the-borgias-they-had-warfare-terror-murder-and-bloodshed-they-orson-welles-277430So what are they going to do long-term? Switzerland, of course, is not just a pretty rock-face. Three of the largest fifty companies in the world are headquartered there (and I don’t just mean tax headquartered). The tourist industry  is massive. And there is, of course, its impressive watch industry. However, 75% of the economy comes from services. Banking secrecy has been permanently compromised, and tax tourism seems to be following suit.

The Gnomes of Zürich must have something under their hats, surely? If there is one thing the Swiss are not, it is cuckoo.

 

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