The following points highlight the top five techniques of tax planning. The techniques are: 1. Hybrid Entities: Check-the-Box Rules (United States) 2. Hybrid Financial Instruments 3. Derivative Financial Instruments (DFI) 4. Transfer Pricing and Tax Planning 5. Use of Offshore Trusts.
Tax Planning: Technique # 1. Hybrid Entities: Check-the-Box Rules (United States):
Prior to January 1997, the United States applied a multi-factor test to determine whether an entity was a corporation or association, partnership or single-member entity for US federal tax purposes.
Four factors under the old Kintner Regulations were applied to determine non-transparent tax status.
(i) Limited liability for all its owners,
(ii) Centralized management,
(iii) Continuity of life and
(iv) Free transferability of ownership interest.
To qualify as a taxable corporation, the entity had to meet at least three of the four tests. A business entity could be classified only as a corporation, partnership or sole proprietorship for tax purposes. The rules were applied on a case-by-case basis by the US tax authorities.
The “Check-the-Box” rules introduce a simple and flexible system based on an election by the taxpayer to be treated either as a taxable entity or as fiscally transparent. If an entity is “eligible”, a taxpayer can choose it to be taxed either as a non-transparent entity or on a pass-through basis.
To be an “eligible” entity, the enterprise must not be a per se corporation. All other entities may be classified either as a corporation, partnership or a disregarded entity, depending on the number of owners.
For example, an eligible entity with at least two members can elect to be classified as an association (and thus a corporation taxed separately from its owner) or as a transparent partnership.
An eligible entity with a single owner can elect to be classified as an association (and thus a corporation taxed separately from its owner) or be disregarded, i.e. treated as a branch or division or sole proprietorship of the single owner for US federal tax purposes.
A disregarded entity is an eligible “business entity” having only a single owner (or member) which is disregarded as an entity separate from its owner. (Treasury Regulations No. 301.7701-2(c) (2)).
If an eligible entity does not make an election, the regulations provide a default status.
The default rule varies for US and foreign entities, as follows:
(a) US entities:
The basic rule is fiscal transparency. A non-electing eligible entity is a partnership if it has two or more members or a disregarded entity if there is a single owner.
(b) Foreign entities:
The default rule depends on the limited liability of the members with regard to their ownership interest in the enterprise. A member of a foreign entity has limited liability if the member has no personal liability for the debts of, or claims against, the entity as a member.
It is an association if all of the members (even if only one owner) have limited liability. It is treated as a partnership if there are two or more members and at least one does not have limited liability. It is a disregarded entity if the sole owner does not have limited liability.
Without an election, an entity’s tax status as non-transparent (corporation) or transparent (partnership or proprietorship) is determined under the default rule. A listed per se corporation (domestic and foreign) cannot change its tax status.
Any other eligible entity can make an election to change its default tax status. An initial election for an entity is not considered a change in classification. After an initial election, a subsequent election is available every five years. The 60-month rule limits how often an eligible entity may change its classification.
Once a change in classification is made, an entity generally may not change its status again for 60 months. Generally, an election may be made effective from any date up to 75 days before the filing date. The election can be made either by the entity or by the unanimous consent of all its members.
A key feature of the check-the-box election is that it applies to both domestic and foreign entities, regardless of their commercial or tax status abroad, for US federal tax purposes. An unlisted foreign corporate entity is treated as fiscally transparent if it checks the box on Form 8832 and elects to be classified for tax purposes as a partnership.
On the other hand, a partnership may elect to be treated as a non-transparent association by checking the box. A domestic sole proprietorship or branch is a “disregarded” entity unless it elects to be treated as a corporation.
Unlike a domestic enterprise, a single member foreign enterprise with limited liability, which is not a per se corporation, is not a disregarded entity without the election. The default rule for foreign enterprises retains its corporate status.
Tax Planning through “Check-the-Box” Rules:
The “Check-the-box” Rules have provided a wide range of international tax planning opportunities on US-related business activities. The election allows various combinations of taxable and transparent entities within multinational groups involving both inbound and outbound US investments.
Usually, the US hybrid entity is a limited liability company (LLC) which is transparent for US tax purposes but treated as a corporation under the foreign tax law. Similarly, a single owner foreign corporate entity is a hybrid entity if it elects to be disregarded for US tax purposes.
A wholly-owned foreign subsidiary may elect to be disregarded under the check-the-box rules and be taxed as a branch. Reverse hybrids have also been used for planning purposes and arise where an entity elects to be taxed as a corporation for US tax purposes while it remains a transparent entity for foreign tax purposes.
There are several tax advantages associated with the use of the check-the-box election for foreign entities which are not per se corporations, particularly with respect to the use of single member entities or SMEs.
Unlisted foreign SMEs may elect to be disregarded for US tax purposes while they remain corporate entities for foreign tax purposes. Such enterprises are called hybrid branches. This ability to make a SME “disappear” under the US tax rules is often used in structures based on the check-the-box rules.
Some examples of tax planning structures include:
(i) The election to be a disregarded entity makes the foreign entity a branch or division of the US entity or a direct business of the US owner. Therefore, its profits and losses are taxed currently in the hands of the US owner.
This tax treatment is beneficial when the foreign entity is producing losses. It is possible to have a fiscally transparent entity abroad during the start-up loss phase and subsequently elect to make it a corporation for US tax purposes when it becomes profitable.
(ii) Under US tax rules, foreign tax credits are given to US persons only for direct foreign taxes imposed upon them. However, domestic corporations can claim indirect or underlying credits imposed upon their subsidiaries if they own qualifying voting shares in the foreign entity.
The credits are available only upon the repatriation of the earnings through dividends which generated the tax liability. Moreover, the foreign tax credits are subject to various basket limitations. As a disregarded entity is a branch or sole proprietorship, it is not subject to these rules since it is directly taxable on its profits.
(iii) A disregarded entity may be used to reduce the impact of the US anti-deferral rules. Unless it satisfies the branch rules in the CFC regime, it is not treated as a CFC but as a division or branch of the owner.
Most of these structures are based on a foreign SME taxable as a “hybrid” branch due to its election to be disregarded for US tax purposes; otherwise, it would be subject to the Subpart F rules.
(iv) A transaction (e.g. a sale) between the US parent and its foreign subsidiary, which elects to be disregarded, is an internal transfer for US tax purposes. Therefore, such transactions are not subject to US transfer pricing rules. However, the transaction may still be subject to the transfer pricing rules in the foreign country.
(v) Tax liability of a foreign subsidiary of a US corporation may be reduced through arm’s length charges or deductions made by a hybrid branch set up in a low-tax country to shift the income from a high-tax foreign jurisdiction to a low-tax jurisdiction.
Some of these tax-planning structures have now been classified as abusive by the US tax authorities. However, once litigated, the Courts have generally not invalidated such planning efforts.
(a) Claiming of direct foreign tax credits for indirectly paid taxes:
In Guardian Industries v Commissioner, the US taxpayer succeeded in claiming indirect foreign tax credits on deferred income in a Luxembourg holding company and its subsidiaries. The Luxembourg company, a wholly-owned subsidiary, was not a per se corporation. It elected to be treated as a disregarded entity (i.e. fiscally transparent) and therefore was considered a branch of its US parent company, a Delaware corporation.
The taxes paid by the various operating subsidiaries of the Luxembourg holding company were then claimed as tax credits by the US parent, notwithstanding the fact that the related profits had not been received by the US parent as dividends to qualify for the indirect credit.
(b) Deferring Subpart F Income:
In Dover Corp. v Commissioner, a US corporation re-characterized income arising from the sale of the shares of a foreign CFC, from an equity sale to an asset sale. H&C was a foreign subsidiary of a Delaware corporation, which was in turn owned by Dover Corp.
The sale of the shares of the subsidiary was deemed as liquidation proceeds once H&C elected to be a disregarded entity. The “check-the-box” election turned a CFC into a branch so that its sale became an asset sale thus avoiding subpart F.
Tax Planning: Technique # 2. Hybrid Financial Instruments:
Hybrid financial instruments are a combination of debt and equity. They contain features of both debt and equity in varying degrees. As some countries look at substance while others follow the form when making their classification, they may take different views of their form and substance or of their legal and economic features.
For accounting and tax purposes, hybrid instruments may either be split into their debt and equity components or classified according to their dominant feature. In practice, their characterization is usually based on the predominant character and normally there is no attempt to deconstruct or bifurcate them. Therefore, a hybrid instrument is often treated either as debt or equity (“all or nothing” treatment).
The tax rules vary widely. In a cross-border transaction, a hybrid instrument may be treated differently in two countries. These differences arise due to mismatches or “asymmetries” in the national tax systems. As common tax treatment is an exception and not the rule, it is possible to exploit the differences in the two jurisdictions either to avoid tax or to claim double benefits.
Therefore, differing tax treatment of hybrid instruments may provide opportunities for tax arbitrage in cross-border transactions. They may be used to transfer the tax benefits to, or acquire the tax benefits from, certain investors.
For example, an investor may claim an interest deduction on his funds when it is classified as debt in one country and receive payment as tax-free dividends in another country. He may also avoid capital duties on equity contributions treated as debt, or capital gains tax on the repayment as a loan.
Hybrid instruments often merge the economic benefits of two or more separate instruments. A bond with warrants combines an interest- bearing bond with a warrant whose cost is ignored for tax purposes until the warrant lapses or is sold. They are often embedded with derivative instruments such as forward purchase contracts, options and other derivatives.
There is a wide range of hybrid financial instruments, such as:
i. Debt instruments carrying features such as subordination, no repayment schedule or a return that is either dependent on the success of the business of the issuer, or effectively equity capital of the issuer;
ii. Debt instruments that are either convertible into shares of the issuer, or exchanged for shares in another entity, whether related or unrelated;
iii. Preferred shares with or without voting rights or maturity date, or with the right of conversion to equity shares;
iv. Securities issued by a special purpose subsidiary (SPV) of the ultimate user of the funds;
v. Interest in entities that are not corporations, such as interests in partnerships or other “hybrid” entities; etc.
Hybrid instruments differ from hybrid transactions or hybrid entities. Hybrid instruments reflect the characteristics normally associated with both traditional debt and traditional equity instruments.
Hybrid transactions are transactions (or composite of transactions) that are regarded differently in different jurisdictions. They differ from hybrid entities, such as a partnership, which is taxed as a company in one jurisdiction and is fiscally transparent in another jurisdiction.
Some examples are given below:
(i) Convertible debt instruments:
Convertible debt instruments comprise financial obligations that allow an investor to receive shares instead of cash on maturity. They are widely used to reduce the interest cost for the issuer while allowing the investors to benefit from the higher equity return on conversion with lower risks.
Most countries that follow the legal form regard them as debt until conversion and equity thereafter. Others either split the instrument or tax it as equity. It can be regarded as a debt instrument with an embedded option to convert.
Convertible debt is structured in the same way as conventional debt. However, the holder has the right to convert the debt into shares of the issuer. Any interest accrued since the last interest payment date is forgone on the exercise of the conversion right. The issuer is regarded as having repaid the debt instrument for an amount equal to the principal amount, without recognition of any gain or loss on conversion.
(ii) Participating debt instrument:
Participating debt instrument grants the holder a debt claim against the issuer and payment rights determined by reference to profits, cash flow or similar attribute of the issuer. The lender receives interest income at a variable rate based on the level of profits earned by the borrower.
The interest is expressed as both a percentage of the loan amount (principal) as well as related to actual profits of the borrower. Thus, participating (i.e. profit-sharing) loan provides for interest that is contingent on the financial performance of the issuer.
Tax treatment varies. In many countries the consideration is treated as a dividend distribution. However it can also be treated as a tax-deductible expense for the issuer.
The actual legal categorization can be of a single contract with the consideration as interest, or it might be viewed as two contracts – one as a loan and another as a contractual right to a share in profits. The OECD Commentary recommends that the interest on participating bonds should not normally be considered as a dividend unless the loan effectively shares the risks of the debtor.
Profit participating debt may also be regarded as a subordinated loan or quasi-equity of the lender. Country practices vary. Canada does not treat it as payment for borrowed money and disallows the interest expense.
Similarly in Italy, a subordinated loan, which involves participation and is perpetual, is treated as equity. In France, pure participating loans are treated as debt for tax purposes and equity under the corporate law, if they are subordinated to other borrowings of the enterprise.
(iii) Subordinated debt instrument:
Subordinated debt instrument is used in many countries for regulatory purposes to maintain the statutory solvency margin of banks and insurance companies.
Subordinated debt is generally treated like debt and the interest is usually tax deductible (Examples: Canada, Sweden). However the instrument is deemed as equity for solvency purposes and repayable only on insolvency or liquidation. Usually, they do not have any participation right (Example: Germany).
(iv) Perpetual debt instrument:
Perpetual debt instrument is a loan with no set maturity date. It has interest payments but may be repayable only on insolvency or liquidation. The issuer pays a fixed rate of interest and usually a percentage of profits.
The debt is effectively subordinated to other non-equity liabilities and therefore resembles equity. Perpetual debt is often used by issuers in a regulated industry where they do not have voting rights and can be treated as equity for solvency ratio purposes.
As subordinated debt it has a weaker claim for repayment than unsubordinated debt, should the issuer default on its obligations. The interest paid on a subordinated loan or perpetual debt may be treated as dividend on equity capital or annuity income.
Many countries treat perpetual debt as debt, unless it is clear from the outset that it will never be repaid, except on liquidation. For example, loans granted by shareholders and loans to finance a loss-making subsidiary with no ability to repay are treated as equity in the Netherlands.
(v) Preferred or preference share:
Preferred or preference share is a share issued with a fixed dividend rate but restricted voting rights. Preference shares are hybrid in nature, since they have ownership rights like equity and fixed income like a loan debenture.
Preferred shares are normally issued to tax-exempt investors by companies that either cannot benefit (e.g. charities), or do not need the benefit (e.g., loss-making entities), from the interest deduction.
Preferred shares are also used where the investor has current taxable profits but with tax loss carry-forwards. Like a loan debenture, they may be redeemable at maturity or convertible into equity shares.
Preferred shares usually bear a dividend rate lower than the interest rate on a similar loan. The party providing the financing would obtain advantageous after-tax dividends and the party paying the interest expense would incur lower financing while foregoing an interest expense deduction that it could not use currently.
The share gives the shareholder preferential rights as to dividend payments at a predetermined fixed rate.
The ‘preference’ element refers to the fact that the preference share dividends are paid before dividends on normal shares. The investor is willing to take a lower return on the financing, thereby passing on some of the tax advantage to the issuer.
Convertible preferred shares typically refer to a preferred share that may be converted into ordinary shares of the issuer. Such shares may be regarded as “double hybrids”. Firstly, the preferred share itself is a hybrid. Secondly, the ordinary share conversion provides a right of participation in the equity of the issuer on conversion.
(vi) Redeemable preference share:
Redeemable preference share gives the shareholder preferential rights as to dividend payment up to a fixed rate and on liquidation. The share is automatically redeemed (purchased) by the issuer after a set period, often three to five years.
The commercial effect of such financing is similar to a loan. It could lead to cross-border tax arbitrage if Country A considers it as a loan and treats the dividend payments as tax-deductible interest. In Country B, the investor may be deemed to have a shareholding with the dividend either exempt or taxed at a low rate.
(vii) Silent partnership:
Silent partnership helps raise capital at a lower cost for the issuer and provide higher profit-sharing income for the investor. The profits from a silent partnership are treated as interest income in some countries and as business or dividend income in other countries.
Several German tax treaties regard the income from jouissance rights, silent partnerships and participating loans as dividends, even when the payments are tax deductible as interest under the domestic law.
Silent partnerships may be either typical or atypical. A typical silent partnership provides for profit, and possibly loss, sharing but no participation in hidden reserves or corporate decisions. In an atypical partnership the investor also participates in the hidden reserves and goodwill and can influence corporate decisions.
Under German domestic law, a typical partnership is treated as a loan for tax purposes and the profit share is tax-deductible for the payer. In an atypical partnership, it is regarded as income and the profit share of the silent partner is not deductible.
A hybrid transaction is characterized differently in two countries. It refers to a type of transaction that is regarded in one way for tax purposes and in another way for other purposes (for example, financial statement presentation or foreign tax).
Hybrid transactions include:
(i) Repurchase transaction or “repo”:
Repurchase transaction or “repo” is a financial arrangement where securities are sold to an investor and then repurchased at a future date for a fixed buy-back price including the repo rate or fee when the option is subsequently exercised by the issuer.
A party (A) sells a security or other asset to counterparty (B) on the condition that A will subsequently repurchase the property. There is a transfer of legal title and a reversal on completion of the transaction. The repo transaction allows the selling party to obtain cash, and the purchaser legally owns the securities for the period of the transaction.
Repo involves the purchase and sale of shares under a contract whose terms are determined at the outset. Therefore, there is in substance a loan with security in the form of securities that are held for the term of the transaction.
Depending on the jurisdiction, these transactions can be regarded as a financing transaction, providing liquidity in return for the asset as security, or as the disposal and reacquisition of an investment asset. Repo differs from a stock lending arrangement where there is generally no purchase or sale price.
Although the economic substance of such a transaction is essentially one of lending, the tax treatment both for the repo buyer (investor) and seller (issuer) varies widely. Generally, it depends on whether the country respects the form or substance of the transaction.
If form over substance is followed, a transfer of legal and economic title occurs on purchase and is subsequently reversed on completion of the transaction when repurchased. Capital gains on sale and repurchase is taxable on the issuer and the investor respectively. The repo fee and any dividends received by the investor are taxable as income currently or adjusted against the repurchase price.
If substance over form is followed in both countries, the transaction is essentially a loan for tax purposes. For financial statement purposes, the repo may be treated as a secured financing: the cash purchase price is treated as a loan, the repo spread is treated as interest, and the transferred property as security for the loan.
The capital gain on the subsequent sale is taxable as interest income of the investor, subject to withholding tax. This approach requires the issuer country to treat the amount received by the investor as deemed interest expense for the seller and deemed interest income of the repo buyer.
The distributions received by the repo buyer or investor are deemed as dividend income of the seller or issuer. Many investor countries tax-exempt such income.
Many countries follow the form (e.g. Ireland, Singapore) while some examine the underlying substance (e.g. United States, United Kingdom). The precise treatment of repos or stock lending depends on the concept of ownership of the instrument in a country.
For example, it may recognize a legal transfer of ownership but allow the retention of some or all of the economic benefits, such as the right to receive interest or dividends. Tax planning opportunities arise in hybrid transactions when the tax treatment in the two countries is inconsistent.
(ii) Original Issue Discount (OID):
Original Issue Discount (OID) Bond refers to a loan instrument issued at a discounted price with payment at par on maturity. The return to the bondholder or the issuer’s borrowing cost includes the amount of the discount, as well as any periodic payments designated as interest in the instrument.
The issue discount is in substance loan interest payable on maturity. As it accrues to the holder solely by the passage of time it should be accrued for tax purposes. On the other hand, unlike interest, it is not earned nor does it accrue from day to day.
It is also not subject to withholding tax, taxable only on realization, and generally not tax deductible from taxable income. The use of a discount instead of an interest-bearing bond defers the tax.
Zero coupon bonds are an example of original issue discount bonds. They are issued at a deep discount to par value and pay no interest during their term. Moreover, the holder is only entitled to repayment of the principal sum on the maturity date. The gain is often taxed as capital gains on the holder, while the issuer may claim a tax deduction for the discount as an interest payment on an accrual basis.
Some jurisdictions tax the discount amount as interest over the life of the bond. In such cases, a drawback of such bonds is that the tax is due annually on the accrued interest, but the interest is not received until the bond matures.
In the United States, original issue discount is accrued for tax purposes by a constant interest method. The issuer and holder of a discount obligation annually accrue a portion of the discount as interest expense and income.
The remainder represents a capital gain or loss. This method taxes the holder on the interest income before it is received. The two other alternatives include (a) accruing the discount on a straight line basis and recognizing the discount only as paid, and (b) the entire discount is recognized at maturity or when the bond is sold, if earlier.
Since discount income is a substitute for interest income it is taxed as ordinary income and not capital gains. Tax revenues are affected if the issuer’s and holder’s countries follow different rules.
Most OECD countries consider discount income to be subject to interest withholding tax under Article 11. However, it is not very practical. Tax can be withheld from payments but not from accrued interest income. Moreover, withholding tax should not be levied on the gains from the sale of investments. There is no feasible means of withholding tax on zero coupon bonds.
Use of Hybrids in Tax Planning:
The use of hybrid instruments is generally motivated by considerations unrelated to taxes, such as regulatory considerations, reduction in financing costs or transfer of risks. However, cross-border hybrid instruments can also be used to take advantage of the different classification in the national tax laws (“tax arbitrage”) for tax planning.
These tax arbitrage techniques usually involve the exploitation of mismatches between jurisdictions arising from difference in tax rates, timing for tax deduction and accrual, classification of entity or income, structuring techniques, split legal/economic ownership, etc. The taxpayer may exploit these differences in their characterization, source, timing and amount for tax planning purposes.
Some common tax-driven objectives for using hybrid instruments include:
a. To achieve double deduction (i.e. double dipping) of interest;
b. To lend money within a group to achieve deductible interest in one country without corresponding taxable income in the other country;
c. To counter anti-avoidance rules (e.g. structures that circumvent thin capitalization or rules against back-to-back loans);
d. To avoid or reduce withholding taxes or, capital taxes;
e. To delay derivation of income or advance getting a tax deduction; etc.
Hybrid financial instruments permit tax planning of income and deductions by either bringing forward or deferring them for tax purposes. For example, the income may be taxed on realization or accrual basis, or recognized pro rata over time under the mark-to- market principle.
Tax planning for foreign currency transactions usually involves considerations on when the losses may be deducted and when the gain should be included in the taxable income. The potential for tax arbitrage is created by the inconsistent characterization rules in cross-border transactions. They can lead to double taxation as well as double non-taxation that may assist tax planning.
Hybrid instruments also offer opportunities for tax planning that take the advantage of the differences in the classification rules under domestic laws and tax treaties. Several countries have attempted to apply administrative procedures to limit tax arbitrage using hybrid instruments that are a sham or entered solely for tax avoidance purposes.
The panel discussion at the 2000 IFA Congress in Munich agreed that the tax treatment of hybrids should look for a specific solution that defines the meaning and concept of hybrids, and also regulates them in accordance with their substance.
Tax Planning: Technique # 3. Derivative Financial Instruments (DFI):
Derivatives are traded either on organized exchanges, with a physical location where all trades occur, or over a decentralized network of financial institutions, called the Over- the- Counter (OTC) market.
The financial intermediaries, such as dealers or brokers, facilitate these transactions among end-users. They usually group them into trading portfolios (or “books”) of similar offsetting risks. The unmatched risks that are not hedged provide them with speculative income or losses.
Derivatives provide opportunities for risk sharing among investors. Different components of transactions can be split to create products that give different risk. Therefore, they may be viewed as mechanisms to allocate capital efficiently and to share risks.
Recent years have witnessed a significant growth in the use of bespoke derivative financial instruments (DFIs). The DFI providers analyse and manage different types of risks and sell products based on these risks.
Most of these instruments are tailored to meet the needs of the individual customer and not provided in a standard “off the shelf’ form. Generally, tax and regulatory reasons are not the main reason for such transactions
What is a Derivative Financial Instrument (DFI)?
The term “derivative” refers to the fact that the market value of the contract is derived from a reference rate, index, or the value of an underlying asset. Financial instruments are called “derivative financial instruments” when the rights and obligations under the instrument are derived in some way from the value of another underlying instrument.
A DFI is a contractual right, constructed and priced by reference to something else, such as a security, equity, commodity or an index based on them. The payment rights and the obligations of the parties are decided by or derived from the objective value of the “underlying” or “base instrument”, which is used as a reference point.
The underlying instrument can be any objectively ascertainable index, such as interest rates, foreign exchange rates, stock market indices, commodity prices, or credit qualities. It is usually based on the cash or physical market (e.g. foreign exchange, securities, commodities), or some other financial indices.
The contractual terms express the risks and rewards accepted by each party and are determined, either conditionally or unconditionally, under a mathematical relationship to the underlying instrument.
Types of Derivatives:
Derivatives comprise both price-fixing and price-insurance instruments. The basic derivative transactions are forwards, futures, options and swaps (also known as notional principal contracts).
(a) Forwards and futures:
Forward or future transactions oblige the holder to buy or sell a specific amount or value of the underlying instrument at a specified price on a specified future date. Futures are generally standardized contracts traded on organized exchanges usually without taking physical delivery on maturity.
There is only an obligation to receive or pay a specified amount of cash in settlement at defined future points of time. In many countries, derivatives are known as “contracts for differences”. Forwards are customized transactions entered into on over-the-counter markets? The economic function of a forward contract is to fix a price in the future.
There are several methods used to tax financial futures. Some of them tax profits and losses on futures as ordinary income, and others as capital gains and losses. Besides tax rates, countries also differ on the time when the profits and losses on financial futures are recognized.
Three principles commonly used are:
(a) Realization principle,
(b) Mark-to- market principle, and
(c) Matching principle.
The matching principle best meets the goals of neutrality toward hedging transactions. Derivatives markets thrive on low transaction costs.
Options give the right to buy or sell at a specified price (“strike price”) for a premium payable by the buyer (“call option”) or seller (“put option”). The time value of money affects the market price of the premium. In the United States, no tax consequences occur until the option is exercised, expires or is sold.
On exercise, it is added to the cost of the buyer for a put option and as income of the seller for a call option. Any gain or loss on lapse or sale is capital gains unless the option is held or issued in the ordinary course of business or trade.
Options are bets on volatility. Buying an option entails an upfront payment. In contrast, the seller of an option receives the premium, and faces the possibility of having to make a payment in the future. Options on interest rates are called caps, floors, and their combination, collars.
Instead of actually buying the asset, it is sufficient to define a cash payment on exercise. From a tax viewpoint, however, cash settlement creates a realized profit. However, even though the positions are economically equivalent, the problem is that they may be taxed differently, therefore creating opportunities for tax arbitrage.
A swap transaction is an arrangement under which two parties agree to pay each other defined amounts or a series of amounts at defined times, but with a different character. In a swap transaction, each party makes simultaneous payments based on a notional principal amount at a specified rate or index and settle any difference in cash.
Swaps are used more often to hedge market risks but can be used for speculative transactions as well. Typically, the swap is made through a financial institution which holds a balanced portfolio of contracts. Most swaps can be analyzed as a series of forward contracts.
The issue is whether the payments under the swap are in the nature of interest. The term “debt-claims” is not defined in the Model treaty. Although there is a possibility that a country could treat interest rate swaps as a “debt-claim”, most countries regard periodic payments as business income and expense.
Non-periodic payments may be treated similarly or amortized over the term of the instrument. Lump sum payments might be subject to withholding tax. However, if they are treated as contractual payments, then the “other income” Article (Article 21) should apply. Under the UN Model, the source State could tax the payment and would not be bound to provide any reductions in withholding rates, as required by Article 10.
(d) Hedge instruments:
As hedge instruments, DFIs may be used to decrease or neutralize an existing or future risk due to price, currency or interest rate changes. The seller takes a short position in the underlying and the buyer takes a long position in the future contract. It is not common to pay a premium when the contract is made.
However, in exchange- traded contracts a margin deposit is payable by each party, which is adjusted daily on mark-to-market basis. They can therefore be used for speculation; however, more often they are used for hedging.
The hedging may be complete or partial for a specific risk, or again apply to a group of underlying positions. Alternatively, the users may wish to take open speculative positions for a profit.
DFIs may also be traded for arbitrage purposes to take advantage of the volatility in financial and other markets. In such situations, they neutralize or limit the rate differences in global markets through arbitrage transactions, when current risks and rewards vary in different locations.
(e) “Synthetic” investments:
The two basic building blocks of derivatives are forward rate agreements (including futures) and options. The former (e.g., forward contract) fix the price of an asset by obliging one party to purchase the asset at a specified price. The latter (e.g., options) are contingent contracts where the payment or receipt is conditional on probabilistic outcomes.
Depending on whether the payment is contingent (e.g., option) or non-contingent (e.g., forward), there could be wide variations in the transactions. Moreover, they can be combined with traditional instruments to achieve any desired economic outcome or risk exposure through synthetic instruments.
Examples of Tax Planning:
Derivatives can be used to take advantage of inconsistencies in the tax treatment of debt and equity under various derivatives.
Some examples include:
(a) Derivatives have the ability to move assets and liabilities (including cash flows) to achieve an economic effect, which is different from the economic effect that is reported in a company’s financial statements. They also offer the potential to move assets and liabilities (including cash flows) from one accounting period to another.
(b) A forward contract may be used to avoid payment of withholding tax on interest. For example, it is possible to borrow in a hard foreign currency with a low interest rate instead of borrowing in a weak local currency with a high interest rate.
The debt is repaid at maturity through the purchase of hard currency under a forward contract. Instead of paying a large amount of interest, most of the interest payment is effectively converted into a payment which is not subject to withholding tax, and the loan amount as purchase consideration is fully deductible.
(c) Dividend withholding tax can be avoided by entering into an equity swap with a local bank, which purchases the underlying shares. There is no withholding tax when the dividend is paid to the bank as a domestic shareholder. The bank offsets this dividend income with the dividend equivalent amount payable under an equity swap to the foreign investor, free of withholding tax.
(d) Most countries do not apply withholding tax on payments to nonresidents under derivatives. If no withholding tax is levied, derivative transactions may be used to avoid withholding tax on dividends and interest.
As derivatives can also be combined to behave economically like non-derivative financial instruments, they can be used for tax avoidance. Derivatives can convert an investment from one type to another with similar economic characteristics. They may also be characterized differently, e.g., ordinary income or capital gains, or taxed in different periods (e.g. realization v accrual basis).
A country that imposes a withholding tax on derivatives payments faces difficulties. Firstly, it requires that all derivative payments be subject to withholding tax since, virtually, anything that can be done by a swap can also be done by options, futures or forward transactions. Secondly, it makes derivatives unprofitable.
Most tax treaties exempt derivative payments from withholding tax under the capital gains or other income article. Their low margins do not permit withholding tax in the source State on transactions that are economically loans. These practical limitations on derivative transactions force tax authorities to apply substance over form rules to avoid tax avoidance, if they cannot impose withholding tax.
Derivatives also raise classification issues under tax treaties. Income may be taxable as business profits, capital gains or other income depending on the domestic law and treaty interpretation. If income and capital gains are treated differently, different reliefs, exemptions and allowances are available in respect of their cash flow. These inconsistencies in tax treatment provide opportunities for cross-border tax planning.
Tax Planning: Technique # 4. Transfer Pricing and Tax Planning:
International business operations have benefited from globalization and advances in telecommunications, electronic data systems and business practices and become truly multinational.
Although functional reorganization of multinational groups is normally dictated by economic efficiency considerations and lower costs due to location savings, they may also be undertaken for global tax minimization. Taxes are a significant cost of global business operations of MNEs.
Multinational enterprises (MNEs) have the flexibility to locate their business operations wherever they wish. They are not restricted by national borders and operate globally based on economic efficiencies.
Their search for cost reductions leads to outsourcing and offshoring functions to lower cost centres, particularly developing countries (Examples: India and China), global or regional regrouping of functions to achieve economies of scale, and worldwide cooperation in functions, such as research and development activities and customer relationship management.
Use of Transfer Pricing Guidelines:
The transfer pricing rules under the OECD Guidelines provide opportunities for tax planning, for both affiliates and permanent establishments. The functional analysis allocates the contribution made by an entity or transaction, based on the functions performed, taking account of the risks assumed and tangible and intangible assets used. It follows the economic principle that higher functional responsibilities, risks and assets justify higher levels of profitability.
When profits are allocated under the OECD Transfer Pricing Guidelines, the global activities can sometimes be restructured to move high-risk (i.e. high value) activities and valuable intangibles to low-tax jurisdictions and vice versa.
If the functions are genuine, the risks real and effectively transferred, the intangibles appropriately transferred, the income allocation based on the selection of the transfer pricing method and proper comparables with the necessary documentation, the tax authorities may find it difficult to deny the structure and transactions of the taxpayer.
As an example:
(a) A MNE may establish a trading company in an intermediary low-tax country to plan, manage, supervise, and control the functions and also manage the risks. The trading company purchases and owns all inventories (and even assets) and provides them to a contract manufacturer based in a high tax jurisdiction.
It also owns the intangible property (both trading and marketing) relating to the manufactured products and allows the contract manufacturer the use of these intangibles solely to make the products on its behalf.
The contract manufacturer in practice would usually receive a cost plus fee for its manufacturing activities, and allow the remaining manufacturing profits to be retained by the trading company in a low-taxed jurisdiction.
If other functions, such as research and development, treasury, human resources, are performed in high-tax countries, a local affiliate performs the functions for the trading company and receives a fee as a risk-free return.
(b) Manufacturing activities may be organized as a riskless contract or toll manufacturer. A contract manufacturer owns the plant and machinery and employs the labour force, but instead of making goods, holding them as stock and selling them to distributors, it makes the goods only for the principal.
He owns the raw materials and work-in-progress, but does not carry the risks associated with holding finished goods or selling them. In toll manufacture, the principal retains the title to the goods throughout the manufacturing process.
He buys the raw materials or semi-assembled goods and bears all the inventory and selling risks. Both of them receive an arm’s-length fee or margin only for their virtually riskless functions, usually calculated under the cost-plus method.
(c) Sales and marketing operations in high-tax countries may be organized as limited- risk distributors, commission agents, or commissionaires for the trading company to divert profits to a low-taxed base.
A commissionaire under civil law provides a low-risk distributor arrangement where a person represents the principal in his local market without revealing his relationship. Like a buy-sell distributor, he acts in his own name, but on behalf of and at the risk of the principal.
He does not take legal title to the goods, and is only entitled to a commission from the principal. The products remain the property of the principal until they pass directly from the principal to the customer. The functions and risks involved with buying and holding stock and the credit risk of selling the goods stay with the principal.
It differs from a limited-risk distributor, who retains the risks relating to inventory and debtors, but subject to reimbursement by the principal. A commission agent solicits customers for a fee but does not negotiate or conclude contracts with them.
(d) The trading company guarantees the marketing affiliate a fixed return (typically a percentage of sales) for its activities and assumes most of the risks of the marketing operations in the country.
The trading company, rather than the local affiliate, owns the inventories sold into the local market, holds the customer accounts receivable, pays all advertising and promotion expenses in the local market, and bears the credit, foreign currency, and product liability risks. Again, this structure enables the bulk of the profits to be extracted in a low-tax jurisdiction.
The change from a decentralized business model to a centralized or even global business model using “shared services centres” may be motivated by economic considerations, such as changing customer demands, to capture synergies and opportunities to reduce costs. Some multinationals favour a strategy of centralizing their administrative functions, while others tend towards operational autonomy.
In this new model, functions, such as procurement, supply chain management, product management, marketing, pricing, and credit & collection, etc. may be centralized. They may also be used for tax planning to shift taxable profits through transfer of functions, assets and risks.
The Transfer Pricing Guidelines and the proposed PE attribution rules open up possibilities for international tax planning through transfer of functions, assets and risks among associated enterprises and permanent establishments.
It is possible through tax effective supply chain management to ensure that significant profits are retained in a low-tax intermediary jurisdiction by splitting business functions and transferring risks to low-tax jurisdiction. It should also be possible to split the functions into separate operations and locations or treating them as auxiliary and preparatory activities.
As in all tax planning, it is usually easier to plan for profit diversion in a new structure than through changes in an existing structure. In other words, income can be kept outside a jurisdiction’s tax net from the outset through appropriate corporate structures allocating functions, assets and risk, than to divert it once it has already been included in the taxable income, and has a tax history.
Increasingly, MNEs are changing their global structure to transfer functions, risks and intangibles to group companies in low-tax jurisdictions. Therefore, high-risk intangibles are owned by low-tax jurisdictions, and full-fledged manufacturing and distribution activities are reorganized as low-risk contract manufacture or stripped buy-sell distributor arrangements in high-tax countries.
Although these new structures help minimize global taxes for multinationals, the changes in the supply chains adversely affect global taxes through base erosion and the global allocation of tax revenues of both source and residence countries. They also create certain other tax anti-avoidance issues. Some of them are discussed below.
Normally, the commissionaire arrangement should not create a permanent establishment since it does not involve any authority to conclude contracts required by a dependent agent under OECD MC Article 5(5).
A commissionaire only concludes contracts in his own name and binds himself. However, several countries (Examples: Australia, France,Germany, Italy, Japan, Korea, United Kingdom) disagree with this view and treat them as dependent agency PEs with authority to conclude contracts on behalf of their suppliers or principals.
A dependent agency PE also raises the issue of attribution of profits, which is taxable in the source State.
In such a case, an arm’s-length commission to the agent for his activities should reduce such profit to a nil figure (“single taxpayer approach”), unless the profits attributable to the dependent agency PE are in excess of the commission fee (e.g. when intangibles that belong to the foreign resident are attributed to the dependent agency PE for the purposes of taxable profit allocation).
Several tax administrations (including the OECD) take a “two taxpayer approach”.The agent (which may be a subsidiary) and the dependent agency PE of the foreign resident are two different legal entities, each of which is taxable in the source country.
The transfer-out of risks from the agent does not avoid the profit attribution to the dependent agency PE unless the related significant people functions are also carried outside the source State or performed by third parties. The restructure from a fully-fledged to a risk- free entity of an existing global enterprise may also raise transfer-pricing issues.
For example, the change in tax status of the stripped entity may justify a tax demand for imputed termination or compensation claims as well as capital gains tax on presumed transfer of intangibles to the trading company.
According to the OECD Transfer Pricing Guidelines, the tax authorities cannot ignore the form and restructure the taxpayer’s transactions for transfer pricing purposes, unless:
(a) The economic substance of the transaction differs from its form, or
(b) The form and substance of the transaction are the same but the arrangements made in relation to the transaction, viewed in their totality, differ from those which would have been adopted by independent enterprises behaving in a commercially rational manner.
Moreover, the actual structure must practically impede the tax administration from determining an appropriate transfer price. They should determine the transfer pricing consequences based on transactions actually undertaken by the taxpayer as they have been structured by it. However, they may still apply anti-abuse rules and restructure transactions for reasons other than transfer pricing.
In theory, any function or process can be reallocated with or without the attached risks. Risks can be transferred through a contractual arrangement or a change in the transfer pricing system, or by an asset transfer.
In general, the bulk of the profits or losses should be allocated to the company that assumes most of the risks while functions make a smaller profit contribution. Assets include both tangible and intangible assets.
The transfer of intangible assets creates complex issues in both how they are identified and then valued. Identifiable intangibles are those that generate a measurable amount of economic benefits. Non-identifiable intangibles form part of goodwill. In case the functions, risks and assets constitute a business, the related goodwill should also be transferred.
However, tax administrations are increasingly vigilant and tend to question whether the transfer of functions, assets and risks is effective and was made at arm’s-length conditions; whether the restructuring itself was properly compensated where appropriate; whether the post-restructuring arrangements are remunerated at arm’s length; and whether a PE can be found to exist after the restructure (Article 5(1) or 5(5) of the Model Tax Convention) to which profits should be attributed in excess of the profits attributed to the stripped entity.
Tax Planning: Technique # 5. Use of Offshore Trusts:
The main applications for trusts in international tax planning relate to:
(a) Cross-border estate tax planning for families,
(b) Providing tax-efficient pre-immigration vehicles for individuals and families moving to a new jurisdiction, and
(c) Providing a tax efficient vehicle for investing in another jurisdiction.
The structure depends on the residence or domicile of the settlor, the type of trust and the location of the beneficiaries and trustees. Several countries (Examples: New Zealand, United Kingdom, United States) offer international trust structures, which are tax exempt provided the settlors, beneficiaries and the assets are nonresident. It is also possible to take advantage of tax treaties in certain jurisdictions.
Under the domestic law in many common law countries, trusts are generally taxed as individuals with certain modifications. The trustee(s) are taxable on the trust income as a separate physical person and file a tax return on its behalf. The trust pays tax on its income at the top marginal individual rate on its worldwide income.
In some countries, the trust is taxed only on the retained income while the distributions are taxed directly in the hands of the beneficiaries. The trustees can therefore decide the taxable income and the trust is fiscally transparent to that extent.
Hence, there are two main systems for taxing trust income:
(i) The trust is taxed on the entire income of the trust and the income is either tax- exempt or creditable for the taxes paid by the trust when distributed to the beneficiaries.
(ii) The beneficiaries pay the tax on the distributions made to them, and the trust pays the tax on the remaining undistributed income. Any taxed income of the trust is subsequently distributed tax-free.
Offshore trusts provide opportunities for tax planning based on differing tax rules affecting them in different jurisdictions. For example, in an offshore trust, normally both the settlor and the beneficiaries are nonresident and the income is foreign-source. The trust income is usually not taxable either on the trust or its nonresident beneficiaries.
Moreover, a beneficiary resident in an onshore jurisdiction is generally not taxable at home on the trust income, unless he has a vested interest or the trust funds are distributed or applied for his benefit. Thus, the income in which he has a contingent interest can be accumulated tax-free in a low-tax jurisdiction.
Tax planning using offshore trusts requires the settlor to transfer his property to a trust in a jurisdiction where:
(a) The trust income can be received from the source State at nil or low withholding tax,
(b) The trust itself is tax exempt on its income and can pay it out without withholding tax in its jurisdiction, and
(c) There is no taxation in the state of the beneficiary. Such tax planning usually needs the trust to be located in a state where it is recognized under its laws, has a treaty network and is tax exempt under the domestic law.
Several international financial centres have tax treaties, which can be used for planning purposes using their offshore trusts.
International trusts are treated as resident but not domiciled and are eligible for treaty relief. The tax residence is based on the residence of the trustee. While retained domestic source income of the trust is taxable, foreign source income is not taxed. This income can be received, whether remitted or not, and distributed tax-free to nonresident beneficiaries.
Offshore trusts may elect to be either resident or nonresident (by annual election) for tax purposes. Nonresident trusts are fully tax-exempt, but cannot avail of tax treaties. As resident trusts, they pay tax on their income at an effective 3% rate and income distributed to beneficiaries is fully exempt.
(c) New Zealand:
The foreign income of a New Zealand trust is fully tax-exempt provided the settlor and beneficiaries are nonresident, even if it is not distributed. If the trustee/ s are tax resident, the trust can avail of its tax treaties as the trustee qualifies as a beneficial owner for treaty benefits.
(d) United Kingdom:
A UK trust with nonresident settlors and nonresident beneficiaries is usually tax-exempt on trust income, except for the income it makes for itself as the UK trustee. The trust is not taxable on UK capital gains and income but is treated as resident for treaty purposes.
(e) United States:
The United States follows a “flow through” approach. It includes trusts as persons for treaty purposes. However, the term “resident” under the treaty applies only to the extent it derives income, which is taxable as income of a resident either in the hands of the trustees or the beneficiaries.
Thus, trusts are useful for treaty shopping. The relevant treaty is between the State where the trustee or trust is tax resident and the jurisdiction where the trust asset or source is located. The United States and Canadian tax treaties treat a trust as a taxable person.
In New Zealand, a trust whose settlor is nonresident is not liable to tax on non-New Zealand income, but is a resident for treaty purposes. Similarly, in the United Kingdom a nonresident person can establish a UK trust which is tax-free for foreign income and capital gains regardless of location of the asset.
A trust involves a relationship between:
(i) The trustee and beneficiary,
(ii) The beneficiary and trust asset/source, and
(iii) Trust asset/source and trustee.
(iv) There may also be another relationship between the settlor and trust asset or source in certain countries under their anti-avoidance rules.
These relationships may lead to dual or triangular taxation. Such situations also provide opportunities for tax planning using hybrid trust entities. In some countries, the trust arrangement is regarded as ‘transparent’ and the taxing authorities look through to the beneficiaries for tax purposes whilst in others, the trust is ‘opaque’ and the trustees are treated as owners.
As part of tax planning, a trust may be preferable to a company. The use of trusts provides other non-tax benefits as compared to a corporation. Unlike a company, the terms of a trust document are private and subject to less disclosure.
Generally, only the settlor and trustee have full knowledge and the beneficiaries are only entitled to limited information on the trust and its activities. An inter vivos trust may also be used as an alternative to a will to avoid probate administration to make distributions of income and capital following a death.
They also provide greater flexibility in their structure than a company, which is subject to detailed regulations and corporate laws as well as anti- avoidance rules. Offshore trusts may not be subject to controlled foreign corporation rules and thin capitalization rules since they are not corporate entities.
Many developed countries have enacted special anti-avoidance rules to counter the abuse of offshore trusts. Detailed reporting obligations are frequently imposed upon certain persons associated with the establishment of trusts.
In order to impose taxation, a taxing authority must first know that a chargeable event, such as the creation of a trust, has happened. They have complex provisions regarding how trusts shall be taxed and also how trusts can be prevented from being used for tax avoidance.
Special rules often apply to nonresident trusts that defer foreign source income through nonresident discretionary funds. In their case, the ultimate beneficiaries are not known until the distribution is made.
Some countries treat them like a grantor trust (Example: Australia, New Zealand, United Kingdom, United States) while others treat the trust as resident and make the trustees and resident beneficiaries jointly liable for tax in the income (Example: Canada).
The high level of confidentiality, particularly in respect of the settlors and beneficiaries, in offshore trusts has also led to demand for greater disclosure requirements to combat money laundering and tax evasion in recent years. Besides ensuring legal compliance, as part of tax planning advance tax rulings should be obtained, wherever they are given.