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THE FUTURE WORLD OF INTERNATIONAL TAX

Updated: 17 Mar 2017

The IBSA held its first Transatlantic video conferencing meeting at the New York and London offices of Squire Patton Boggs (SPB) on Wednesday 15th March. It was a fascinating insight into how the US and UK are likely to evolve their tax systems in the coming years, contemplating the proposed tax reform of President Trump in the US, and the Brexit consequences for the UK.

I introduced the proceedings by explaining what the International Business Structuring Association is all about, and how our discussion group meetings focus on areas of interest for all professional advisors of varying disciplines who help their clients develop their international business.  I then introduced Bernhard Gilbey of SPB as the moderator for the evening and despite several attempts to sabotage his own video conferencing facilities at the start of the meeting, our New York based attendees manged to see and hear the London meeting, and our London attendees were able to link up with both New York and with Mitch Thompson in Cleveland (following his failed attempt to arrive in snowbound New York). 

Jeremy Cape of SPB was the first speaker and explained that now that the Brexit Bill had passed Parliament, Theresa May is able to trigger Article 50.  However, he reassured the meeting that at this point, nothing changes tax-wise and existing legislation remains.  The UK is currently competent to set rates of tax, as indeed Ireland is able to do, even whilst remaining a member of the EU. In fact, it has become a very attractive jurisdiction partly because the European Court of Justice has ensured that rules such as the previous controlled foreign company laws in the UK, could not infringe freedom of movement and operational activities, a fundamental tenet of the European Union. 

Jeremy forecast that there may not be that many changes in UK taxation following Brexit, although there was the potential for a 15% corporate tax rate, and with the U-turn on National Insurance recently by Philip Hammond, it is unlikely that there will be major tax increases in the immediate future.  What may be different is the access to EU Directives such as the Parent/Subsidiaries Directive, the Merger Directive, or the Interest and Royalties Directive.  Here, US headquarter companies may ultimately find it expedient to transfer their EU subsidiary companies away from the UK, (where dividends can currently be routed from say Germany and Spain, without the withholding tax that would otherwise apply on a direct remittance to the US), to countries such as Luxembourg.  He completed his initial discussion by suggesting that VAT will not be allowed to change as it raises too much revenue, although when the UK leaves the EU there are certain anomalies in VAT legislation that may be amended to give a competitive advantage to the UK.

Bern then passed the floor to Mitch Thompson in SPB Cleveland to talk about the unprecedented potential changes in the US tax system.  Mitch gave as background information the fact that the US Government has operated in a deficit situation for many years and has the highest nominal corporate income rates of tax of any developed economy.  This, together with its global tax system as opposed to a territorial one provides little opportunity for permanent tax mitigation.  It now seems inevitable that there will be tax reform, and this is desired by both Democrats and Republicans, but with very different approaches of course.  In this way, the US can stop companies re-domiciling through corporate inversions into other jurisdictions.  However, with just 52 Republicans in the Senate and a requirement to have a 60+ majority, the only way of getting both health reform and tax reform through Congress is through the Budget Reconciliation Acts of which only one can be passed for any budget year.  It would appear that the Obamacare repeal is higher on the agenda than tax reform, and therefore any corporate tax reform is only after that issue is resolved. 

When it does happen, it is likely that corporate tax rates will indeed come down to perhaps 20%-25%, but at the same time deductions will be limited or eliminated.  In addition to eliminating net interest deductions, for example, new tax revenue will be needed from something like the border adjustment tax (discussed later), which could increase US tax costs in a novel manner. It is nevertheless likely that the US will migrate to a territorial system, as it has seen how attractive the UK system has been for holding companies, and there is certainly a requirement for wholesale changes to be made to the US tax code.  

Cees-Frans Greeven from Buren, the Dutch and Luxembourg lawfirm, then commented on the use of hybrid instruments and how countries such as the Netherlands and Luxembourg are adopting the OECD BEPS Action points.  He expressed some surprise that although the BEPS initiatives had only started in 2013 yet they had concluded in final recommendations in 2015.  However, the BEPS recommendations are indeed only recommendations and are in effect ‘soft law’, and implementation is necessary in each jurisdiction since there is no current enforcement mechanism for these recommendations. 

There is a consensus reached amongst many countries that hybrid mismatch is harmful to competition, but there is no firm consensus as to how interest deductibility is going to be limited, whether this be through the EBITDA rule limiting interest deductibility to between 10% and 30% of EBITDA, or based on the group ratio rules. 

However, the European Union is able to embrace the BEPS initiative and create ‘hard law’, so that effective from 21 February 2022, reverse hybrid mismatch denial will be applicable also in situations involving third (non-EU) countries, so that Luxembourg CPECs and the Dutch CV/BV structures may no longer be effective from 2022.  It is true that Luxembourg has been slow to implement EU directives, but the Netherlands may be quicker to embrace the initiatives adopted by the EU. 

In the final presentation before some very interesting questions, Robert Kiggins of Culhane Meadows talked about new US rules under Section 385 interest deductibility, and how generally speaking the US is not paying much attention to the BEPS initiative except in relation to interest deductibility.  Section 385 rules are now adopted and they potentially limit debt push-downs and other leverage transactions by recharacterising certain related party debt in the US as equity. He advocated two procedures to address these new Section 385 rules. The first is that there needs to be documentation to support any relevant loan agreements with effect from 1 January 2018, although compliance should commence now with lawyers documenting any loan arrangements.  He also discussed the so-called ‘re-cast’ rules where loans made to the US by foreign lenders may be considered to be re-cast as equity if they are made in connection with certain transactions, and these rules were effective from 4 April 2016. 

He warned that if interest is re-cast as dividends for example, then not only would the amount paid be non-deductible for US tax purposes, but could also be subject to the withholding tax that would normally be levied on dividend declarations.  The standard withholding tax rate is 30% if the recipient is not in a treaty jurisdiction, but otherwise would generally be between 5%-15% for double tax treaty jurisdictions.  He also highlighted that inter-company trade payables would fall within the new regulations, so that where there is an inter-company current account through trading activities, the account should be documented in terms of dates of repayment, interest rates and any other requirements normally applicable to loan arrangements. 

I started the question time with a rather flippant question given to me by Cees-Frans as follows.  “Which US president said this: “recently more and more enterprises organised abroad by American firms have arranged their corporate structures ….. so as to exploit the multiplicity of foreign tax systems and international agreements – in order to reduce sharply or eliminate completely their tax liabilities both at home and abroad?””  I asked any of the panel in both New York and London for their suggestions and amongst those who stated Barack Obama or Donald Trump came the right answer – John F Kennedy in 1961 with his message to Congress on taxation.  So, there seems to be no doubt that tax reform is a long awaited necessity in the US. 

The meeting then discussed the ‘destination based cash flow taxation’ system, otherwise known as the ‘border adjustability tax’.  This was quite revelatory since it basically creates a territorial system where, for example, a US company buying US source goods would be subject to normal taxation as at present.  However, those US companies exporting product out of the US would suffer no tax on sales proceeds, since such sales would be considered achieved outside of the US, ie a destination based system.  But the corollary of this is that those US companies importing goods from abroad and selling them in the US would not be able to deduct the cost of purchases from their sales proceeds, limiting deductions only to US labour costs and similar US source costs.  I asked Mitch whether any accountant had looked at these proposals (as opposed to lawyers), since clearly a company importing product from abroad and selling them in the US with a relatively small profit margin of say 10%, would nevertheless suffer a corporate tax rate of say 20% on its entire turnover, ie the tax payable would be higher than the profit margin.  Mitch responded that companies like Walmart, which bought most of their product from abroad, have been lobbying against this potential tax and the discussion continued as to the merits of attempting to create a territorial system through this method of taxation. 

The meeting also discussed whether this was in fact a tax or a tariff similar perhaps to VAT.  Mitch and Bob suggested that the border adjustability tax could be described in a similar way to VAT (with similar initials of BAT!), and Jeremy confirmed that if this were the case, double tax treaty arrangements would not necessarily apply, since a tax similar to VAT would not be similar to the ordinary corporate taxes covered by a double tax treaty.  This would give the potential for a huge amount of double taxation issues where the US were to tax under the border adjustability tax system, whilst say the UK were taxing on the ordinary global tax system.  He therefore believes that it would be impossible for the US to adopt such a system without other countries with whom the US trades adopting a similar system. 

Mitch stated that something does need to be done to reduce the revenue deficit resulting from US tax reform and thought that up to 50% of this could come from the destination based cash flow taxation system.  However, the lobby groups, such as Walmart and others, would have to create a sufficient number of exemptions that actually the tax raised may be significantly lower than anticipated through this new system of taxation. 

Finally, the meeting discussed the way in which tax administrations worldwide were becoming increasingly aggressive vis-à-vis the taxpaying community. For example, Bern mentioned the Apple case and how the position of the European Commission may not be as strong (in relation to State Aid) as they assert.  He suggested that the real reason for taking these cases to Court would be to deter taxpayers from adopting similar structures, and even if the case is eventually lost, the perceptive of tax planning would have altered.

He also commented that the number of judicial review cases in the UK is increasing due to the fact that tax administrations are not necessarily correct when interpreting government legislation, but have to create opportunities to increase the tax revenue of countries, and indeed other countries like France, Italy and Spain are similarly motivated. 

The meeting concluded with some drinks and excellent canapes supplied by Squire Patton Boggs for which many thanks both for hosting the event and the technical ability to create a three-way video conferencing meeting.