Inbound Developments. Your panel

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1 Inbound Developments 29 th Annual Institute on Current Issues in International Taxation JW Marriott, Washington, DC December 16, 2016 Your panel Chair: Mary C. Bennett Baker & McKenzie LLP Panelists: Joan C. Arnold Pepper Hamilton LLP Amanda P. Varma Steptoe & Johnson LLP Quyen Huynh Associate International Tax Counsel Department of Treasury Sharon Porter Director, Treaty & Transfer Pricing Operations, IRS 2 1

2 Today s topics The IRS s inbound distributor transfer pricing pilot program Withholding tax developments Cashless withholding Section 305(c) proposed regulations, FATCA, LOB codes on Forms W 8BEN E and 1042 S The US Model Treaty and its effect on inbound deals Transparency proposed section 6038A reporting by wholly owned LLCs 3 IRS S INBOUND DISTRIBUTOR TRANSFER PRICING PILOT PROGRAM 4 2

3 Inbound Distributor TP Pilot Program LB&I realigned to be more issue focused and utilize up front issue identification. Our inbound distributor transfer pricing pilot is testing up front issue identification. This pilot began in 2015 by training 19 revenue agents with basic international law and specific training on the issue focus is on inbound distributors. We expanded the pilot in 2016 to bring in an additional 17 revenue agents. All Revenue Agents are supported by experienced international examiners and economists. 5 WITHHOLDING TAX DEVELOPMENTS 6 3

4 Withholding Dividends and Deemed Distributions Convertible noteholders U.S. Cor p Stockholders Dividend s Dividends and interest subject to 1441 and 1471 withholding unless an exception exists. No surprises there Deemed distributions on convertible instruments change in conversion ratios change in redemption price difference between redemption price and issue price redemption treated as 301 dividend similar transactions Treated as a distribution on stock under 305(c) if the holder has a proportionate increase in e&p/assets as a result of such action, and there is a concomitant taxable distributor to stockholders, and it is not an anti dilution protection 7 Deemed Distributions Example Convertible Instruments Warrantholders Convertible Noteholders U.S. Cor p Stockholder s When a convertible note or a warrant is issued, there is a ratio at which the note or warrant may be converted into stock of the issuer Certain corporate actions may alter the ratio, so that the holders are entitled to more stock of the U.S. Corp on exercise For example, if U.S. Corp pays a dividend to the stockholders, the note and warrant holders do not participate because they are not stockholders To maintain value, the conversion ratio of the note and warrant would be adjusted to provide that the holders have the right to get more stock on exercise 8 4

5 Convertible Bonds Example U.S. Corp issues $10MM in convertible bonds with a 5% yield. Assume that the stock price on date of issuance is $40 a share, and it is a 1:1 ratio. One bond gets the holder one share (there would normally be a premium) Assume U.S. Corp pays a taxable dividend in cash to stockholders, which the note holders don t receive To put note holders in same economic position, assume the exchange ratio changes to 1:1.25 one bond gets the holder 1.25 shares That is a 305(c) deemed distribution 9 Deemed Distribution Issues What causes a deemed distribution? What is the amount? At what point in time does it occur? What are the withholding obligations and upon whom are they imposed? Reporting obligations 10 5

6 What Causes a Deemed Distribution Clarification, no real changes to 305(b)/(c) Generally changes in conversion ratios, changes in redemption prices and similar transactions if the result is that the holders of the convertible instrument have an increased interest in the e&p/assets of the company 11 What is the Amount of Deemed Distribution to Noteholder? Possible alternatives today (at Holder s Election) (New conversion ratio old conversion ratio) X stock price = amt of deemed distribution Effectively the current value of the incremental stock that can be obtained on conversion OR the value of the option to acquire the incremental shares on conversion Proposed regulations when finalized The value of the option component of the note after the deemed distribution less the value of the option component of the note before the deemed distribution 12 6

7 What is Amount if Deemed Distribution is to Stockholder? Actual value of shares that are deemed distributed There is no optionality present in this case 13 Timing of Deemed Distribution The earlier of the date upon which the conversion ratio adjustment is effective under the terms of the convertible instrument, or the date of the actual distribution that gives rise to the deemed distribution If the convertible instrument doesn t provide the date on which the conversion ratio adjustment is effective for publicly traded stock, use ex dividend date for non publicly traded stock, date a stockholder is entitled to the actual distribution that triggered the 305(c) 14 7

8 Withholding on Deemed Distribution Who is the withholding agent? Direct Holders of CN DTC Holder of Record of CN U.S. Corp U.S. Corp is withholding agent as to the deemed distribution to the direct holders of the convertible notes DTC provides U.S. Corp with W 9, which ends U.S. Corp s 1441 and 1471 withholding obligation DTC is then a withholding agent as to the deemed distribution that passes through to the beneficial holders 15 Withholding on Deemed Distribution Current regs generally preclude withholding if there is no control over property or money, but that exclusion doesn t apply to distribution with respect to stock Proposed regs W/H Agent, other than issuer, Withholds if before due date for filing from 1042 the issuer meets its obligations for reporting the deemed distribution, or the W/H agent has actual knowledge of the deemed distribution If W/H Agent, other than issuer, does not have actual knowledge, and the issuer has failed to property report, the W/H Agent is off the hook for withholding 16 8

9 Withholding on Deemed Distribution If W/H Agent has obligations to withhold, payment is due on the earlier of date of cash payment with respect to the security date the security is transferred out of the custody of W/H Agent due date for the W/H Agent to file its form 1042 for the year in which the deemed distribution occurs 17 Withholding on Deemed Distributions CN Holders interest, deemed distribution U.S. Corp Customer s DTC CN Holder interest, deemed distribution The interest payable in cash would be a source of funds to collect withholding on deemed distribution If note is high yield, PIK, no cash to W/H? 18 9

10 Withholding on Deemed Distribution Cashless withholding issues W/H agent is ware of the deemed distribution,but has no cash from which to collect. Warrants that have a deemed distribution but expire worthless Holdco receives a deemed distribution but it transfers the note to a new withholding agent before a withholding date occurs. Old W/H Agent remains liable for the tax 19 Reporting Form 8937 the missed and misunderstood form. Required to be filed with the IRS within 45 days of deemed distribution, or if earlier, January 15 of the next year, or posted to website within 45 days of deemed distribution No late election relief Under proposed regs, would need to be filed even for normally exempt recipients like C Corps, so W/H Agents can fulfill obligation 20 10

11 FATCA Final revised QI, WP and WT due out and implemented by December 31, 2016 Temporary regulations sunset in 2017 Update on status 21 Revised Form W 8BEN E Form W 8BEN E was revised in April 2016 to require a foreign entity claiming treaty benefits to identify which LOB provision it satisfies Form 1042 S was also updated to add an LOB reporting code In October 2016, the IRS stated that withholding agents may accept the prior (February 2014) revision of Form W 8BEN E until January 1,

12 Enhanced QI LOB Procedures Notice contains a proposed new QI Agreement that, among other provisions, would require the collection of new LOB information for entity account holders claiming treaty rates of withholding Generally required for accounts opened or documented on or after January 1, 2017 For pre existing accounts (subject to change in circumstances): Forms W 8 may be relied upon until normal expiration period Where account was documented with documentary evidence, there is a two year transition period for collection of information New LOB information may be Form W 8 or treaty statement containing LOB certification QI cannot rely on LOB claim if it has actual knowledge or reason to know claim is incorrect Reason to know=treaty under which benefits are claimed does not exist or is not in force 23 U.S. MODEL TREATY 24 12

13 2016 U.S. Model Treaty Certain draft provisions released in May 2015 for public comment Final Model released February 2016 Preamble explaining certain changes also released Model Technical Explanation not yet released U.S. Model Treaty Since the release of the 2016 U.S. Model, Luxembourg and Ireland have announced they are renegotiating their U.S. tax treaties Eight treaties/protocols await Senate approval Country Date Signed Chile (Treaty) February 4, 2010 Hungary (Treaty) February 4, 2010 Japan (Protocol) January 24, 2013 Luxembourg (Protocol) May 20, 2009 Poland (Treaty) February 13, 2013 Spain (Protocol) January 14, 2013 Switzerland (Protocol) September 23, 2009 Vietnam (Treaty and Protocol) July 7,

14 Key New Provisions Denial of withholding tax reductions for certain payments subject to a special tax regime Denial of U.S. withholding tax reductions for certain amounts paid by expatriated entities Revised triangular PE rule Provisions to address subsequent changes in law Revised LOB article Mandatory binding arbitration 27 Special Tax Regimes Special Tax Regimes provisions would deny reductions on withholding tax rates for payments of interest, royalties, and guarantee fees to related persons where the recipient benefits from a special tax regime with respect to the payment Rule applies only to payments to connected persons (generally 50% relatedness threshold, or control based on facts and circumstances) 28 14

15 Special Tax Regimes (cont d) Special tax regime generally includes any statute, regulation, or administrative practice that Results in a preferential tax rate or permanent reduction in tax base for interest, royalties, or guarantee fees or certain companies not engaged in an active trade or business; In the case of royalties, does not condition benefits on the extent of R&D activities; Is generally expected to result in a tax rate equal to the lesser of 15% or 60% of the general statutory rate in the source state; Does not apply principally to pension funds, tax exempt organizations, or RIC or REIT equivalents; and Has been identified by the source state as a special tax regime and identified through written public notification (after consultation with the residence state) 29 Payments by Expatriated Entities Treaty benefits for U.S. withholding taxes are denied for U.S. source Dividends, Interest, Royalties, and Guarantee fees treated as other income paid by a U.S. company that is an expatriated entity, as defined in the Code, to a connected person. Expatriated entity is fixed to the meaning it has under section 7874(a)(2)(A) as of the date the bilateral tax treaty is signed Preexisting U.S. subsidiaries of the foreign acquirer generally are not expatriated entities for purposes of the treaty unless, after the acquisition, such entities join in filing a U.S. consolidated return with the domestic entity or another entity connected to the domestic entity prior to the acquisition Provision applies for 10 years after inversion 30 15

16 Payments by Expatriated Entities: Example Assume: FP is a surrogate foreign corporation under section 7874 with respect to USCO USS is a historic FP subsidiary (never related to USCO) Treaty benefits are denied for dividends paid by USCo and interest paid by USCo Sub Provision does not impact eligibility of USS dividends for treaty benefits Historic FP shareholder s 35% FP 65% (Countr Dividend y X) Dividend USCo USCo Sub Historic USCo shareholders USS Interest 31 Triangular PE/Exempt PE Provision Article 1(8) would deny treaty benefits where income is derived from the source country and the residence country treats the income as profits attributable to a PE outside the residence state, and The PE profits are subject to an aggregate effective rate of tax in the residence state and the PE that is less than the lesser of 15% or 60% of the residence state company tax; or The income is excluded from the tax base of the residence country and attributable to a PE in a third country that does not have a tax treaty with the source country The United States and Luxembourg have announced their intent to include such a provision in a protocol to the existing treaty Treaty Co P E Loa n US Interest 32 16

17 Subsequent Changes in Law Provision is triggered if a treaty partner s general rate of company tax falls below the lesser of either 15 percent, or 60 percent of the other country s general statutory rate of company tax Treaty partners to consult to determine if amendments to the treaty are necessary to restore an appropriate allocation of taxing rights between the two countries It is only after such consultations fail to progress that a treaty partner may issue a diplomatic note stating that it will cease to grant certain benefits under the treaty 33 Model LOB Article: Key changes and new features Inclusion of derivative benefits test New QIO requirement for intermediate owners Headquarters company test Refined active trade or business test Refined base erosion tests 34 17

18 Derivative Benefits Test First time included in U.S. Model Requires: Company to be 95% directly or indirectly owned by 7 or fewer equivalent beneficiaries Equivalent beneficiary is: Generally a person entitled to benefits under a treaty with the source state by virtue of being an individual, government, pension, tax exempt organization, or publicly traded company» Not limited to EU or NAFTA residents Entitled to treaty benefits that are at least as favorable as those sought Any intermediate owner must be a qualified intermediate owner ( QIO ) Company and tested group must satisfy a 50% base erosion test 35 Derivative Benefits Test Dividend, interest, and royalty articles have provisions addressing cliff effect issue under derivative benefits test In this example, instead of denying treaty benefits completely (resulting in 30% withholding), the tax charged shall not exceed the highest rate that the equivalent beneficiaries would have been entitled if they had received the payment directly (10% in this case) 10% treaty rate on direct dividends 5% treaty rate on direct dividends FP (Country X) FS1 (Country Y) USS Dividend 36 18

19 Intermediate Owner Requirements Subsidiary of publicly traded company, ownership/base erosion, and derivative benefits tests look to whether any intermediate owner is a QIO QIO= Resident in same country as entity seeking benefits, or Resident in a third country that has a tax treaty with the source state that includes STR and notional interest deductions analogous to those in the Model 37 Intermediate Owner Requirements Test 2016 Model 2006 Model Subsidiary of publicly traded company test Ownership/base erosion test Derivative benefits Resident of source country or QIO QIO QIO Resident of either contracting state Resident in same country as entity seeking benefits N/A* * The 2006 Model did not contain a derivative benefits provision. Existing treaties with derivative benefits provisions generally do not contain intermediate owner restrictions

20 Qualified Intermediate Owner Example Assume that there is a new Country Z US treaty based on the 2016 Model Country X and Country Y have older U.S. tax treaties (without STR provisions) Assume all other relevant requirements are satisfied FS2 cannot satisfy derivative benefits test because Country Y treaty lacks STR provision What if FS1 were resident in Country X? What if FS2 were resident in Country X? FP (Country X) FS1 (Country Y) Publicly traded FS2 (Country USS Z) Interest 39 LOB Base Erosion Tests Base erosion tests are included in subsidiary of publicly traded company, ownership/base erosion, derivative benefits test, and headquarters company tests In general, requires that less than 50% of gross income be paid or accrued to: Persons not entitled to benefits as individuals, governmental entities, publiclytraded companies, or pensions or tax exempts, Connected persons that benefit from an STR with respect to the payment, or With respect to interest, connected persons that benefit from notional deductions

21 LOB Base Erosion Tests (cont d) Derivative benefits test looks to whether payments are made to persons that are not equivalent beneficiaries Even payments to equivalent beneficiaries are bad if the equivalent beneficiary benefits from an STR or notional interest regime Tests apply to company and tested group Tested group includes company seeking benefits and any company that participates with the tested resident in a tax consolidation or lost sharing regime 41 Mandatory Binding Arbitration Certain disputes between tax authorities must be resolved through mandatory binding arbitration The baseball or last best offer arbitration approach in the 2016 US Model is substantively the same as the arbitration provision that is found in 4 U.S. tax treaties in force and 3 additional U.S. tax treaties that are awaiting Senate approval

22 Other Provisions Direct Dividends 2016 Model contains 12 month holding period requirement to obtain 5% rate on direct dividends Beneficial owner must have been a resident of the other contracting state or of a qualifying third state Qualifying third state =State that has a treaty with the source state that would have allowed beneficial owner to benefit from a rate of tax on dividends that is less than or equal to 5% At least 10% of vote and value of payor must have been owned directly by the beneficial owner or a qualifying predecessor owner Qualifying predecessor owner = Connected person with respect to beneficial owner of dividend, and Resident of state that has a treaty with the source country and that would have allowed the predecessor owner to benefit from a rate of tax less than or equal to 5% 43 Other Issues Note age of treaties that may be renegotiated and evolution of treaty policy since then Ireland (signed in 1997) Luxembourg (signed in 1996) Others? Examples Publicly traded test in LOB Base erosion tests 44 22

23 PROPOSED SECTION 6038A REPORTING BY WHOLLY OWNED LLCS 45 Transparency U.S. DRE vs. U.S. Corporate Sub Currently SH SH For. Co For. Co U.S. LLC No EIN for U.S. LLC No U.S. tax return filed by U.S. LLC No readily apparent ownership info No clear delineation between U.S. income and For. Co income on 1120F (if it needs to be filed) U.S. Corp U.S. Corp has EIN Files 1120 Files 5472 showing For. Co ownership and related party transactions Requires maintenance of records 46 23

24 Why Use a DRE a Commercial Reason U.S. Corp $ services For. Co If services are performed outside U.S., For.Co is not ETB, no U.S. tax What if U.S. Corp will only contract with a U.S. entity? U.S. Corp For. Co U.S. LLC Mere existence of U.S. LLC does not cause For.Co to be ETB If services are performed outside U.S., still not ETB 47 Transparency Proposed 6038A U.S. is concerned that there is insufficient information collected to be able to provide information pursuant to treaty requests Proposed regulations Treat U.S. DREs as foreign owned U.S. corporations for SPECIFIC purposes of 6038A file 5472 maintain records sufficient to be able to complete Form 5472 obtain EIN, filing an SS 4 be able to report transactions with related persons, even though the transaction m ay not exist because U.S. LLC is a DRE Effective date 48 24

25 Inbound Developments Thank you! 49 25