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Achieving Tax Efficiency with cross-border services and royalties in Latin America

In the global economy the growth of royalties and services associated to intellectual property and information technology has become critical for international taxation. On one-side governments of importing countries regularly source payments as territorial, based on the jurisdiction or location of payor. On the other, exporting countries push to resolve the issue through tax treaties. Unfortunately for US companies, one of their natural expansion markets is a “no-tax-treaty battleground”: Latin America (only Mexico and Venezuela have treaties with the US. A treaty with Chile is expected to be ratified by both countries soon).

Achieving Tax Efficiency with cross-border services and royalties in Latin America presents an important tax planning challenge in outbound taxation for US companies; as the corresponding inbound activity in Latin American countries is subject to high rates of income tax withholdings, and eventually, reverse VAT issues. In countries like Brazil, on top the income withholding tax issues, the scenario becomes even more complicated when the CIDE tax becomes applicable. The CIDE tax is a 10% surcharge withheld on certain services or royalties considered to be importation of technology. As such, the CIDE tax will not be creditable against US income taxes under the Internal Revenue Code, as it is not an income tax nor in lieu of income taxes.

The subject has become increasingly important, particularly in absence of tax treaties. In the US, under the Internal Revenue Code, the tax credit system might be insufficient to resolve the issue from a cash flow perspective; and, secondly, it might present some tax optimization issues as well. Thirdly, another problem could arise when the royalty or service activity is parallel to certain support services, programming or commercialization activities in the importing country. Generally the use of independent contractors could be problematic and eventually not escape potential tax liability issues, including those emerging from the notion of “engagement in a local trade or business”, in absence of a protective permanent establishment provision per a tax treaty.

Three options to consider, from a tax planning perspective are:

1. Playing as a local with a Tax Hybrid. Reducing withholding taxation on the overseas service payments by creating a Sociedad de Responsabilidad Limitada (hereinafter referred as “SRL”), which is the equivalent of an LLC (or other eligible entity under the check-the-box regulations). This option is optimal when treaty networking becomes complex, expensive or unviable, as well when the growth is focused or concentrates in a particular country.

The SRL (or eligible entity) will become a tax hybrid, thus a disregarded entity in the US but a legal independent entity in the Latin American country. Accordingly the entity is a blocker and a conduit at the same time. As such, the parent company is protected from tax exposure or any other liability issues locally (particularly relevant when there is related marketing or support activity in the importing country), but from a tax perspective all taxes paid flow-through as direct tax credits, and all expenses as deductions, including as the latter all indirect taxes paid.

The key in this planning technique is that income tax withholdings on local payments for services or royalties are very low (or none), compared to the high rates applicable to cross border payments for the same. Additionally, the withholding tax is applicable over the gross amount paid, whereas the entity is taxed on a net basis. Most jurisdictions in Latin America do not tax dividends when declared after previously taxed profits or earnings, but this is an important issue to look country by country as a pre-condition, because it is necessary to ensure that surpluses flow back without tax implications. Thus, with proper planning, the efficiency and savings are significant.

In countries like Brazil, where strategizing becomes highly relevant not only from an income tax perspective but from a CIDE tax and indirect taxation perspective as well, there are additional options to bring efficiency. Brazilian tax law allows that any legal entity provided that its income is below the BzR$ 2.4 million threshold, to elect taxation under the simplified “presumed profits method”. One alternative to consider is to create one SRL for each contract or revenue stream from royalties or services, to meet the income threshold necessary to meet the presumed profits method election. Accordingly, in a service scenario, the presumed profits are considered to be 32% of gross revenue. With nominal tax rates in the 35%, the effective rate of taxation upon this election becomes 11,2 (compared to a 25% flat withholding rate applicable, including the 10% CIDE tax, when the payments are made directly to a foreign provider or licensor). Finally, any net profits accumulated at the local entity in Brazil can be repatriated as dividends at 0% income tax withholdings. Another advantage of the presumed profits method is that it will significantly simplify local compliance and reporting packages.

2. Treaty Networking. Avoiding withholding taxation on Service Payments adopting a Tax Treaty Country. Another approach if significant expansion is expected in several Latin American countries is to create an IP holding incorporated or filed on a jurisdiction with a good tax treaty network.

The critical factor is to overcome the limitation of benefit provisions provided under the treaties, as well as giving substance to the IP toolbox or holding. Jurisdictions of choice for Latin America are Spain and the Netherlands.

3. Transactional Structuring. Another alternative to avoid withholding taxation on royalties and technical assistance is by creating and selling a legal entity. This approach is relevant in a transactional planning scenario. An entity is formed in an offshore low tax and non-blacklisted jurisdiction (preferably with a tax treaty) and capitalized with a contribution in pre-paid royalties and services. Thereafter, the local client, affiliate or partner purchases the stock in the capitalized offshore entity.

A jurisdiction to consider in this planning technique is Barbados, as it is not blacklisted by the OECD and has tax treaties with a number of countries, including the United States.

Read more at: Tax Times blog

Foreign Investors in U.S. Partnerships Miss Schedule P

Foreign investors often miss Schedule P.

It applies to the ownership of any U.S. partnership including a limited liability company. Many foreign investors use a foreign corporation with the hope of avoiding US estate taxes. 

Now, the 2011 Schedule P (Form 1120-F) is required by a foreign corporation’s ownership of a U.S. partnership. Schedule P also reports the distributive shares of partnership effectively connected income and the foreign corporation’s effectively connected outside tax basis in interest. 
Part I is used to identify all partnership interests the foreign corporation directly owns that give rise to distributive share of income or loss that effectively connected with a trade or within the United States of the corporation. 

Part II is used to the foreign corporation’s distributive share of ECI and allocable expenses with the total income and expenses reported to it on Schedule K-1 1065), Partner’s Share of Income, Deductions, Credits, etc. 

Part III is used follows: The corporation’s outside its directly-held partnership that include ECI in the corporation’s distributive share is apportioned between ECI and non-ECI Regulations section 1.884-1(d)(3) determine the average value treated as asset for interest expense allocation purposes under Regulations.

Read more at: Tax Times blog

U.S. Wins Three Tax Cases Involving Big Banks, KPMG

United States prosecutors said Tuesday they had won three major cases against American clients of questionable tax shelters, including ones used by a Dallas billionaire and Wells Fargo Co. and others designed by Citibank and accounting firm KPMG LLP.

The separate cases, the verdicts of which were rendered in October, represent a significant victory for the Justice Department, which was sued by each of the three clients when the Internal Revenue Service denied their claimed deductions that totaled hundreds of millions of dollars.

The rulings also underscore how the two agencies, in the midst of a crackdown on offshore tax evasion by wealthy Americans at Swiss banks, are continuing to pursue corporate tax shelters used by large American companies.

In the first case, the 5th Circuit appeals court in New Orleans upheld a lower court ruling that D. Andrew Beal, a Dallas billionaire banker, improperly used a sham shelter to deduct $200 million in federal income taxes stemming from more than $1 billion on sham losses.

A Justice Department statement said the shelter involved Beal acquiring "a portfolio of non-performing Chinese debt for less than $20 million, disposing of the portfolio and generating more than $1 billion in artificial paper losses approximately equivalent to the debt's face value."

Beal is the founder of Beal Bank, a small bank headquartered in Dallas and is No.39 on the Forbes 400 list of wealthiest Americans with a $7 billion personal fortune.

In the second case, a federal judge in Iowa ruled that Principal Life Insurance Co., part of Principal Financial Group in Iowa, a large investment company, could not claim $21 million in foreign tax credits stemming from a $300 million transaction with Bred Banque Populaire and Natexis Banque Populaire, two French banks, from 2000 through 2005.

The judge found that the transaction lacked both economic substance and a business purpose -- two key features of questionable tax shelters -- and was a loan rather than an investment. The transaction, the judge ruled, was designed solely to generate foreign tax credits and thus violated anti-abuse regulations at the Treasury Department.

The complex transaction involved a Delaware company called Pritired 1 LLC, in which Principal Financial and Citicorp North America, a division of Citigroup, were the sole investors. Pritired, the tax matters partner in the lawsuit, sued the US government -- meaning, in this case, the IRS -- in 2008 after the agency disallowed its refund claims.

Court papers said that Bruno Rovani and John Buckens, both employees of a London-based division of Citi's Structured Products Group, Citi Capital Structuring Group, designed and carried out the transactions underpinning the shelter.

Principal Financial Group, a member of the Fortune 500 largest American companies, manages nearly $336 billion in assets, mainly retirement plans and investment funds. It manages 10 of the 25 largest pension plans in the world, according to its website.

In his decision, Judge John Jarvey wrote that "the facts of this case are exceedingly complex. American companies sent $300 million to French banks who combined the $300 million with $900 million of their own. The money was used to earn income from low-risk financial instruments. French income taxes were paid on the income from this approximately $1.2 billion investment."

The judge also said "the American companies received some cash from the income on the securities, but, more importantly, were given the ability to claim foreign tax credits on the taxes paid on the entire $1.2 billion pool. Through this transaction, the French banks were able to borrow $300 million at below market rates. The American companies received a very high return on an almost risk-free investment."

In the third decision, a federal judge in Minnesota disallowed a claim by a Wells Fargo subsidiary for more than $82 million in tax refunds.

The claim stemmed from a sham transaction in 1999, improperly valued at nearly $424 million, that involved capital losses stemming from Wells Fargo's transfer of "underwater" commercial leases to a subsidiary in conjunction with a related sale of stock to Lehman Brothers, the defunct investment bank. Wells Fargo had tried to claim the tax refunds on its 1996 corporate tax return.

Court papers show that Wells Fargo bought the shelter from the accounting firm KPMG LLP for $3 million in 1998, part of what court papers said KPMG characterized a "quick hit" tax strategy on the eve of Old Wells Fargo's merger that year with Norwest. Wells Fargo sued the US in 2007 when the IRS denied its refund claims.

Joel Resnick, a former KPMG partner, offered testimony in the case about KPMG having sold Wells Fargo a "tax product" called an "economic liability transaction," according to court papers.

"KPMG employees developing the economic liability transaction product knew that a company needed a non-tax business purpose to justify the transaction," wrote Judge John Tunheim, of Minneapolis, in his decision.

KPMG narrowly averted an indictment in 2005 over its sale of questionable tax shelters to wealthy Americans. It paid a $456 million fine and was put on probation through a deferred-prosecution agreement that has now expired.

Read more at: Tax Times blog

Final Form 8939 and Instructions Now Available

The IRS just released the final Form 8939 and Instructions.

Form 8939 is required to be filed by an Executor of a 2010 decedent’s estate to make the election to opt out of the federal estate tax system and apply the modified carry-over basis rules under Internal Revenue Code (“IRC”) Section 1022.

The deadline for filing Form 8939 is January 17, 2012. No further extension of time to file or to make the IRC Section 1022 election will be allowed.

Read more at: Tax Times blog