Category: International Taxation

“An undertaking to answer for the payment or performance of another person’s debt or obligation in the event of a default by the person primarily responsible for it.”

OECD’s Statistical Glossary defines Loan Guarantee as: “A legally binding agreement under which the guarantor agrees to pay any or all of the amount due on a loan instrument in the event of non payment by the borrower.”

Wikipedia defines Loan Guarantee as: “A loan guarantee, in finance, is a promise by one party (the guarantor) to assume the debt obligation of a borrower if that borrower defaults. A guarantee can be limited or unlimited, making the guarantor liable for only a portion or all of the debt.” A Guarantee may be implicit or explicit.

Implicit Guarantee
Implicit guarantee is one when the lender assumes that the borrower being part of a well known group or with financial backing of its parent company, its dues/debts are secured. In case of any unforeseen circumstances, the borrower will be rescued/bailed out by its parent or other group companies.

Implicit guarantees are informal and hence not enforceable in law. Implicit guarantees are not recognised by many countries and normally do not enter the transfer pricing arena.

Explicit Guarantee
Explicit guarantee is one where a formal guarantee agreement is executed whereby the guarantor undertakes to make good loss to the lender in case of default by the borrower. Guarantee commission on explicit guarantees between Associated Enterprises (AEs) needs to be benchmarked on an arm’s length basis applying provisions of the transfer pricing regulations.

Other types of guarantees are letter of comfort/letter of intent whereby the parent company assures the lender that it will safeguard the interest of its subsidiary. This type of guarantee may not have a legally binding force. At times, the parent may undertake to replenish capital in the event of continuing losses which may erode subsidiary’s net worth. Safe Harbour Rules in the Indian Transfer Pricing Regulations clearly define what types of guarantee is covered. The definition of the Corporate Guarantee as per said Rules is as follows:

“Corporate guarantee” means explicit corporate guarantee extended by a company to its wholly owned subsidiary being a non-resident in respect of any short-term or long term borrowing. (Emphasis supplied)

Explanation:– For the purposes of this clause, explicit corporate guarantee does not include letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of a similar nature.

Provisions of the Safe Harbour Rules (SHRs) throw light on the following issues:

• SHRs are applicable for explicit corporate guarantees (Implicit Guarantees and other forms of guarantees are not covered);
• SHRs cover guarantees given by an Indian Company (i.e., only the outbound scenario);
• SHRs are applicable only when a guarantee is given to the Wholly Owned Subsidiary (WOS) and not otherwise;

Q. What are the regulations under FEMA for obtaining and issuing Guarantees by an Indian entity?
A. FEMA Regulations for issuing guarantees:
(Master Circular on Direct Investment by Residents in Joint Venture (JV)/Wholly Owned Subsidiary (WOS) Abroad Para B.1)

Indian entities can offer any form of guarantee – corporate or personal (including personal guarantee by indirect resident individual promoters of the Indian Party)/primary or collateral/guarantee by the promoter company/guarantee by group company, sister concern or associate company in India provided that:

i) All financial commitments including all forms of guarantees are within the overall ceiling prescribed for overseas investment by the Indian party i.e., currently within 100% of the net worth as on the date of the last audited balance sheet of the Indian party.
ii) No guarantee should be ‘open ended’ i.e., the amount and period of the guarantee should be specified upfront. In the case of performance guarantee, time specified for the completion of the contract shall be the validity period of the related performance guarantee.
iii) I n cases where invocation of performance guarantees breach the ceiling for the financial exposure of 100% of the net worth of the Indian Party, the Indian Party shall seek prior approval of the Reserve Bank before remitting funds from India, on account of such invocation.

[Note: In case of invocation of a performance guarantee, which had been issued before 14th August, 2013, the limit of 400% shall be applicable and remittance on account of such invocation over and above 400% of the net worth of the Indian party shall require prior approval of the Reserve Bank.]

iv) A s in the case of corporate guarantees, all guarantees (including performance guarantees and Bank Guarantees/SBLC) are required to be reported to the Reserve Bank, in Form ODI-Part II. Guarantees issued by banks in India in favour of WOS/JV outside India, and would be subject to prudential norms, issued by the Reserve Bank (DBOD) from time to time.

Note: Specific approval of the Reserve Bank will be required for creating a charge on immovable/moveable property and other financial assets (except pledge of shares of overseas JV/WOS) of the Indian party/group companies in favour of a non-resident entity within the overall limit fixed (presently 100%) for the financial commitment subject to submission of a ‘No Objection’ by the Indian party and its group companies from its Indian lenders.

FEMA Regulations for obtaining overseas guarantees: (Foreign Exchange Management (Guarantees) Regulations, 2000, Para 3A)

With prior approval of RBI:
A Corporate registered under the Companies Act, 1956 can avail of domestic rupee denominated structured obligations by obtaining credit enhancements in the form of guarantee by international banks, international financial institutions or joint venture partners.

Without prior approval of RBI:
A person resident in India may obtain without the prior approval of the Reserve Bank, credit enhancement in the form of guarantee from a person resident outside for the domestic debts raised by such companies through issue of capital market instrument like bonds and debentures subject to the following conditions:

• Eligibility:
– A person resident in India
– Other than branch or office in India owned or controlled by a person resident outside India
– I n accordance with the provisions of the

Automatic Route Scheme specified in schedule Automatic route scheme: (Foreign Exchange Management

(Borrowing or Lending in Foreign Exchange) Regulations, 2000, Schedule I, Regulation 6(1)] Borrowing (Guarantee) in Foreign Exchange up to $ 500 million or its equivalent:

Eligibility:
• Any company registered under the Companies Act, 1956, other than a financial intermediary (such as bank, financial institution, housing finance company and a nonbanking finance company)

•    The borrowing should not exceed in tranches or otherwise $ 500 million or equivalent in any one financial year (April – March)

End use purpose:
•    For investment in real sector – industrial sector including Small and medium enterprises (Sme) and infrastructure sector in india.

•    For first stage acquisition of shares in the disinvestment process and also in the mandatory second stage  offer to the public under the Governments’ disinvestment programme of PSU shares.

•    For direct investment in overseas Joint Ventures(JV)/ Wholly owned Subsidiaries (WoS) subject to the existing guidelines on Indian Direct Investment in JV/WOS abroad.

Q. Whether Guarantee is an “international transaction” under the Indian Transfer Pricing regulations?

A. In one of the earlier rulings on the subject of guarantee, delivered on 9th September, 2011, the hyderabad Tribunal in case of Four Soft limited [(hyd. ITAT) – 62 DTr 308] ruled that:

“The corporate guarantee provided by the assessee company does not fall within the definition of international transaction. The TP legislation does  not  stipulate  any  guidelines in respect to guarantee transactions. In the absence of any charging provision, the lower authorities are not correct in bringing aforesaid transaction in the TP study. In our considered view, the corporate guarantee is very much incidental to the business of the assessee and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution. In view of this matter, we hold that no TP adjustment is required in respect of corporate guarantee transaction done by the assessee company.”

However,  thereafter  the   Income   tax   Act, 1961 (“Act”) was amended vide Finance Act 2012 to bring guarantees and other financial transactions within the ambit of the Transfer Pricing regulations (TPrs). Explanation to section 92B was added to the definition of the term “International Transaction”, which reads as follows (only the relevant extract is reproduced):

“Explanation—For the removal of doubts, it is hereby clarified that—

(i) the expression “international transaction” shall include—

(c)    Capital financing, including any type of long-term  or  short-term  borrowing,   lending  or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;”

from the above, it is clear that loans and guarantees between AEs are covered under the TPRs of India  retrospectively
w.e.f. 1st april 2002.

Post the above amendment, divergent rulings of the tribunals have come which are enumerated hereunder:

i)    Bharati Airtel Ltd. vs. ACIT [2014] 43 Taxmann.com 150 (delhi – trib.)

In  this  case,  the  tribunal  held  that  “even  after  the amendment to Section 92 B, by amending explanation to section 92 B, a corporate guarantee issued for the benefit of the aes, which does not involve any costs to the assessee, does not have any bearing on profits, income, losses or assets of the enterprise and or therefore, it is outside the ambit of ‘international transaction’ to which ALP adjustment can be made.”

ii)    The  mumbai  tribunal,  in  cases  of  (a)  Everest  Kanto Cylinder Ltd. vs DCIT (ITA No. 542/Mum/2012) and (b) Technocraft Industries (India) Ltd. vs. ACIT (ITA No.7519/ Mum/2011), Mumbai (January 2014) held that post amendment of section 92B guarantee transactions are covered by the Transfer Pricing Regulations.

Safe harbor Provisions as applicable to Guarantee transactions [Notified on 18th September 2013 applicable for Five Assessment years beginning from Ay 2013-14]

The Australian Taxation Office in its Discussion Paper on “Intra-group Finance Guarantees & Loans Application of Australia’s Transfer Pricing and Thin Capitalization Rules
 
Between AES be given without charging any commission?

A. Post amendment of section 92B of the Act, transactions of cross border Guarantees between two aes are covered under the transfer pricing regulations. however, we have divergent decisions from tribunals on this point. (Refer Ans. 3 supra)

OECD Guidelines on Transfer Pricing (Para 7.13) provide intra-group services are said to be rendered when an AE derives benefits from an active association in the form of explicit guarantee from a group member and/or global marketing and promotion of the group whereas no services are said to be rendered where there is incidental benefits due to passive association of the ae with its group members. in the former case, issuance of guarantee would demand charging whereas, in the later case there is no need of any charge as no services are said to be rendered.

Australian Discussion Paper (2008) (paragraph 31) on “intra-group  finance  Guarantees  and  loans”  states  that “incidental benefits from association with a larger group where the market accords those benefits without an associated company actually providing an economic service that confers a benefit on the recipient would not usually be a basis for imposing a charge.”

From the above discussion, one may conclude that in the following circumstances, intra-group guarantees may not carry any charge or commission and therefore, are out of ambit of the transfer pricing regulations:

i)    When the benefit  obtained  by an AE is on  account  of a passive association (something akin to implicit guarantee);

ii)    When the corporate guarantee is issued for the benefit of the ae, which does not involve any costs to the assessee and therefore does not have any bearing June 2008” (paragraph 181 on page 42 of the Paper)  has opined that where the provision of a guarantee relates exclusively to the establishment or maintenance of a parent company’s participation as an investor, the costs of such participation should not be allocated to the subsidiary and should not affect the allocation of profit between the parent and subsidiary. in such a circumstance it could be fair and reasonable to determine that the arm’s length consideration for the provision of the guarantee is nil. On profits, income, losses or assets of the Guarantor (Based on the
decision of the delhi tribunal in case of Bharati Airtel (I.T.A. No.
5816/Del/2012));

iii)    Where the guarantee is provided for the debt which is in lieu of equity or which is in the nature of equity.

At Paragraph 105 of the Paper it is reported that: “The pricing of a guarantee is calculated as a percentage or spread on the amount of the debt being guaranteed. no chargeable percentage or spread arises on any portion of the debt that serves the purposes of equity.”

Q. What are the provisions under the OECD Transfer Pricing Guidelines regarding cross border guarantees?

A. Paragraph 7.13 of the (Chapter VII- Intra-Group Services) OECD Guidelines on Transfer Pricing (July 2010) makes a distinction between an “active  association” and a “passive association”  between  aes.  according to the Guidelines, in case of a passive association, an AE would receive incidental  benefits  just  because  it is part of the  multinational  enterprise  Group.  in such a scenario, no services are said to be rendered even though it receives higher credit rating being affiliated to a larger group. however, in case of an active association, services are said to be rendered when the ae receives higher credit rating because of guarantee offered by another group member or benefit obtained from the group’s reputation deriving from global marketing and public relation campaigns.

Benefit on account  of  “passive  association”  is  akin to “implicit guarantee”  whereas,  benefit  on  account  of “active association” is akin to “explicit guarantee”. therefore, even oeCd supports the view that there is no need of any charge in the case of implicit guarantee whereas explicit guarantee needs to be charged and benchmarked under transfer pricing regulations.

Q. how does one benchmark guarantee fee?
a.    Benchmarking of guarantee fee is a complex issue in view of unavailability of comparable data and unique nature of the transaction.

Various methods or approaches can be used to benchmark a guarantee fee depending upon the facts of the case and availability of the comparable data. Various situations and appropriate methods/approaches are discussed in the Australian Discussion Paper (2008) (paragraphs 128 to 171) on “intra-group finance Guarantees and loans” as well as arising from different case laws, as follows:

i)    CUP Method
CUP Method is the most appropriate method where sufficient data for comparison are available.

Under this method, the guarantee fee is determined by comparing the arm’s length guarantee fee charged by an independent party for providing similar guarantee on similar terms and conditions. in this approach, quantum of risk, type of guarantee, period of guarantee, borrower’s standalone credibility etc. are considered for arriving at arm’s length guarantee fee.

There may be Internal CUP or External CUP. In the case of the former, the spread between guaranteed and non-guaranteed third party loans are compared and the guarantee fee charged is equivalent or more due to difference in interest rates between these two types of loans.

In case of External CUP the fees applicable to Letter of Credit or Collateral debt Securities data are used.

The CUP method would be ideal in cases where a creditworthy subsidiary that is able to raise the debt funding it needs on a stand-alone basis obtains better terms with the benefit of a parent guarantee.

ii)    Benefit/yield Approach
This  approach  is  also  known  as  “interest  Saving approach”. in this method, arm’s length guarantee fee is determined through the interest rate saving which the subsidiary earns due to explicit guarantee by its parent. Thus, this method/approach seeks to benchmark the guarantee fee from the perspective of the borrower.

Under this approach, uncontrolled interest  rates,  risk assessments and market indicators are used as indirect benchmarks for arriving at the arm’s length fee, rather than using uncontrolled guarantee fee as a benchmark.

In other words, an arm’s length fee is estimated as the spread between the interest rate the borrower would have paid without the guarantee and the rate it pays with the guarantee, less the arm’s length discount. the remaining spread, net of the discount, would have to be sufficient to make the deal attractive to an independent guarantor for the additional risk it would assume, if it provided the guarantee. if there is no additional risk, then consideration has to be given to the economic substance of the arrangement between the parties.

In the case of General electric Capital Canada inc.’s in  december  2009  (Ge  Capital),  the tax  Court  of Canada (TCC) (2009 TCC 563 Date: 20091204)
Upheld the yield approach for determination of arm’s length fee for the explicit guarantee provided to the Canadian subsidiary (GE Canada) by the US Parent Co. (Ge uSa).

In the case of Four Soft Ltd. vs. DCIT [(Hyd. ITAT)
– 62 DTR 308], the Tribunal, while upholding non charging of guarantee fees by the indian Company in respect of overseas aes observed that “the subsidiary company has not received any benefit in the form of lower interest rate by virtue of the corporate guarantee given by the assessee company and at the same time, the assessee company significantly benefited from such transaction”. Thus the Tribunal did look at the “benefit approach” in benchmarking guarantee fees.

iii)    Profit Split Method
this  method  is  useful  where  there  are  series  of transactions owing to special relationship between the parent company and its subsidiary.

For example, the parent may supply trading stock to a subsidiary, purchase outputs from the subsidiary and also provide debt funding and a guarantee. There may be benefits flowing from the parent to the subsidiary as well as from the subsidiary to the parent. Such cases require a careful analysis of benefit flows and their impacts on the respective parties in order to appropriately determine the share of profit each party should receive for its contribution to the profit channel.

iv)    Risk/Reward Based Approach or Cost Based approach

This approach takes into account the risk the parent would take in extending guarantee to its subsidiary/ ae in the event of default and reward it in terms of increased profitability and sustainability or viability of subsidiary’s business. the reward could also be based on the quantified risk and perceptions of the probability that the risk will not materialise compared to the probability that it will materialise.

This approach seeks to value the guarantee fee from the perspective of the guarantor by focussing on the actual and potential financial and other impacts of providing guarantee. The  benchmarking  is  done  as  if  such  guarantee transaction is entered into by two independent parties taking into account the circumstances of the borrower. The borrower’s creditworthiness [to be determined based on arm’s length, i.e., as if it is an independent enterprise] is of utmost importance as it has a direct bearing on its financial strength and the default risk.

v)    The  other  two  approaches  are,  namely:  (i)  option Pricing  Model  Approach  [Using  financial  model for valuing options where the guarantee fee is ascertained as equivalent to a premium chargeable for insuring the underlying loan asset] or (ii) Credit Default Swaps [which is akin to a financial guarantee where a parent would make a periodic fixed payment to a third party should the subsidiary default on its obligation].

Both the above approaches are not much in vogue and hence not discussed at length.

In actual practice, especially in complex cases a combination of various approaches may be used.

Q. What are the Judicial Precedents for benchmarking of cross border guarantees?

A.    Indian experience and judicial precedents (in addition to cases discussed hereinabove) on charging of guarantee fees are summarised as follows:

Indian Experience
Indian Transfer Pricing Administration prefers CUP method for benchmarking guarantee commission in cases of outbound guarantees (i.e., where indian company has given guarantee to its overseas ae). in most cases, interest rate quotes and guarantee rate quotes available from banking companies are taken as the benchmark rate to arrive at the ALP. The Indian tax administration also uses the interest rate prevalent in the rupee bond markets in india for bonds of different credit ratings. the difference in the credit ratings between the parent in india and the foreign subsidiary is taken into account and the rate of interest specific to a credit rating of indian bonds is also considered for determination of the arm’s length price of such guarantees.

In the above context, it is interesting to note the observations of the hyderabad tribunal in case of four Soft limited (supra) wherein the tribunal observed that “in our considered view, the corporate guarantee is very much incidental to the business of the assessee and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution.”

In case of M/s. Asian Paints Ltd. vs. ACIT (ITA No. 408/ Mum/2010), the Mumbai Tribunal upheld following observations of the Cit (a) which are worth noting:

“The TPO has collected data from the Website of Allahabad Bank,  hSBC  Bank  and  robo  india  finance  and  applied the flat rate of 3%. That is to say the TPO has adopted a ‘naked quote’ without factoring in the qualitative factors which determine the fees. a quotation given by a  third party e.g. a Banker does not constitute a CUP since it is quotation and not an actual uncontrolled “transaction”. the TPO has adopted a 3% rate or guarantee fees when the Citi Bank Singapore (the bank providing the loan amount) itself has charged interest at the rate of 1.625% only on the loan granted to its ae at Singapore. this makes the stand of the TPO unsustainable as guarantee fees can in no circumstances exceed the rate at which interest is charged on loan.”

From the above, two principles emerge which are as follows:

(i)    Banks’ quotes of “Guarantee Commission” cannot be applied blindly (naked quote) without factoring into qualitative factors thereunto
(ii)    Under no circumstances, guarantee fees can exceed the rate of interest charged on the underlying loan for which guarantee is given.

In the case of Reliance Industries Ltd. [I.T.A. No.4475/ Mum/2007], the Mumbai Tribunal held as follows:

(i)    Guarantee transactions do fall within the definition of the “International Transaction” under the Transfer Pricing regulations post retrospective amendment of section 92B of the act vide the finance act 2012;

(ii)    For benchmarking of guarantee fees, one cannot apply any naked bank rate, as guarantee fee largely depends upon the terms and conditions on which loan has been given, risk undertaken, relationship between bank and the client, economic and business interest etc.

In the case of Glenmark Pharmaceuticals Limited vs. ACIT [TS-329-ITAT-2013(Mum)-TP], the Mumbai Tribunal also held as follows:

(i)    CUP is the most appropriate method for benchmarking Guarantee transactions.

(ii)    There   is   a   conceptual   difference   between   Bank Guarantee and Corporate Guarantee. Bank Guarantee is a foolproof instrument of security for the customer and failure to honour the guarantee is treated as deficiency of services of the Bank under the Banking laws. on the other hand, the CG – Corporate Guarantee is provided by the Company either to the Customer or to the Bank for giving loans to the sister concerns/AEs of the said company; but it is not foolproof. failure to honour the guarantee may attract contract laws and it is however a legally valid document and the Customer/Bank can sue the company in Court if it does not pay up.

(iii)    Unless the ‘naked quotes’ of the  bank  guarantee  rates as given in the websites for public, are adjusted to various controlling factors, these rates are no good CUP.

(iv)    Conclusion:

From  the  above  discussion,  it  can  be  concluded  that guarantee given by an Indian Parent to its overseas subsidiary needs to be benchmarked as per transfer pricing regulations in India. The CUP method is ideal subject to availability of comparable data. in complex cases one or more methods/approaches can be used. Indian Safe harbour provisions provide considerably higher rate of guarantee commission/fees and therefore, less likely
to be opted by assesses in india.

Benchmarking of guarantee is never an easy task in view of commercial  exigencies  and  other  factors  involved. The Indian Transfer Pricing Administration (ITPA) should therefore adopt a comprehensive approach in arriving at arm’s length fees rather than adopting naked rates/fees as are quoted on the website of the Banks/Financial Institutions. It would be interesting to see whether the ITPA would be willing to allow as deduction guarantee commission/fee charged by the foreign parent to its indian subsidiary based on the bank rate.

The Supreme Court recently issued a judgment that the marketing fee paid by a Thai franchisee would be subject to Thai withholding tax as the fee constituted royalty income.

In a typical international franchise scheme, the foreign franchisor would charge the Thai franchisee a franchise fee, which typically consists of a royalty for the intellectual property and a marketing fee. It is common practice for the franchisor to ensure that any marketing activity undertaken by the franchisee is in line with the franchise’s international standards, and for the marketing fee to be computed based on net sales.

From a tax perspective, there remains no question that the franchise fee is categorised as royalty income, which would be subject to Thai withholding tax at the rate of 15% u/s. 70 of the Revenue Code. However, the marketing fee incurred by the Thai franchisee via payments made to Thai advertising companies had largely gone unnoticed for Thai withholding tax purposes.

The Supreme Court has now held that marketing fees paid in Thailand to Thai advertising firms would be subject to 15% Thai withholding tax as royalty, as if it had been paid to the foreign franchisor. The Court based the judgment on the following:

— the fee is deemed to be the additional income of the franchisor, as it directly, or indirectly, benefits the brand as well as the trademark of the franchisor;

— the franchisor effectively has control over the advertising activities; and

— this fee is calculated in a similar manner to franchise fee, i.e., based on sales.

It appears that the Court has ruled in this manner so as to prevent tax planning by a foreign company (which was not carrying on any business in Thailand) from avoiding withholding tax u/s. 70 of the Revenue Code.

This judgment is expected to have a huge impact on audits carried out by revenue officers with revenue officers raising more assessments on the franchisee in Thailand for past payments.

14. United Kingdom: Determination of residence for individuals

Court of Appeal rules on HMRC’s interpretation of IR20
On 16th February 2010, the Court of Appeal dismissed applications for judicial review in the cases of R (oao Davies and anor) v. CRC; R (oao Gaines- Cooper) v. CRC.

The taxpayers sought judicial review of HMRC’s determination that they were resident and ordinarily resident in the United Kingdom.

(a) Facts and legal background. The issue centred on guidance published by HMRC on residence and ordinary residence of individuals, known as IR20.

Paragraph 2.2 of IR20 provided that a taxpayer would be treated as non-resident and non-ordinarily resident if:

— he left the UK for the purposes of full-time employment abroad;

— he remained abroad for at least a whole tax year, and

— his visits to the UK totalled less than 183 days in any tax year, and averaged less than 91 days per tax year.

Paragraphs 2.7 to 2.9 of IR20 dealt with ‘Leaving the UK permanently or indefinitely’. Thereunder, HMRC reiterated the 91-day rule mentioned above. That section also stated that HMRC might request evidence of permanent abode outside the UK.

The taxpayers had left the United Kingdom, but not for the purposes of employment abroad. As such, their situation fell under IR20 paras 2.7.-2.9, and not IR20 para 2.2.

HMRC issued a determination that the taxpayers were resident in the United Kingdom, on the basis that they had not made a ‘distinct break’ from ties in the United Kingdom. Thus, it was not sufficient for the taxpayers simply to meet the 91-day rule.

The taxpayers argued that the ‘distinct break’ requirement was contrary to the guidance in IR20. They argued further that even if the requirement were found to be in line with the guidance, HMRC had, in practice, previously not insisted on this requirement. The fact that HMRC only began to require such evidence in 2004-05 amounted to a change in approach, and this breached their legitimate expectations.

(b) Issue. The issues were:

— whether, in requiring evidence of a distinct break, HMRC had departed from the terms of IR20, and

— even if HMRC had not so departed, whether HMRC had changed their approach, leading to a breach of the taxpayers’ legitimate expectations.

(c) Decision. IR20 para 2.2. dealt with leaving the United Kingdom for the purposes of full-time employment abroad. Under this paragraph, there was no requirement for a ‘distinct break’. Thus, for individuals who came within the terms of that paragraph, there was no need for HMRC to look into any persisting social or family ties in the UK.

The Court rejected the taxpayers’ argument that this interpretation should also apply to IR20 paras 2.7-2.9. According to the Court, because IR20 paras 2.7-2.9 deal with leaving the United Kingdom ‘permanently or indefinitely’, these words are crucial in terms of construing those paragraphs. It is therefore important to consider the extent to which the taxpayer has retained social and family ties within the United Kingdom.

There is therefore a clear distinction between the determination of residence for individuals who have left the UK for full-time employment abroad, and those who have left the UK permanently or indefinitely.

The taxpayers fell within IR20 paras 2.7-2.9, and therefore HMRC was entitled to request from them evidence of having left the United Kingdom ‘permanently or indefinitely’, and this included evidence of a ‘distinct break’.

On the change of approach point, Moses LJ stated that there was no public law obligation of fairness that prevents HMRC from increasing, without warning, the intensity or scrutiny of claims by taxpayers to be non-resident. Indeed, the absence of warning might be a powerful tool to deploy, to ensure that taxpayers provide frank disclosure. Nevertheless, the Court held that HMRC’s rejection of the taxpayers’ claim was not as a result of a changed approach. The appeals were dismissed.

Ward LJ, while agreeing with the decision, nevertheless, expressed some sympathy for the taxpayers. He understood the taxpayers’ suspicions that HMRC had indeed changed their policy. However, he was persuaded that what has been construed to be a change in HMRC policy was actually the effect of a closer and more rigorous scrutiny and policing of a growing number of claims. This is permissible for HMRC to undertake, and is not a root-and-branch change in policy.

Note: In 2009, IR20 was withdrawn and replaced by new guidance document, HMRC6.

15. France: Administrative Supreme Court clarifies notion of domicile for individuals

On 27 January 2010, the Supreme Administrative Court gave its decision in the case of SCP Vier (No. 294784) concerning the domestic notion of fiscal domicile. Details of the decision are summarised below.

(a) Legal background. Domestic law treats individual taxpayers as residents for tax purposes when they have their fiscal domicile in France. The definition of fiscal domicile, provided by Article 4B of the Code Général des Impôts (CGI), is based on three alternative criteria:

— personal: the home or principal place of residence; or

— professional: performance of a trade, business or professional activity; or

— economic: the centre of the economic interests.

Under the economic criterion, an individual is considered to have the centre of his economic interests in France, if the individual:

—  has made major investments;

— has a main office or effective place of management; or

—  derives most of his income in France.

(b)    Facts. The taxpayer possessed immovable and movable assets situated in France, while his regular income was derived from an employment in Greece. After a tax investigation, the French tax authorities decided to assess the taxpayer as a French resident on his worldwide income. They took the position that due to the location of his assets, the taxpayer met the economic criteria provided by Article 4B1(c) of the CGI: the ‘centre of its economic interests’. The taxpayer claimed not to be a resident and, thus, only liable to French source income.
    
(c)    Issue. The issue was whether the notion of ‘centre of economic interests’ should be considered as (i) the place where the individual has made major investments, regardless of their profitable nature; or (ii) the place where the individual derives most of his actual income.

(d)    Decision. The Administrative Supreme Court ruled in favour of the taxpayer and held that the notion of ‘centre of economic interests’ refers primarily to the place where an individual derives most of his income. Thus, the location of the assets must be regarded as a secondary criterion in the definition of ‘centre of its economic interests’.

16.    United States: Transfer Pricing:

US Court of Appeals withdraws decision in Xilinx transfer pricing case

The US Court of Appeals for the Ninth Circuit has withdrawn its decision in the case of Xilinx Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue, (Docket No. 06-74246). See TNS:2009-06-05:US-1.

The decision was issued 27th May 2009 and held that the specific rules for cost-sharing agreements (CSAs) in the US Treasury Regulations issued u/s. 482 of the US Internal Revenue Code prevailed over the general arm’s-length standard.

As a result, the value of stock options granted by Xilinx in connection with a CSA were required to be included in the pool of costs to be shared under the CSA even when the facts indicated that companies operating at arm’s length would not do so. The Court of Appeals also determined that this result did not violate the provisions of the 1997 US-Ireland income tax treaty due to the saving clause in Article 1(4).

The decision of the Court of Appeals, which was by a 2:1 majority of a three-member judicial panel, proved controversial, and the taxpayer petitioned the Court for re-hearing (see TNS:2009-08-18:US-1) . The Court’s Order withdrawing the decision is dated 13th January 2010. It does not indicate the next step to be taken in the proceeding.

17.    Spain: Substance v. Form

Treaty between Spain and US-Spanish Supreme Court takes substance over form in approach applying treaty

The Supreme Court gave its decision on 25th September 2009 in the case of the sale of shares of the Spanish company La Cruz del Campo, S.A. owned by US Stroh Brewery Company to Guinness Plc (Recurso de Casación 3545/2003). Details of the decision are summarised below.

(a)    Facts. The appellant, Stroh Company, held shares representing 28.45% of the capital of La Cruz del Campo, S.A. In January 1991, Stroh accepted the offer by Guinness Plc to buy those shares. It also told the buyer that it would exercise the transfer in several steps. At the time of the offer, the shares were deposited in the United States. In January 1991, Stroh transferred part of the shares to its US subsidiary, Victors Company, in exchange for 17 shares in the latter. Victors Company sold the shares to Guinness Plc for the same price as that for which it had acquired them. In May 1991, Stroh transferred the remaining shares in La Cruz del Campo S.A. to another US subsidiary, Hoya Ventures, in exchange of 100% in the latter’s capital. These shares represented less than 25% of the capital in La Cruz del Campo, S.A. The shares were sold by Hoya Ventures to Guinness Plc in February 1992 for the same price as that for which it had acquired them. The tax administration and the decision of the First Instance Court considered that the capital gain of the sale was obtained by Stroh, and was therefore taxable in Spain.

(b)    Issue. Spanish corporate income tax legislation at the time of transactions considered income derived from securities issued by Spanish resident companies to be taxable in Spain, but the law only expressly taxed capital gains derived from assets located in Spain. Therefore, the appellant claimed that Spain did not have taxing rights on the transaction.

Article 13(4) of the USA-Spain tax treaty states that gains derived from the alienation of stock in the capital of a company resident in a contracting state may be taxed in this state if the recipient of the gain during the 12 -month period preceding the alienation had a participation, directly or indirectly, of at least 25% of the capital. Item 10(c) of the protocol to the treaty establishes an exception to the taxation of an alienation when the alienations are contributions between companies of the same group, and the consideration thereof consists of a participation in the capital of the acquiring company.

The appellant considered that there was a breach of the tax treaty since the tax administration and the First Instance Court decision qualified as ‘sales’ the transactions that were non-monetary contributions to the capital of the subsidiaries, which were excluded from taxation by the protocol. In addition, the interpretation of an international convention could not be undertaken unilaterally by one of the parties. Moreover, the second transaction entailed less than 25% of the capital, so it could have only been taxable in the United States. Furthermore, in case the transactions were subject to tax in Spain, the taxable capital gains should be those obtained by the subsidiaries from the difference between the selling price and the acquisition cost. In this case, there was no difference between the two.

(c)    Decision. The Supreme Court held that as the company issuing the shares was resident in Spain and the shareholder’s rights should be exercised in Spain, the shares should be considered as being located in Spain independently of where the shares were deposited. Therefore, the capital gain was subject to tax in Spain.

The Court stated that the person applying the law must qualify any act or transaction in accordance with its real juridical nature, bearing in mind its content, consideration and legal effects, without following the forms or names given by the parties. Therefore, both the tax administration and the Court of First Instance were allowed to qualify the transactions when those transactions did not correspond to the true legal nature of the considerations.

At the time of acceptance of the offer, Stroh fulfilled the two requirements established in Article 13(4) of the treaty, which allow the transaction to be taxed in Spain. The purpose of the subsequent share transactions with the subsidiaries was not for restructuring reasons. When examining the transactions involved as a whole, it appeared
that the intention of the appellant was not the one that is usually assigned to these types of transactions.

Therefore, there was a relative contractual simulation that occurs when there is an (unwanted) fictitious transaction aimed at disguising the real transaction (that was made in breach of the law). The effect of the law is to reveal the legal implications that the parties had tried to avoid. Therefore, the Court concluded that the tax administration was correct in its assessment.

18.    Australia: Foreign Tax Credit

ATO Interpretative Decision ATO ID 2010/175 — FTC for foreign tax paid in respect of gain not fully assessable in Australia

On 8 October 2010, the Australian Taxation Office (ATO) issued an Interpretative Decisions (ATO ID).

ATO ID 2010/175 deals with the entitlement to a foreign income tax offset (i.e., foreign tax credit) for a foreign tax paid in respect of a gain where the gain is not fully assessable in Australia. The ATO reached a decision that based on the wording of the legislation, only a proportion of the foreign tax should be available as a credit. Interestingly, the ATO ID notes a statement in Explanatory Memorandum to the Bill implementing the new foreign tax credit rules that seems to suggest that a full credit should be available. The ATO expressed its view that the statement is inconsistent with the words and purpose of the legislation and should be disregarded.

19.    United States; France: Foreign Tax Credit

Treaty between US and France-US Tax Court: income earned in or over foreign countries; US or international airspace (saving clause, foreign earned income exclusion, FTC)

The US Tax Court has decided on the availability of the foreign -earned income exclusion and foreign tax credit with regard to a flight attendant’s income. Savary v. Commissioner of Internal Revenue, T.C. Summary Opinion 2010-150, Docket No. 6839-09S (6 October 2010).

The case involved a taxpayer who was a US citizen but resident of France. She worked as a flight attendant on flights between France and the United States:

— 38.2% of her income was earned in or over for-eign countries (the ‘foreign income’); and

— the remaining portion was earned while in the United States or in international airspace (the ‘US/international airspace income’).

US-France tax treaty

The first issue was whether the United States was precluded from taxing her income by Article 15(3) of the treaty between the United States and France signed on 31st August 1994 (the ‘Treaty’), which provides that income from employment as a crew member of a ship or aircraft operated in international traffic is taxable only by the country of which the taxpayer is a resident.

The Tax Court held that the saving clause in Article 29(2) of the Treaty, which provides that the United States may tax its citizens and residents as if the Treaty had not come into effect, took precedence and thus her income was taxable under the Internal Revenue Code (IRC).

Foreign earned income exclusion

The second issue was whether the taxpayer was entitled to claim the foreign-earned income exclusion under IRC section 911.

The Tax Court concluded that the ‘US/international airspace income’ was US source income and not foreign-earned income, noting that international airspace is not a foreign country for purposes of IRC section 911.    Accordingly, the taxpayer was not entitled to claim the foreign-earned income exclusion.

On the other hand, the taxpayer was allowed to exclude the ‘foreign income’.

FTC:

The third issue was whether the taxpayer was entitled to a foreign tax credit in the United States under Article 24 of the Treaty and IRC section 901 for the taxes paid to France.

The Tax Court denied a US credit for US tax payable on the ‘foreign income’, on the ground that the taxpayer was already allowed a US exclusion of such foreign source income under IRC section 911.

Further, the Tax Court disallowed a US credit for French tax paid on the ‘US/international airspace income’, explaining that the United States consented in Article 24 only to provide a FTC on income attributable to sources in France, as determined under the source of income rules of the IRC, and not to US source income. The Tax Court stated that a credit in France would be the only treaty relief from double taxation. The Tax Court noted that the French tax authorities had already denied the credit on the basis of Article 15(3) of the Treaty. The Tax Court was of the view, however, that the French tax authorities had erred in this regard, and that the taxpayer could seek reconsideration from the French authorities or, as a last resort, competent authority relief under Article 26 of the Treaty.

Accuracy-related penalty:

The fourth and final issue was whether the tax-payer was liable for the accuracy-related penalty under IRC section 6662.

The Tax Court declined to impose the penalty be-cause it was not demonstrated that the taxpayer’s underpayment was attributable to her negligence or disregard of rules or regulations.

20.    Italy: Beneficial Owner

Treaty between Italy and Luxembourg — Italian decision on interpretation of term ‘beneficial owner’

On 19 October 2010, the Lower Tax Court of Piemonte (Commissione tributaria provinciale del Piemonte/Torino) issued decision no. 124 regarding the interpretation of the term ‘beneficial owner’ contained in Article 12 (Royalties) of the tax treaty between Italy and Luxemburg (the Treaty). Details of the decision are summarised below.

(a)    Facts. The taxpayer is an Italian company that signed an agreement for the use of a trademark owned by a Luxemburg company (Luxco). Luxco is wholly owned by a company resident in Bermuda.

On the royalties paid by the Italian taxpayer to Luxco, the reduced withholding tax (10%) provided for by Article 12 of the Treaty was withheld instead of the domestic withholding tax of 30%.

The Italian tax authorities claimed that Luxco was not the beneficial owner of the royalty’s payment; therefore, it cannot benefit from the reduced with-holding tax provided for by the Treaty.

(c)    Decision. The taxpayer asserted that Luxco was the beneficial owner of the royalties payments based on the following grounds:

— Luxco was the owner of the trademark, which was accounted for in Luxco’s annual balance sheet;

— the trademark was properly registered in Luxemburg;

— the use of the trademark was granted by a proper licence agreement between the Italian taxpayer and Luxco;

— the income generated by the licence agree-ment was properly accounted for in Luxco’s profit and loss accounts.

The Court noted that the arguments put forward by the taxpayer only prove that Luxco was the formal owner of the trademark and that it formally received the royalty payments, but not that Luxco was the beneficial owner. Therefore, the Court rejected the arguments of the taxpayer, giving the following reasons:

— The beneficial owner must have an autonomous organisation to provide services and must bear the entrepreneurial risks of such activity. This was not the case in respect to Luxco. Indeed, Luxco acquired the trademark free of charge and it has no costs related to such trademark; moreover, Luxco had a very small operative organisation (no movable properties, low employment costs). In this respect, Luxco is acting without any entre-preneurial risks.

—  Luxco was wholly owned by a sole shareholder (resident in Bermuda).

21.    Finland: Transfer Pricing

Supreme Administrative Court rules on interest rate on intra-group loan

The Supreme Administrative Court of Finland (Korkein hallinto-oikeus, KHO) gave its decision on 3 November 2010 in the case of KHO:2010:73. Details of the decision are summarised below.

(a)    Facts. As part of restructuring the financial structure of a group, the taxpayer, Finnish company A Oy, paid back two loans taken from a third party and took a corresponding loan from a Swedish company B AB, which was acting as the group financing company. The loans taken from the third party carried interest at the rates between 3.135% and 3.25%, whereas the interest rate on the intra-group loan was set to 9.5% based on the average group interest rate. The average group interest rate was determined by interest rates applied on loans that the group had taken from third parties and loans from its shareholders.

(b)    Legal background. Affiliated companies are required to observe the arm’s-length principle. If the tax authorities conclude, based on section 31 of the Law on Tax Procedure, that the arm’s-length principle has not been observed in transactions between group companies, the taxation may be corrected and reassessment may be made to re-flect the arm’s-length conditions.

(c)    Issue. The issue was whether the interest rate set on the intra-group loan, 9.5%, was at arm’s length, considering that the loans taken from a third party had been subject to interest rates of 3.135% and 3.25%.

(d)    Decision. The Court emphasised that the interest rate on an intra-group loan cannot be based on an average group interest rate in circumstances (e.g., the company’s good creditworthiness) where financing could have been obtained from a non-related party at a substantially lower interest rate than the average group interest rate. The Court pointed out that the taxpayer’s financing needs did not substantially change in the refinancing and it had not received any financial services from B AB which may have influenced the interest rate.
The Court held that the interest rate on the intra-group loan was not at arm’s length and increased the taxpayer’s taxable income by the amount of non-deductible interest which was the difference between the interest rate on intra-group loan (9.5%) and the interest rate of 3.25%.

United States: Residency

USVI District Court denies residency for lack of intent to become USVI residents

The US District Court of the United States Virgin Islands (USVI) has determined that five family members were not bona fide residents of the USVI on the ground that they failed to demonstrate their genuine intent to become USVI residents. VI Derivatives, LLC v. United States, Case No. 3:06-CV-12 (18 February 2011).

This case involved five members of the Vento family — Richard Vento (husband), Lana Vento (wife), Nicole Mollison (daughter), Gail Vento (daughter), and Renee Vento (daughter). They filed their income tax returns with the USVI Bureau of Internal Revenue (BIR) in 2001. Both the BIR and the US Internal Revenue Service (IRS) issued Notices of Deficiency to the Vento family. Each Vento family member filed a petition to determine their income tax liability for 2001 and their petitions were con-solidated into this case.

The Vento family took the position that they were exempt from US taxation on the income reported in the USVI u/s. 932 of the US Internal Revenue Code (IRC) because they were present in the USVI on the last day of 2001 with intent to become residents. The BIR contended that the petitioners’ pattern of repeated travel to the USVI and their development of a residential property was sufficient to establish USVI residency. The IRS argued that the petitioners were not bona fide residents of the USVI, because they did not take sufficient action to demonstrate an intent to become USVI residents and did not abandon their prior residences by the end of 2001.

The District Court stated that under IRC section 932, as applied in 2001, a taxpayer who was a bona fide resident of the USVI at the end of a year generally was exempt from filing a US federal income tax return or paying income taxes to the United States for that year. The District Court further stated that IRC section 932, however, drew a distinction between a bona fide residents and mere transients or sojourners, and required the latter to file a tax return with both the IRS and the BIR for income received from the USVI.

The District Court noted that both parties agreed the standard set forth in Sochurek v. Commissioner, 300 F.2.d 34 (7th Cir. 1962) should be applied in deciding whether the Vento family members were bona fide USVI residents at the end of 2001.

The District Court further noted that while the abandonment of a prior residence is not required to claim residency elsewhere, a court may consider whether a taxpayer maintains strong ties to a location other than the claimed residence.

The District Court stated that the subjective Sochurek factors — whether the petitioners intended to be USVI residents at the end of 2001 or whether they travelled to the USVI for the purpose of avoiding US income taxes — had particular relevance, given the suspicious timing of the family’s decision to ‘move’ to the USVI. The District Court noted that in early 2001, the family realised a gain of USD 180 million from the sale of their shares in a technology business (Objective Systems Integrators, Inc.), of which Richard Vento was a founder, and that the USVI residency for 2001 would allow them tax savings of more than USD 9 million.

The District Court held that the Vento family’s testimony that they intended to become USVI residents by the end of 2001 was undermined by the objective facts:

— the house they purchased in the USVI was not liveable by the end of 2001, despite efforts to renovate it as quickly as possible;

— the house was not fully furnished by the end of 2001;
—  none of the family’s furniture or valuable personal possessions were brought to the house;

—  the family spent very little time in the USVI during 2001 and 2002 and primarily engaged in vacation-type activities when in the USVI;

— the family did not have a bank account in the USVI in 2001;

— neither of the two businesses Richard Vento was starting in the USVI was up and running by the end of 2001;

— there is no evidence that Richard and Lana Ventos were involved in community activities in the USVI or had assimilated into its culture in 2001;

—  the family’s office remained in Nevada;

— Richard and Lana Ventos purchased property in Nevada in May 2001 with a plan to construct a mansion on the property;

— Nicole Mollison’s children were enrolled in school in Nevada in 2001; and

—  in 2001, Gail Vento was attending college in Colorado, and Renee Vento had a clear goal of obtaining a master’s degree in California.

After applying the relevant Sochurek factors, the District Court concluded that no member of the Vento family was a bona fide resident of the USVI at the end of 2001.

Acknowledgment/Source

We have compiled the above summary of decisions from the Tax News Service of the IBFD for the period April, 2010 to March, 2011.

Background

According to
the provisions of the Internal Revenue Code of 1986 (IRC) as amended, of
the USA, all U.S. residents, green-card holders and citizens must file
their tax returns in the U.S. on their global income and pay taxes on
that income in the U.S. The penalties for failure to pay tax on global
income in the U.S. can be quite severe. This includes penalty for
failure to file return of income in time, failure to pay the taxes by
the due dates and levy of interest for delay in payment of taxes.

In
order to ensure that all the U.S. taxpayers comply with the provisions
of the IRC, the followings additional reporting requirements for
offshore income have been prescribed:

(b) Accordingly, U.S. residents or persons in and
doing business in the U.S. must file a report with the government if
they have a financial account in a foreign country with a value
exceeding INR614,567 at any time during the calendar year. Taxpayers
comply with this law by reporting the account on their income tax return
and by filing Form TD F 90–22.1, the Report of Foreign Banks and
Financial Accounts (FBAR). The FBAR must be received by the Department
of the Treasury on or before June 30th of the year immediately following
the calendar year being reported. The June 30th filing date may not be
extended. Willfully failing to file a FBAR can be subject to both
criminal sanctions (i.e., imprisonment) and civil penalties equivalent
to the greater of INR6,145,675 or 50% of the balance in an unreported
foreign account — for each year since 2004 for which an FBAR was not
filed.

B. Statement of Specified Foreign Financial Assets under the Foreign Account Tax Compliance Act (FATCA) — Form 8938

(a)
The FATCA, enacted in 2010 as part of the Hiring Incentives to Restore
Employment (HIRE) Act, is an important development in U.S. efforts to
combat tax evasion by U.S. persons holding investments in offshore
accounts.

Under FATCA, certain U.S. taxpayers holding financial
assets outside the United States must report those assets to the IRS. In
addition, FATCA will require foreign financial institutions to report
directly to the IRS certain information about financial accounts held by
U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a
substantial ownership interest.

(b) Reporting by U.S. Taxpayers Holding Foreign Financial Assets

FATCA
requires certain U.S. taxpayers holding foreign financial assets with
an aggregate value exceeding INR3,072,837 to report certain information
about those assets on a new form (Form 8938 — Statement of Specified
Foreign Financial Assets) that must be attached to the taxpayer’s annual
tax return. Reporting applies for assets held in taxable years
beginning after March 18, 2010. For most taxpayers this will be the 2011
tax return they file during the 2012 tax filing season. Failure to
report foreign financial assets on Form 8938 will result in a penalty of
INR614,567 (and a penalty up to INR3,072,837 for continued failure
after IRS notification). Further, underpayments of tax attributable to
non-disclosed foreign financial assets will be subject to an additional
substantial understatement penalty of 40 percent.

(c) Reporting by Foreign Financial Institutions

FATCA
will also require foreign financial institutions (‘FFIs’) to report
directly to the IRS certain information about financial accounts held by
U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a
substantial ownership interest. To properly comply with these new
reporting requirements, an FFI will have to enter into a special
agreement with the IRS by June 30, 2013. Under this agreement a
‘participating’ FFI will be obligated to:

(i) undertake certain identification and due diligence procedures with respect to its accountholders;

(ii)
report annually to the IRS on its accountholders who are U.S. persons
or foreign entities with substantial U.S. ownership; and

(iii)
withhold and pay over to the IRS 30% of any payments of U.S. source
income, as well as gross proceeds from the sale of securities that
generate U.S. source income, made to

(a) non-participating FFIs,

(b) individual ac-countholders failing to provide sufficient information to determine whether or not they are a U.S. person, or

(c) foreign entity accountholders failing to provide sufficient information about the identity of its substantial U.S. owners.

(d)
Form 8938 is and will be a significant tool for the IRS to identify the
scope of international tax non-compliance of a given U.S. taxpayer. The
reason why Form 8938 is so useful for the IRS is that Form 8938 now
requires a taxpayer to disclose more information, which connects various
parts of a taxpayer’s international tax compliance including the
information that escaped disclosure on other forms earlier.

(e)
Form 8938, allows the IRS to effectively identify the overall scope of a
taxpayer’s noncompliance. Form 8938 may lay the foundation (and road
map) for an IRS investigation of whether the taxpayer has been in
compliance previously. For example, Question 3a of Form 8938 indirectly
asks a problematic question: it requires the taxpayer to tick the box
‘account opened during tax year’, if the account is opened during the
tax year.

(f) For older accounts, this is a dangerous question.
Answering that the account was not opened in the tax year, implicitly
(and affirmatively by omission) states that account was opened in a
prior year. As a result, prior years FBARs should have been filed. The
answer to question 3a could provide incriminating evidence to the IRS.

(g)
The IRS is tracking foreign accounts in all countries, but thanks to
recent indictments of account-holders in countries like Switzerland and
India (several HSBC India account-holders have been indicted), there
could be increased focus on these countries.

(h) For Basic
Questions and Answers on Form 8938, the interested reader can refer to
the IRS website link at www.irs.gov/businesses/
corporations/article/0,,id=255061,00.html.

Offshore Voluntary Disclosure Program (OVDP)

For years, the IRS has been pursuing the disclosure of information regarding undeclared interests of U.S. taxpayers (or those who ought to be U.S. taxpayers) in foreign financial accounts. On January 9, 2012, the IRS announced yet another Offshore Voluntary Disclosure Program (the 2012 OVDP) following the success of the 2009 Offshore Voluntary Disclosure Program (the 2009 OVDP) and the 2011 Offshore Voluntary Disclosure Initiative (the 2011 OVDI), which were announced many years after the 2003 Offshore Voluntary Compliance Initiative (OVCI) and the 2003 Offshore Credit Card Program (OCCP).

The OVDP programs basically eliminate the risk of criminal prosecution for taxpayers that are accepted into the program, and provide for reduced civil penalties than would apply if the IRS were to discover the taxpayer’s non-compliance in this area. In part, the success of such initiatives often depends on the perception that strong government tax enforcement efforts will follow.

2012 OVDP — Salient features

(a)    The IRS on 9th January, 2012 reopened the OVDP to help people hiding offshore accounts get current with their taxes.

(b)    The program is similar to the 2011 OVDI program in many ways, but with a few key differences. Unlike 2011 OVDI, there is no set deadline for people to apply. However, the terms of the program could change at any time going forward. For example, the IRS may increase penalties in the program for all or some taxpayers or defined classes of taxpayers — or decide to end the program entirely at any point.

(c)    The overall penalty structure for the 2012 OVDP is the same as was for 2011 OVDI, except for taxpayers in the highest penalty category. For the 2012 OVDP, the penalty framework requires individuals to pay a penalty of 27.5% of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight full tax years prior to the disclosure. That is up from 25% in the 2011 OVDI. Some taxpayers will be eligible for 5 or 12.5% penalties; these remain the same in the 2012 OVDP as in 2011 OVDI. Smaller offshore accounts will face a 12.5% penalty. People whose offshore accounts or assets did not surpass $75,000 in any calendar year covered by the 2012 OVDP will qualify for this lower rate. As under the prior programs, taxpayers who feel that the penalty is disproportionate may opt instead to be examined.

(d)    Participants must file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as pay accuracy-related and/or delinquency penalties.

Who should take advantage of the OVDP?

Taxpayers who have undisclosed offshore accounts or assets are eligible to apply for the 2012 OVDP penalty regime.

Taxpayers who reported and paid tax on all their taxable income but did not file FBARs, should not participate in the 2012 OVDI but should merely file the delinquent FBARs with the Department of Treasury, Post Office Box 32621, Detroit, MI 48232-0621 and attach a statement explaining why the reports are filed late. Under the 2011 OVDI, the IRS agreed not to impose a penalty for the failure to file the delinquent FBARs if there were no underreported tax liabilities and taxpayers filed the FBARs by September 9, 2011 (FAQ 17). Presumably, the IRS will follow the same course under the 2012 OVDP since those with no underreported tax liabilities are not truly within the range of taxpayers the IRS is trying to identify.

However, those taxpayers who have failed to report their foreign income altogether, might consider taking the advantage of 2012 OVDP. The ability of a U.S. taxpayer to maintain an undisclosed, ‘secret’ foreign financial account is fast becoming impossible. Foreign account information is flowing into the IRS under tax treaties, through submissions by whistleblowers, from others who participated in the 2009 OVDP and the 2011 OVDP who have been required to identify their bankers and advisors.

It does not matter if the failure to report foreign income or tax evasion was unintentional. For many years the IRS has, as part of the tax return in Schedule B of the Form 1040 — U.S. Individual Income Tax Return, had asked for information on foreign bank accounts and hence a taxpayer is expected to be aware of this.

Additional information will become available as the FATCA and new mandatory IRS Form 8938 — Statement of Specified Foreign Financial Assets has become effective. Under such circumstances, the decision to apply for 2012 OVDP involves fair bit of risk management. Although the 2012 OVDP penalty regime may seem overly harsh for many, the decision to participate should include an economic analysis of the taxpayer’s projected future earnings that could be generated from the foreign funds. It is important to note that if a taxpayer is discovered before any voluntary disclosure submission, there could be harsh criminal (in addition to civil) penalties. The risks may outweigh the benefits.

For those taxpayers at substantial risk of being treated as willful non-filers by the IRS, the OVDP’s fixed civil penalties, generally, are substantially lower than the potential maximum willful penalties. Therefore, filing under the OVDP generally should be a good deal for such taxpayers.

For those few taxpayers, however, who have credible and strong reasonable cause arguments to avoid penalties completely, the fixed penalties of the OVDP program generally do not appear to be an attractive option.

For the vast majority of taxpayers who fall somewhere in between (i.e., clearly not a willful non-filer, but also no credible reasonable cause arguments), the decision becomes a difficult one of number-crunching and comparing all possible outcomes, followed by risk-tolerance and risk-aversion based choices from amongst those possible outcomes in deciding which course to follow. Anyone considering an OVDP submission must carefully examine all potential civil penalties and evaluate the risk of criminal prosecution.

Options available to taxpayers

Taxpayers who have not disclosed their foreign assets and wishing to come into compliance, have the following two options:

(a)    a formal disclosure through the IRS’s standard voluntary disclosure program (a ‘noisy disclosure’) or

(b)    simply trying to file prior year original or amended returns and hope they slip through the cracks and don’t get audited (a ‘silent disclosure’).

Taxpayers must be clearly aware that the IRS is getting more aggressive in auditing ‘silent disclosures’ of offshore accounts and, therefore, this option remains highly risky and is not advisable for most taxpayers. However, a silent disclosure could be a preferred option for some taxpayers, depending on their specific circumstances and that the IRS will never be able to succeed in forcing all taxpayers into a noisy disclosure, which is their stated goal. It is strongly advisable to consult one’s tax advisor for his specific situation. An individual’s situation maybe different from the facts of a generic article of this type and hence it’s better to look at getting the right advice.

Risks of non-reporting and IRS initiatives to seek Foreign Accounts Information

There are rumors regarding ongoing ‘John Doe’ summons (A John Doe summons is any summons where the name of the taxpayer under investigation is unknown and therefore not specifically identified) activity seeking to force foreign financial institutions to deliver account-holder information to the U.S. government as well as possible indictments of foreign financial institutions. Recently, several foreign institutions have advised their account-holders to consult U.S. tax advisers regarding the IRS voluntary disclosure program and their U.S. tax reporting relating to their foreign financial accounts. It is reasonable to assume that such institutions will take whatever action is necessary to avoid being indicted, beginning with the delivery of information regarding account-holders to the U.S. government.

It is likely that the U.S. will require foreign financial institutions doing business in the United States to disclose account-holders having relatively small accounts and earnings. There have been rumors of discussions regarding accounts having a high balance of the equivalent of $50,000 at any time between 2002 and 2010. U.S. persons having interests in foreign financial accounts should not find comfort in a belief that their foreign financial institution will somehow refrain from disclosing very small accounts in the current enforcement environment. Those who think too long may be sorely surprised at the high level of ultimate cooperation of their institution with the U.S. government.

The U.S. government is establishing special disclosure pacts with France, Germany, Italy, Spain and the United Kingdom. Under this approach, foreign banks would disclose data on U.S. account-holders to their own governments, which would then provide information to the IRS. The U.S. government is looking to expand these pacts to other countries as well.

It is important to keep in mind that the U.S. government has prosecuted taxpayers in many cases who did not report their foreign accounts and foreign income. The list of some of such cases is given below:

(a)    U.S. v. Mauricio Cohen Assor (Florida, 2011) got 120 months jail time — his son was also convicted and received the same jail time.

(b)    U.S. v. Diana Hojsak (San Francisco, CA, 2007) got 27 months jail time.

(c)    U.S. v. Igor Olenicoff (Orange County, CA, 2007) got 2 years probation and 120 hours community service.

(d)    U.S. v. Monty D. Hundley (New York, 2005) got 96 months jail time.

(e)    U.S. v. Brett G. Tollman (New York, 2004) got 33 months jail time — his mother and other relatives were also convicted.

Conclusion

Taxpayers having undisclosed interests in foreign financial accounts must consult competent tax professionals before deciding to participate in the 2012 OVDI. Others may decide to risk detection by the IRS and the imposition of substantial penalties, including the civil fraud penalty, numerous foreign information return penalties, and the potential risk of criminal prosecution. If discovered before any voluntary disclosure submission, the results can be devastating. Waiting may not be a viable option.

In view of the above discussion, the NRIs, PIOs and green-card holders living in the USA would be well advised to plan investments in India in a manner that they are able to obtain full credit for Indian taxes paid/withheld at source against their U.S. Tax liability on such Indian income. Further, planning to have the tax-free/low-taxed income in India may not be very prudent in many cases, in view of tax liability of such income in the USA.

The purpose of this article is to bring awareness about the 2012 OVDP of U.S. IRS and the potential risks of non-reporting of foreign financial accounts. This article is based on the information given on U.S. IRS website and views, experiences of earlier OVDPs and articles of U.S. tax experts, available in public domain. The reader is advised to consult U.S. Tax Expert(s) before taking advantage of 2012 OVDP.