July 1999
Natwest May Be The Law, But Is It Right
By John A. TownsendMr. Townsend has published an article by this title in Tax Analysts Publications as follows:, Tax Notes International Tax Notes Int'l, July 26, 1999, p. 417; Worldwide Tax Daily, 19 Tax Notes Int'l 417 (July 26, 1999), Tax Notes 84 Tax Notes 772 (8/2/99) and Tax Notes Today 1999 TNT 147-80 (8/2/99).. The article discusses the recent Court of Federal Claims decision in National Westminster Bank, PLC v. United States, ___ F. Cl. ___ (7/7/99)The following is a summary of the article and assumes that the reader has considerable familiarity with the international tax rules applying to branches and at some some familiarity with U.S. tax treaties.
Facts
NatWest is a global bank resident, that is, it is incorporated in the United Kingdom. NatWest operates in the United States through a branch, which is a permanent establishment (PE) as defined in the U.S.-U.K. treaty; thus, NatWest is subject to U.S. tax on net income from the PE operations. NatWest substantially funds its operations with debt (deposits and other types of borrowings). NatWest funded its U.S. PE operations (financing transactions) with intracompany advances, although the precise source of the funds NatWest advanced its U.S. PE (that is, whether it came from outside debt -- and, if so, what outside debt -- or capital) is not addressed in the opinion. On a separate profit center basis, the U.S. PE treated the intracompany advances as notional borrowings. That is, the U.S. PE, although a branch and not a separate entity, set up notional payables to its main office in the United Kingdom on which the U.S. PE accrued interest.
For the years in issue (1981-1987), in filing its U.S. tax return, NatWest deducted the interest notionally owed on the notional intracompany loans, thus substantially reducing its U.S. tax. NatWest's return position was that, under the treaty's notional separate entity concept, NatWest's U.S. PE was entitled to the interest deductions because had it operated through a separate entity (presumably a type of notional subsidiary), it would also have borrowed from its notional parent (the U.K. corporation) to fund its U.S. operations and, thus, it would have been entitled to deduct the interest on the borrowings. The U.S. Internal Revenue Service objected and sought to apply a methodology in the U.S. tax regulations that would apportion NatWest's systemwide debt and interest to its U.S. operations, an apportionment methodology that produces less U.S. interest deductions than NatWest claimed.
Legal Background
The U.S./U.K. treaty requires that "permanent establishment" branch operations ("PE") in one treaty country by a resident of the other treaty country be taxed as if the PE were a separate entity. This meant that Natwest's U.S. PE operations must be taxed as if the PE were a separate entity. Under this concept the notional separate entity calculates its U.S. tax by reference to its U.S. income less deductions attributable to the U.S. income. So far, so good, and this drill is not altogether different from the drill all foreign owned U.S. branch operations must undertake under the effectively connected income ("ECI") regime for attributing ECI and related deductions to determine U.S. tax liability. The key difference at issue in Natwest was whether intracompany loans and the "interest" on such intracompany would be respected for U.S. tax purposes. Normally, under the U.S. rules for foreign branch operations in the U.S., intracompany accounts are ignored in determining U.S. tax liability and the U.S. branch is permitted to attribute some portion of home office outside debt that relate to the U.S. operations. And, because debt is viewed as fungible, the 882 Regulations apply a formulary approach for attributing debt and interest on the debt. The IRS sought to apply the Regulations rather than honor Natwest's intracompany profit center accounting treating the intracompany debt as debt supporting deductible interest.
Issue
The court framed the issue as follows (emphasis added):
In practical terms, the precise, narrow issue for resolution at this juncture in the proceedings is whether, in the determination of the interest expense deduction for the U.S. Branch, the interest expense reflected in its books of account - - with appropriate adjustments, if necessary, to reflect imputation of adequate capital and arm's-length, market interest rates in intra- corporate 'borrowing' transactions -- may be used in calculating plaintiff's U.S. tax liability, or whether, with respect to interest expense, the defendant may require use of a formulary approach, such as that in Treas. Reg. section 1.882-5, which disregards intra-corporate 'lending' transactions reflected in the books of account.
Thus framing the issue, the Court of Federal Claims moved handily o accept the taxpayer's argument and reject the IRS's. The court reasoned that the regulations' formulary approach is not the same as the fact-specific inquiry required by the separate entity concept in the treaty and, of course, the treaty trumps the regulations just as a treaty trumps a statute (setting aside timing issues). The court was concerned that, under the (perhaps any) formula, U.S. liabilities and U.S. interest would ultimately be determined by worldwide liabilities and interest, a result it did not view as compatible with the separate entity concept.
The court then took the leap to say that it would bless NatWest's intracompany notional debt arrangements, rather than attempt to allocate out to the U.S. operations some portion of NatWest's debt to outsiders. As suggested in the examples above, attributing and allocating the foreign corporations' debt to outsiders to the various operations is a real conceptual problem and virtually requires some formulary approach to be workable. The court avoided the whole inquiry by holding that it would honor NatWest's intracompany notional borrowings, which may or may not reflect its outside borrowings.
The court, nevertheless, recognized that there may be limits on a foreign corporation's ability to leverage U.S. interest deductions with intracompany loans. As noted above, the court recognized that there might be some adjustments for a capital requirement that the notional separate entity would be subject to if it were in fact a separate entity. The court also noted that there might be some adjustment to the interest rate charged under arm's- length concepts. The court directed the parties to file a joint status report by August 9, 1999, to suggest further proceedings, consistent with its holding, to get to the bottom line.
Comments
Debt Without Debt?
Intracompany debt is, of course, not debt. The intracompany "debt" is just notional, not real, a fiction. The debt may not be fairly reflective of the corporation's real debt to outsiders and, indeed, the corporation conceivably could have no outside debt, but treat its capital advanced to branches as intracompany debt, so that, for tax purposes, it has debt without debt. Nevertheless, it could have such debt with an actual separate entity such as a real subsidiary carrying on the same operations as the branch, so long as it safely skirted the debt/equity rules and other tax and nontax requirements for capitalizing a true separate entity. But, if there is a true separate entity, there is real debt.
Debt/Equity and Related Rules in a Notional World?
How do the debt equity rules apply in this notional world? Presumably, since the drill required by the treaty is to treat the PE as a notional entity, those rules will apply to the debt/equity structure the taxpayer created for its PE. What if it leverages the PE too much? Is all intracompany debt then transformed into equity, or only enough to clear the debt/equity rules?
A related issue is whether all U.S. rules that would otherwise apply to a true separate entity apply to this notional separate entity? The Court addressed one such set of rules by saying that some type of regulatory capital requirement might be imposed on the notional separate entity. What does that mean? In the case of Natwest, is this notional separate entity subject notionally to federal and/or state regulatory rules and, if so, which ones? And, if the PE is just a lending branch (i.e., it does not seek U.S. deposits), is it subject to any regulation at all?
The Treaty Governs
The Court seemed to set this issue up as to whether the treaty would apply or not. On that basis, the result is an easy lay up, for the treaty must apply. The IRS position was not based upon ignoring the treaty or urging that the rules in the Regulations or any Code rules upon which the Regulations were based overrode the treaty. Rather, the IRS's position was that the formulary method in the Regulations for attributing debt to PE operations was consistent with the mandate of the statute. Seen in this light and the fact that a taxpayer can arbitrarily manipulate intracompany books of account so as to manipulate tax results, the IRS position was that it was a reasonable implementation of the statute (not a perfect one surely and perhaps not the only reasonable one, but certainly a reasonable one). By framing the IRS's position as being whether the treaty applied or not, the Court set up a straw man that it handily knocked down.
Are Financial Institutions Different?
The issue as I see it is whether the taxpayer's profit center accounting controls the results. The Court said that it did, subject to capital structure requirements that would have applied if the PE were a separate entity. But, it is clear that the general rule in U.S. treaties and counterpart OECD Model Treaties is that such intracompany accounts are generally ignored simply because they can manipulate the results. The Commentaries to an earlier OECD Model Treaty had so stated but had also stated that special considerations apply to financial institutions. Since they are different, the Commentaries suggested that perhaps profit center accounting for intracompany loans would be honored. The OECD commentaries (a sort of "legislative history" for the OECD Model Treaty, but hardly "legislative history" for the U.S./U.K. treaty) did suggest that such profit center accounting might be honored. Taking a leap of faith that the drafters of the U.S./U.K. treaty must have had a similar notion in mind in the bare separate entity concept they adopted, the Court decided that intracompany accounts -- to wit, debt and interest on that "debt" -- would be honored in calculating the notional separate entity U.S. tax.
I raise the question in the article whether financial institutions are really different simply because they deploy their assets to make loans (usually) or simply because they are highly leveraged. There are highly leveraged nonfinancial business operations -- do they get the same treatment. The answer to the latter is, of course, no, and seems to turn only on the fact that they do not use their funds the way financial institutions do. But that does not tell us why financial institutions are different in terms relevant to the different tax treatment they seek. The Court also does not tell us in any persuasive way.
In this regard, one apologist for the Natwest decision, suggested that, because banks are highly leveraged, any ratable allocation of outside debt would produce a high debt to equity ratio in any event and with such a relatively small equity anyway, there is little room for tax manipulation. Yet, that is precisely the room that banks exploit to make their profit and the swing is quite a big one, for banks such as Natwest make big bucks on their relatively small equity (relative to their debt of course). Nevertheless, the conventional wisdom in this context is that financial institutions, just as the rich, are different.
Natwest is silent about whether Natwest sought competent authority resolution of the issue. Since writing the article, I am advised that the U.K. filed an amicus brief on Natwest's behalf, so presumably the U.S. would not have been able to convince the U.K. to accept the result in competent authority proceedings. Indeed, maybe there were proceedings and the U.S. simply refused to budge, on the notion that its application of the formulary rule was a reasonable implementation of the statute.
Interest Rate Opportunity
Whether the separate entity rule is ultimately held consistent or inconsistent with the treaty, there will be debt attributed to the PE. Under the separate entity construct that everyone agrees controls, the interest rate should not be the foreign notional parent's interest rate to outsiders. That interest rate is supported by a much larger equity base (the worldwide base) and is thus lower than the notional separate U.S. entity would obtain in an arm's length transaction. This will permit further erosion of the U.S. tax base and the tax base of any treaty country that has a similar notional separate entity construct with respect to treaty country PE operations in that country. But, in reverse, it will permit the residence country (e.g., the U.S. as to U.S. financial institutions operating through PE's in treaty countries) to assert that the foreign countries' tax bases should get eroded by a higher interest rate in favor of the U.S. What is sauce for the goose is also sauce for the gander. Hence there are interest rate opportunities and risks for all involved.
Conclusion
I think that the case is strong to have some formulary rule to avoid unbridled taxpayer manipulation through intracompany profit center accounting. Notwithstanding that, however, under the notional separate entity concept, taxpayers could structure the capital of the separate entities, so long as they satisfy all the rules that would apply to the separate entity (e.g., tax rules such as debt/equity and regulatory rules for minimum capital). If that is the benchmark, then perhaps the taxpayer's internal accounting should control, just as it would for a true separate entity simply by making the accounting external (i.e., between two separate real entities).
Compaq Wins Transfer Pricing Case
By John A. TownsendThe venerable Compaq (venerable in the high-tech industry) recently handed the IRS a significant defeat in Compaq Computer Corp. v. Commissioner, T.C. Memo. 1999-220 (7/2/99). I shall not here deal with the details. Suffice it say that Compaq, in reporting on the return, used a cost-plus formula. Prior to trial, Compaq abandoned that methodology as support for its transfer prices and relied instead upon a "comparable uncontrolled price" ("CUP") method to support its prices. Prior to trial, the IRS too abandoned its earlier methodology and instead relied upon a cost-plus methodology.
The Court rejected the IRS's audit methodology because it had been abandoned and rejected the IRS's trial methodology, based on specific enumerated inadequacies. . On that basis, the Court concluded that the IRS's "allocations lead to an unreasonable result and are thus arbitrary, capricious, and unreasonable." The IRS did attempt to justify the inadequacies based upon alleged inability to get good information from Compaq. The IRS drew support for this argument from ASAT, Inc. v. Commissioner, 108 T.C. 147, 166-167 (1997), which dealt with Section 6038A. The Court rejected the argument on the basis that Compaq did not withhold information and that Compaq's change of methodology was not the equivalent of unfair withholding of evidence.
The Court then said that "In addition to proving that the deficiencies set forth in the notice are arbitrary, capricious, or unreasonable, petitioner must also prove that the prices charged by Compaq Asia were consistent with arm's-length pricing." The Court then analyzed the taxpayer's methodology, the CUP method, and found that it could be applied because quantifiable adjustments to the comparable uncontrolled sales could be made. I shall not review here the fact specific analysis. The Court concluded bottom-line that the taxpayer had it right and the IRS had it wrong.
T&J Comments on Compaq
1. Perhaps the most fascinating in the Court's statement of the burden on the taxpayer. Traditional Section 482 analysis has been that the taxpayer must prove that IRS's determination was "arbitrary, capricious and unreasonable." The question that I have addressed before in discussing the DHL case (you may review those musings by clicking here) is what then happens? What happens then if the Court is in a state of equipoise as to a proper transfer price -- does the IRS prevail or does the taxpayer prevail. Trial records are not this crisp, but if they were the question stands. The Court addressed that issue in the quote noted above, which I requote for emphasis: "In addition to proving that the deficiencies set forth in the notice are arbitrary, capricious, or unreasonable, petitioner must also prove that the prices charged by Compaq Asia were consistent with arm's-length pricing." So the taxpayer must still prove the propriety of the transfer prices it desires even if the IRS is "arbitrary, capricious and unreasonable." As I have asked before, what then does it achieve to show that the IRS's position is "arbitrary, capricious and unreasonable. I suppose the answer is that, so long as the IRS's determination is just wrong but not arbitrary, capricious, the taxpayer may be stuck with the wrong transfer prices. Please see my discussion of this issue in my discussion of the DHL case.
2. Another issue I have pondered is whether the taxpayer can force a more favorable transfer price than it initially claimed. The Court of Claims indicated in Pikeville that, once the IRS makes a Section 482 determination and the taxpayer contests it in court, the court can apply the proper transfer price even if it is more favorable than the taxpayer established and claimed in its return. See Pikeville Coal Co., et al. v. United States, 37 Fed. Cl. 304 (1997), my discussion of which may be reviewed by clicking here. In Compaq, the Court said:
Petitioner somewhat inconsistently asks at some points that the Compaq Asia price be adjusted upward and at others that no section 482 adjustment be made. To the extent that petitioner implies that it is entitled to an affirmative adjustment reducing its U.S. tax liability, the evidence shows only consistency with arm's-length pricing, not inadequate pricing. In view of the necessity of approximations and adjustments, we are not persuaded that the prices contemporaneously charged by Compaq Asia to Compaq U.S. and used in petitioner's tax reporting should be retroactively adjusted to the advantage of petitioner.
Factually, therefore, the Court held that no favorable adjustment was required, but seems to hold out the possibility that a favorable adjustment could occur.
3. I also found interesting the Court's holding that volume discounts were not appropriate. Compaq's biggest foreign supplier of PCA's was an affiliated company and the IRS urged that prices charged smaller independent suppliers were thus not comparable. The Court first held:
The regulations do not enumerate volume as a factor that may impact price; rather, the regulations merely provide that comparable uncontrolled sales "do not include sales at unrealistic prices, as for example where a member makes uncontrolled sales in small quantities at a price designed to justify a nonarm's-length price on a large volume of controlled sales."
Then, perhaps sensing that this was not wholly adequate to address the IRS's argument, the Court moved to the facts and made an astounding holding that, factually, volume had no effect on the transfer prices. The Court said:
Petitioner presented substantial evidence showing that the prices that Compaq U.S. actually paid to unrelated suppliers, although quoted by volume, were not ultimately established by volume. Testimony on this point came from the unrelated subcontractors as well as from Compaq U.S. purchasing personnel. The industry experts, Ray Prasad, Charles-Henri Mangin, and Tim Faucett, similarly opined that the higher volume did not lead to lower prices in this case. The testimony was that volume had no effect on price because unrelated subcontractors gave Compaq U.S. their best prices in light of the Compaq U.S. market position and overall level of potential business. Compaq U.S. was big enough and bought enough PCA's that it was able to demand and receive the best prices regardless of volume.
I have nothing further to add on this issue that would not be obvious to a reader who has gone this far.
4. The Court also blessed the use of comparables in years other than the years in issue, so long as they were not so remote as to be unpersuasive on prices in the year in issue. Basically, the Court is realistic in realizing that, due to the difficulty of transfer pricing, it must take persuasive evidence wherever it finds it, for the drill is to achieve a fair transfer price not a perfect one.
Tax Court Insists the It Does Have the Right to Do Equity -- At Least Estoppel Equity
By John A. TownsendIn Estate of Branson v. Commissioner, 113 T.C. No.2 (7/13/99), the Tax Court insisted that it did have the right to apply equitable recoupment to reduce the amount of the deficiency otherwise determined by the Court for the year before the Court. This has been a "hot" issue over the last several years, because the Tax Court suddenly discovered in Estate of Mueller v. Commissioner, 101 T.C. 551 (1993) that indeed it could apply the doctrine of equitable recoupment. (I would love to,but shall avoid the temptation, to develop the legal nuances of the issue, simply because it would not be helpful to most readers of this newsletter.) Mueller was a watershed case, because the Tax Court suddenly flexed its equitable muscles as a court (which it has been since 1969). (The Tax Court is not known for having any equitable muscles, but perhaps it had overdosed on steroids when Mueller popped up.) However, on appeal in Mueller, the Sixth Circuit put the Tax Court in its place by holding that the Tax Court had no such power and was instead limited to determining the amount, if any, of the deficiency for the year (in the case of an income tax) or event (in the case of an estate or gift tax) before it. In Branson, the Tax Court had the first opportunity to pronounce whether it was convinced by the Sixth Circuit's limitation on its authority, and the Tax Court announced (not surprisingly) that it was not persuaded. Since Branson is appealable to the Court of Appeals for the Ninth Circuit, the Sixth Circuit's decision in Mueller is no more than an appellate court's ramblings to which the Tax Court is not bound (under the Tax Court's venerable Golsen rule) and need not be persuaded. The Tax Court stuck to its guns in Branson, thus giving the Ninth Circuit the opportunity to get it right. If the Ninth Circuit does get it right (i.e., agree with the Tax Court (that's the only editorial comment I will make)), then it appears that the issue may be resolved by the Supreme Court. In any event, the Fifth Circuit (the court to which appeals in Texas are taken) has not yet spoken on this issue and, to the extent experience (actual and vicarious) is a predictor of what the Fifth Circuit would say, we think there is a better than even chance that the Fifth Circuit will not side with the Sixth Circuit on this issue unless commanded to do so by the Supreme Court.
Taxpayers and their advisors should be careful to note the limitations of the application of the doctrine of equitable recoupment. It simply applies to prevent the IRS or the taxpayer from double benefitting from inconsistent treatment. In Branson, it prevented the double benefit by reducing the deficiency in the open year before the Tax Court, but not below zero (i.e., it will not permit a refund for net taxes overpaid in the barred year even if the tax in the barred year was not due). The doctrine of equitable recoupment is a two way street -- i.e., it can apply in the IRS's favor where the taxpayer has double benefitted and the erroneous benefit is now barred by the statute of limitations. Much of this ground prevoiusly covered by the doctrine of equitable recoupment is now covered by the mitigation provisions of the Code (Sections 1311 - 1314). But in cases where the mitigation provisions do not apply, taxpayers and the IRS may fall back to the general equitable recoupment doctrine and (hopefully) find some relief.
Joint Committee on Taxation Issues Penalty and Interest Study
The Joint Committee on Taxation has released its mandated study on penalties and interest. The study will be influential in shaping the debate on congressional changes to these rules. The study may be downloaded in pdf format from the Joint Committee Web page. The Joint Commitee Home Page is http://www.house.gov/jct/ and the specific link for the new study is http://www.house.gov/jct/s-3-99.pdf
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