Tax planning becomes a reality when the growth of a multinational enterprise form its very beginnings brings in the tax and structural issues inherent in its growth and these issues virtually affect all companies expanding into different territories. At this stage the tax strategies are used to minimise the overall tax cost. The variable and elements for international tax planning include the following:
a. The transaction factor: The first and an important factor for consideration is that what are the tax costs and tax benefits of each transaction. For example if we use check the box option for a CFC, then we have to take into consideration what benefits will be there for a transparent entity or for a disregarded entity?
b. The character factor: Tax is related with income so how is the nature of the tax going to affect the relevant income is an important factor for tax planning. For example, consider interest income accruing to a CFC, and how the tax character is going to affect a taxable entity.
c. The timing factor: Timing factor has many characteristics, for example withholding tax time, time for exemptions or the relevancy of the period in which the transaction take place. A good example is the rendering of a personal services in a source country for more than 183 days, the person's income will be taxable in the country of residence at the relevant time.
d. Entity factor: It is concerned with the company or the business or an entity, which will carry out the transaction. For example a transparent or a disregarded entity in a check the box selection for a CFC for US tax purposes. It is an important factor for consideration.
e. Jurisdictional factor: Where the tax event took place. In this regard reference is invited to Vodafone's case decided by an Indian court where situs source, connection, and jurisdiction all became relevant.
How do they interrelate to one another Each factor compliments each other and is related. For example the purpose of tax planning is to reduce the average tax rate and for that, all the elements are relevant. In case of subpart F income, it is the entity, its character, jurisdiction, timing and transaction all that are important to be considered for obtaining the tax benefit either as a disregarded entity or transparent entity. However, recently enacted US legislation on taxation measures has embodied in itself the economic substance doctrine, this paper examines, that in the context of tax planning, how this doctrine is going to affect individuals, business and multinational enterprises.
President Obama has signed the Health Care and Education Affordability Reconciliation Act of 2010,1 and it (the "Act"). Codifies the economic substance doctrine and applies to transactions entered into after March 30, 2010. The economic substance doctrine is a judicially-developed doctrine under which the anticipated tax benefits from a transaction may be denied if the transaction does not result in a meaningful change to the taxpayer's economic position other than reducing federal income taxes. This result can occur even if the transaction otherwise satisfies all statutory and administrative requirements.
The Act provides2 that in the case of any transaction "to which the economic substance doctrine is relevant," the transaction shall be treated as having economic substance only if (1) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer's economic position and (2) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into such a transaction.
While the new statute specifies the test that must be met in order to have economic substance, it does not specify when that test must be applied. It merely states that the determination of whether the economic substance doctrine is relevant to a particular transaction and will be made in the same manner as if the new statutory economic substance provision had not been enacted. Unfortunately, existing authorities do not clearly define the types of transactions that are subject to the economic substance doctrine. Accordingly, taxpayers are left with substantial uncertainty as to the circumstances in which this new statute will be applied.
The Act includes a new 40% strict liability penalty that will be imposed on underpayments resulting from transactions found to lack economic substance or failing to meet the requirements "of any similar rule of law." The penalty is reduced to 20% of the underpayment if the transaction is disclosed by the taxpayer. If it is determined that the doctrine applies to a transaction and the test is not met, this harsh penalty will apply, regardless of the reasonableness of a taxpayer's belief that the economic substance doctrine is not relevant to a transaction or that the transaction satisfies the statutory economic substance test.
Why this doctrine is important for cross-border tax planning? The new statutory economic substance provision will greatly complicate tax planning. The impact of these provisions is quite broad, and many legitimate business transactions, if tested for economic substance, could fail the test of this statutory enactment. It may not affect certain common transactions to which the doctrine is not applicable, yet there will be situations in which a taxpayer may reasonably expect that the doctrine is not relevant, but is unable to assess the real impact of these legal provisions.
These factors may lead to situations in which the doctrine is or may be relevant and situations where it is not certain, whether or not the statutory test is satisfied. For these reasons, and because of the related strict liability penalty, taxpayers will have to accept the increased tax risk of tax charging in respect of some transactions. In all likelihood, such measures will deter taxpayers from engaging in such transactions that would have been undertaken in normal circumstances.
1. See Section 1409 of the Health care and Education Affordability Reconciliation Act of 2010.
2. See §7701(o) of IRC.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates)