Let’s suppose that country X has determined that a specific transaction is somehow abusive of the tax treaty it has signed with country Y. How does country X somehow void the transaction and strip it of its non-sanctioned benefits?
The treaty commentaries offers two viable options; the choice really depends on how treaties interact with local law as defined in that jurisdiction. This question goes to a treaty’s dual status – they are interpreted at a “public international” level (the level of the state and higher) and a domestic level (the level of the state and lower). For a further explanation of how this works, please see Professor Michael Edwards-Ker’s writings on tax treaties.
When the tax treaty is interpreted as being superior to local law, the commentaries offer the following solution:
Other States prefer to view some abuses as being abuses of the convention itself, as op-posed to abuses of domestic law. These States, however, then consider that a proper construction of tax conventions allows them to disregard abusive transactions, such as those entered into with the view to obtaining unintended benefits under the provisions of these conventions. This interpretation results from the object and purpose of tax conventions as well as the obligation to interpret them in good faith (see Article 31 of the Vienna Convention on the Law of Treaties).
As I noted in my first post on tax treaties, they in general have the understood purpose of promoting the exchange of goods and services between countries and increasing the flow of payments between countries. Transactions which do not promote these ends could be considered de facto abusive, giving the state the ability to deny treaty benefits.
When local or domestic law governs treaty interpretation, the commentaries offer the following solution:
Thus, any abuse of the provisions of a tax convention could also be characterised as an abuse of the provisions of domestic law under which tax will be levied. For these States, the issue then becomes whether the provisions of tax conventions may prevent the application of the anti-abuse provisions of domestic law, which is the second question above. As indicated in paragraph 22.1 below, the answer to that second question is that to the extent these anti-avoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax treaties and are therefore not affected by them. Thus, as a general rule, there will be no conflict between such rules and the provisions of tax conventions
Put in less formalistic terms, should the domestic law govern, the tax treaty does not void nor have any voice in the application of that jurisdiction’s anti-avoidance law provisions. As an aside, almost all jurisdictions have some type of “substance over form” doctrine. In the US this is referred to as the “economic substance” doctrine and has been formally codified. But regardless of the specific name, most jurisdictions have some set of rules to apply in this situation.
In my last blog post, I noted that, according to the OECD’s treaty commentary, there are several purposes for which the tax treaty was written. The two specifically mentioned are to promote the “exchanges or goods and services and the movement of capital and persons.” The treaty also has an anti-avoidance and anti-evasion policy. It is to this point that we now turn.
The anti-avoidance test is found in the treaty commentaries:
9.5 It is important to note, however, that it should not be lightly assumed that a taxpayer is entering into the type of abusive transactions referred to above. A guiding principle is that the benefits of a double taxation convention should not be available where a main purpose for entering into certain transactions or arrangements was to secure a more favourable tax position and obtaining that more favourable treatment in these circumstances would be contrary to the object and purpose of the relevant provisions
This is a two prong test. First, the taxing authority must prove one of the main reasons for entering into the transaction was to obtain a more favorable tax treatment. This is a subjective inquiry. Next, the taxing authority must prove obtaining that benefit would contrary to the “object and purpose of the relevant provisions.” This is an objective inquiry into the section's purpose. It’s important to remember that both elements must be present. Let’s take this in the order presented.
Determining whether securing tax benefits was a main purpose for entering into the transaction is an inquiry into the participant’s subjective intent. Under US law, this requires a very in-depth treatment of the relevant facts, where all material is used to make the determination. Sales literature is a very popular method of proof, as is contemporaneously prepared documentation (reports, memos etc..) used to communicate with others in an organization. Email can also be very revealing, as the informality of this medium may encourage more freedom to say exactly what is on the writer’s mind.
In addition to determining the taxpayer’s subjective intent, we must also rule if granting the benefits of a particular section (which probably means beneficial tax treatment) under conditions proposed by the taxpayer’s transactions would violate that sections purpose. For example, sections 10, 11 and 12 of the treaty allow for preferential tax treatment of cross-border flows, the purpose of which is to promote the remittances between counties. But inherent in each of these sections is the requirement of actual and meaningful activity. For example, a dividend is paid after a company has excess earnings and profits. Interest is paid after one company negotiates a loan and another company agrees to extend credit. Royalties are paid after an intellectual product is developed and the rights to use it are sold to a third party.
These are very complex questions to answer. If you have any questions regarding this, please contact me domestically at 832.330.4101 or over Skype at the name bonddad.
A little commented on section of the OECD Model Tax Treaty is its anti-avoidance sections. In fact, there are several pages of discussion on this issue in the commentary on Section 1 (see paragraphs 7-25). For the next few blog posts, I want to turn to a discussion of this issue as it relates specifically to the OECD Model Treaty and more generally international planning.
Let’s begin at paragraph 7, the first in the explanation’s section on “Improper Uses of the Convention.”
The principal purpose of double taxation conventions is to promote, by eliminating international double taxation, exchanges of goods and services, and the movement of capital and persons. It is also a purpose of tax conventions to prevent tax avoidance and evasion
The convention’s primary purpose is to make it easier to move goods from point A to point B by eliminating the biggest problem facing international trade: double taxation. The tax treaty does this by allowing for the taxation of goods at a jurisdictional nexus (some type or permanent establishment or formal agency in a jurisdiction where the transaction occurs) and granting those companies taxed on this transaction a credit or deduction in their home country (assuming they are taxed on their world-wide income).
For example, a US Company X sells goods through a bricks and mortar store in Germany. Because the US has a world-wide taxation system, this transaction may be subject to tax in two locations: in Germany at the point of sale and in the US on the base company’s total income "from all sources, whatever source derived." But under the tax treaty (and corresponding US law), the Company X is granted a tax credit on its US tax which in theory should eliminate the negative earnings impact of the German Tax.
In the Model Treaty, the above transaction would come under Sections 5 (Permanent Establishment) and sections 23 (Method of Eliminating Double Taxation. See also section 7 on agency.)
The treaty also encourages cross-border flows of capital. Here the biggest impediment is high taxation at the country’s border of dividend, interest or royalty payments. For example, country X imposes a 30% tax on a payment of interest or royalties moving from within to another country. To eliminate this problem, cross-border payments are typically taxed at a lower rate under tax treaties. (See general sections 10, 11 and 12).
So far, we know the tax treaties are supposed to encourage international trade in goods. Next time, I’ll start to look at how they eliminate or discourage tax avoidance and evasion. Should you have any questions, please contact me domestically at 832.330.4101 or internationally via Skype, where my name is bonddad.
Today, I’m going to finish looking at a basic view of US partnership taxation by giving a general overview of selling the partnership interest.
As with all sales transactions, we start with section 1001(a) which states:
The gain from the sale or other disposition of property shall be the excess of the amount realized therefrom over the adjusted basis provided in section 1011 for determining gain, and the loss shall be the excess of the adjusted basis provided in such section for determining loss over the amount realized.
This is a straightforward proposition and concept for anyone who’s ever been involved with any transaction.
Next, we turn to the partnership subchapter; specifically referencing sections 741 and 751. We start with section 741, which states:
In the case of a sale or exchange of an interest in a partnership, gain or loss shall be recognized to the transferor partner. Such gain or loss shall be considered as gain or loss from the sale or exchange of a capital asset, except as otherwise provided in section 751 (relating to unrealized receivables and inventory items).
This means the sale of the partnership interest is subject to capital gains tax rates. However, this does not apply to the selling partners proportionate share of partnership inventory and accounts receivable, which must receive ordinary income treatment under 751:
The amount of any money, or the fair market value of any property, received by a transferor partner in exchange for all or a part of his interest in the partnership attributable to—
(1) unrealized receivables of the partnership, or
(2) inventory items of the partnership,
shall be considered as an amount realized from the sale or exchange of property other than a capital asset.
Finally, if the partner is relieved of his proportionate share of partnership liabilities, this amount must be considered as money received by the partner in exchange for his interest under 752(d):
In the case of a sale or exchange of an interest in a partnership, liabilities shall be treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships.
That ends this look at US Partnership tax. If you have any questions about this very complex section of the tax code, please call us at 832.330.4101.
Basis is one of the most important concepts in tax, as it is used to determine gain or loss from the sale of an asset (see generally sections 1001-1016). The partnership tax rules are no different. When a partner contributes property to a partnership, the basis of the contributed property becomes the partner’s basis in his partnership interest:
The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721 (b) to the contributing partner at such time.
Like other business formation sections of the code, the creation of the new business entity leads to deferred recognition of gain from the contributed property, largely to encourage the formation of new businesses. So, assume a partner has a basis of $100 in contributed property. That basis could carry over to his partnership interest.
Lets’ add another wrinkle to the discussion and discuss the effect of liabilities on the partner’s basis. The partnership tax code distinguishes between recourse and non-recourse liabilities. “A liability is a recourse liability to the extent that any partner or related person bears the economic risk of loss for that liability under section 1.752-2. (Treas. Reg. 1.752-1(a)(1)). Section 752 of the Treasury Regulations uses a method called a “constructive liquidation” to determine a partner’s responsibility for a liability. In this calculation the following events happen:(i) All of the partnership's liabilities become payable in full;(ii) With the exception of property contributed to secure a partnership liability (see § 1.752-2(h)(2)), all of the partnership's assets, including cash, have a value of zero;
(iii) The partnership disposes of all of its property in a fully taxable transaction for no consideration (except relief from liabilities for which the creditors's right to repayment is limited solely to one or more assets of the partnership);
(iv) All items of income, gain, loss, or deduction are allocated among the partners; and(v) The partnership liquidatesBasically, the calculations assume the worst possible economic situation happens: namely, that the partnership suddenly has absolutely no assets and the partners are on the hook for the entire amount of the liabilities. To fast forward to the end, “In this context, “economic risk of loss” is a proxy for loss allocations. (Taxation of Partnerships and Partners, Mckee, Nelson and Whitmire, ©2008 RIA, 8.03(1)). In contrast to recourse liabilities are non-recourse liabilities which are liabilities that are “nonrecourse to the extent that no partner or related person bears the economic risk of loss for that liability under 1.752-2. (Treas. Reg. 1.752-1(a)(2)). Before explaining these rules, a bit of history is in order. In the 1970s, tax shelters marketed to high net worth individuals commonly used limited partnership that were loaded up with non-recourse liabilities (and a minimal initial contribution of cash), which were in turn, usually structured in such a way that the partnership never really paid on them. For example, a partnership would require a cash contribution of $10,000 from a limited partner while taking out a $1 million dollar non-recourse loan that was essentially structured with a massive balloon payment that would occur far after the useful life of the partnership was over. The reason for this was to inflate the partner’s basis, thereby allowing him to take a large amount of deductions for minimal capital input. Therefore, the non-recourse allocations were changed “so as to reflect the manner in which partners share partnership profits. (Taxation of Partnerships and Partners, as above)”Again, please remember this is a general introduction to partnership tax; there are numerous nuances to this section of the tax code that are far beyond the points listed above. Should you have any questions, please call us at 832.330.4101. And, as always, this is not any specific legal advice for anyone reading this.
One of the greatest benefits of a partnership tax structure is the ability to have disproportionate allocations. For example, suppose A and B form an equal partnership -- that is, they each receive 50% of the partnership's profits and losses. However, the partnership uses a disproportionate allocation method. Partner A could really use the actual income while partner B doesn't need it. Under this situation it's possible to allocate 90% of the income to partner A and 10% to partner B. However, these allocations must also be "substantial" -- a term of art used in partnership tax which is fleshed out in the accompanying Treasury Regulations.
A word of caution: substantial partnership allocations are perhaps one of the most complex areas of tax law. What follows is a brief explanation of this concept. In reality, this section of the code requires many pages to explain its nuances (my "learned treatise" collection of this concept extends to literally hundreds of pages). With that being said, here is the central concept of "substantiality."Except as otherwise provided in this paragraph (b)(2)(iii), the economic effect of an allocation (or allocations) is substantial if there is a reasonable possibility that the allocation (or allocations) will affect substantially the dollar amounts to be received by the partners from the partnership, independent of tax consequences. Notwithstanding the preceding sentence, the economic effect of an allocation (or allocations) is not substantial if, at the time the allocation becomes part of the partnership agreement, (1) the after-tax economic consequences of at least one partner may, in present value terms, be enhanced compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement, and (2) there is a strong likelihood that the after-tax economic consequences of no partner will, in present value terms, be substantially diminished compared to such consequences if the allocation (or allocations) were not contained in the partnership agreement.
Let's translate the above statement into English. Conceptually, think of each potential allocation being a see-saw. When a partner receives more of something, the other partners must receive less. So, in our examples above, when partner A receives 90% of the partnership's income, Partner B receives 10%. This allocation substantially effects the two partners' allocations. In addition, the allocation passes the second test as Partner A has receives more benefits while Partner B's situation is substantially diminished (he's receiving less income). Again, it's important to remember there are many nuances to this concept that are far beyond a blog post. However, the see-saw analogy helps to convey the basic concept. If you have any additional questions, please call us at 832.330.4101.
Today, I want to continue looking at the partnership capital account. But before I get into the details, let’s review a few basic points. First, from a tax perspective, partners share the economic benefits and burdens of ownership. That means if a partnership makes money, the partners do too. But if the partnership needs more money to continue as a going concern, the partners will have to contribute additional funds. In addition, the allocations of a partner’s capital account must have “substantial economic effect.” This is a term of art in the tax world. In order to have economic effect, the computations for the partner’s capital account must comply with three requirements. I covered the first last week. This week, we’ll look at the remaining two.
Under the accompanying Treasury Regulations,
(2) Upon liquidation of the partnership (or any partner's interest in the partnership), liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (2) and requirement (3) of this paragraph (b)(2)(ii)(b)), by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), and
(3) If such partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, as determined after taking into account all capital account adjustments for the partnership taxable year during which such liquidation occurs (other than those made pursuant to this requirement (3)), he is unconditionally obligated to restore the amount of such deficit balance to the partnership by the end of such taxable year (or, if later, within 90 days after the date of such liquidation), which amount shall, upon liquidation of the partnership, be paid to creditors of the partnership or distributed to other partners in accordance with their positive capital account balances (in accordance with requirement (2) of this paragraph (b)(2)(ii)(b)).
Before you get confused by the excess verbiage, remember that partners have to share the benefits and burdens of being partners. So, under number (2) above, we see that partners share the benefits of being partners; if a partnership is liquidated and there are excess funds available after paying off creditors, the partners get to share in the profits in direct proportion to the ownership in the partnership.
In contrast, if there is a deficit in each or any partner’s account, they have to make an additional contribution to the partnership.
Here’s a simple example to illustrate both points. Partners A and B each have $50 in their capital account after the partnership has wound up its business and paid off all creditors. They will each receive $50 of the remaining available funds. Let’s reverse the process and say that each partner has ($50) – a $50 deficit account after the partnership has paid off all its debts. That means the partnership was an economic failure and each partner gets to contribute an additional $50 to pay off the partnership’s creditors.
As an FYI, the above examples are deliberately very simple to illustrate the underlying policy of these regulations. As I mentioned in last week’s post, partnership accounts are one of the most complex areas of tax law with many nuances that go far beyond these posts. However, the above illustrations should give you a good general overview of the basic concepts involved.
Next I’ll look at some of the requirements for “substantial.”
Remember that from a tax perspective, partners agree to share the economic benefits and burdens of ownership. This means that not only will they share profits, but they will also share losses and – in a worst case scenario -- perhaps contribute additional capital in support of the business. For tax purposes, we need to create and maintain some record of this activity.
Enter the partner’s capital account. This is the most important element of partnership taxation; it’s an ongoing record documenting the partner’s economic participation in the partnership. The actual workings of this account are one of the most complex in US taxation and therefore beyond the scope of a few blog posts. However, some initial observations can be made.
Always remember that we we’re keeping a record that shows ongoing participation in the benefits and burdens of partnership ownership.
Under the treasury regulations, partnership allocations must have “substantial economic effect” – a term of art in the partnership tax world. Economic effect, in turn, has three factors, the first of which is this
… each partner's capital account is increased by (1) the amount of money contributed by him to the partnership, (2) the fair market value of property contributed by him to the partnership (net of liabilities that the partnership is considered to assume or take subject to), and (3) allocations to him of partnership income and gain (or items thereof), including income and gain exempt from tax and income and gain described in paragraph (b)(2)(iv)(g) of this section, but excluding income and gain described in paragraph (b)(4)(i) of this section; and is decreased by (4) the amount of money distributed to him by the partnership, (5) the fair market value of property distributed to him by the partnership (net of liabilities that such partner is considered to assume or take subject to), (6) allocations to him of expenditures of the partnership described in section 705 (a)(2)(B), and (7) allocations of partnership loss and deduction (or item thereof), including loss and deduction described in paragraph (b)(2)(iv)(g) of this section, but excluding items described in (6) above and loss or deduction described in paragraphs (b)(4)(i) or (b)(4)(iii) of this section; and is otherwise adjusted in accordance with the additional rules set forth in this paragraph (b)(2)(iv).
In effect, all we’re doing is increasing the partner’s account when he contributes money or property and when he receives some allocation from the partnership (NOT a distribution) and decreasing his account when the partnership distributes money or cash to the partner, or when the partnership allocates some loss or deduction.
Let’s look at simple example.
1.) Partner X contributes $100 cash to a partnership on formation (he’s a 50/50 partner with partner y). This increases his capital account by $100.
2.) Partnership makes $50 in year 1. As Partner X is a 50% partner, the partnership allocates $25 to Partner X, increasing his partnership account to $125.
3.) In year 1, the partnership distributes $75 cash to Partner X. This decreases partner X’s capital account by $75 to a final total of $50.
Again, always remember the prime purpose of the partnership capital account is to keep an ongoing record of the partner’s actual economic participation and you should be fine.
Next week, we’ll look at two more factors the capital accounts must comply with.
The Bancroft case has been working its way through various federal jurisdictions over the last few years. In theory, it involves a captive insurance scenario. In reality, it's tax evasion, plain and simple.
For me, the dead giveaway is the the "round trip" nature of the transaction. Consider this explanation of the program from the decision:
Sigel and Barros formed Bancroft. They didn’t know much about insurance so they outsourced the underwriting function, actuarial responsibility, claims handling, accounting function, due diligence inquiries, and routine paperwork chores. They also outsourced much of the investment operation. One of Bancroft’s primary investment vehicles was to make commercial loans back to the various participants who gave their money to Bancroft in the first place. Not coincidentally, Bancroft would loan back 70% of the premium dollars that had been committed for “coverages.” Bancroft would outsource responsibility for securing the loans and perfecting the security to the borrower. Perhaps not surprisingly, the perfection of the security was, on occasion, “forgotten.” The insuring end of the business similarly went lacking. Scolari was asked how much he wanted to pay in premium dollars. In 2006 he responded: $2.6 million, and in 2007, $5 million. In return, Scolari received a tax deduction for the full premium, and insurance coverage that he and his company didn’t need. He also received a promise that, if his claims were low and the investments were successful, he would receive a refund of his premium dollars after five years.
Anti-avoidance law is littered with cases involving this type of fact pattern: parent makes payment to a controlled company. The payment provides some tax benefit to the parent (usually an outsized deduction). The controlled company holds the money for a short period of time and then funnels the money either directly back to the parent or to another entity that somehow allows the parent to still control or gain benefit from the funds. This is one of the primary reasons the tax code has section 482, which is the US codes transfer pricing section (the law's section is short; the accompanying Treasury Regulations are extensive).
At the heart of the IRS’ concern regarding captives is the captive is nothing more than an accounting reserve rather than an independent stand-alone insurance company. Defined broadly a reserve is a, “separation of retained earnings to provide for such payouts as dividends, contingencies, improvements, or retirement of preferred stock.” Several early tax cases (tried to the Bureau of Tax Appeals, the predecessor of the Tax Court) specifically disallowed the deduction of payments into a reserve fund, based on the following reasons:
1.) The tax code allowed a deduction for business expenses, but not for amounts paid into an internally held reserve. This is supported by a strict reading of the statute (currently 26. U.S.C. 162(a) and the accompanying Treasury Regulations).
2.) Moving funds internally – from cash to a reserve or from one corporate “pocket” to another – does not shift the risk as required by insurance. This is essentially an analysis based on a strict reading of this occurrence at the balance sheet level.
3.) Preventing the manipulation of gross income through the use of “reserves” and “contingency funds” as outlined in Spring Canyon Coal.
4.) Both accrual and cash accounting methods require the taxpayer to deduct specific “realized” amounts. A taxpayer cannot deduct a speculative amount. As the ultimate amount of the payout from the reserve is speculative, a deduction is not allowed.
Realistically, the service is ultimately concerned with point number 3 above – using the establishment, maintenance and eventual dissolution of a reserve to manipulate earnings. As an example of the fact pattern, suppose Acme Corp. has strong yearly earnings this year. In order to lower their gross income (and hence taxable income) they establish a reserve for some type of reasonably foreseeable contingency. However, five years later when earnings are lower, the company declares the contingency no longer exists and hence dissolves the contingency fund, bringing the reserves back onto the company’s income statement at a time when the tax burden is lower.
Regardless of the feasibility – or lack thereof – of the preceding hypothetical fact pattern, it does provide prospective captive owners with a clear compliance mandate: after establishing the captive, the longer the captive’s funds remain separate and non-distributed to the parent the better. Regrettably, there is no formal guidance providing a minimum amount of time during which the captive’s funds must remain entirely separate from the parent. However, we do have several examples from non-captive case law wherein a company’s corporate existence was too short to create sufficient corporate substance. The corporation established by the taxpayer in the landmark anti-avoidance case Gregory c. Helvering, existed for a mere three days. Several anti-avoidance cases from the 1990s involved partnerships which were in existence for periods up to one fiscal year. Beyond the period of a year, however, guidance becomes far murkier. However, common sense informs us that the longer a captive is in existence with its funds separate from the parent, the better. Ideally, the minimum time which the parent should commit to running the captive without payments from the captive going to the parent is three to five years. This length of time will allow the captive to fully develop initial capital and surplus relative to the original underlying risks being underwritten by the captive.
 Barron’s Finance and Investment Handbook, page 446 © 1990 Barron’s Educational Series, Inc.
 See also Appeal of William J. Ostheimer 1.B.T.A. 18, 21 (“The statute specifies what deductions are allowable and, except in the case of in insurance companies, no provision is made in the 1918 Act for the deduction of a reserve as such.”).
 See also Appeal of Consolidated Asphalt, 1 B.T.A. 79, 81 (“When estimating the reserve to set aside for a construction contract, the appellant’s accountant doubled the amount set aside for the years in question.”).
 See General Counsel Memorandum 35340, 05/15/1973 (“However, because anticipated casualty losses are contingent in nature, it is a firmly established principle of tax accounting that even as accrual basis taxpayer may not deduct amounts it adds to a reserve for insuring its own risks.”).
 Gregory v. Helvering, 293 U.S. 465 (1935).
 ACM Pshp. v. Commissioner, T.C. Memo 1997-115 (T.C. 1997), ASA Investerings Partnership v. Commissioner, 201 F.3d 505 (DC Cir. 2000),