International Tax Update
The Organization for Economic Cooperation and Development (OECD) issued its final recommendations from its base erosion and profit shifting (BEPS) project on October 5, 2015. These recommendations are intended to provide a comprehensive and coordinated approach to international taxation of multinational companies and will have a far reaching effect on the international tax landscape. The G20 Finance Ministers, who requested the OECD look into these issues, are expected to agree to these recommendations in their entirety.
The OECD is a policy making body where the governments of 34 democracies with market economies work with each other, as well as more than 70 non-member economies, to promote economic growth, prosperity and sustainable development. The OECD provides a forum in which governments can work together to share experiences and develop solutions to common problems. Issues regarding the taxation of multinational companies have been a key focus of the OECD for many years with their attention mostly focused on the avoidance of double taxation. However, in more recent years the focus has shifted to the avoidance of taxation by multinational companies altogether and the reason why the OECD was asked to undertake its comprehensive BEPS project.
Changes proposed under the OECD’s BEPS Action Plan can be classified into the following categories:
- Aligning taxation with substantive value added activity including eliminating tax treaty abuse and transfer pricing inconsistencies and unifying taxable nexus standards,
- Eliminating tax “gaps” including the use of hybrid entities, hybrid financial arrangements and other “harmful” tax practices,
- Increased transparency requiring significant additional disclosure on a country by country basis to relevant tax authorities, increased transfer pricing documentation and disclosure and detailed reporting of ”tax schemes”,
- Addressing the complex challenges related to taxation of the “digital economy” including direct and indirect (e.g. VAT) taxes,
- Improvements to dispute resolution processes including development of a multilateral agreement to overwrite many bilateral treaties currently in force.
The report is significantly complex and comprehensive. The recommendations contained in the report are not binding on any of the OECD members. Many countries have already begun a process of unilateral changes to their system of taxation of multinationals to address some of their concerns regarding loss of tax revenue. In order to achieve the desired results, the OECD is encouraging its members to adopt its recommendations across the board to allow for application of a consistent and comprehensive set of tax rules to multinational companies. However, it is a tall task indeed to expect that this will occur in the short term. Therefore, we should expect a combination of multilateral and unilateral changes in the system of taxation of many of the industrialized nations over the next several years resulting in continued or new disparities in the application of international tax laws with a corresponding increase in controversies with tax authorities.
Federal Tax Developments
Tax Court ruling in Altera case invalidates regulations regarding sharing of stock-based compensation expenses
This summer the Tax Court in Altera Corp. v Commissioner, 145 T.C. No. 3 (2015), ruled that a portion of the Treasury Regulations governing related party transactions was invalid. The specific section of the Treasury Regulations impacted by this decision was that requiring certain stock based compensation expenses to be includable in the cost pool for related party cost-sharing arrangements (CSA). CSAs are often entered into between two or more related parties when they share in the development and ownership of intellectual property. Many High Technology companies have structures where such CSAs are an integral part of their overall tax and business planning strategy. Often times the US related party is the recipient of a cost sharing payment from other related parties who are included in the arrangement. The issue of whether stock compensation charges should be considered part of the costs to be shared has a significant impact on the taxation of the US related party. If not included, all stock compensation tax deductions incurred by the US related party reduce its taxable income. For High Technology companies this is a significant tax deduction. If included in the cost pool these deductions are “shared” with other related parties and reduce the US related party’s stock compensation tax deductions.
This issue has been ongoing for some time beginning with the Xilinx case which was decided in favor of the taxpayer some years ago. In Xilinx the court held that stock based compensation expenses were not required to be included in the cost pool. The Treasury in response to this case issued regulations requiring such costs to be included but gave taxpayers a choice as to how to quantify it. Under these regulations, taxpayers generally could elect to include compensation expenses as determined for financial statement purposes or base the includable compensation expense on the taxpayer’s tax deductions as reflected on its tax returns. Altera challenged this regulation on a number of grounds and won.
It remains to be seen whether the IRS will appeal this decision. The implications of this case go beyond just the inclusion of stock based compensation in CSAs. The court called into question the validity of any tax regulation that is not based on “reasoned decision making.“ This relates to the administrative process the Treasury must follow when it issues regulations.
We haven’t heard the last of this issue. While it is unclear whether the IRS will appeal the Altera decision, there is certain to be more activity on this topic in the future.
Treasury issues proposed regulations regarding section 83(b) elections
Taxpayers who receive restricted property in return for performing services have the opportunity to elect under section 83 to complete the transfer of property for tax purposes. If such an election is not made, the taxpayer is taxed on the value of the property as the restrictions lapse. Such election is commonly referred to as an “83(b)” election referencing the code section authorizing the election. Currently, taxpayers must not only make this election within 30 days of receipt of the property but must also attach a copy of the election to their tax return for the year of the election. Failure to do either could result in an invalid election.
However, those taxpayers who appropriately attach an 83(b) election to their return are not able to electronically file their return. In order to facilitate the electronic filing of returns, Treasury has proposed eliminating the requirement that a copy of the 83(b) election be attached to the return. The change is proposed for taxable years beginning January 1, 2016. However, taxpayer’s can rely on this new regulation for property transferred on or after January 1, 2015. Note, however, the requirement to file an 83(b) election within 30 days of the date of transfer is still a requirement.
State Tax Developments
California adopts Federal tax conformity measure
Unlike most other states, California’s taxable income computation does not follow the federal taxable income computation. Instead California’s tax laws are a mixture of California-only provisions and federal provisions selectively incorporated into California law. California law provides for this selective conformity to federal law by reference to the federal tax code as of a particular date. This date is not automatically updated as federal law changes are made. The conformity date referenced under California law for several years now has been the federal tax code as of January 1, 2009. The current legislative change updates California conformity to the federal tax code as of January 1, 2015, effective for years beginning on or after January 1, 2015. While this is a step in the right direction toward simplification, there remain many differences between federal and California tax law. For example, in spite of this recent legislative change California tax law does not conform to the federal tax provisions regarding bonus depreciation or first year expensing of personal property acquisitions. California taxpayers, therefore, remain burdened with the need to analyze their tax affairs under two separate sets of rules.
Washington extends economic nexus standards for sales tax and Business and Occupation Tax
The state of Washington passed legislation effective September 1, 2015 extending economic nexus standards for the Business & Occupation (B&O) Tax to out of state wholesalers and establishing a sales tax click-through nexus standard. Additionally, effective August 1, 2015, the B&O tax rate on royalties was increased from 0.484 percent to 1.5 percent.
Under prior law, certain out-o f-state taxpayers were considered to have economic nexus with Washington if they had (1) $53,000 of property in the state, (2) $53,000 of payroll in the state or (3) $267,000 of receipts from Washington sources. Wholesalers were not specifically referenced in the Washington tax statutes. Effective September 1, 2015, out-of-state wholesalers will now be subject to this economic nexus standard.
Additionally, effective September 1, 2015, Washington established a new “click through” nexus standard. This new standard creates a rebuttable presumption of nexus when (1) a remote seller enters into an agreement for consideration under which a resident of Washington directly or indirectly refers potential customers to the seller and (2) the remotes seller’s cumulative gross receipts from such sales exceed $10,000 during the preceding calendar year. If the remote seller is taxable for retail sales purposes under these new “click through” rules, they will also be considered taxable for purposes of Washington’s B&O Tax. Washington is following a long list of states which are continuing to expand their definition of nexus in order to preserve or increase their tax base.