By Paul Tadros and Marc Schwartz
After swimming (Treading water? Drowning?) in the new tax law for a few weeks, it’s healthy to pull back and look at some bigger picture items based on the changes to our and other countries’ laws. Here’s 3 items of interest (at least to us!).
US as a Tax Haven?
We first mentioned this at a presentation to a global CPA group over the summer to mixed commentary and, unfortunately, we were right. The reduced 21% corporate tax rate may cause problems for inbound investment into the US. As just 1 example, Mexico has CFC-like rules applicable when there is certain non-Mexico income that enjoys preferential tax treatment locally. Those rules generally apply if the source country does not tax the income or if it’s taxed at a rate lower than 75% of the Mexico income tax. Mexico’s corporate tax rate is 30%. Why do we care? Why should you? Is anyone still reading?
Well, 75% of the Mexico rate is 22.5% The US corporate tax rate is 21%. That last we checked, 21 is less than 22.5 meaning. . . what? Meaning that a Mexico company investing in the US may find itself subject to the Mexico CFC rules. We’re not Mexico tax experts, but the point is that you need to check the impact. For instance, an active trade or business in the US may nullify the tax hit. But, even if there’s not increased tax, you may have additional Mexico reporting / disclosure requirements. Other jurisdictions (e.g., Japan and Brazil) have similar rules, so it’s not just Mexico (and its US subsidiaries) that have this issue.
Intellectual Property (“IP”)
It seems that given: (1) most US IP is owned by US multinationals; (2) the preferential rate on royalties (the “carrot”); (3) the tax on excess returns from royalties earned by foreign affiliates (the “stick”); (4) the denial of deductions to no/low-tax jurisdictions; (5) application of the principal purpose test (“PPT”) under the OECD’s BEPS (base erosion and profit shifting) program; and (6) the current non-extension of the US look-through rule for royalties, it might be more beneficial that IP not be transferred outside the US. As we’ve mentioned in prior discussions, Germany has brought in a restriction on the deductibility of royalties (and interest) paid between related parties. The restriction applies if all of the following conditions are met (the last one is, obviously, geared to cross-border payments):
- The licensee is a resident of Germany;
- The licensor and licensee are related (25% direct/indirect common ownership);
- The royalties are subject to a preferential tax rate lower than the normal rate and such rate is lower than 25%;
- The nexus connection between the revenue and the activities do not comply with chapter 4 of the OECD’s action 5 report; and
- Germany’s CFC rules are not applicable.
The amount of the non-deductible portion is (25% – tax burden on the royalties) / 25%. For example if the normal corporate rate is 30% but the royalties are taxed at a 5% rate (patent-box), then 80% of the royalties will not be deductible [(25%-5%)/25%].
If the royalties are paid directly to the US, full deductibility should still be achievable. (While, under reform, conditions 1,2,3, and 5 will be met, condition 4 will not be met given that the IP is developed in the US where substantial substance exists.) If “round-tripping” occurs, the royalties will be restricted, i.e., the Irish/Dutch sandwich structure will be caught. For example: US wholly owns Bermuda (the owner of the IP) which owns the Dutch BVCO which owns the Irish IRCO. IRCO receives royalties from third-parties and pays most of those royalties to BVCO which pays most of the royalties to Bermuda. This is caught by Germany (i.e., perhaps not deductible) and, possibly, the US tax on excess returns – a sub-optimal answer on both sides of the Atlantic.
Treaty Shopping re: Dividends
We’re not shy about utilizing the UK as a holding company jurisdiction in certain cases (e.g., where the ultimate owner is not the US nor in an EU country). The Netherlands has passed legislation (effective January 1, 2018) which extends the exemption from withholding tax for dividends under the EU directive to countries with which it has treaties. However, this comes with anti-abuse provisions mirroring the PPT under BEPS. For example: Chile owns UK which owns BV. If UK has no substance (e.g., one of the conditions is the UK must have, at least, €100,000 in annual wage costs and personnel must perform the services in the UK), the withholding tax is 15%. If the US owned the UK which owned BV, there is no withholding tax (there is a look through rule for treaties akin to the equivalent beneficiary rules found in Limitation on Benefits provisions) even if UK has no substance.
So, it’s not just the US with potentially frustrating tax rules. It’s been a global trend for some time and likely to continue.