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In this article, we review some of the tax administration issues facing multinational concerns - from the largest conglomerates to small start-ups with foreign sales subsidiaries.
Globalization: As economies worldwide continue to globalize, the traditional borders associated with business operations are disappearing and businesses everywhere feel a need to operate globally to remain competitive. Governments, and particularly regulators, are catching up with these market and business trends.
In August 2006, the US Internal Revenue Service (IRS) Commissioner Mark Everson summed up the trend as follows: "Many of my counterparts in the international tax community have expressed the need for greater cooperation to fight the proliferation of abusive tax practices... Tax administration is being increasingly challenged by globalization, the mobility of capital, the immediacy and fluidity of information and knowledge transfer and the access individuals and businesses have to sophisticated tax planning and, in some cases, tax avoidance advice and products. These developments pose a direct challenge to national tax administrations that act in isolation."
In the future, globalization of tax administration by governments may occur and this may even be beneficial from a corporate governance and tax policy perspective. This is because businesses, governments, and citizens - should benefit from greater consistency in tax administration and greater certainty about the tax ramifications of business decisions.
But in the short-term, businesses must deal with asymmetrical rules, inconsistent tax administration and new-found enforcement mechanisms. The result is increased risk of double taxation, and a need for appropriate tax planning.
Shifting trends: Some countries that previously emphasized attracting foreign businesses are shifting emphasis instead toward more aggressively asserting taxing jurisdiction over companies that have committed to do business in their country - for example, China.
Meanwhile, countries that are more established in the global market such as Australia, the UK and the US, are seeking to retain a competitive tax environment for their own multinationals by liberalizing the rules regarding outbound investment for locally headquartered companies. Examples can be seen in Australia's liberalization of its CFC (controlled foreign company) rules, recent enactment of substantial shareholding exemption rules in the UK and the recent legislative and regulatory liberalization of the US' CFC rules.
Israel is a mixed case - the 2003 tax reform resulted in tax on worldwide income of Israeli residents, tough CFC rules and reportable tax planning regulations. But Israel has also improved the tax breaks for productive and tech companies that have a "privileged enterprise."
Tax Authorities Work Together: To gain information on cross-border transactions, countries are increasingly relying on information exchange agreements, and, through double-tax treaties, are using "specifically-focused requests" to gather information on perceived abusive transactions.
Routine data sharing is also on the rise. Tax authorities in Australia, France, Italy, Mexico, South Africa the UK and the US are all embracing the so-called "spontaneous" exchange of information.
In September 2006, 39 member countries of the international Forum for Tax Administration (FTA), a panel of national tax administrators that is part of the OECD, issued the "Seoul Declaration." The FTA, which was created "to promote dialogue between national revenue bodies and identify good tax administration policies," includes the 30 members of the OECD, plus observer countries such as India and China (not Israel apparently). In the Seoul Declaration, the member countries agreed to develop a directory of aggressive tax planning schemes; examine the role of tax intermediaries in noncompliance and the promotion of unacceptable tax minimization arrangements and; improve the training of tax officials on international tax issues.
Other multilateral efforts include the Joint International Tax Shelter Information Centre (JITSIC), a joint effort between the tax bodies of Australia, Canada, the UK and the US to identify and share information on a real-time basis about abusive tax avoidance transactions.
The Seven Country Working Group on Tax Havens (Australia, Canada, France, Germany, Japan, the UK and the US) is another example of multiple jurisdictions working together to share information on perceived tax abuses - specifically, those arising from the use of tax havens.
And the revenue commissioners of China, India and South Korea have joined the Leeds Castle Group, which meets regularly to discuss global tax issues and which also includes the revenue commissioners of Australia, Canada, France, Germany, Japan the UK and the US.
Transfer pricing: One area receiving significant attention is intercompany transfer pricing. Tax authorities around the world - including Israel - are increasingly focused on ensuring that companies are compliant with transfer pricing legislation. Transfer pricing documentation rules now exist in more than 40 countries - with most of those countries adopting penalty regimes for noncompliance. With tax authorities rigorously enforcing transfer pricing rules, multinationals are increasingly likely to face audits and have their more complex transactions scrutinized.
Phoney loans: Another "audit flag" area is highly-engineered financing arrangements. As a general rule, when examining these transactions, tax authorities are focusing on the following issues:
* Why was the debt incurred?
* How much is the debt?
* Is the interest rate at arm's length?
* Are the terms of the debt reasonable?
* Is there evidence of negotiation?
* Is there a higher debt locally than in the worldwide group?
IRS Chief Counsel Donald Korb recently stated, "â€¦alarm bells should go off when a transaction offers a taxpayer a noneconomic loss either by creating a loss where there is none or by accelerating a future loss, or where there is a highly technical legal theory, often based on complex structured facts developed to support such loss against challenge in the event of audit."
What to do? Multinationals need to fully appreciate the linkage between business operations and the "tax environment" in the jurisdictions in which they do business and be prepared to respond to more frequent multi-jurisdictional inquiries. Specifically, companies should consider:
* How do the business operations in each country fit into the company's overall global business operations?
* How are taxes imposed and collected in the local taxing jurisdiction? What are the reporting requirements?
* What transactions have been identified by the jurisdiction as "of interest?"
* Establish and document the arm's-length nature of intercompany transfer pricing policies.
* Review agreements (for example, distribution agreements, contract research and development agreements, and so forth) to ensure their terms and conditions are consistent with the economic substance of the transaction and the party's conduct.
* Regular and ongoing communication between the tax department, treasury, accounting and operations is essential to manage risk.
* Consider obtaining advance tax rulings and advance pricing agreements, to help achieve certainty and reduce risk.
The Road Ahead: As nations face financial pressures, and at the same time strive to attract global capital, global tax administration will come under increased pressures. The US, in particular, may face tremendous budget pressure beginning in 2008 when its baby boom generation begins to retire and draw down Social Security surpluses that currently mask the true severity of the nation's budget situation.
Conclusion: As governments accelerate their cooperative efforts, and think more strategically about tax administration in the global economy, multinationals should think strategically about tax, and align their tax and business planning. As always, professional advisors should be consulted in each relevant country.
The writer is an International Tax Partner at Ernst & Young Israel. With grateful acknowledgements to a report "Tax Administration Goes Global: Complexity, Risks, Opportunities" by Ernst & Young LLP, March 2007.