Global issues dominate TEI's summer: U.S. contract manufacturing, Canadian tax reform, European consolidated tax base, Ontario legislation all command attention.

The increasingly global reach of TEI's advocacy was evident this summer in the submissions filed by Tax Executives Institute. In Canada, TEI weighed in on federal tax reform and retroactive legislation in Ontario. A second set of comments was filed on a proposal to consolidate the corporate tax base in Europe. And the U.S. contract manufacturing regulations were reviewed in written comments filed with the U.S. Department of Treasury and Internal Revenue Service; TEI also testified at an IRS hearing 011 the regulations in July. In addition, at the IRS's request, TEI participated in two all-day meetings--the first on tax return transparency and disclosures, and the second on enterprise compliance risk.

TEI President Vincent Alicandri called the broad swatch of technical submissions "remarkable," commending TEI's committees for the depth of their technical expertise in so many different subjects.

Canadian Tax Reform

In November 2007, the Government of Canada created an Advisory Panel on International Taxation, which issued a consultation paper, entitled Enhancing Canada's International Tax Advantage, in April 2008. That action prompted TEI's Canadian Income Tax Committee to swing into action. Drawing on the rich experience of its members on myriad international tax issues, TEI prepared comprehensive comments, which were filed on July 15. In its comments, TEI welcomed "the government's decision to establish the Panel to review the framework and administration of Canada's international tax regime, which has been in effect in its current form since 1976."

"Although the Consultation Paper and TEI's analysis are divided generally between the taxation of inbound and outbound investments," the Institute stated, "the demarcation between the two is not always clear." It cited an example of Canadian multinationals that may wish to have their foreign subsidiaries access the Canadian market but face tax disincentives to doing so. "On the other hand," TEI said, "many foreign-owned Canadian taxpayers exercise substantial stewardship activities over outbound investments, which should be encouraged."

The Institute recommended that the panel urge the government to adhere to a legislative process that encourages confidence in the fairness and stability of the Canadian legal environment. The organization outlined four principles urging Parliament to:

* refrain from enacting retroactive legislation, except where absolutely necessary and in accord with principles previously articulated by the Department of Finance;

* afford reasonable consultation periods for proposed legislation;

* return to the historical practice of providing reasonable transition periods or grandfather rules or delaying the effective date of legislative initiatives that overturn longstanding rules; and

* ensure that legislative action is prompt and that the effective date either follows the enactment date of is deferred until legislation receives Royal Assent.

TEI urged Parliament to articulate an overriding policy that lends predictability to current and, especially, future legislative and administrative policy developments. It also suggested that Canada's tax and budget policy development can be improved by greater transparency. "It is unclear, for example, what purpose is served by the secrecy that currently shrouds the development of Canada's annual budget," the Institute stated.

The professional organization also recommended that attempts to correct abuses in the tax system be addressed through targeted legislation rather than broad anti-abuse rules. "Broad anti-abuse rules create uncertainty that hinders legitimate commercial activity and often inflict harm worse than the perceived problem the legislation is designed to curb," TEI said. It recommended that any anti-abuse rules proposed by the panel--or by the government itself--be subject to extensive consultation with affected taxpayers before Finance drafts legislation.

In respect of other tax policy issues, the Institute stated that "except in rare and extreme circumstances, tax legislation should be prospective in scope." It also noted that "[e]xcessively complex legislation is all too common in Canada," raising concerns about the ability of taxpayers to comply as well as the likely inability of the Canada Revenue Agency to administer it. Finally, TEI suggested that the government devote more resources to reducing the time lag between the introduction of legislation and its final enactment.

On the administrative side, the Institute explained that while CRA is one of the most efficient and effective tax administrations in the world, "the Agency, especially the Appeals Division, may lack the resources necessary to address more complex tax matters inherent in the large-case files of multinational business taxpayers." It cited the need for more training in complex business transactions and more oversight of audits by upper management.

TEI's comments also addressed the taxation of outbound and inbound direct investments, withholding taxes, transfer pricing rules, and barriers to international tax activity. The comments are reprinted in this issue, beginning on page 279.

Contract Manufacturing

In its July 29 testimony before the IRS, TEI commended the government "for working to bring certainty to the treatment of contract manufacturing arrangements under the Subpart F rules." TEI's testimony was presented by Daniel R. Goff of Xilinx, Inc., vice chair of the Institute's International Tax Committee.

The current regulations under section 954(d) of the Internal Revenue Code set forth two separate tests--the substantial transformation and substantive tests--to determine whether a controlled foreign corporation (CFC) is considered to manufacture, produce, or construct personal property that it sells, Mr. Goff explained. Adding that the "world has changed dramatically since the regulations addressing foreign base company sales income were issued in 1964," he agreed with the government that updated rules "ate important to the continued competitiveness of U.S. businesses operating abroad."

Although the proposed regulations do update and clarify many issues, however, TEI expressed concern that they may unnecessarily increase taxpayers' exposure to permanent establishment claims by foreign jurisdictions, and harm some taxpayers' competitiveness.

Referring to the new substantial contribution test, Mr. Goff noted that the test is used for determining "not only whether the CFC qualifies for the manufacturing exception [to Subpart F inclusion], but also whether the branch is a manufacturing branch under the branch rule." He pointed out that the rule's application could result in the treatment of a branch as a manufacturer when the taxpayer merely purchases from, and sells, to unrelated parties. To avoid this result, the Institute recommended providing a specific exclusion that the substantial contribution rules do not apply if there are no related-party transactions.

In respect of the regulations' list of nine non-exclusive factors to determine whether the substantial contribution test is met, the Institute stated that the examples seemingly emphasize oversight and direction, leading some commentators to suggest that the first factor is a "super factor." "We understand this was not the government's intent," Mr. Goff said, "and recommend that the issue be clarified in the final regulations." TEI also recommended adding ownership of intangibles to the list of factors to be considered under the test.

Turning to the automated processes example in the proposed regulations, Mr. Goff stated that the example "ignores current business practices and penalizes productivity and efficiency in manufacturing processes." He suggested that an example be added to show that a CFC with a system that conducts automated oversight, procurement purchasing, and quality control makes a substantial contribution, as long as a CFC employee monitors the process and intervenes when problems arise.

Mr. Goff next addressed the secondment of employees and the satisfaction of the substantial contribution test through the activities of the CFC's own employees--a point on which the government had requested comments. "In today's global economy, many individuals under the control of one corporation may have employment relationships with another corporation, but are nevertheless employees of the first corporation under common law principles," he stated. "There are many reasons for these arrangements, including the continuation of home country benefits and the effect of foreign profit-sharing requirements. We recommend that the final regulations expressly provide that the employment relationship need not be exclusive with respect to the relevant CFC--that is, an individual may be employed by two of more persons simultaneously."

TEI also commented on the branch rules, which currently employ an effective-rate-of-tax comparison test for determining whether the physical manufacturing exception to Subpart F applies. In response to the government's request for comments on whether modifications should be adopted, Mr. Goff responded that the answer "is unequivocally 'yes,' especially in light of changes in the financial reporting rules that make the need for clarity even more important." Noting that the five-percentage-point rate disparity test of the current regulations is unnecessarily narrow, the Institute recommended that the test be expanded to at least 15 percentage points to avoid trapping economically substantive business operations.

Finally, in respect of the effective date, TEI applauded the election to have the new rules apply to all open years. The organization suggested, however, that this election--which is set forth in the preamble--be included in the final regulations, and that the final regulations provide that only the taxpayer may elect to apply the regulations retroactively.

TEI's written comments were filed on June 11 and are reprinted in this issue, beginning on page 297.

European CCCTB

At the end of June, TEI submitted comments to a task force established by the European Commission to study the benefits and costs of implementing a common consolidated corporate tax base (CCCTB) in the European Union. TEI's letter to task force chair Thomas Neale follows up on its May 2007 submission.

Referring to the Commission's objective to reduce obstacles that hinder competitiveness, the Institute explained that two critical items among the many obstacles are burdensome transfer-pricing rules and the lack of ah offset for losses incurred in one Member State against profits in another. "Conflicts in respect of transfer-pricing rules are especially burdensome," the organization said, "since business taxpayers are frequently stakeholders in disputes between Member States over the respective share of income allocable to the states." TEI also cited the costs of complying with 27 different tax systems, which impose substantial burdens on businesses.

TEI reiterated five elements required to gain the support of business taxpayers for the CCCTB. "First and foremost, the CCCTB must remain optional," the organization said. Second, the national tax regimes of many Member States draw distinctions between business and non-business income and assets, generally to prevent closely held companies from paying personal expenses of their shareholders. Stating that the CCCTB should be based on the presumption that an entity liable to corporate taxation is carrying on a business activity, the Institute recommended against distinguishing between business and non-business income or requiring allocation of costs among different sources of revenues.

The third element cited in TEI's comments was an allocation key that avoids reintroducing transfer-pricing disputes. "Shielding businesses from transfer-pricing documentation requirements, penalties, and transfer-price adjustments on intra-group transactions occurring within CCCTB jurisdictions may be the single most important benefit promised by the proposed system."

A consolidated tax base--permitting the consolidation of intercompany accounts in the determination of the group's taxable income as well as offsetting of overall losses from entities in one Member State against the income earned in other Member States--was the fourth element urged by TEI.

Finally, the CCCTB must "have a system of centralised management and administration," TEI stated. In other words, there should be a "principal tax authority" or "one stop shop" for filing the consolidated return and making a self assessment; verifying the taxable income allocable to the Member States; issuing reassessments (or filing amended returns); making inquiries, inspections, and examinations; and filing administrative or judicial appeals.

TEI also provided suggestions for implementing the CCCTB, as well as recommendations for dealing with foreign currency issues where the Euro is not the functional currency, the use of anti-abuse rules, and the need for transitional rules.

TEI's comments are reprinted in this issue, beginning on page 305. Its prior comments 011 the CCCTB were reprinted in the May-June 2007 issue of The Tax Executive, beginning at page 293.

Ontario's Retroactive Legislation

On June 20, TEI wrote Dwight Duncan, Ontario's Minister of Finance, concerning the retroactive amendment of the Province's Retail Sales Tax Act (RST), noting that "the new provisions represent nothing more than the government's effort to overturn, without the benefit of any consultation, an unfavourable court decision." The legislation was enacted in the wake of the government's loss in Proctor & Gamble, Inc. v. Ontario (Minister of Finance), which considered whether rented wooden pallets used to ship products to customers were exempt from RST as "tangible personal property purchased for the purpose of being processed, fabricated or manufactured into, attached to, or incorporated into tangible personal property for the purpose of sale" that are not "returnable containers." The Ontario Court of Appeal held that the wooden pallets fell within this definition and therefore no RST was due. The legislation effectively nullified the decision on a retroactive basis back to May 7, 1997.

Urging reconsideration of the legislation, the Institute wrote that, "[e]ven if the substance of the new provisions could be justified as sound tax policy, the retroactive enactment of the legislation violates core principles underlying Ontario's tax regime - namely, fairness and predictability." That there were no public consultations with affected parties "reflects either governmental hubris or, perhaps, implicit recognition that the indefensible could not be defended," TEI concluded.

TEI's letter is reprinted in this issue, beginning on page 309.

TEI Participates in Two IRS Forums

Tax Transparency Roundtable. On June 5, senior TEI leaders -including Institute President Robert McDonough, Treasurer Paul O'Connor, Secretary Neil Traubenberg, and Chief Tax Counsel Eli Dicker--participated in an IRS Roundtable on Tax Return Transparency and Disclosure. The day-long program brought together representatives from government and business organizations including the Financial Accounting Standards Board, Securities and Exchange Commission, PCAOB, and Joint Committee on Taxation, as well as the ABA's Tax Section, AICPA, and MAPI. Among the government participants were IRS Commissioner Douglas Shulman, LMSB Commissioner Frank Ng, and JCT Chief of Staff Edward Kleinbard.

Participants were asked to address issues as diverse as disclosure alternatives that leverage non-tax reporting requirements, the establishment of a framework to seek reporting alternatives, and identification of the challenges to enhanced transparency and disclosure. Government representatives reported on the tools each currently employ to enhance transparency including, in the case of the IRS, the Schedule M-3 (Book-Tax Differences), Form 8886 (relating to reportable transactions) and e-filed return data. Following the presentations, the TEI representatives participated in sessions to discuss specific aspects of the tax transparency debate, including the look of the tax return of the future and realistic disclosure alternatives.

TEI will continue to monitor developments in this area.

Enterprise Compliance Risk. On July 22, TEI representatives participated in an Enterprise Compliance Risk Symposium sponsored by the IRS's Large and Mid-Size Business Division. The symposium was organized to afford LMSB's top managers an opportunity to (1) understand the reasons for, and the administrative challenges of, the significant growth in the number of pass-through entity tax returns being filed, with the goal of developing risk analysis tools and audit management strategies. The Institute was represented by Federal Tax Committee Chair Carita Twinem of Briggs & Stratton Corporation; Vice chair John A. Mann of Walgreens Corporation; and TEI Tax Counsel Jeffery P. Rasmussen.

Ah LMSB panel opened the symposium, reporting on the current tax return filing and audit environment. The panel also discussed the administrative challenges posed by the government's structure and practices, including the lack of expertise in partnership tax law, shortcomings in IRS data collection and analysis, and audit management practices now geared toward examining taxable corporations. In addition, the participants noted that the lack of transparency in complex, multi-tiered structures with layers of pass-through, taxable, and exempt entities impairs the IRS's ability to select the taxpayers for examination and undertake proper risk analyses.

TEI's representatives addressed the business purposes and federal, state, and foreign tax reasons that pass-through entities, including single-member LLCs, are used within corporate groups and in commercial joint ventures. A panel of tax professionals from major accounting firms provided insights on the challenges of preparing Form 1065 partnership returns for complex enterprises, including multi-tiered, master limited, and publicly traded partnerships. The final panel of legal experts addressed tax planning strategies, the uses of flow-through entities by hedge funds and private equity investors, and procedural issues involved in auditing TEFRA partnerships.

LMSB Commissioner Ng closed the symposium by acknowledging that the IRS must improve its awareness of the business uses of partnerships as well as its technical understanding of Subchapter K. LMSB managers met separately the following day to assess the issues and develop new auditing approaches. Although no formal report will be issued about the symposium, Mr. Ng said that LMSB will continue its study of pass-through entities in order to:

* Assess compliance risks;

* Distinguish between legitimate business structures and tax-motivated transactions;

* Improve audit planning and procedures;

* Issue new guidance where needed; and

* Minimize taxpayer burdens.

Monitoring developments in this area will remain a TEI priority.