How to plan your global tax strategy for the 1990s.

How to plan your global tax strategy for the 1990s

In the 1960s, international taxation functioned on the premise that U.S. companies were investing abroad. In the 1980s, however, the flow has reversed. There is a significant inflow of investments from foreign countries. This requires a different mind-set by international tax experts.

At the present time, much of America - including Congress and to some extent the Internal Revenue Service - is out of sync with capital flow thinking. The February 5, 1989, edition of The New York Times commented that Citicorp is now more a domestic bank than an international bank. What was to be expected, given the significant pulling back by U.S. companies of their operations to the U.S., coupled with a significant inflow of foreign investment into the U.S.?

Another element in the international tax environment is what happened to Sub Part F. Instead of significant U.S. taxation emerging from that legislation, we have experienced an increase in foreign tax credits. Sub Part F has contributed to U.S. companies generating significant foreign taxes, which in turn revert to the U.S. as offsetting credits.

Still another factor is the "super royalty" concept. The Tax Reform Act (TRA) of 1986 enabled the U.S. government to reach beyond its borders and change transactions with foreign subsidiaries not only when they are entered into, but also after they have been consummated. This, of course, creates the impression that the government is trying to grab every bit of revenue that emanates from exporting U.S. technology. It is also an overreach in today's international business environment.

Indeed, there may be more revenue for the U.S. government in the taxation of the U.S. operations of foreign companies than there is in the taxation of investments abroad by U.S. companies. What is difficult, however, is to measure the income from U.S. activities of a foreign corporation. The IRS can monitor the U.S. parent and its foreign subsidiaries much easier than it can foreign entities operating in the U.S.

Finally, U.S. companies have tried to correct their international tax difficulties by adjusting transactions. The new environment, however, particularly with the TRA of 1986, requires the restructuring of organizations. Transfer pricing, licensing, financing arrangements, leasing, service activities - these were the mechanisms used in the past. Now, the restructuring of corporate entities will provide the solutions for years to come. The ultimate goal is restricting U.S. taxation to U.S. operations only.

Hot areas for planning

Given this background, what are the hot subjects in taxation and the planning opportunities that are available to the global company?

One: tax credits - Excess foreign tax credits face many U.S.-based companies dealing in international markets. These are the major reasons for it:

* U.S. tax rates have gone down and foreign tax rates have gone up. * Rules that determine which income of the U.S. taxpayer is foreign and which is U.S. source have changed. The new rules determine the source based on the residence of the taxpayer. This means U.S. source income does not help in calculating the foreign tax credit limitation. * Rules to fix which expenses are allocable to foreign source income have been complicated by new tax regulations. In effect, the regulations now attribute larger amounts of interest and R&D expenses to foreign source income, thereby making the utilization of foreign taxes as credits more difficult. * TRA 1986 introduced a multiplicity of "baskets" for calculating the foreign tax credit. What purports to be an overall limitation is really becoming a per-item limitation. This is even more restrictive than the old per-country limitation.

These four complications impact the use of foreign taxes as credits. They are essentially saying to U.S. companies: "You've just got to get the foreign tax bill down; otherwise, you are going to experience excess foreign tax credits indefinitely." Perhaps an even stronger message is: "Come back home to the United States." Operating abroad, in other words, will put companies in the position of incurring foreign taxes, taxes that will not be absorbable in the U.S. and that will negatively impact earnings per share.

Two: foreign subsidiary transactions - The Section 482 "white paper" deals with intercompany transactions between U.S. companies and their foreign subsidiaries. The white paper was mandated by Congress at the time of TRA 1986. The idea was to see to what extent legislation was effective in correcting a movement of technology abroad without adequate compensation.

The white paper also delves into the way in which information is made available to IRS agents when a taxpayer's return is examined. The white paper came from a survey taken of IRS examiners who deal mostly with international examinations. Delays by taxpayers in providing information led the examiners to recommend early documentation of the methods used in pricing products, setting up technology licensing arrangements, organizing financing agreements, and, indeed, dealing in any way with their foreign subsidiaries.

The white paper also asks the taxpayer to attest to the pricing methods used at the time the tax return is prepared. There aren't many areas in tax law where you are required to attest to a part of the tax return. In addition, the white paper urges IRS people to assess penalties in areas where a taxpayer does not comply with these proposed rules.

Taxpayers must set forth on their tax return the pricing methods involved in sales to foreign subsidiaries. This presents a difficulty. Court decisions indicate that the methods called for in the tax regulations have not really been applied in a consistent way. Although present regulations contain the comparable uncontrolled price method, resale price method, and cost plus method, a large percentage of cases have been decided on the basis of an undetermined "fourth method." The white paper talks about creating a new basic arm's-length rate of return "ballroom" method. Essentially, it says that if you can't find comparables (and very often you cannot), you must first determine a reasonable rate of return on the tangible assets of the business. You then use that to determine the portion of the profit going to the affiliate owning the tangible assets. Everything else is related to intangible assets, which, says the white paper, is the portion of the profit that would be attributable to the U.S. shareholder.

An alternative would be a reverse approach. That is, determine whether intangibles are involved. If not, the exhaustive method described in the white paper would not have to be used. How would you determine the intangibles? Use industry ratios to compare the taxpayer's overall rate of return with those of other companies in the industry. If intangibles are involved, calculate a "split of the profit." The result is to recognize that not all technology is found in the U.S.

Now, the reasonable conclusion to all this is to move your R&D outside the U.S. It is becoming just too complicated, from the U.S. tax standpoint, to do research in the U.S. without having it result in significant negative tax results. But sending research to be done outside the U.S. would automatically put U.S. corporate taxpayers in the position of using the U.S. tax rules against the U.S. for tax planning. It's sad to have to come to this conclusion in terms of our national priorities. But U.S. tax policy is really running counter to the U.S. desire to become preeminent in the area of high technology.

Three: cost allotments - With regard to the cost of financing operations, U.S. tax regulations now are stacked against the U.S. corporate taxpayer. Executives can seldom use normal business thinking to determine what financing costs are attributable to U.S. and what to foreign source income for foreign tax credit purposes. The regulations now require that interest expense, even when incurred for U.S. business purposes, be allocated to foreign source income. From a tax planning standpoint, the obvious conclusion is that financing be done outside the U.S., so that its cost will not negatively impact the U.S. company in calculating its foreign tax credit.

Four: foreign exchange - Treating foreign currency gains as U.S. source income is based on looking at the residence of the taxpayer. The ability to treat foreign exchange gains as foreign source income has been removed by the TRA 1986 legislation. One strategy is to shift the foreign exchange risk abroad rather than have it fall in the U.S. Given proper advance planning, such risk (particularly where it results in foreign exchange losses) could reduce foreign tax liabilities and not run afoul of the U.S. source of income rules.

Five: foreign audits - Another hot spot is foreign audits. One research project is investigating the audit in 12 of the more developed countries. To what extent do items arise more quickly in the U.S. than in foreign countries? While the study is not complete, it is clear that the U.S. is used as a "leading indicator" to identify international tax matters for auditing by tax authorities worldwide. In addition, such countries as Germany and the U.K. are waiting to see to what extent the U.S. taxpayers will try to shift income from their countries back to the U.S. - in order to partly solve their foreign tax credit problems.

Six: foreign banks - Foreign banks doing business in the U.S. represent a major industry and may be a significant source of revenue in the future. The IRS has already visited the head offices of these foreign banks to examine the expenses they incurred abroad and determine the extent to which they relate to U.S. operations. In one recent case, the IRS visited the London branch of a Japanese bank to determine the extent to which the pound sterling cost of money is being appropriately calculated by the Japanese bank for utilization on its U.S. return.

Seven: tax treaties - The past assumption was that the tax treaty between the U.S. and a foreign government had preeminence over the Internal Revenue Code. That is no longer true. Now the question is: which one was enacted later? That one seems to override its predecessors.

Regarding treaty "shopping," tax treaty benefits will not apply unless the foreign company can prove that it is a "qualified resident" in a tax treaty country. If it is just a company set up in a tax treaty country by people who are not connected with the treaty country, U.S. tax authorities will disallow the benefits of the tax treaty.

Eight: information exchange - The routine exchange of information between countries is now developing between OECD countries as part of a mutual assistance agreement. This is worth watching, since it will produce a closer scrutiny of tax planning techniques that try to reduce foreign tax burdens. While it appears that the U.S. will sign the agreement, it could well backfire. U.S. companies may end up incurring higher amounts of foreign tax, which will, in turn, mean even more foreign tax credits.

Nine: tax shelters - In connection with penalties imposed in the international tax area, one worth watching is Section 6661, dealing with the matter of what constitutes a tax shelter. Essentially, harsher penalties (or stricter return filing requirements) are imposed on people involved in tax shelters. The definition of tax shelter covers arrangements that have tax avoidance as their principal purpose.

Tied into this matter of penalties is the white paper, which criticizes IRS agents for not imposing more penalties on taxpayers in their international tax examinations. It also urges more reliance on Section 982, dealing with formal requests for documents. In essence, the IRS will be more "penalty minded" in conducting international tax examinations.

Ten: AICPA recommendations - In its comments on the white paper, the AICPA requests that Section 482 examinations stick to products with high value, indicating there is no need for the additional information requested. Companies, it says, really don't price their products the way that tax regulations are written. The AICPA paper also requests that a "safe harbor" rule be built into the regulations. In other words, if the transaction is with a taxpayer in a country paying at least 90 percent of the U.S. tax rate, it would not be necessary to have a Section 482 examination.

Eleven: foreign tax systems - The world is moving to an integrated system of taxation that couples the shareholder and the corporation. This is not the system we have in the U.S.; but if you look around the world, countries like Canada, the U.K., Germany, and Japan do have such a system. As a result, we are apt to see significant confusion in trying to match foreign tax burdens with the U.S. system of foreign tax credits.

Some predictions - and what

they mean to you

Having set the stage of international taxation today and described 11 "hot subjects," I will be bold enough to make some predictions, along with some tax planning suggestions.

* United States business abroad will continue to be discouraged by the American government.

From a planning standpoint, therefore, U.S. companies might consider the selling of their distribution systems outside the U.S. Selling distribution systems in Europe will be attractive for companies who may want to cash in on their investments in view of the European Community 1992 deadline. * Foreign business coming to the U.S. will be subjected to even higher U.S. tax burdens in the future than they have been in the past.

From a planning standpoint, it will be worthwhile for such foreign companies to probe the use of financing arrangements, R&D licensing, and transfer pricing in order to minimize their U.S. tax burdens. The Section 482 white paper concepts can be used by these companies against the IRS. * Foreign tax credit usage will shift from the emphasis on changes in transactions, such as maximizing the foreign source of income and minimizing the allocation of expenses. These techniques will be curtailed because of the new rules in TRA 1986.

From a planning standpoint, U.S. companies should restructure their international operations so that U.S. activities bear only U.S. taxation, and foreign operations are subject only to foreign taxation. * Foreign tax administrations will not allow the shifting of profits from their countries back to the U.S., where U.S. companies seek the advantage of foreign tax credits.

From a planning standpoint, U.S. companies need to become more familiar with the critical issues that concern foreign tax authorities - in order to avoid a backlash of double taxation.

Here are some further predictions - predictions that most companies will find less than promising: * The alternative minimum tax limitation on the foreign tax credit will creep into the regular tax system. It is not unthinkable that one day there will be outright percentage limitations on the ability to use foreign taxes to offset U.S. taxes. * Since the white paper criticizes them for not being aggressive enough, IRS agents will begin demanding information on transfer pricing and other aspects of inter-company transactions. They also will impose penalties quickly when the information is not forthcoming. * There will be more tax relief for U.S. companies exporting their goods. However, U.S. companies will have less to export competitively. * Foreign exchange rules, from a tax standpoint, have substituted certainty for logic. Consequently, past flexibility for utilizing foreign exchange exposures to minimize U.S. taxation will eventually give way to shifting exposure to the foreign affiliates. * In the process of restructuring operations internationally, more use will be made of Section 304, which allows funds to be brought back to the U.S., through the sale of international subsidiaries, with a minimum of foreign taxation. * The documentation that will be required to support foreign tax credits will be more strictly policed, and documentation that companies are used to providing may become unacceptable. * In the past, the purpose of tax planning was to make sure that foreign corporations were not considered "controlled" by U.S. parties. Since noncontrol is now a disadvantage in foreign tax credit baskets, it will now become more desirable to make sure that such affiliates are controlled. * If foreign subsidiaries have net operating losses or require restructuring, the "withering" of such subsidiaries (accompanied by the transfer of their assets to new foreign subsidiaries) will become desirable. * The partnership structure will grow in use, particularly where the avoidance of controlled foreign corporations is desirable. * The exchange of information between governments is only at its starting point. Such exchanges will grow and become more efficient. In essence, "the fisc" will know as much about a company's international operations as the company itself.

If these predictions seem gloomy, they reflect the fact that U.S. business is losing its global influence. Indeed, the trend for U.S. multinationals to come home will accelerate, unless some major shift takes place in U.S. tax policy. The new area for international tax planning will be with foreign companies doing business in the U.S.

PHOTO : Part of the "Soldiers of the Queen" series, lead cast, U.S.A., 1981

PHOTO : The warship "New York," a tin clockwork boat, Germany, circa 1904

PHOTO : A warship with planes, a tin clockwork-powered toy, France, circa 1914

This article is based on an address by Mr. O'Connor at a meeting of the New York City chapter of FEI. Mr. O'Connor was formerly vice chairman, international, of KPMG Peat Marwick.