As part of an initiative to curb tax inversions, the IRS and Treasury recently released proposed regulations to Section 385, which authorizes the Secretary of the Treasury to determine if financial instruments should be considered stock or indebtedness. Prior to these regulations, case law was the primary source of guidance.

In addition to provisions dealing specifically with loans created as part of reorganization or distribution transactions, the proposed regulations contain two more widely applicable sections: “Financial Instrument as Part Debt and Part Equity” and “Documentation Requirements.”

The section on financial instruments specifically states that, based on an appropriate analysis, a financial instrument may be considered as part debt and part equity by the Commissioner. Historically, case law ruled that financial instruments are either entirely debt or equity.  This new approach will give the IRS more flexibility in attacking debt arrangements resulting from aggressive tax planning.

The section on documentation lays out strict requirements to support an instrument that’s considered debt for federal tax purposes. Documentation must include:

  • Unconditional obligation to pay the debt at one or more fixed dates.
  • Creditor’s rights, similar to those rights with a unrelated third party, including a superior right to shareholders to share in the assets in case of dissolution.
  • Reasonable expectation of ability to repay the debt obligation. This analysis may include cash flow projections, forecasts, financial ratios compared to competitors, and financial statements or reports used internally to monitor financial performance.
  • Actions evidencing a debtor-creditor relationship. These could include interest and principal payments or events related to default.

These rules do not replace prior case law; they simply detail the minimum burden taxpayers must meet to allow analysis of the instrument. Perhaps most importantly, the proposed regulations state that documentation must be in place within 30 days of issuance.  If taxpayers are unable to provide the IRS with documentation or reasonable cause for the failure, the instrument will be considered stock.

While these regulations are not finalized, they will be effective upon publication — which could be as soon as August.

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As of May 1, China completed the transformation from business tax (BT) to value-added tax (VAT) (the “B2V Reform”). The B2V Reform aims to reduce the tax burden to taxpayers in China, including established enterprises of foreign entities, such as a wholly foreign owned entity.

For many years, China has operated a dual indirect tax system. VAT was applicable to the sale and importation of goods, typically at 17 percent, while BT was applicable to most services at a rate of 3 percent to 20 percent. BT was generally considered an inefficient sales tax as it effectively taxed each stage of a supply chain, regardless of the profit or value added by businesses within the supply chain.

The B2V Reform was first introduced in Shanghai on January 1, 2012 and was implemented in stages, industry by industry. In general, small scale taxpayers pay 3 percent for VAT, but tax rates for general taxpayers vary from industry to industry:

  • Services — 6 percent is for general service provisions, and 11 percent applies to transportation and communication.
  • Tangible goods — The standard rate is 17 percent. 11 percent applies to real estate services, and 13 percent applies to utilities, books, and newspapers.

Eliminating the dual indirect tax system aimed to reduce the tax burden for all industries, which is the main contributor to the estimated increase in China’s deficit of RMB 560 billion in 2016. However, the tax impact on individual business should be assessed on a long-term basis. For many, the cost of investing in major fixed assets may decrease by up to 17 percent.  Traditional manufacturing, wholesale, and retail businesses will be able to claim VAT credits when they purchase services and reduce cost by 5 percent compared to paying BT before the B2V reform. For others, there’s a possible tax increase in the initial stage.  And for some companies in the final stage of a VAT chain, the tax burden could increase.

Companies doing business in China are strongly recommended to analyze closely the impact of the tax reform on their cash flows, review tax-related contract clauses, implement enhancement of VAT risk control and accounting system changes, and seek to understand how to comply with the changes in the VAT regime.

Our Global Services consulting team is available to assist you. Please contact us if you have any questions or concerns.

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China eliminates prohibited export subsidies, leveling playing field

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As a result of a complaint filed by the United States, the Chinese government now recognizes that export subsiding is prohibited by the World Trade Organization (WTO). On April 14, 2016, China and the U.S. signed an agreement to eliminate the subsidizing of Chinese companies that meet certain export performance targets. According to the Office […]

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Switzerland, long known as a tax haven, is changing its corporate tax landscape to be more in line with the global landscape. The new reform, referred to as Corporate Tax Reform III, will aim to increase transparency in the tax system, while remaining favorable and appealing to international businesses. Countries around the world have been […]

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2016 U.S. Model Income Tax Convention: What’s New?

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On February 17, 2016, the Treasury Department released a revised 2016 U.S. Model Income Tax Convention (the 2016 Model), which is the baseline text the Treasury Department uses when it negotiates tax treaties. Here are the updates. Special Tax Regimes The 2016 Model denies treaty benefits for related party-interest payments, royalty payments, or guarantee fees […]

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Between the Presidential primaries and an extended opening on the Supreme Court, the U.S. has its fair share of political challenges. When you look over to the U.K., however, which is currently voting on “Brexit”— Britain departing from the European Union (EU) — you’ll see we’re not alone. But do U.S.-based multinationals have an interest […]

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What guidance do IRS agents look at during an audit?

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The IRS has developed an online reference library providing internal guidance, or “practice units,” to serve as international tax job aids and training materials for IRS agents. The practice units provide explanations of general international tax concepts as well as information about specific types of transactions. According to the IRS, practice units will continue to […]

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What a relief: Canada issues form for non-resident employer certification program

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On January 12, the Canada Revenue Agency released the Form RC473 Application for Non-Resident Employer Certification. This is a big change for non-resident companies who can now apply for relief from Canadian payroll withholdings. Under Canadian tax rules, non-resident companies sending employees temporarily into Canada are required to determine the amount of salary/wages attributable to […]

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IRS releases new draft Form W-8BEN-E: How does this impact you?

January 27, 2016

Do you or your clients take advantage of reduced withholding rates by collecting Form W-8BEN-E from foreign vendors? If so, you should be aware of proposed changes that would require taxpayers to identify the limitation of benefits clause they meet in order to qualify for the benefit. Before we discuss proposed changes to Form W-8BEN-E, […]

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Internal control health assessment: What about your foreign affiliates?

January 18, 2016

As the pendulum of internal controls swings to a more conservative approach, many middle-market companies and larger, privately held organizations are starting ask, “What about my foreign affiliates?” To be sure, many organizations that have taken a holistic approach to risk management should have identified critical business and financial risks at foreign operations, but many […]

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