Worldwide: The World Tax Advisor - July/August 2005 (Recent Developments in The Americas)

This article discusses international tax developments and has been prepared by professionals in the member firms of Deloitte Touche Tohmatsu.

Contents

• Canada - CRA to Intensify Focus on Nonresident Employer Obligations / Canada, U.S. Sign Memorandum of Understanding on MAP

• Chile - Mining Tax Finally Introduced

• Mexico - 2005 Tax Administrative Rules Published

• United States - Dual Consolidated Loss Regulations Proposed / IRS Exampines Stock Ownership Requirement Under U.S.-U.K. Tax Treaty

The Canada Revenue Agency (CRA) has undertaken a new audit initiative aimed primarily at nonresident employers that do not meet their Canadian payroll obligations. The CRA will be examining the income tax returns of individuals who report employment income that had not been recorded by the employer on the year-end wage slip (i.e. T4 slip). It is possible that individuals affected by this project will soon receive requests for additional information from the CRA.

This initiative could have a number of consequences for an employer. First, the employer could be required to pay Canada Pension Plan (CPP) contributions or Employment Insurance (EI) premiums. Second, the employer could be assessed penalties and interest for failing to report the employment income on a T4 slip and for failing to withhold and remit taxes as required by the Income Tax Act and Regulations. Finally, it is possible that a payroll audit of the employer could ensue.

The project coincides with the recent release of an updated version of CRA’s Information Circular IC-75-6R2, Required Withholding from Amounts Paid to Non-Residents Providing Services in Canada, which discusses both the Canadian income tax requirements and the CRA’s administrative policies with respect to such payments. Highlights from the Circular are noted below.

Remuneration paid to nonresident employees who work in Canada is subject to income tax withholding ("Regulation 102 withholding") and remitting requirements. Additionally, employers must report the remuneration to the CRA. These obligations apply equally to resident and nonresident employers.

• Employers must withhold and remit income tax, CPP contributions and EI premiums for each of their employees unless a waiver or exemption has been obtained. Failure to withhold and remit the amounts as required may result in interest and penalties.
• Employers must prepare and file a "T4 Information Return," reporting all amounts paid to their employees whether or not a waiver was received. Failure to do so can result in penalties and interest levied against the employer.

Where an employee is resident in a country that has concluded a tax treaty with Canada, and the facts surrounding the employee’s work in Canada are such that the treaty will eliminate the employee’s Canadian tax obligation, it may be possible to obtain a waiver of the employer’s Regulation 102 withholding requirements.

• The nonresident employee should apply for the waiver at least 30 days before employment in Canada or at least 30 days before the initial payment. A waiver application (which must contain all of the information to support applicability of the relevant treaty provisions) also may be made at a later date, but the waiver will not apply retroactively.

• The employer can apply for the waiver with the employee’s authorization.

It is becoming increasingly important for companies that are not resident in Canada to be aware of the Canadian tax withholding, remitting and reporting obligations, as well as any opportunities to obtain relief from these obligations. The specific facts and circumstances of each employment arrangement should be examined as early as possible to ensure there are no unwelcome surprises.

The Competent Authorities for Canada and the U.S. on 3 June 2005 signed a memorandum of understanding (MOU) that lists the most difficult issues to resolve and establishes principles and guidelines to improve the performance and efficiency of the mutual agreement procedure (MAP) in the Canada-U.S. income tax treaty.

As Canada Revenue Agency (CRA) and U.S. Internal Revenue Service (IRS) auditors become more sophisticated and more aggressive, the number of cases requiring resolution under the MAP has increased substantially in recent years, and the issues have become more complex, often resulting in prolonged or unsuccessful negotiations between the Competent Authorities.

The MOU identifies a number of issues that have resulted, or could result, in a failure to resolve double taxation or taxation contrary to the treaty. These issues include, but are not limited to: consignment manufacturing; profitsplit method and relative value of contributions; non-routine intangible assets and arm’s length value; existence of a permanent establishment and income allocation; whether income is from services or the license of an intangible; closure and relocation of a business; and conflicts between the laws of the source and residence country.

To facilitate reaching an agreement in the MAP process, the two countries agreed that positions taken will be "principled, reasonable and consistent." Specifically, the Competent Authorities will seek to resolve similar cases in a similar manner and advance positions only if prepared to grant equivalent relief.

Absent an exceptional reason for doing so, the Competent Authorities will accept the taxpayer’s structure of the transaction and other surrounding facts. If they cannot agree on the underlying facts after a six-month period, the factual determination will be elevated to a joint panel selected by the heads of the two tax authorities’ appeals divisions. A future MOU will detail the procedure for such cases. Additionally, if an agreement is not reached on an overall MAP request within two years from its acceptance date, the case will be elevated to the CRA Director General, International Tax Directorate, and IRS Director-International, LMSB.

The Competent Authorities also agreed to identify and eliminate procedural barriers to case completion of a MAP. Additionally, "notification" will be broadly interpreted (as detailed in an as yet executed MOU) to be "as inclusive as possible" in allowing MAP requests to proceed.

The Competent Authorities agreed to follow the Organization for Economic Cooperation and Development’s (OECD) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations to resolve substantive issues.

The Competent Authorities also expressed their commitment to reach an agreement establishing guidelines to resolve cases involving the issues mentioned above and other issues that have delayed negotiations thus far. The leadership of both the CRA and the IRS recognize they may be required to call on additional resources within their respective tax administrations to assist in developing these guidelines.

As noted above, parts of the MOU merely evidence a commitment to reach future agreement on specified issues. To that end, the MOU provides that future discussions on the above issue will be initiated as soon as possible. No time frame was provided on when those discussions will occur.

The signing of this MOU is a positive step toward enhancing the MAP process and restoring taxpayer confidence in the efficacy and effectiveness of the Competent Authority process. The MAP process has the necessary elements to function as an effective dispute resolution mechanism. This MOU is the first sign of a renewed commitment by the Canadian and U.S. Competent Authorities to ensure that roadblocks that may have impeded that goal are removed. The MOU also provides a road map of the most difficult issues currently raised by CRA and IRS audit teams and addressed in the MAP process, which taxpayers should carefully review with their advisors to determine the sufficiency of their current transfer pricing documentation.

After extensive debate and controversy, a tax on mining income in Chile will be levied as from 1 January 2006. The new law imposes a tax of 5% of operating profits on mining operators that produce more than 50,000 metric tons of copper per year. A previous attempt to impose a royalty on mining income failed because the proposal was unable to get the requisite number of votes in the Congress.

The tax will be imposed on a progressive scale on the taxable operating income of mining operators depending on the amount of copper produced each year. Taxable operating income is calculated by making adjustments to the normal net taxable income of the company.

Companies that produce less than 12 metric tons per year will not be subject to the tax; the rate for companies with a small amount of sales is between 0.5% and 4.5%, increasing up to a maximum of 5% for companies with annual sales of more than 50,000 metric tons of copper.

To prevent taxpayers from using artificial structures and/or allocations to avoid or reduce the mining tax, the law provides that, in calculating the tax rate, the mine operator must include the total value of sales of mining products of the group of entities related to the mining operator (to the extent such persons are engaged in the exploitation of mining). Further, the Chilean tax authorities will be allowed to challenge transfer prices and make relevant adjustments to income as needed.

Taxpayers subject to the mining tax will be required to make monthly provisional payments at a rate that will be calculated on the basis of sales (monthly gross income), but at a minimum of 0.3%.

The law introducing the mining tax also amends the foreign investment law (Decree Law 600) so that the tax treatment of mining investments protected under Decree 600 is in conformity with the new mining tax. Investors in mining projects valued at more than USD 50 million will be entitled to enter into a "stability pact" with the Chilean government, whereby the rate of the mining tax will not increase for a period of 15 years.

Chile is the world’s largest producer of copper and the mining industry represents nearly 10% of GDP.

The 2005 tax reform introduced a number of new, and controversial, tax provisions, including new definitions of "tax haven" and "business profits" and new thin capitalization rules.

Many of the tax changes in the reform required clarification, some of which have been provided as part of the "Resolución Miscelánea," or tax administrative rules that were issued 30 May 2005. These rules are usually issued in April, but were delayed, ostensibly so the government could draft clarifying provisions to some of the reform measures. Unfortunately, while some clarifications are made to the tax haven rules, the Resolución Miscelánea does not address issues arising under the amended definition of business profits or the transition rules under the thin cap provisions.

The 2005 reform replaced the "black list" of countries used to determine whether an investment is deemed to be in a low-tax jurisdiction with a different procedure. Under the reform, if foreign-source income is not subject to tax abroad or if it is subject to an income tax that is less than 75% of the income tax computed under Mexican tax legislation, the investment will be deemed to be in a low-tax jurisdiction. It is possible under the new rules that a country not typically classified as a tax haven might fall under the less-than-75% rule. Income derived from an entity located in a tax haven will be subject to taxation in Mexico in the year the income is derived and taxpayers earning such income must file an annual information return.

Under the Resolución Miscelánea, the tax haven rules will not apply for purposes of the 75% test if the profits derived from foreign entities are subject to tax at a rate of at least 23% in their country of incorporation (or where they have their principal place of business or place of effective management). Dividends from entities in that jurisdiction are not taken into account in determining the tax rate.

Informal sources at the Ministry of Finance had suggested that a simplified procedure may be introduced to determine whether the 75% test was met. However, basically no simplified procedure was announced and, therefore, taxpayers still must determine on a case-by-case basis whether a transaction will be deemed to be with a tax haven entity.

The Resolución Miscelánea provides that the following income will not be deemed to be derived from a tax haven:

• Income derived by Mexican residents or nonresidents with a permanent establishment in Mexico, provided the income is taxable under the Mexican Income Tax Law;
• Income derived by credit institutions from transactions with unrelated foreign entities, provided the foreign entity is resident in a country that has concluded a tax information exchange agreement with Mexico; and
• Income derived by individual taxpayers up to MP 160,000 during tax year 2005.

It was anticipated that the Resolución Miscelánea would specifically clarify that the amended definition of "business activities" in the Mexican Income Tax Law was not intended to override the application of the business profits article of Mexico’s (more than 30) tax treaties. The revised definition of business activities excludes specific types of income received by nonresidents that previously would have been exempt from withholding tax if the income qualified as business profits under an applicable tax treaty. The effect of the reform is to tax as Mexican-source income several types of income that clearly would not be taxed under Mexico’s treaties because the income would be classified as business income subject to taxation only if the nonresident has a PE in Mexico.

It is unfortunate that no clarification was issued because the uncertainty created by the amended domestic law definition of business activities may give rise to (otherwise avoidable) conflicts between taxpayers and the tax authorities that likely will need to be resolved by the Mexican judiciary or in the context of the mutual agreement procedure in Mexico’s treaties. However, the tax authorities are willing to issue particular rulings confirming the tax treaty protection, and it is our understanding that they also may be considering publication of a clarifying rule.

Unfortunately, the 2005 Resolución Miscelánea does not include any guidance on the new thin capitalization legislation. Beginning in 2005, interest paid on cash loans granted by related parties in excess of three times stockholders’ equity may not be deducted. Under a transition rule, taxpayers that determine that their debt-to-equity ratio exceeds 3:1 when World Tax Advisor 7 of 11 July/August 2005 the new law enters into effect have five years from 1 January 2005 to reduce such debts proportionately in equal parts in each of the five fiscal years until they reach the 3:1 ratio. If the taxpayer’s debt-to-equity ratio exceeds 3:1 at the end of this period, any interest paid on the debt exceeding the limit as of 1 January 2005 will not be deductible. The lack of guidance is causing concern because taxpayers must make decisions now to comply with the five-year transition rules. Although there have been unofficial comments originating in the Ministry of Finance suggesting that application of the legislation would be deferred until 2006, no rules have been published.

On 19 May 2005, the U.S. Treasury and Internal Revenue Service (IRS) issued proposed dual consolidated loss (DCL) regulations (under Internal Revenue Code §1503(d)).

The DCL rules are designed to prevent U.S. corporations from using the same loss taken on the U.S. consolidated tax return to offset income of another entity under the local country’s tax laws. The preamble to the proposed regulations describes three "fundamental concerns" with the current regulations that motivated and influenced the new rules. First, the proposed regulations adjust the scope and application of the DCL regime in an attempt to better focus on instances of double dipping (i.e. cases where a single economic loss is used to offset separate streams of income in two jurisdictions). Next, the proposed regulations consider and integrate the check-the-box regulations. The check-the-box rules post-date the current DCL rules and provide for choice of entity elections for non per se corporations. Finally, the proposed regulations attempt to reduce administrative burden, on both taxpayers and the government, caused by the DCL rules.

The regulations are proposed to be effective for DCLs incurred in taxable years beginning after the date the regulations are published as final in the Federal Register. While the proposed regulations state a comprehensive regime intended to eventually replace the current DCL rules, the new regulations’ application solely to DCLs incurred after finalization would cause the current regulations to remain fully effective with respect to pre-effective date DCLs. As a result, the current regulations would stay relevant for up to 15 years after the new rules are finalized.

In a private letter ruling (PLR 200522006), the U.S. Internal Revenue Service (IRS) recently examined the 12-month stock ownership requirement found in (Dividends) article 10(3)(a) of the new U.K.-U.S. Treaty (Treaty). For purposes of meeting the requirement, the IRS ruled that the Taxpayer is the direct owner of shares in a U.S. company that are directly owned by Taxpayer’s wholly-owned, disregarded entities.

Under the facts presented in the PLR, Taxpayer is a U.K. corporation and a member of a U.K. group. On unspecified dates, Taxpayer owned 100% of the stock in two foreign disregarded entities identified as B Co and C Co. Following a restructure, some B Co stock was transferred to C Co, with both B Co and C Co remaining disregarded entities. B Co in turn has wholly owned a U.S. corporation (US Co) but recently transferred its interest to Taxpayer. Further, at the time the ruling request was made, it was anticipated that US Co would repurchase some of its stock from Taxpayer in less than 12 months from the date on which Taxpayer acquired legal title to US Co’s shares; such repurchase would be considered a dividend for U.S. tax purposes to the extent of US Co’s earnings and profits and also, as represented by Taxpayer, would be a dividend under the Treaty.

Article 10(3)(a) provides exclusively residence-based taxation for dividends if the beneficial owner meets certain other requirements and (1) is a company resident in the other contracting state (the U.K.), and (2) owns shares representing 80% or more of the distributing company’s voting power for a 12-month period ending on the dividend declaration date. Such ownership of shares is required to be "direct," as explained in Treasury’s Technical Explanation to the Treaty. Under the facts presented, while Taxpayer wholly owned US Co through disregarded entities for the required time period, it will not have held legal title for the required period and its ownership through disregarded entities must be considered if it is to meet the holding period requirement.

In making its ruling that ownership through disregarded entities qualifies as direct ownership, the IRS noted that the Technical Explanation does not define "direct ownership." The Treaty’s general rules of interpretation provide, however, that undefined terms are defined under the laws of the Contracting State (the U.S.) applying the Treaty. Consequently, the IRS examined the check-the-box rules, which provide that the activities of a disregarded entity "are treated in the same manner as a sole proprietorship, branch, or division of the owner." Moreover, the IRS stated that "[d]omestic law clearly contemplates that the sole owner of a disregarded entity is considered to own the assets…for federal tax purposes."

The generally applicable definition under U.S. laws, however, may not apply if the context of the Treaty’s language requires a different result. To determine the rationale for the zero rate on certain intercompany dividends, the IRS consulted the Joint Committee on Taxation’s Treaty Explanation. An 80% ownership, according to the explanation, warrants treating the recipient corporation as a direct investor – as opposed to remote investors who "warrant" second level source-country taxation. Additionally, the test serves to prevent reorganizations effected for the purpose of obtaining the zero rate in circumstances where the Limitation-on-Benefits article does not adequately guard against treaty shopping. Prevention of treaty shopping is bolstered by the active trade or business test and the ownership-base erosion test, and the effect of the holding period is to prevent "short-term shifting of ownership."

Allowing Taxpayer to qualify as a direct owner during the periods the stock was held by Taxpayer’s wholly owned, disregarded entity, the IRS concluded, would not contradict the intended results of the U.K. and U.S. in agreeing to the Treaty’s terms.

Although the PLR is directed only to the taxpayer requesting it, and may not be used or cited as precedent, it indicates that the IRS will, in some circumstances, allow ownership of stock held through a disregarded entity to satisfy the direct ownership requirements of the Treaty. Furthermore, because a similar zero withholding rate has been included in other recent U.S. treaties, the PLR’s approach may also be followed elsewhere. Finally, the PLR provides some insight into the IRS’s more general views on the treaty treatment of disregarded entities.

This article is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter. This bulletin should not be relied on as a substitute for such advice. While all reasonable attempts have been made to ensure that the information contained in this bulletin is accurate, Deloitte Touche Tohmatsu accepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

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