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Tax Treaties F. Hale Stewart, JD, LLM, CAM, CWM, CTEP For the Law Office of Hale Stewart 832.330.4101 On Skype under the name: Bonddad.

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Presentation on theme: "Tax Treaties F. Hale Stewart, JD, LLM, CAM, CWM, CTEP For the Law Office of Hale Stewart 832.330.4101 On Skype under the name: Bonddad."— Presentation transcript:

1 Tax Treaties F. Hale Stewart, JD, LLM, CAM, CWM, CTEP For the Law Office of Hale Stewart On Skype under the name: Bonddad

2 Suppose the Following A US company wants to sell its goods in another country but there is no tax treaty between the countries. Also assume the US still uses a world wide taxation system. In this situation, the company faces a strong possibility of double taxation – being taxed on the same income by two separate countries. The US would tax the company on foreign income under the world wide system, and the other country would exert its taxing jurisdiction based upon a taxing nexus existing between the point of sale and the country’s territory. While the US does allow a credit against foreign taxes paid, depending on the level of international exposure, the company may not be fully immune to double taxation.

3 Fundamental Reasons for Tax Treaties The preceding examples highlight what is perhaps the most important reason for writing double tax treaties: avoiding the incidence of double taxation. There are also other strong fundamental reasons for signing these agreements. – Allocate the right to tax between countries – Enhancing international trade by creating certainty – Prevention of fiscal evasion – Exchange of information

4 A Brief History The OCED issued its first draft treaty in 1963, largely in reaction to the post WWII increase in international trade. This treaty was revised in 1977 and again 1992 when t was released in loose-leaf form, allowing periodic updates and revisions. The UN issued its model treaty in 1979, which was based on the OECD model, but which was more oriented towards capital importers rather than capital exporters. The US issued their first model treaty in 1977, which was replaced in 1981 and again in There is a remarkable degree of similarity between all three model treaties. Going forward, we will be using the OECD Model Treaty as the basis for the discussion. I will highlight some of the more pronounced differences between the treaties.

5 Who Does the Treaty Apply To? Article 1: “This Convention shall apply to persons who are residents of one or both the contracting states.” – The term “person” includes an individual, a company or any other body of persons – Residency will be discussed in a moment

6 What Taxes Are Covered By the Treaty? Article 2, Section 1: “this convention shall apply to taxes on income and on capital imposed on behalf of a contracting state or of its political subdivisions or local authorities, irrespective of the manner in which they are levied.” Article 2, Section 2: “There shall be regarded as taxes on income and on capital taxes imposed on total income, on total capital or on elements of income or of capital, including taxes on gains from the alienation of movable or immovable property”

7 Taxing Nexus Central to the idea of taxation is the concept of “nexus” which dictionary.com defines as “a means of connection; tie, link.” In other words, there has to be a connection between an economic event and the jurisdiction asserting its taxing authority. From the US tax perspective, consider code sections 881 et. al that deal with income from sources within and without the United States

8 Residency Article 4 Section 1: – For the purposes of this Convention, the term “resident of a Contracting State” means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.

9 Residency.. means any person who, – Remember the treaty definition of person: “The term “person” includes an individual, a company or any other body of persons” under the laws of that State. – “The definition refers to the concept of residence adopted in the domestic laws” (Commentary) – As such, we need to know what the domestic law says

10 Residency In many States, a person is considered liable to comprehensive taxation even if the Contracting State does not in fact impose tax. For example, pension funds, charities and other organisations may be exempted from tax, but they are exempt only if they meet all of the requirements for exemption specified in the tax laws. They are, thus, subject to the tax laws of a Contracting State. Furthermore, if they do not meet the standards specified, they are also required to pay tax. Most States would view such entities as residents for purposes of the Convention (commentary)

11 Residency “This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.” … a person is not to be considered a "resident of a Contracting State" in the sense of the Convention if, although not domiciled in that State, he is considered to be a resident according to the domestic laws but is subject only to a taxation limited to the income from sources in that State or to capital situated in that State. (commentary) – So, if a person owns property in a state, they will probably still be taxed on issues related to that property, but won’t become a resident of the company under the treaty. For example, see 26 U.S.C. 861 Income from sources within the United States

12 Residency John is the CEO of a company that has operations in the United States and China. He spends 6 months of the year in both locations and has houses in both locations. In both locales he has a close circle of friends, attends church and even participates in local charities. However, he is a US national.

13 Residency The fact pattern illustrates a situation that is becoming more and more common; people who are “citizens of the world.” They live in multiple locations and have connections to each. However, as tax planners we must still determine where their primary residence is for tax purposes. To solve this problem, the tax treaty has given us a series of “tie breakers.”

14 Residency Where by reason of the provisions of paragraph 1 an individual is a resident of both Contracting States, then his status shall be determined as follows: – he shall be deemed to be a resident only of the State in which he has a permanent home available to him; if he has a permanent home available to him in both States, he shall be deemed to be a resident only of the State with which his personal and economic relations are closer (centre of vital interests);

15 Residency Central to the concept of residency is the idea of home. In fact, this is where most inquiries stop. – The type of home (house, apartment, chateau) is not important. – “The permanence of the home is essential. The individual must have arranged to have the dwelling available to him at all times continuously, and not occasionally for the purpose of a stay which is necessarily of short duration” (commentary) – The permanent use of the home is of prime importance. Remember that John has homes in both locations.

16 Residency If the individual has a permanent home in both Contracting States, it is necessary to look at the facts in order to ascertain with which of the two States his personal and economic relations are closer. Thus, regard will be had to his family and social relations, his occupations, his political, cultural or other activities, his place of business, the place from which he administers his property, etc. The circumstances must be examined as a whole, but it is nevertheless obvious that considerations based on the personal acts of the indi- vidual must receive special attention. If a person who has a home in one State sets up a second in the other State while retaining the first, the fact that he retains the first in the environment where he has always lived, where he has worked, and where he has his family and possessions, can, together with other elements, go to demonstrate that he has retained his centre of vital interests in the first State. (commentary)

17 Residency Remember in our fact pattern, John was equally involved in both the US and China; he went to church in both locations and participated in charity events in both locations. As such he need to move onto the next tie-breaking rule.

18 Residency if the State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him in either State, he shall be deemed to be a resident only of the State in which he has an habitual abode; Habitual is defined by time; or, “the state where he stays more frequently…For this purpose, regard must be had to stays made by the individual not only at the permanent home in the State in question, but also at any other place in the same state” (commentary)

19 Residency If residency cannot be determined by the presence of a habitual abode, the state where the individual is a national takes presence. If the individual is a national of both countries, the “competent authorities” of both countries must come to an understanding.

20 Residency; Corporations Where by reason of the provisions of paragraph 1 a person other than an individual is a resident of both Contracting States, then it shall be deemed to be a resident only of the State in which its place of effective management is situated. The place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity’s business as a whole are in substance made. (commentary)

21 Permanent Establishment Why is permanent establishment an important concept? – Article 7, Section 1 states: The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment. – Remember the concept of Nexus: there must be a physical connection between the business and the jurisdiction.

22 Permanent Establishment For the purposes of this Convention, the term “permanent establishment” means a fixed place of business through which the business of an enterprise is wholly or partly carried on. 2. The term “permanent establishment” includes especially: – a) a place of management; – b) a branch; – c) an office; – d) a factory; – e) a workshop, and – f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources.

23 Permanent Establishment "The paragraph defines the term "permanent establishment" as a fixed place of business, through which the business of an enterprise is wholly or partly carried on. This definition, therefore, contains the following conditions: the existence of a "place of business", i.e. a facility such as premises or, in certain instances, machinery or equipment; – this place of business must be "fixed", i.e. it must be established at a distinct place with a certain degree of permanence; – the carrying on of the business of the enterprise through this fixed place of business. – This means usually that persons who, in one way or another, are dependent on the enterprise (personnel) conduct the business of the enterprise in the State in which the fixed place is situated.

24 Permanent Establishment According to the definition, the place of business has to be a "fixed" one. Thus in the normal way there has to be a link between the place of business and a specific geographical point. It is immaterial how long an enterprise of a Contracting State operates in the other Contracting State if it does not do so at a distinct place, but this does not mean that the equipment constituting the place of business has to be actually fixed to the soil on which it stands. It is enough that the equipment remains on a particular site

25 Permanent Establishment Since the place of business must be fixed, it also follows that a permanent establishment can be deemed to exist only if the place of business has a certain degree of permanency, i.e. if it is not of a purely temporary nature. A place of business may, however, constitute a permanent establishment even though it exists, in practice, only for a very short period of time because the nature of the business is such that it will only be carried on for that short period of time. It is sometimes difficult to determine whether this is the case. …. experience has shown that permanent establishments normally have not been considered to exist in situations where a business had been carried on in a country through a place of business that was maintained for less than six months (conversely, practice shows that there were many cases where a permanent establishment has been considered to exist where the place of business was maintained for a period longer than six months).

26 Permanent Establishment For a place of business to constitute a permanent establishment the enterprise using it must carry on its business wholly or partly through it. … [T]he activity need not be of a productive character. Furthermore, the activity need not be permanent in the sense that there is no interruption of operation, but operations must be carried out on a regular basis. (commentary)

27 Permanent Establishment 4. Notwithstanding the preceding provisions of this Article, the term “permanent establishment” shall be deemed not to include: a) the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise; b) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display or delivery; c) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; d) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or of collecting information, for the enterprise; e) the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary character; f) the maintenance of a fixed place of business solely for any combination of activities mentioned in sub-paragraphs a) to e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary character.

28 Permanent Establishment Notwithstanding the provisions of paragraphs 1 and 2, where a person —other than an agent of an independent status to whom paragraph 6 applies —is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph. An enterprise shall not be deemed to have a permanent establishment in a Contracting State merely because it carries on business in that State through a broker, general commission agent or any other agent of an independent status, provided that such persons are acting in the ordinary course of their business.

29 Permanent Establishment These principles are illustrated by the following examples where representatives of one enterprise are present on the premises of another enterprise. A first example is that of a salesman who regularly visits a major customer to take orders and meets the purchasing director in his office to do so. In that case, the customers premises are not at the disposal of the enterprise for which the salesman is working and therefore do not constitute a fixed place of business through which the business of that enterprise is carried on (commentary) A second example is that of an employee of a company who, for a long period of time, is allowed to use an office in the headquarters of another company (e.g. a newly acquired subsidiary) in order to ensure that the latter company complies with its obligations under contracts concluded with the former company. In that case, the employee is carrying on activities related to the business of the former company and the office that is at his disposal at the headquarters of the other company will constitute a permanent establishment of his employer, provided that the office is at his disposal for a sufficiently long period of time so as to constitute a "fixed place of business" and that the activities that are performed there go beyond the activities referred to in paragraph 4 of the Article (commentary).

30 Business Profits 1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to that permanent establishment. 2. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment. 3. In determining the profits of a permanent establishment, there shall be allowed as deductions expenses which are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.

31 Business Profits 4. Insofar as it has been customary in a Contracting State to determine the profits to be attributed to a permanent establishment on the basis of an apportionment of the total profits of the enterprise to its various parts, nothing in paragraph 2 shall preclude that Contracting State from determining the profits to be taxed by such an apportionment as may be customary; the method of apportionment adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article. 5. No profits shall be attributed to a permanent establishment by reason of the mere purchase by that permanent establishment of goods or merchandise for the enterprise. 6. For the purposes of the preceding paragraphs, the profits to be attributed to the permanent establishment shall be determined by the same method year by year unless there is good and sufficient reason to the contrary. 7. Where profits include items of income which are dealt with separately in other Articles of this Convention, then the provisions of those Articles shall not be affected by the provisions of this Article.

32 Interest 1. Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. 2. However, such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax so charged shall not exceed 10 per cent of the gross amount of the interest. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of this limitation. 3. The term “interest” as used in this Article means income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article.

33 Interest 4. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the interest, being a resident of a Contracting State, carries on business in the other Contracting State in which the interest arises through a permanent establishment situated therein and the debt-claim in respect of which the interest is paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply. 5. Interest shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the interest, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment, then such interest shall be deemed to arise in the State in which the permanent establishment is situated. 6. Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest, having regard to the debt-claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention.

34 Dividends 1. Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State. 2. However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed: a) 5 per cent of the gross amount of the dividends if the beneficial owner is a company (other than a partnership) which holds directly at least 25 per cent of the capital of the company paying the dividends; b) 15 per cent of the gross amount of the dividends in all other cases. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of these limitations. This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.

35 Dividends 3. The term “dividends” as used in this Article means income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders' shares or other rights, not being debt-claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident. 4. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the dividends, being a resident of a Contracting State, carries on business in the other Contracting State of which the company paying the dividends is a resident through a permanent establishment situated therein and the holding in respect of which the dividends are paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply. 5. Where a company which is a resident of a Contracting State derives profits or income from the other Contracting State, that other State may not impose any tax on the dividends paid by the company, except insofar as such dividends are paid to a resident of that other State or insofar as the holding in respect of which the dividends are paid is effectively connected with a permanent establishment situated in that other State, nor subject the company's undistributed profits to a tax on the company's undistributed profits, even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in such other State.

36 Royalties 1. Royalties arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall be taxable only in that other State. 2. The term “royalties” as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, any patent, trade mark, design or model, plan, secret formula or process, or for information concerning industrial, commercial or scientific experience. 3. The provisions of paragraph 1 shall not apply if the beneficial owner of the royalties, being a resident of a Contracting State, carries on business in the other Contracting State in which the royalties arise through a permanent establishment situated therein and the right or property in respect of which the royalties are paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply.

37 Royalties Where, by reason of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the royalties, having regard to the use, right or information for which they are paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention.

38 Capital Gains 1. Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State. 2. Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise), may be taxed in that other State. 3. Gains from the alienation of ships or aircraft operated in international traffic, boats engaged in inland waterways transport or movable property pertaining to the operation of such ships, aircraft or boats, shall be taxable only in the Contracting State in which the place of effective management of the enterprise is situated. 4. Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State. 5. Gains from the alienation of any property, other than that referred to in paragraphs 1, 2, 3 and 4, shall be taxable only in the Contracting State of which the alienator is a resident.

39 Income From Employment 1. Subject to the provisions of Articles 16, 18 and 19, salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised, such remuneration as is derived therefrom may be taxed in that other State. 2. Notwithstanding the provisions of paragraph 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if: a) the recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days in any twelve month period commencing or ending in the fiscal year concerned, and b) the remuneration is paid by, or on behalf of, an employer who is not a resident of the other State, and c) the remuneration is not borne by a permanent establishment which the employer has in the other State.

40 Non-Discrimination 1. Nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances, in particular with respect to residence, are or may be subjected. This provision shall, notwithstanding the provisions of Article 1, also apply to persons who are not residents of one or both of the Contracting States. 2. Stateless persons who are residents of a Contracting State shall not be subjected in either Contracting State to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of the State concerned in the same circumstances, in particular with respect to residence, are or may be subjected. 3. The taxation on a permanent establishment which an enterprise of a Contracting State has in the other Contracting State shall not be less favourably levied in that other State than the taxation levied on enterprises of that other State carrying on the same activities. This provision shall not be construed as obliging a Contracting State to grant to residents of the other Contracting State any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents.

41 Non-discrimination 4. Except where the provisions of paragraph 1 of Article 9, paragraph 6 of Article 11, or paragraph 4 of Article 12, apply, interest, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State. Similarly, any debts of an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State. 5. Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State are or may be subjected.

42 Mutual Agreement 1. Where a person considers that the actions of one or both of the Contracting States result or will result for him in taxation not in accordance with the provisions of this Convention, he may, irrespective of the remedies provided by the domestic law of those States, present his case to the competent authority of the Contracting State of which he is a resident or, if his case comes under paragraph 1 of Article 24, to that of the Contracting State of which he is a national. The case must be presented within three years from the first notification of the action resulting in taxation not in accordance with the provisions of the Convention. 2. The competent authority shall endeavour, if the objection appears to it to be justified and if it is not itself able to arrive at a satisfactory solution, to resolve the case by mutual agreement with the competent authority of the other Contracting State, with a view to the avoidance of taxation which is not in accordance with the Convention. Any agreement reached shall be implemented notwithstanding any time limits in the domestic law of the Contracting States.

43 Mutual Agreement ]3. The competent authorities of the Contracting States shall endeavour to resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the Convention. They may also consult together for the elimination of double taxation in cases not provided for in the Convention. 4. The competent authorities of the Contracting States may communicate with each other directly, including through a joint commission consisting of themselves or their representatives, for the purpose of reaching an agreement in the sense of the preceding paragraphs.

44 Anti-Avoidance Law and International Tax Treaties

45 What is Anti-Avoidance Law? Generally, anti-avoidance law is a series of common law doctrines that prevent a taxpayer from manipulating the tax code and/or transactions in such a way as to bastardize congressional intent. For example, a corporate reorganization is a tax-free event. Therefore, taxpayers will try to make a transaction look like a reorganization when in fact it is not.

46 For Example A corporate reorganization must meet the following requirements: – There must be a plan of reorganization – The plan must meet the continuity of interest and business enterprise tests. – There must be a sound business purpose (the business purpose test). If a “reorganization” does not meet these requirements, a court can strip the taxpayers of their tax-free treatment.

47 But, There is a Tension Within the Law On one hand, taxpayers cannot manipulate the code in a way not intended or contemplated by the underlying statute. On the other hand, taxpayers are allowed to plan their transactions from a tax perspective to minimize the rate of taxation.

48 Therefore, Remember the Following Two Rules. In General, a Taxpayer who is a party to any transaction must be able to demonstrate: – there is a genuine multiple-party transaction – with economic substance that is – compelled or encouraged by business or regulatory realities, – that is imbued with tax-independent considerations, and – that is not shaped solely by tax-avoidance features to which meaningless labels are attached. This documentation must occur before the transaction is complete. Think “duty of care” Occam's razor (or Ockham's razor), is the meta-theoretical principle that "entities must not be multiplied beyond necessity" (entia non sunt multiplicanda praeter necessitatem) and the conclusion thereof, that the simplest solution is usually the correct one.

49 There are 5 Anti-Avoidance Rules Substance over form The Sham Transaction Business Purpose Economic Substance The Step Transaction

50 Substance Over Form In these circumstances, the facts speak for themselves and are susceptible of but one interpretation. The whole undertaking, though conducted according to the terms of subdivision (B), was in fact an elaborate and devious form of conveyance masquerading as a corporate reorganization, and nothing else.….. To hold otherwise would be to exalt artifice above reality and to deprive the statutory provision in question of all serious purpose.

51 Sham Transaction “[i]t is well established that a transaction entered into solely for the purpose of tax reduction (the Goldstein prong) and which has no economic or commercial objective to support it (the Knetsch prong) is a sham and without effect for Federal income tax purposes.”

52 The Business Purpose Test “[I]n construing words of a tax statute which describe commercial or industrial transactions we are to understand them to refer to transactions entered upon for commercial or industrial purposes and not to include transactions entered upon for no other motive but to escape taxation.”

53 The Economic Substance Doctrine Prong One: The transaction is rationally related to a useful non-tax business purpose that is plausible in light of the taxpayer’s conduct and economic situation Prong Two: the transaction results in a meaningful and appreciable enhancement in the net economic position of the taxpayer other than to reduce tax.

54 The Step Transaction Doctrine A given result at the end of a straight path is not made a different result because reached by following a devious path. The mutual-interdependence test finds that the step-transaction doctrine applies where individual transactions were “so interdependent that the legal relationship created by one transaction would have been fruitless without a completion of the series. The relationship between the steps, rather than their “end result,” is examined. In the end results test, “purportedly, separate transactions will be amalgamated into a single transaction when it appears that they are really component parts of a single transaction intended from the outset to be taken for the purpose of reaching the ultimate result.” Put another way, “Separate steps will also be integrated if they are a part of a single scheme designed to achieve a single result.”

55 Therefore, Remember the Following Two Rules. In General, a Taxpayer who is a party to any transaction must be able to demonstrate: – there is a genuine multiple-party transaction – with economic substance that is – compelled or encouraged by business or regulatory realities, – that is imbued with tax-independent considerations, and – that is not shaped solely by tax-avoidance features to which meaningless labels are attached. This documentation must occur before the transaction is complete. Occam's razor (or Ockham's razor), is the meta-theoretical principle that "entities must not be multiplied beyond necessity" (entia non sunt multiplicanda praeter necessitatem) and the conclusion thereof, that the simplest solution is usually the correct one.


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