I spent the last week of September in Canada attending the BDO Canada tax conference. The discussion centered on cross-border business transactions and planning. After all, Canada is just behind China as the largest U.S. trading partner. Canada is now the largest source of U.S. energy imports, and the importance of the Keystone pipeline is to assist in transporting this supply of energy. The planning for U.S.-Canada transactions is similar to that in other cross-border transactions.
Cross-border activity surrounds us and one can’t go a day or two without hearing of significant cross-border business transactions. The way we communicate with each other is an example. Looking at our mobile devices and service providers shows the extent of some recent cross-border transactions. Nokia is currently selling a significant portion of its business assets to Microsoft. BlackBerry is having its issues and is currently entertaining bids for its company. Samsung is passing Apple in terms of the sales of smartphones. Verizon is in the process of buying out its U.K. partner, Vodafone. Deutsche Telekom’s T-Mobile and Metro PCS completed a merger a few months ago. All of these transactions involved significant analysis and tax planning.
The Verizon purchase of the Vodafone stake in Verizon Wireless for a reported $130B generated some interest in the U.K. over the reported small amount of taxes Vodafone was incurring on the sale. Since the sale was of shares of the Vodafone U.S. subsidiary owning its 45 percent interest in the wireless business, there is no U.S. income tax on the share gains since the U.S. tax code does not generally tax gains of share sales where a foreign individual or entity is not a resident the U.S.
In addition, Vodafone’s Dutch holding company, which owned the shares in the U.S. subsidiary, benefits from no tax on the gain as a result of the Dutch participation exemption on sales of the shares of subsidiaries. The U.K. has a similar provision for substantial shareholdings in foreign subsidiaries as do several other U.S. trading partners.
There will be some taxes paid related to the Vodafone/Verizon transaction. Vodafone did announce that a considerable portion of the sales proceeds were to be distributed to Vodafone shareholders. The shareholders will pay income tax, in most cases, on the distribution of the proceeds. Thus, income tax is being paid on the proceeds, though at the individual shareholder level and not at the corporate level.
In cross-border acquisitions, the source of the acquirer’s cash becomes a consideration and the tax cost associated with accessing such cash. We continue to see reports of the tranches of cash that remain invested in U.S.-based companies’ foreign subsidiaries. Microsoft indicated it its press release that it will acquire the Nokia assets using cash from its non-U.S. subsidiaries. The reason is likely the same as for the reports of many U.S. multinationals maintaining cash in their non-U.S. subsidiaries: The transfer of the cash to the U.S. results in U.S. tax on the earnings since the U.S. taxes worldwide income and provides for a tax credit regime rather than a participation exemption/territorial regime. By not routing the cash through the U.S., this saves taxes for these companies. The fact that the U.S. does not have an equivalent to the participation exemption regime used by most of our major trading partners places the U.S. tax system at a competitive tax disadvantage.
In another recent cross-border transaction, T-Mobile completed a merger with Metro PCS. This transaction was the subject of a proxy fight regarding the deal terms. Some large shareholders in Metro PCS had concerns over the intercompany debt the combined company was going to have post-merger with Deutsche Telekom, the 74 percent parent (post-merger) of the combined company, T-Mobile US. The interest rate, the debt terms and the amount of debt were of concern. The opposing Metro PCS shareholders’ position was that a portion of the debt should be contributed to the equity of the combined company and the interest rate reduced on the intercompany debt based on how other peer companies have structured their capital structures and debt terms. Ultimately, Deutsche Telekom and the opposing Metro PCS shareholders agreed to modified deal terms that took these concerns into account.
The approach used by Metro PCS shareholders was an approach the IRS may take when reviewing the terms and conditions related to intercompany debt transactions. Whether investing from the U.S. to foreign markets or from foreign into the U.S., taxing authorities have concerns with intercompany transactions and in particular the use of intercompany debt to strip out earnings in a tax deductible manner (as interest payments). Most countries have either thin capitalization requirements that set limitations on debt to equity ratios, or have limitations on the amount of interest expense that may be deducted in a given tax year. Canada recently reduced its allowable debt to equity ratio to 1.5 to 1 (or a 60 percent/40 percent ratio). In addition, Germany and Japan have recently tightened interest expense deduction limitations.
This summer several public companies have disclosed that the IRS has challenged interest expense deductions related to intercompany debt arrangements. In these situations, the IRS has reviewed the specific facts and debt terms and has made proposed assessments to taxable income by disallowing a portion of the interest deductions claimed by these companies. The stakes are high for these companies as the loss of the deductions increases taxable income and the payments will be recast as dividends rather than interest if the IRS assessment is successful. These cases deal with hundreds of millions of dollars in tax, interest and penalty assessments.
The fight over debt and equity has led to some court battles. In 2012, there were several U.S. Tax Court decisions involving debt and equity characterization and the characterization of payments as interest or dividends. It appears the increased audit activity and assessments by the IRS may bring additional decisions from the Courts in the U.S. One of the key elements in these cases may be the amount of contemporaneous documentation the taxpayers maintained at the time the intercompany debt arrangements were entered into and the specific terms and conditions of the debt instruments and whether a third-party lender would have lent on comparable terms and conditions.
The public cross-border transactions discussed above all demonstrate the need for a complete analysis of the tax issues and opportunities, in addition to the business and financial considerations of the deals. Proper planning and documentation can avoid later disputes with revenue authorities.
Bill Roth is a tax partner with the local office of BDO USA LLP. The views expressed are those of the author and not necessarily of BDO. The comments are general in nature and not to be considered specific tax or accounting advice and cannot be relied upon for the purposes of avoiding penalties. Readers are advised to consult with their professional advisers before acting on any items discussed herein.