Sunday, December 29, 2013

Taxing the Corporation: Home Depot and the State's Claim of Right

The Arizona Court of Appeals recently issued a decision in the Home Depot case, which involves determining when the state has jurisdiction to tax a corporation. The case is about a domestic multi-state business but it has interesting implications for the taxation of multinationals. In brief, Home Depot (a Delaware corporation headquartered in Georgia) formed a subsidiary in 1991 to hold its trademarks. It then entered into a licensing agreement with the sub, Homer, under which it paid a royalty for the use of the trademarks. The royalty started at 1.5% of gross sales, and increased to 4% in the years at issue. The Arizona Department of Revenue decided that Homer and Home Depot constituted a unitary business for Arizona state tax purposes, the Arizona Tax Court agreed, and the Court of Appeals affirmed.

So here we have a Delaware corporation, headquartered in Georgia, doing business in Arizona through retail stores, but stripping its income out of the state in order to avoid the state level corporate income tax. That is, of course, the basic modus operandi of Google, Apple, Starbucks, GE, Amazon, et al, each of which sells products and services around the world yet pays low single digit corporate tax rates in each jurisdiction by stripping out its income in the form of license fees, interest, and other inter-company payments to subsidiaries located in low-tax jurisdictions.

Internationally the defense that countries employ against this behavior is the arm's length standard, under which each government that claims jurisdiction over any part of the multinational treats that part as if it was an independent party acting at arm's length with respect to the rest of the company. Indeed Home Depot raised its compliance with the arm's length standard as a reason for the court to dismiss the Arizona revenue authority's jurisdictional claim over Homer. But the Court points out that compliance with arm's length is not the issue in a question about establishing a jurisdictional claim:
Home Depot, nevertheless, argues its transactions with Homer have been at arm’s length, and points out that the Department has not challenged the appraisal establishing the legitimacy of the royalty it pays Homer. [Under prior case law] the principle [is] that unitary treatment will be imposed or allowed whenever the activities of the affiliated organizations affect the other(s) in ways that are "so pervasive as to negate any claim that they function independently from each other."
Under a statutory regime that allows for unitary taxation, in other words, the state can claim jurisdiction to tax with respect to any corporation anywhere, if it can establish pervasive links among affiliated corporations, or "operational integration." And what are the marks of such operational integration, such that the state's jurisdiction to tax is established? The Court lists fifteen, pursuant to Arizona state law:
1. The same or similar businesses conducted by components;
2. Vertical development of a product by components, such as manufacturing, distribution, and sales;
3. Horizontal development of a product by components, such as sales, service, repair, and financing;
4. Transfer of materials, goods, products, and technological data and processes between components;
5. Sharing of assets by components;
6. Sharing or exchanging of operational employees by components;
7. Centralized training of operational employees;
8. Centralized mass purchasing of inventory, materials, equipment, and technology;
9. Centralized development and distribution of technology relating to the day-to-day operations of the components;
10. Use of common trademark or logo at the basic operational level;
11. Centralized advertising with impact at the basic operational level;
12. Exclusive sales-purchase agreements between components;
13. Price differentials between components as compared to unrelated businesses;
14. Sales or leases between components; and
15. Any other integration between components at the basic operational level. 
Not every listed factor must be present in order to establish operational integration. Having established its jurisdictional claim, the state does not claim all of the income of the entire multistate operation, but rather applies its own internal formula for determining what portion of the whole is attributable to the group's Arizona operations. 

Herein lies the lesson for international taxation: corporate taxation of a multi-state group is possible on a unilateral basis--a state need only stake its own jurisdictional claim and have the werewithal to enforce it. Arizona's Court of Appeals seems to be suggesting that the state's jurisdictional claim need not be hampered by any artificial constructs, whether these be rules assigning corporate residence or contracts allocating rights. Presumably the allocation formula cannot be 100% but also relies on some decision about the extent of the jurisdictional claim--although this has not been argued or established here. The decision further implies that enforcement is possible as a practical matter, presumably on the basis of the operations and assets that are currently in the state. The question raised is whether the Arizona market will continue to be attractive to Home Depot, such that it will accept unitary taxation by the state in order to continue to do business there. These are empirical questions, and the economic evidence I have seen so far suggests that the business will not leave solely as a result of the tax (especially if there is no alternative market that would deliver the same profits at a lower tax cost: here is a short summary that covers some of the bases on this question).

Substituting nation-state for state in these assumptions, these are big normative claims about the right of the state to assert a jurisdictional claim to tax, as well as its ability to follow through once the claim of right has been established. These assumptions raise even bigger normative claims about the fairness and efficiency of any system that fails to exercise a jurisdictional claim where it exists, since failure to exercise a claim in one sector forces the other sectors to take up the slack thus distorting tax outcomes on the basis on noneconomic factors. 

Sunday, December 8, 2013

FATCA Q&A--A Work in Progress

Just a few questions I get a lot, together with some of the answers I typically give. This is not an exhaustive account of anything, nor is it legal advice. If you have or think you have FATCA-related problems, you need to consult legal counsel.
What is FATCA?
  • FATCA is the Foreign Account Tax Compliance Act. It is law in the United States, enacted as part of the Hiring Incentives to Restore Employment Act, (HIRE Act), which was signed into law by President Obama on March 18, 2010. (It is found at §§ 501-531, Pub. L. No. 111-147, 124 Stat. 71 (2010). It has been codified in scattered sections of the Internal Revenue Code.
  • In brief, the law requires foreign financial institutions (broadly defined) to identify any of their accounts (also broadly defined) held by "US persons" (expansively defined) and then furnish the US with periodic reports on those accounts including identifying information and amounts of transfers in and out of the accounts. Targeted institutions that fail to comply are to be penalized with a 30% toll charge on all of their US-source payments (again expansively--not just payments connected to targeted accounts).
  • There are numerous rules and exceptions and exceptions to the exceptions applicable to the above statement.
  • "US person" includes everyone in the world who is a US citizen, whether or not that person lives or has ever lived in the US and whether or not that person is also a citizen of somewhere else. The US is the only country in the world that taxes its citizens on this basis. Citizenship-based taxation violates the membership principle as well as the global standard of residence-based taxation, and has therefore been denounced as unjust or bad economic policy or both by most academics, including Reuven Avi-Yonah and myself among others.
  • The US considers any account to be foreign if it is not in the US, so for people who live in other countries, their neighbourhood bank where they have their checking account in the local currency is "foreign."
Why was FATCA part of the HIRE Act?
  • The HIRE Act was a jobs bill that included payroll tax holidays and other credits for employers. FATCA was unrelated to this purpose, but was included in the form of revenue-raising “Offset Provisions”. The Chair of the House Budget Committee claimed that the HIRE Act was a responsible piece of legislation that “was fully paid for… by cracking down on overseas tax havens." Congressional Record (4 March 2010) page H1152 (statement of Sen. Allyson Schwartz). However, no cost-benefit analysis appears to have been undertaken, and pursuant to CBO projections, the sums to be raised under FATCA could do little by way of offset, even if they were fully implemented (see below, What is the cost/benefit of FATCA).
  • The placement as a revenue raiser tacked onto a bill aimed at unrelated objectives has been viewed by opponents of FATCA as a sign that its passage was undertaken with some degree of stealth. See, e.g., Recovery Partners, “FATCA: The Empire Strikes Back” (4 July 2011); Koshek Rama Moorthi, “FATCA: Obama’s New Year Surprise Against American Expats” (30 November 2012), The Examiner; American Citizens Abroad, “ACA’s Voice in the News” (October 2012) online. The addition of unrelated riders and last minute addenda, especially revenue raisers, is a standard feature of US lawmaking, though it may appear anomalous to observers from other countries. For a brief discussion of how reconciliation and pay-as-you-go rules and standards affect tax policymaking in the US, see Center on Budget and Policy Priorities, “Policy Basics: Introduction to the Federal Budget Process” (3 January 2011).
  • Presented as a revenue offset at the tail end of a long, complex, and contested piece of legislation did allow FATCA to pass with minimal debate or discussion in 2010. But the seeds for FATCA had been sown in earlier (failed) legislative attempts, both in Senator Levin’s Stop Tax Haven Abuse Act of 2009 and Senator Baucus’ stand-alone FATCA Act of 2009. See Carl Levin, “Summary of the Stop Tax Haven Abuse Act” (2 March 2009); H.R. 3933 (111th): Foreign Account Tax Compliance Act of 2009 (27 October 2009); See also Douglas Shulman, “Prepared Remarks of Commissioner Douglas Shulman before the 22nd Annual George Washington University International Tax Conference” (10 December 2012) (stating that “the Administration and the IRS are focused on a multi-year international tax compliance strategy…to put a serious dent in offshore tax evasion” and expressing support for the FATCA Act of 2009).
Why was FATCA created in the first place?
  • The clear impetus for FATCA was the UBS scandal, involving thousands of bank accounts held in Switzerland by Americans living in the United States. It seems clear the target was rich tax cheats who live in America but don't want to pay taxes there, and who have been helped in that quest via unscrupulous sales pitches by offshore bankers offering banking secrecy as a shield against taxation by the USA. The legislation failed twice as stand alone bills (see above), and was tacked on to another, unrelated bill in 2010 (the HIRE act) as a revenue raiser, without any discussion or much analysis by US legislators. Many appear to have never even heard of FATCA.
  • A lot of people seem to think FATCA was intended to smoke out and punish Americans who live permanently in other countries and who have not kept up with their US tax obligations out of ignorance or otherwise. I do not think that is the case. I think these Americans have become collateral damage of FATCA.
What is the cost/benefit of FATCA? 
  • To my knowledge, no cost analysis has been undertaken with respect to FATCA.
  • Amounts expected to be raised by FATCA were projected to be $343 million, $448 million, and $710 million, for 2010, 2011, and 2012, respectively. See Congressional Budget Office (18 February 2010) “Letter and Table Outlining Budgetary Effects of HIRE Act” ). The HIRE Act was expected to produce a revenue deficit in the amount of $4,380,000 despite the bold claim that it was "was fully paid for… by cracking down on overseas tax havens." See Congressional Record (15 April 2010) page S2368 “Budget Scorekeeping Report: Table 2: Supporting Detail for the Current Level Report for On-Budget Spending and Revenues for Fiscal Year 2010, as of April 9, 2010. 
  • This precarious budgetary situation was aggravated by the fact that while the spending provisions of the HIRE Act were apparently immediately implemented, most of the FATCA provisions have yet to be enforced. For example, the disclosure of US accounts by foreign financial institutions was, according to the statute, to begin after December 2012, but the enforcement has been delayed more than once. See IRS, “Notice 2012-42” (24 October 2012) (which delayed the implementation of information reporting until 31 March 2015 and gross withholding until 1 January 2017); see also chart of initial and revised implementation times, DLA Piper, “Comparison of FATCA Timeframes” (October 2012).
  • I have not found any information about whether any amount of taxes or penalties has been collected pursuant to FATCA to date.
What is an IGA?
  • An IGA is an "intergovernmental agreement." The US has been signing these with some countries and is looking to sign a lot more with a lot more countries. 
  • There are two categories of IGAs. In one category, the foreign country agrees to change whatever domestic law exists that might bar their financial institutions from complying with FATCA (e.g., consumer privacy protection laws). In the other category, the foreign country agrees to act as intermediary, collecting the info the US wants and handing it over as a government-to-government exchange. This typically bypasses any privacy protection regimes that might exist as people don't generally have privacy protection as against their own government's tax authority.
  • IGAs are not treaties from the US perspective, in fact, just what exactly they are is a mystery. Treasury has implied that to the extent the US undertakes anything in these IGAs (in fact, precious little), they are "interpretive" in nature that is, they interpret existing tax treaties. Hence perhaps some confusion: if a country wants an IGA which involves the US providing anything in return, Treasury is suggesting a treaty will be needed for the IGA to "interpret." In my own view the idea that IGAs are interpretive in nature is a stretch: IGAs look like sole executive agreements to me. Treasury will not be putting them through any ratification procedures. Other countries have been typically (but not universally) treating these as they are, which is to say they are new treaties that require internal ratification procedures to place in force.
What are the IGAs for?
  • In general the purpose of the IGA is to override the statutory structure of FATCA, making the unilateral statute less onerous than it otherwise would be, and to overcome domestic consumer privacy protections to enable institutions in other countries to pass personal financial information to the IRS. Thus, IGAs are a way of reducing both the administrative and the political burden Congress created for Treasury with FATCA. 
How does or will FATCA impact non-US financial institutions? 
  • I can only speculate on this as I am not a compliance expert. However, it is to be expected that at minimum, compliance costs and risk of penalty from the US goes up, and if other counties implement their own regimes as the UK is currently doing, the costs and risks will be multiplied. 
  • It seems to me possible that financial institutions face litigation risk with respect to customers who are mistakenly identified as having US indicia and whose information is turned over to the IRS, or whose accounts are closed, or who are asked for personal information that is not required to be asked or not allowed to be shared with third parties under domestic banking laws, whatever those may be. It seems possible that this risk might make an IGA seem more palatable than direct compliance with FATCA, from the perspective of a financial institution.

How will FATCA impact consumers? 

  • Again I can only speculate, based on what people tell me. 
  • First, a generalized fear seems to be setting in about US surveillance and a powerful and determined IRS that is interested in imposing, anywhere it can, enormous penalties all out of proportion to any taxes that might have been owed. The US Taxpayer's Advocate has expressed dismay at this state of affairs.
  • Second, it is likely that everyone will see increased costs for financial services across the globe, even for those with no ties to the US of any kind, as compliance will have to be done on every account and institutions can be expected to pass on these costs in the form of higher fees and charges. 
  • Third, it seems that data security risks rise as bulk data including social security numbers, account numbers, financial transactions, and other personal information is collected and shared with the IRS. If the info will be shared with other US federal agencies, as Senator Levin has suggested ought to be the case, this seems to compound the data security risk. 
  • Fourth, there appears to be no remedy for error, compounding the problems noted above. If an institution flags a person as a "US person" in error, that person seems to be caught in a system with little or no review mechanisms in place. I am not sure how a person manages a case of mis-characterization. 
  • Finally tax compliance is extremely costly when you live in another country, so as more Americans try to get compliant the global personal compliance industry (e.g. tax accountants and lawyers with US expertise) stands to profit handsomely. This is another payoff in the form of rent seeking courtesy of the regulatory state. This is also a boon to the institutional compliance industry, i.e., software and systems designers, auditors, risk assessors, and so on, who will benefit from selling their products and services to financial institutions. It also seems to be a boon to people who know how to help one expatriate from the US--which is neither a straightforward nor cheap option.
What should people who are worried about FATCA do? 
  • I cannot and do not give legal advice on this. I urge those who are or may be harmed by the injustice of US citizenship-based taxation on themselves, their children or parents or other loved ones, to contact their local government representatives and the senators and congress members of any state to which they have any ties in the USA, to tell their stories and ask why the USA wants to tax their children's education savings plans or other government-sponsored savings plans in the countries where they live, why it is in the interest of the US to make life so difficult for Americans and dual citizens who engage in small businesses in other countries, why the US is so hopelessly out of step with international standards which impose taxation based on actual residence rather than inherited nationality, and why the US expects all of its citizens no matter where they live to fulfill tax obligations yet withholds tax benefits that help the poorest, such as the earned income tax credit. 
Send me additional questions in comments or by email and I will update this post.

Thursday, December 5, 2013

Call for US Citizenship-based tax/FATCA stories

If you are in the Montreal area and would like to speak to the media about your experience as a Canadian who is or was affected by US citizenship-based taxation, whether or not you are or could be impacted by FATCA, and whether you wish to speak anonymously or not, could you please get in touch with me either in the comments to this post (moderated, so just indicate if you do not wish publication) or through my contact info, here?