tax notes international - Tuck School of Business - Dartmouth College

tax notes international 

Volume 53, Number 5 February 2, 2009 

Minding the Book-Tax Gap 

U.S. Widens Swiss Bank Probe 

Indian Supreme Court Denies Vodafone Appeal 

U.S. Companies Facing Chinese Compliance Burdens 

Treatment of Intangibles in Spain 

Attributing Profits to Agency PEs 

Multinationals Accumulate to Repatriate 

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369 

371 

376 

380 

381 

383 

IN THIS ISSUE 

by Cathy Phillips 

HIGHLIGHTS 


by Joann M. Weiner 

Multinationals Accumulate to 

Repatriate 

by Lee A. Sheppard and Martin A. Sullivan 

U.S. Widens Investigation of Swiss Bank 

by Randall Jackson 

Indian Supreme Court Denies Vodafone 

Appeal 

by Kristen A. Parillo 

AP Photo/Martin Meissner 

Canadian Budget Delivers Outbound 

Tax Relief 

by Steve Suarez 

387 COUNTRY DIGEST 

FEATURED PERSPECTIVES 

411 Buddy, Can You Spare a Dime? 

by Trevor Johnson 

415 

BOOK REVIEW 

The Global Tax Revolution: The Rise of 

Tax Competition and the Battle to 

Defend It 

417 

419 

421 

447 

PRACTITIONERS’ CORNER 

New Rules for Valuing Intangible 

Assets In Spain 

by Sonia Velasco and Ana Colldefors 

Deduction of School Fees Under 

German Law 

by Marko Wohlfahrt and Katrin Köhler 

SPECIAL REPORTS 

Different Methods of Attributing Profits 

To Agency PEs 

by Carlos Eduardo Costa M.A. Toro 

U.S. Tax Review 

by James P. Fuller 

475 CALENDAR 

ON THE COVER 

Minding the Book-Tax Gap. . . . . . . . . . . . . . .371 

U.S. Widens Swiss Bank Probe . . . . . . . . . . . .380 

Indian Supreme Court Denies Vodafone Appeal . . . 381 

U.S. Companies Facing Chinese Compliance 

Burdens. . . . . . . . . . . . . . . . . . . . . . . .389 

Treatment of Intangibles in Spain. . . . . . . . . . .417 

Attributing Profits to Agency PEs. . . . . . . . . . .421 

Multinationals Accumulate to Repatriate . . . . . . .376 

Cover photo: Newscom 

TAX NOTES INTERNATIONAL FEBRUARY 2, 2009 • 367 


ARGENTINA 

387 Buenos Aires’ New Stamp Tax 

Triggered by Two Core Events 

BANGLADESH 

388 Government Revokes Import Tax on 

Renewable Energy Imports 

CAMBODIA 

388 Tax Breaks Targeted to Critical 

Garment Industry 

CHILE 

389 Stimulus Package Wins Unanimous 

Approval 

CHINA (P.R.C.) 

389 U.S. Companies Facing Compliance 

Burdens in China 

ECUADOR 

390 Congress Approves Tax Package 

EUROPEAN UNION 

391 Austrian Leasing Rules Incompatible 

With EC Treaty, ECJ Says 

GERMANY 

393 Former Deutsche Post CEO Convicted 

Of Tax Evasion 

HAITI 

394 Mobile Phone Service Providers 

Oppose Tax Hike 

HUNGARY 

394 Employer Tax Cut, VAT Increase Under 

Consideration 

INDIA 

395 Indian PE Not Responsible for 

Withholding, Tax Tribunal Says 

396 Subsidiaries in India Do Not Constitute 

A PE, Tribunal Rules 

NEWS AT 

A GLANCE 

INDONESIA 

397 Exit Tax Rules Revised 

398 Regulation Amends CFC Rules, Clarifies 

Export Duty 

JAMAICA 

399 World Bank Backs Jamaican Tax 

Reform Effort 

JAPAN 

399 Consumption Tax Measure Advances 

MULTINATIONAL 

400 IASB Rejects Proposal to Allow 

Discounting of Current Tax in IAS 12 

NORWAY 

401 Government Proposes Carryback Rule 

For Losses 

OECD 

402 OECD Group Addresses CIVs, 

Cross-Border Investors 

PORTUGAL 

405 Government Submits Budget 

Supplement 

RUSSIA 

406 Court Dismisses Claim for Back Taxes 

Against Ernst & Young 

SPAIN 

407 Directors’ Remuneration Not 

Deductible, Supreme Court Says 

SWEDEN 

408 Government Proposes to Defer 

Employee Tax Payments 

UNITED STATES 

408 Drafters of Temporary Branch Regs 

Defend Rules’ Complexity 

368 • FEBRUARY 2, 2009 TAX NOTES INTERNATIONAL 


y Cathy Phillips 

The news that Sarah Palin’s shoes recently sold for 

more than $2,000 on eBay shouldn’t fool anyone 

into thinking the economic crisis is over. If you believe 

the pundits, the worst is yet to come as the global 

economy continues its precipitous slide. Recovering 

will be an agonizingly slow process. 

But how did we get here? Contributing editor Joann 

Weiner has some ideas, and tax policymakers should 

take heed. As Weiner explains, financial transactions 

are at the root of the crisis. But for too long, she says, 

policymakers have failed to see the impact of financial 

transactions on the economy at large. Both the accounting 

community and tax policymakers should focus 

on financial accounting. Together they might see 

how differences in book and tax accounting have allowed 

companies to skew their financial statements 

and tax filings — and engage in the kind of shenanigans 

that got us in trouble in the first place (p. 371). 

Squandering Stimulus? 

Big pharmaceuticals, software companies, and financial 

intermediaries are holding vast amounts of profits 

offshore in anticipation of another repatriation tax 

holiday. As you can imagine, battle lines are forming 

over whether these companies deserve another chance 

to bring back the dough. Contributing editors Lee 

Sheppard and Martin Sullivan make no bones about 

their opposition to the idea, arguing that a second repatriation 

‘‘would constitute frittering of stimulus of a 

high order’’ (p. 376). 

In the News 

U.S. prosecutors have increased their scrutiny of 

Swiss bank UBS, and now believe that the bank helped 

far greater numbers of U.S. clients hide income in offshore 

accounts than originally thought (p. 380). U.K. 

telecom giant Vodafone hit another roadblock in its 

ongoing challenge of a $2 billion capital gains tax 

claim. India’s Supreme Court refused to hear 

Vodafone’s appeal in the case, which stemmed from 

Vodafone’s 2007 merger with Indian telecom Hutchison 

Essar (p. 381). Canada has managed to escape the 

worst of the global economic downturn, but its 2009 

budget nevertheless contains substantial stimulus measures. 

The budget also features improvements to Canada’s 

outbound regime, as well as corporate and individual 

income tax relief measures (p. 383). 

Commentary 

Our first report, by Carlos Eduardo Costa M.A. 

Toro, deconstructs article 7 of the OECD model convention, 

which deals with business profits, in an attempt 

to clear up uncertainties on the tax consequences 

of setting up a business involving an agency PE (p. 

421). Jim Fuller’s U.S. tax review returns this week 

with his expert analyses of the final contract manufacturing 

regs, the temporary branch rules, and the revised 

cost-sharing regs. He also discusses recent U.S. treaty 

developments and offers an alternative to reinstating 

section 965 (p. 447). 

Do banks matter in an age of government takeovers? 

Trevor Johnson contends that U.K. business 

owners needing a loan to pay the tax bill might as well 

go directly to the government for the money, rather 

than ask a bank for a loan that likely won’t be approved 

(p. 411). 

A practice article by Sonia Velasco and Ana Colldefors 

discusses Spain’s advantageous new tax rules on 

valuing intangible assets (p. 417). Another practice article, 

by Marko Wohlfahrt and Katrin Köhler, reviews 

German law on the deductibility of school fees (p. 

419). 

Chris Edwards and Daniel J. Mitchell of the Cato 

Institute have written a book on tax competition that 

even a liberal could love. So says Gary Clyde Hufbauer 

in his review of The Global Tax Revolution: The Rise of 

Tax Competition and the Battle to Defend It. Hufbauer characterizes 

the book as ‘‘entertaining’’ and a good resource 

for policy wonks (p. 415). 

♦ Cathy Phillips is editor of Tax Notes 

International. 



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NEWS ANALYSIS 


by Joann M. Weiner 

For too long, tax policy experts have acted as if 

financial transactions have no impact on the real 

economy. If the current economic crisis, which financial 

transactions largely spawned, hasn’t clearly established 

that connection, then it’s time for tax policymakers 

to go back to business school. 

Experts in financial accounting and tax policy made 

that point loud and clear at the 12th annual UNC Tax 

Symposium held January 23 and 24 at the Kenan- 

Flagler Business School at the University of North 

Carolina in Chapel Hill. 1 

‘‘We want to take a big-tent approach and broaden 

our audience to scholars outside the accounting community,’’ 

said Douglas A. Shackelford, the Meade H. 

Willis Distinguished Professor of Taxation at UNC. 

‘‘Accountants know the difference between reported tax 

expenses and actual taxes paid. It is time for others to 

understand the implication of this difference.’’ 

The importance of this outreach should not be underestimated 

as accounting rule makers and tax policymakers 

begin to focus on issues such as how differences 

in book and tax accounting may lead firms to 

manipulate their financial statements, tax filings, or 

both, Shackelford added. 

Prof. Joel Slemrod of the University of Michigan 

warned that economists might be missing the policy 

impact because they ignore the financial accounting 

issues. ‘‘This could be a really, really big issue. If financial 

decisions are correlated across firms with respect 

to tax policy, the errors we make might be compounded,’’ 

Slemrod said. 

Accounting for Income Taxes 

Public corporations expend much effort properly 

accounting for their income taxes, yet practitioners rou- 

1 The UNC Tax Symposium papers are available at http:// 

areas.kenan-flagler.unc.edu/Accounting/taxsym09/Pages/ 

AcceptedPapers.aspx. 

tinely condemn the poor quality of the information, 

implying that it is relatively useless. However, researchers 

disagree, as they use these data to analyze 

many issues concerning the tax position of public corporations. 

The tax information reported in financial accounts 

is critically important to researchers for one simple reason: 

The tax information reported on corporate tax 

returns is confidential. Thus, financial statements are 

generally the only source of public information about a 

corporation’s tax situation. 

The reliability of financial information is important 

not only in the academic world, but also in the real 

world. Policymakers regularly rely on financial statement 

tax information, and studies based on that information, 

to guide their tax policies. Thus, understanding 

the real implications of how firms account for their 

income taxes is one of the most critical issues tax 

policy analysts face today. 

Along with coauthors John Graham of Duke University 

and Jana Smith Raedy of UNC, Shackelford 

presented the report, ‘‘Research in Accounting for Income 

Taxes,’’ highlighting the importance of understanding 

how the financial accounting treatment of income 

taxes has a real effect on tax policy. 

For example, the authors note that when tax law 

and financial accounting treat transactions in the same 

manner, the accounting for income taxes is ‘‘straightforward, 

intuitive, and relatively simple.’’ But when 

book and tax treatment differ, the tax accounts can 

materially affect both the income statements and balance 

sheets, the authors cautioned. 

Those book-tax differences are not trivial. The most 

recent IRS data from 2005 show that corporations reported 

about $32 billion less in taxable income than in 

book income, which reduced their 35 percent statutory 

tax rate to an effective tax rate of about 23.5 percent. 

The authors evaluate how well the tax information 

in financial statements does in approximating actual 

tax return information and for assessing a firm’s tax 

strategy. In a word, the answer is ‘‘poorly.’’ This poor 

performance is not the fault of the accounting statements, 

which are designed to provide information 

about the firm’s financial condition and not its tax status. 

But more worrisome to the authors is that ‘‘attempts 

to extract confidential tax return information 



HIGHLIGHTS 

from the tax accounts in the financial statements can 

lead to erroneous and misleading inferences.’’ 

The confidentiality of corporate tax returns, however, 

places researchers in an unenviable position. 

Either they apply to the IRS for permission to use confidential 

data, as many researchers have done, or they 

develop ways to tease tax information out of the financial 

reports. Shackelford and his coauthors chose the 

latter path and suggest ways to use this imperfect public 

information to better approximate information in 

the confidential tax return. 

Book-Tax Differences 

As Shackelford noted, accountants and the IRS frequently 

take different views of what constitutes income. 

For a given accounting definition, the differences 

in book and tax treatment largely arise from tax legislation 

designed to encourage a specific behavior, such as 

additional investment spending or simplification. 

These differences may be permanent or only temporary. 

For example, the tax law exempts municipal bond 

income from tax, while accounting rules include the 

income in book income. This creates a permanent difference 

between book and tax income and will drive 

down the reported effective tax rate (the income tax 

expense divided by net income before taxes) in the financial 

statements. The income tax expense is the 

product of the statutory tax rate and book income adjusted 

for permanent differences. 

Temporary differences in book and tax income generally 

do not cause effective and statutory tax rates to 

differ. However, because permanent differences in book 

and tax income reduce the effective tax rate, corporate 

managers likely value transactions that reduce permanent 

income more highly than those that reflect only 

temporary differences in tax payments. 

Those differences have drawn the attention of many 

researchers. David Weisbach 2 and George Plesko 3 have 

argued that firms seek to enter tax shelters precisely 

because they permanently reduce income reported to 

the government while having no impact on financial 

statement earnings. Mihir Desai 4 suggests that the unexplained 

growth in book-tax differences may largely 

be explained by the growth in tax shelters. Jeri 

2 David Weisbach, ‘‘Ten Truths About Tax Shelters,’’ 55 Tax 

Law Review, 215-253 (2002). 

3 

George Plesko, ‘‘Corporate Tax Avoidance and the Properties 

of Corporate Earnings,’’ LVIII National Tax Journal, 729-737 

(2004). 

4 

Mihir Desai, ‘‘The Divergence Between Book Income and 

Tax Income,’’ Tax Policy and the Economy 17, edited by James M. 

Poterba, National Bureau of Economic Research and MIT Press 

(Cambridge, Mass.), 169-206 (2003). 

Seidman5 examined data from 1995 to 2004 and found 

that after narrowing during the 2001 economic downturn, 

the book-tax gap significantly widened in 2003 

partly because of earnings management. 

These book-tax differences are not inconsequential. 

As the Senate Homeland Security and Governmental 

Affairs Permanent Subcommittee on Investigations6 noted when investigating the collapse of Enron, the 

firm regularly showed positive financial earnings while 

reporting losses for tax purposes. The committee’s report 

concluded that: 

some U.S. financial institutions have been designing, 

participating in, and profiting from complex 

financial transactions explicitly intended to help 

U.S. public companies engage in deceptive accounting 

or tax strategies. This evidence also 

shows that some U.S. financial institutions and 

public companies have been misusing structured 

finance vehicles, originally designed to lower financing 

costs and spread investment risk, to carry 

out sham transactions that have no legitimate 

business purpose and mislead investors, analysts, 

and regulators about companies’ activities, tax 

obligations, and true financial condition. 

While no one has yet accused any of the companies 

involved in the current financial crisis of engaging in 

Enron-style abuses, I believe something seems wrong 

when a company can regularly report high, positive 

earnings to the financial community while reporting 

low or no taxable income to the tax authorities. 

The Treasury Department had already placed booktax 

differences under suspicion in its 1999 tax shelter 

study. (See Doc 1999-22641 or 1999 WTD 128-43 and Doc 

1999-22867 or 1999 WTD 128-44.) Whether tax shelters 

or other, innocuous tax planning explains today’s booktax 

differences has yet to be determined. I believe the 

IRS is years away from providing the data necessary to 

determine the extent to which a favorable interaction 

between financial and tax reporting contributed to the 

current financial crisis. 

Shining a Spotlight on the Accounts 

Because corporate tax returns are not public, it is 

difficult to determine whether book-tax differences indicate 

that the firm is participating in a tax shelter or 

whether it has legitimate tax deductions. Researchers 

without access to tax data have had to look elsewhere. 

5 

Jeri Seidman, ‘‘Interpreting Fluctuations in the Book-Tax 

Income Gap as Tax Sheltering: Alternative Explanations,’’ working 

paper, University of Texas (2008). 

6 

U.S. Congress, Senate Committee on Governmental Affairs, 

‘‘Report on Fishtail, Bacchus, Sundance, and Slapshot: Four Enron 

Transactions Funded and Facilitated by U.S. Financial Institutions,’’ 

Permanent Subcommittee on Investigations, Jan. 2, 

2003. For a reference to the study, see Doc 2003-511 or 2003 TNT 

2-22. 



A few years ago, Lillian Mills, Kaye Newberry, and 

William Trautman7 turned the spotlight on areas where 

the tax community may wish to start looking. First, 

financial firms and multinational corporations report 

the largest gap between book and taxable income, and 

the gap is concentrated among the largest firms. Second, 

off-balance-sheet structured transactions or special 

purpose entities accounted for part of the differences. 

These researchers may be on to something big. Offbalance-sheet 

structured transactions and special purpose 

entities have been identified as culprits behind the 

economic crisis. And financial institutions are the primary 

players in this game. 

As much as he might have liked to use that evidence 

to conclude that firms exploit book-tax differences, 

Shackelford could not reassure users of financial statements 

that their data were up to the task. As the study 

notes, because we do not know whether using the best 

publicly available firm-level tax data ‘‘leads to minor 

mismeasurement or substantial errors in scholarship, 

practice, and policy,’’ we should ‘‘interpret scholarly 

findings with caution.’’ 

Firms’ ability to increase their book income without 

increasing their tax liability has led many to call for 

conformity between the two measures. However, there 

is no agreement on the wisdom of that move. John 

McClelland of the Treasury Department and Lillian 

Mills of the University of Texas8 summarized the pros 

and cons of conformity and came out in favor of continuing 

nonconformity. Shackelford also reports that a 

study by Danqing Young and David A. Guenther9 of 

book and tax conformity in 13 countries reveals that 

countries with a high degree of conformity exhibit reduced 

international capital mobility. From his survey 

of the issue, Shackelford concludes that ‘‘the empirical 

evidence suggests that conformity would adversely affect 

the information that financial reports provide the 

capital markets.’’ Shackelford calls for more research 

rather than for continued nonconformity. 

International Financial Reporting Standards 

Some conference participants mentioned that because 

they require more disclosure than U.S. generally 

accepted accounting principles, the move to international 

financial reporting standards might help address 

the issues that arise under book-tax nonconformity. In 

7 Lillian Mills, Kaye Newberry, and William Trautman, 

‘‘Trends in Book-Tax Income and Balance Sheet Differences,’’ 

Tax Notes, Aug. 19, 2002, p. 1109, Doc 2002-19155, or2002 TNT 

161-49. 

8 John McClelland and Lillian Mills, ‘‘Weighing Benefits and 

Risks of Taxing Book Income,’’ Tax Notes, Feb. 19, 2007, p. 779, 

Doc 2007-1810, or2007 TNT 35-61. 

9 Danqing Young and David A. Guenther, ‘‘Financial Reporting 

Environments and International Capital Mobility,’’ 41 Journal 

of Accounting Research, 553-579 (2003). 

HIGHLIGHTS 

August 2008 the Securities and Exchange Commission 

issued for comment a proposal to start allowing voluntary 

adopting of IFRS, and eventual mandatory adoption 

beginning in fiscal 2014. A more general move to 

adapt U.S. rules to IFRS may be postponed. The Global 

Oversight Committee of the Financial Executives 

Institute recently removed the Accounting Principles 

Board (APB) Opinion No. 23, ‘‘Accounting for Income 

Taxes — Special Areas,’’ exception for the treatment of 

permanently reinvested earnings (PRE) from the convergence 

project. 

Other conference participants warned that although 

the accounting profession is moving toward international 

rules, the U.S. Congress might be unwilling to 

cede its ability to provide tax incentives to an international 

forum. 

Earnings Management 

The General Rule 

With Congress considering reintroducing a temporary 

dividend repatriation tax holiday, the way that 

corporations account for their foreign earnings may 

greatly influence whether a corporation repatriates dividends. 

That only a fraction of the firms that could 

have participated in the 2004 dividend repatriation tax 

holiday took advantage of it suggests that the repatriation 

decision may be more complicated than initially 

understood. 

In general, a U.S. multinational pays U.S. tax on 

foreign earnings only when it receives the dividend 

from its foreign subsidiary. However, the accounting 

and the tax rules differ in how they treat the tax liability 

associated with those foreign earnings. And it is 

that difference that can lead firms to alter their financial 

decisions to benefit from the tax provisions. 

Under GAAP, firms immediately recognize both 

their foreign earnings and the expected tax associated 

with those foreign earnings, although they pay the tax 

only when the earnings are repatriated to the United 

States. Thus, for accounting purposes, the firm takes a 

hit on its financial earnings, but it benefits by avoiding 

an earnings reduction when it later repatriates the 

earnings. 

That companies may continually reinvest their foreign 

earnings complicates the decision. Because many 

firms never expect to return their foreign earnings to 

the U.S., the accounting rules under APB 23 have, 

since 1972, provided an exception to that general rule 

that allows the firm to disclose its potential U.S. tax 

liability only in a footnote to its financial statements. 

This treatment creates a permanent difference between 

book and taxable income. The firm immediately benefits 

when it declares that it is permanently reinvesting 

its foreign earnings, because it recognizes those earnings 

without recognizing a related tax expense for the 

residual U.S. tax on those earnings. 



HIGHLIGHTS 

However, if the firm reconsiders and later decides to 

repatriate those earnings, it faces a disadvantage because 

it must recognize an income tax expense on 

those earnings but cannot recognize any earnings because 

it has already recognized the income in an earlier 

accounting period. So firms that decide to repatriate 

PRE face a dilemma: Should they take advantage 

of the tax holiday and repatriate the earnings despite 

the reduction in earnings, or should they continue to 

reinvest the earnings abroad and skip the tax holiday? 

As demonstrated by the surge in dividend repatriations, 

many firms decided the tax benefit outweighed the adverse 

impact on earnings. 

The bottom line is that firms can increase their financial 

earnings without increasing their tax liability 

by increasing the amount of foreign profits designated 

as PRE. This incentive to manipulate earnings is one 

of many possibly unintended consequences that the 

differences between book and tax accounting may have 

on real behavior — the repatriation of foreign earnings. 

International Effects of the PRE 

Multinational firms benefit from their PRE in many 

ways. Empirical evidence suggests that they take advantage 

of the discretion allowed under GAAP to designate 

at least some portion of their foreign earnings as 

permanently reinvested abroad so that they have the 

flexibility to manage their earnings as needed to meet 

market expectations. Shackelford and his coauthors 

discussed research showing that the amount firms report 

as PRE depends on the difference between analysts’ 

forecasts and their premanaged earnings. 

This discretion in the treatment of foreign earnings 

may have unintended consequences. Linda Krull10 of 

the University of Oregon examined the disclosures in 

the financial statements of 267 multinational firms 

from the 1990s and found that firms took advantage of 

the discretion allowed under the accounting rules to 

actively manage their PRE. Her research revealed that 

when the firms increased their PRE, their earnings rose 

by an amount sufficient to meet analyst expectations. 

Krull also noted that given the minimal information 

that firms report about their foreign operations, it is 

difficult for analysts to understand the source of these 

additional earnings. As one conference participant 

noted, stock analysts sometimes lack the expertise or 

experience to understand these variations in earnings 

reporting. 

So it isn’t surprising that multinational firms have 

accumulated more than $600 billion in permanent reinvestment 

foreign earnings since the dividend repatria- 

10 Linda Krull, ‘‘Permanently Reinvested Foreign Earnings, 

Taxes, and Earnings Management,’’ 79 The Accounting Review 

745-767 (2004). 

tion tax holiday expired. The discretion allowed under 

the accounting rules makes this behavior an acceptable 

way to manage earnings. However, as Krull noted in 

her paper, firms that report large fluctuations in PRE 

as the tax treatment of dividend repatriations changes 

might deserve greater scrutiny regarding how long the 

firms actually intend to reinvest the earnings abroad. 

More on the Lock-In Effect 

Krull and Leslie Robinson, in a paper titled ‘‘Is U.S. 

Multinational Intra-Firm Dividend Policy Influenced 

by Capital Market Incentives?,’’ revisited the issue of 

the lock-in effect of the dividend repatriation tax. The 

paper identifies two major disincentives public firms 

face — an actual cash tax liability and a reduction in 

their reported pretax earnings — when deciding 

whether to repatriate their foreign earnings to the 

United States. 

That research shows that financial accounting rules 

can and do have large impacts on the real economy. 

For example, because the accounting rules do not require 

firms to report a tax expense on PRE, firms 

(such as those operating in low-tax countries that did 

not have foreign tax credits from high-tax countries 

that would shield their repatriations) may have been 

encouraged to accumulate their earnings abroad rather 

than repatriate them to the United States. 

Prior research on the impact of the American Jobs 

Creation Act of 2004 largely ignored the financial accounting 

cost of repatriation. Krull and Robinson’s 

study shows that capital market pressures to report 

high earnings deter firms from repatriating their foreign 

earnings and that those pressures are consistent with 

both the buildup in undistributed foreign earnings and 

the surge in dividend repatriations under the Jobs Act. 

This example demonstrates that financial rules had a 

clear impact on real tax decisions. 

Firms have many avenues to minimize the repatriation 

tax cost, whether through borrowing funds abroad, 

corporate reorganizations, or by routing income 

through low-tax locations and expenses through hightax 

locations. As Krull noted, however, ‘‘These effects 

are not costless.’’ Firms incur many costs — whether 

in the form of actual tax expenses or in compliance 

and tax planning costs — to minimize the tax on returning 

their earnings to the United States. To the list 

of well-known tax costs to repatriation, Krull and Robinson 

add financial reporting costs. 

The tax and accounting rules converge in one area. 

Because firms can defer their U.S. tax liability on foreign 

earnings until they are repatriated, the tax code 

creates a lock-in effect to keep earnings offshore, and 

the accounting rules reinforce that effect. As Krull and 

Robinson noted, ‘‘The results of this study provide evidence 

that APB 23 creates incentives to leave earnings 

offshore.’’ Conference participants added another cost 



to the dividend repatriation tax — a cost to the competitiveness 

of U.S. companies. Two of the United 

States’ major trading partners, Japan and the United 

Kingdom, are moving away from taxing dividend repatriations, 

while a third major partner, the Netherlands, 

has few restrictions on income repatriations. 

The evidence is overwhelming that the U.S. international 

tax system badly needs reform. I believe it is 

time for Congress to add the financial reporting and 

the competitiveness costs when it considers changing 

the tax treatment of the foreign profits of U.S. multinational 

corporations. 

Cross-Country Differences in Tax Systems 

Slemrod, along with coauthor Leslie Robinson of 

the Tuck School of Business at Dartmouth College, 

took a global view of tax systems. They took advantage 

of new OECD information to analyze how variations 

in tax systems beyond the tax rate and the tax 

base affect real economic behavior. Their study, ‘‘Measuring 

the Impact of Tax Systems on Economic Behavior 

Using New Cross-Country Data,’’ examined how 

variations in tax administration, enforcement, withholding, 

and corruption, for example, help explain 

variations in economic behavior across countries. 

‘‘Tax systems are multidimensional,’’ Robinson explained. 

‘‘Ignoring these differences may skew our view 

of how tax rates affect economic behavior. Leaving out 

important aspects of tax systems may bias estimated 

partial effects of tax rates, and/or miss entirely the effects 

of other tax system features.’’ For example, while 

prior research has shown that countries with high tax 

rates tend to have a smaller informal sector, Robinson 

noted that the tax rate impact largely disappears once 

tax administration is taken into account. Somewhat 

counterintuitively, she found that although countries 

with high penalty rates have a smaller informal 

economy, countries that use extensive withholding systems 

have larger informal sectors. 

The reason, she suggests, is that withholding systems 

make it less attractive to work in the formal sector, 

because withholding makes it difficult to avoid paying 

taxes. Given that more corrupt countries exhibit 

greater use of withholding, that may partially explain 

why prior research has found a strong positive association 

between corruption and the informal sector. 

One main benefit of Slemrod and Robinson’s paper 

is that it references a 2006 OECD report 11 that provides 

internationally comparable data on the aspects of 

tax systems in 30 OECD countries and 14 non-OECD 

countries. 

11 For the report Tax Administration in OECD and Selected Non- 

OECD Countries: Comparative Information Series, see Doc 2006-22140 

or 2006 WTD 210-10; for related coverage, see Tax Notes Int’l, 

Sept. 25, 2006, p. 1046, Doc 2006-19457, or2006 WTD 180-2. 

HIGHLIGHTS 

It’s no surprise that tax systems vary significantly 

across countries — some countries have effective tax 

administrations, while others have weak administrations; 

some countries tend to rely on withholding, 

while others rely on self-assessment; some countries 

have strong debt collection powers, while others have 

low ratios of tax administrators per worker. 

Until the OECD published its data, researchers had 

no comparable cross-country information on how tax 

systems varied, other than in their rates and their 

bases, and so could not examine the factors that explained 

why tax systems varied across countries. Slemrod 

and Robinson used the OECD data to show that 

tax system differences affect real economic behavior, 

because they affect how the taxpayer perceives the expected 

tax burden triggered by its actions. 

The authors also explore a well-known tax fact: 

Rich countries levy more taxes per capita than poor 

countries. The OECD data confirm that, but also show 

that tax systems in high-income countries tend to share 

some characteristics and that there may be underlying 

factors about those countries that explain the tax burden. 

Relative to low-income countries, high-income countries 

impose withholding and reporting on fewer types 

of income, have fewer powers to facilitate debt collection, 

impose lower penalties, are less likely to use selfassessment 

principles, and hire more tax administrators, 

but they do not spend significantly more on 

administrative costs as a share of income. 

For example, Luxembourg, Iceland, and the Netherlands 

are in the top per capita income quartile but tend 

to fall in the lowest quartiles for penalty rates, withholding 

taxes, and information reporting. Chile, China, 

and South Africa fall in the lowest income bracket but 

tend to fall in the highest brackets for imposing penalties, 

levying withholding taxes, and relying on information 

reporting. 

Those correlations suggest that high-income countries 

tend to design their tax systems in ways that explain 

why those countries have a relatively high tax 

burden. As Robinson noted, an analysis that considers 

only tax rates will miss the effect of other factors that 

may affect the size of the informal economy and may 

bias the estimates of how tax rates affect tax burdens. 

Robinson said it might be a variation in tax system 

design that is correlated with national income, rather 

than national income itself, that affects a country’s tax 

burden. 

In conclusion, Slemrod emphasized: ‘‘Leaving out 

consideration of administrative issues can lead to severely 

biased measures of the role of tax rates in the 

economy.’’ 

♦ Joann M. Weiner is a contributing editor to Tax 

Analysts. E-mail: jweiner@tax.org 



HIGHLIGHTS 

NEWS ANALYSIS 

Multinationals Accumulate to 

Repatriate 

by Lee A. Sheppard and Martin A. Sullivan 

Printing lots of unsecured money is bad enough. Frittering 

it away on courtiers is worse. 

That was historian Paul Kennedy writing in The 

Wall Street Journal about the coming stimulus bill and 

the dismal prospects for gargantuan U.S. budget deficits 

stretching into the future (The Wall Street Journal, Jan. 

14, 2008, p. A13). 

Elsewhere in his piece, Kennedy compared the U.S. 

budget to that of ‘‘Iceland or some poorly run Third 

World economy.’’ He could have mentioned Italy, 

which routinely incurs government debt equal to GDP, 

but has the luxury of selling its debt to its own citizens. 

The United States does not have that luxury, and 

Kennedy predicts that the Chinese purchasers of U.S. 

government debt will demand higher interest. 

Our subject today, however, is the courtiers asking 

that money be frittered away on them in the stimulus 

bill. Big pharma, software companies, and financial 

intermediaries have accumulated vast amounts of foreign 

profits that some of them are lobbying to repatri- 

Billions 

$800 

$700 

$600 

$500 

$400 

$300 

$200 

$100 

$0 

ate at very low tax rates. Since 2005, they have accumulated 

foreign profits at a greater rate than 

historically. 

Well, so what, don’t they just have very profitable 

foreign operations? Data examined in this article 

strongly suggest that section 965 may have encouraged 

more shifting of profits offshore than usual in preparation 

for another repatriation tax holiday. Of course, 

multinationals have always had ample incentives to 

shift profits offshore. Section 965 enlarged their incentives 

to do so. This phenomenon argues that repatriation 

tax holidays have the effect of encouraging the 

very behaviors they were intended to reverse. In short, 

another repatriation tax holiday would constitute frittering 

of stimulus of a high order. 

After their last repatriation tax holiday, U.S. multinationals 

went back to work building up earnings in 

foreign jurisdictions. Here we show the increase in undistributed 

foreign earnings of 40 of the largest U.S. 

corporations since the American Jobs Creation Act of 

2004 allowed them ‘‘one-time’’ dividend relief. Although 

these 40 multinationals account for less than 5 

percent of the 832 multinationals that repatriated earnings 

under the Jobs Act provision, they received 44 

percent of the total $362 billion of repatriated earnings, 

as reported by the IRS. (Melissa Redmiles, ‘‘The 

One-Time Received Dividend Deduction,’’ IRS Statistics 

of Income Bulletin, spring 2008.) 

Figure 1. Accumulated Foreign Earnings of 40 U.S. Multinationals, 2002-2007 

$261.7 

$321.8 

$389.4 

$484.4 

$300.3 

$580.7 

$395.9 

2002 2003 2004 2005 2006 2007 

Fiscal Years 

Source: Company annual reports as shown in table. 

Simulated Assuming No Jobs Act 

Actual Accumulated Foreign Earnings 


$702.8 

$518.0 


Figure 2. Annual Flow of Tax-Advantaged Foreign Earnings of 40 U.S. Multinationals, 2003-2007 

Billions 

$140 

$120 

$100 

$80 

$60 

$40 

$20 

$0 

$60.1 

$67.6 

For this group of 40, the accumulated stock of unrepatriated 

foreign earnings hit a temporary low in 

2005 of $300.3 billion. Under the Jobs Act provisions, 

these companies repatriated a total of $184.8 billion of 

foreign earnings — about 90 percent in that year. By 

the end of fiscal 2007 these multinationals had replenished 

their stash of unrepatriated earnings to $518 billion 

— a 72 percent increase in two years. These totals 

are shown in a solid line in Figure 1. Company-bycompany 

figures are presented in the table at the end 

of the article. 

Another view is provided in Figure 2. It shows 

growth in the stock of unrepatriated foreign earnings 

plus earnings repatriated under the Jobs Act. In other 

words, it shows the annual change in accumulated foreign 

earnings that would have occurred each year without 

the Jobs Act. This is a measure of how much 

profit multinationals are keeping offshore to maximize 

tax advantages. From 2003 to 2007 the annual increase 

approximately doubled — from $60 billion to $122 billion. 

The two figures show multinationals are loading up 

on unrepatriated earnings at a far greater rate than before 

the tax holiday legislated in 2004. This is a result 

of higher worldwide profitability since the prior recession 

and an increasingly larger share of business activity 

taking place abroad. But as documented previously 

in these pages, it is also a result of greater profit shifting 

by multinationals out of the United States and into 

$95.0 $96.4 

$122.1 

2003 2004 2005 

Fiscal Years 

2006 2007 

Source: Dotted line in Figure 1. 

foreign jurisdictions. (For that discussion, see Tax Notes 

Int’l, Mar. 17, 2008, p. 910, Doc 2008-4725, or2008 

WTD 49-5.) 

What’s Next? 

HIGHLIGHTS 

These data suggest that the pressure for another repatriation 

holiday may be greater than ever. Despite 

this, it looks like the growing opposition could thwart 

any repeat. 

First of all, there is widespread skepticism that these 

repatriations work as advertised. For most lawmakers, 

the debate about the need for a repeat of the ‘‘onetime’’ 

tax relief for repatriated dividends centers on the 

economy and job creation. Did those lucky multinationals 

increase jobs as they told Congress they would 

and as they outlined in their legally required dividend 

repatriation investment plans? The evidence is in, and 

the answer clearly is no. (Dharmapala, Foley, and 

Forbes, ‘‘The Unintended Consequences of the Homeland 

Investment Act: Implications for Financial Constraints, 

Governance, and International Tax Policy,’’ 

2008.) 

Besides job creation, there is the additional issue of 

how temporary repatriation relief affects the web of 

global tax checks and balances. Repeated ‘‘one-time’’ 

relief would send a signal to multinationals that they 

no longer need to consider profits shifted offshore as 

trapped. This increases the benefit of aggressive transfer 

pricing practices that would otherwise be held in 



HIGHLIGHTS 

check by full tax on any unlocking of offshore cash. 

And this in turn reduces U.S. tax revenue as well as 

provides an added incentive for multinationals to locate 

facilities abroad. 

President Barack Obama campaigned on reducing 

the incentives for offshore job creation that U.S. tax 

law provides by deferring tax on unrepatriated foreign 

earnings. Temporary repatriation relief is a pro-deferral 

provision. 

In early 2008, Senate Finance Committee member 

John Ensign, R-Nev., tried to include an amendment 

that would provide another round of foreign dividend 

relief in the Finance Committee markup of the first 

stimulus bill. His efforts failed then, and any repeated 

effort would likely run into even tougher opposition. 

And according to a January report by Ryan J. Donmoyer 

of Bloomberg News, there is little support in the 

House for another round of repatriation relief. 

Business lobbyists know all this, so now there is talk 

of a substitute for section 965 for multinationals whose 

foreign earnings are available in cash. Some policy- 

makers see expansion of section 956, which treats a 

controlled foreign corporation’s investment in U.S. 

property as gross income to its U.S. shareholder, as an 

acceptable alternative to a revival of section 965. 

As also reported in the Donmoyer article, Morgan 

Stanley, United Technologies, General Electric, and 

unnamed other multinationals are promoting a plan to 

Congress that would waive U.S. tax under subpart F 

on businesses that borrow from their offshore units. 

This would be a statutory expansion of the section 956 

relief the Treasury provided in October to the general 

rule that loans from foreign subsidiaries should be 

treated as gross income. In Notice 2008-91, 2008-43 

IRB 1001, Doc 2008-22166, 2008 WTD 202-27, the IRS 

lengthened the permissible period of short-term loans 

from CFCs. 

♦ Lee A. Sheppard is a contributing editor to Tax 

Analysts. E-mail: lees@tax.org 

Martin A. Sullivan is a contributing editor to Tax 

Analysts. E-mail: martysullivan@comcast.net 



HIGHLIGHTS 

Reported Accumulated Foreign Profits and Jobs Act Repatriations of 40 U.S. Multinational Corporations, 

1996-2008 (millions of dollars) 

Jobs Act 

Repatria- 

Company Company Fiscal Year 

tion 

Amount 

2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 

1,200 General Electric - 62,000 47,000 36,000 29,000 21,000 15,000 * * * * * * 

37,000 Pfizer - 60,000 41,000 27,000 51,600 38,000 29,000 18,000 14,000 8,200 6,500 4,500 3,900 

- Exxon Mobil - 56,000 47,000 41,000 25,000 22,000 17,000 17,000 14,000 11,100 8,400 6,600 6,200 

- American 

International 

Group 

- 21,200 17,600 13,800 7,000 6,500 5,100 4,500 3,500 3,100 3,300 2,900 3,100 

3,200 Citigroup - 21,100 14,700 10,600 10,000 5,800 3,200 2,000 1,500 1,300 1,300 1,300 * 

- ChevronTexaco - 20,557 21,035 14,317 10,000 10,541 10,108 9,003 8,544 8,002 7,958 7,900 7,420 

9,500 IBM - 18,800 14,200 10,100 19,644 18,120 16,631 16,851 15,472 14,900 13,165 12,511 12,111 

15,900 Merck - 17,200 12,500 8,300 20,100 18,000 15,000 12,400 9,700 7,500 5,800 6,600 5,400 

7,200 Procter & 

Gamble 

21,000 17,000 16,000 10,300 16,750 14,021 10,698 9,231 8,828 7,764 6,739 6,108 5,078 

1,200 Cisco Systems 21,900 16,300 11,100 6,800 4,300 2,500 1,200 707 411 133 * * * 

7,500 PepsiCo - 14,700 10,800 7,500 11,900 8,800 7,500 * * * * * 4,000 

9,000 Bristol-Myers- 

Squibb 

- 14,100 11,300 8,400 16,900 12,600 9,000 8,800 6,000 4,400 3,200 2,600 2,506 

1,800 Merrill Lynch - 13,000 9,800 7,700 8,100 5,900 4,300 4,800 3,700 3,300 2,230 1,645 1,206 

4,300 Abbott 

Laboratories 

- 12,330 7,320 5,800 7,900 5,194 4,304 4,681 2,432 1,980 1,818 1,549 1,312 

2,700 Wyeth - 12,060 9,420 7,480 8,790 6,435 6,000 * * * * * * 

6,100 Coca-Cola - 11,900 7,700 5,100 9,800 8,200 6,100 5,900 3,700 3,400 3,600 1,917 542 

5,500 Altria Group - 11,000 11,000 9,300 11,800 8,600 7,100 5,600 4,700 5,800 3,400 3,000 4,200 

9,100 DuPont - 9,644 7,866 7,031 13,865 13,464 10,320 9,106 8,865 6,666 5,996 7,007 5,928 

8,000 Eli Lilly - 8,790 5,700 4,100 2,800 9,500 8,000 6,400 5,200 2,610 1,010 115 1,833 

- Alcoa - 8,753 8,470 7,562 7,248 6,154 5,893 4,399 3,861 1,838 1,528 1,389 1,115 

- Walmart Stores 10,700 8,700 6,800 5,300 4,000 2,141 1,000 722 * * * * * 

4,100 Dell 10,800 7,900 5,700 2,900 5,100 4,100 711 492 541 263 127 97 70 

14,500 Hewlett-Packard 12,900 7,700 3,100 1,200 15,000 14,400 14,500 13,200 11,500 9,000 7,100 5,200 3,800 

- Xerox - 7,500 7,000 3,900 6,000 5,000 5,000 3,400 5,000 4,900 4,700 4,500 3,900 

6,200 Intel - 6,300 4,900 3,700 7,900 7,000 6,300 5,500 4,200 2,200 2,200 1,505 992 

780 Microsoft 7,500 6,100 n.a. 4,100 2,300 1,640 780 * * * * * * 

9,400 Schering-Plough - 5,800 4,200 3,100 2,200 11,100 9,400 7,600 6,400 5,020 3,475 2,850 2,119 

4,000 Morgan Stanley - 5,800 4,400 3,900 5,800 4,900 4,000 4,700 4,300 3,100 2,600 2,200 * 

- Goldman Sachs 

Group 

- 4,970 2,900 2,400 1,650 1,100 209 * * * * * * 

- American 

Express 

- 4,900 3,900 3,200 2,700 2,900 2,400 2,100 1,900 1,600 1,200 873 677 

- Conoco Phillips - 4,381 3,597 2,773 2,091 2,046 2,171 1,687 1,661 Merger 

2,700 Honeywell 

International 

- 4,100 2,900 2,100 3,900 3,300 2,200 2,000 2,100 1,600 552 355 326 

4,600 Motorola - 4,100 4,000 2,800 5,600 6,100 7,600 7,100 7,900 * * * * 

2,100 International 

Paper 

- 3,700 2,700 2,400 2,700 3,300 2,500 1,800 1,800 1,200 1,100 555 361 

1,900 J.P. Morgan 

Chase Co. 

- 3,400 1,900 1,500 2,600 2,300 1,900 1,667 1,404 1,054 764 * 

755 Apple 3,800 2,400 823 1,200 972 822 755 755 755 520 437 395 395 

1,290 Texas 

Instruments 

- 1,620 1,290 1,010 2,034 1,604 1,293 * * * 620 870 760 

- Viacom - 939 457 351 155 2,000 1,900 1,600 1,600 1,400 1,500 1,500 1,300 

2,200 Verizon - 900 3,000 3,000 5,100 3,400 4,500 4,000 3,600 Merger 

1,100 Weyerhaeuser - 357 828 1,300 1,700 1,300 1,100 972 1,259 993 789 827 792 

Note: * indicates information not available. 

Source: Company annual reports. 



HIGHLIGHTS 

U.S. Widens Investigation of 

Swiss Bank 

by Randall Jackson 

U.S. prosecutors reportedly are expanding their investigation 

of the actions of UBS AG, the Swiss banking 

giant that has been accused of helping its U.S. clients 

conceal taxable assets. 

Officials are looking into the possibility that the 

bank helped tens of thousands of U.S. taxpayers hide 

income in offshore accounts. New evidence reportedly 

has led investigators to believe that the original estimate 

that UBS helped about 17,000 U.S. residents 

evade taxes may be too low and that thousands of previously 

unknown accounts may exist. 

Investigators now are looking into whether previously 

unidentified investment vehicles may have been 

used and whether divisions of the bank in addition to 

the previously targeted wealth management section 

may have been involved, according to a January 26 

Wall Street Journal report. 

The talk of additional illegal activity comes close on 

the heels of a January 13 order declaring former UBS 

official Raoul Weil a fugitive. Weil failed to surrender 

to U.S. authorities after the November 12, 2008, unsealing 

of an indictment charging him with conspiring 

to defraud the U.S. government. (For prior coverage, 

see Tax Notes Int’l, Jan. 26, 2009, p. 307, Doc 2009-856, 

or 2009 WTD 10-1.) 

Weil was head of the international portion of UBS’s 

wealth management division from 2002 to 2007 and 

was appointed chair and CEO of the bank’s global 

wealth management and business banking division on 

July 6, 2007. 

Peter Kurer, who was appointed chair of UBS on 

April 23, 2008, told investors in a January 15 presentation 

that the bank’s key goals for 2009 include reaching 

a settlement with the U.S. Justice Department and ensuring 

the ‘‘recovery of UBS’s reputation,’’ according 

to the Wall Street Journal report. 

UBS is at the center of both criminal and civil investigations 

in the United States and reportedly is hoping 

to avoid felony indictments through ongoing talks with 

the Justice Department. Unnamed sources close to the 

discussions say UBS officials have offered to confess to 

criminal activity and pay a fine in the neighborhood of 

$1.2 billion as part of a deal. 

In the civil case, the Justice Department and the 

IRS reportedly are contemplating an additional, perhaps 

more comprehensive, summons aimed at forcing 

UBS to turn over the names of American account 

holders. On July 1, 2008, a federal judge in Miami issued 

a John Doe summons requiring the bank to disclose 

the U.S. account holders’ names. However, UBS 

has thus far failed to comply. 

Unnamed individuals involved in the case say UBS’s 

best hope appears to be a resolution of the criminal 

case while the civil case continues. Furthermore, any 

deal is likely to be between the U.S. government and 

UBS, and will not include the American taxpayers allegedly 

involved. 

‘‘It’s my impression that whatever the settlement is 

between the bank and the U.S. government, this will 

not legally impact the taxability or non-taxability of 

the bank’s customers,’’ William M. Sharp Sr., a Tampa 

tax attorney with UBS clients, said in the Journal report. 

The criminal case has proven particularly damaging 

to UBS as it tries to cope with the global financial crisis. 

In October 2008 the bank reportedly required a $60 

billion bailout from the Swiss government to stay 

afloat. 

♦ Randall Jackson is a legal reporter with Tax Notes 

International. E-mail: rjackson@tax.org 



Indian Supreme Court Denies 

Vodafone Appeal 

by Kristen A. Parillo 

India’s Supreme Court on January 23 declined to 

hear an appeal by U.K. telecom giant Vodafone in the 

company’s challenge of a $2 billion capital gains tax 

claim stemming from its 2007 merger with Indian telecom 

company Hutchison Essar. (For prior coverage, 

see Tax Notes Int’l, Dec. 15, 2008, p. 854, Doc 2008- 

25691, or2008 WTD 236-3.) 

The Court’s decision means Vodafone now will have 

to reply to a show-cause notice issued in September 

2007 by the Indian Income Tax Department demanding 

that the company explain why it should not be 

treated as an ‘‘assessee in default’’ for failure to withhold 

tax when it acquired the controlling stake in 

Hutchison Essar. The tax department will then take a 

HIGHLIGHTS 

‘‘final view’’ on the issue of Vodafone’s tax liability, 

said Sishir Jha, a spokesman for India’s Central Board 

of Direct Taxes. 

In February 2007 Vodafone (through its Dutch unit, 

International Holdings BV) paid Hong Kong-based 

Hutchison Telecom International Ltd. (HTIL) $11.2 

billion for the entire share capital of CGP Investments 

(Holdings), a Cayman Islands entity. CGP Investments, 

through a chain of intermediary entities (including 

Mauritius entities), indirectly held a 67 percent stake in 

Hutchison Essar, which at the time was India’s fourthlargest 

mobile phone company. 

India’s tax authorities claim that Vodafone should 

have withheld approximately $2 billion in CGT at source 

when it paid HTIL. The authorities maintain that because 

most of the assets were in India, the deal was subject 

to Indian CGT, and that under Indian law the buyer 

AP Photo/Martin Meissner 

Vodafone hit another dead-end as it continues to challenge Indian tax authorities' claim that the telecom giant failed to 

withhold $2 billion in capital gains tax. 



HIGHLIGHTS 

is required to withhold CGT and pay it to the government. 

In September 2007 the authorities issued showcause 

notices to Vodafone and Vodafone Essar. (The notice 

to the latter demanded that the company explain 

why it should not be treated as an agent, or representative 

assessee, of Vodafone under Indian tax law.) 

Vodafone and Vodafone Essar challenged the showcause 

notices in writ petitions filed with the Bombay 

High Court in October 2007. Vodafone argued that it 

had no Indian tax liability on the transaction because 

the transfer of shares took place outside of India and 

that any tax liability lies with the seller of the shares 

— that is, HTIL — and not the buyer. 

The company submitted an amended writ petition in 

June 2008 challenging the constitutionality of a retroactive 

amendment to India’s tax laws in May 2008 that 

widened the scope of the term ‘‘assessee in default’’ for 

withholding tax purposes, thereby enabling Indian tax 

authorities to take action against companies that do 

not withhold taxes when making a transaction. 

The High Court dismissed Vodafone’s petition on 

December 3, 2008. (Vodafone Essar’s petition is still 

pending.) Vodafone later filed an appeal with the Indian 

Supreme Court. 

Appeal Dismissed 

At a January 23 hearing on the matter, the Supreme 

Court declined to intervene and directed the Income 

Tax Department to decide whether it has jurisdiction 

to tax the transaction, saying that ‘‘the substantial 

question of law raised in the petition is left open.’’ The 

Court said that if the authorities decide against 

Vodafone on the jurisdictional issue, the company can 

challenge the decision in the High Court. 

The Supreme Court seemed to suggest that 

Vodafone’s petition was filed prematurely. ‘‘It’s only a 

show-cause notice,’’ Justice S.B. Sinha reportedly told 

Vodafone’s counsel. The Court further questioned why 

Vodafone had refused to file with the Bombay High 

Court the agreements relating to the transaction. ‘‘Why 

were the details not disclosed to the High Court? It has 

not even been shown to us,’’ Sinha said. 

The government’s counsel, Additional Solicitor General 

Mohan Parasaran, noted that Vodafone had finally 

submitted the agreements. 

‘‘The ball is now in the court of the income tax authority,’’ 

Parasaran told the media after the hearing. ‘‘It 

will look into all the relevant material to arrive at the 

conclusion. However, we are now in possession of all 

relevant documents of agreement between Vodafone 

and HTIL.’’ He added that the tax department will 

now issue a revised notice to Vodafone for a hearing 

on its tax liability. 

In a January 23 statement, Vodafone said, ‘‘Given 

the fact that the petition filed by Vodafone involves 

important questions of jurisdiction, the Honorable Su- 

preme Court of India has asked the tax authorities to 

decide, as a preliminary issue only, whether it has jurisdiction 

to proceed against Vodafone (and no other issues).’’ 

The company added, ‘‘Should Vodafone be aggrieved 

by the order of the tax authorities’ preliminary 

adjudication on jurisdiction, Vodafone has been permitted 

to again directly approach the High Court.’’ 

♦ Kristen A. Parillo is a legal reporter with Tax Notes 

International. E-mail: kparillo@tax.org 



Canadian Budget Delivers 

Outbound Tax Relief 

by Steve Suarez 

Canadian Finance Minister Jim Flaherty on January 

27 delivered to the House of Commons the 2009 federal 

budget, which includes improvements to Canada’s 

outbound taxation system as well as corporate and individual 

income tax relief measures. (For prior coverage, 

see Doc 2009-1706 or 2009 WTD 16-1.) 

The budget is the minority Conservative government’s 

first item of business since proroguing Parliament 

near the end of 2008 to avoid being defeated in 

the House by the three opposition parties. As TNI 

went to press, newly installed Liberal leader Michael 

Ignatieff signaled he would support the budget contingent 

on the government agreeing to provide quarterly 

progress reports starting in March. The other two opposition 

parties (the New Democratic Party and the 

Bloc Québécois) have already declared their intention 

to vote against the budget. Hence, it is likely but not 

certain that the budget has the support necessary to 

pass the House of Commons. 1 

Canada has enjoyed exceptional economic performance 

over the past several years, running a series of 

budget surpluses and reducing Canada’s debt-to-GDP 

ratio to the lowest level in the G-7. However, Canada 

is not immune to the dramatic economic downturn 

that has swept across the globe over the past year; Flaherty 

announced that he anticipates Canada’s real 

GDP will contract by 0.8 percent over the next year. 

As a result, the budget contains more spending than 

taxing, and the government has clearly adopted the 

same posture as other G-7 countries (particularly the 

U.S.) by embarking on a very substantial spending program 

in an effort to stimulate the economy. The budget 

contains a wide variety of stimulus measures amounting 

to about 1.9 percent of Canada’s GDP (near the 

IMF’s suggested target of 2 percent). The measures are 

forecast to lead to budgetary deficits totaling over C 

$60 billion during the next two years. The budget optimistically 

projects a return to budgetary surpluses by 

2013 to 2014. 

The budget announces some very important changes 

to Canada’s outbound taxation system, which would 

be improved by withdrawing (or potentially withdrawing) 

existing proposed amendments. 

1 Current standings in the House of Commons are: Conservative, 

143; Liberal, 77; Bloc Québécois, 49; New Democratic 

Party, 37; Independent, 2. See http://www/parl.gc.ca. 

HIGHLIGHTS 

Outbound Taxation: A Brief History 

Canada’s manner of taxing Canadian taxpayers’ 

foreign-source income and the entities they invest in 

has been in a state of flux for almost a decade. First, 

very far-reaching and complex rules (the foreign investment 

enterprise and nonresident trust (NRT) rules) 

were announced in 1999 and released as draft legislation 

in June 2000 that dealt with the taxation of passive 

(or what is supposed to be passive) foreign-source 

income of Canadians. These rules, which have been 

criticized for their extreme complexity (even by tax 

standards) and overly broad scope, have gone through 

a number of variations and amendments and have still 

not been enacted into law (in their most recent form, 

they are proposed to be effective retroactively). (For 

prior coverage of the FIE/NRT rules, see Doc 2005- 

16307 or 2005 WTD 148-2.) 

In 2004 a number of proposed changes were announced 

relating to Canada’s foreign affiliate regime, 

which governs the taxation of investments in foreign 

entities that meet a certain ownership threshold so as 

to make the foreign entity a foreign affiliate (or in 

some cases a controlled foreign affiliate) of the Canadian 

taxpayer. These changes were also very complex 

and far-reaching and in many cases, seem to produce 

unintended effects. Among the proposed amendments 

(much of which has not yet been enacted into law) 

were the expansion of the controlled foreign affiliate 

definition (with the effect of increasing the likelihood 

that foreign-source passive income would be imputed 

to the Canadian taxpayer and taxed on an accrual basis) 

and so-called surplus suspension rules designed to 

prevent perceived abuses on the recognition of income 

on intragroup transactions. These provisions have created 

a great deal of uncertainty and made it difficult 

for Canadian taxpayers with foreign affiliates to plan 

their affairs on an ongoing basis (many of these rules 

are also to be effective retroactively). (For prior coverage 

of the 2004 package, see Doc 2004-6779 or 2004 

WTD 60-2.) 

Finally, the 2007 federal budget included an initiative 

directed at foreign affiliates and the manner in 

which they are financed. The original proposal effectively 

eliminated the ability of Canadian taxpayers to 

deduct interest expense on money borrowed to invest 

in a foreign affiliate earning exempt surplus (active 

business income earned in a country with which 

Canada has a tax treaty). The basis for this proposal 

was that because exempt surplus is not taxable in 

Canada when repatriated, allowing interest deductibility 

on borrowed money used to earn such income 

amounted to an undue subsidy of foreign business operations. 

Widely condemned by the business community as 

putting Canadian multinationals at a severe disadvantage 

relative to their foreign competitors, these rules 

were ultimately scaled back to a more limited objective 

of denying interest deductibility on money borrowed 



HIGHLIGHTS 

by a Canadian taxpayer and used to finance a foreign 

affiliate that in turn made some kinds of intragroup 

loans that generated deductible interest in another jurisdiction 

(double dipping). These more modest provisions 

were ultimately enacted in the form of section 

18.2 of the Income Tax Act (Canada), effective after 

2011, and remain controversial because of both their 

underlying rationale and the uncertainty of their application 

in a variety of circumstances. (For prior coverage, 

see Doc 2007-7732 or 2007 WTD 60-1; see also Doc 

2007-11796 or 2007 WTD 94-1.) 

The Advisory Committee’s Report 

An offshoot of the 2007 budget was the minister of 

finance’s establishment of an advisory committee to 

review Canada’s international taxation system and 

make recommendations. The advisory committee delivered 

its report to the minister in December 2008, making 

a number of detailed recommendations concerning 

both inbound and outbound taxation. (For prior coverage, 

see Tax Notes Int’l, Jan. 26, 2009, p. 345, Doc 2009- 

84, or2009 WTD 15-11.) 

Among the report’s recommendations were: 

• Canada should move to a broader exemption system 

for taxing foreign-source active business income 

earned through foreign affiliates; 

• the Department of Finance should reconsider the 

need for the FIE/NRT rules, in particular with a 

view to reducing complexity and overlap in Canada’s 

antideferral regimes (while ensuring that passive 

foreign-source income earned by Canadian 

taxpayers is taxed on a current basis); and 

• ITA section 18.2 should be repealed, and no new 

interest deductibility restrictions should be imposed 

on borrowing to finance foreign affiliates of 

Canadian taxpayers. 2 

The Budget 

The budget’s most important business tax measure 

is the announcement that ITA section 18.2 would be 

repealed as recommended by the advisory panel. The 

government cited the negative effect that this provision 

could have had on foreign investment by Canadian 

multinationals. This development should please that 

segment of the tax community. In the current economic 

environment more than ever, Canadian businesses 

must be competitive internationally in order to 

survive, and a disadvantageous tax system is an illogical, 

unnecessary cost. The government should be commended 

for assembling a very knowledgeable panel of 

experts and then acting on their advice. The repeal of 

2 Measures against a specific practice referred to as debt 

dumping were advocated. 

section 18.2 is a very important and welcome development 

for Canadian business. 

The budget also indicates that the government has 

carefully considered the advisory panel’s views on 

other elements of the outbound taxation regime. The 

budget states that the government will: review the existing 

FIE/NRT rules in light of the advisory panel’s 

comments and the many submissions it has received 

about them; and consider the advisory panel’s comments 

on the foreign affiliate system before proceeding 

to enact the outstanding measures contained in the 

2004 foreign affiliate amendments (a number of which 

would be unnecessary under a full exemption regime). 

Although statements about reconsidering legislative 

initiatives that have been so heavily criticized do not 

constitute an outright abandonment of those proposals, 

they are a positive development for the many taxpayers 

who are overwhelmed by the complexity of the tax 

system — and these provisions in particular — and 

who would welcome simpler, more narrowly targeted 

rules that do a better job of focusing on the real areas 

of potential abuse. Many of the current proposals are 

simply not working satisfactorily, and it would not be 

surprising if these statements are the first step toward a 

larger redesign of the outbound taxation system. The 

government should again be commended for listening 

to the business community. Making the entire outbound 

taxation system simpler, more efficient, and 

more internationally competitive would significantly 

boost the Canadian economy. 

Other Business Tax Measures 

Accelerated Capital Cost Allowance 

Capital cost allowance (CCA) is the Canadian tax 

version of the accounting concept of depreciation. Under 

the CCA system, the cost of capital property is 

deducted from income over a period of years on a declining 

balance basis, 3 matching (to some degree) the 

expenditure on the property to the business income it 

produces. 

The 2007 budget provided a temporary incentive to 

invest in capital equipment by accelerating the rate at 

which CCA could be claimed (thereby allowing a 

larger deduction from income sooner for tax purposes) 

on eligible machinery and equipment used in manufacturing 

and processing. Instead of the usual 30 percent 

declining balance CCA rate generally applicable, the 

3 Declining balance means that the depreciation rate is applied 

in each year against the remaining portion of the property’s cost, 

such that each year’s deduction is smaller than the preceding 

year’s. For example, a C $100 property depreciated at 50 percent 

on a declining balance yields a C $50 deduction in year 1 (C 

$100 x 50 percent), a C $25 deduction in year 2 (50 percent x (C 

$100 - C $50)), and so forth. 



2007 budget allowed most such property acquired before 

2009 to be written off entirely over three years 

under a special 50 percent straight-line CCA rate (subject 

to the usual half-year rule limiting the first year’s 

deduction). The 2008 budget then extended this deduction 

for an additional three years by proposing that: 

• for eligible property acquired in 2009, the same 

CCA rate announced in the 2007 budget would 

apply; and 

• for eligible property acquired in 2010 and 2011, 

less generous CCA rates would apply. 4 

The 2009 budget would extend to eligible property 

acquired in 2010 or 2011 the more generous 50 percent 

straight-line CCA rate applicable to eligible property 

acquired in 2009 (the half-year rule would still apply). 

Another budget proposal would offer faster CCA on 

eligible computers and software acquired after January 

27, 2009, and before February 2011. Instead of the 55 

percent declining balance rate currently applicable, the 

CCA rate would be 100 percent and the half-year rule 

would not apply, meaning that the cost of the property 

would be written off entirely in the year it is acquired 

by the business. The property eligible for this faster 

write-off would be most general purpose electronic 

data processing equipment (and related systems software) 

that: 

• is located in Canada; 

• is acquired by the taxpayer for use in a Canadian 

business or to earn income from property located 

in Canada (or to lease to someone so using it); 

and 

• was not previously used (or acquired for use) before 

being acquired by the taxpayer for use in 

Canada. 

Canadian-Controlled Private Corporations 

A corporation that is a Canadian-controlled private 

corporation (CCPC) enjoys a number of advantages 

within the Canadian tax system. In particular, a CCPC 

may benefit from a low 11 percent tax rate on the first 

C $400,000 of qualifying active business income that it 

earns via a mechanism called the small-business deduction. 

5 The budget would increase the maximum in- 

4 

In both cases the deduction in the first year was limited by 

the half-year rule. 

5 

When two or more corporations are associated, they must 

share the limit. To limit this tax preference to smaller businesses, 

the deduction begins to phase out when the CCPC has taxable 

capital employed in Canada of C $10 million, and is eliminated 

completely when the CCPC has C $15 million of taxable capital 

employed in Canada. 

HIGHLIGHTS 

come eligible for the deduction from C $400,000 to C 

$500,000 effective January 1, 2009. 6 

CCPCs are also eligible to earn investment tax 

credits at an enhanced 35 percent rate on up to C $3 

million of qualifying scientific research and experimental 

development. The C $3 million threshold is reduced 

once the CCPC’s taxable income for the previous year 

reaches C $400,000 and eliminated entirely once 

previous-year taxable income reaches C $700,000. The 

budget would increase the C $400,000 and C $700,000 

amounts to C $500,000 and C $800,000, respectively, 

expanding the availability of the enhanced ITCs. 

Finally, the budget would correct a technical problem 

arising from a court decision in 2006, which affects 

the precise time at which control of a CCPC is 

acquired on the relevant day. The ruling had created 

anomalous results arising from determining exactly 

when control of the corporation had been acquired, 

and the CCPC had thereby lost its status as a CCPC. 

Administrative Matters 

The budget proposes to require that some taxpayers 

file their tax returns electronically, effective for tax 

years ending after 2009. Corporations with annual 

gross revenue over C $1 million would be required to 

file electronically except in situations (to be announced 

later) when the Canada Revenue Agency believes electronic 

filing would be inefficient. 7 Some minor amendments 

to related penalty provisions have also been proposed. 

The budget also proposes that in 2010 and 

thereafter a taxpayer that files 50 or more of any particular 

type of information return would be required to 

do so electronically. This would occur most frequently 

in the case of T4 reporting returns for employment 

income. 

Previously Announced Measures 

When Parliament was prorogued in December 2008, 

a number of tax measures had not yet been enacted 

into law and were automatically terminated. The budget 

confirms the government’s intention to reintroduce 

many of these previously announced proposals, including: 

• changes to the taxation of financial institutions to 

better align income tax laws with accounting 

rules; and 

• draft amendments relating to the rules allowing 

some taxpayers to report their Canadian income 

tax in a foreign (‘‘functional’’) currency. 

6 

This increase in the small-business limit would also: result in 

some CCPCs earning between C $400,000 and C $500,000 in 

taxable income having an additional month to pay any balance 

of tax owed; and entitle some CCPCs to be eligible to pay their 

taxes in quarterly installments rather than monthly. 

7 

Examples provided of such exceptions include nonresidents 

and insurance companies. 



HIGHLIGHTS 

Personal Tax Measures 

The budget also contains a number of relatively minor 

personal income tax amendments, largely directed 

at low- and middle-income earners. These include: 

• the basic personal amount (the amount of income 

that can be earned before any tax is payable) 

would increase from C $9,600 for 2009 to C 

$10,320 for 2010 and would thereafter be indexed 

to inflation; 

• the upper limit of the two lowest tax brackets 

would be increased for 2009, with the 15 percent 

tax bracket ending at C $40,726 instead of C 

$37,885 and the 22 percent tax bracket ending at 

C $81,452 instead of C $75,769 — both brackets 

would be indexed to inflation thereafter; and 

• the tax credit for persons 65 and older would increase 

by C $1,000 to C $6,408. 

A new home renovation tax credit of up to C 

$1,350 would be introduced for qualifying home renovation 

expenditures (excluding routine repairs and furniture) 

of up to C $10,000 incurred between January 

28, 2009, and February 1, 2010. This tax credit may 

not cost the government much in forgone tax revenue 

because much home renovation activity occurs under 

the table as part of the underground economy. That 

activity would have to come into the tax system for the 

credit to be claimed. The budget would also introduce 

a small first-time home buyer’s tax credit on qualifying 

homes acquired after January 27, 2009. Also, the 

amount of money that a first-time home buyer could 

withdraw from his registered retirement savings plan 

(RRSP, a tax-sheltered individual retirement fund 

analogous to a U.S. 401(k)) would increase from C 

$20,000 to C $25,000. The budget also proposes relief 

provisions to compensate for the decrease in the value 

of investments in an RRSP (or some similar 

retirement-related vehicles) following the death of the 

annuitant to prevent undue hardship when investments 

decline in value postmortem before the deceased’s 

property is distributed. 

Finally, the 15 percent mineral exploration tax credit 

available to individuals who invest in flow-through 

shares of mining exploration companies would be extended 

another year for flow-through share agreements 

entered into by March 31, 2010. 

♦ Steve Suarez is a partner with Osler, Hoskin & 

Harcourt LLP in Toronto. 

Full Text Citations 

• Finance Minister Jim Flaherty describes Canada’s 2009 

budget economic action plan. Doc 2009-1816; 2009 WTD 

17-9 

• Summary of 2009 budget tax relief measures. Doc 2009- 

1817; 2009 WTD 17-10 

• Prime Minister Stephen Harper notes home renovation 

tax credit. Doc 2009-1819; 2009 WTD 17-11 

• Flaherty’s budget speech. Doc 2009-1823; 2009 WTD 

17-12 



Argentina 

Buenos Aires’ New Stamp Tax 

Triggered by Two Core Events 

Buenos Aires’ official gazette on January 19 published 

Resolution 10/09, the first set of implementing 

rules for the city’s stamp tax, which was reenacted on 

January 9 by Law 2997. (For prior coverage, see Tax 

Notes Int’l, Jan. 26, 2009, p. 294, Doc 2009-822, or2009 

WTD 9-2.) 

The stamp tax, which was limited to real estate 

transactions until December 2008, was absent from 

Buenos Aires for more than five years. The stamp tax 

is a local levy, so each jurisdiction provides its own 

legislation. Accordingly, the taxable events, exemptions, 

taxable amounts, tax rates, terms for payment, penalties, 

and interest vary by jurisdiction. However, the 

general aspects of the stamp tax are shared by most 

jurisdictions. 

Buenos Aires’ stamp tax can be triggered by two 

core events resulting in the assessment of an instrumentality 

tax or a financial transaction stamp tax. 

Instrumentality Tax 

This tax is triggered by written legal contracts either 

executed or having effects within the city of Buenos 

Aires. In general, the term ‘‘effects’’ refers to the execution 

of the contractual obligations. The fact that the 

contract is executed outside Argentina does not relieve 

the parties thereto from their obligation to satisfy the 

stamp tax because the agreement — though executed 

abroad — could still have effects in Buenos Aires. 

The taxable amount is equal to the contractual value 

during its whole term. However, there are specific rules 

for contracts subject to automatic renewal or extension 

terms beyond five years. The new rules provide that in 

the absence of a fixed taxable amount set forth in the 

contract, it should be reasonably estimated — with the 

evidence and data available to the taxpayer when the 

taxable event is triggered — using, for example, any of 

the following guidelines: similar past agreements; the 

forecasted revenue in the relevant jurisdiction; or the 

COUNTRY 

DIGEST 

figures of the developing business. If the local tax authority 

challenges the taxable amount assessed and 

proves that the estimation procedure was wrong, fines 

and interest will be applied. 

The new legislation provides rules aimed at avoiding 

double taxation within Argentina. If a contract is executed 

in one jurisdiction and the assets are located in 

a different one, taxing powers are granted with priority 

to the jurisdiction where the assets are located. 

Tax rates vary depending on the taxable events. The 

standard tax rate is 0.8 percent, while a higher rate up 

to 2.5 percent applies to real estate transactions. A reduced 

rate of 0.5 percent applies to leasing agreements, 

and a higher rate of 1 percent applies to set contracts 

involving trading of rights of soccer players. All parties 

to the agreement are jointly and severally liable before 

the State Revenue Service for the payment of the full 

amount of the stamp tax triggered by a given agreement. 

Like the stamp tax in most provinces, the Buenos 

Aires stamp tax is governed by the ‘‘instrumentality 

principle,’’ according to which the taxable event is only 

triggered when a contract or document is prepared in 

writing by the parties or the party to the agreement; 

and such written document sufficiently prove the rights 

and obligations of the parties — namely when it reproduces 

the main elements of the contract, disregarding 

the facts and actions taken by the taxpayers. This instrumentality 

principle is also stated in the federal coparticipation 

of taxes law, a law passed by the National 

Congress that provides for the allocation of tax revenues 

between the federal government and the provinces. 

This law imposes a restriction on the taxing 

powers of the provinces. 

Some tax planning devices have been used countrywide 

to avoid payment of the stamp tax. They have 

mainly consisted of agreements implemented in such a 

manner that they do not fit within the instrumentality 

principle. These options are available under the new 

Buenos Aires legislation, but taxpayers must carefully 

implement them to ensure that the Supreme Court precedents 

governing these matters can be reasonably relied 

upon. 

There are a number of exemptions available, which 

should be scrutinized on a case-by-case basis. Some of 



ARGENTINA 

the most significant exemptions relate to contracts for 

the incorporation of companies in Buenos Aires, as 

well as their capital increases and liquidations; all contracts 

aimed at papering public listing of securities; and 

guarantee agreements that secure other taxable instruments, 

life insurance agreements, labor agreements, 

export related agreements, and so on. 

Financial Transaction Stamp Tax 

This tax is triggered on all loans or credits that a 

financial institution is party to that imply a delivery or 

receipt of principal (or funds in general) that triggers 

interest over time and that are registered and recorded 

by such financial entities. The taxable amount is 

deemed to be the figures used to calculate the interest 

times the tax rate, which is the standard one of 0.8 

percent per year. So the tax burden is proportional to 

the term the taxable transaction remains in place: The 

larger the term, the higher the tax burden. 

The persons contracting with the financial entities 

are deemed to be the taxpayers and such entities are 

deemed to be the collecting agents. Accordingly, they 

are subject to joint and several liability. 

Specific exemptions apply to this taxable event, the 

most significant being that related to transactions subject 

to the instrumentality tax: To the extent such burden 

is triggered, even in a different jurisdiction, there 

will be no financial transaction tax on the same transaction. 

Also, bank deposits in savings accounts, time 

deposits, and checking accounts are exempt, as well as 

mortgage deeds and other security agreements used to 

secure taxable transactions. 

As of the enactment of Law 2997, taxpayers are 

required to monitor the stamp tax legislation in the city 

of Buenos Aires in conjunction with the one applicable 

in other provinces to ensure they take advantage of tax 

planning options or at least avoid double taxation 

when transactions that are executed in one location 

have effects in a different one. 

Bangladesh 

♦ Cristian Rosso Alba, Rosso Alba, 

Francia & Ruiz Moreno, Buenos Aires 

Government Revokes Import Tax on 

Renewable Energy Imports 

Bangladeshi Prime Minister Sheikh Hasina Wajed 

on January 15 announced that all taxes and duties assessed 

on imports of solar power generating equipment 

have been revoked to encourage the use of renewable 

energy as the country continues to struggle with power 

shortages. 

Previously, imports of renewable energy equipment 

were subject to a 3 percent import duty and a 15 percent 

VAT. 

The withdrawal of the import taxes is part of the 

country’s new renewable energy policy, which was approved 

in December 2008. The policy also provides for 

a five-year corporate tax holiday for income from renewable 

energy projects. The government’s goal is for 

the country to derive 5 percent of its electricity from 

renewable sources by 2015 and 10 percent of its overall 

electric supply by 2020. 

In addition to commercial-scale solar energy plants, 

the government also seeks to promote the use of microlevel 

solar energy for domestic use. More than 300,000 

households are using solar energy equivalent to 15 

megawatts, accounting for less than 1 percent of the 

country’s total electricity generation of around 3,500 

megawatts. 

Hasina also heads the Ministry of Electricity, Oil, 

and Mineral Resources. 

♦ Aziz Nishtar, Nishtar & Zafar Advocates, Karachi 

Cambodia 

Tax Breaks Targeted to Critical 

Garment Industry 

The Cambodian government has announced that it 

will offer tax breaks targeted to the clothing industry 

(accounting for 320,000 jobs in a country of 14.2 million) 

as a way to address the global financial crisis’s 

impact on Cambodia, according to media reports. 

Because the Phnom Penh government lacks cash, it 

reportedly cannot undertake the kind of stimulus packages 

seen in neighboring countries like Thailand, Malaysia, 

and Singapore. 

In addition to the tax breaks, the government plans 

to invest in infrastructure such as power plants, rural 

roads, irrigation systems, and telecommunications in an 

attempt to establish the kinds of structures the country 

will need when growth returns. According to the Economic 

Institute of Cambodia (a Phnom Penh think 

tank), up to 66 percent of the workforce works in the 

rural sector at some point during the year. 

The projects are to be funded through donor contributions, 

according to a January 26 article on 

Bloomberg.com. Contributor countries in December 

2008 pledged $950 million in aid for fiscal 2009, a 40 

percent increase over fiscal 2008. The money will go 

toward Cambodia’s $1.8 billion 2009 budget, which 

includes the infrastructure expenditures. Cambodia’s 

fiscal year runs January 1 to December 31. 



‘‘We cannot distribute cash to the people. What we 

can do is give targeted tax cuts to garment factories 

and spend more on infrastructure so we can prepare 

for economic developments in the future,’’ Hang 

Chuon Naron, secretary-general of the Ministry of 

Economy and Finance, said in a January 23 interview 

with Bloomberg.com. 

Despite its problems, Cambodia has experienced 

four straight years of growth above 10 percent. This 

growth has stemmed largely from special deals for foreign 

firms, such as tax holidays and greatly reduced 

import tariffs. 

Furthermore, 60 percent of that growth has arisen 

from just three sectors: tourism, construction, and garment 

manufacturing, with the latter accounting for 12 

percent of GDP in 2007. However, weakening demand 

in crucial retail markets like the United States, which 

receives 70 percent of Cambodia’s textile exports, has 

forced Cambodia to close 10 percent of its garment 

factories, triggering the loss of 20,000 jobs, according 

to Roger Tan of the Garment Manufacturer’s Association 

of Cambodia. 

Hang Chuon Naron anticipates a drop in garment 

exports of 2 percent. He also foresees a 20 percent 

drop in the number of tourists visiting Cambodia and 

the virtual collapse of the construction sector. He 

hopes the tax breaks will keep businesses afloat 

through the difficult times. 

The IMF has predicted that Cambodia will grow at 

a rate of 4.75 percent in 2009, the slowest pace since 

1998. 

Chile 

♦ Randall Jackson, Tax Analysts. 

E-mail: rjackson@tax.org 

Stimulus Package Wins Unanimous 

Approval 

The Chilean Senate on January 14 unanimously approved 

a $4 billion economic stimulus plan presented 

by President Michelle Bachelet on January 5. (For 

prior coverage, see Tax Notes Int’l, Jan. 19, 2009, p. 212, 

Doc 2009-349, or2009 WTD 5-3.) 

The plan, which was unanimously approved by the 

Chamber of Deputies on January 8, still must be 

signed by Bachelet, a formality that Finance Minister 

Andrés Velasco said would soon be addressed. 

Tax measures in the plan include the temporary 

elimination of the stamp tax, a reduction in the 

monthly advance tax payments made by businesses 

(expected to take effect as early as this month), and 

provisions to accelerate income tax refunds for the 

2010 tax year and to accelerate the tax credit available 

for some training costs. 

Velasco called the package ‘‘important and urgent’’ 

and expressed gratitude for the political consensus that 

led to the approval of the package in a unanimous and 

expedited manner. 

China (P.R.C.) 


♦ Lisa M. Nadal, Tax Analysts. 

E-mail: lnadal@tax.org 

U.S. Companies Facing Compliance 

Burdens in China 

U.S. companies with operations in the People’s Republic 

of China now face much more significant tax 

compliance obligations, according to panelists on a 

January 15 PricewaterhouseCoopers International Tax 

Services webcast. 

The P.R.C. government last year introduced a new 

annual enterprise income tax return package, new 

related-party transaction (RPT) forms, and new contemporaneous 

transfer pricing documentation requirements. 

The new EIT return package and the new transfer 

pricing disclosure rules are very complex, PwC tax 

partner Todd Landau said. ‘‘It is always a common 

experience with respect to China that there’s only some 

of what we need to know that is known today, with 

additional information that will clearly need to be 

known as time progresses throughout the period prior 

to deadlines’’ for the filing of returns and the submission 

of contemporaneous transfer pricing documentation, 

he said. 

For example, the State Administration of Taxation 

(SAT) released guidance on the EIT return, plus 45 

pages of explanatory notes, late in 2008, PwC tax partner 

Michael Ho said. But those notes are no longer 

valid because a new set of notes (Guo Shui Han [2008] 

No. 1081) released on January 7 has superseded them. 

This has left many companies struggling to keep up. 

Background 

The SAT on October 30, 2008, issued a new annual 

EIT return package (Guo Shui Fa [2008] No. 101) for 

use by taxpayers that must file returns under the EIT 

law that took effect on January 1, 2008. The return 

package includes a main return and 15 schedules, all of 

which must be filed by May 31. (For prior coverage, 

see Tax Notes Int’l, Dec. 22, 2008, p. 945, Doc 2008- 

24993, or2008 WTD 247-14.) 




On December 16, 2008, the SAT released nine RPT 

disclosure forms (Guo Shui Fa [2008] No. 114) to replace 

forms required under China’s previous annual 

income tax return filing system for foreign investment 

enterprises. The new RPT forms ask companies to disclose 

whether they have prepared contemporaneous 

transfer pricing documentation when filing the annual 

CIT return. (For prior coverage, see Doc 2008-26922 or 

2008 WTD 247-18.) The RPT forms must be filed together 

with the annual EIT return package. 

The SAT on January 9 published the Implementation 

Regulations for Special Tax Adjustments (Guo 

Shui Fa [2009] No. 2, or Circular 2), which define the 

scope of China’s transfer pricing rules and set out the 

contemporaneous transfer pricing documentation rules 

that both foreign and domestic enterprises must follow 

under China’s new EIT law. (For prior coverage, see 

Tax Notes Int’l, Jan. 19, 2009, p. 205, Doc 2009-521, or 

2009 WTD 7-1.) 

Circular 2 provides for some exemptions from the 

contemporaneous documentation rules. For example, 

companies may be exempt if the value of their intercompany 

tangible goods transactions is below CNY 

200 million (about $30 million) and if the value of 

their intercompany nontangible goods transactions is 

below CNY 40 million (about $6 million), not counting 

sales and purchases that are covered by cost-sharing 

agreements or advance pricing agreements. 

An exemption is also available if the foreign shareholding 

in the enterprise is less than 50 percent and the 

enterprise traded only with domestic related parties. 

Finally, an exemption is available for transactions covered 

by an APA. 

Details 

Ho outlined the company filing requirements for 

calendar year 2008, saying companies must file the 

new annual EIT return package and the new RPT 

forms by May 31, and prepare the contemporaneous 

transfer pricing documentation by December 31, which 

is an extended deadline for calendar year 2008. Normally, 

the due date for contemporaneous documentation 

will be May 31 of the year following the tax year, 

he said. 

The new EIT return asks for information taxpayers 

previously did not have to provide. For example, Ho 

said, the new return now has lines for: 

• a tax adjustment of assets measured at fair value; 

• an analysis of income or loss from long-term investments; 

• a tax adjustment of advertising and promotion 

expenses; 

• a tax adjustment of depreciation or amortization; 

and 

• a tax incentive statement for both grandfathered 

and new tax incentives. 

Ho also urged taxpayers to act swiftly to complete 

the nine new RPT forms by May 31 for tax year 2008 

— even though they only came out in December 2008. 

‘‘While it seems like we still have a few more months 

to go, given the uncertainty and the difficulties in handling 

some of the taxation treatment, there may not be 

a lot of time in preparing the returns for filing,’’ Ho 

said. He said the new RPT forms are much more complex 

than the old filing regime that was in place for 

calendar year 2007. 

After the webcast, Ho told Tax Analysts that the 

new EIT return forms contain many items and adjustments 

that will be subject to subsequent regulations 

and further SAT guidance. ‘‘As a result, there will be 

many cases of uncertain tax treatment, which will 

likely increase taxpayer compliance burdens,’’ he said. 

The obligation to provide more detailed information 

on intercompany transactions and other new filing 

rules ‘‘may be too great a responsibility to delegate entirely 

to the tax and accounting staff of the Chinese 

subsidiaries’’ of U.S. parents, Ho said. ‘‘Therefore, a 

much more coordinated effort to work with the local 

Chinese entity will likely be necessary to satisfy the 

greater Chinese compliance responsibilities.’’ 

Landau predicted the expanded information available 

to Chinese tax examiners could make future tax 

examinations ‘‘a very bumpy ride.’’ He said U.S. companies 

with Chinese operations may need to undertake 

‘‘new information gathering processes and protocols’’ 

to meet the new compliance requirements. 

Finally, the panelists cautioned that companies must 

correlate the EIT return package, RPT forms, and any 

contemporaneous transfer pricing documentation. Even 

though the forms and filings are all separate, taxpayers 

must ensure a consistent position for all of them, according 

to PwC. 

Ecuador 

♦ Charles Gnaedinger, Tax Analysts. 

E-mail: cgnaedin@tax.org 

Congress Approves Tax Package 

Ecuador’s recently inaugurated National Congress 

has approved a new tax package designed to combat 

the effects of the global financial crisis, including 

amendments to the income and capital flight taxes and 

a new tax on deposits held abroad. The amendments 

entered into full force and effect on January 1. 

The amendments, published in Official Gazette 497 

on December 30, 2008, are in response to a package of 

measures prepared by President Rafael Correa Delgado. 

Ecuador’s economy is largely dependent on oil 



exports, and the recent drop in oil prices has created a 

difficult economic scenario that will affect government 

funding and the cash flow of private enterprises. (For 

prior coverage of the Tax Fairness Bill, see Doc 2008- 

472 or 2008 WTD 7-5.) 

The new law extends a 10 percentage point reduction 

in the 25 percent corporate income tax rate to financial 

entities and cooperatives that reinvest their 

profits by increasing their capital and purchasing assets 

that would help their operations. 

The amendments provide for the reduction or dismissal 

of the advance income tax payment when there 

are economic effects for a given industry or economic 

sector. To be approved by the president, the Ministry of 

Economy and Finance and the tax administration must 

issue technical reports of an income reduction in the 

industry or economic sector. The reduction or dismissal 

of the payment must be evaluated on a yearly basis. 

The new law establishes 2009 as a transition year 

regarding withholding tax on interest paid on foreign 

credits. The normal 25 percent withholding rate over 

interest, which does not exceed the Ecuadorian Central 

Bank’s rate, has been reduced to 5 percent until December 

31, 2009. Payments made by financial entities 

are free from withholding during the entire year. 

The capital flight tax rate has been increased from 

0.5 percent to 1 percent, and all but one exclusion have 

been eliminated. Therefore, all payments (including 

those made for imports) are charged with the 1 percent 

capital flight tax. Individuals can leave the country 

with up to US $8,570 in cash free of tax. 

All imports whose payment is made with funds located 

abroad are deemed to be made with local money 

and therefore will be taxed. 

To encourage financial entities and those entities 

participating in the stock market to bring billions of 

Ecuador dollars of their clients’ deposits into the country, 

the National Congress has created a new tax. This 

tax will be charged on all deposits held abroad by the 

above-mentioned companies at a monthly rate of 0.084 

percent of the amount of their assets held abroad. 

♦ Roberto M. Silva Legarda, professor of tax law, 

Pontificia Universidad Católica del Ecuador, Quito, and 

partner, Tributum Consultans 

European Union 


Austrian Leasing Rules Incompatible 

With EC Treaty, ECJ Says 

Austrian rules that denied an investment-premium 

tax advantage to lessors of goods used by lessees in 

other EU member states violated article 49 of the EC 

Treaty (the freedom to provide services), the European 

Court of Justice said in its December 4, 2008, judgment 

in Jobra Vermögensverwaltungs-Gesellschaft mbH v. 

Finanzamt Amstetten Melk Scheibbs (C-330/07). (For the 

judgment, see Doc 2008-25509 or 2008 WTD 235-10.) 

Background 

Jobra was an Austrian company with a wholly 

owned subsidiary, Braunshofer, also an Austrian resident 

company. Jobra purchased some trucks and leased 

them to Braunshofer, which used the trucks in EU 

member states other than Austria. Consequently, Jobra 

was denied an investment-premium tax advantage because 

the leased assets were used ‘‘primarily abroad’’ 

and not in Austria. 

The Austrian tax rules at issue made the tax advantage 

available only if the assets had been used at an 

Austrian place of business for at least half the time 

they had been in use. Jobra argued that the rules were 

incompatible with its rights under EC Treaty articles 

43 (freedom of establishment) and 49 (freedom to provide 

services). 

Considerations 

The ECJ noted that the leasing of vehicles is a service 

under article 50 of the EC Treaty. 

The Court went on to determine that the Austrian 

tax regime at issue — ‘‘which applies a less favourable 

tax regime to investments in assets which, once they 

have been hired out for remuneration, are used in other 

Member States, than to investments in such assets that 

are used domestically — is likely to discourage undertakings 

that would be eligible for that tax advantage 

from providing rental services to economic operators 

that carry out their activities in other Member States.’’ 

Justifications 

The ECJ examined and rejected three possible justifications: 

the need to ensure balance in the allocation 

of taxing rights, the need to safeguard the coherence of 

the national tax system, and the need to prevent abuse. 

Allocation of Taxing Rights 

The Austrian and German governments argued that 

the investment-premium rules at issue were consistent 

with the allocation of taxing rights between the member 

states. They pointed out that the conditional granting 

of the investment-premium tax advantage ‘‘aims to 




ensure that there is a connection between, on the one 

hand, the granting of that tax advantage and, on the 

other hand, the taxation of profits generated through 

the use of those assets.’’ 

The ECJ replied that the rental income at issue is 

taxable in Austria; therefore, Austria’s right ‘‘to exercise 

its taxing powers in relation to activities carried on 

in its territory’’ was not jeopardized. 

Coherence of the Tax System 

In response to arguments about the need to safeguard 

the coherence of the tax system, the ECJ noted 

that there was no direct link between the investmentpremium 

tax advantage granted to the lessor and the 

subsequent taxation of the lessee’s income generated 

through the use of the leased assets. 

Need to Prevent Abuse 

The Austrian government argued that the tax rules 

at issue were aimed at preventing ‘‘wholly artificial arrangements 

involving transfers for remuneration.’’ One 

concern mentioned by the government was that ‘‘the 

lessor could hand over all or part of the premium to 

the lessee which, for its part, could use that asset to 

generate profits in other Member States. Thus, it would 

be possible to circumvent the fact that the advantage is 

limited to Austria.’’ Without the tax rules at issue, ‘‘it 

would be possible, merely by setting up the leasing 

company for a corporate group in Austria, to claim the 

investment premium for all the acquisitions made by 

that group, irrespective of where those assets are 

used,’’ it said. 

The ECJ agreed that the member states can have 

national tax rules that restrict the freedom to provide 

services, provided that those rules specifically target 

‘‘wholly artificial arrangements which do not reflect 

economic reality and whose only purpose is to obtain a 

tax advantage.’’ However, it said the leasing of assets 

to another undertaking for use in other member states 

‘‘cannot be the basis of a general presumption of abusive 

practice and justify a measure which compromises 

the exercise of a fundamental freedom guaranteed by 

the Treaty.’’ 

The ECJ observed that the Austrian tax rules affected 

every lessor eligible for the investment-premium 

tax advantage that hired out assets for remuneration to 

undertakings operating cross-border activities, ‘‘and 

does so even where nothing points towards the existence 

of such an artificial arrangement. Furthermore, 

the legislation does not allow lessors to adduce evidence 

that no abuse is taking place.’’ 

The Judgment 

Accordingly, the ECJ held that because the Austrian 

tax rules did not make it possible to limit the denial of 

the investment-premium tax advantage to cases involving 

wholly artificial arrangements, the rules could not 

be justified by overriding reasons of public interest and, 

consequently, were precluded by article 49 of the EC 

Treaty. 

The ECJ further stated that there was no need to 

examine whether the EC Treaty provisions on freedom 

of establishment might also preclude the rules. 

Analysis 

This case is particularly interesting because of the 

ECJ’s comments on justifications — particularly the 

need to prevent tax abuse. The judgment appears to 

take the ECJ’s previous reasoning in this context one 

step further. The judgment also represents the latest in 

a line of cases concerning the taxation of leasing services 

and how the tax rules interact with the fundamental 

freedoms. 

Balancing the Allocation of Taxing Rights 

In Jobra, that justification of the Austrian rules was 

unsuccessful because Austria failed to take into account 

the rental income received by Jobra from its subsidiary 

in relation to the leased assets. That income remained 

taxable in Austria. Thus, even though the leased assets 

might be used outside Austria, the income received 

from the leased assets remained within Austria’s tax 

jurisdiction. Consequently, the argument that there was 

an impact on the allocation of taxing rights was rejected, 

because although Austria granted an 

investment-premium tax advantage for the leased assets, 

which in this case were not used mainly in Austria, 

that did not impinge on Austria’s right to tax the 

income from those assets. 

Preventing Tax Abuse 

The ECJ acknowledged that the member states retain 

the right to prevent abuse in situations when the 

national rules specifically target ‘‘wholly artificial arrangements 

which do not reflect economic reality and 

whose only purpose is to obtain a tax advantage.’’ This 

was, in many respects, a repeat of its mantra from earlier 

cases such as Marks & Spencer (C-446/03), in which 

the ECJ noted that the member states were ‘‘free to 

adopt or to maintain in force rules having the specific 

purpose of precluding from a tax benefit wholly artificial 

arrangements whose purpose is to circumvent or 

escape national tax law.’’ 1 (For the ECJ judgment in 

Marks & Spencer, see Doc 2005-25015 or 2005 WTD 239- 

16.) 

The word ‘‘specific’’ should be emphasized because, 

as the ECJ explained once again in Jobra, problems 

1 This harks back to the much earlier ECJ judgment in ICI v. 

Colmer (C-264/96), in which the ECJ held that the U.K. rules 

were precluded by the freedom of establishment because they 

applied generally to all situations in which most of the group’s 

subsidiaries were established for whatever reason outside the 

United Kingdom. 



occur when the national antiabuse rules are general in 

nature. The ECJ stated that it could not be claimed 

that there was such abuse when an undertaking hired 

assets out for remuneration to another undertaking that 

used them primarily in other member states, highlighting, 

in particular, that that hiring out ‘‘cannot be the 

basis of a general presumption of abusive practice and 

justify a measure which compromises the exercise of a 

fundamental freedom guaranteed by the Treaty.’’ This 

key flaw in the design of many member states’ tax 

antiabuse rules is apparent from the ECJ’s jurisprudence, 

including the Austrian rules in this case. 

Burden of Proof 

Clearly, the burden of proof in the area of tax abuse 

should remain on the tax authorities, at least until they 

make a prima facie case that the abuse exists. However, 

this is rarely the case when the antiabuse rules are 

drafted in a general way to include situations like those 

seen in Jobra, where no apparent abuse was happening. 

The ECJ dealt with this issue for the first time in Jobra 

when it commented that ‘‘the legislation at issue affects 

every lessor eligible for the investment premium which 

hires out assets for remuneration to undertakings carrying 

out cross-border activities, and does so even where 

nothing points towards the existence of such an artificial 

arrangement.’’ 

The requirement that some evidence pointing toward 

the existence of wholly artificial arrangements or 

abuse should exist may be helpful to taxpayers facing 

antiabuse rules in the future as, clearly, they can advance 

the argument to the tax authorities that the 

ECJ’s ruling in Jobra specifically mentioned that there 

is an onus on the tax authorities to at least demonstrate 

that something abusive is occurring. This is an 

additional part of the tax authorities’ burden of proof 

before the burden gets transferred over to the taxpayer 

to show that no abuse is taking or has taken place. 

The ECJ, following the reasoning of its earlier tax 

avoidance case law, goes on to make it clear that in the 

circumstances of this case, the Austrian rules do not 

allow lessors ‘‘to adduce evidence that no abuse is taking 

place.’’ The consequences of this are significant 

because the taxpayer is never given the opportunity to 

rebut the allegation of abuse. Perhaps more importantly, 

as a result, the ECJ found that the Austrian tax 

rules at issue do not make it possible to limit the refusal 

to grant the investment-premium tax advantage to 

cases involving wholly artificial arrangements, which 

indicates that the rules go too far and are a disproportionate 

restriction on the fundamental freedom to provide 

services. 

Protective Nature of the Austrian Rules 

Finally, it is useful to highlight the protective nature 

of the Austrian tax rules at issue in Jobra. Article 49 of 

the EC Treaty precludes such rules because their aim 

was to provide tax advantages mainly for Austrian residents 

who leased assets to other Austrian residents 

who used the leased assets mainly in Austria. In an 

internal market, it is clear that such rules seriously 

hamper cross-border trade and economic activity, and 

the provision of leasing services in particular, because 

the tax advantage is limited to Austrian lessors and 

lessees who lease assets for mainly Austrian domestic 

use purposes. 

With many leasing companies providing services 

cross-border, Jobra may be one of the ECJ’s most significant 

preliminary rulings in the area of cross-border 

leasing, on a par with its earlier judgment in Eurowings 

(C-294/97), in which German tax rules that penalized 

a German company for obtaining its leasing services 

from an Irish company came under scrutiny and were 

found to be incompatible with the freedom to provide 

(and to receive) services as set forth in EC Treaty article 

49. 

In the eyes of the ECJ, protectionist rules of this 

nature have no place in an ‘‘area without internal frontiers.’’ 

Although direct taxation remains within the 

competence of the member states, the exercise of that 

competence when the member states design their tax 

systems must take place in full compliance with EU 

law. In this case, the protectionist Austrian tax rules 

will have to be either amended (to ensure compliance) 

or repealed. 

♦ Tom O’Shea, Queen Mary University of London, Centre 

for Commercial Law Studies 

Germany 

GERMANY 

Former Deutsche Post CEO Convicted 

Of Tax Evasion 

A German court on January 26 convicted Klaus 

Zumwinkel, former CEO of Deutsche Post and the 

most prominent German taxpayer to be caught up in 

the Liechtenstein tax scandal, of tax evasion, according 

to media reports. 

The Bochum court reportedly handed down a twoyear 

suspended sentence and fined Zumwinkel €1 million 

(about $1.3 million). 

The fine and two-year suspended sentence was what 

prosecutor Gerrit Gabriel called for in his closing remarks, 

according to a January 26 Associated Press report. 

‘‘He knew exactly what he was doing,’’ Gabriel 

was quoted as saying. 

Gabriel requested a relatively light sentence (conviction 

of tax evasion can lead to up to 10 years in prison 

under German law) given that Zumwinkel has paid 

€3.9 million (about $5.1 million) in back taxes and 



GERMANY 

confessed to his wrongdoing on January 22 at the start 

of his trial. (For prior coverage, see Doc 2009-1382 or 

2009 WTD 13-3.) 

Since news of the Liechtenstein scandal broke in 

February 2008, German prosecutors have reportedly 

recovered over €150 million from German taxpayers 

seeking to avoid a trial. German authorities claim that 

up to €4 billion was hidden in Liechtenstein. 

Haiti 



Mobile Phone Service Providers 

Oppose Tax Hike 

Mobile phone service providers in Haiti are protesting 

a 2008-2009 budget measure that would increase 

the tax on mobile phone users. 

Radio Kiskeya, a Port-au-Prince news radio station 

reported on January 16 that the new proposal would 

amend the taxation component of the Telecommunications 

Act of 2002. 

Mobile service providers have joined together to oppose 

the tax increase, claiming it would hurt the 

economy. Digicel, Voila, and Haitel insist that raising 

the tax on cell phone use would actually reduce tax 

revenue by discouraging cell phone use and in turn 

reducing general business activity. 

The three companies say they have invested more 

than $600 million in the nation’s networks and services 

over the past 10 years, and that they directly employ 

more than 2,000 Haitians. They claim that as many as 

55,000 jobs indirectly rely on the smooth functioning 

of the telecommunications sector. 

Haiti’s General Tax Directorate acknowledged that 

the telecom sector has been the greatest source of government 

tax income since 1999, producing 28 percent 

of Haitian revenues in fiscal 2007-2008, which ended 

September 30, 2008. 

The proposed changes reportedly include a new 

charge of HTG 3.60 per minute (about $0.09) for local 

calls and HTG 4 per minute for international calls. The 

new charges would come on top of the current charge 

of HTG 4.70 per minute that subscribers must pay; the 

current charge includes a 10 percent revenue tax. 



Hungary 

Employer Tax Cut, VAT Increase 

Under Consideration 

The Hungarian government has proposed cutting 

the payroll tax employers must contribute to the nation’s 

social security system by 5 percentage points to 

augment employment as Hungarian businesses struggle 

with liquidity and credit issues arising from the world 

financial crisis. 

In announcing the proposed payroll tax cut, Prime 

Minister Ferenc Gyurcsany was careful to emphasize 

that overall government revenue cannot be allowed to 

plummet as a result of tax breaks, according to media 

reports. He therefore also proposed increasing the VAT 

rate by 2 to 3 percentage points — to 22 percent or 23 

percent — to offset the revenue loss from the payroll 

tax reduction. 

The government estimates that the proposed payroll 

tax reduction would cost an estimated HUF 300 billion 

(about $1.4 billion). 

The tax proposals follow a January 25 meeting at 

which Gyurcsany told economists that a reduction in 

Hungary’s tax and contribution rates is necessary to 

maintain the nation’s competitiveness. 

The economists suggested that Budapest put in place 

an overall economic and social reform plan that would 

cover the next three to four years, extending beyond 

the next parliamentary elections in 2010. 

Hungarian industrialists offered their own suggestion 

at the January 25 gathering. Peter Furo, head of the 

Confederation of Hungarian Employers and Industrialists, 

told the Hungarian press that his organization suggested 

that Budapest suspend the capital gains tax for a 

year or two to spur savings and the purchase of government 

securities. 

While Gyurcsany was receptive to the economists’ 

suggestion, he remained noncommittal toward the 

CGT proposal. 

The government expects the economy to contract by 

2 percent to 3 percent in 2009, forcing an adjustment 

in the budget that was approved in December 2008. 

But while Gyurcsany pointed to the need to lessen the 

tax burden on businesses, he also spoke of the need to 

maintain the budget’s deficit target of less than 3 percent 

of GDP, as required by the European Union. 

The government therefore hopes it can redistribute 

the tax burden, freeing up corporate money while preserving 

the income needed to hold down borrowing 

and the potential of an inflated deficit. 

Unnamed government sources were quoted as saying 

that Budapest wants to rearrange about HUF 1 trillion 

of spending and revenue items in the 2009 budget, 



ut will insist on offsetting tax cuts in one area with 

increases in another, such as with the VAT increase to 

offset the payroll tax reduction. 

Peter Szijjarto, spokesman for the right-wing opposition 

Hungarian Civic Union, labeled Gyurcsany’s 

January 25 meeting a failure, according to a January 

26 report in The Budapest Times. 

The Alliance of Free Democrats, a fellow left-wing 

party to Gyurcsany’s Hungarian Socialist Party, said in 

a statement that while it applauds Gyurcsany’s desire 

to reduce taxes and contributions, it questions his earnestness 

in light of a December 2008 statement in 

which he said that tax cuts in 2009 or 2010 would be 

impossible. The Alliance of Free Democrats called 

Gyurcsany’s inconsistency ‘‘harmful’’ to the Hungarian 

economy. 

The parties were scheduled to meet in an extraordinary 

session of parliament on January 29 to discuss 

the worsening economy and the government’s proposed 

legislation. The government plans to submit the 

most pressing bills to the parliament by mid-March to 

facilitate an effective date of July 1, Gyurcsany said in 

a statement. 

India 



Indian PE Not Responsible for 

Withholding, Tax Tribunal Says 

The Mumbai Income Tax Appellate Tribunal on 

December 5 issued its ruling in DCIT v. Stock Engineer 

and Contractors BV, clarifying the withholding tax obligation 

on payments made to nonresidents by an Indian 

permanent establishment of a Dutch company, as well 

as the deductibility of some expenses for such a PE. 

In the case at issue, which related to assessment 

year 2000-2001, Stock Engineer and Contractors (the 

assessee), a company incorporated in and resident of 

the Netherlands, was engaged in the design and construction 

of oil, gas, and petrochemical plants. It 

signed a contract with an Indian oil company for the 

engineering, procurement, and construction of a facility 

in India on a turnkey basis. For that purpose, the 

assessee set up project and site offices in India (an Indian 

PE) after obtaining the due regulatory approval. 

The assessee in turn subcontracted a part of the work 

to its Malaysian subsidiary. 

Under that agreement, the Malaysian subsidiary was 

to supply personnel to the assessee for the purpose of 

INDIA 

executing the Indian project. Those personnel stayed in 

India for a period of more than six months during the 

year under consideration. 

Separately, the assessee also engaged a U.K. company 

to deploy employees for supervision of the Indian 

project, and another Dutch company to provide engineering 

services. Both of those companies were unrelated 

to the assessee. 

The personnel of the U.K. company were deployed 

in India for 135 days. The assessee did not withhold 

any Indian income tax when paying the Malaysian, 

U.K., and Dutch suppliers. (The assessee also had 

some employees at its head office who dedicated part 

of their time providing technical support to the Indian 

PE; however, none of those employees visited India for 

the project work.) 

During the 2000-2001 assessment year, the assessee 

deducted the payments it made to the Malaysian subsidiary 

and the unrelated U.K. and Dutch companies 

in computing the Indian PE’s taxable income. The assessee 

also deducted part of the salary cost incurred by 

the head office for its employees based on the number 

of hours the employees spent on the Indian project. 

In the course of assessment proceedings, the tax 

officer concluded that the assessee was subject to a 

withholding tax obligation on the payments it made to 

the various service suppliers. Because no tax was withheld, 

those payments were not deductible in computing 

the taxable profits of the Indian PE, 1 the tax officer 

said. 

In particular, the tax officer took the position that 

the Malaysian subsidiary had a PE in India under article 

5(4)(a) of the India-Malaysia income tax treaty, 

which states that a PE is created if supervisory activities 

are carried out in India for more than six months 

in connection with a construction, installation, or assembly 

project in India. 

The tax officer also held that the U.K. company had 

a PE in India under article 5(2)(k) of the India-U.K. 

income tax treaty, which states that a services PE is 

created if the aggregate stay of the personnel in India 

exceeds 90 days. 

Regarding the payment to the Dutch company, the 

tax officer held that it constituted a payment for technical 

services, which is subject to tax under the India- 

Netherlands income tax treaty. 

1 Failure to meet the withholding tax obligation leads to, 

among other things, the denial of a tax deduction for the payment 

in question (ITA section 40(a)(i)). The withholding tax obligation 

in the case of payment to a nonresident is triggered under 

ITA section 195 if the payment is subject to Indian income 

tax in the hands of the recipient. 



INDIA 

Addressing the assessee’s deduction of the salary 

costs of some employees in its head office, the tax officer 

said those costs were in the nature of head office 

expenses, which are subject to a deductibility cap under 

section 44C of the Indian Income Tax Act. 2 Subjecting 

it to that limit, the tax officer denied the deduction. 

The assessee successfully argued its case before the 

commissioner of income tax (appeals). The Revenue 

Department then appealed to the tribunal. 

Tribunal’s Ruling 

The tribunal held that the Malaysian company did 

not have a PE in India under article 5(4)(a) of the 

India-Malaysia tax treaty. It noted that the personnel 

supplied by the Malaysian company were under the 

direct control of the assessee, that the Malaysian company 

had no further role after the personnel were supplied 

to the assessee, and that the Malaysian company 

did not carry out any direct supervisory activities in 

India. 

Also, the tribunal noted that there is no article in 

the India-Malaysia tax treaty that deals specifically 

with fees for technical services. Consequently, there 

was no obligation on the assessee to withhold Indian 

tax from the payments it made to the Malaysian company 

and the payments were therefore tax deductible. 

The tribunal also noted that article 5(2)(j) of its tax 

treaties, which provides for a threshold of six months 

in India, specifically refers to a building site, installation, 

or assembly project, or supervisory activities in 

connection therewith. 

Turning to the assessee’s payments to the U.K. company, 

the tribunal noted that, in contrast to article 

5(2)(j), a PE is triggered under article 5(2)(k) when services, 

including managerial services, are performed in 

India for an unrelated party for a period of more than 

90 days in any 12-month period. 

The tribunal therefore applied the settled legal principle 

that if two provisions are equally applicable to a 

situation, the one that is most beneficial to the taxpayer 

should be adopted. Because the personnel of the 

U.K. company were deployed in India for no more 

than 135 days, there was no PE for the U.K. company 

under article 5(2)(j) of the India-U.K. tax treaty. Consequently, 

the assessee was not required to withhold any 

Indian tax from its payments to the U.K. company and 

the payments were therefore tax deductible. 

Regarding the services supplied by the Dutch company, 

the tribunal held that those services, while tech- 

2 ITA section 44C limits the deduction for head office expenses 

to 5 percent of taxable income, computed as specified. 

Head office expenses have been defined to mean executive and 

general administrative expenditures incurred by the assessee outside 

of India, including salaries, rent, travel expenses, and so on. 

nical, did not make any technical knowledge or experience 

available to the assessee. As such, the assessee’s 

payments to the Dutch company could not be classified 

as fees for technical services within the meaning of 

article 12 of the India-Netherlands tax treaty, the tribunal 

said. The assessee therefore was not required to 

withhold any Indian tax from the payments, and the 

payments were tax deductible, the tribunal ruled. 

On the final question, the tribunal held that the deductibility 

cap on head office expenses is limited to 

executive and general administrative expenses incurred 

by the head office for a common purpose — for example, 

for purposes of managing the head office as 

well as all branches and PEs in general. In the case at 

issue, the payment was made to employees who 

worked in the head office and did not work exclusively 

on the Indian project (that is, they also worked for the 

head office, as shown by the allocation of part of the 

salary costs based on the hours spent on the Indian 

project). Therefore, there was a common purpose for 

those expenses as envisaged in ITA section 44C, the 

tribunal said. 

However, because the employees were providing specific 

technical services to the Indian project, their costs 

could not be classified as executive and general administrative 

expenditures, which refer to managerial and 

administrative services alone and do not include technical 

services, the tribunal said. Therefore, those costs 

were not subject to the deductibility cap imposed by 

ITA section 44C and were fully deductible in computing 

the taxable profits of the Indian PE. 

For nonresidents with a PE in India, this ruling may 

make it easier to fully claim a deduction for costs relating 

to services other than managerial and administrative 

services, subject of course to the arm’s-length principle 

under the transfer pricing code. 

♦ Shrikant S. Kamath, tax consultant, Hong Kong 

Subsidiaries in India Do Not 

Constitute a PE, Tribunal Rules 

A German company’s Indian subsidiaries do not 

constitute a permanent establishment in India; therefore, 

the company is not subject to taxation in India, 

according to the Pune Income Tax Appellate Tribunal. 

The tribunal’s ruling in ACIT v. Epcos AG — issued 

on June 30, 2008, and made public on January 21 — 

involves the 2003-2004 assessment year and deals with 

issues relating to the Germany-India income tax treaty 

and the Indian Income Tax Act, 1961. (For the ruling, 

see Doc 2009-1333 or 2009 WTD 14-21.) 

Background 

Epcos AG is a multinational company that designs, 

manufactures, and markets electronic components. It 



has operations in Germany and subsidiaries across the 

world, including two in India. During the year under 

consideration, the German arm of Epcos AG supplied 

services such as marketing, sales support, and technology 

support to the Indian subsidiaries in return for royalty 

payments. 

In its Indian tax return, the German arm of Epcos 

AG classified the payments it received from the Indian 

subsidiaries as royalties and fees for technical services, 

which were subject to Indian income tax at a rate of 

10 percent under article 12 of the Germany-India income 

tax treaty. 

The Indian tax officer requested details about the 

services supplied to the Indian subsidiaries by the assessee, 

and the company submitted that sales are 

handled by Epcos AG’s regional sales offices, whereas 

marketing efforts are centralized at the German headquarters 

in Munich. 

The company said it is organized by product divisions, 

and each division has a central marketing team 

that works for all the manufacturing subsidiaries in that 

division. Epcos AG charges an arm’s-length fee for the 

services that the central marketing team renders for the 

benefit of the various manufacturing subsidiaries. 

The transfer pricing officer (TPO) agreed that the 

services provided by the assessee were supplied to the 

Indian subsidiaries on an arm’s-length basis, as required 

by the transfer pricing provisions of the ITA. 

The tax officer, however, thought that the assessee 

had a PE in India in the form of the two subsidiaries 

because the assessee was conducting its business in India 

through those subsidiaries and more specifically, 

through the employees of the subsidiaries. He classified 

the payments at issue as business profits under article 7 

of the Germany-India tax treaty and assessed tax on a 

gross basis at the 20 percent rate provided under the 

ITA. (For the year in question, the ITA did not allow a 

deduction for any expenses related to royalties and fees 

for technical services earned by a foreign company.) 

The commissioner of income tax (appeals) subsequently 

overturned the assessment, holding that the 

services supplied by Epcos AG were routine in nature 

and were provided to enable the Indian subsidiaries to 

carry on their own business activities, and not the business 

of the assessee. The Revenue Department then 

appealed to the tribunal. 

The Tribunal’s Decision 

In the tribunal’s own words, the commissioner of 

income tax (appeals) properly rejected the tax officer’s 

‘‘overzealous approach.’’ 

The tribunal held that a tax treaty generally provides 

for an alternate tax regime and not an exemption regime. 

Therefore, the burden is first on the Revenue Department 

to show that the assessee has taxable income 

under the treaty, and then the burden is on the assessee 

to show that its income is exempt under the treaty. Unless 

a tax jurisdiction has a right to tax an income, it is 

irrelevant whether, under the domestic tax legislation 

of that tax jurisdiction, the income in question is taxable. 

In a situation in which India has no right to tax a 

particular income in the hands of the nonresident covered 

by a tax treaty, the provisions of ITA do not 

come into play at all. 

The tribunal confirmed that when an economic activity 

is carried out in a fixed place of business available 

to a foreign enterprise, that place will be a PE of 

the foreign enterprise regardless of whether the activities 

at issue are core activities or peripheral activities. 

However, if the PE carries on an activity that does not 

serve the overall purpose of the foreign enterprise or 

does not contribute to the profits of the foreign enterprise, 

the existence of such a PE is wholly academic 

and does not have any tax implications in the source 

jurisdiction (in this case, India). 

While Epcos AG’s business is to supply certain 

types of services to its Indian subsidiaries, the business 

of the Indian subsidiaries is to manufacture and sell 

their own products, the tribunal said. The fact that the 

employees of the Indian subsidiaries were also engaged 

in marketing and information technology support activities 

does not mean that those employees were doing 

the business of the assessee, it said. 

Further, the TPO had agreed that the payments 

made by the Indian subsidiaries to Epcos AG were at 

arm’s length, and the assessee had not reimbursed the 

subsidiaries for any costs incurred in connection with 

their employees in India, and as such, there could not 

be any payment for, or in connection with, the services 

rendered by those employees. 

The tribunal therefore held that the Indian subsidiaries 

did not constitute a PE of Epcos AG in India, and 

that the assesssee was not subject to taxation in India 

on royalties or technical service fees paid by the Indian 

subsidiaries. 

♦ Shrikant S. Kamath, tax consultant, Hong Kong 

Indonesia 

Exit Tax Rules Revised 

INDONESIA 

Indonesia’s Directorate General of Taxation on December 

21, 2008, issued Regulation PER-53/PJ/2008 

(later amended by PER-1/PJ/2009 of January 9, 

2009), regarding the procedures for payment, exemption, 

and administration of the fiscal (exit) tax for resident 

individuals traveling overseas. 



INDONESIA 

As of January 1 and continuing through December 

31, 2010, the new rates for the fiscal tax are IDR 2.5 

million for travel by air and IDR 1 million for travel by 

sea. 

Indonesian tax residents who are 21 years and older 

and who have not registered and received a tax identification 

number (NPWP) are required to pay the fiscal 

tax, which is creditable against the individual’s income 

tax payable at the end of the year (once the taxpayer 

has obtained an NPWP). The new regulation does not 

address the mechanism for crediting fiscal tax against 

an employer’s income tax payable at year-end. 

In contrast, taxpayers who have registered and received 

an NPWP are no longer required to pay the fiscal 

tax. The taxpayer’s spouse and dependent family 

members also will be exempt from the tax, provided 

that they are listed on the family card (Kartu Keluarga) 

of the NPWP holder. For families of foreign citizens 

with an NPWP, the taxpayer must attach a photocopy 

of a Certificate of Expatriate’s Family Structure or 

other official document equivalent to the certificate, 

indicating the family relationship status. 

Exemptions from the fiscal tax are granted to foreign 

taxpayers who do not reside in Indonesia or who 

stay in Indonesia for no more than 183 days in a 12month 

period. Diplomats and representatives of international 

organizations and their families, Indonesian 

citizens permanently residing abroad, hajj pilgrims, individuals 

crossing land borders, Indonesian students 

studying abroad, Indonesian workers with migrant 

worker cards, and individual tax residents with annual 

income below the nontaxable income threshold also 

are exempt from the fiscal tax. 

♦ Firdaus Asikin and Connie Chu, 

Deloitte Touche Tohmatsu, Jakarta. Copyright © 2009 

Deloitte Touche Tohmatsu. All rights reserved. 

Regulation Amends CFC Rules, 

Clarifies Export Duty 

Indonesia’s Ministry of Finance recently issued 

Regulation 256/PMK.03/2008 (dated December 31, 

2008) revising the previous controlled foreign corporation 

rules under Ministry of Finance Decree 650/ 

KMK.04/1994. 

The new rules, which entered into force on January 

1, no longer contain blacklisted countries; thus, Indonesia 

no longer distinguishes between the jurisdictions of 

foreign subsidiaries. Any undistributed profits of unlisted 

companies with Indonesian control of 50 percent 

or more that are incorporated in foreign countries will 

be deemed to be distributed if they are not distributed 

within four months of the most recent submission of 

an annual tax return in that foreign country. 

If there is no obligation to file an annual tax return 

in that foreign country, the undistributed profits will be 

deemed distributed if they are not distributed within 

seven months after the tax year ends. 

Distributed dividends received from foreign subsidiaries 

are taxed in the normal manner. The ordinary 

foreign tax credit with a per-country limitation does 

not extend to the underlying corporate tax. 

Like the old CFC regulations, the new rules apply 

only to foreign subsidiaries that are directly held by 

Indonesian tax residents and do not have grandfathering 

provisions that extend to foreign subsidiaries indirectly 

owned by Indonesian tax residents through their 

direct foreign subsidiaries acting as mixer companies. 

It is unclear whether the CFC rules are still applicable 

if the Indonesian shareholder does not have 

rights to receive dividends under the relevant laws in 

the jurisdiction of the foreign subsidiary. 

Export Duty 

The Ministry of Finance also issued Regulation 

214/PMK.04/2008 (dated December 16, 2008), which 

clarifies Export Duty Regulation 214. Regulation 214, 

which entered into force on January 1, implemented 

Customs Law 17 of 2006 and articles 2(5), 14, and 18 

of Regulation 55 of 2008 concerning the application of 

export duty. 

Generally, exported goods are subject to export duty, 

with the exception of: 

• goods owned by foreign missions or their officials 

who are posted in Indonesia, based on the principle 

of reciprocity; 

• goods that are owned and used by museums, 

zoos, and similar public places, as well as goods 

used for nature conservation; 

• goods used in scientific research and development; 

• goods that are used as samples and are not for 

commercial use; 

• belongings of individual passengers and carrier 

crew members traveling cross-border, and shipments 

up to a certain value of export duty or in 

specified amounts; 

• goods that were imported and reexported; and 

• exported goods that will later be imported. 

To be eligible for the export tax exemption, an exporter 

must file a written declaration with the head of 

the customs office reporting goods that fall into the 

first four categories mentioned above, and must file an 

application with the head of the customs office for the 

last two categories of goods mentioned above. 

The export duty rate is based on a percentage of the 

export value (ad valorum) or the specific amount of 

the export value. The rate is based on the export value 

stipulated on the date the export declaration is filed 

with the customs office. 



The exporter or its customs proxy generally must 

pay the export duty by the time the export declaration 

is filed with the customs office. For some exports, the 

deadline is 60 days after the departure of the carrier of 

those goods. 

As with other customs and tax disputes, any dispute 

over export duty shall begin with the filing of an objection 

application to the Directorate General of Customs 

and Excise. If the directorate’s decision is not satisfactory, 

the exporter may appeal to the tax court. 

Jamaica 

♦ Freddy Karyadi, senior lecturer, 

Trisakti University, Jakarta 

World Bank Backs Jamaican Tax 

Reform Effort 

The World Bank has issued a $100 million development 

policy loan to Jamaica that is intended to assist 

the Caribbean nation as it seeks to improve its finances 

and reform its tax system. 

The World Bank on January 15 announced it had 

approved the fiscal and debt sustainability development 

policy loan to aid Jamaica in containing public spending, 

improving financial management and budgeting 

processes, and ‘‘enhancing the efficiency and fairness 

of the tax system.’’ The loan will have a 30-year term 

and will defer payments for the first five years. 

The Jamaican government laid out its proposal to 

reform both tax policy and tax administration in its 

December 2008 loan request. The proposal calls for 

reporting the costs of tax exemptions and special rates 

to lawmakers, eliminating general consumption tax exemptions 

for nonfood categories and certain purchaser 

categories, taking steps to ensure that corporate profits 

are taxed at either the corporate or individual level, 

and increasing the income tax threshold. 

To improve tax system administration, the proposal 

calls for reducing filing requirements through payroll 

tax consolidation, increasing enforcement efforts, and 

improving the tax authorities’ ability to collect and use 

information to detect fraud and evasion. 

In his April 2008 budget speech, Prime Minister 

Bruce Golding had outlined the challenges faced by the 

government as it seeks to reform taxation. Golding 

called the current system ‘‘inequitable, inefficient and 

leaky.’’ According to Golding, the government is collecting 

only 20 percent of applicable corporate taxes 

and only half of applicable property taxes. He also 

said that outside the country’s pay as you earn (PAYE) 

system, only 4,000 individuals pay income tax. Gold- 

ing estimated that 250,000 self-employed individuals 

who are liable to pay income tax are not doing so. 

‘‘We could significantly reduce taxes and collect significantly 

more taxes, if everybody paid and this will 

be the aim of the comprehensive tax reform program, 

which we intend to introduce next year,’’ Golding said. 

The Jamaica Confederation of Trade Unions 

(JCTU) has criticized the current income tax system as 

creating an ‘‘unfair and unjust tax burden’’ on PAYE 

workers. In a January 4 opinion article published in 

The Gleaner, JCTU General Secretary Lloyd Goodleigh 

called on Parliament to ‘‘implement a tax reform package 

that is efficient and equitable.’’ 

‘‘Parliament can correct an economic inefficiency 

and transform the society by putting in place an 

efficient/equitable tax system and seeking to secure 

national consensus on a social covenant between the 

government of Jamaica and its citizens,’’ Goodleigh 

wrote. 

On January 17 the Jamaican government announced 

the Domestic Tax Administration Project, which targets 

the same tax administration goals included in the 

World Bank proposal. Under the plan, the government 

will consolidate three collection departments to fall 

within the authority of the commissioner general. 

‘‘The new regime is expected to achieve increased 

revenue through significant improvements in the efficiency 

and effectiveness of the organization of domestic 

tax; contribute directly to macroeconomic stability, 

stimulate greater voluntary compliance and collect 

more of the revenues due; reduce dependence on borrowing 

by making additional financial resources available 

on a sustainable basis to finance budgetary needs 

and be able to reduce tax rates through widening of 

the tax base,’’ the government said in a January 17 release. 

Japan 

JAPAN 

♦ David D. Stewart, Tax Analysts. 

E-mail: dstewart@tax.org 

Consumption Tax Measure Advances 

Japanese Prime Minister Taro Aso’s Cabinet on 

January 23 approved a supplementary clause in the 

implementation legislation for the proposed 2009 

budget proposal that paves the way for an increase in 

the current 5 percent consumption tax rate in or after 

fiscal 2011. (For related coverage, see Doc 2008-26445 or 

2008 WTD 243-2.) 

The final wording of the supplementary clause reflects 

a compromise between members of the ruling 

Liberal Democratic Party (LDP) who opposed Aso’s 



JAPAN 

insistence that the bill include a hard and fast commitment 

to raise the consumption tax in fiscal 2011, and 

those who supported Aso’s position. The clause also 

stresses the need for Tokyo to promote administrative 

reform and to deal with wasteful expenditures — important 

points for many LDP members who opposed 

the initial 2011-specific wording. With an election 

looming later this year, Aso reportedly wants to avoid 

creating tension within his party. 

The LDP needs to receive a two-thirds majority in 

the powerful lower house of the Diet to have any 

hopes of passing budget-related bills that may be rejected 

by the opposition Democratic Party of Japan 

(DPJ), the majority party in the upper house. 

The revised clause states that the actual date for increasing 

the tax rate will be specified in a separate bill, 

but that all necessary legal preparations will be put in 

place by fiscal 2011, which would enable the government 

to implement the tax increase and other related 

tax reforms as soon as a date is agreed upon. 

By revising the supplementary clause the Cabinet 

has aligned itself with the LDP’s Treasury and Finance 

Division and its Policy Deliberation Committee, both 

of which reportedly gave their approval a day earlier. 

The party’s General Council also signaled its backing 

of the implementation legislation, including the supplementary 

clause, on January 23. The 2009 budget proposal 

was presented to the Diet on January 19. 

Some LDP lawmakers continue to harbor concerns. 

‘‘The wording is still ambiguous. Prime Minister Aso 

has a responsibility to give a full account of the plan,’’ 

said Kenichi Mizuno, an LDP member of the House 

of Representatives (lower house), according to a January 

22 Kyodo News report. 

‘‘I find it acceptable if the government would 

specify the rate increase and the specific date in separate 

legislation,’’ added Ichita Yamamoto, an LDP 

member of the House of Councillors (upper house) 

who had previously opposed the clause. However, 

Yamamoto told reporters that ‘‘it is impossible to raise 

the consumption tax in fiscal 2011.’’ The Japanese fiscal 

year runs April 1 to March 30. 

Not surprisingly, the opposition DPJ was quick to 

condemn the consumption tax clause. At a January 23 

press conference in Tokyo, DPJ acting President Naoto 

Kan said the clause ‘‘has highlighted Prime Minister 

Aso’s flip-flop on another important issue.’’ Kan apparently 

was alluding to Aso’s indecision about whether 

high-income individuals should accept cash payments 

from Tokyo as part of the government’s overall stimulus 

plan. Aso initially suggested that high-income individuals 

should not accept any of the ¥2 trillion (about 

$22.5 billion) dispersal, but he reportedly changed his 

mind, later saying that everyone should use the money 

to stimulate the economy. 

LDP supporters defended Aso at various Tokyo 

press conferences on January 23. In one conference, 

Chief Cabinet Secretary Takeo Kawamura downplayed 

the possibility that LDP members will still oppose the 

bill when it comes up for vote in the Diet and denied 

that the wording indicates a retreat from Aso’s original 

position. ‘‘The policy presented remains the same,’’ he 

told reporters. 

Aso now hopes to build support among the Japanese 

public for an eventual consumption tax increase. 

He reportedly has assigned Akira Amati, state minister 

in charge of administrative reform, to draw up a plan 

that will address needed administrative reforms, spotlight 

wasteful spending, and suggest ways to make the 

public servant system more efficient. All of those steps 

are reflected in the supplementary clause as steps to be 

taken before resorting to a consumption tax increase. 

Aso’s approval rating has plummeted recently to 

below 20 percent, partly as a result of rising unemployment 

and falling wages. His decreasing popularity 

raises the threat of an LDP defeat in the general elections, 

which are to be held by September. 

Multinational 



IASB Rejects Proposal to Allow 

Discounting of Current Tax in IAS 12 

The International Accounting Standards Board 

January 23 voted against a proposal included in a ballot 

draft of an exposure document of amendments to 

International Accounting Standard No. 12, ‘‘Income 

Taxes,’’ that would broadly allow for the discounting of 

a company’s current tax assets and liabilities. 

At its board meeting in London, the IASB also decided 

to ‘‘stay silent’’ and not include any discussion 

on the discounting of current tax in the forthcoming 

exposure draft. The board members agreed there is no 

need to mention a specific requirement in IAS 12 because 

a company can use existing accounting literature 

during rare circumstances when a discount could apply 

because of a government agreement. 

IASB member James Leisenring objected to the ballot 

draft’s proposal, but noted that discounting of current 

tax can depend on circumstances, such as when 

there are taxes that are owed but for which a settlement 

can be reached with a revenue service. He added 

that he had no problem with a company discounting 

that tax amount. 

IASB member Robert Garnett added that in practice 

large accounting firms discount current taxes when 

there has been an agreement with a government that 

falls outside the normal tax code for deferred payment. 



He added that he doesn’t believe firms routinely discount 

current taxes across the board. 

Leisenring also said the proposal created a ‘‘fundamental 

difference’’ from U.S. generally accepted accounting 

principles during the ongoing convergence 

project with the U.S. Financial Accounting Standards 

Board. 

An agenda paper prepared for the meeting notes 

that FASB’s Financial Accounting Standard No. 109, 

‘‘Accounting for Income Taxes,’’ does not include a 

specific requirement or prohibition regarding the discounting 

of current tax. 

Leisenring took issue with the proposal’s also failing 

to note the differences between U.S. GAAP and what 

the IASB was considering. ‘‘It’s just so frustrating to 

work on convergence projects and have these lastminute 

180s come up, and it’s no wonder we don’t get 

things done,’’ he said. 

‘‘I do not think this is worth it during a project that 

is complicated enough,’’ Leisenring said. The IASB has 

said its current project to reduce the differences between 

IAS 12 and FAS 109 will lead to an exposure 

draft of an international financial reporting standard to 

replace IAS 12 by early 2009 and to a final standard in 

2010. 

Norway 

♦ Thomas Jaworski, Tax Analysts. 

E-mail: tjaworsk@tax.org 

Government Proposes Carryback Rule 

For Losses 

The Norwegian government on January 26 presented 

a NOK 20 billion (about $2.93 billion) ‘‘crisis 

package’’ that includes tax proposals that would allow 

companies to carry back losses in 2008 and 2009 and 

would expand the research and development credit. 

Norway has not been hit hard by the global financial 

crisis, but the government is concerned about rising 

unemployment levels. Unemployment is expected 

to reach 4 percent this year, a small number by international 

standards but high by Norwegian standards. 

Business and opposition politicians are disappointed 

that the package does not contain more tax reductions, 

but the government has concluded that most tax reduction 

proposals are expensive compared with the number 

of jobs they create. Therefore, most of the package’s 

money would go to municipalities, public works, 

and environmental investments. 

The most important tax proposal would grant companies 

a carryback for losses in 2008 and 2009. Under 

NORWAY 

the ordinary rules, such a carryback is granted only 

when the taxpayer’s business is terminated. Under the 

proposal, companies with profits in previous years, 

back to 2006, but losses in 2008 and/or 2009 would be 

granted the deduction earlier — perhaps much earlier 

— than under the ordinary carryforward rules, immediately 

increasing cash flow. However, the proposed 

rules would apply only to losses up to NOK 5 million 

for each of the income years 2008 and 2009. There is 

no rule regarding consolidated companies belonging to 

the same group, so presumably, one cap of NOK 5 

million would apply to each company of a group. The 

rules would also apply to a nonresident company doing 

business in Norway through a branch. 

To avoid complicated recalculations of taxable income 

and taxes for earlier years, the rule is technically 

framed as a cashing out in 2009 and/or 2010 of 28 

percent of the losses sustained in 2008 and/or 2009, to 

the extent that these losses do not exceed the taxable 

profits of 2006 to 2008. The 28 percent reflects the 

company tax rate for all the relevant years. As a consequence, 

the right to carry forward losses from 2006 to 

2008 is reduced by the same amount as the losses in 

2008 and 2009, the tax value of which has been cashed 

out. 

The revenue loss, and the corresponding cash flow 

for the companies, is estimated to amount to NOK 

3.25 billion in 2008 and a similar amount in 2009. 

However, because the rules imply that losses to be carried 

forward to later years are correspondingly reduced, 

future taxes would increase. 

The other tax proposal would raise the cap on the 

R&D tax credit. Currently, taxpayers can claim an income 

tax credit of 20 percent of costs for R&D (and 

have the difference cashed out if the credit exceeds the 

calculated taxes) if the project is accepted by the Norwegian 

Research Council. The cap would be raised 

from NOK 4 million to NOK 5.5 million for the company’s 

own research and from NOK 8 million to NOK 

11 million for a project carried out by a research institution. 

This proposal would reduce tax revenue, and 

increase the relevant companies’ cash flow, by NOK 

180 million in 2009. Unlike the loss carryback proposal, 

this proposal is not limited to 2009 and 2010. 

♦ Frederik Zimmer, Department of Public and 

International Law, University of Oslo 



OECD 

OECD 

OECD Group Addresses CIVs, 

Cross-Border Investors 

An informal consultative group (ICG) organized by 

the OECD has released two reports that address the 

application of treaty benefits to collective investment 

vehicles and cross-border investors 

Issued on January 12, the reports — ‘‘Granting of 

Treaty Benefits With Respect to the Income of Collective 

Investment Vehicles’’ (the CIV report) and ‘‘Possible 

Improvements to Procedures for Tax Relief for 

Cross-Border Investor’’ (the procedures report) — were 

commissioned by the OECD in December 2006 when 

the informal consultative group was established. 

The CIV report deals with conceptual and practical 

issues relating to income tax treaty benefits when investors 

in one country invest, through a fund organized in 

a second country, in investments in a third country. 

The procedures report deals more generally with the 

practical problems of making claims for treaty relief 

when investors hold investments through intermediary 

institutions, such as banks and brokerages, and are not 

the owners of record of the investments. 

Fund managers with cross-border investments or 

investors, banks, and brokerages should be aware of 

this development, since it might be a harbinger of future 

developments in international tax treaty practice. 

It must be emphasized that at this stage, the reports 

contain only the views of the ICG. The OECD’s Committee 

for Fiscal Affairs has not adopted the ICG’s 

conclusions as a statement of the OECD’s official 

views, although it may do so in the future. 

The CIV Report 

It is very common for an investment fund organized 

in one country (the fund country) owned by investors 

in a second country (the investor country) to invest in 

securities issued by residents of a third country (the 

source country). Most source countries impose withholding 

taxes on payments of interest, dividends, or 

both to foreign investors, and some (such as Canada, 

Spain, and Australia) impose tax on some capital gains 

realized by foreign investors. 

Thus, investors are often very interested in whether 

relief from source-country tax is available under an 

applicable income tax treaty. There may be a treaty 

between the source country and the fund country, a 

treaty between the source country and the investor 

country, or both. Unfortunately, even if the source 

country has tax treaties with both the fund country and 

the investor country, it is often very difficult for investments 

made by such a fund to qualify for benefits un- 

der either treaty. There are conceptual and practical 

reasons for this. (The practical reasons are discussed in 

the procedures report.) 

Source-Country/Fund-Country Treaty 

A fund typically will be able to claim treaty benefits 

in its own right under the source-country/fund-country 

treaty only if it is a resident of the treaty country. Article 

4(1) of the 2008 OECD model income tax treaty 

defines a resident of a treaty country as ‘‘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.’’ 

There are three common reasons why a source 

country might not treat a fund as a resident of the 

fund country for treaty purposes, thereby denying 

treaty benefits. 

First, the source country might not view the fund as 

a ‘‘person’’ for treaty purposes. Some types of vehicles 

commonly used for investment funds are treated as 

contractual relationships, and not legal entities, as a 

matter of domestic law. One very common example is 

the Luxembourg fond commun de placement (mutual 

fund). Also, funds organized as trusts create problems 

because the concept of a trust frequently does not exist 

under the laws of non-English-speaking countries. 

Second, a fund most likely is not subject to tax in 

the fund country at the full statutory rate. It might be 

exempt from tax or taxable at a special low rate, it 

might be fiscally transparent, or it might get a deduction 

for dividends paid (like U.S. mutual funds of the 

usual type). The source country might not view such a 

fund as subject to tax in the fund country. 

The view of the United States is that an entity is 

subject to tax in the fund country if the fund country 

has taxing jurisdiction over the entity, so under general 

principles of fund-country law, the entity could be subject 

to fund-country tax, even if the entity is subject to 

a special tax exemption. Other countries are not as lenient. 

Third, although limitation on benefits clauses historically 

were unique to U.S. income tax treaties, sometimes 

a source country will want some assurance that 

the fund is not being misused by investors resident in 

countries that do not have an income tax treaty with 

the source country. There are several situations in 

which a source country will not grant treaty relief to a 

fund without knowing something about who owns the 

fund. 

Source-Country/Investor-Country Treaty 

The problem with a claim by an investor for relief 

under the source-country/investor-country treaty is that 

the fund is in the middle. Treaties based on the OECD 

model provide relief to a beneficial owner of income. 

But the OECD model treaty does not purport to define 

what a beneficial owner is, and this issue is the subject 

of much debate. 



Internal Revenue Code section 894(c) and Treas. 

reg. section 1.894-1(d) deal with this issue in cases 

when the United States is the source country. An investor 

can claim benefits of the U.S./investor-country 

treaty on the investor’s share of the fund’s income if 

the fund is fiscally transparent in the investor country 

and the investor is not fiscally transparent in the investor 

country. The analysis in other countries can be different, 

or unclear. 

The CIV report is limited in scope to funds that are 

both widely held and subject to investor protection 

regulations, that is, are under the Investment Company 

Act of 1940 in the United States, or the UCITS Directive 

in the EU. It does not address the usual type of 

hedge fund or private equity fund. 

The report concludes that under existing treaties, a 

fund that does not have legal personality under domestic 

law, such as a fond commun de placement, most likely 

is not a person for treaty purposes and therefore cannot 

claim benefits under the source-country/fund-country 

treaty in its own right. On the other hand, a fund organized 

as a corporation or a trust should be regarded 

as a person for treaty purposes, the report says. 

It concludes that a fund that receives an exemption 

for specific types of income should be viewed as subject 

to tax for treaty purposes, as should a fund that 

receives a deduction for dividends paid (as is the case 

with U.S. mutual funds). But a fund that is fiscally 

transparent (treated like a partnership) in the fund 

country or is exempt from fund-country tax on all of 

its income should not be subject to tax in the fund 

country. 

The majority view in the report, though not without 

dissent, is that a fund that is a resident should be 

viewed as the beneficial owner of its income for treaty 

purposes. In any event, it is important that source 

countries clarify their views as to whether CIVs are 

entitled to benefits under current treaties. 

The ICG also considered situations under existing 

treaties in which a fund cannot claim benefits under 

the source-country/fund-country treaty in its own right. 

In those cases, the report concludes that in principle, 

investors should be able to claim treaty benefits on 

their share of the fund’s income under the sourcecountry/investor-country 

treaties. 

This approach — investor-level benefits under the 

source-country/investor-country treaties — was viewed 

as less desirable than fund-level benefits because of the 

difficulty of allocating the fund’s income among the 

investors in a widely held fund with investors coming 

and going daily. It was also recognized that many investors 

would not bother to file requests for relief under 

the source-country/investor-country treaties for 

small amounts of money. Thus, it was argued in these 

cases that the fund should be able to file claims for 

relief under the source-country/investor-country treaties 

on behalf of the investors. However, a minority of 

OECD 

the ICG did not believe that investors resident outside 

of the fund country should be able to claim treaty benefits 

under the applicable source-country/investorcountry 

treaty. This view would allow investor-level 

claims only to residents of the fund country. 

The CIV report suggests that future treaties should 

address the issues raised by CIVs directly, and contains 

draft language for revisions to the commentary to the 

OECD model income tax treaty. The preferred approach 

is that a fund should always be a treaty beneficiary 

in its own right, although perhaps with relief cut 

back proportionately to the extent that the investors are 

not themselves entitled to benefits under a sourcecountry/investor-country 

treaty with benefits comparable 

to the source-country/fund-country treaty. 

For example, if the fund was 80 percent owned by 

treaty-protected investors and 20 percent owned by 

non-treaty-protected investors, one might limit benefits 

under the source-country/fund-country treaty to 80 

percent of the fund’s income. (The issues regarding 

how such a fund is to ascertain who owns it are discussed 

in the procedures report.) 

The ICG felt that allowing funds to claim treaty 

benefits under the source-country/fund-country treaty 

for the future is preferable to allowing an investor to 

claim treaty benefits under the source-country/investorcountry 

treaty on the investor’s share of the fund’s income. 

But the latter alternative might be preferable if, 

for example, a substantial number of investors in the 

investor country are pension funds that are entitled to 

special treaty benefits not available to ordinary investors. 

This would allow pension funds to claim their 

special treaty rates on their share of the fund’s income, 

albeit at the cost of more complexity. 

The Procedures Report 

Under modern securities processing, interests in a 

fund or any widely held or publicly traded security 

might be owned through multiple levels of brokers, 

banks, and other financial intermediaries. For example, 

the investor of record might be a central securities depository 

such as the Depository Trust Company in the 

United States or Clearstream or Euroclear in Europe. 

The depository holds investments for the account of 

its participants, which typically are banks and brokerages. 

The banks and brokerages in turn hold investments 

on account of their customers, typically through 

omnibus accounts that combine securities held on behalf 

of multiple customers. 

This system exists for reasons that have nothing to 

do with tax. But as a result, the payers in the source 

country might have no idea who the ultimate owners 

of the income that they are paying are, and a fund 

might not know who owns it. Obtaining this information 

can be very difficult. This can be even more 

troublesome if some of the intermediaries are subject 

to bank secrecy rules. 



OECD 

Furthermore, a source country frequently will want 

some documentary proof that someone claiming treaty 

benefits is in fact entitled to them. Can the payers in 

the source country deal with a mountain of paperwork 

from all of the ultimate customers and investors, especially 

given that the fund or financial intermediary 

looks like one investor on the books of the sourcecountry 

payers? 

If some of the investors can benefit under an income 

tax treaty with the source country and others 

cannot, will the source country allow withholding on 

only a proportion of the payments? 

If relief at source is impossible, the investors might 

be able to request refunds from the source country. But 

what documentation will they need from the fund or 

financial intermediary that will be acceptable to the 

source country? 

Can the fund or financial intermediary generate the 

necessary documentation without undue burden? Will 

the investors bother to file claims for refunds of small 

amounts? 

These problems may not be too troublesome for 

funds with a small number of sophisticated investors, 

such as the pension pooling vehicles that are coming 

into use in Europe. But these issues are daunting for 

financial intermediaries with a large number of customers 

and for retail funds with a large number of 

small investors. 

The goal of the procedures report is to set forth best 

practices for how countries should handle claims for 

treaty relief when an investor that is entitled to treaty 

relief in its own right does not own the investment directly, 

but owns it through a CIV or through one or 

more levels of intermediaries. 

The ICG considered how to reduce costs and ensure 

that tax administrators’ rules were being followed. Its 

conclusions are as follows: 

• As much as possible, source countries should allow 

treaty relief at source, rather than requiring 

investors to file claims for refunds afterward. 

• Intermediaries that have been authorized by the 

source country should be allowed to make claims 

for treaty relief on behalf of their customers on a 

pooled basis, without having to provide detailed 

information on customers for each payment. 1 

• Authorized intermediaries should be required to 

pass along detailed information about customers 

that have claimed treaty benefits to the source 

country after the fact so that the source country 

can verify that the treaty claims are proper. The 

source country would share this information with 

1 This suggestion clearly bears a resemblance to the U.S. qualified 

intermediary system and the Irish qualifying intermediary 

system. 

the investor countries so that they can confirm 

that the income is being reported properly. 2 

• Countries that do not use unique taxpayer identification 

numbers should do so, to allow information 

to be properly matched. 3 

• Investors should be permitted to claim treaty benefits 

based on their own self-certification, rather 

than being required to obtain residence certificates, 

at least for small accounts. 4 

Implications 

As stated earlier, the conclusions of these reports 

have not been accepted by the OECD, and the OECD 

does not make tax laws. But the OECD’s recommendations 

have been very influential on the treaty policies 

of developed countries. Thus, if these reports are 

adopted by the OECD, international treaty practice 

might move in the direction outlined in the reports. 

The Committee for Fiscal Affairs now is considering 

the reports, and has invited public comments on them. 

Comments are due by March 6. 

♦ Matthew Blum, Ernst & Young LLP, Boston. 

The author appreciates the assistance of Alastair Campbell, 

a senior in Ernst & Young’s International Tax Services 

Group in Boston. 

2 

This is not like the U.S. qualified intermediary system because 

the U.S. system is designed to respect bank secrecy for 

non-U.S. investors. 

3 

Note that the United States does not require foreign persons 

claiming treaty benefits relating to publicly traded investments 

(and some other types of investments) to obtain U.S. taxpayer 

identification numbers. 

4 

As is the practice in the United States. 



Portugal 

Government Submits Budget 

Supplement 

The Portuguese government on January 19 submitted 

to the parliament a budget supplement proposal 

containing several tax measures, including a new investment 

tax credit for 2009, an expansion of the research 

and development tax credit, and the extension 

of the Portuguese holding regime to EU-incorporated 

entities moving their seat or place of effective management 

into Portugal. (For prior coverage of the recently 

passed 2009 Budget Law, see Tax Notes Int’l, Jan. 12, 

2009, p. 137, Doc 2009-232, or2009 WTD 4-1.) 

The supplementary budget bill, titled ‘‘Initiative for 

Employment and Investment,’’ is the government’s reaction 

to the worsening economic conditions in Portugal. 

If approved, the bill’s measures would be effective 

from January 1, 2009. 

New Investment Tax Credit 

The bill includes a new tax incentive designed to 

stimulate investment. The Regime Fiscal de Apoio ao 

Investimento (RFAI 2009) would provide several tax 

benefits for qualified investments made in some business 

sectors. 

The RFAI 2009 includes the following tax benefits: 

• an ITC that operates as a deduction against corporate 

income tax otherwise payable (up to a limit 

of 25 percent of the tax due) equal to 20 percent 

(for qualified investments lower than €5,000,000) 

or 10 percent (for qualified investments higher 

than €5,000,000) of the qualified investment; any 

unused credit may be carried forward for four 

years; and 

• an exemption on real estate transfer tax (IMT), 

property tax (IMI), and stamp tax on the acquisition 

of real estate for investment purposes; the 

real estate tax exemptions are subject to the approval 

of the municipality where the investment is 

made. 

The following investments are eligible for the tax 

incentive: 

• new tangible assets; however, the following new 

assets are excluded: land (except when used for 

resource extraction), buildings (except when used 

for factories or administrative offices), noncommercial 

vehicles, furniture (except when used for 

tourism purposes), social equipment (except if acquired 

under legal obligation), and other assets 

that are not directly connected with the activity 

developed; and 

• intangible assets that qualify as expenses with 

transfer of technology through the acquisition of 

patent rights, licenses, know-how, or unpatented 

technical knowledge; for large companies (that is, 

those not qualifying as small and medium-size 

enterprises under the EU definition), the investments 

in intangible fixed assets may not exceed 50 

percent of the qualified investment. 

Under the RFAI 2009, qualifying investments must 

be maintained for a five-year period subject to a recapture 

rule and the qualifying investment must be designed 

to promote the creation of employment during 

2009. 

The RFAI 2009 is limited to taxpayers engaged in 

the following business sectors: agriculture, forestry, 

agro industries, energy, tourism, and manufacturing or 

extraction industries (except steelwork industries, shipbuilding, 

and synthetic fibers as defined in article 2 of 

Commission Regulation 800/2008). The tax incentive 

is also extended to companies that realize investments 

in next-generation broadband equipment. The RFAI 

2009 is not applicable to companies that fall within the 

meaning of ‘‘company in difficulty’’ as defined by the 

EU guidelines on state aid for rescuing and restructuring 

firms in difficulty. 

This ITC may not be used concurrently with any 

other similar tax incentive, and the total tax incentive 

cannot exceed the maximum amount of aid for a given 

region as stipulated by the guidelines on national regional 

aid for 2007 to 2013. 1 

R&D Tax Incentive 

PORTUGAL 

The bill would also amend the Portuguese R&D 

investment tax credit. The Sistema de Incentivos 

Fiscais em Investigação e Desenvolvimento Empresarial 

(SIFIDE) would ultimately increase the amount 

of tax credit available for qualifying R&D investments. 

Under the proposal, credits against corporate tax liability 

would be available for qualifying R&D expenses up 

to the following amounts: 

• a basic credit equal to 32.5 percent of the qualifying 

expenses for the relevant year; and 

• an additional credit equal to 50 percent of the 

amount by which the qualifying expenses for the 

relevant year exceed the average R&D expenses 

incurred over the two preceding years, with a ceiling 

of €1.5 million. This deduction would only be 

applicable to costs that have not been subsidized 

by the state. Any unused credit would remain to 

be carried forward for six years. 

1 

Guidelines on national regional aid for 2007-2013 (2006/C 

54/08). 



PORTUGAL 

Extension of Portuguese Holding Regime 

The proposal would extend the tax regime applicable 

to Portuguese incorporated holding companies 

(Sociedade Gestora de Participações Sociais, or SGPS) 

to foreign EU-incorporated entities that move their 

statutory seat or place of effective management into 

Portugal. The objective of this amendment is twofold. 

First, the measure is designed to eliminate a potential 

incompatibility with EU law regarding the nonapplication 

of this beneficial regime to foreign EU holding 

companies effectively managed in Portugal. Second, 

the measure aims to stimulate investment and to create 

an incentive to transfer capital into the Portuguese territory. 

Under the proposal, the more favorable regime for 

participation exemption on dividends received and 

capital gains realized that is applicable to SGPSs 

would apply equally to companies incorporated under 

the law of another EU member state that have their 

statutory seat or place of effective management located 

within Portuguese territory and that have as their sole 

corporate purpose the management of participations in 

other companies provided the conditions established 

for SGPSs under the Portuguese legal framework are 

met. 2 

Under the current applicable legal framework, the 

activities defined as holding activities include only: 

mere holding of investments in which at least 70 percent 

of the total investments must be in companies in 

which the holding company owns directly or indirectly 

a minimum of 10 percent of the share capital with voting 

rights for more than one year 3 ; rendering of technical 

services and/or management services to companies 

in which the holding company holds directly or indirectly 

a qualified participation; and lending of funds 

and providing cash management to subsidiaries and 

other qualifying holdings (that is, minimum direct or 

indirect holding of 10 percent). Also, the holding company 

is restricted to acquiring or holding real estate 

unless the real estate is used for the premises of its 

head office or of its subsidiaries. 

2 

The legal framework of SGPSs is contained in Decree Law 

495/88 as amended by Decree Law 318/94, Decree Law 378/ 

98, and Law 109-B/2001. Article 32 of the Tax Benefits Statute 

incorporates the tax regime applicable to SGPSs. 

3 

The holding company may nonetheless invest in mere passive 

holdings (that is, less than 10 percent of the voting rights) if: 

the amount does not exceed 30 percent of the investments made 

in other holdings; the value of each passive holding is not less 

than €5 million; the purchase results from the target company’s 

merger or demerger; and the holding company has formalized a 

managerial subordination agreement with the target company, 

under which the management of the subordinated company’s 

business activities is entrusted to the holding company. 

Other Amendments 

The proposal would reduce the minimum amount of 

special advance corporate tax payments, which is essentially 

meant to function as a minimum tax, to 

€1,000. The amount of the advance corporate tax payment 

is basically equal to 1 percent of annual turnover 

capped with a limit of €70,000 and payable in two or 

three installments. 

When VAT return shows a credit balance, the excess 

input tax may be carried forward or a refund may be 

requested if the credit balance during a period of 12 

calendar months exceeded €250. The bill proposes a 

reduction to €3,000 (from the previous €11,250) of the 

minimum excess input VAT necessary to request a refund 

before the 12-month period elapses. 

The bill would allow the government to establish a 

reverse charge rule for VAT payers covering the supply 

of goods and services within public procurement contracts 

of a value equal to or greater than €5,000 when 

the acquirer of the goods or services is the Portuguese 

state or other public entities. 

The bill would extend the tax credit available 

against personal income tax for acquisition of personal 

computers and related equipment to cover expenses 

from the acquisition of next-generation broadband 

equipment. The tax credit would remain equal to 50 

percent of the acquisition costs of the taxpayer with a 

limit of €250. 

Russia 

♦ Paulo Núncio and Tiago Cassiano Neves, 

Garrigues, Lisbon 

Court Dismisses Claim for Back Taxes 

Against Ernst & Young 

The Moscow Arbitration Court on January 27 

quashed a RUB 390 million claim for back taxes 

against Ernst & Young’s Russian subsidiary, Ernst & 

Young Vneshaudit, according to a January 27 report by 

RIA Novosti, the state news agency. 

Further details on the court’s decision were not 

available. 

The company had challenged a December 29, 2007, 

decision of the Moscow Tax Inspectorate ordering it to 

pay RUB 390 million in profits taxes, VAT, and fines 

and penalties for 2004. The tax authorities accused the 

company of underreporting its 2004 profits of RUB 

10.5 million by RUB 630.3 million. 

Ernst & Young Vneshaudit had deducted that sum 

as expenses for consulting services performed by its 

parent company in Cyprus. The authorities said those 



expenses were unjustified and that the services were 

actually performed by the Russian office. 

In a similar case, Russia’s Higher Arbitration Court 

on January 20 quashed a RUB 260 million claim for 

back taxes against the Moscow branch of PricewaterhouseCoopers, 

according to media reports. The 

tax authorities had accused PwC of illegally deducting 

consulting service payments made to PwC’s Dutch 

branch, saying those services were actually performed 

by the Russian office. (For prior coverage, see Tax Notes 

Int’l, Apr. 21, 2008, p. 230, Doc 2008-8429, or2008 

WTD 75-1.) 

Spain 

♦ Kristen A. Parillo, Tax Analysts. 

E-mail: kparillo@tax.org 

Directors’ Remuneration Not 

Deductible, Supreme Court Says 

Spain’s Supreme Court recently issued two judgments 

denying corporate income tax deductions for the 

remuneration of directors of a public limited company 

(PLC). The November 13, 2008, judgments (2578/2004 

and 3991/2004), which were only recently made public, 

have caused quite a debate. 

The Tax Inspectorate had initiated two separate proceedings 

against a PLC, claiming that the directors’ 

remuneration it had included as a deductible expense 

did not qualify. 

After exhausting all appeal procedures, the company 

brought its case to the Supreme Court, which also concluded 

that the directors’ remuneration was nondeductible. 

The company’s bylaws described the directors’ 

remuneration as ‘‘a fixed amount that could be reviewed 

annually, in addition to a share of the company’s 

profits in line with the limits laid down by legislation.’’ 

In its interpretation of the current Public Limited 

Companies Act and of section 13(ñ) of the Corporate 

Income Tax Act 1978 (now abrogated), the Court concluded 

that for the remuneration of the directors of a 

PLC to be tax deductible, the company bylaws must 

specify the directors’ remuneration ‘‘with certainty.’’ 

The remuneration will be considered certain if it meets 

the following conditions: 

(a) the bylaws must specify a definite earnings 

system and not contemplate several systems from 

which the board of directors can choose; 

(b) for variable earnings based on profit sharing, 

the bylaws must establish a definite percentage, 

and not a maximum percentage; and 

SPAIN 

(c) for fixed earnings, the bylaws must establish a 

definite amount, or alternatively, must establish 

criteria to calculate the exact amount without 

leaving scope for discretion. 

The Court’s conclusions, which appear to diverge 

from the current corporate income tax regulation, 

could have significant practical repercussions. 

The finding on fixed remuneration in point (c) is 

particularly controversial because the bylaws of many 

companies define directors’ remuneration as a fixed 

amount to be established every year by the general 

shareholders meeting. 

Points (a) and (b), on the other hand, reflect existing 

common practice: The bylaws must specify the earnings 

system, and, in the case of variable earnings, they 

must specify a definite percentage of profit sharing. 

Under the previous regulation on corporate income 

tax (section 13(ñ) of the Corporate Income Tax Act 

1978) applicable to the fiscal years subject to the Supreme 

Court’s analysis, for an expense to qualify as tax 

deductible, it must be a mandatory expense and, therefore, 

necessary for the company to engage in its activity. 

The current regulation does not refer to those requirements. 

It states that an expense is considered tax 

deductible if the company enters it into its books and 

meets the conditions of the commercial regulation on 

directors’ remuneration. Thus, controversy may arise if 

the tax authorities rely on the Supreme Court’s judgments 

and not on the criteria of the Directorate General 

of Registries and Notarial Affairs (Dirección General 

de los Registros y del Notariado), concluding that 

companies that do not specify the remuneration 

amount in their bylaws are in breach of the commercial 

regulation. This would result in the remuneration 

of the directors not being tax deductible. 

This risk is limited to PLCs and does not extend to 

limited liability companies (the most common type of 

company in Spain). Under section 66.3 of the Limited 

Liability Companies Act, fixed remuneration ‘‘will be 

set every fiscal year by agreement of the shareholders 

general meeting.’’ The act itself thus prevents LLCs 

from establishing a definite amount in their bylaws, 

stating that the shareholders general meeting must set 

the amount annually. 

The Court’s judgments of November 2008 are especially 

relevant for listed PLCs. The Spanish tax authorities 

may consider that the remuneration those companies 

pay to their directors is nondeductible if their 

bylaws do not specify a definite remuneration amount, 

or alternatively, the criteria needed to calculate the exact 

amount without leaving scope for discretion. Therefore, 

it is important to pay close attention to how the 



SPAIN 

tax authorities interpret the judgments in the context of 

the current wording of the Corporate Income Tax Act. 

Sweden 

♦ Ana Martinez, senior tax associate, 

Cuatrecasas, Barcelona office, and 

Sonia Velasco, tax partner, 

Cuatrecasas, New York office 

Government Proposes to Defer 

Employee Tax Payments 

In the face of growing liquidity problems experienced 

by Swedish companies, the Swedish government 

on January 22 proposed allowing employers to defer 

paying employee taxes (arbetsgivaravgifter) for two 

months, according to a statement posted on the Swedish 

government’s website. 

Finance Minister Anders Borg and Enterprise Minister 

Maud Olofsson focused on corporate liquidity during 

a press conference in Stockholm, pointing out that 

current turmoil in global financial markets has made it 

increasingly difficult to arrange borrowing. Without the 

proposed tax deferral measure, they said, companies 

will soon find themselves short of cash needed to meet 

even minimal operating needs. 

The government has estimated that the proposal will 

cost about SEK 500 million (approximately $61 million). 

The employee tax deferral proposal follows a 1.7 

percentage point corporate tax rate cut, from 28 percent 

to 26.3 percent, that took effect on January 1. The 

government announced the corporate tax cut in September. 

(For prior coverage, see Tax Notes Int’l, Sept. 

22, 2008, p. 984, Doc 2008-19804, or2008 WTD 181-1.) 

The government is now referring the tax deferral 

plan to the Council on Legislation (Lagrådet), which 

will decide whether the proposal is legally valid. 



United States 

Drafters of Temporary Branch Regs 

Defend Rules’ Complexity 

Drafters of the recently issued section 954(d)(2) temporary 

branch rules on January 23 defended the complexity 

of the foreign base company sales income regulations 

issued a month earlier. (For the final and 

temporary contract manufacturing regulations (T.D. 

9438), see Doc 2008-27115 or 2008 WTD 249-34; for accompanying 

proposed regulations (REG-150066-08), 

see Doc 2008-27116 or 2008 WTD 249-35.) 

‘‘Complexity of business necessitates a complex 

rule,’’ Michael DiFronzo, IRS deputy associate chief 

counsel (international), said during a BNA Tax Management 

International Tax luncheon in Washington 

sponsored by Buchanan Ingersoll & Rooney. 

Itai Grinberg of Treasury’s Office of the International 

Tax Counsel said the most important evolution 

between proposed regulations (REG-124590-07) issued 

in February 2008 and the temporary regulations was 

the creation of a uniform rule on the location of 

manufacturing. (For REG-124590-07, see Doc 2008-4147 

or 2008 WTD 40-31.) He told the group that the drafters 

made the change in response to commenter recommendations 

that suggested that the rules should not treat 

CFCs satisfying the physical manufacturing test differently 

from CFCs that satisfy the substantial contribution 

test. (For prior coverage, see Tax Notes Int’l, Jan. 

26, 2009, p. 274, Doc 2009-756, or2009 WTD 9-1.) 

‘‘The temporary regulations are concerned with the 

deflection of income to jurisdictions that fail the tax 

rate disparity test, not with the mere dispersion of activities,’’ 

Grinberg said. 

Asked about the complexity of the branch rules, 

Grinberg explained that while developing the rules officials 

decided to work from the preexisting branch rules 

and to address more complicated fact patterns to arrive 

at the temporary regulations. 

Herman Bouma, a tax attorney with Buchanan 

Ingersoll & Rooney, questioned the rules’ complexity, 

arguing that they could achieve the same outcome by 

comparing a CFC’s effective foreign tax rate for sales 

income and its effective foreign tax rate for manufacturing 

income to determine if there is a tax rate disparity. 

‘‘We made a determination early on in the project 

not to open the tax rate disparity test question,’’ Di- 

Fronzo said. He also noted that current statutory provisions 

may prevent such a regulatory solution. 

During an earlier discussion of the final contract 

manufacturing rules, Jeffrey Mitchell, branch chief, IRS 



Office of Associate Chief Counsel (Income Tax and 

Accounting) discussed proposals that had been rejected 

in the course of developing the rules. He said the 

drafters considered and received comments on including 

a substantial contribution safe harbor, but decided 

not to adopt the safe harbor because of the ‘‘broad 

range of activities covered by the regulations’’ preventing 

the creation of an appropriate rule. 

Mitchell added that the IRS rejected including an 

antiabuse provision that would have precluded CFCs 

from meeting the substantial contribution test if a related 

person had significant involvement in the production 

process. 

‘‘We decided that the CFC’s contribution really 

should be evaluated on its own and we ultimately decided 

that even more than one person could make a 

substantial contribution,’’ Mitchell said. ‘‘If another 

party makes a contribution to the manufacturing process, 

it doesn’t preclude the CFC from having a substantial 

contribution.’’ 

♦ David D. Stewart, Tax Analysts. 

E-mail: dstewart@tax.org 

CORRECTION 

An article in the January 26, 2009, issue of Tax 

Notes International (‘‘U.S. Tax Returns for Foreign Nationals,’’ 

p. 337) contained an error. On p. 340, in the 

section titled ‘‘Disclosure Requirements,’’ references to 

Schedule A should be to Schedule B. 

Tax Analysts regrets the error. 

UNITED STATES 





U.K. Tax Update 

Buddy, Can You Spare a Dime? 

by Trevor Johnson 

Trevor Johnson, FTII, AITI, ATT, is a chartered tax adviser and a past president of the Association of 

Taxation Technicians. However, the views expressed are entirely his own. 

In the words of Private Frazer of the popular British 

sitcom Dad’s Army, ‘‘We’re all doooomed!’’ Socalled 

experts are queuing up to outdo each other with 

prophesies of gloom and despondency. The Bank of 

England base rate, which stood at 5 percent last September, 

is now at 1.5 percent. This is the lowest rate 

since the bank was formed in 1694, the year in which 

Sir Isaac Newton discovered gravity and about 80 years 

before the United States came into existence. 

The Bank’s Monetary Policy Committee meets 

again on February 5, when some commentators expect 

a further cut and predict that at some point this year it 

will end up at, or very close to, zero. These dramatic 

reductions conjure up an image of desperation; the 

bank is at the wheel of the British economy careering 

down the mountain toward the abyss, and is pumping 

the foot brake harder and harder because that’s all it 

can do. 

And yet as far as businesses are concerned, the base 

rate is meaningless as the banks are neither passing on 

the reductions to existing borrowers nor advancing new 

loans. Their point is that the London Interbank Offered 

Rate, the rate at which banks borrow in the London 

Interbank Market, is 2.7 percent for 12-month sterling. 

They also have become more defensive since the 

subprime fiasco and are trying to rebuild their capital 

and profitability, which is why they are incurring the 

wrath of the government and the public at large. We, 

the public, see the government giving our money to the 

banks so that they can lend it back to us — a crazy 

situation, but one that isn’t working as the money is 

sticking in the bank’s coffers. 

After handing out £37 billion to the banks, the government 

has introduced two sets of measures to increase 

the banks’ liquidity and get them lending again. 

These include: 

• Guaranteeing up to 50 percent of borrowings to 

businesses with turnovers below £500 million and 

taking as security some of the banks’ ‘‘toxic’’ investments 

and loans. 

• An extension of the Small Business Finance 

Scheme outlined in last autumn’s prebudget report, 

available to businesses with a turnover of up 

to £25 million. This scheme will guarantee 75 percent 

of loans of up to £1 million over 10 years. 

• The establishment of a fund to allow businesses 

to sell debt to the government in exchange for 

equity. In other words, they will swap some of 

their debt for a slice of their business. Companies 

with a turnover of up to £50 million will be able 

to gain equity of between £250,000 and £2 million. 

• Allowing banks to take up government insurance 

against their expected bad debts, but only up to 90 

percent of those loans. 

• The Bank of England buying high-quality assets 

from companies in all sectors in return for cash. 

• Restructuring last October’s bailout by allowing 

Northern Rock more time to repay its government 

loan and allowing Royal Bank of Scotland to issue 

ordinary shares to the government in exchange 

for the preference shares to reduce the 

dividend burden on the bank. 




We, the taxpayers, are now in a situation in which 

not only are we giving the banks money to lend to 

businesses, we are also going to relieve the banks of 

most of the risk of lending. I can’t help but ask why 

we now need the banks at all. The government could 

just cut out the middlemen and take over the banking 

sector, lock, stock, and barrel. 

Of course there is one sector that is immediately 

affected by the reduction in base rate — those with 

savings. The banks and building societies have taken 

the opportunity to reduce interest rates paid to investors, 

though some have not passed on the full reduction. 

Nevertheless, it was recently reported that some 

40 percent of savings accounts were paying less than 1 

percent and 26 percent were paying less than 0.5 percent. 

If rates on the majority of accounts get much 

lower, investors may well consider withdrawing all their 

savings and keeping them under the floorboards. At 

least there the money will not be at the mercy of the 

bank and they can derive pleasure from taking it out 

and counting it every once in a while. If we ever experience 

deflation, as the more pessimistic have 

claimed, the investors will find their savings’ purchasing 

power increased and there would be no tax to pay! 

As savings income is dropping, there is clearly going 

to be a drop in the income tax receipts on that income, 

which is why the Conservatives’ latest tax policy seems 

an empty gesture. The proposal was to exempt savings 

income from income tax for all but those who pay tax 

at the highest rate of 40 percent (currently those who 

have a total taxable income, after the deduction of allowances, 

of £36,000 and above). This, coupled with a 

large increase in the personal allowance for those over 

65, was stated to be to help the ‘‘innocent victims of 

the downturn.’’ All very laudable, but would it really 

be of any help at a time when there is little or no income 

to be exempted? The cynic in me thinks this is 

just posturing before an expected spring general election. 

The real practical help for these times has taken the 

form not of rate cuts, which are unlikely to stimulate 

the economy and in any event would have a delayed 

impact, but of allowing businesses to spread their tax 

payments over an agreed period. This was a measure 

announced in the prebudget report with the setting up 

of the HM Revenue & Customs’ Business Payment 

Support Service (BPSS). The objective at the time was 

to enable ‘‘businesses in temporary financial difficulty 



and unable to pay their tax bills to spread payment of 

their bills over a timetable they can afford.’’ All taxes 

paid by businesses are covered: corporation tax, income 

tax, value added tax on sales, income tax deducted 

from the wages and salaries of employees, and 

national insurance contributions. This is a nonstatutory 

measure and therefore will not feature in the forthcoming 

Finance Bill. It also means that if the Revenue do 

not agree to a postponement, there is no right of appeal. 

When it was first announced, some business proprietors 

thought that it meant they were free to pay their 

taxes when they wanted. Instead, it is a matter of negotiating 

with someone in the BPSS a planned program 

of payments for liabilities becoming due. It is not 

an option open to all — only trading companies, sole 

traders, and partnerships. The Revenue have set out 

three conditions: The business must be in genuine difficulty, 

unable to pay the tax on time, and likely to be 

able to pay if it was allowed more time. 

The real practical help for 

these times has taken the 

form not of rate cuts, but 

of allowing businesses to 

spread their tax payments 

over an agreed period. 

I have no experience of, nor have I heard of, any 

anecdotal evidence of how this facility is working. According 

to a January 14 press release, the Revenue state 

that over 20,000 businesses had been allowed to defer 

more than £350 million of taxes, which sounds impressive, 

but averages out at only £1,750 each. The press 

statement also claims that, in the majority of cases, it 

can take the Revenue as little as 10 minutes to reach a 

decision, although we are not told what that decision 

is. 

For sole traders and partners, any income tax that 

remains unpaid 28 days after the due date attracts a 5 

percent late payment surcharge and a further 5 percent 

if it is still unpaid six months later. If a deferment plan 

is agreed on, there is no surcharge imposed for late 

payment. However, there is, of course, a price to pay, 

and that is in the form of interest, currently 4.5 percent 

(in other words, 3 percentage points above base rate). 

When I had a real job and was running my own 

practice on overdraft, I was being charged 2.5 percentage 

points above my bank’s own base rate. This would 

currently mean a rate of 4 percent; so the rate charged 

by the Revenue is not too bad, at least at first sight. It 

is easy to overlook the fact that interest charged on late 


payment of tax is not itself tax deductible. Depending 

on the rate and type of tax being paid, it is an effective 

gross rate of between 5.62 percent to 7.5 percent. So a 

business with cash flow problems would be better using 

its existing overdraft facilities if possible. 

The problem is, of course, that many will probably 

be at the limits of their permitted borrowings, and 

therefore agreeing on a deferral plan with the Revenue 

may be the only way out. Certainly it is much more 

advisable than for the business proprietor to seek a personal 

unsecured loan, which can carry interest of at 

least 8 percent, which again would not be tax deductible 

(or, for that matter, to stick his head in the sand 

and hope the problem goes away). 

Although 200,000 businesses were said to have 

made use of this deferral option, I expect there will be 

many more applications in the next couple of weeks. 

Most companies in the U.K. tend to have a March 31 

or December 31 year-end, and as the corporation tax 

of small and medium-size companies is due nine 

months after the year-end, many will have had to pay 

the tax on October 1, 2008, for the year to March 31, 

2008, or on January 1, 2009, for the year to March 31, 

2008. Possibly the majority of the 200,000 businesses 

referred to in the Revenue’s press release are in that 

category. The next category to apply for deferment will 

be the sole traders and partnerships. Their tax liabilities 

are not as straightforward as companies. 

To begin with, they are charged tax for a tax year, 

not for the period for which they prepare their accounts. 

The amount charged for an ongoing business 

for the tax year 2007-2008, for example, will be the 

tax-adjusted profits of its accounting period ending in 

that tax year. As sole traders and partnerships are free 

to choose whatever accounting date they wish, those 

profits may have been earned as long ago as the year 

to April 30, 2007, in the days when the word 

‘‘subprime’’ had not entered into common parlance 

and most people thought Northern Rock was a popular 

dance. Income tax for 2007-2008 is payable by two 

amounts, each being half of the final liability for the 

tax year 2006-2007, due on January 31, 2008, and July 

31, 2008, and a final ‘‘catch-up’’ payment on January 

31, 2009, if the actual liability for the year turns out to 

be more than that for the previous year, as it should do 

if the business is growing. 

Although a prudent small-business proprietor who 

had made good profits in the year to April 30, 2007, 

will make sure he has the cash available to pay the tax 

when it comes due, life is not like that. Most business 

proprietors pay last year’s tax out of this year’s income. 

The problem is that there may not be any income 

this year. On January 31, 2009, the proprietor is 

therefore faced with having to pay a large tax bill on 

income earned in the year ended April 30, 2007, which 

has been spent when there’s nothing in the kitty this 

year to pay it. But that’s not all — on that same date 




he has to pay the first installment of his 2008-2009 liability, 

which is half of the large 2007-2008 liability 

based on his profits for the year to April 30, 2008, a 

year when we had heard of subprime and Northern 

Rock, but before the recession hit. Those profits may 

have been equally as high as the previous years, so a 

real problem exists. 

The reality is that instead of the business having to 

go to its bank to ask for a loan to pay the tax (which it 

probably will not get), the government is taking over 

the role of banker and lending the business the money 

instead. Once more, we have to ask, ‘‘Do we really 

need the banks?’’ ◆ 



The Global Tax Revolution: The Rise of Tax 

Competition and the Battle to Defend It 

The Global Tax Revolution: The Rise of Tax 

Competition and the Battle to Defend It 

by Chris Edwards and Daniel J. Mitchell 

Published by the Cato Institute: Washington 

(2008). 

255 pages 

Price: $21.95 

Reviewed by Gary Clyde Hufbauer, Reginald Jones 

senior fellow, Peterson Institute for International 

Economics. 

Simply because it’s published by Cato, this book 

might be dismissed by the tax engineers of the 

Obama administrations — people like Chief Economist 

Lawrence Summers, Treasury Secretary Timothy 

Geithner, House Ways and Means Committee Chair 

Charles B. Rangel, D-N.Y., and Senate Finance Committee 

Chair Max Baucus, D-Mont. That would be a 

mistake. 

In response to globalization, many countries have 

adopted simpler tax systems with lower rates, seeking 

to improve their competitive position in the world 

economy. By and large, these efforts have succeeded. 

Critics may deplore the outbreak of tax competition, 

but Chris Edwards and Daniel Mitchell come to celebrate 

the revolution, not reverse it. It’s hard to argue 

with success; yet three criticisms are often voiced: Tax 

competition undermines the ability of government to 

collect revenue; with the result that public goods and 

social programs are underfunded; and as collateral 

damage, progressivity is eroded because tax cuts favor 

capital income and highly paid personnel. 

Where others see vice, Edwards and Mitchell find 

virtue. Small government is their goal. America’s problem 

is not the starvation of public programs, it’s too 

much money thrown at social entitlements and bridges 

to nowhere. Progressive taxation loads the heaviest burdens 

on human and physical capital, and thereby 

cripples economic performance. 

Surveying reforms around the world, the authors 

conclude that tax competition spurs investment and 

promotes growth. Not only does tax competition unleash 

entrepreneurial energy at home, it also attracts 

foreign investment and skilled labor. The authors award 

special merit to countries that join the ‘‘flat tax club’’ 

— in its ideal form (who can forget the famous Hall- 

Rabushka postcard return?), a single low-rate tax 

across all forms of income. On this prescription, Edwards 

and Mitchell would especially like the Obama 

administration to take notice. A simple flat tax system 

is the path the United States must follow, in their view, 

to meet rising competition from the likes of Brazil, 

Russia, India, China, and Korea — the BRICKs. As 

the first step, the authors recommend sharp cuts in 

both individual and corporate tax rates: slashing individual 

tax rates to a range between 15 percent and 25 

percent, and corporate tax rates to 15 percent. 

The rationale behind a ‘‘starve the beast’’ strategy 

for reaching smaller and more efficient government is 

straightforward: Reduced revenues will restrain public 

spending and eventually force government to curtail 

excessive promises. On this proposition, I must note 

two ironies. First, in recent years, an absence of revenue 

has persuaded neither Italy nor the United States 

to curb expenditure, despite the ‘‘conservative’’ leadership 

of Berlusconi and Bush. Second, as the authors 

recognize, tax competition has yet to reduce public revenues 

as a share of GDP. Laffer-curve effects — base 

broadening and less tax avoidance — are sufficiently 

strong that tax revenues typically remain stable or even 

rise in the wake of rate cuts. 

Recent experience not only contradicts critics who 

fear a race to the bottom in terms of public expenditure, 

but also disappoints advocates who devoutly urge 



BOOK REVIEW 

smaller government. But the authors are more optimistic 

than the critics: They keep their fingers crossed that 

future installments of tax competition will eventually 

‘‘starve the beast.’’ Count me a skeptic. Given demographic 

aging in all OECD countries and sharp income 

inequalities among the elderly, it seems doubtful that 

tax competition will curtail entitlement spending. Indeed, 

entitlement spending could easily double over the 

next generation, with medical care accounting for most 

of the expansion. In the contest between tax cuts and 

grandmother’s heart surgery, guess who wins. 

For me, the compelling argument for tax competition 

is that it serves to align fiscal charges with public 

benefits — just as that hero of public finance, Charles 

Tiebout, described a half century ago. Tiebout, of 

course, was talking about local governments. But in the 

face of rising tax competition, many national governments 

have not only reformed their tax systems but 

also have enhanced the business environment by improving 

transportation, power grids, telecommunications, 

schools, hospitals, and museums. 

Given the virtues of tax competition, Edwards and 

Mitchell condemn attempts to harmonize national tax 

systems, led by the OECD and the European Union. 

In fact, the anti-tax-competition crowd has gradually 

lost its voice in recent debates. However, it seems 

wrong to dismiss wholesale the arguments advanced 

for tax harmonization. 

One subject where I agree with the tax harmonization 

school is the need to share information on investments 

by nonresidents between the host country and 

the home country. In the Cato view, the creation of 

efficient reporting networks will suppress tax competition. 

That’s true, if the term ‘‘tax competition’’ is 

stretched to encompass means of furthering tax evasion. 

But my belief is that the country of citizenship or 

residence of natural persons has the right to tax their 

worldwide income if it chooses; accordingly, capital 

income earned abroad should be reported by the host 

country as a matter of comity between nations. 

This issue is closely related to an important but often 

overlooked question: Do the virtues of tax competition 

apply with equal force to personal income taxation 

as to corporate income taxation? That’s where Tiebout 

entered the debate, with the metaphor of disaffected 

citizens ‘‘voting with their feet.’’ But citizens cannot 

change nationality as easily as residence; and in some 

countries, the rights and privileges associated with citizenship 

are extremely valuable. Against this factual 

background, I think it’s an open question whether unfettered 

tax competition is appropriate in the realm of 

personal taxation. 

Edwards and Mitchell have written a most entertaining 

book — not an easy feat when the subject is taxation. 

Casual readers will enjoy stories about celebrities 

— Ringo Starr of Beatles fame, Irish rock band U2, 

Swedish pop group ABBA, and others — who have 

channeled their wealth and royalties to tax haven jurisdictions. 

Policy wonks will appreciate the comprehensive 

surveys of tax reform. There’s something for 

everyone — even the Obama team and its congressional 

allies. ◆ 



New Rules for Valuing Intangible Assets in Spain 

by Sonia Velasco and Ana Colldefors 

Sonia Velasco is a partner with Cuatrecasas in New York, and Ana Colldefors is an associate with Cuatrecasas 

in Barcelona. 

The tax treatment of some intangible assets in 

Spain has been modified and presents substantial 

advantages. (See Tax Notes Int’l, Feb. 18, 2008, p. 597, 

Doc 2008-2042, or2008 WTD 35-11.) 

Under Act 16/2007 of July 4, 2007, Spain grants a 

50 percent corporate tax credit for income derived from 

the rights to use and exploit patents and other intangible 

assets. 

On February 13, 2008, the European Commission 

announced that this Spanish corporate tax credit designed 

to promote research and development is compatible 

with EU rules on state aid, as the tax credit 

applies to all companies, regardless of their size or sector. 

In relation to the application of this 50 percent tax 

credit, the Spanish tax authorities issued a binding tax 

ruling (V1299-08) on June 19, 2008, to clarify which 

expenses must be taken into account when determining 

the value of intangible assets. The value of intangible 

assets is relevant because this tax credit may only be 

applied until the tax period following the year in which 

the value of the income was more than six times 

greater than the cost of the intangible assets. The intangible 

assets must be created by the entity applying 

the exemption or by a group company in a tax group. 

As a general rule, the value of an asset for tax purposes 

is its book value with modifications mentioned in 

the Spanish Corporate Tax Act. The expenses incurred 

in the development of an intangible asset constitute its 

book value. The year’s expenses can only be registered 

as the asset’s book value if the expenses are clearly 

individualized and allocated to one particular project 

or intangible asset, and there are sufficient reasons to 

believe in the technical and economic success of the 

intangible asset. Therefore, only some expenses incurred 

in creating an intangible asset can be registered 

as an increase in the value of the intangible asset being 

developed. 

With this ruling, the Spanish tax authorities took a 

taxpayer-friendly position because they considered that 

the cost basis for tax purposes of the intangible asset, 

in particular when calculating the limit on the 50 percent 

tax credit, should take into account the intangible 

asset’s book value (following the rules above) but also 

expenses incurred that may not be registered as an increase 

of the book value of the assets (for example, 

R&D expenses of the year). 

The Spanish tax authorities’ interpretation reduces 

substantially the effect of the limit to six times the 

value of the intangible asset, given that this value can 

sometimes be much higher than the intangible asset’s 

book value. This makes the tax regime for patents and 

other intangible assets, in effect in Spain since January 

2008, more attractive. ◆ 





Deduction of School Fees Under German Law 

by Marko Wohlfahrt and Katrin Köhler 

Marko Wohlfahrt is a consultant and Katrin Köhler is a senior manager with Deloitte Touche Tohmatsu in 

Düsseldorf. 

Copyright © 2009 Deloitte Touche Tohmatsu. All rights reserved. 

German tax law allows a tax deduction for school 

fees paid during the German tax year (the calendar 

year) for some accredited private German schools. 

Fees paid to foreign private schools, however, generally 

cannot be deducted from the German income tax base. 

This limit on the deductibility of school fees has given 

rise to issues as to whether the rules are compatible 

with EC law, specifically the freedom to provide services 

in another EU member state. 

German Domestic Law 

According to article 10 of the German Income Tax 

Code (Einkommensteuergesetz, or EStG), 30 percent of 

fees paid for private German schools can be treated as 

special expenses on a taxpayer’s German income tax 

return if the following requirements are met: 

1) the taxpayer is entitled to receive German 

child benefit payments or the child allowance for 

the child attending the private school; 

2) the expenses relate to education costs (that is, 

expenses for accommodation, meals, and general 

mentoring are excluded); and 

3) the school is recognized as an approved substitute 

or supplementary school to the German public 

school system. 

In late 2004 the Federal Finance Court (Bundesfinanzhof) 

decided that some private German and European 

schools also are within the scope of requirement 

3 above, even if the schools are located outside of 

Germany but are within the European Economic Area. 

Fees for other private schools are not considered deductible 

as special expenses, even though the schools 

are located in Germany. 

The Case 

The case involved German resident spouses who 

were jointly assessed German income tax and whose 

children attended a private school in Scotland in the 

years at issue, 1998 and 1999. The German tax authorities 

denied a deduction for the school fees paid to 

the Scottish private school as special expenses for income 

tax purposes. 

The case was appealed to the local Finance Court of 

Cologne (Finanzgericht Köln), which in 2005 had to 

decide whether fees paid by German tax residents to a 

private non-German school in Scotland could be considered 

special expenses. The court had concerns about 

the compatibility of the German legal position with the 

freedom of services provision of the EC Treaty, because 

restricting the deduction for school fees to German 

schools could discriminate against foreign individuals 

who move to work in Germany but whose 

children attend schools in their home countries, as well 

as German individuals who move to work abroad (but 

remain subject to worldwide German tax liability) and 

whose children attend schools abroad. Therefore, the 

Finance Court of Cologne referred the issue to the European 

Court of Justice. 

The ECJ issued its decision on September 11, 2007, 

concluding that while German law allows the deduction 

for some accredited schools within Germany and 



PRACTITIONERS’ CORNER 

for German schools within the EEA, the practice of 

the German tax authorities disallowing a tax deduction 

for school fees for private schools located outside Germany 

but within the EEA is not compatible with EC 

law, in particular with the freedom of services and freedom 

of movement principles in articles 49 and 18 of 

the EC Treaty (Schwarz/Gootjes-Schwarz (Case C-76/ 

05)). 

The ECJ concluded that the German rule constitutes 

an obstacle to the freedom to provide services 

because it dissuades German residents from sending 

their children to private schools established in another 

member state and impedes private schools established 

in other member states from offering education to the 

children of German residents. The German rule generally 

results in a higher tax burden for taxpayers who 

sent their children to a private school located in another 

EU member state because the school fees would 

not be deductible. Finally, the ECJ ruled that the German 

provision violates the free movement of citizens 

because it places the taxpayers who have children attending 

schools in another member state at an unjustifiable 

disadvantage compared with persons who have 

not exercised that right. 

Consequences of the ECJ Decision 

Based on the ECJ decision, the Finance Court of 

Cologne ruled on February 14, 2008, that the fees paid 

by the taxpayers to the school in Scotland had to be 

treated as special expenses on the taxpayer’s German 

income tax return. However, the fiscal court granted 

leave to the German tax authorities to appeal to the 

German Federal Finance Court to obtain further clarification 

on the impact on domestic tax law if EU law 

is violated (for example, because of proof required by 

the tax authorities related to requirement 3 above). The 

tax authorities filed an appeal in April 2008, and the 

outcome is still pending. 

Following the ECJ’s decision, the German tax authorities 

generally intend to consider fees paid to 

schools within the EU/EEA as special expenses for 

German income tax purposes. The tax authorities require, 

however, that the foreign school leads to a 

graduation approved by the Conference of Cultural 

Ministers of the German Federal States or the Ministry 

of Culture of a German federal state. Also, the German 

tax resident claiming the tax deduction must provide 

the tax authorities with confirmation from the foreign 

school that access to the school is not limited to 

students who can afford to pay the school fees (that is, 

for purposes of meeting requirement 3 above), but that 

students with limited financial funds also can attend 

the school (for example, through scholarships). 

Should the school fees not be taken into account in 

a German income tax assessment notice (for example, 

the taxpayer could not provide the requested proof because 

the school had not forwarded necessary documents), 

the taxpayer should file an objection and request 

a postponement of the final assessment until the 

Federal Finance Court issues its decision in the case. 

2009 Tax Act 

The lower house of the German Parliament (Bundestag) 

on November 28, 2008, approved the 2009 annual 

Tax Act (Jahressteuergesetz 2009), and the upper house 

(Bundesrat) approved it on December 19, 2008. The 

Tax Act provides that school fees for private non- 

German schools in the EU/EEA whose graduation is 

approved by the German authorities will be treated as 

special expenses. While the act maintains the 30 percent 

deduction level for school fees, the deduction will 

be capped at €5,000. The new rule is retroactive from 

January 1, 2008, and for all prior-year cases for which 

a relevant income tax assessment notice has not become 

final. ◆ 



Different Methods of Attributing Profits to Agency 

PEs 

by Carlos Eduardo Costa M.A. Toro 

Carlos Eduardo Costa M.A. Toro is a partner with Zilveti e Sanden Advogados in São Paulo. 

This article is based on the advanced LL.M. paper the author submitted in fulfillment of the requirements 

of the advanced LL.M. in international tax law at the International Tax Center Leiden (Leiden University). 

I. Introduction 

It has been said that article 7 is the heart of the 

OECD model convention. 1 Indeed, article 7 of the 

OECD model2 deals with the most important category 

of income — business profits, which comprise most of 

the income that arises in international transactions. 3 It 

therefore covers a wide extent of activities carried out 

by an enterprise, either by forbidding the host state to 

tax when the permanent establishment threshold is not 

met or by allowing taxation when such requirement is 

fulfilled. 

Its acknowledged importance aside, article 7 still 

presents some debatable issues regarding its interpretation, 

such as the attribution of profits to agency PEs. 

This issue becomes even more controversial when the 

PE is a separate enterprise associated with its principal, 

in most cases a subsidiary constituting a PE of its foreign 

parent company. In this context, despite being one 

of the most important concepts of international taxation 

and being extensively dealt with in the OECD 

model convention and its commentary, PE characterization 

is still a controversial issue around the world, 

1 

Alberto Xavier, Direito Tributário Internacional do Brasil, 6th ed. 

(Rio de Janeiro: Forense, 2004), p. 695. 

2 

Unless otherwise indicated, all references are to the 2005 

OECD model convention. 

3 

Klaus Vogel, Klaus Vogel on Double Taxation Conventions, 3rd 

ed. (London: Kluwer Law International, 1997), p. 399. 

since it involves a factual analysis that can only be 

made on a case-by-case basis. 4 

As pointed out by the OECD in the introduction to 

its model convention, member countries have long recognized 

the need to ‘‘clarify, standardize, and confirm 

the fiscal situation of taxpayers who are engaged in 

economic activities in other countries through the application 

by all countries of common solutions to identical 

cases of double taxation.’’ 5 However, this aim of 

the OECD is not always met in practice, as the interpretation 

of relevant provisions of the OECD model 

convention often diverges between states. The OECD 

itself recognizes that the practices of the countries 

around the world regarding the attribution of profits to 

PEs and the interpretation of article 7 differ significantly. 

6 

The OECD’s findings were confirmed by a study 

carried out by the International Fiscal Association on 

the occasion of its 60th Congress held in Amsterdam 

in 2006. The general report of this congress indicated a 

wide divergence among the branch reporters regarding 

the interpretation of article 7. According to the general 

report, the only point on which most of the branch 

4 Massimiliano Gazzo, ‘‘Permanent Establishment Through 

Related Corporations: New Case Law in Italy and Its Impact on 

Multinational Flows,’’ Bulletin (June 2003), pp. 257-264. 

5 Para. 2 of the introduction to the 2005 OECD model. 

6 Para. 1 of the update of the status of the OECD project on 

the attribution of profits to PEs (2006), available at http:// 

www.oecd.org/dataoecd/55/14/37861293.pdf. 




reports were of the same view is that there is little or 

no guidance from the tax authorities on the issue of 

attribution of profits to PEs. Moreover, most jurisdictions 

have little, if any, case law on this issue. 7 

The existence of different interpretations on the 

scope of article 7 is therefore against the purpose of a 

tax convention for the avoidance of double taxation, 

giving rise to harmful consequences on the exchange of 

goods and services between states. The lack of consistency 

in applying a treaty provision is a major contradiction 

to the purpose of that treaty in providing a harmonized 

sharing of taxing rights between the 

contracting states. 8 

In this context, this article discusses the application 

of the provisions of article 7 of the OECD model convention 

regarding the situation when an agency PE is 

found to exist, especially in the case when a subsidiary 

constitutes an agency PE of its foreign parent company. 

In other words, it is intended to analyze through 

the existing case law the main features of this particular 

type of PE. 

Furthermore, the different approaches to attribute 

profits to agency PEs will be addressed, namely the 

functionally separate entity approach, also known as 

the authorized OECD approach or dual taxpayer approach; 

and the single taxpayer approach, also referred 

to as the zero-sum approach. It is intended to provide 

an answer to the question of whether there may be a 

profit attributable to an agency PE in excess of the 

arm’s-length remuneration paid to the dependent agent. 

Phrased differently, the issue at stake is whether it is 

possible to attribute a separate profit to an agency PE 

once the agent had an arm’s-length reward for the service 

provided for the nonresident enterprise. This is a 

very controversial issue, as there is much disagreement 

in the international tax community with the OECD 

preferred approach. 

It is a very sensitive issue in practice as it directly 

affects the supply chain management of multinational 

enterprises, when the characterization of an agency PE 

may have a significant impact on the overall costs. 9 

Through their supply chain management, multinational 

enterprises will often seek to structure their activities in 

a foreign country in a manner that either avoids the 

7 

Philip Baker and Richard S. Collier, General Report, ‘‘The 

Attribution of Profits to Permanent Establishments,’’ Cahiers de 

Droit Fiscal International, Vol. 91b, Subject II (Amersfoort: Sdu 

Fiscale & Financiële Uitgevers, 2006), pp. 34-35. 

8 

In some situations, the existence of different interpretations 

may derive from the domestic legislation of a particular state, 

giving rise to the issue of treaty override. 

9 

Hans Pijl, ‘‘The Zero-Sum Game, the Emperor’s Beard and 

the Authorized OECD Approach,’’ Eur. Tax’n (Jan. 2006), pp. 

29-35. 

characterization of an agency PE 10 or provides for the 

most advantageous allocation of functions, assets, and 

risks. Generally, multinational enterprises will seek to 

allocate functions, assets, and risks in a low-tax jurisdiction 

to achieve a lower worldwide effective tax rate. 

In this context, the lack of clear guidance on the appropriate 

atribution of profits to agency PEs is a significant 

obstacle to the structuring of an optimal supply 

chain from a multinational enterprise’s perspective. 

Indeed, it is widely recognized that in the field of 

taxation the lack of certainty is harmful to both taxpayers 

and states as it may hinder cross-border trade. 11 

The importance of this subject can also be deduced 

from the decision of the International Fiscal Association 

to dedicate a plenary session to the attribution of 

profits to PEs at its 60th Congress. Among the issues 

discussed in the plenary session was the attribution of 

profits to agency PEs when there is a supplementary 

profit attributable to such PE in addition to the arm’slength 

reward paid to the agent. The lack of consensus 

among the panel members indicates the extent of the 

controversy on this issue. 

Therefore, it is hoped that the analysis of the relevant 

case law, especially Morgan Stanley and SET Satellite, 

and the opinions of prominent tax scholars might 

point towards a predominant direction on the interpretation 

of the issue at stake that could avoid the uncertainty 

on the tax consequences of setting up a business 

involving an agency PE. 

II. The Agency PE 

The main rule of article 7 of the OECD model tax 

convention basically states that the profits of an enterprise 

must only be taxed in its state of residence (home 

state) unless the enterprise carries on business in the 

other contracting state through a PE situated therein 

(host state). In this latter case, the profits of the enterprise 

may be taxed in the other state, but only so much 

of them as are attributable to that PE. 

It derives from the wording of the provisions of article 

7 that the existence of a PE is the decisive factor 

for the allocation of taxing rights regarding the business 

profits of an enterprise. As stated by Brian J. Arnold, 

the PE requirement ‘‘is a minimum threshold 

10 

Avoiding the characterization of a PE is not only a matter 

of achieving a lower worldwide effective tax rate, but also avoiding 

a high burden of compliance costs. 

11 

As early as 1776, Adam Smith outlined certainty as one of 

the four principles of an ideal tax system, along with equity, convenience, 

and economy. Adam Smith, An Inquiry Into the Nature 

and Causes of the Wealth of Nations (London: Methuen and Co., 

Ltd., ed. Edwin Cannan, 1904), available at http:// 

www.econlib.org/library/Smith/smWN21.html. 



that must be satisfied before a country can tax residents 

of other treaty countries on their profits derived 

from the other country.’’ 12 

At this stage, it is worthwhile to remember what 

Kees van Raad cited as one of the fundamental rules 

in applying tax treaties, that ‘‘tax treaties restrict the 

application of internal tax law.’’ 13 Stated differently, a 

tax treaty might restrict taxation, but not impose a tax 

that does not otherwise exist under domestic law. The 

main purpose of tax treaties is to establish a mechanism 

to avoid double taxation by restricting tax claims 

in areas where overlapping tax claims are expected to 

occur. 14 

In this sense, the PE threshold must be met to allow 

the host state to tax the items of income arising within 

its territory, if its domestic law so provides. Broadly 

speaking, the rationale behind the PE provision is that 

as the enterprise is deriving profits in the host state by 

having a presence thereof, that is, by being economically 

connected with that state and using its infrastructure, 

the host state should be entitled to tax such 

profits. 

The characterization of a PE is governed by article 

5, provided that the relevant states concluded an 

OECD-patterned treaty. For the present analysis, what 

is relevant is the characterization of an agency PE, 

which is governed by the provisions of article 5, paragraph 

5 of the OECD model tax convention. 

The first use of article 5, paragraph 5 in a model 

dates back to the 1935 League of Nations draft. 15 The 

underlying principle of this provision is that a person 

acting on behalf of the enterprise in the host state 

leads to a taxable presence thereof, that is, a PE, even 

though the enterprise may not have a fixed place of 

business in that state in the sense of paragraphs 1 and 

2 of article 5. 16 This particular feature of the agency 

PE — irrelevance of a fixed place of business — illustrates 

the difficulty in characterizing such a PE in practice, 

as opposed to the physical PE set forth in article 

5, paragraphs 1 and 2. While the characterization of 

the latter type is rather obvious, tax authorities face a 

more difficult task in identifying agency PEs because of 

12 

Brian J. Arnold, ‘‘Threshold Requirements for Taxing Business 

Profits Under Tax Treaties,’’ Bulletin — Tax Treaty Monitor 

(Oct. 2003), pp. 476-492. 

13 

Kees van Raad, ‘‘Five Fundamental Rules in Applying Tax 

Treaties,’’ Liber Amicorum Luc Hinnekens (Bruxelles: Bruylant, 

2002), pp. 587-597. 

14 

Vogel, supra note 3, at 27. 

15 John F. Avery Jones et al., ‘‘The Origins of Concepts and 

Expressions Used in the OECD Model and Their Adoption by 

States,’’ Bulletin — Tax Treaty Monitor (June 2006), p. 237. 

16 Vogel, supra note 3, at 329. 

the need to focus on the activities of the enterprise as 

carried out by the dependent agent. 17 

Under article 5, paragraph 5 of the OECD model 

tax convention, an agency PE is found to exist when 

the following characteristics are met: (i) a person (individual 

or company) is acting on behalf of the enterprise, 

(ii) other than an agent of independent status, 

(iii) with authority to conclude contracts, (iv) in the 

name of the enterprise, (v) on a regular basis. In the 

OECD language, as long as these requirements are 

met, the agency PE is characterized a dependent agent 

(DA) and a dependent agent PE (DAPE). There are 

countless debatable questions in connection with each 

of these requirements, all of which, however, fall outside 

the scope of this article. 18 For the purposes of this 

article, it is assumed that every time an agency PE is 

mentioned, the requirements at stake were met. 

In this context, though this is not the core issue of 

this article, the scope of article 5, paragraphs 5 and 6 

of the OECD model convention is quite disputable 

among scholars, especially when it comes to the difference 

between common-law and civil-law practitioners. 

From a common-law perspective, it is often argued that 

article 5, paragraphs 5 and 6 cover only agents concluding 

contracts binding on their principal. 19 However, 

a different view based on civil law is that article 5(5) of 

the OECD model convention refers to direct representatives, 

while article 5(6) relates to indirect representatives. 

20 These diverse views reflect the essential difference 

between common and civil law: 

When an agent makes a contract in his own 

name, but on behalf of an undisclosed principal, 

as a general rule under common law, the principal 

is bound by the contract, whereas under civil 

law, again as a general rule, only the agent, and 

not the principal, is bound by such a contract. 21 

This difference between common and civil law is 

often viewed as a tax planning opportunity. Multinational 

enterprises will take into account all the abovementioned 

factors that characterize an agency PE 

when setting up a business abroad. Under their supply 

chain management and international tax planning strategy, 

multinational enterprises will often seek to structure 

their activities in a foreign country in a manner 

17 Arnold, supra note 12, at 479. 

18 For reference to the controversial issues involving the 

agency PE notion, see Giuseppe Persico, ‘‘Agency Permanent 

Establishment Under Article 5 of the OECD Model Convention,’’ 

Intertax, Vol. 28, No. 2 (2000), pp. 66-82. 

19 John F. Avery Jones and David A. Ward, ‘‘Agents as Permanent 

Establishments Under the OECD Model Tax Convention,’’ 

Eur. Tax’n (May 1993), pp. 154-181. 

20 Sidney I. Roberts, ‘‘The Agency Element of Permanent Establishment: 

The OECD Commentaries From the Civil Law 

View,’’ Eur. Tax’n (Mar. 2008), pp. 107-113. 

21 Avery Jones and Ward, supra note 19, at 156. 





that either avoids the characterization of an agency 

PE 22 or provides for an optimal allocation of functions, 

assets, and risks to shift income to a low-tax jurisdiction. 

Taking into account a particular company willing to 

distribute its goods in a foreign country, there are basically 

two distribution models that may be adopted to 

accomplish this goal: (i) the buy-sell model, involving a 

local distributor that may be related to the company, 

and (ii) the agency model. Both models have their variances, 

triggering different tax consequences, and often 

multinational enterprises play around with the features 

of each model to shift income to a low-tax jurisdiction 

(for example, by using a limited risk distribution 

model, under which part of the risk is shifted from the 

distributor to the principal, so the former is entitled to 

a lower profit). Essentially, the allocation of functions, 

assets, and risks will determine the arm’s-length remuneration 

of a distributor in a buy-sell model. However, 

one of the main tax consequences of the agency model 

is the possibility of the constitution of an agency PE in 

the host state once the requirements of article 5, paragraph 

5 of the OECD model tax convention are met. 

Because of the extensive use of the OECD model 

convention and its commentary and the development 

of case law and doctrine, it can be said that nowadays 

the characterization of an agency PE is not as complicated 

as it was in the past, although it still requires a 

case-by-case analysis. Nonetheless, an open question, 

both to tax authorities and taxpayers, is how much 

profits must be attributed to that PE. 

III. Subsidiary Constituting an Agency PE 

Before addressing the core issue of the different approaches 

to attribute profits to agency PEs, attention 

should be given to the particular phenomenon of a 

subsidiary constituting an agency PE of its foreign parent 

company, as this might lead to different consequences 

regarding the attribution of profits to that PE. 

The provisions of article 5, paragraph 7 of the 

OECD model tax convention set forth that: 

the fact that a company which is a resident of a 

contracting state controls or is controlled by a 

company which is a resident of the other contracting 

state, or which carries on business in that 

other state (whether through a PE or otherwise), 

shall not of itself constitute either company a PE 

of the other. 

This ‘‘anti-single-entity’’ clause makes clear that a 

subsidiary should not be considered a PE of its parent 

company for the mere fact of their corporate relationship 

(that is, that they belong to the same group of 

companies). 

22 Arnold, supra note 12, at 483. 

The commentaries on article 5, paragraph 7 of the 

OECD model tax convention reaffirm this rule and 

stress that the fact that the trade or business carried on 

by the subsidiary company is managed by the parent 

company is not sufficient to consider the former a PE 

of the latter. 

However, it is also generally accepted that the subsidiary 

cannot hide behind its independent legal status 

to avoid an agency PE characterization because ‘‘there 

is no reason why a subsidiary company acting as an 

agent of its parent company should be treated differently 

than a third party acting as an agent.’’ 23 In the 

same way, the commentaries on article 5, paragraph 7 

provide for this possibility. 

As will be demonstrated below, several decisions 

were issued recently recognizing the existence of a subsidiary 

constituting a PE of its parent company. The 

decisions were not always received by the international 

tax community free of criticism. 

A. Interhome 

The Interhome case24 involves a decision of the Conseil 

d’Etat (Supreme Administrative Court of France) 

ruling that a French subsidiary (Interhome Gestion) 

may constitute an agency PE of its Swiss parent company 

(Interhome AG), but only if the former: 

• cannot be regarded as an independent agent of its 

parent company; and 

• habitually exercises an authority to bind the Swiss 

parent in commercial activities that are related to 

those of the parent. 

Interhome AG is a group of companies headquartered 

in Switzerland engaged in the business of renting 

holiday accommodations. In this context, Interhome 

AG concluded mandate contracts with owners in several 

European countries and promoted the houses in a 

catalogue, while its subsidiary in France — Interhome 

Gestion — was responsible for the proper execution of 

these contracts within the French territory. 25 (See Figure 

1.) 

Under this scenario, French tax authorities argued 

that Interhome Gestion should be considered an 

agency PE of Interhome AG and therefore the income 

received by the latter, comprised of commission on the 

rents, should be taxed in France as profits attributable 

to that PE. 26 

23 

Arthur Pleijseir, ‘‘The Agency Permanent Establishment, 

Practical Applications. Part Two,’’ Intertax, Vol. 29, Nos. 6-7, 

(2001), pp. 223-224. 

24 

Conseil d’Etat (Supreme Administrative Court of France), 

June 20, 2003, decision 224407. 

25 

Id. 


26 Id. 


Switzerland 

France 

Execution of 

contracts 

The French tax authorities’ arguments were overruled 

by the Court of Appeals of Paris because the 

activities carried out by Interhome Gestion were legally 

different from those of Interhome AG and the former 

did not have legal authority to bind the latter. 27 

Later on, the case was brought before the Supreme 

Administrative Court, which held that Interhome Gestion 

would only constitute a PE of its parent company 

if the requirements of article 5 of the France- 

Switzerland treaty, equivalent to article 5(5) of the 

OECD model, were met. In other words, such characterization 

would only occur if Interhome Gestion 

could not be considered an independent agent and if it 

habitually exercised in France an authority, legal or 

factual, to conclude contracts in the name of Interhome 

AG that relate to ordinary business activities of 

that company. 28 Therefore, the Supreme Administrative 

Court maintained the core part of the decision of the 

Court of Appeals of Paris, rejecting the characterization 

of Interhome Gestion as a PE of its parent company. 

Despite this outcome (that is, no characterization of 

the subsidiary as being a PE of its parent company), 

the relevance of this case to the present analysis is that 

the Supreme Administrative Court of France clearly 

described the requirements by which a subsidiary 

might constitute a PE of its parent company, emphasizing 

the possibility of a subsidiary binding de facto 

its parent company and not only legally. According to 

27 

Court of Appeals of Paris, decision 96-859 2e (released 

June 13, 2000). 

28 

Klaus Vogel in cooperation with the IBFD’s Tax Treaty 

Unit, ‘‘1. Subsidiaries as Permanent Establishments?’’ Bulletin — 

Tax Treaty Monitor, Tax Treaty News (Oct. 2003), p. 474. 

Figure 1. Interhome 

Interhome AG 

Interhome 

Gestion 


Other European States 

Mandate contracts with 

house owners 

Payment of commission on 

the rents 

the Conseil d’Etat, the exercise of the authority to bind 

the Swiss parent should be determined not only by reference 

to a legal mandate, but also by reference to the 

actual circumstances. 

This factual approach adopted by the Conseil d’Etat 

would prove to be decisive in a later case — Zimmer — 

analyzed below, that was heavily criticized by some 

scholars. 

B. Philip Morris 

The importance of the Philip Morris case29 to the 

present work resides not only in that it involves a dependent 

agent that is a subsidiary of its principal, but 

also, and most important, because of the particular 

features envisaged by the Italian Supreme Court for the 

characterization of what it called a ‘‘multiple PE’’ — a 

PE within a group of companies. 

Philip Morris involves an audit carried out by the 

Italian tax authorities regarding the character of the 

activities performed by Intertaba SpA, the Italian company 

of the Philip Morris group, which was structured 

at the time of the facts as shown in Figure 2. 

The decision of the Supreme Court of Italy stated 

that because of the activities carried out by Intertaba 

SpA in supervising the performance of the licensing 

and distribution contracts concluded among the other 

companies of the Philip Morris group and its participation 

in negotiating such contracts, the company could 

be deemed to be a ‘‘place of management’’ at the disposal 

of the entire group. Intertaba SpA was then considered 

to constitute a ‘‘multiple subsidiary’’ PE in 

29 Italian Supreme Court, Dec. 20, 2001, decisions 3367 and 

3368; Italian Supreme Court, Dec. 20, 2001, decision 7682; and 

Italian Supreme Court, Dec. 20, 2001, decision 10925. 




U.S. 

Germany Switzerland FTR 

Italy 

Italy under the notion provided in article 5(1) of the 

OECD model convention, as well as an agency PE as 

provided in article 5(3). 30 

The reasoning of the Supreme Court of Italy is that 

the incorporation of Intertaba SpA was intended to 

disguise the existence of a PE in Italy to avoid full 

taxation of the royalties derived from the licensing contracts 

concluded with the Italian state monopoly for 

the sale of tobacco products. 31 

In addition to the introduction of the concept of a 

multiple PE, the Supreme Court of Italy identified the 

following principles to determine the existence of a 

PE: 32 

• an Italian company may be a multiple PE of foreign 

companies belonging to the same group and 

pursuing a common strategy; 

• the supervision or control of the performance of a 

contract cannot, in principle, be considered an 

30 Gazzo, supra note 4, at 259. 

31 Id. at 258. 

Royalties 

Italian State 

Monopoly Co. 

32 Caterina Innamorato, ‘‘The Concept of a Permanent Establishment 

Within a Group of Multinational Enterprises,’’ Eur. 

Tax’n (Feb. 2008), p. 81. 

Figure 2. Philip Morris 

Sale of filters 

Philip Morris 

U.S. 

98% 2% 

Intertaba SpA 

Philip Morris 

Europe 

auxiliary activity within the meaning of article 

5(4) of the OECD model convention and the corresponding 

article of the Germany-Italy tax treaty; 

• the participation of representatives or employees 

in a phase of the conclusion of a contract may be 

regarded as an authority to conclude contracts; 

• the entrusting of the management of business 

transactions to a resident company by a corporation 

that is not resident in Italy makes the resident 

company a PE of the foreign corporation; and 

• the existence of a PE should be verified by adopting 

a substantial rather than formalistic approach. 

The line of reasoning of the Supreme Court of Italy 

has been extensively criticized. The criticism focused 

on the characteristics that the Italian Supreme Court 

took into account to determine the existence of a PE, 

which somewhat deviates from what is provided in 

article 5 of the OECD model convention and the 

treaty applicable to the case. Indeed, the reasoning of 

the decision and especially the statement that the participation 

in the negotiation of contracts was sufficient 

to create an agency PE caused great concern and repercussions 

in the international tax community. 

Apparently, that was not the intention of the Court. 

Justice Enrico Altieri from the Tax Division of the Italian 

Supreme Court later stated that the Court did not 



U.K. 

France 

Until 1995 

Distribution 

capacity 

intend to create a new notion of permanent establishment 

(the multiple PE of a group), but that it simply 

identified a common structure for the pursuit of a 

group strategy. 33 

Intentional or not, the repercussions of this case and 

the concern that other courts could follow the Supreme 

Court of Italy’s reasoning and adopt such principles in 

deviation from what is stated in the OECD model convention 

and its commentary led the OECD to amend 

the commentary on article 5 for clarification purposes. 

34 

Apart from the criticism that it may have been subjected 

to, the importance of this decision to this article 

is that the factual analysis of the activities performed 

by a company, as provided for by the audit carried out 

by the Italian tax authorities, might well lead to the 

constitution, by that company, of a PE of its affiliated 

companies. 

C. Zimmer 

As mentioned above, the main purpose of tax planning 

in an international setting is to achieve a lower 

worldwide effective tax rate. Therefore, the location of 

the key business functions of a company (for example, 

manufacturing, distribution, sales, and research and 

development) should be, as much as possible, in a lowtax 

jurisdiction. Significant functions and risk, and 

therefore the associated profit, should be allocated in a 

low-tax jurisdiction to provide for a lower worldwide 

effective tax rate. Establishing core business functions 

in low-tax jurisdictions or shifting such functions or the 

risk associated with such functions to low-tax jurisdictions 

is likely to result in the migration of income to 

such locations. As a consequence, a reduction in the 

worldwide effective tax rate is achieved, provided the 

Figure 3. Zimmer 

Zimmer 

Ltd. 

Zimmer 

SAS 

shift in income and risk is supported by operational 

substance and arm’s-length transfer pricing principles. 35 

In this context, a typical example of functions and 

risk shifting that occurred in the past few years is the 

conversion of fully fledged distributors into commissionaires. 

36 This phenomenon is well illustrated in Zimmer, 

a recent decision of the Court of Appeals of Paris 

involving a U.K. company, Zimmer Ltd., and the 

French tax authorities. 37 Zimmer commercialized its 

orthopedic products in France until 1995 through a 

French distributor, Zimmer SAS. However, from March 

27, 1995, Zimmer SAS commercialized Zimmer Ltd.’s 

products in a commissionaire capacity under a commissionaire 

agreement. The French tax administration 

assessed corporate income tax (plus 10 percent surcharge) 

for the years 1995 and 1996 on the grounds 

that it had a PE. Zimmer Ltd. objected to the assessment 

and brought the case before the court. 38 

33 Id. at 83. 


Zimmer Ltd. 

Main Functions/Risks 

• Manufacturing function 

Zimmer SAS 


Distribution function 

Marketing function 

Market risk 

Inventory risk 

Credit risk 

34 

Most of the changes, first released as a public discussion 

draft (available at http://www.oecd.org/dataoecd/34/9/ 

31483903.pdf), were later adopted in the 2005 commentary to 

the OECD model tax convention to avoid the repetition of the 

interpretation of the Supreme Court of Italy. 

35 

Raffaele Russo et al., Fundamentals of International Tax Planning 

(Amsterdam: IBFD Publications BV, 2007), p. 75. 

36 

As pointed out by Giuseppe Persico, ‘‘the commissionaire 

structure is particularly attractive and widely used since it provides 

the opportunity to centralize the entrepreneurial risks in the 

hands of the principal’’ (emphasis added); Persico, supra note 18, 

at 76. 

37 

Court of Appeals of Paris, Feb. 2, 2007, decision 

05PA02361. 

38 

Id. 




The operations carried out by the Zimmer group are 

described in figures 3 and 4. 

The main issue was whether Zimmer SAS constituted 

an agency PE of Zimmer Ltd. and as a consequence 

a part of the latter’s company profits were attributable 

to that PE and subject to tax in France. The 

court concluded that Zimmer SAS constituted a PE of 

Zimmer Ltd., and the profits realized in France by 

Zimmer Ltd. were taxable in France. 39 

There was a lengthy discussion on the characterization 

of an agency PE because the parties concluded a 

commissionaire arrangement, a particular feature of 

civil-law jurisdictions. A commissionaire can be defined 

as an intermediary that acts on behalf of its principal, 

in its agency capacity, but in its own name. The commissionaire 

performs an indirect representation; it assumes 

personally the rights and obligations arising 

from the contracts concluded with a third party and 

the latter does not have a legal relationship with the 

principal. This particular feature of the commissionaire 

arrangement gives rise to two separately legal relationships: 

• a principal and commissionaire relationship; and 

• a commissionaire and third-party relationship. 40 

Thus, the two main differences of the commissionaire 

under French law and the agent described in the 

OECD model convention and its commentary are: 

• the commissionaire is legally responsible before 

the client, while the typical agent described in the 

OECD model convention and its commentary is a 

person acting on behalf of the enterprise and not 

on its own capacity; and 

39 Id. 

U.K. 

France 

40 Persico, supra note 18, at 76. 

After 1995 

Commissionaire 

arrangement 

Figure 4. Zimmer 

Zimmer 

Ltd. 

Zimmer 

SAS 

Zimmer Ltd. 


Manufacturing function 

Marketing function 

Market risk 

Inventory risk 

Credit risk 

Zimmer SAS 


Sales function 

• the commissionaire concludes contracts in its own 

name, whereas the agent has authority to conclude 

contracts in the name of the enterprise. This 

notion is strange to common law, in which a contract 

concluded by an agent always binds the principal, 

irrespective of whether the principal was 

disclosed. 41 

In the taxpayer’s view, these features of the commissionaire 

arrangement would be sufficient to avoid the 

characterization of a PE in France. Indeed, unlike a 

conventional distribution carried out through a typical 

agent, a commissionaire should not be considered to 

constitute an agency PE in the sense of article 5(5) of 

the OECD model convention because it does not have 

power to bind the principal and because it concludes 

sale contracts in its own name, rather than in the name 

of the principal. In practice customers may not be 

aware that they are dealing with an agent because they 

only have a contractual relationship with the commissionaire. 

Of course, one should not rely on an extreme 

formalistic approach to limit the application of article 

5(5) of the OECD model convention to agents that 

enter into contracts literally in the name of the enterprise, 

as such provisions equally apply to agents that 

conclude binding contracts that are not actually in the 

name of the enterprise. 42 However, under a commissionaire 

arrangement the issue is not only the name of 

whom the contract is entered into with, but also, and 

more important, the lack of binding effects regarding 

the principal. 

I believe that as a result, in a typical commissionaire 

arrangement the requirements of article 5(5) of the 

41 

See Avery Jones et al., supra note 15, at 236; Persico, supra 

note 18, at 68. 

42 

Vogel, supra note 3, at 329. The same view is expressed in 

para. 32.1 of the OECD commentary on article 5. 



OECD model convention are not met and therefore no 

agency PE is found to exist. 43 It is up to dispute 

among scholars whether commissionaires fall under the 

scope of article 5(5) of the OECD model convention, 

especially because of the diverse views arising from the 

common-law and civil-law notions of agents. 

One might argue that economically the commissionaire 

performs basically the same activities as a conventional 

agent under article 5(5) of the OECD model 

convention, but legally there is no contractual relationship 

between the customer and the principal. The customers 

only have a contractual relationship and therefore 

can only sue the commissionaire, not the 

principal, which is why the characterization of a typical 

commissionaire as an agent within the meaning of 

article 5(5) of the OECD model convention is, in my 

view, unreasonable. 

That was not the interpretation of the Court of Appeals 

of Paris in concluding that Zimmer SAS could 

de facto bind its parent company, Zimmer Ltd. Phrased 

differently, the court clearly adopted an economic substance 

approach to conclude that the principal was actually 

bound by the commissionaire. 

This should not be considered a good decision because 

it ignored the particular features of a commissionaire 

arrangement, a typical concept of civil-law 

jurisdictions. It is therefore expected that tax authorities, 

especially in France, will feel encouraged to challenge 

commissionaire structures on the basis of an economic 

approach. 

Despite this controversial issue of the substanceover-form 

approach adopted by the Court of Appeals 

of Paris, the question of what portion of profits should 

be attributed to that PE remained unanswered. This 

question is addressed in the following section. 

A. Introduction 

IV. Different Approaches 

The origins of article 7 of the current OECD model 

convention dates back to the 1920s and to the work of 

the League of Nations, predecessor of the OECD. At 

that time, under the 1927 League of Nations draft convention, 

article 5 governed the taxation of what was 

then called ‘‘income from a trade or profession’’; there 

was little guidance on how to determine the income 

taxable in each contracting state. 44 

43 See Stéphane Gelin and David Sorel, ‘‘French Commissionnaire: 

A PE for Its Foreign Principal?’’ Tax Notes Int’l, Aug.6, 

2007, p. 581, Doc 2007-16318, or2007 WTD 154-6. 

44 Raffaele Russo, ‘‘Tax Treatment of ‘Dealings’ Between Different 

Parts of the Same Enterprise Under Article 7 of the 

OECD Model: Almost a Century of Uncertainty,’’ Bulletin — Tax 

Treaty Monitor (Oct. 2004), pp. 472-485. 


The current wording of article 7(2) establishing the 

separate enterprise concept — that the profits of a PE 

will be ‘‘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 PE’’ — has its origins in 

article 3 of the 1933 League of Nations draft convention 

and was generally followed by the subsequent 

Mexico and London model conventions of 1943 and 

1946, respectively. 45 

There are two main 

interpretations of article 7 

regarding the attribution of 

profits to PEs. 

Since then, the study of the issue of attribution of 

profits to PEs has evolved greatly, but despite the efforts 

of the OECD no consensus has been achieved 

among states until the recent adoption of the revised 

commentary on the current article 7 to be included in 

the 2008 update to the model tax convention. This revised 

commentary is a great achievement and will provide 

more guidance on this issue. 

There are two main interpretations of article 7 regarding 

the attribution of profits to PEs: the functionally 

separate entity approach, also known as the authorized 

OECD approach; and the relevant business 

activity approach. 

Generally, the authorized OECD approach provides 

that the profits to be attributed to a PE must be the 

profits that it ‘‘would have earned at arm’s length if it 

were a legally distinct and separate enterprise performing 

the same or similar functions under the same or 

similar conditions.’’ 46 The relevant business activity 

approach provides that the expression ‘‘profits of an 

enterprise’’ in article 7(1) of the OECD model convention 

refers to the profits of business activities in which 

the PE has participated. The main feature of this approach 

is that ‘‘profits are earned only from transactions 

with third parties (or with associated enterprises): 

no profit is earned from a transaction between the PE 

and the enterprise of which it is part.’’ 47 Under the 

relevant business activity approach, article 7(1) limits 

45 

Id. at 474; see also para. 81 of the OECD ‘‘Report on the 

Attribution of Profits to Permanent Establishments,’’ Part I 

(General Considerations), (2006). 

46 

Para. 10 of the ‘‘Report on the Attribution of Profits to Permanent 

Establishments,’’ Part I (General Considerations), (2006). 

47 

Baker and Collier, supra note 7, at 30. 




the profits that may be attributable to a PE, on the basis 

of article 7(2), to the overall profits of the whole 

enterprise. One major consequence of this is the impossibility 

of attributing profits to a particular PE if 

the enterprise, considered as whole, makes a loss. 

When it comes to the attribution of profits to 

agency PEs, the controversial issue is determining 

whether there may be a profit attributable to the 

agency PE in excess of the arm’s-length remuneration 

paid to the dependent agent. The issue is whether it is 

possible to attribute a separate profit to an agency PE 

once the agent had an arm’s-length reward for the service 

provided. 

The two different approaches provide for completely 

different answers: The application of the authorized 

OECD approach to agency PEs leads to the possibility 

of a separate profit and loss attribution to that PE, 

while the single taxpayer approach provides that once 

the dependent agent received an arm’s-length reward, 

no profit or loss can be attributed by the host state. 

The authorized OECD approach leads to the treatment 

of the dependent agent and the agency PE as two different 

taxable entities (also known as the dual taxpayer 

approach). Conversely, the single taxpayer approach 

provides that an arm’s-length remuneration paid only 

to the dependent agent is in compliance with the PE 

treshhold. 

B. OECD Project on Attribution of Profits to PEs 

Before analyzing the authorized OECD approach in 

detail, it is important to present an overview of the 

OECD project on attribution of profits to permanent 

establishments to examine what is the legal status of 

such approach as well as its role in interpreting current 

treaties. This analysis is necessary since one of the 

main controversies regarding the authorized OECD 

approach refers to its applicability regarding treaties 

currently in force. While some argue that the approach 

is the most proper interpretation of article 7 of the current 

version of the OECD model convention, others 

argue that the application of the authorized OECD 

approach is dependent on changes to be made in the 

wording of tax treaties and therefore cannot be applied 

to the treaties currently in force. 

The starting point of this project was the OECD’s 

attempt to analyze how the principles developed in the 

1995 OECD transfer pricing guidelines, which deals 

with the application of the arm’s-length principle to 

transactions between associated enterprises, should apply 

in the context of the relationship between a PE and 

its general enterprise. 48 The aim of this effort was to 

achieve a greater consensus on the attribution of profits 

48 Para. 2 of the update of the status of the OECD project on 

the attribution of profits to PEs (2006). 

to PEs and the interpretation of article 7 of the OECD 

model tax convention, avoiding the risk of double taxation. 

In this context, the OECD released in 2001 parts I 

(General Considerations) and II (Banks) 49 and in 2003 

Part III (Global Trading) 50 of a discussion draft on the 

attribution of profits to PEs. In 2004 a revised discussion 

draft of parts I, 51 II, and III was released for public 

comment. Finally, in December 2006, the Committee 

on Fiscal Affairs released new versions of parts I, 

II, and III of its ‘‘Report on the Attribution of Profits 

to Permanent Establishments.’’ 52 

Moreover, in December 2006 the OECD Committee 

on Fiscal Affairs decided that to provide ‘‘improved 

certainty for the interpretation of existing treaties based 

on the current text of article 7, a revised Commentary 

should be prepared taking into account those aspects of 

the Report that do not conflict with the existing Commentary’’ 

(aspects that constitute a mere clarification 

of the proper interpretation of article 7). 53 Therefore, 

on April 10, 2007, as a first part of the implementation 

package, a discussion draft of the revised commentary 

on article 7 was released for public comment taking 

into account many of the conclusions included in parts 

I, II, and III of the ‘‘Report on the Attribution of 

Profits to Permanent Establishments.’’ 54 

The revised commentary on the current article 7 of 

the OECD model tax convention was then included in 

the 2008 update to the model tax convention, which 

was adopted by the committee at its meeting of June 

24-25, 2008, when the committee also adopted the 

‘‘Report on Attribution of Profits to Permanent Establishments.’’ 

The revised commentary will be included 

in the new version of the OECD model tax convention 

that will soon be published; the report will also be published 

separately. 55 

Furthermore, the OECD Committee on Fiscal Affairs 

intends to implement the conclusions of the report 

not only through a new version of the commentary 

on the current text of article 7, but also through a 

new version of article 7 itself with accompanying new 

49 

See http://www.oecd.org/LongAbstract/ 

0,3425,en_2649_201185_1923011_1_1_1_1,00.html. 

50 


0,3425,en_2649_201185_2497688_1_1_1_1,00.html. 

51 


0,3425,en_2649_201185_33637686_1_1_1_1,00.html. 

52 


0,3425,en_2649_201185_37861284_1_1_1_1,00.html. 

53 


0,3425,en_2649_201185_38361712_1_1_1_1,00.html. 

54 

See http://www.oecd.org/document/52/ 

0,3343,en_2649_201185_38376628_1_1_1_1,00.html. 

55 

See http://www.oecd.org/document/52/ 

0,3343,en_2649_33747_38376628_1_1_1_1,00.html. 



commentary to be used in the negotiation of future 

treaties and of amendments to existing treaties. Thus, 

the OECD Committee on Fiscal Affairs recently released 

as a discussion draft what it called the second 

part of the implementation package — a new version 

of article 7 and related commentary changes. The committee 

will be receiving comments on this discussion 

draft until December 31, 2008, and it is expected that 

the new article and the commentary changes will be 

included in the next update to the OECD model tax 

convention, which is tentatively scheduled for 2010. 56 

Considering that this article is focused on case law 

on the attribution of profits to agency PEs, and the 

decisions were held before the release of the discussion 

draft of the new version of article 7 and related commentary 

changes, all comments made refer to the current 

wording of the OECD model convention and the 

‘‘Report on the Attribution of Profits to Permanent 

Establishments.’’ One first important issue that arises is 

what weight should be given to this report in applying 

tax treaties currently in force. The specialized doctrine 

has already discussed at length the legal status of the 

commentary to the OECD model convention, and it 

can be said that there is no generally accepted view on 

this controversial issue. 57 If the legal status of the commentary 

is unclear and subject to a variety of different 

interpretations, more obscure is the role of a report 

that was, at the time the decisions being analyzed were 

held, not implemented yet. 

The OECD recognizes in paragraph 7 of the revised 

commentary on article 7 that there are differences between 

some of the conclusions of the report and the 

interpretation of article 7 previously given in the commentary 

in a way that the report should only provide 

guidelines for the application of the arm’s-length principle 

incorporated in the article to the extent that it 

does not conflict with the commentary. In case of conflict 

between the two, the commentary should always 

prevail over the report. 58 

This is not mere academic debate; rather, it is a very 

important issue in practice as the conclusions of the 

report lead to major consequences on the attribution of 

profits to PEs in general and particularly to agency 

PEs. The Indian Income Tax Appellate Tribunal had to 

56 See id. 

57 See, e.g., Vogel, supra note 3, at 43; David A. Ward, ‘‘The 

Role of the Commentaries on the OECD Model in the Tax 

Treaty Interpretation Process,’’ Bulletin — Tax Treaty Monitor 

(Mar. 2006), p. 98; and John F. Avery Jones, ‘‘The Effect of 

Changes in the OECD Commentaries After a Treaty Is Concluded,’’ 

Bulletin — Tax Treaty Monitor (Mar. 2002), pp. 102-109. 

58 Mary Bennett and Raffaele Russo, ‘‘OECD Project on Attribution 

of Profits to Permanent Establishments: An Update,’’ 

Int’l Transfer Pricing J. (Sept./Oct. 2007), p. 283. 


face this dilemma in the SET Satellite case; the taxpayer 

referred to the report as ‘‘what the law should be and 

not what the law is.’’ 59 

To address the different interpretations, I will first 

present a summary of the authorized OECD approach 

to attribute profits to PEs in general, followed by an 

analysis of its specific features regarding agency PEs, 

and finally the particularities of the single taxpayer approach. 

C. The Authorized OECD Approach 

Between the two main interpretations of the provisions 

of article 7 of the OECD model convention regarding 

the attribution of profits to PEs, the OECD 

opted for the functionally separate entity approach, 

rather than the relevant business activity approach. 

Now one can see that the reason why the first is also 

called the authorized OECD approach is because it 

provides for the OECD preferred interpretation of article 

7. 60 

The authorized OECD approach provides that the 

profits to be attributed to a PE must be the profits that 

it ‘‘would have earned at arm’s length if it were a legally 

distinct and separate enterprise performing the 

same or similar functions under the same or similar 

conditions.’’ 61 Conversely, the functionally separate entity 

approach does not limit the profits of the PE by 

reference to the profits of the enterprise as a whole. As 

a consequence, it is perfectly possible under this approach 

to attribute profits to a PE even if the enterprise, 

considered as whole, incurs a loss. 

The OECD report reaffirms the primacy of the 

arm’s-length principle in attributing profits to PEs by 

determining the adoption of the functionally separate 

entity approach. As shown below, the application of 

this approach requires a stretch: The PE is supposed to 

be treated as a functionally separate entity of its head 

office, though it is part of the same enterprise. Once 

the PE cannot enter into actual transactions with other 

parts of the enterprise of which it is part, it is necessary 

to provide for the recognition of the dealings between 

the PE and its head office, which goes against 

the axiom that an enterprise cannot make a profit from 

dealing with itself. 

1. The Authorized OECD Approach to PEs 

The application of the functionally separate entity 

approach under the report requires a two-step analysis: 

• the functional and factual analysis; and 

• the comparability analysis. 

59 

Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision 

535/Mum/04 and 205/Mum/04. 

60 

Para. 78 of the ‘‘Report on the Attribution of Profits to Permanent 

Establishments,’’ Part I (General Considerations), (2006). 

61 

Id. at para. 10. 




In essence, the first step involves the application, by 

analogy, of the principles described in the 1995 OECD 

transfer pricing guidelines to identify the economically 

significant activities and responsibilities undertaken by 

the PE, while the second step is the comparability 

analysis and the application of the transfer pricing 

methods to determine an arm’s-length profit of the PE. 

The two-step analysis is summarized as follows in 

the OECD ‘‘Report on the Attribution of Profits to 

Permanent Establishments’’: 

Step One 

A functional and factual analysis, leading to: 

• The attribution to the PE as appropriate of the 

rights and obligations arising out of transactions 

between the enterprise of which the PE is a part 

and separate enterprises; 

• The identification of significant people functions 

relevant to the attribution of economic ownership 

of assets, and the attribution of economic ownership 

of assets to the PE; 

• The identification of significant people functions 

relevant to the assumption of risks, and the attribution 

of risks to the PE; 

• The identification of other functions of the PE; 

• The recognition and determination of the nature 

of those dealings between the PE and other parts 

of the same enterprise that can appropriately be 

recognised, having passed the threshold test; and 

• The attribution of capital based on the assets and 

risks attributed to the PE. 

Step Two 

The pricing on an arm’s length basis of recognised 

dealings through: 

• The determination of comparability between the 

dealings and uncontrolled transactions, established 

by applying the Guidelines’ comparability factors 

directly (characteristics of property or services, 

economic circumstances and business strategies) 

or by analogy (functional analysis, contractual 

terms) in light of the particular factual circumstances 

of the PE; and 

• Applying by analogy one of the Guidelines’ traditional 

transaction methods or, where such methods 

cannot be applied reliably, one of the transactional 

profit methods to arrive at an arm’s length 

compensation for the dealings between the PE 

and the rest of the enterprise, taking into account 

the functions performed by and the assets and 

risks attributed to the PE. 

The functional and factual analysis described in step 

one of the report resembles the analysis provided in 

the 1995 OECD transfer pricing guidelines. The difficulty 

in replicating the principles developed in the 

guidelines in a PE setting is that, differently from what 

happens when applying article 9 to associated enter- 

prises dealings, a PE is not legally a separate enterprise 

but is part of the same enterprise of its head office. 

The solution found by the OECD Committee on 

Fiscal Affairs to cope with this difficulty was to look at 

the functions of the people working for the enterprise 

to attribute the assets, risks, capital, rights, and obligations 

belonging to the PE. 62 As a result, under the authorized 

OECD approach, economic ownership of assets 

should be attributed to the PE in accordance with 

the significant people functions as well as the risks related 

to the functions performed by people in that PE. 

Also, the authorized OECD approach establishes 

mechanisms to attribute capital to the PE in line with 

the assets and risks attributed to it and criteria for the 

recognition and determination of the dealings between 

the PE and its general enterprise. 

The second step involves the determination of remuneration 

of any dealings between the hypothesized 

enterprises on the basis of the functions performed, 

assets used, and risks assumed, as provided for in the 

1995 OECD transfer pricing guidelines. 63 

2. The Authorized OECD Approach to Agency PEs 

Regarding the attribution of profits to agency PEs, 

the OECD believes that the same principles adopted 

for other types of PEs should apply. As a matter of 

consistency, the OECD believes there is no reason to 

apply a different mechanism of profits attribution when 

it comes to agency PEs. 

Consequently, profits should be attributed to the 

agency PE on the basis of the assets and risks of the 

nonresident enterprise relating to the functions performed 

by the former on behalf of the latter. 

The authorized OECD 

approach leads to the 

treatment of the 

dependent agent and the 

agency PE as two different 

taxable entities. 

As pointed out by Hans Pijl, the authorized OECD 

approach takes the functions performed in the host 

state as the starting point for the attribution of profits. 

Moreover, under the notion that assets and risks follow 

functions, the functional and factual analysis will determine 

the assets and risks that must be attributed to the 

62 Id. at para. 18. 




Home State 

Host State 

Figure 5. Authorized OECD Approach to Agency PEs 

Agent P&L 

Gross income 200 

Cost of services (150) 

Profit 50 

agency PE. 64 Considering, for example, the situation 

when the credit risk on accounts receivable is not 

borne by the dependent agent itself but directly by the 

principal, a reward for such risk will have to be attributed 

to the agency PE. 65 

One major aspect of the authorized OECD approach 

is that it leads to the treatment of the dependent 

agent and the agency PE as two different taxable 

entities. This means that the agency PE is not the dependent 

agent per se; its hypothetical existence is apart 

from the dependent agent and is derived because the 

general enterprise in the home state has a dependent 

agent in the host state. As a consequence, the authorized 

OECD approach challenges the widespread idea 

that the profit of an agency PE is zero by definition. 

Under the authorized OECD approach, it is not 

only the income earned by the dependent agent itself 

that matters but also the income the general enterprise 

earns through its agency PE in the host country. Whatever 

is paid to the dependent agent (for example, salary, 

fixed amount, or percentage of sales) should be 

considered as an expense in ascertaining the agency PE 


This is precisely when the authorized OECD approach 

differs from the single taxpayer approach. The 

payment of the dependent agent remuneration and its 

deduction on the computation of the agency PE profits 

does not mean that there will be no profits left. Those 

profits will be determined on the basis of the functions 

performed by the agency PE. 

In this context, it is possible that no profit be attributable 

to the agency PE depending on the functions 

performed by that PE. 66 Indeed, under the OECD report, 

there is no presumption that the agency PE will 

always generate profits, as it may well happen that little 

or no profit is attributed to it if only routine functions 

General Enterprise 

Permanent Establishment 

Agent 

are performed. Nothing prevents the general enterprise 

from organizing its business in the host state in a manner 

in which little or no functions are performed by the 

agency PE and, as a consequence, little or no tax must 

be attributable to it under the authorized OECD approach. 

The authorized OECD approach determines that the 

dependent agent be rewarded for the service provided 

to the nonresident enterprise on an arm’s-length basis; 

that is, taking into account its assets and risks, while 

the profits of the agency PE should be determined on 

the basis of the assets and risks of the nonresident enterprise 

in relation to the functions performed by the 

dependent agent on behalf of the enterprise, added by 

sufficient capital to support those assets and risks. 67 

By definition, the overall taxable income of the dependent 

agent plus the income of the agency PE 

(deemed to be independent) must be equal to the taxable 

income a company would earn in an arm’s-length 

transaction. In a simplistic fashion, the authorized 

OECD approach can be described on the basis of the 

example illustrated in Figure 5. 68 

Under the authorized OECD approach, there is a 

profit attributable to the agency PE in excess of the 

64 Pijl, supra note 9, at 30-31. 

65 Raffaele Russo, ‘‘Application of Arm’s Length Principle to 

Intra-Company Dealings: Back to the Origins,’’ Int’l Transfer Pricing 

J. (Jan./Feb. 2005), p. 14. 

66 Pijl, supra note 9, at 32. 

67 Bennett and Russo, supra note 58, at 282. 


GE P&L 

Gross income 2,000 

Cost of goods (500) 

Agent fee (200) 

Profit 1,300 

PE P&L 


Cost of goods (1,000) 



68 This example was drafted based on a similar diagram provided 

by Hans Pijl in ‘‘The Zero-Sum Game, the Emperor’s 

Beard and the Authorized OECD Approach,’’ supra note 9, at 

32. 




Figure 6. Single Taxpayer Approach to Agency PEs — Agent Is PE 

Home State 

Host State 

Agent P&L 


Cost of services (150) 


arm’s-length remuneration paid to the dependent agent. 

In other words, the $200 ‘‘paid’’ by the general enterprise 

to its dependent agent, which is assumed to be an 

arm’s-length reward, does not eliminate the need to 

attribute a separate profit to the agency PE in accordance 

with the assets, risks, capital, and rights and obligations 

referring to that PE. 

As shown below (referring to the single taxpayer 

approach), the arm’s-length remuneration of $200 is 

sufficient to comply with the tax liabilities that arose in 

the host state. 

D. The Single Taxpayer Approach to Agency PEs 

The single taxpayer approach is based on the axiom 

that the agency PE profit is zero by definition. Under 

this approach, an arm’s-length remuneration paid to 

the dependent agent extinguishes any PE tax liability 

in the host state. The rationale behind this approach is 

that if the dependent agent is fully rewarded at arm’s 

length for all functions performed, assets used, and 

risks assumed, then there can be no additional profit to 

be attributed to the agency PE. 69 

Differently from the authorized OECD approach 

(which leads to the treatment of the dependent agent 

and the agency PE as two different taxable entities), 

under the single taxpayer approach the ‘‘individual or 

entity whose activities create the PE is considered to be 

the PE himself/itself,’’ 70 that is, one single taxpayer. 

69 Baker and Collier, supra note 7, at 33. 

70 Annika Deitmer, Ingmar Dörr, and Alexander Rust, ‘‘Invitational 

Seminar on Tax Treaty Rules Applicable to Permanent 

Establishments — in Memoriam of Prof. Dr. Berndt Runge,’’ 

Bulletin — Tax Treaty Monitor (May 2004), p. 187. 

General Enterprise P&L 

Permanent Establishment 

Agent 

This particular feature of the single taxpayer approach 

— that the agent is the PE — can be described 

on the basis of the example illustrated in Figure 6. 71 

By comparing the two hypothetical figures, it is 

clear that the single taxpayer approach leads to a lesser 

portion of profit to be attributable to the host state, 

that is, $50 instead of $850. This is an inherent consequence 

of the assumption that the dependent agent 

and the agency PE are one and the same thing. 

Now that the main features of both the authorized 

OECD approach and the single taxpayer approach 

have been outlined, it is time to analyze the interpretation 

of this controversial issue by the courts. Sadly, 

there are only a few decisions dealing with the attribution 

of profits to agency PEs. The lack of a significant 

amount of case law highlights the importance of the 

Morgan Stanley and SET Satellite cases. Both cases were 

judged in Indian courts, but many scholars felt the 

cases had opposite outcomes, demonstrating that the 

controversy of this issue remains, even within the 

boundaries of a single state. 

E. Morgan Stanley 

The Morgan Stanley case involves the taxation on 

activities carried out between entities of the Morgan 

Stanley group. 72 Morgan Stanley and Co. (MSCo), an 

investment bank located in the United States, entered 

into a services agreement with Morgan Stanley Advantages 

Services Pvt. Ltd. (MSAS), a service company 

71 See supra note 68. 

GE P&L 


Cost of goods (500) 


Profit 1,300 

PE P&L 




72 

Supreme Court of India, July 9, 2007, decision 2114/07 

and 2415/07. 



U.S. 

India 

established in India, by which the latter provided support 

services to the former. The services were characterized 

as back-office activities and comprised: 

• equity and fixed income research; 

• account reconciliation; and 

• information technology services (for example, 

back-office operation, data processing, and support 

centers). 73 

In connection with the services agreement concluded 

by the parties, MSCo staff was seconded to 

MSAS, although continued to be legally employed and 

receiving salary from MSCo. 

The transactions entered into by MSCo and MSAS 

are summarized in Figure 7. 

Of great importance to this case is that MSCo filed 

with the Indian tax authorities a request for an advance 

ruling to determine whether the services provided by 

MSAS, under the services agreement entered into between 

the two, could lead to the constitution of a PE 

in India of MSCo within the meaning of article 5(1) of 

the treaty concluded between India and the United 

States, and if so, the amount of profit attributable to 

that PE. 74 

The Authority for Advanced Ruling (AAR) in India 

decided: 

• MSCo cannot be regarded as having a fixed PE 

within the meaning of article 5(1) of the India- 

U.S. treaty; 

• MSAS cannot be regarded as being an agency PE 

in the sense of article 5(4) of the India-U.S. 

treaty; 

• MSCo would be regarded as having a PE in India 

within the meaning of article 5(2)(l) of the India- 

U.S. treaty ‘‘if it were to send some of its em- 

73 Id. at 2-3. 

74 Id. at 3. 

Arm’s-length 

remuneration for 

support services 

Figure 7. Morgan Stanley 

Morgan Stanley 

and Company 

Morgan Stanley 

AS Pvt. Ltd. 

ployees to India as stewards or as deputationists 

in the employment of MSAS’’; and 

• the transactional net margin method was the most 

appropriate transfer pricing method to determine 

the arm’s-length price of the services provided by 

MSAS. 75 

Both the Indian Department of Revenue and MSCo 

filed an appeal before the Supreme Court of India. The 

arguments of both appellants can be summarized as 

follows: 76 

• The Department of Revenue argued that MSCo 

should be considered to have a fixed PE in India 

in the sense of article 5(1) of the India-U.S. treaty 

as it proposes to carry on its business in India 

through MSAS and there was a fixed place of 

business in Mumbai; and MSAS should be considered 

to constitute an agency PE of MSCo in 

India under article 5(4) of the India-U.S. treaty, as 

the former was legally and financially dependent 

on the latter. 

• MSCo argued that the activities carried out by 

MSAS did not constitute a PE under article 5(2)(l) 

of the India-U.S. treaty. 

Because of its importance to the analysis of this 

case and the fact that the provisions of article 5(2)(l) of 

the India-U.S. treaty are not standard provisions under 

the OECD model convention, a full look at the relevant 

provisions of the India-U.S. treaty is necessary. 

(See Table 1.) 

Regarding the existence of a fixed PE within the 

meaning of article 5(1) of the India-U.S. treaty, the 

Supreme Court of India recognized the existence of a 

fixed place of business, but held that the second requirement 

of article 5(1) of the treaty — through 

75 Id. at 4-5. 

76 Id. 


Support Services 

Equity and fixed income research 

Account reconciliation 

IT services 




Table 1. Comparison of OECD Model Convention and India-U.S. Treaty 

OECD Model Convention Convention Between the Government of the United States of America and the 

Government of the Republic of India for the Avoidance of Double Taxation 

and the Prevention of Fiscal Evasion with respect to Taxes on Income, signed 

in New Delhi on September 12, 1989 

Article 5—Permanent Establishment Article 5 —Permanent Establishment 

1. 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. 

(...) 

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 subparagraphs 

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. 

5. 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. 

1. 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. 


(a) a place of management; 

(b) a branch; 

(c) an office; 

(d) a factory; 

(e) a workshop; 

(f) a mine, an oil or gas well, a quarry, or any other place of extraction of 

natural resources; 

(...) 

(l) the furnishing of services, other than included services as defined in 

Article 12 (Royalties and Fees for Included Services), within a Contracting 

State by an enterprise through employees or other personnel, but only if: 

(i) activities of that nature continue within that State for a period or periods 

aggregating more than 90 days within any twelve month period; or 

(ii) the services are performed within that State for a related enterprise 

(within the meaning of paragraph 1 of Article 9 (Associated Enterprises)). 

(...) 

3. Notwithstanding the preceding provisions of this Article, the term 

‘‘permanent establishment’’ shall be deemed not to include any one or more of 

the following: 

(a) the use of facilities solely for the purpose of storage, display, or occasional 

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 occasional 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 

advertising, for the supply of information, for scientific research or for other 

activities which have a preparatory or auxiliary character, for the enterprise. 

4. Notwithstanding the provisions of paragraphs 1 and 2, where a person — 

other than an agent of an independent status to whom paragraph 5 applies — 

is acting in a Contracting State on behalf of an enterprise of the other 

Contracting State, that enterprise shall be deemed to have a permanent 

establishment in the first-mentioned State if: 

(a) he has and habitually exercises in the first-mentioned State an authority to 

conclude contracts on behalf of the enterprise, unless his activities are limited 

to those mentioned in paragraph 3 which, if exercised through a fixed place 

of business, would not make that fixed place of business a permanent 

establishment under the provisions of that paragraph; 

(b) he has no such authority but habitually maintains in the first-mentioned 

State a stock of goods or merchandise from which he regularly delivers goods 

or merchandise on behalf of the enterprise, and some additional activities 

conducted in that State on behalf of the enterprise have contributed to the 

sale of the goods or merchandise; or 

(c) he habitually secures orders in the first-mentioned State, wholly or almost 

wholly for the enterprise. 



which the business of an enterprise is wholly or partly 

carried on — was not satisfied regarding the backoffice 

activities. 

Moreover, the Court considered that the back-office 

services to be provided by MSAS fall under article 

5(3)(e) of the India-U.S. treaty, which excludes the 

characterization of a PE regarding ‘‘the maintenance 

of a fixed place of business solely for the purpose of 

advertising, for the supply of information, for scientific 

research or for other activities which have a preparatory 

or auxiliary character, for the enterprise.’’ 77 

Concerning the existence of an agency PE, the Supreme 

Court of India concluded that there was no PE 

because MSAS did not have authority to enter into or 

conclude contracts (which were entered and concluded 

in the United States). 78 

Moreover, regarding the stewards seconded by 

MSCo to work in India as employees of MSAS, the 

Supreme Court of India disagreed with the ruling provided 

by the AAR and held that their activity did not 

lead to the constitution of a PE within the meaning of 

article 5(2)(l) of the India-U.S. treaty. According to the 

Court, the stewardship activities did not constitute a 

service provided by MSCo to MSAS, rather, ‘‘MSCo is 

merely protecting its own interests in the competitive 

world by ensuring the quality and confidentiality of 

MSAS services.’’ 79 The underlying idea is that the enterprise 

must provide a service to a third party to 

qualify as a PE — a PE does not arise when the enterprise 

is providing a service to itself. Under the Court’s 

view, as no service was being provided to a third party 

by the stewards, no PE was found to exist. 

However, regarding the deputationists deployed by 

MSCo to work in India as employees of MSAS, the 

Supreme Court of India held that they did not become 

employee of MSAS; they retained their employment 

lien with MSCo and therefore constituted a service PE 

in the sense of article 5(2)(l) of the India-U.S. treaty. 

The Court found that MSAS was therefore a service 

PE in India regarding the services performed by the 

deputationists deployed by MSCo. 80 

Once the Supreme Court of India concluded that 

MSCo had a service PE in India, the question was 

how much profit could be attributed to that PE. The 

Court first made reference to the ruling provided in the 

AAR that when the nonresident compensates a PE at 

arm’s length no further profits could be attributable to 

India. Then the judges presented their agreement with 

this ruling: 

77 Id. at 15, 16, and 18. 

78 Id. at 16. 

79 Id. at 20-21. 

80 Id. at 21-22. 

The impugned ruling is correct in principle insofar 

as an associated enterprise, that also constitutes 

a PE, has been remunerated on an arm’s 

length basis taking into account all the risk-taking 

functions of the enterprise. In such cases nothing 

further would be left to be attributed to the PE. 

The situation would be different if the transfer 

pricing analysis does not adequately reflect the 

functions performed and the risks assumed by the 

enterprise. In such a situation, there would be a 

need to attribute profits to the PE for those 

functions/risks that have not been considered. 81 

The widespread interpretation of this case law supports 

that it is in line with the single taxpayer approach 

since it provides that no further profit is left to be attributed 

to the PE once the dependent agent has received 

an arm’s-length reward for the service provided. 

Nevertheless, there is a dissenting view headed by 

Hans Pijl (and shared by me) that considers this decision 

as favoring the authorized OECD approach. 82 

Indeed, a careful reading of the decision’s reasoning 

reveals that the Supreme Court of India left open the 

possibility of a further profit attribution to the PE as 

long as there are other functions performed or risks 

assumed by the enterprise that are not reflected in the 

dependent agent remuneration. This conclusion results 

from the final part of the decision: ‘‘The situation 

would be different if the transfer pricing analysis does 

not adequately reflect the functions performed and the 

risks assumed by the enterprise. In such a situation, 

there would be a need to attribute profits to the PE for those 

functions/risks that have not been considered.’’ 83 (Emphasis 

added.) This is clearly in line with, if not a definition 

of, the authorized OECD approach. 

It can be derived from the decision that no further 

profit was attributed to the PE in India precisely because 

no other functions or risks were identified in the 

framework of the activities carried out by that PE, not 

because the Supreme Court of India opted as a matter 

of principle for the single taxpayer approach. 

It is interesting that this decision is always promoted 

as being one of the most important precedents in favor 

of the single taxpayer approach when it really invalidates 

it. 

All the conflicting views presented above result from 

the confusing wording of the decision in its concluding 

section. Although the wording of the decision is somewhat 

ambiguous, I feel it safe to conclude that this is a 

81 Id. at 46. 


82 Hans Pijl, ‘‘Morgan Stanley: Issues Regarding Permanent 

Establishments and Profit Attribution in Light of the OECD 

View,’’ Bull. for Int’lTax’n (May 2008), pp. 174-182. 

83 Supreme Court of India, July 9, 2007, decision 2114/07 

and 2415/07, p. 46. 




Singapore 

India 

precedent in favor of the authorized OECD approach, 

rather than the single taxpayer approach as it might 

look at first sight. 

F. SET Satellite 

SET Satellite involves a Singaporean broadcasting 

company named SET Satellite (Singapore) Pte. Ltd. 

that was engaged in the business of marketing and distributing 

satellite television channels in India. 84 SET 

Satellite appointed SET India Pvt as its agent in India, 

whose activity mainly comprised marketing airtime 

slots to various advertisers in India on behalf of SET 

Satellite, as illustrated in Figure 8. 

When filing its tax returns, SET Satellite assumed 

the position that it was not subject to tax in India because 

it did not have a PE within the meaning of article 

5(8) of the India-Singapore tax treaty. For the sake 

of clarity, the provisions of article 5(8) of the treaty 

deviate from the wording of the OECD model convention 

by enlarging the notion of agency PE to other activities, 

such as: 

• maintenance of stock of goods or merchandise to 

be delivered on behalf of the enterprise; or 

• habitually securing orders wholly or almost 

wholly for the enterprise itself or for the enterprise 

and other enterprises controlling, controlled 

by, or subject to the same common control as that 

enterprise. 

However, the India-Singapore treaty provides for the 

essential features of the typical concept of agency PEs 

as established in the OECD model: (i) a person (individuals 

or companies) acting on behalf of the enterprise, 

(ii) other than an agent of independent status, 

84 Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision 

535/Mum/04 and 205/Mum/04. As both appeals pertained 

to the same person, involved interconnected issues, and were 

heard together, the tribunal disposed of both appeals in a consolidated 

order. 

Figure 8. SET Satellite 

SET Satellite 

Arm’s-length 

remuneration for 

marketing services SET India 

(iii) with authority to conclude contracts, (iv) in the 

name of the enterprise, (v) on a regular basis. Different 

from the OECD model, the India-Singapore treaty 

does not require that the dependent agent concludes 

contracts ‘‘in the name of the enterprise,’’ but ‘‘on behalf 

of the enterprise.’’ In my opinion, however, this 

difference does not lead to major consequences because, 

as explained above regarding the Zimmer case, 

one should not rely on an extreme formalistic approach 

to limit the application of article 5(5) of the OECD 

model convention to agents that enter into contracts 

literally in the name of the enterprise, as such provisions 

apply equally to agents that conclude binding 

contracts that are not actually in the name of the enterprise. 

For the sake of clarity, a full look at the relevant 

provisions of the India-Singapore treaty is necessary. 

(See Table 2.) 

According to the court, there was no dispute about 

whether SET Satellite had a dependent agent in India. 

The issue was whether once the dependent agent (SET 

India) was paid an arm’s-length remuneration for the 

services rendered to its principal (SET Satellite), any 

further income, other than the income earned by the 

dependent agent, can be said to be attributed to the 

dependent agent PE and therefore subject to tax in India. 

85 

Indian tax authorities argued that: 

• though the purchase and sale of airtime are effected 

in Singapore, the receipt regarding broadcasting 

advertisement is in the territory of India; 

• the income regarding, or in connection with the 

relay of, advertisements, accrues in India; and 

• SET Satellite has a PE in India in the form of 

SET India, and therefore, advertisement revenue 

from AXN channel is taxable in India as business 

income. 

85 Id. at paras. 6 and 31. 

Marketing services in 

the Indian market 



Table 2. Comparison of OECD Model Convention and India-Singapore Treaty 

OECD Model Convention Agreement Between the Government of the Republic of Singapore 

and the Government of the Republic of India for the Avoidance of 

Double Taxation and the Prevention of Fiscal Evasion with respect 

to Taxes on Income concluded January 24, 1994 

Article 5—Permanent Establishment Article 5—Permanent Establishment 

1. 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. 


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. 

(...) 

5. 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. 

To support its arguments, Indian tax authorities relied 

mainly on the OECD ‘‘Report on the Attribution 

of Profits to Permanent Establishments.’’ SET Satellite 

argued that, according to the provisions of article 7(2) 

of the India-Singapore treaty, since SET India was remunerated 

on an arm’s-length basis there was no additional 

profit to be taxed in India regarding the advertisement 

revenues. The arguments raised by SET 

Satellite were supported by the writings of Philip Baker 

and Richard S. Collier, guidance previously issued by 

the Indian tax authorities, and the decision of the 

AAR in Morgan Stanley, in which an arm’s-length reward 

paid by a foreign enterprise to its dependent 


1. For the purposes of this Agreement, the term ‘‘permanent 

establishment’’ means a fixed place of business through which the 

business of the enterprise is wholly or partly carried on. 


(a) a place of management; 

(b) a branch; 

(c) an office; 

(d) a factory; 

(e) a workshop; 

(f) a mine, an oil or gas well, a quarry or any other place of 

extraction of natural resources; 

(g) a warehouse in relation to a person providing storage facilities 

for others; 

(h) a farm, plantation or other place where agriculture, forestry, 

plantation or related activities are carried on; 

(i) premises used as a sales outlet or for soliciting and receiving 

orders; 

(j) an installation or structure used for the exploration or 

exploitation of natural resources but only if so used for a period 

of more than 120 days in any fiscal year. 

(...) 

8. Notwithstanding the provisions of paragraphs 1 and 2, where a 

person — other than an agent of an independent status to whom 

paragraph 9 applies — is acting in a Contracting State on behalf of 

an enterprise of the other Contracting State that enterprise shall be 

deemed to have a permanent establishment in the first-mentioned 

State, if: 

(a) he has and habitually exercises in that State an authority to 

conclude contracts on behalf of the enterprise, unless his activities 

are limited to the purchase of goods or merchandise for the 

enterprise; 

(b) he has no such authority, but habitually maintains in the 

first-mentioned State a stock of goods or merchandise from which 

he regularly delivers goods or merchandise on behalf of the 

enterprise; or 

(c) he habitually secures orders in the first-mentioned State, wholly 

or almost wholly for the enterprise itself or for the enterprise and 

other enterprises controlling, controlled by, or subject to the same 

common control, as that enterprise. 

agent for the service provided extinguishes the tax 

liability of the foreign enterprise in India. 

The court clearly adopted an interpretation in line 

with the authorized OECD approach or dual taxpayer 

approach by treating the dependent agent and the 

agency PE as two different taxable units: 

A dependent agent cannot, strictly speaking, be 

termed as PE because neither the Dependent 

Agent belongs to the PE, nor can one have something 

as a result of having the same thing, i.e. if 

a dependent agent is itself a PE, one cannot have 

a PE as a result of having a dependent agent. In 




such a case, the treaty could have simply stated 

that a dependent agent or agency shall be deemed 

to be PE of the enterprise; there was no need to 

say, as has actually been said, that an enterprise 

shall be deemed to have a PE by the virtue of 

having a dependent agent and meeting one of 

tests set out in the relevant sub article. Dependent 

Agent and the Dependent Agent PE, therefore, 

cannot be one and the same thing. 86 

Regarding the determination of the profits of the 

agency PE, the court relied on the OECD ‘‘Report on 

the Attribution of Profits to Permanent Establishments’’ 

and followed the functionally separate entity 

approach by stating that: 

the profit computations of the PE have to proceed 

on the basis that the PE is wholly independent 

of its GE [General Enterprise], which from a 

purely accounting and commercial point of view, 

generally means nothing more than the hypothesis 

that intra organization transactions are to be 

taken into account at arm’s length price. 87 

According to the court: 

the DAPE and DA88 has to be, therefore, treated 

as two distinct taxable units. The former is a hypothetical 

establishment, taxability of which is on 

the basis of revenues of the activities of the GE 

attributable to the PE, in turn based on the 

FAR89 analysis of the DAPE, minus the payments 

attributable in respect of such activities, in 

simple words, whatever are the revenues generated 

on account of functional analysis of the 

DAPE are to be taken into account as hypothetical 

income of the said DAPE, and deduction is 

to be provided in respect of all the expenses incurred 

by the GE to earn such revenues, including, 

of course, the remuneration paid to the DA. 

The second taxable unit in this transaction is the 

DA itself, but this taxability is in respect of the 

remuneration of the DA. 90 

Regarding the AAR’s ruling in Morgan Stanley, the 

court stated that this argument was not persuasive as it 

is ‘‘well settled in law that these rulings have binding 

value only on the assessee and on the Commissioner 

with reference to that particular transaction.’’ 91 

The court went on to conclude: 



88 

DAPE stands for ‘‘dependent agent permanent establishment,’’ 

and DA means ‘‘dependent agent.’’ 

89 

The court uses this acronym to refer to functions performed, 

assets used, and risks assumed. 

90 

Indian Income Tax Appellate Tribunal, Apr. 20, 2007, decision 

535/Mum/04 and 205/Mum/04, para. 11. 

91 


We are of the considered view that in addition of 

the taxability of the DA in respect of remuneration 

earned by him, which is in accordance with 

the domestic law and which has nothing to do 

with the taxability of the foreign enterprise of 

which he is dependent agent, the foreign enterprise 

is also taxable in India, in terms of the provisions 

of Article 7 of the tax treaty, in respect of 

the profits attributable to the dependent agent 

PE. 92 

SET Satellite is an important case because it involves 

the effective application of the conclusions of the ‘‘Report 

on the Attribution of Profits to Permanent Establishments,’’ 

despite the arguments raised by the taxpayer 

against its legal status and applicability while no 

change in the wording of the OECD model convention 

or its commentary has been put in place. The judges 

had to reconcile the interpretation that seemed to be 

more appropriate with the relevant arguments raised by 

the taxpayer, especially the legal status of the report, 

which, at the time of the judgment, was not part of 

the commentary to the current OECD model convention. 

The report was not part of the commentary in 

place at the time of the conclusion of the India- 

Singapore treaty, which creates an additional argument 

for those that defend a static, rather than an ambulatory, 

interpretation of the commentary to the OECD 

model convention. 

As shown below, I believe this decision is correct 

and provides for the most appropriate interpretation of 

article 7 regarding the attribution of profits to PEs. 

However, this decision was made by the Indian Income 

Tax Appellate Tribunal, so it is unclear whether 

the Supreme Court of India will uphold the decision or 

whether it will clarify its earlier ruling in Morgan Stanley 

and rule in favor of the taxpayer. 

V. The Most Suitable Approach 

It seems safe to conclude that the authorized OECD 

approach is indeed the most appropriate approach to 

attribute profits to PEs. 

A. Adequate Allocation of Risks 

The single taxpayer approach is quite attractive at 

first sight, as it provides for an outcome that is apparently 

quite logical: As the dependent agent is remunerated 

on an arm’s-length basis, both home and host 

states seem to get their fair share of the income that 

arises in a particular transaction. 93 The home state 

taxes the profits of the enterprise, while the host state 

is entitled to tax the income paid to the dependent 


93 Para. 272 of the ‘‘Report on the Attribution of Profits to 

Permanent Establishment,’’ Part I (General Considerations), 

(2006). 



agent in accordance with the functions it performs — 

an arm’s-length remuneration. 

This apparently logical reasoning hides the possibility 

of other functions being performed in the host state 

as risks are allocated to the agency PE in the framework 

of its dealings with its head office. 

Indeed, the single taxpayer approach is firmly rejected 

by the OECD in its report precisely because: 

it ignores assets and risks that relate to the activity 

being carried on in the source jurisdiction simply 

because those assets and risks legally belong 

to the non-resident enterprise....Thesingle taxpayer 

approach simply does not consider that if 

the risks (and reward) legally belong to the nonresident 

enterprise it is nonetheless possible to 

attribute those risks (and reward) to a PE of the 

nonresident enterprise created by the activity of 

its dependent agent in the host country. 94 

Undeniably, the single taxpayer approach ignores the 

possibility of other risks being assumed in the host 

state, which may not reflect the entire activities of the 

enterprise in that state. This is what Raffaele Russo 

called a misallocation of the risks within the enterprise: 

‘‘that the risk is legally borne by the nonresident enterprise 

should not impede the allocation of it to the PE 

for purposes of profit attribution.’’ 95 

If, for example, the credit risk on accounts receivable 

is not borne by the dependent agent itself but directly 

by the principal, a reward for such risk must be 

attributed to the agency PE. 96 

In my view, the strange outcome of ignoring such 

functions and risks is a direct consequence of the 

axiom that involves the notion of the single taxpayer 

approach, that the individual or entity whose activities 

create the PE is considered to be the PE himself/ 

itself. 97 

As, under the single taxpayer approach, the figures 

of the dependent agent and the agency PE are mixed 

into one, the eventual other functions performed and 

risks assumed in the framework of the agency PE are 

blurred into this single taxable unit and remain unrevealed. 

Therefore, it can be said that the single taxpayer approach 

might lead to a hidden profit escaping taxation 

of the host state depending on the facts and circumstances. 

94 Id. 

95 

Raffaele Russo, The Attribution of Profits to Permanent Establishments: 

The Taxation of Intra-Company Dealings (Amsterdam: 

IBFD Publications BV, 2005), p. 30. 

96 

Russo, supra note 65, at 14. 

97 Deitmer, Dörr, and Rust, supra note 70, at 187. 


It is only the authorized OECD approach that allows 

the host state to ‘‘see’’ and be able to tax eventual 

other functions that are being performed or risks being 

assumed within its territory. Considering the example 

of a typical agency PE, only a functional and factual 

analysis as provided by the authorized OECD approach 

will reveal to the host state a profit that otherwise 

would be completely hidden. 

The single taxpayer 

approach might lead to 

a hidden profit escaping 

taxation of the host state 

depending on the facts and 

circumstances. 

With the characterization of two clear separate taxable 

units — the dependent agent and the agency PE 

— the precise amount of income is attributed to each 

one of them in accordance with the functions performed, 

assets used, and risks assumed by each taxable 

unit. 

The Supreme Court of India, though ruling in Morgan 

Stanley that there was no further profit to be attributed 

to the PE in excess of an arm’s-length remuneration, 

was able to see the possibility that other functions 

might be performed and risks assumed in the host 

state, different from those relating to the dependent 

agent: 

The impugned ruling is correct in principle insofar 

as an associated enterprise, that also constitutes 

a PE, has been remunerated on an arm’s 

length basis taking into account all the risk-taking 

functions of the enterprise. In such cases nothing 

further would be left to be attributed to the PE. 

The situation would be different if the transfer pricing 

analysis does not adequately reflect the functions performed 

and the risks assumed by the enterprise. In such a 

situation, there would be a need to attribute profits to the 

PE for those functions/risks that have not been considered. 

98 [Emphasis added.] 

A careful reading of the decision’s reasoning reveals 

that the Supreme Court of India left open the possibility 

of a further profit attribution to the PE as long as 

there are other functions performed or risks assumed 

by the enterprise that are not reflected in the dependent 

agent remuneration. 

98 Supreme Court of India, July 9, 2007, decision 2114/07 

and 2415/07, p. 46. 




If the single taxpayer approach is adopted, these 

eventual additional functions or risks of the enterprise 

in the host state will never be remunerated, which is 

clearly against the wording of article 7, and which is 

intended to provide for tax sharing between home and 

host states weighted on the basis of the functions performed, 

assets used, and risks assumed. 

This interpretation is shared by Richard Vann; 

though he believes that the existing theories regarding 

the allocation of profits to PEs are not convincing, he 

expresses his preference for what he called the ‘‘rowing 

or relay theory,’’ under which: 

every transaction within the boundaries of the 

firm is intended to produce a profit over and 

above the market price of any intra-firm transaction 

or dealing that operates as an input into that 

profit and that profit is allocated to all parts of 

the firm which participate in the realisation of 

the ultimate profit on the sale to the third party. 99 

The name of this theory refers to the idea that each 

member of the team contributes to the overall profit as 

they all work together towards the same goal, which 

resembles a rowing race. 

Therefore, it is clear that the authorized OECD approach 

is the only method that entails an adequate allocation 

of risks within the enterprise, avoiding an undue 

limitation of the host state taxing rights. If the 

resulting increase in host state taxation is undesirable, 

this is an issue of tax policy that does not overcome 

the conclusion that the authorized OECD approach 

provides for a proper allocation of risks within the enterprise, 

as opposed to its contrary single taxpayer approach. 

B. The Rationale Behind Article 7 

In my view, it is undisputable that the rationale of 

the OECD report is in line with the underlying principle 

codified in article 7. 

Article 7 upholds primacy of the arm’s-length principle 

in attributing profits to PEs as a natural consequence 

of the adoption of the separate entity fiction. 100 

The OECD report reaffirms the primacy of the 

arm’s-length principle in attributing profits to PEs by 

determining the adoption of the functionally separate 

entity approach. In the framework of an agency PE, 

the host state is therefore entitled to tax the profits that 

99 

Richard J. Vann, ‘‘Tax Treaties: The Secret Agent’s Secrets,’’ 

Brit. Tax Rev. (50th Anniversary Edition), no. 3 (2006), p. 

345. 

100 

In 1933 the League of Nations draft already provided for 

the arm’s-length principle as the guidance for the allocation of 

profits to intracompany dealings; see Russo, supra note 65, at 7. 

In this sense, the convention determined that a PE must be 

treated in the same manner as independent enterprises operating 

under the same or similar conditions. 

the agency PE might be expected to make if it were a 

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 PE. 

Some authors expressed concern about the requirement, 

under the authorized OECD approach, of the 

PE recognizing notional payments as a deduction or as 

basis for attributing profits, based on the notion that 

‘‘an enterprise cannot make a profit from dealing with 

itself.’’ 101 

However, by adopting the transfer pricing guidelines 

to a general enterprise and PE relationship, the only 

result that is harmonious is that the PE profits must be 

determined in accordance with the assets and risks of 

the nonresident enterprise relating to the functions performed 

by the dependent agent on behalf of the nonresident 

enterprise, together with sufficient capital to 

support those assets and risks. As a matter of principle, 

the authorized OECD approach is the only one that 

leads to an outcome that is coherent with the fiction of 

independence provided in article 7(2). It is undeniable 

that the single taxpayer approach does not fully accomplish 

the fiction of independence of article 7(2), which 

is the same as saying that it results in a partial application 

of its provisions. This outcome cannot be accepted, 

as it is against the rationale and wording of 

article 7. 

In this sense, as noted by Hans Pijl, the authorized 

OECD approach is correct from the perspective of tax 

treaty interpretation because the result ‘‘coincides with 

the source principle ...that the state in which the activities 

are carried on has the right to levy tax.’’ 102 

Moreover, it is clear that, under the OECD report, 

there is no presumption that the agency PE will always 

generate profits. Sometimes little or no profit is attributable 

to it if only routine functions are performed. As 

the profits will be allocated among the relevant states 

in accordance with the functions performed and the 

risks assumed by the enterprise, each state will always 

be entitled to tax the profits that arise from activities 

carried out within its territory. 

Other criticism to the authorized OECD approach 

raised by Philip Baker and Richard Collier is that it 

‘‘represents a significant departure from the interpretation 

of article 7 as set out in the current commentary.’’ 

103 In other words, they argue that the current 

wording of article 7 of the OECD model convention 

and its commentary does not leave room for the application 

of the authorized OECD approach and therefore 

amendments must be made at least in the commentary. 

Further, they conclude that considering the 






existing case law and guidance, the adoption of the 

authorized OECD approach will be very hard in several 

jurisdictions without an explicit change in the 

wording of article 7. 104 

In this sense, it is argued that the current wording of 

article 7(3) only allows actual expenses to be taken into 

account and not notional expenses, in a way that the 

fiction of independence of the PE, on the basis of the 

current wording of article 7(2), is not complete. 

An analysis of the history of article 7 demonstrates 

that the underlying rationale of this provision has always 

been the separate entity fiction. In this sense, the 

outcome resulting from the adoption of the single taxpayer 

approach is clearly against this rationale, leading 

to an unreasonable reduction of the host state taxing 

rights. 

Despite this, it is worth remembering that the 

OECD Committee on Fiscal Affairs recently adopted 

the revised commentary on the current article 7 of the 

OECD model tax convention and included it in the 

2008 update to the model tax convention, which will 

be soon published. 105 

Also, as mentioned above, the OECD Committee on 

Fiscal Affairs intends to implement the conclusions of 

the report not only through a new version of the commentary 

on the current text of article 7, but also 

through a new version of article 7 itself with accompanying 

commentary to be used in the negotiation of future 

treaties and amendments to existing treaties. 

Therefore, although it seems that the most proper 

interpretation of article 7, on the basis of the current 

OECD model convention and commentary, requires 

the adoption of the authorized OECD approach irrespective 

of any modification in its wording, the necessary 

changes to improve certainty on this interpretation 

are being made by the OECD. 

C. The Need for Consistency 

Another argument against the single taxpayer approach 

is that its acceptance would result in applying 

the OECD approach in different manners depending 

on what type of PE is involved. 

In this sense, regarding other types of PEs, assets 

and risks would be attributed to the PE in accordance 

with the functions carried on by it, with the consequent 

attribution of profits. No one would dispute that 

these assets and risks legally belong to the nonresident 

enterprise, but are attributable to the PE under the 

OECD approach because of the functions performed 

by that PE. However, once the single taxpayer approach 

is adopted, no profits would be attributed to an 

104 Id. at 57. 

105 See http://www.oecd.org/document/52/ 

0,3343,en_2649_33747_38376628_1_1_1_1,00.html. 

agency PE regarding the risks and assets of the nonresident 

enterprise, even if they arise from activities 

carried out through the agency PE. 106 

There is no relevant difference between the fixed PE 

and the agency PE to justify a different methodology 

in attributing profits to them. 

As analyzed above, the single taxpayer approach is 

based on the axiom that the agency PE profit is zero 

by definition. However, there is no empirical, theoretical, 

or legal basis for achieving this conclusion. First, 

there is no significant difference between the characteristics 

of a fixed PE and an agency PE that may justify 

a difference in treatment regarding the attribution of 

profits. Second, no convincing theoretical support has 

been provided in favor of the single taxpayer approach. 

107 Third, nothing in the wording of articles 5 

and 7 of the OECD model seems to support a difference 

in treatment. Quite the opposite, the basis for attributing 

profits to all types of PEs is precisely the 

same provision of article 7 and the arm’s-length principle. 

Therefore, there is no reason why the attribution of 

profits to an agency PE should be treated differently 

from the attribution of profits to other types of PE. 

D. Do Not Assume the Law Is Redundant 

One of the principles that guides the legal interpretation 

process is that the law does not have useless 

words. 

Adopting the single taxpayer approach would make 

article 5(5) of the OECD model superfluous and this 

outcome is against the principle of the effective interpretation 

of conventions incorporated into the concept 

of good faith in article 31(1) of the Vienna Convention 

on the Law of Treaties. 108 

Indeed, it must be recognized that the adoption of 

the single taxpayer approach leads to the concept of 

agency PE becoming meaningless, because the profits 

of the agency PE will be taxed anyway by its state of 

residence. Therefore, if there is no additional profit to 

be attributed to the agency PE over and above the 

arm’s-length reward of the dependent agent, there is no 

need to have article 5(5). 

The characterization of an agency PE would have 

the sole consequence of ensuring that the dependent 

agent receives an arm’s-length remuneration. Basically, 

once an agency PE is found to exist, the consideration 

paid by the nonresident enterprise to its dependent 

106 

Para. 273 of the ‘‘Report on the Attribution of Profits to 

Permanent Establishment,’’ Part I (General Considerations), 

(2006). 

107 

Pijl, supra note 9, at 35. 

108 Id. at 32. 





agent would be as if the parties were associated enterprises, 

an outcome similar to subjecting them to the 

provisions of article 9. 

However, no attribution of profits would be made to 

the agency PE, which is a major contradiction to the 

sole purpose of article 7. 

There is no doubt that when dealing with the transactions 

between associated enterprises (that is, the remuneration 

of the dependent agent regarding the services 

provided to the nonresident enterprise), article 9 is 

the relevant article in determining whether the transactions 

were carried out on an arm’s-length basis. 109 

However, regarding the attribution of profits to the 

agency PE in the host state, article 7 is clearly the relevant 

provision. 110 In this context, as discussed above, 

‘‘the assets and risks of the nonresident enterprise relating 

to the functions performer on its behalf by the 

dependent agent enterprise, together with sufficient free 

capital to support those assets and risks,’’ should first 

be attributed to the agency PE. 111 Under the authorized 

OECD approach, this factor will be the measure 

of the profits to be attributed to the agency PE. In this 

scenario, the arm’s-length remuneration of the dependent 

agent mentioned in the previous paragraph should 

be deducted in the determination of the agency PE 


As a consequence, a legal reasoning that has the 

consequence of not attributing profits to a PE, as it is 

the single taxpayer approach, should be rejected because 

it does not comply with the traditional standards 

of legal interpretations, which should not assume that 

the law, for articles 5 and 7 of OECD model, is redundant. 

E. Practical Difficulties Should Not Prevent 

Adoption 

Philip Baker and Richard S. Collier raise arguments 

of a practical nature against the authorized OECD approach. 

According to Baker and Collier, it is particularly 

difficult to determine the profit, if any, to be attributed 

to the agency PE in excess of the arm’s-length 

reward to the dependent agent because there are many 

implementation difficulties, namely the need to provide 

documentation of an agency PE when the nonresident 

enterprise is not aware of its existence. 112 

Some tax authorities, especially in common-law 

countries, adopt the single taxpayer approach because 

of practical considerations and try to charge, to the 

extent possible, the profit left from the dependent 

109 

Para. 276 of the ‘‘Report on the Attribution of Profits to 

Permanent Establishments,’’ Part I (General Considerations), 

(2006). 

110 


111 Id. at para. 278. 


agent. 113 It would be much easier for the tax authorities 

of the host state to challenge the arm’s-length remuneration 

paid to the dependent agent, rather than 

seek to tax the agency PE. 114 

A higher difficulty in determining the profit to be 

attributed to an agency PE in excess of the arm’slength 

reward paid to the dependent agent should not 

be an obstacle to the implementation of the authorized 

OECD approach. Simplicity in the field of taxation is 

always welcome, but not if the price to pay is ignoring 

one of the basics of the taxation of business profits. 

Although recognizing the positive aspects of the 

single taxpayer approach as being a simple system from 

an administrative perspective, there is no need for complicated 

functional and factual analysis, and this approach 

has no theoretical support. 115 

Therefore, an interpretation that entails an adequate 

allocation of the risks within the enterprise and that is 

in line with the rationale underlying article 7 precedes 

any considerations of a practical nature. The need for 

simplicity in the field of taxation should never overcome 

a legal interpretation that is harmonious with the 

wording of the legal text. 

VI. Conclusion 

It seems safe to conclude that the authorized OECD 

approach is indeed the most appropriate approach to 

attribute profits to PEs. 

The authorized OECD approach is the only one 

that entails an adequate allocation of the risks within 

the enterprise because the single taxpayer approach 

ignores the possibility of other functions being performed 

or risks being assumed in the host state, which 

may not reflect the entire activities of the enterprise in 

that state. Therefore, the single taxpayer approach 

might lead to a hidden profit escaping from taxation of 

the host state, while the authorized OECD approach 

allows the host state to ‘‘see’’ and be able to tax eventual 

other functions or risks that are being performed 

or assumed within its territory. 

Moreover, it is undisputable that the rationale of the 

authorized OECD approach is in line with the underlying 

principle codified in article 7. This provision upholds 

the primacy of the arm’s-length principle in attributing 

profits to PEs as a natural consequence of the 

adoption of the separate entity fiction. By adopting the 

arm’s-length principle to dealings between the general 

enterprise and its PE, the only result that is harmonious 

is that the PE profits must be determined in accordance 

with the assets and risks of the nonresident enterprise 

relating to the functions performed by the 






dependent agent on behalf of the nonresident enterprise, 

together with sufficient capital to support those 

assets and risks. Therefore, the authorized OECD approach 

is the only one that leads to an outcome that is 

coherent with the fiction of independence provided in 

article 7(2). 

Furthermore, there is no reason why the attribution 

of profits to an agency PE should be treated differently 

than the attribution of profits to other types of PEs. 

The adoption of the single taxpayer approach results in 

applying the OECD approach in different manners depending 

on what type of PE is involved, which is 

clearly unreasonable. 

Also, the adoption of the single taxpayer approach 

would make article 5(5) of the OECD model superfluous, 

which is against one of the main principles that 

guides the legal interpretation process — that the law 

does not have useless words. 

Finally, considerations of a practical nature should 

not overcome a legal interpretation that is harmonious 

with the wording of the legal text, and is the reason 

why the authorized OECD approach should prevail 

over the single taxpayer approach, even if the former 

may be a more difficult application in practice. 


The analysis of the relevant case law shows that attribution 

of profits to PEs is still a controversial issue, 

although a trend towards the adoption of the authorized 

OECD approach can be seen. 

Moreover, the criticisms of the application of the 

authorized OECD approach to treaties currently in 

force are somehow weakened as the OECD Committee 

on Fiscal Affairs adopted, at its meeting of June 24-25, 

2008, the revised commentary on the current article 7 

of the OECD model and included it in the 2008 update 

to the model. 

Tax practice shows that there will always be room 

to discuss the legal status of the OECD commentary 

as well as the historical debate between the static and 

ambulatory interpretation of the commentary. 

Therefore, the states that concluded OECDpatterned 

treaties should put all their efforts into implementing 

the necessary changes to adopt the authorized 

OECD approach because only a uniform interpretation 

of article 7 of the OECD model among the states can 

ensure that no double taxation will arise, greatly benefiting 

cross-border trade. ◆ 





U.S. Tax Review 

by James P. Fuller 

James P. Fuller is an attorney and a partner at Fenwick & West in Mountain View, Calif. 

Contract Manufacturing: Final Regulations 

The IRS and Treasury issued final contract manufacturing 

regulations that will apply to tax years of 

controlled foreign corporations beginning after June 30, 

2009. (For the final regulations, see Doc 2008-27115 or 

2008 WTD 249-34.) New branch rule regulations were 

also issued, albeit in temporary form. Those are discussed 

separately below. A taxpayer may choose to apply 

the new contract manufacturing regulations and the 

temporary branch rule regulations retroactively for its 

open tax years. A taxpayer may so choose only if the 

taxpayer and all members of its affiliated group apply 

both the contract manufacturing regulations and the 

temporary branch rule regulations in their entirety to 

the earliest tax year of each CFC that ends with or 

within an open tax year of the taxpayer and to all subsequent 

tax years of the taxpayer. 

Substantial Contribution Test: Employees 

The proposed regulations provided that a CFC will 

satisfy the substantial important contribution test regarding 

personal property only if all the facts and circumstances 

show that the CFC made a substantial contribution 

through the activities of its employees to the 

manufacture of the property. The proposed regulations 

provided a nonexclusive list of activities to be considered 

in determining whether the CFC satisfies the substantial 

contribution test. 

The final regulation defines employees by reference 

to Treas. reg. section 31.3121(d)-1(c). That provision, 

entitled ‘‘Common-Law Employees,’’ states that every 

individual is an employee if, under the usual commonlaw 

rules, the relationship between him and the person 

for whom he performs services is the legal relationship 

of employer and employee. It continues by stating that 

generally, such a relationship exists when the person 

for whom services are performed has the right to con- 

trol and direct the individual who performs the services, 

not only as to the result to be accomplished by 

the work but also as to the details and means by which 

that result is accomplished. That is, the regulation 

states, an employee is subject to the will and control of 

the employer and not only as to what will be done but 

how it will be done. 

It is not necessary under that provision that the employer 

direct or control the manner in which the services 

are performed; it is sufficient if he has the right to 

do so. 

The right to discharge is also an important factor 

indicating that the person possessing that right is an 

employer. Other factors characteristic of an employer, 

but not necessarily present in every case, are the furnishing 

of tools, and the furnishing of a place to work, 

to the individual who performs the services. 

If an individual is subject to the control and direction 

of another merely as to the result to be accomplished 

by the work and not as to the means and 

methods for accomplishing the result, he generally is 

an independent contractor. An individual performing 

services as an independent contractor is not as to those 

services an employee under the usual common-law 

rules. Whether the relationship of an employer and 

employee exists will be determined upon an examination 

of the facts of each case. 

The IRS and Treasury state that this clarification of 

the term ‘‘employee’’ will promote more effective application 

of the contract manufacturing regulations. The 

IRS and Treasury believe that the activities performed 

by certain nonpayroll workers should be considered in 

determining whether a CFC provides a substantial contribution 

through its employees. The IRS and Treasury 

concluded that it would be inappropriate to broaden 

the definition of employee to include anyone in an 

agency relationship with the CFC, because it could 




create unintended branch rule issues for taxpayers (for 

example, as a result of employees of a contract manufacturer 

being treated as employees of the CFC under 

such a definition). 1 

Thus, the final regulations, the preamble states, provide 

that employee means any individual who under 

Treas. reg. section 31.3121(d)-1(c) has the status of an 

employee for U.S. federal income tax purposes. This 

definition of the term ‘‘employee’’ may encompass 

some seconded workers, part-time workers, workers on 

the payroll of a related employment company whose 

activities are directed and controlled by CFC employees, 

and contractors, so long as those individuals 

are deemed to be employees of the CFC under Treas. 

reg. section 31.3121(d)-1(c). 

The preamble notes that this definition may result in 

an individual being treated as an employee of two or 

more entities simultaneously. 

Substantial Contribution Activities 

The substantial contribution activities, that is, the 

nonexclusive list of activities that will be considered in 

determining whether manufacturing takes place, are at 

the heart of the new regulation. They were reworded 

somewhat and are set forth below: 

1. Oversight and direction of the activities or 

processes pursuant to which the property is 

manufactured, produced, or constructed (under 

the ‘‘physical manufacturing’’ rules). 

2. Activities that are considered in, but that are 

insufficient to satisfy, the tests for ‘‘physical 

manufacturing.’’ 

3. Material selection, vendor selection, or control 

of the raw materials, work-in-process, or finished 

goods. 

4. Management of manufacturing costs or capabilities 

(for example, managing the risk of loss, 

cost reduction, or efficiency initiatives associated 

with the manufacturing process, demand planning, 

production scheduling, or hedging raw material 

costs). 

5. Control of manufacturing-related logistics. 

6. Quality control (for example, sample testing or 

establishment of quality control standards). 

7. Developing, or directing the use or development 

of, product design and design specifications, 

as well as trade secrets, technology, or other intellectual 

property for the purpose of manufacturing, 

producing, or constructing the personal property. 

1 See below for a discussion of the possible effects of this new 

rule under the temporary branch rule regulations. 

Under Treas. reg. section 1.954-3(a)(4)(iv)(c), all 

CFC employee functions contributing to the manufacture 

of the personal property will be considered in the 

aggregate when determining whether a substantial contribution 

is made to the manufacture of the personal 

property through the activities of the CFC’s employees. 

There is no single activity that will be accorded more 

weight than any other activity in every case or that will 

be required to be performed in all cases. There is no 

minimum threshold for functions performed by employees 

of a CFC before the functions regarding a 

given activity may be taken into account as part of the 

substantial contribution test. Therefore, all functions 

performed by a CFC’s employees are considered (and 

given appropriate weight) under the substantial contribution 

test, even if the CFC’s employees perform only 

some of the functions in connection with any one activity 

(for example, some of the vendor selection) considered 

under that test. 

The weight given to any functions performed by employees 

of the CFC regarding any activity will be 

based on the economic significance of those functions 

to the manufacture, production, or construction of the 

relevant personal property and will vary with the facts 

and circumstances. Only activities of the CFC’s employees 

are considered in the substantial contribution 

analysis, and, consequently, purely contractual assumptions 

of risk are not considered in the substantial contribution 

analysis. A CFC will not be precluded from 

making a substantial contribution simply because other 

persons make a substantial contribution to the manufacture, 

production, or construction of that property. 

The importance of oversight and direction of the 

activities or processes under which personal property is 

manufactured, produced, or constructed will vary 

based on the facts and circumstances associated with 

the manufacture, production, or construction at issue. 

The preamble states that oversight and direction of the 

activities or process under which personal property is 

manufactured are likely to be important elements in 

many substantial contribution analyses. In some industries, 

a substantial contribution could be made by a 

CFC without its employees engaging in oversight and 

direction of the activities or process under which personal 

property is manufactured. 

Since the regulations provide that only activities of 

the CFC’s employees are considered in the analysis, 

mere contractual rights, legal title, tax ownership, or 

assumption of economic risk are not considered in the 

substantial contribution analysis. The CFC does not 

need to own the raw materials that are used in the 

manufacturing process. 

The proposed regulations used the term ‘‘management 

of the manufacturing profits.’’ The IRS and Treasury 

intend that the substantial contribution test recognize 

contributions made by a CFC’s employees to the 

manufacturing process through functions that help ensure 

a plant is run in an economically efficient manner, 



such as optimization of plan capacity and reduction of 

waste (for example, waste of raw materials). However, 

not all corporate managerial decisions are intended to 

be considered in the substantial contribution test, because 

they may not be directly related to the manufacture 

of the personal property. For example, the IRS 

and Treasury do not intend that corporate finance decisions 

be considered in the substantial contribution test. 

Similarly, the IRS and Treasury do not intend that the 

general management of enterprise risk be considered in 

the substantial contribution test. 

In considering logistics, the activity is intended to 

include, for example, arranging for delivery of raw materials 

to a contract manufacturer, but to exclude delivery 

of finished goods to a customer. Thus, the final 

regulations revised the activities’ description to read 

‘‘control of manufacturing related logistics.’’ 

Changes were made in the ‘‘use of trade secrets’’ 

provision (number 7 above) to clarify that developing, 

or directing the use or development of, trade secrets, 

technology, or other intellectual property are considered 

under the substantial contribution test, but only 

when activities of this nature are undertaken for the 

purpose of the manufacture of the personal property. 

The term ‘‘protection’’ regarding trade secrets was 

deleted. The IRS and Treasury were concerned that 

absent this clarification, the final regulations could read 

to provide that legal work performed by a CFC’s inhouse 

legal staff was considered under the substantial 

contribution test, including in cases in which, for example, 

litigation success could be heavily correlated to 

profitability or business failure regarding a product. 

The activity as described in both the proposed and 

final regulations concerns intellectual property used in 

the manufacture of the personal property. Thus, developing, 

or directing the use or development of, marketing 

intangibles is not intended to be considered in the 

substantial contribution test. 

Other Matters 

The IRS and Treasury had requested comments on 

whether the substantial contribution test should include 

an antiabuse rule and safe harbor. In particular, comments 

were requested as to whether it would be appropriate 

to add an antiabuse rule to prevent a CFC from 

satisfying the substantial contribution test when a significant 

part of the direct or indirect contributions to 

the manufacture of personal property provided collectively 

by the CFC and any related U.S. persons are provided 

by one or more related U.S. persons. Commentators 

recommended that in determining whether a CFC 

makes a substantial contribution, it should not be relevant 

whether other persons (whether U.S. or foreign, 

related or unrelated) contribute to the manufacturing 

process. The IRS and Treasury agreed with those commentators. 

Thus, the final regulations do not adopt an 

antiabuse rule. 


The IRS and Treasury also concluded that no safe 

harbor could fairly apply across the range of industries 

potentially subject to these contract manufacturing 

rules, and therefore no safe harbor was provided in the 

final regulations. 

A CFC may provide a 

substantial contribution to 

a largely automated 

manufacturing process 

through its employees. 

Commentators requested that the regulations adopt 

principles to determine when the employees of a partnership 

should be treated as employees of the CFC for 

purposes of determining whether the CFC’s relative 

economic interest in the partnership should be relevant 

to determining whether the CFC satisfies the substantial 

contribution test. The IRS and Treasury concluded 

that this issue was beyond the scope of the regulatory 

project, but they continue to study the issue and welcome 

comments. Thus, the final regulation provides 

only that a CFC’s distributive share of income of a 

partnership will be considered earned from products 

manufactured, produced, or constructed by the CFC 

only if the manufacturing exception would have applied 

to exclude the income from subpart F income if 

the CFC had earned the income directly, determined 

by taking into account only the activities of the employees 

of, and the property owned by, the partnership. 

The proposed regulations contained a rebuttable presumption 

that a CFC does not satisfy the substantial 

contribution test when the activities of a branch of the 

CFC satisfy the physical manufacturing test. In response 

to comments, the IRS and Treasury concluded 

that the substantial contribution test can be administered 

without the benefit of a rebuttable presumption, 

and the final regulations do not contain this rebuttable 

presumption. 

Automated manufacturing (Example 4 in the proposed 

regulations) was the subject of significant comment. 

A number of examples were added to clarify 

that a CFC may provide a substantial contribution to a 

largely automated manufacturing process through its 

employees. The examples are discussed below. 

The IRS and Treasury generally agreed with commentators 

that if the substantial contribution test is 

sufficient to constitute the manufacture of the personal 

property where a CFC substantially contributes to the 

manufacture, production, or construction of that property, 

then it should be equally sufficient if those activities 

are performed by a related person in the CFC’s 




country of organization. Therefore, the final regulations 

provide that the same-country manufacturing exception 

is available to taxpayers in cases when a related 

person provides a substantial contribution to the manufacture 

of the personal property in the CFC’s country 

of organization. The final regulations also retain the 

rule provided in the proposed regulations to reflect that 

personal property manufactured, produced, or constructed 

in the country of organization of the selling 

corporation will qualify for the same country exception 

regardless of whose employees engage in the qualifying 

manufacturing activities in that country. 

The IRS and Treasury continue to believe, as described 

in the preamble to the proposed regulations, 

that the so-called ‘‘its’’ argument is contrary to existing 

law and represents an incorrect reading of section 

954(d)(1). Thus, despite some criticism by commentators 

and at the hearings on the proposed regulations, 

the final regulations maintain the rules provided in the 

proposed regulations regarding when personal property 

sold by a CFC will be considered to be other than the 

property purchased by the CFC: ‘‘A controlled foreign 

corporation will not be treated as having manufactured, 

produced, or constructed personal property which the 

corporation sells merely because the property is sold in 

a different form than the form in which it was purchased.’’ 

Examples 

Example 1 

FS, the CFC in question, does not exercise, through 

its employees, its powers to control the raw materials, 

work in process, or finished goods, and FS also does 

not exercise its powers of oversight and direction. Likewise, 

FS does not through its employees, develop, or 

direct the use or development of the intellectual property 

for the purpose of manufacturing Product X. FS 

does not satisfy the substantial contribution test. 

Example 2 

The facts are the same as in Example 1, except that 

FS, through its employees, engages in product design 

and quality control and controls manufacturing-related 

logistics. FS’s employees exercise the right to oversee 

and direct the activities of the third-party contract 

manufacturer in the production of Product X. FS satisfies 

the substantial contribution test. 

Example 3 

FS, a CFC, enters into a contract with an unrelated 

contract manufacturer to produce Product X. Employees 

of FS select the materials that will be used to 

manufacture the product. FS does not own the materials 

or work-in-process during the manufacturing process. 

FS, through its employees, exercises oversight and 

direction of the manufacturing process and provides 

quality control. FS manages the manufacturing costs 

and capabilities of the product by managing the risk of 

loss and engaging in demand planning and production 

scheduling. FS satisfies the substantial contribution 

test. 

Example 4 

FS purchases raw materials from a related person. 

They are manufactured into Product X by an unrelated 

contract manufacturer under an agreement. The contract 

manufacturer contracts with another corporation 

for its employees to operate the contract manufacturer’s 

plant and transform, assemble, or convert the raw materials 

into Product X. Apart from physical performance 

of the substantial transformation, assembly, or 

conversion of the raw materials into Product X, employees 

of FS perform all of the other manufacturing 

activities required in connection with the manufacture 

of Product X (for example, oversight and direction of 

the manufacturing process; vendor selection; control of 

raw materials, work-in-process and finished goods; control 

of manufacturing-related logistics; and qualify control). 

FS satisfies the substantial contribution test. 

Example 5 

FS purchases raw materials from a related person. 

The raw materials are manufactured into Product X by 

an unrelated contract manufacturer selected by FS. At 

all times, FS retains ownership of the raw materials, 

work-in-process, and finished goods. FS retains the 

right to oversee and direct the activities or process according 

to which the product is manufactured, but does 

not exercise, through its employees, its powers of oversight 

and direction. FS is the owner of sophisticated 

software and network systems that remotely and automatically 

(without human involvement) take orders, 

route them to the contract manufacturer, order raw materials, 

and perform quality control. FS has a small 

number of computer technicians who monitor the software 

and network systems to ensure that they are running 

smoothly and apply any necessary patches or 

fixes. The software and systems were developed by employees 

of the U.S. parent company. The parent company’s 

employees supervise the computer technicians, 

evaluate the results of the automated manufacturing 

business, and make operational and manufacturing decisions. 

The parent’s employees develop and provide to 

FS all of the upgrades to the software and network 

systems. The parent’s employees also direct and control 

other aspects of the manufacturing process such as 

vendor material selection, management of the manufacturing 

costs and capabilities, and the selection of the 

contract manufacturer. FS does not satisfy the substantial 


Example 6 

Assume the same facts as in Example 5, except that 

FS, through its employees, engages in the activities undertaken 

by the parent’s employees in Example 5. The 

parent’s employees also contribute to product and 

manufacturing process design and provide support and 



oversight to FS in connection with the functions performed 

by FS through its employees. FS satisfies the 

substantial contribution test. Selection of the contract 

manufacturer, even though not specifically identified on 

the nonexclusive factors list, is considered in determining 

whether FS makes a substantial contribution to the 

manufacture of Product X through its employees. 

Example 7 

Assume the same facts as in Example 6, except that 

the software and network systems, and the upgrades to 

those systems, were purchased by FS rather than developed 

by employees of FS. FS satisfies the substantial 

contribution test. The lack of performance of software 

and network system development activities is not determinative 

under the facts and circumstances of the business. 

Further, this determination does not require a 

comparison between the activities of FS and the activities 

of the domestic parent. 

Example 8 

FS has raw materials manufactured into Product X 

by an unrelated contract manufacturer. FS controls the 

raw materials, work-in-process, and finished goods. FS 

controls the manufacturing-related logistics, manages 

the manufacturing costs and capabilities, and provides 

quality control for the contract manufacturer’s manufacturing 

process and product. No intellectual property 

of significant value is required to manufacture the 

product. FS does not own any intellectual property or 

hold an exclusive or nonexclusive right to manufacture 

Product X. FS satisfies the substantial contribution test. 

Example 9 

FS1 and FS2, unrelated CFCs, contract with an unrelated 

contract manufacturer to manufacture Product 

X. Neither FS1 nor FS2 owns the materials or work-inprocess 

during the manufacturing. FS1, through its employees, 

designs Product X. FS1 directs the use of the 

product design and design specifications and other intellectual 

property for the purpose of manufacturing 

Product X. Employees of FS1 also select the materials 

that will be used in the manufacture of the product 

and the vendors to provide those materials. FS2, 

through its employees, designs the process for manufacturing 

Product X. FS2, through its employees, manages 

the manufacturing costs and capabilities for Product X. 

FS1 and FS2 each provide quality control and oversight 

and direction of the contract manufacturer’s 

manufacturing activities for different aspects of the 

manufacture of Product X. Both FS1 and FS2 satisfy 

the substantial contribution test. Each independently 

makes a substantial contribution through the activities 

of its employees for the manufacture of the product. 

Example 10 

FS purchases raw materials and has them manufactured 

into Product X by an unrelated contract manufacturer. 

Products in the X industry are distinguished 

(and vary widely in value) based on the raw materials 

used to make the product and the product design. FS 


designs the product and selects the materials that the 

contract manufacturer will use to manufacture the 

product. FS also manages the manufacturing costs and 

capabilities. Product X can be manufactured from the 

raw materials to FS’s design and specifications without 

significant oversight and direction, quality control, or 

control of manufacturing-related logistics. The activities 

most relevant to the substantial contribution analysis 

under these facts are material selection, product design, 

and management of the manufacturing costs and capabilities. 

FS makes a substantial contribution through 

the activities of its employees to the manufacture of 

the product. 

Example 11 

FS purchases raw materials and has them manufactured 

into Product X by an unrelated contract manufacturer. 

FS controls the raw material, work-in-process, 

and finished goods; manages the manufacturing costs 

and capabilities; and provides oversight and direction 

of the manufacture of Product X. Employees of FS 

visit the manufacturer’s facility for one week each 

quarter and perform quality control tests on a random 

sample of the units of Product X produced during the 

week. In the industry, quarterly visits to a manufacturing 

facility by qualified persons are sufficient to control 

the quality of manufacturing. FS satisfies the substantial 


Manufacturing Branch Rules 

The manufacturing branch rule regulations that were 

proposed with the contract manufacturing regulations 

were adopted as temporary regulations. (For the proposed 

regulations, see Doc 2008-27116 or 2008 WTD 249- 

35.) Treasury and the IRS presumably concluded that 

there were sufficient changes in these regulations such 

that they should be issued in temporary form and also 

reproposed. A public hearing has been scheduled for 

the proposed version of these regulations on April 20, 

2009. The temporary regulations apply to tax years of 

CFCs beginning after June 30, 2009, and for tax years 

of U.S. shareholders in which these tax years of CFCs 

end. As discussed above, the temporary regulations 

under some conditions may be applied retroactively by 

a taxpayer for its open tax years. 

Branch Definition: Important Issues 

The proposed regulations did not define the term 

‘‘branch.’’ Some commentators suggested that the regulations 

define the term. These commentators suggested 

various definitions for the IRS and Treasury to consider. 

Some commentators suggested, for example, that 

a branch be defined as a permanent establishment, as a 

business activity in a jurisdiction outside a CFC’s 

country of organization that has separate books and 

records, or as a trade or business outside a CFC’s 

country of organization. Commentators pointed to precedents 

in the section 367 and section 987 regulations. 

Alternatively, some commentators requested that the 




regulations make clear that a de minimis amount of 

activity outside a CFC’s country of organization (for 

example, traveling employees) does not constitute a 

branch. 

Other commentators warned that requiring too high 

a level of activity outside a CFC’s country of organization 

before a CFC is treated as having a branch 

would make it possible for a CFC organized in a 

lower-taxed jurisdiction to contribute substantially to 

manufacturing activities in a higher-tier jurisdiction 

without causing the CFC to operate through a branch. 

Still other commentators suggested that courts have 

concluded that the IRS and Treasury lack the regulatory 

authority to determine what constitutes a branch, 

and that they may address only the consequences flowing 

from the existence of a branch. 

The IRS and Treasury determined that defining a 

branch was beyond the scope of this regulatory project. 

However, the temporary regulations retain an example 

similar to an example in the proposed regulations that 

illustrates that employees of a CFC that travel to a 

contract manufacturer’s location outside the CFC’s 

country of organization do not necessarily give rise to 

a branch in that location. 

An important issue in this regard, however, was left 

unstated and unaddressed in both the branch rule regulations 

and the preamble to those regulations. The contract 

manufacturing regulations define ‘‘employee’’ by 

reference to section 3121. The branch rule regulations 

are silent on this point. 2 

If employees of one corporate entity (Corp B) can 

be treated as a branch of another corporate entity, 

Corp A, so that Corp A has a branch in Country B 

simply because an IRS examining agent contends that 

Corp A’s employees have section 3121 control over 

Corp B’s employees, then the new branch rule is much 

different from the old branch rule. 

Ashland Oil and Vetco may have been overruled, or at 

least placed in question. There is no reason this lookthrough, 

if it is the rule, couldn’t apply to unrelated 

persons, as well as related persons. It also has nothing 

necessarily to do with contract manufacturing; this rule 

also presumably could apply in other branch rule contexts, 

for example, under the sales branch rule. 

Should it make a difference whether it is the taxpayer 

who asserts that certain persons are employees 

for purposes of the contract manufacturing rules, or 

can IRS examining agents on their own make that assertion? 

Could one such ‘‘employee’’ constitute a 

branch, or does it require many ‘‘employees’’? 

The court in Ashland Oil considered the dictionary 

definition of branch (‘‘division, office or other unit of 

business located at a different location from the main 

2 See, however, note 1, supra. 

office or headquarters’’; a business dictionary similarly 

stated an ‘‘office’’ in a different location from the ‘‘parent 

company.’’) 

The court in Ashland stated that regardless of the 

precise ordinary meaning of branch, the court was 

confident that it didn’t encompass Tensia, an unrelated 

corporation operating under an arm’s-length contractual 

arrangement with the taxpayer’s CFC. 

Until this treatment of ‘‘employees’’ is made clearer 

under the branch rule regulations, it might be a reason 

not to apply the contract manufacturing regulations 

retroactively. To do so, the branch rule regulations also 

must be applied retroactively. 

Also, a recent statement by an IRS spokesperson 

raises more questions. It was to the effect that a sales 

branch might exist even in the absence of selling activities: 

‘‘If a branch is booking sales income, the IRS will 

argue that it is a sales branch.’’ I certainly do not see 

such a rule anywhere in the regulations, where selling 

activity is necessary to have a sales branch. It seems at 

odds with the court’s discussion in Ashland Oil as well 

as the statutory language. To be consistent with Ashland 

Oil and section 954(d), a branch would need to be 

present before this could arise. But that was not the 

question being addressed. The statement was in response 

to a question about whether the existence of a 

sales branch is based on earning income or sales activities. 

We may have some new rules. 

Hypothetical Effective Tax Rate 

The tax rate disparity tests take into account the 

actual tax rate paid on the sales income by the selling 

branch or remainder and the hypothetical effective tax 

rate that would be paid by the manufacturing branch 

(or remainder) on that sales income under the rules of 

the country in which the manufacturing branch is located 

(or, in the case of a remainder, the country of 

organization of the CFC) if it were derived from the 

sources within that country. The IRS and Treasury 

agreed with commentators that uniformly available tax 

incentives are to be considered in determining the hypothetical 

effective tax rate to be used in applying the 

tax rate disparity tests. 

On the other hand, if a sales affiliate in the country 

of manufacturing can theoretically receive certain tax 

relief by taking certain actions, for example, by applying 

for special treatment under a ruling process, but the 

taxpayer has not affirmatively obtained that tax relief 

for the manufacturing branch (or a remainder), then 

the hypothetical effective tax rate that would be paid 

by the manufacturing branch (or remainder) were it to 

derive the sales income should be the effective tax rate 

that would be applicable in that jurisdiction without 

such relief. 

The IRS and Treasury state that no change to the 

text of the existing regulation is necessary to address 

these points. However, a new Example 8 is included in 

the temporary regulations to illustrate that uniformly 



applicable incentive tax rates are taken into account in 

determining the hypothetical effective tax rate. 

Location of Manufacturing 

Under the proposed regulations, the relevant tax rate 

disparity test was applied by giving satisfaction of the 

physical manufacturing test precedence over satisfaction 

of the substantial contribution test when multiple 

branches, or one or more branches and the remainder 

of the CFC, perform manufacturing activities for the 

same item of personal property. 

If more than one branch (or one or more branches 

and the remainder of the CFC) each independently 

satisfies the physical manufacturing test, then the 

branch or the remainder of the CFC located or organized 

in the jurisdiction that would impose the lowest 

effective rate of tax is treated as the location of manufacturing, 

producing, or constructing the personal property 

for purposes of applying the tax rate disparity 

tests. 

If none of the branches or the remainder of the 

CFC independently satisfies the physical manufacturing 

test, but the CFC as a whole satisfies the substantial 

contribution test, then under the proposed regulations, 

the location of manufacturing was the location of the 

branch or the remainder of the CFC that provides the 

predominant amount of the CFC’s substantial contribution 

to the manufacturing of the personal property. 

If a predominant amount of the CFC’s contribution is 

not provided by any one location, then under the proposed 

regulations, the location of manufacturing for 

purposes of applying the manufacturing branch tax 

rate disparity test was that place (either the remainder 

of the CFC or one of its branches) where the manufacturing 

activity for that property is performed and that 

would impose the highest effective tax rate. 

Commentators suggested that the same rule should 

apply consistently when a branch (or remainder) independently 

satisfies the manufacturing test, regardless of 

whether it satisfies the physical manufacturing test or 

the substantial contribution test. The IRS and Treasury 

agree. Therefore, the rules in the proposed regulations 

were modified. The temporary regulations provide that 

the lowest-of-all-rates rule will apply whenever a 

branch (or remainder) independently satisfies the 

manufacturing test. 

The IRS and Treasury also believe, however, that 

providing for parity of treatment for satisfaction of the 

physical manufacturing test and the substantial contribution 

test regarding the lowest-of-all-rates rule is not 

sufficient to determine the location of manufacturing 

in cases in which a CFC satisfies the substantial contribution 

test, yet no branch (or remainder) independently 

satisfies the substantial contribution test. 

The temporary regulations thus revise the rules for 

determining the location of manufacture of the personal 

property when more than one branch (or one or 

more branches and the remainder) contributes to the 


manufacture of the personal property, but no branch 

(or remainder) independently satisfies the physical 

manufacturing test or the substantial contribution test. 

If a demonstrably greater amount of manufacturing 

activity regarding personal property occurs in jurisdictions 

without tax rate disparity relative to the sales or 

purchase branch, the location of the sales or purchase 

branch will be deemed to be the location of manufacture 

of the personal property. Otherwise, the location 

of manufacture of the personal property will be 

deemed to be the location of a manufacturing branch 

(or remainder) that has tax rate disparity relative to the 

sales or purchase branch. 

The location of any activity 

with respect to the 

manufacture of the 

personal property is where 

the CFC’s employees 

engage in that activity. 

The location of any activity for the manufacture of 

the personal property is where the CFC’s employees 

engage in that activity. When an employee travels to 

perform his or her activities, those activities are 

credited to the location in which the activities are conducted 

if there is a branch or remainder of the CFC in 

that jurisdiction. The activities of employees while traveling 

to a country with a CFC that does not maintain 

a branch or remainder are not credited to the branch or 

remainder where the traveling employees are regularly 

employed for purposes of determining the location of 

manufacturing under the branch rule. Those activities, 

however, can be taken into account for purposes of 

satisfying the manufacturing exception and the substantial 


Multiple Manufacturing Branch Rules Summary 

In summary, the rules for multiple locations performing 

activities that contribute to the manufacture of 

the product are as follows: 

1. If one or more branches or the remainder of 

the CFC independently satisfies the manufacturing 

test, the location of manufacturing is the 

branch with the lowest effective rate of tax on the 

income allocated to the remainder for branch rule 

testing purposes. 

2. If no location independently satisfies the 

manufacturing test, but the CFC as a whole 

makes a substantial contribution to the manufacture 

of personal property, then the location of 




manufacturing is the tested manufacturing location 

unless the tested sales location provides a 

demonstrably greater contribution to the manufacture 

of the property. 

3. The tested manufacturing location is the location 

of any branch or remainder that contributes 

to the manufacture of the property and that 

would be treated as a separate corporation under 

the tax rate disparity test and that would have the 

lowest effective rate of tax under the tax rate disparity 

test. 

4. The tested sales location is where the CFC 

purchases or sells the personal property. The 

tested sales location includes the activities of any 

branch or remainder that would not be treated as 

a separate corporation under the tax rate disparity 

test. 

5. The tested manufacturing location will be 

deemed to include the activities of any branch or 

remainder that would be treated as a separate 

corporation from the tested sales location under 

the tax rate disparity test. 

6. If the tested sales location provides a demonstrably 

greater contribution to the manufacturing, 

or if there is no tested manufacturing location, 

then the tested sales location is the location of 

manufacturing. 

Coordination of Branch Rules 

The current manufacturing branch rule contemplates 

the existence of a sales or purchase branch and a 

manufacturing branch. The rules provide that in some 

instances, the sales or purchase branch is treated as the 

remainder of the CFC for purposes of applying the tax 

rate disparity test. However, the sales or purchase 

branch rules of the existing regulations do not indicate 

that those rules do not apply in cases in which the 

manufacturing branch rules are applied. Treasury and 

the IRS believe that if one or more sales or purchase 

branches are used in addition to a manufacturing 

branch, and the manufacturing branch rule’s multiple 

branch rule test is applied for income from the sale of 

an item of personal property, then the sales or purchasing 

branch rules should not apply to determine 

whether that income is foreign base company sales income 

(FBCSI). The temporary regulations reflect this 

new clarifying coordination rule. 

Unrelated to Unrelated Transactions 

Commentators suggested that there was uncertainty 

as to whether a substantial contribution to the manufacture, 

production, or construction of personal property 

by a CFC could cause the CFC to earn FBCSI in 

cases when, in the absence of the substantial contribution 

test, some taxpayers had taken the position that 

they were outside the scope of the FBCSI rules. For 

example, the CFC might purchase property from unrelated 

persons and sell that property to unrelated per- 

sons. Some commentators expressed concern that 

transactions that are not currently subject to the existing 

regulations may become subject to the regulations 

as a result of the interaction of the substantial contribution 

test and the manufacturing branch rule. Other 

commentators suggested more generally that it was unclear 

if the substantial contribution test might create a 

branch through which a CFC carries on activities in a 

contract manufacturer’s jurisdiction. 

The IRS and Treasury agree that taxpayers may be 

subject to the FBCSI rules as a result of CFC employees 

performing indicia of manufacturing activities 

through a branch outside the country of organization 

of the CFC. The IRS and Treasury believe this result is 

clear in the proposed regulations, and therefore no 

modifications are made to the text of the temporary 

regulations to further clarify this result. 

The IRS and Treasury note in the preamble that in 

response to comments, physical manufacturing and 

activities satisfying the substantial contribution test are 

treated with equal importance. Thus, the IRS and Treasury 

did not incorporate in the temporary regulations 

an exception for activities performed through a branch 

located outside the country of organization of a CFC 

for cases in which, in the absence of the substantial 

contribution test, some taxpayers have taken the position 

that they were outside the scope of the FBCSI 

rules. 

One commenter recommended that the IRS and 

Treasury consider a special delayed effective date to 

allow taxpayers with unrelated to unrelated transactions 

that may now become subject to the FBCSI rules 

time to restructure their operations in light of the regulations. 

The commenter argued that these taxpayers 

were outside the scope of the FBCSI rules before adoption 

of these regulations and should be provided 

enough time to restructure. A special effective date was 

not provided, but the temporary regulations generally 

have a delayed effective date. 

Examples 

I will describe the regulation’s examples in the order 

in which they appear in the temporary regulation, and 

I will not renumber them. This hopefully will help 

readers match up the examples with the text in the 

regulation. Unless stated otherwise, FS is a CFC organized 

under the laws of Country M. 

1. Example — Figure 1 

FS operates three branches. Branch A in Country A 

manufactures Product X. Branch B located in Country 

B sells Product X manufactured by Branch A to customers 

for use outside Country B. Branch C located in 

Country C sells Product X manufactured by Branch A 

to customers for use outside Country C. FS conducts 

no manufacturing or selling activities of its own. Country 

M imposes an effective tax rate on sales income of 

0 percent. Country A imposes an effective tax rate on 



sales income of 20 percent. Country B imposes an effective 

tax rate on sales income of 20 percent. Country 

C imposes an effective tax rate on sales income of 18 

percent. The manufacturing branch rule is applied to 

the sales income derived by Branch B by treating 

Branch B as though it alone were the remainder of the 

CFC. The use of Branch B does not have the same tax 

effect as if Branch B were a wholly owned subsidiary, 

because the tax rate applicable to income allocated to 

Branch B (20 percent) is not less than 90 percent of, 

and at least 5 percentage points less than, the effective 

rate of tax that would apply to that income under the 

laws of Country A (20 percent). The rules are applied 

separately to the sales income derived by Branch C by 

treating Branch C as though it alone were the remainder 

of the CFC. The use of Branch C also does not 

have the tainted tax effect under the rate disparity test. 

Under the temporary regulation’s new coordination 

rule, the sales branch rules do not apply. (See Figure 

1.) 

FS 

A B C 

20% 

Mfgs 

Figure 1 

Does not Mfg or Sell 

20% 18% 

Sells Sells 

2. Example — Figure 2 

FS purchases raw materials and sells finished products. 

FS is subject to a 10 percent tax rate on its sales 

income. It has two branches, A, which makes Product 

X, and B, which makes Product Y. A’s country taxes 

sales at 20 percent, and B’s country taxes sales at 12 

percent. As to Branch A, the branch rule applies, and 

A is treated as a separate corporation. As to B, the 

branch rule does not cause B to be treated as a separate 

corporation. (See Figure 2.) 

3. Example 1 — Figure 3 

FS has three branches. Branch A located in Country 

A designs Product X. Branch B located in Country B 

provides quality control and oversight and direction. 

Branch C physically manufactures Product X. The 

activities of Branch A and Branch B do not independently 

satisfy the manufacturing rules. Employees 

FS 

A B 

Product 

X 

20% 

Figure 2 

of FS in Country M purchase the raw materials used 

in the manufacture of Product X from a related person 

and control the work-in-process and finished goods 

throughout the manufacturing process. Employees of 

FS in Country M also manage the manufacturing cost 

and capabilities and oversee the coordination between 

the branches. Employees of FS in Country M sell 

Product X to unrelated persons for use outside Country 

M. The sales income from the sale of Product X is 

taxed in Country M at an effective rate of 10 percent. 

Country C imposes an effective rate of tax of 20 percent 

on sales income. 

Country C is the location of manufacture for purposes 

of applying the branch rule tests, because only 

the activities of Branch C independently satisfy the 

manufacturing rules. Under the branch rule tax rate 

disparity test, Branch C is treated as a separate corporation. 

Therefore, sales of Product X by the remainder 

of FS are treated as sales on behalf of Branch C. In 

determining whether the remainder of FS will qualify 

for the manufacturing exception, the activities of FS 

will include the activities of Branch A and Branch B, 

respectively, if each of those branches would not be 

treated as a separate corporation under the tax rate 

disparity test. (See Figure 3.) 

4. Example 2 — See Figure 3. 

10% 

Product 

Y 

12% 


Sells X and Y 

Assume the same facts in Example 1 (3. above), except 

that in addition to the design of Product X, 

Branch A also performs in Country A other manufacturing 

activities, including those ascribed to FS in Example 

1 that are sufficient to satisfy the substantial 

contribution test. Country A imposes a 12 percent tax 

on sales income. Branch A and Branch C through their 

activities each independently satisfy the manufacturing 

test. Therefore, the branch rule is applied using the 




FS 

A B C 

Designs X 

Figure 3 

QC 

Oversight 

Sells 

Purchases RM 

Controls inventories 

Manages cost/capabilities 

Oversees manufacturing 

10% tax 

Physical 

Mfg X 


Location 

of Mfg 

lowest effective tax rate that would apply to sales income 

in either Country A or Country C. Therefore, 

Branch A is treated as the location of manufacture. 

Neither Branch A nor Branch C is treated as a separate 

corporation. Sales of Product X by the remainder of 

FS are not treated as made on behalf of any branch. 


FS purchases from a related person raw materials 

that are manufactured into Product X by an unrelated 

corporation under a contract manufacturing agreement. 

FS has two branches. Branch A located in Country A 

designs Product X. Branch B in Country B controls 

manufacturing-related logistics, provides oversight and 

direction during the manufacturing process, and controls 

the raw materials and work-in-process. FS manages 

the manufacturing costs and capabilities related to 

the manufacture of Product X through employees located 

in Country M. Employees of FS located in 

Country M oversee the coordination between the 

branches. Employees of FS located in Country M also 

sell Product X to unrelated persons for use outside 

Country M. Country M imposes an effective tax rate 

on sales income of 10 percent. Country A imposes an 

effective rate of tax on sales income of 20 percent, and 

Country B imposes an effective rate of tax on sales 

income of 24 percent. Neither the remainder of FS nor 

any branch of FS independently satisfies the manufacturing 

test. As a whole, FS provides a substantial contribution 

to the manufacture of Product X. 

The tested sales location is Country M. The location 

of Branch A is the tested manufacturing location, because 

the effective rate of tax (10 percent) is less than 

90 percent of, and at least five percentage points less 

than, the effective rate of tax that would apply to this 

income in Country A (20 percent), and Country A has 

the lowest effective rate of tax among the manufacturing 

branches that would be treated as separate corporations. 

The activities of Branch B will be included in the 

contribution of Branch A for purposes of determining 

the location of manufacture, because Branch B would 

also be treated as a corporation separate from FS under 

the tax rate disparity test. The activities of the remainder 

of FS would not provide a demonstrably 

greater contribution to the manufacture of Product X 

than the activities of Branch A and Branch B considered 

together. Therefore, the location of manufacture is 

Country A, the location of Branch A. (See Figure 5.) 

CM 


Figure 5 

FS 

A B 

Design design 

20% 

Location 

of MFG Mfg 


manages Manages 

Oversees oversees 

Oversight oversight 

24% 

The facts are the same as in Example 3 (5. above), 

except that the effective rate of tax on sales income in 

Country B is 12 percent. Also, the activities of employees 

of FS located in Country B and Country M, if 

considered together, provide a demonstrably greater 

contribution to the manufacture of Product X than the 

activities of employees of FS located in Country A. 

The tested sales location is Country M. The location of 

Branch A is the tested manufacturing location because 

of the tax rate disparity and the fact that Branch A is 

the only branch that would be treated as a separate 

corporation. The activities of Branch B will be considered 

in the contribution of the remainder of FS for 

purposes of determining the location of manufacture 

of Product X, because there is no tax rate disparity. 

Since the activities of Branch X and the remainder of 

FS provide a demonstrably greater contribution to the 

manufacture of Product X than the activities of Branch 



B, neither Branch A nor Branch B will be treated as a 

separate corporation. (See Figure 6.) 

Same as in Example 3 (Figure 5 above), except B is 12% 

tax. In addition, B and FS in Country country M together provide 

demonstrably greater contribution than A. 

FS 

10% 

A B 

20% 

Tested Mfg 

Location 

Figure 6 

12% 

No branch is a 

separate corp. 


The facts are the same as in Example 3 (5. above), 

except that selling activities are also performed by 

Branch D in Country D, where Country D imposes a 

16 percent effective rate of tax on sales income. Also, 

the activities of FS located in Country A and Country 

M, considered together, provide a demonstrably greater 


activities of employees of FS located in Country B. 

The results for the remainder of FS are the same as 

in Example 3: A is treated as a separate corporation. 

These rules also must be applied regarding Branch 

D because it performs selling activities for Product X. 

Figure 7 

Same as in Example 3 (Figure 5 above) except 

Branch D sells. 

FS 

10% Sells 

A B D 

20% 24% Sells 

16% 


Thus, for purposes of that sales income, the location of 

Branch D is the tested sales location. The location of 

Branch B is the tested manufacturing location because 

there is a tax rate disparity between Country D and 

Country B, and Branch B is the only branch that 

would be treated as a separate corporation. The manufacturing 

activities performed in Country M by the remainder 

of FS and the manufacturing activities performed 

in Country A by Branch A will be included in 

Branch D’s contribution to the manufacture of Product 

X for purposes of determining the location of manufacture 

of Product X regarding Branch D’s sales income. 

Branch D, Branch A, and the remainder of FS, 

considered together, provide a demonstrably greater 


activities of Branch B. Therefore, the branch rules will 

not apply to Branch D, and neither Branch A nor 

Branch D will be treated as a separate corporation. 

(See Figure 7.) 


FS purchases from a related person raw materials 

that are manufactured into Product X by an unrelated 

contract manufacturer (CM). CM physically manufactures 

the goods in Country C. Employees of FS located 

in Country M sell Product X to unrelated persons 

for use outside Country M. 

Employees of FS located in Country M engage in 

product design, manage the manufacturing costs and 

capabilities for Product X, and direct the use of intellectual 

property for purposes of manufacturing Product 

X. Quality control and oversight and direction of the 

manufacturing process are conducted in Country C by 

employees of FS who are located in Country M but 

who regularly travel to Country X. Branch A is the 

only branch of FS. Product design for Product X conducted 

by employees of FS located in Country A are 

supplemental to the bulk of the design work, which is 

done by employees of FS located in Country M. At all 

times, employees of Branch A control the raw materials, 

work-in-process, and finished goods. Employees of 

FS located in Country A also control manufacturingrelated 

logistics for Product X. Country M imposes an 

effective rate of tax on sales income of 10 percent. 

Country A imposes an effective rate of tax on sales 

income of 20 percent. Neither the remainder of FS nor 

Branch A independently satisfies the manufacturing 

test, although FS as a whole provides a substantial 

contribution to the manufactured Product X. 

The tested sales location is Country M because the 

remainder of FS performs the selling activities regarding 

Product X. The tested manufacturing location is 

the location of Branch A because there is a tax rate 

disparity, and Branch A is the only branch that would 

be treated as a separate corporation. Although the activities 

of traveling employees are considered in determining 

whether FS as a whole makes a substantial 

contribution, the activities of the employees of FS that 




are performed in Country C are not taken into consideration 

in determining whether Country M, the jurisdiction 

under the laws of which FS is organized, is the 

location of manufacture. The activities of employees of 

FS performed in Country M do not provide a demonstrably 

greater contribution to the manufacture of 

Product X than the activities of employees of FS located 

in Country A. Therefore, the location of manufacture 

is Country A. (See Figure 8.) 

Employees Employee travel 

FS 

20% 

A 

Location 

of Mfg MFG 

Some design 

controls materials 

CM 

Country C 

Figure 8 

Product design, etc. 

10% 

employees 

Employees 

travel for QC 

and oversight 


This is an example in the current regulations that is 

modified in the temporary regulations. CFC E, incorporated 

under the laws of Country X, is a wholly 

owned subsidiary of CFC D, also incorporated under 

the laws of Country X. E maintains Branch B in 

Country Y. E’s sole activity, carried on through Branch 

B, consists of the purchase of articles manufactured in 

Country X by Corporation D and the sale of those 

articles through Branch B to unrelated persons. Branch 

B is treated as a wholly owned subsidiary corporation 

of E because of a tax rate disparity. Income derived by 

Branch B, treated as a separate corporation, constitutes 

FBCSI. 

If instead D were unrelated to E, none of the income 

would be FBCSI because E’s branch would be 

purchasing from and selling to unrelated persons, and 

if Branch B were treated as a separate corporation, it 

likewise would be purchasing from and selling to unrelated 

persons. Alternatively, if D were related to E, but 

Branch B manufactured the articles before sale, the income 

would not be FBCSI because Branch B, treated 

as a separate corporation, would qualify for the manufacturing 

exception. (See Figure 9.) 


Figure 9 

Dx 

Ex 

By 

FS operates one branch, Branch A, that physically 

manufactures Product X. Raw materials used in the 

manufacture of Product X are purchased by FS from 

an unrelated person. FS engages in activities in Country 

M to sell Product X to a related person for use outside 

Country M. Employees of FS located in Country 

M perform only sales functions. The effective rate imposed 

in Country M on the income from the sale of 

Product X is 10 percent. Country A generally imposes 

an effective rate of tax on income of 20 percent, but 

imposes a uniformly applicably incentive rate of tax of 

10 percent on manufacturing income and related sales 

income. The use of Branch A to manufacture Product 

X does not have substantially the same tax effect as if 

Branch A were a wholly owned subsidiary corporation 

of FS, because the effective rate of tax on FS’s sales 

income from the sale of Product X in Country M (10 

percent) is not less than 90 percent of, and at least 5 

percentage points less than, the effective rate of tax 

that would apply to that income in the country in 

which Branch A is located (10 percent). Branch A is 

not treated as a separate corporation. (See Figure 10.) 



Figure 10 

FS 

A 

Mfg 

20% 

10% incentive rate 


FS has two branches, Branch A and Branch B, located 

in Country A and Country B, respectively. FS 

purchases from a related person raw materials that are 

physically manufactured into Product X by an unrelated 

corporation (CM). CM manufactures the product 

outside FS’s country of organization. FS manages 

manufacturing costs and capacities for the manufacture 

of Product X through employees located in Country 

M. Employees of FS located in Country M oversee the 

coordination between the branches. 

Branch A, through the activities of employees of FS 

located in Country A, designs Product X, controls 

manufacturing-related logistics, and controls the raw 

materials and work-in-process during manufacturing. 

Branch B, through activities of employees of FS located 

in Country B, provides quality control and oversight 

and direction during the manufacturing process. 

Employees of FS located in Country M sell Product X 

to unrelated persons for use outside Country M. Country 

M imposes an effective rate of tax on sales income 

of 10 percent, Country A imposes an effective rate of 

tax on sales income of 12 percent, and Country B imposes 

an effective rate of tax on sales income of 24 

percent. None of the remainder, Branch A or Branch 

B, independently satisfies the manufacturing tests, although 

FS as a whole provides a substantial contribution 

to the manufacture of Product X. The activities of 

the remainder of FS and Branch A, if considered together, 

would not provide a demonstrably greater contribution 

to the manufacture of Product X than the 

activities of Branch B. 

The tested sales location is Country M. The location 

of Branch B is the tested manufacturing location because 

there is a tax rate disparity and Branch B is the 

only manufacturing branch that would be treated as a 

separate corporation. The manufacturing activities performed 

in Country A will be included in the contribution 

of the remainder of FS for purposes of determin- 

ing the location of the manufactured Product X, 

because there is not a tax rate disparity. The location of 

manufacture is Country B. Branch B is treated as a 

separate corporation. To determine whether income 

from the sale of Product X is FBCSI, the remainder of 

FS takes into account the activities of Branch A because 

there is no tax rate disparity. The remainder of 

FS is considered to have manufactured Product X because 

the manufacturing activities of the remainder 

and Branch A, considered together, make a substantial 

contribution to the manufacture of Product X. Therefore, 

income from the sale of Product X by the remainder 

of FS does not constitute FBCSI. (See Figure 11.) 

Figure 11 

FS 

A B 


Activities 

10% 

Activities 12% Activities 24% 

Location of 

Mfg MFG 

Cost Sharing: Temporary Regulations 

The IRS and Treasury issued temporary and proposed 

regulations that cover cost-sharing arrangements 

(CSAs) beginning on January 5, 2009, but with important 

grandfather rules for existing CSAs. (For the temporary 

regs, see Doc 2008-27341 or 2009 WTD 1-24.) The 

temporary regulations apply to buy-in transactions 

(now called platform contribution transactions, or 

PCTs) that occur on or after the date of a material 

change in the scope of a grandfathered CSA. Whether 

a material change in scope has occurred is determined 

on a cumulative basis, and a series of expansions, any 

one of which is not a material expansion by itself, may 

collectively constitute a material expansion. 

While the temporary regulations represent an improvement 

over the proposed regulations, the temporary 

regulations still rely heavily on the controversial 

‘‘investor model’’ and the special pricing methods for 

PCTs. At the inception of a CSA, all participants in 

the CSA should expect to earn a return on their total 

investment that is appropriate given the risk associated 

with each participant’s activities under the CSA. The 

investor model treats each participant in the CSA as 

having made an investment composed of its share of 




the intangible development costs incurred on an ongoing 

basis and any contribution of existing resources 

and capabilities. The alternatives realistically available 

to the participants must be considered. Most commentators 

criticized the model on the grounds that its valuation 

principles are too restrictive. 

Taxpayers may need to amend their written agreements, 

as described in temp. Treas. reg. section 1.482- 

7T(k)(1), for CSAs existing before the effective date of 

the new regulations. If the taxpayer has no agreement 

in place that complies with these requirements by July 

6, 2009, the taxpayer’s CSA may not be grandfathered. 

A CSA statement will also need to be filed by September 

2, 2009. 

One final introductory note: The Ninth Circuit has 

yet to make a decision in Xilinx. That decision could 

ultimately have an important effect on these regulations. 

General 

Several commentators questioned whether and how 

the proposed regulations conformed to the arm’s-length 

standard and the commensurate with income rules. In 

response, the preamble states that the temporary regulations 

provide further guidance on the evaluation of 

the arm’s-length results of cost-sharing transactions 

(CSTs) and PCTs. The regulations address the material 

functional and risk allocations in the context of a CSA, 

including the reasonably anticipated duration of the 

commitments, the intended scope of the intangible development, 

the degree and uncertainty of profit potential 

of the intangibles to be developed, and the extent 

of platform and other contributions of resources, capabilities, 

and rights to the development and exploitation 

of cost-shared intangibles (CSA activity). 

If available data concerning uncontrolled transactions 

reflect, or may be reasonably adjusted to reflect, 

similar facts and circumstances concerning a CSA, 

they may be the basis for application of the comparable 

uncontrolled transaction method to value the 

CST and PCT results. Because of the difficulty of finding 

data that reliably reflect these facts and circumstances, 

the preamble states, the temporary regulations 

also provide for other methods. Those include the income, 

acquisition price, market capitalization, and residual 

profit-split methods. 

The temporary regulations also provide taxpayers 

with more flexibility in designing some aspects of 

CSAs. 

R&D Cost Sharing That Is Not a CSA 

The proposed regulations defined the contractual 

terms, risk allocations, and other material provisions of 

a CSA covered by the cost-sharing rules. While other 

intangible development arrangements might in general 

be referred to as cost-sharing arrangements, they were 

not treated as CSAs by the proposed regulations unless 

either: (1) the taxpayer substantially complied with the 

CSA administrative requirements and reasonably concluded 

that its arrangement was a CSA; or (2) the taxpayer 

substantially complied with the CSA administrative 

requirements and the IRS determined that the 

CSA rules should be applied to the arrangement. 

The IRS and Treasury continue to believe that these 

rules, provided for CSAs, should apply only to the intended 

transactions. The rules are to be applied only to 

the defined scope of intangible development arrangements 

and to apply no more broadly or narrowly than 

intended. Thus, this portion of the proposed regulations 

was adopted. 

Nonconforming arrangements are governed by other 

provisions of the section 482 regulations. Intangible 

development arrangements, including partnerships, outside 

the scope of the cost-sharing rules are governed by 

the transfers of intangible rules or the controlled services 

provisions, as appropriate. Nevertheless, the preamble 

states that the methods and best method considerations 

under the cost-sharing rules may be adapted 

for purposes of evaluating nonconforming intangible 

development arrangements. 

Four examples illustrate these rules. In Example 1, 

P and S execute an agreement that purports to be a 

CSA, but they fail to enter into a PCT for some relevant 

software. P and S substantially complied with the 

contractual requirements and the documentation, accounting, 

and reporting requirements and thus have 

met the administrative requirements. However, because 

they did not enter into a PCT for software that was 

reasonably anticipated to contribute to the development 

of the cost-shared product, they cannot reasonably conclude 

that their arrangement is a CSA. Nevertheless, 

the arrangement between P and S closely resembles a 

CSA. If the Service concludes that the CSA rules provide 

the most reliable measure of an arm’s-length result, 

the Service may apply the CSA rules and treat P 

and S as entering into a PCT for the software. Or the 

Service may conclude that other provisions in the section 

482 rules apply. 

In Example 2, the facts are the same as in Example 

1, except that P and S enter into and implement a PCT 

for the software. The Service determines that the PCT 

payments for the software were not arm’s length. However, 

P and S reasonably concluded that their arrangement 

is a CSA. The Service must apply the CSA rules 

and make an adjustment to the PCT payments as appropriate. 


1, except that P and S enter into a PCT for the software. 

The agreement provides for a fixed consideration 

of $50 million per year for four years, payable at the 

end of each year. The agreement satisfies the arm’slength 

standard; however, S actually pays P consideration 

at the end of each year in the form of four annual 

royalties equal to 2 percent of sales. P and S 

failed to implement the terms of their agreement and 



could not reasonably conclude that their agreement 

was a CSA. Nevertheless, the arrangement closely resembles 

a CSA, and the Service may apply the CSA 

rules and make appropriate adjustments. 


1, except that P does not own proprietary software and 

P and S determine that the arm’s-length amount for 

PCT payments is $10 million. The IRS determines that 

the PCT payments should be $100 million. To determine 

the $10 million present value, P and S assumed a 

useful life of eight years for the platform contribution, 

because that is when the relevant patent expires. However, 

use of the PCT patent rights in research is expected 

to lead to benefits attributable to exploitation of 

the cost-shared intangibles extending many years beyond 

expiration of the PCT patent. P and S expect to 

apply for additional patents. 

The method used by P and S also uses a declining 

royalty based on an application of the CUT method in 

which the purported CUTs all involve licenses to 

manufacture and sell the current generation of the 

product. These make or sell rights are fundamentally 

different from use of the PCT patent rights to generate 

a new product. This further reduces the reliability of 

the method used by P and S. 

The example concludes that the method used by P 

and S is so unreliable and so contrary to the provisions 

of the CSA rules that P and S could not reasonably 

conclude that they had contracted to enter into a CSA. 

Accordingly, the Service is not required to apply the 

CSA rules. Nevertheless, if the Service concludes that 

the CSA rules provide the most reliable measure of an 

arm’s-length result, it may apply the CSA rules and 

make appropriate adjustments. 

Territorial Interests 

The proposed regulations required the controlled 

participants in a CSA to receive nonoverlapping territorial 

interests that entitled each controlled participant to 

the perpetual and exclusive right to the profits in its 

territory attributable to cost-shared intangibles. Commentators 

said this was overly restrictive and did not 

align with common business models. 

The temporary regulations thus permit use of a new 

basis — a field of use division of interests — in addition 

to the territorial division of interests. The regulations 

also authorize other nonoverlapping divisional 

interest, provided that the basis used meets criteria: 

(1) the basis must clearly and unambiguously divide all 

interests in cost-shared intangibles among the controlled 

participants; (2) the consistent use of this basis 

can be dependably verified from the participant’s 

records; (3) the rights of the controlled participants to 

exploit cost-shared intangibles are nonoverlapping, exclusive, 

and perpetual; and (4) the resulting benefits 

associated with each controlled participant’s interest in 

cost-shared intangibles are predictable with reasonable 

reliability. 


If the CSA divides all interests in cost-shared intangibles 

on a territorial basis (territorial divisional interests), 

the entire world must be divided into two or 

more nonoverlapping geographic territories. Each controlled 

participant must receive at least one such territory, 

and in the aggregate all the participants must receive 

all of the territories. Each controlled participant 

must be assigned the perpetual and exclusive right to 

exploit the cost-shared intangibles through the use, consumption, 

or disposition of property or services in its 

territories. Thus, compensation will be required if other 

members of the controlled group exploit the costshared 

intangibles in that territory. 

If the CSA divides all interests in the cost-shared 

intangibles on the basis of all uses (whether or not 

known at the time of the division) to which the costshared 

intangibles are to be put (field of use divisions 

interests), all anticipated uses of the cost-shared intangibles 

must be identified. Each controlled participant 

must be assigned at least one such anticipated use, and 

in the aggregate all the participants must be assigned 

all of the anticipated uses. Each controlled participant 

will be assigned a perpetual and exclusive right to exploit 

the cost-shared intangible through the use or uses 

assigned to it, and one controlled participant must be 

assigned the exclusive and perpetual right to exploit the 

cost-shared intangibles through any unanticipated uses. 

Three examples illustrate these rules. In Example 1, 

P receives the interest in Product Z in the U.S., and S 

receives the interest in the product in the rest of the 

world. Both P and S have plants for manufacturing 

Product Z located in their respective geographic territories. 

For commercial reasons, Product Z is nevertheless 

manufactured by P in the U.S. for sale to customers in 

certain jurisdictions just outside the U.S. in close proximity 

to P’s U.S. manufacturing plant. Because S owns 

the territorial rights outside the U.S., P must compensate 

S to ensure that S realizes all the cost-shared intangible 

profits from P’s sale of products in S’s territory. 

Benefits projected for these sales will be included 

for purposes of estimating S’s reasonably anticipated 

benefits (RAB) share. 

In Example 2, the facts are the same in Example 1, 

except that P and S agree to divide their interests in 

Product Z based on site of manufacturing. P will have 

exclusive and perpetual rights in Product Z manufactured 

in facilities owned by P. S will have exclusive and 

perpetual rights to Product Z manufactured in facilities 

owned by S. Both facilities that will manufacture Product 

Z, and the relative capacities of these sites, are 

known. All facilities are operating at near capacity and 

are expected to continue to operate at near capacity 

when Product Z enters production, so it will not be 

feasible to shift product between P’s and S’s facilities. 

P and S also have no plans to build new facilities. The 

basis for the division of interest is unambiguous and 

clearly defined and can be dependably verified. 





2, except that P’s and S’s manufacturing facilities are 

not expected to operate at full capacity when Product 

Z enters production. Production of Product Z can be 

shifted at any time between sites owned by P and sites 

owned by S, although neither P nor S intends to shift 

production as a result of the agreement. In this case, 

the production of interests based on manufacturing 

sites is not a division that is satisfactory because the 

parties’ relative shares of benefits are not predictable 

with reasonable reliability. 

Platform and Other Contributions 

The proposed regulations described external contributions 

for which compensation was due from other 

controlled participants. Under the proposed regulations, 

an external contribution (buy-in) generally consisted of 

the rights in a ‘‘reference transaction’’ in any resource 

or capability reasonably anticipated to contribute to 

developing cost-shared intangibles. The reference transaction, 

a concept that is not in the temporary regulations, 

essentially was a non-arm’s-length hypothetical 

comparable. 

A platform contribution is 

any resource, capability, or 

right that is reasonably 

anticipated to contribute 

to developing cost-shared 

intangibles. 

The temporary regulations replace the term ‘‘external 

contribution’’ with the term ‘‘platform contribution’’ 

and use the term ‘‘platform contribution transaction.’’ 

The temporary regulations define a platform 

contribution as any resource, capability, or right that a 

controlled participant has developed, maintained, or 

acquired externally to the intangible development activity 

(whether before or during the course of the CSA) 

that is reasonably anticipated to contribute to developing 

cost-shared intangibles. A resource, capability, or 

right reasonably determined earlier not to be a platform 

intangible may be reasonably determined later to be a 

platform intangible. The PCT obligation regarding a 

resource or capability or right once determined to be a 

platform contribution does not terminate merely because 

it may later be determined that the resource or 

capability or right has not contributed, and is not 

longer reasonably anticipated to contribute, to developing 

cost-shared intangibles. 

For purposes of a PCT, the PCT payee’s provision 

of a platform contribution is presumed to be exclusive. 

It also is presumed that the platform resource, capabil- 

ity, or right is not reasonably anticipated to be committed 

to any business activities other than the CSA activity. 

The controlled participants may rebut the 

presumption. For example, if the platform resource is a 

research tool, the controlled participants could rebut 

the presumption by establishing to the Service’s satisfaction 

that as of the date of the PCT, the tool is reasonably 

anticipated not only to contribute to CSA activity 

but also to be licensed to an uncontrolled 

taxpayer. 

To the extent a controlled participant contributes the 

services of its research team for purposes of developing 

cost-shared intangibles under the CSA, the other controlled 

participant would owe compensation for the 

services of the team under temp. Treas. reg. section 

1.482-9T, just as would be the case in a contract service 

arrangement. 3 When there is a combined contribution 

of research services, intangibles in process, or 

other resources, capabilities, or rights, the temporary 

regulations provide for an aggregate valuation where 

that would provide the most reliable measure of an 

arm’s-length result. 

Any right to exploit an existing intangible without 

further development, such as the right to make, replicate, 

license, or sell existing products, does not constitute 

a platform contribution to a CSA, and the arm’slength 

consideration for such rights (make or sell 

rights) does not satisfy the compensation obligation 

under a PCT. 

In an example, P and S enter into a CSA to develop 

the second generation of ABC, a computer software 

program. Before that arrangement, P had incurred substantial 

costs and risks to develop ABC. P executed a 

license with S as the licensee by which S may make 

and sell copies of the existing ABC. This make or sell 

right does not constitute a platform contribution. 

In another example, P and S enter into a CSA in 

accordance with which P will commit to the project its 

research team that has developed a number of other 

vaccines. The expertise and existing integration of the 

research team is a unique resource or capability of P 

that is reasonably anticipated to contribute to the development 

of the cost-shared product. Therefore, P’s provision 

of the capabilities of the research team constitutes 

a platform contribution for which compensation 

is due from S as a part of the PCT. The controlled parties 

designate the platform contribution as a provision 

of services that would otherwise be governed by temp. 

3 Interestingly, the treatment available under the cost-sharing 

rules for the contribution of the services of a research team as 

controlled services is stated to be ‘‘without any inference’’ concerning 

the potential status of workforce-in-place as an intangible 

under section 936(h)(3)(B). The status of workforce-in-place as 

an intangible, of course, has arisen as an issue in the context of 

section 936 exits. 



Treas. reg. section 1.482-9T if entered into by controlled 

parties. The applicable method for determining 

the arm’s-length value of the compensation obligation 

under the PCT will be governed by those regulations as 

supplemented by the CSA rules. 

The platform contribution is presumed to be the exclusive 

provision of the benefits by Company P of its 

research team to the development of Vaccine Z. Because 

the intangible development costs (IDCs) include 

the ongoing compensation of the researchers, the compensation 

obligation under the PCT is only for the 

value of the commitment of the research team by P to 

the CSA’s development efforts net of the researcher 

compensation. The value of the compensation obligation 

of S for the PCT will reflect the full value of the 

provision of services as limited by S’s RAB share. 

Intangible Development Activity and Costs 

The scope of the intangible development activity 

(IDA) includes all activities that could reasonably be 

anticipated to contribute to developing the reasonably 

anticipated cost-shared intangibles. The IDA cannot be 

described merely by a list of particular resources, capabilities, 

or rights that will be used in the CSA, since 

the IDA is a function of what are the reasonably anticipated 

cost-shared intangibles. 

The scope of the IDA may change as the nature or 

identity of the reasonably anticipated cost-shared intangibles 

or the nature of the activities necessary for their 

development becomes clearer. For example, the relevance 

of certain ongoing work to developing reasonably 

anticipated cost-shared intangibles or the need for 

additional work may become clear only over time. 

Regarding stock options and other stock-based compensation, 

the IRS and Treasury continue to consider 

the technical changes and issues described in Notice 

2005-99, 2005-22 C.B. 1214, and comments they have 

received and intend to address the issue in a subsequent 

regulations project. 

Changes in Participation 

A change in participation under a CSA occurs when 

there is either a controlled transfer of interests or a capability 

variation. A controlled transfer occurs when a 

participant in a CSA transfers all or part of its interest 

in cost-shared intangibles under the CSA in a controlled 

transaction, and the transferee assumes the associated 

obligations under the CSA. In that case, the 

transferee will be treated as succeeding to the transferor’s 

prior history under the CSA as it relates to the 

transferred interest, including the transferor’s cost contributions, 

benefits received, and PCT payments attributable 

to such rights or obligations. 

A capability variation occurs when, in a CSA in 

which interests in cost-shared intangibles were divided 

on a basis such as plant capacity, the controlled participants’ 

division of interests, or their relative capabilities 

or capabilities to benefit from the cost-shared intan- 


gibles are materially altered. The capability variation is 

considered to be a controlled transfer of interests. 

If there is a change in participation, the arm’slength 

amount of consideration must be determined 

consistent with the reasonably anticipated incremental 

change in returns to the transferee or transferor resulting 

from the change in participation. 

In one of the examples, P and S agree to divide 

their interests based on the site of manufacturing. Two 

years after formation of the CSA, because of a change 

in plans not reasonably foreseeable at the time the 

CSA was entered into, S acquires additional facilities 

for the manufacture of the product. The acquisition is 

a capability variation. Accordingly, there was a compensable 

change in participation. 

RABs 

RAB shares must be updated to account for changes 

in economic conditions, the business operations and 

practices of the participants, and the ongoing development 

of intangibles under the CSA. For purposes of 

determining RAB shares at any given time, reasonably 

anticipated benefits must be estimated over the entire 

period, past and future, of exploitation of the costshared 

intangibles, and must reflect appropriate updates. 

Indirect bases for measuring anticipated benefits 

include units used, produced, or sold; sales; operating 

profits; and other bases. 

Other bases for measuring anticipated benefits may 

in some circumstances be appropriate, but only to the 

extent that there is expected to be a reasonably identifiable 

relationship between the basis of measurement 

used and additional income generated or costs saved by 

use of the cost-shared intangibles. 

In one example, operating profit is determined to be 

appropriately used to determine RABs because the 

pharmaceutical product will be sold by USP at a 

higher profit than FS will be able to sell the product in 

foreign countries. In another example, sales are inappropriate 

for determining RABs because FP distributes 

the product directly to customers while the U.S. subsidiary 

sells to independent distributors. Sales could be 

used only if adjustments were made to account for differences 

in market levels at which the sales occur. 

General Principles and Best Method Considerations 

The proposed regulations articulated ‘‘general principles’’ 

— such as the realistic alternatives principle — 

applicable to any method to determine the arm’s-length 

charge in a PCT. These provisions were intended to 

provide supplementary guidance on the application of 

the best method rule to determine which method, or 

application of a method, provides the most reliable 

measure of an arm’s-length result in a CSA context. 

That is, these principles provide best method considerations 

to aid in the competitive evaluation of 

methods or applications, and they were not intended 

themselves to be methods or trumping rules. 




The investor model was a core principle of the proposed 

regulations. A PCT payer, through cost sharing 

and payments made in accordance with the PCT, is 

investing for the term of the CSA activity and should 

expect returns over time consistent with the riskiness of 

that investment. Commentators, however, criticized the 

investor model for stripping away risk returns from the 

PCT payer. 

The temporary regulations retain the investor model, 

including the requirement to analyze the alternatives 

realistically available to the taxpayer, but provide additional 

guidance to explain that when the PCT payer 

assumes risks, it accordingly enjoys the returns (or suffers 

the detriments) that may result from those risks. 

In doing a best method analysis, the relative reliability 

of the application of a method depends on the degree 

of consistency of the analysis with the assumption 

that, as of the date of the PCT, each controlled participant’s 

aggregate net investment in the CSA activity 

(attributable to platform contributions, operating contributions, 

and operating cost contributions) is reasonably 

anticipated to earn a rate of return equal to the appropriate 

discount rate for the controlled participant’s 

CSA activity over the entire period of the CSA activity. 

The regulation states that if the cost-shared intangibles 

themselves are reasonably anticipated to contribute 

to developing other intangibles, then the period that 

is used includes the period, reasonably anticipated as of 

the date of the PCT, of developing and exploiting the 

indirectly benefited intangibles. The example in temp. 

Treas. reg. section 1.482-7T(g)(2)(ii)(B) indicates that, 

based on industry experience, the period does not need 

to be infinite. 

The relative reliability of a method also depends on 

the degree of consistency of the analysis with the assumption 

that uncontrolled taxpayers dealing at arm’s 

length would have evaluated the terms of the transaction, 

and entered into the transaction, only if no alternative 

is preferable. This condition is not met, the regulation 

states, when for any controlled participant the 

total anticipated present value of its income attributable 

to its entering into the CSA, as of the date of the 

PCT, is less than the total anticipated present value of 

its income that could be achieved through an alternative 

arrangement realistically available to that controlled 

participant. 

The regulation states that realistic alternatives may 

involve varying risk exposure and thus may be more 

reliably evaluated using different discount rates. Determination 

of the applicable discount rates obviously will 

be important under these rules. In some circumstances, 

the regulation states, a party may have less risk as a 

licensee of intangibles needed in its operations, and so 

require a lower discount rate than it would have by 

entering into a CSA to develop the intangibles, which 

may involve the party’s assumption of additional risk 

in funding its cost contributions to the IDA. Similarly, 

self-development of intangibles and licensing out may 

be riskier for the licensor, and so require a higher discount 

rate than entering into a CSA to develop the intangibles, 

which would relieve the licensor of the obligation 

to fund a portion of the IDCs of the IDA. 

A discount rate should be used that most reliably 

reflects the risk of the set of activities or transactions 

based on all the information potentially available at the 

time for which the present value calculation is to be 

performed. The discount rate may differ among a company’s 

various activities and transactions. The proposed 

regulations indicated that the weighted average 

cost of capital (WACC) of the taxpayer, or an uncontrolled 

taxpayer, could provide the most reliable basis 

for a discount rate if the CSA activity involves the 

same risk as projects undertaken by the taxpayer, or 

uncontrolled taxpayer, as a whole. In appropriate situations, 

a company’s internal hurdle rate for projects of 

comparable risk might provide a reliable basis for a 

discount rate in the cost-sharing analysis. 

Commentators criticized the proposed regulations 

discount rate guidance. Some concluded that the proposed 

regulations inappropriately emphasized the taxpayer’s 

WACC as a basis for analysis. The specific references 

to WACC and hurdle rates are eliminated, but 

without any inference as to a WACC or a hurdle rate 

being an appropriate discount rate, or an appropriate 

starting rate in ascertaining a discount rate, depending 

on the facts. 

While the regulation discusses the possibility of using 

different discount rates to reflect varying risk levels 

— and that is important — there is little additional 

guidance in the regulation in this regard. The taxpayer’s 

or other taxpayers’ WACC and hurdle rates 

seem to be lurking in the background, perhaps as default 

rates. Taxpayers will need to carefully analyze 

and document their discount rates. If the new regulation 

is to work, this is the place where it will need to 

work. 

In an example, P and S form a CSA to develop intangible 

X, which will be used in Product Y. P has a 

platform contribution for which S commits to make a 

PCT payment of 5 percent of its sales of Product Y. In 

determining whether P had a more favorable realistic 

alternative, the Service compares P’s anticipated posttax 

discounted present value of the financial projections 

under the CSA with P’s anticipated posttax discounted 

present value of the financial projections 

under a reasonably available alternative licensing arrangement. 

In undertaking the analysis in the example, 

the Service determines that because it would be funding 

the entire development of the intangible, P takes 

greater risk in the licensing scenario than in the costsharing 

scenario. The Service concludes that because 



there are differences in market-correlated risks between 

the two scenarios, different discount rates should be 

used for the two scenarios. 4 

Arm’s-Length Range 

The temporary regulations provide guidance on the 

use of arm’s-length ranges for some methods in computing 

PCT payments. Some of the methods specified 

in the temporary regulations (for example, the income 

method) have a structure in which an arm’s-length result 

is estimated by performing calculations that depend 

on two or more impute parameters such as the 

relevant discount rate, certain financial projections, and 

a return for routine activities. The temporary regulations 

address the arm’s-length range in the context of 

these methods. 

CUT Method 

The proposed regulations provided for possible use 

of the CUT method to determine the arm’s-length 

charge in the PCT when appropriate in accordance 

with the standards of the intangibles transfer and controlled 

services provisions of the section 482 regulations. 

Some commentators suggested that any arrangements 

that uncontrolled parties may call a cost-sharing 

arrangement should serve as a CUT, even though the 

arrangement may involve materially different risk allocations 

and provisions than addressed in the costsharing 

rules. 

The temporary regulations, in response, describe the 

relevant considerations for purposes of evaluating 

whether a potential CUT may reflect the most reliable 

measure of an arm’s-length result. Although all of the 

factors entering into a best method analysis must be 

considered, comparability and reliability under the 

CUT method in the CSA context are particularly dependent 

on: similarity of contractual terms; degree to 

which allocation of risks is proportional to reasonably 

anticipated benefits from exploiting the results of intangible 

development; similar period of commitment as 

to the sharing of intangible development risks; and 

similar scope, uncertainty, and profit potential of the 

subject intangible development. 

This includes a similar allocation of the risks of any 

existing resources, capabilities, or rights, as well as of 

the risks of developing other resources, capabilities, or 

rights that would be reasonably anticipated to contrib- 

4 At least, I think this is the conclusion in the example. The 

concluding sentence of the analysis states that ‘‘the Commissioner 

concludes that the differences in market-correlated risks 

between the two scenarios, and therefore the differences in discount 

rates between the two scenarios, relate to the differences in 

these components of the financial projections.’’ Temp. Treas. reg. 

section 1.482-7T(g)(2)(v), Example. Examples illustrating the income 

method rules are clearer in illustrating the use of different 

discount rates. Temp. Treas. reg. section 1.482-7T(g)(4)(vii), Examples 

1-3. 


ute to exploitation within the parties’ divisions that are 

consistent with the actual allocation of risks between 

the controlled participants. 

Income Method 

The proposed regulations made the income method 

a specified method for purposes of evaluating the 

arm’s-length charge in a PCT. The arm’s-length charge 

was an amount that equated to a controlled participant’s 

present value of entering into a CSA with the 

present value of the controlled participant’s best realistic 

alternative. 

In one application, based on a CUT analysis, the 

PCT payee’s best realistic alternative was assumed to 

be to develop the cost-shared intangible on its own, 

bearing all the intangible development costs (IDCs) 

itself, and then to license the cost-shared intangibles. In 

the second application, based on a comparable profits 

method analysis, it was assumed that the PCT payer’s 

best realistic alternative would be to acquire the rights 

to external contributions (renamed platform contributions 

under the temporary regulations) for payments 

with a present value equal to the PCT payer’s anticipated 

profit, after reward for its routine contributions 

to its operations, from the CSA activity in its territory. 

Both income method applications provided for a 

cost contribution adjustment in order to allocate to the 

PCT payer the return for its additional risk, as compared 

to its realistic alternative, of bearing its RAB 

share of the IDCs. 

Commentators criticized the income method because 

it strips away risk returns from the PCT payer. 

Commentators pointed to the potential risk differentials 

between cost sharing and the alternative arrangements. 

Cost sharing would generally be more risky for the 

PCT payer than licensing as a result of its sharing with 

the PCT payee the risks of the IDA. Cost sharing, on 

the other hand, would generally be less risky for the 

PCT payee than licensing. Those comments observed 

that these risk differentials would ordinarily be reflected 

in different discount rates being appropriate under 

the cost-sharing and licensing alternatives. 

The temporary regulations in any event adopt the 

income method but provide more guidance. In general, 

they provide that the best realistic alternative of the 

PCT payer to entering into the CSA would be to license 

intangibles to be developed by an uncontrolled 

licensor that undertakes the commitment to bear the 

entire risk of intangible development that would otherwise 

have been shared under the CSA. Similarly, the 

best realistic alternative of the PCT payee to entering 

into the CSA would be to undertake the commitment 

to bear the entire risk of intangible development that 

would otherwise have been shared under the CSA and 

license the resulting intangibles to an uncontrolled licensee. 




The licensing alternative is derived on the basis of a 

functional and risk analysis of the cost-sharing alternative, 

but with a shift of the risk of cost contributions to 

the licensor. The licensing alternative also should assume 

contractual provisions regarding nonoverlapping 

divisional intangible interests, and regarding allocations 

of other risks, that are consistent with the actual CSA 

in accordance with the cost-sharing rules. 

The temporary regulations describe both CUT-based 

applications and CPM-based applications of the income 

method. However, they differ from applications 

described in the proposed regulations by equating the 

cost-sharing and licensing alternatives of the PCT 

payer using discount rates appropriate to those alternatives. 

If the market-correlated risks as between the costsharing 

and licensing alternatives are not materially 

different, a reliable analysis may be possible by using 

the same discount rates for both alternatives. Otherwise, 

as recognized in the best method considerations 

concerning discount rates, realistic alternatives having 

the same reasonably anticipated present value may nevertheless 

involve varying risk exposure and thus generally 

are more reliably evaluated using different discount 

rates. The discount rate for the cost-sharing alternative 

will also depend on the form of the PCT payments 

assumed (for example, lump sum, royalty on sales, and 

royalty on divisional profit). 

The temporary regulations clarify the opportunities, 

depending on the facts and circumstances, for the PCT 

payer to assume risks and accordingly to enjoy the returns 

(or suffer the detriments) that may result from 

those risks. For example, in addition to its cost contributions 

to developing cost-shared intangibles, a PCT 

payer may also make significant operating contributions, 

such as existing marketing or manufacturing process 

intangibles, as well as make significant operating 

cost contributions toward further developing the intangibles. 

To the extent parties to comparable transactions 

undertake risks of similar scope and duration, the PCT 

payer will be appropriately rewarded based on a 

method that relies in whole or part on returns in the 

comparable transactions under an application of the 

income method whether based on a CUT or CPM. 

Some commentators criticized the income method 

as positing an unrealistic perpetual life. The income 

method, the preamble states, is premised on the assumption 

that, at arm’s length, an investor will make a 

risky investment (for example, in a platform for developing 

additional technology) only if the investor reasonably 

anticipates that the present value of its reasonably 

anticipated operational results will be increased at 

least by a present value equal to the platform investment. 

It may be that the technology is reasonably expected 

to achieve an incremental improvement and results 

for only a finite period. The period of enhanced 

results that justifies the platform investment in those 

circumstances effectively would correspond to a finite, 

not a perpetual, life. 

This is helpful. There is not an automatic assumption 

of an infinite period. As noted in the best method 

discussion, an example states that, based on industry 

experience, the period may be limited to a finite period. 

P and S in the example are confident that the 

cost-shared product will be replaced by a new type of 

genetic testing based on an unrelated technology after 

10 years and that then, the cost-shared product will 

have no further value. See temp. Treas. reg. section 

1.482-7T(g)(2)(ii)(B), Example. In temp. Treas. reg. section 

1.482-7T(g)(4)(vii), Example 3, one of the income 

method examples, some cost-shared software will have 

a five-year life. Thereafter it will be rendered obsolete 

and unmarketable by obsolescence of the storage media 

to which it relates. 

Acquisition Price and Market Capitalization 

Methods 

The proposed regulations included guidance on the 

acquisition price and market capitalization methods for 

evaluating the arm’s-length charge in a PCT. Under the 

acquisition price method, the arm’s-length charge for a 

PCT is the adjusted acquisition price, that is, the acquisition 

price increased by the value of the target’s liabilities 

on the date of the acquisition, and decreased by 

the value on that date of the target’s tangible property 

and other resources and capabilities not covered by the 

PCT. 

Under the market capitalization method, the arm’slength 

charge for a PCT is the adjusted average market 

capitalization, that is, the average daily market capitalization 

over the 60 days ending with the date of the 

PCT, increased by the value of the PCT payee’s liabilities 

on that date, and decreased on account of tangible 

property and any other resources and capabilities of 

the PCT payee not covered by the PCT. 

Commentators questioned the reliability of these 

methods in light of volatility of stock prices and lack 

of correlation between stock prices and underlying assets, 

for example, owing to control premiums or economics 

of integration. 

The IRS and Treasury recognize that these comments 

point to considerations that, depending on the 

facts and circumstances, will need to be taken into account 

in a best method analysis that compares the reliability 

of the results under application of these 

methods as against the results under application of 

other methods. 

The temporary regulations retain the best method 

considerations stated in the proposed regulations that 

observed that reliability is reduced under these methods 

if a substantial portion of the target’s nonroutine contributions 

to business activities is not required to be 



covered by a PCT and, in the case of the market capitalization 

method, if the facts and circumstances demonstrate 

the likelihood of a material divergence between 

the PCT payee’s average market capitalization 

and the value of its underlying resources, capabilities, 

and rights for which reliable adjustments cannot be 

made. 

Residual Profit-Split and Other Methods 

The temporary regulations conform the modified 

residual profit-split method from the proposed regulations 

to the changes made to the income method. 

Other unspecified methods also may be used, but they 

must be acceptable under general and cost-sharing best 

method considerations. They also must consider the 

realistic alternatives to the transaction. 

Form of Payment 

The proposed regulations provided that the form of 

payment selected for any PCT had to be specified no 

later than the date of the PCT. In the case of a postformation 

acquisition, the consideration under the PCT 

had to be paid in the same form as the consideration 

in the uncontrolled transaction in which the postformation 

acquisition was made. An example indicated that 

acquisitions for stock were considered to be for a fixed 

form of payment. The temporary regulations do not 

retain the special rule for postformation acquisitions. 

Subsequent acquisitions remain an important source of 

platform contributions that occasion the requirement of 

PCT compensation. Controlled participants may 

choose the form of payment for these PCTs. 

The temporary regulations incorporate rules to ensure 

that a contingent form for PCT payments is applied 

properly by both taxpayers and the IRS. A CSA 

contractual provision that provides for payments for a 

PCT to be contingent on the exploitation of costshared 

intangibles will be respected as consistent with 

economic substance only if the allocation between the 

controlled participants of the risks attendant on this 

form of payment is determinable before the outcomes 

of the allocation that would have materially affected 

the PCT pricing are known or reasonably knowable. 

The contingent payment provision must clearly and 

unambiguously specify the basis on which the obligations 

are to be determined. 

Periodic Adjustments 

The proposed regulations used the commensurate 

with income provisions so that the Service can make 

periodic adjustments for an open tax year and all subsequent 

years of the CSA activity in the event of a periodic 

trigger. A periodic trigger arose if the PCT payer 

realized, over the period beginning with the earliest 

date on which the intangible development occurred 

through the end of the adjustment year, an actually 

experienced return ratio (AERR) of the present value 

of its total territorial operating profits divided by the 

present value of its investment consisting of the sum of 


its cost contributions plus PCT payments, outside the 

periodic return ratio range (PRRR) of between 0.5 and 

2. The Service would use an applicable discount rate, 

which in the case of some publicly traded entities 

would be their WACC, unless the Service determined, 

or the controlled participants established, that another 

discount rate better reflected the degree of risk of the 

CSA activity. 

Commentators offered several criticisms of the periodic 

adjustment rules. Some considered the periodic 

adjustment rules to be inconsistent with the arm’slength 

standard and, through hindsight, to strip away 

returns for risk. Other commentators said taxpayers 

should have the same ability as the Service to make 

periodic adjustments. 

The IRS and Treasury reaffirm that the commensurate 

with income principle is consistent, and periodic 

adjustments are to be administered consistently, with 

the arm’s-length standard. Accordingly, the temporary 

regulations continue to provide for periodic adjustments 

along lines similar to those in the intangible 

transfers portion of the section 482 regulations, as 

adapted for the cost-sharing context. 

In an important narrowing, the temporary regulations 

provide that a periodic trigger occurs if the 

AERR falls outside the PRRR of between 0.667 and 

1.5 (or between 0.8 and 1.25 if the taxpayer has not 

substantially complied with the documentation requirements). 

The preamble states that this is intended to 

isolate situations in which the actual results suggest the 

potential of an absence of arm’s-length pricing as of 

the date of the PCT. 

The IRS and Treasury believe that the periodic trigger 

under the temporary regulations more realistically 

targets the threshold at which periodic adjustment scrutiny 

is appropriate. In determining whether to make 

any periodic adjustments, the Service will consider 

whether the outcome as adjusted more reliably reflects 

an arm’s-length result under all relevant facts and circumstances. 

Periodic adjustments will not be made if the controlled 

participants establish to the satisfaction of the 

Service that all the conditions described in one of the 

exceptions below will apply regarding a trigger PCT. 

The first exception is that the same platform contribution 

was furnished to an uncontrolled taxpayer under 

substantially the same circumstances as those of 

the relevant trigger PCT and with a similar form of 

payment as the trigger PCT. This applies only if the 

transaction served as the basis for the application of 

the CUT method in the first year and all subsequent 

years in which substantial PCT payments relating to 

the trigger PCT were required to be paid. The amount 

of the PCT payments in the first year must have been 

at arm’s length. 




The second exception is that the differential is due 

to extraordinary events beyond the control of the controlled 

participants that could not reasonably have been 

anticipated as of the date of the trigger PCT. 

The third exception is that the periodic trigger 

would not have occurred had the PCT payer’s divisional 

profits or losses used to calculate its present 

value of total profits (PVTP) excluded those profits or 

losses attributable to the PCT payer’s routine contributions 

to its exploitation of the cost-shared intangibles, 

attributable to its operating cost contributions, and attributable 

to its nonroutine contributions to the CSA 

activity. 

In an important narrowing, 

the temporary regulations 

provide that a periodic 

trigger occurs if the AERR 

falls outside the PRRR of 

between 0.667 and 1.5. 

The fourth exception is that the periodic trigger 

would not have occurred had the divisional profits or 

losses of the PCT payer used to calculate its PVTP 

included its reasonably anticipated divisional profits or 

losses after the adjustment year from the CSA activity, 

including its routine contributions, its operating cost 

contributions, and its nonroutine contributions to that 

activity, and had the cost contributions and PCT payments 

of the PCT payer used to calculate its PVI 

(present value of the PCT payer’s investment at the 

start date) included its reasonably anticipated cost contributions 

and PCT payments after the adjustment year. 

Also, a periodic trigger will not be deemed to have 

occurred in any year subsequent to the 10-year period 

beginning with the first tax year in which there is substantial 

exploitation of the cost-shared intangibles resulting 

from the CSA, if the AERR is within the 

PRRR for each year of the 10-year period. It also will 

not be deemed to have occurred in any year of the 

five-year period beginning with the first tax year in 

which there is exploitation of the cost-shared intangibles 

resulting from the CSA if the AERR falls below 

the lower bound of the PRRR. 

The IRS and Treasury intend to issue by revenue 

procedure separate published guidance that provides an 

exception to periodic adjustments in the context of an 

advance pricing agreement. The guidance would provide 

that no periodic adjustments will be made in any 

year based on a trigger PCT that is a covered transaction 

under the APA. An APA process generally is contemporaneous 

with the taxpayer’s original transactions 

and involves transparency concerning a taxpayer’s upfront 

efforts to conform to the arm’s-length standard. 

Treatment of Payments 

CST payments generally will be considered the 

payer’s cost of developing intangibles at the location 

where the development is conducted. For these purposes, 

IDCs borne directly by a controlled participant 

that are deductible are deemed to be reduced to the 

extent of any CST payments owed to it by other controlled 

participants under the CSA. 

The PCT payer’s payment is deemed to be reduced 

to the extent of any payments owed to it from other 

controlled participants. PCT payments will be characterized 

consistently with the taxpayer’s designation of 

the type of transaction. Depending on the designation, 

the payments will be treated as either consideration for 

a transfer of an interest in intangible property or for 

services. 

Administrative Requirements 

Temp. Treas. reg. section 1.482-7T(k) contains the 

CSA administrative requirements. There are four main 

sections: contractual; documentation; accounting; and 

reporting requirements. This section of the temporary 

regulations is lengthy. 

The contractual rules are important. CSA agreements 

already in effect will need to be modified by 

July 6, 2009, by integrating those rules with the transition 

rules in temp. Treas. reg. section 1.482-7T(m). A 

CSA statement also will need to be filed by September 

2, 2009. 

Documentation is especially important under the 

temporary regulations. For example, careful analysis 

and documentation of discount rate choices could be 

very important. Also, the periodic adjustment trigger 

range is narrower for taxpayers that fail to maintain 

adequate documentation. 

New Best Method Examples 

Example 13. USP and FS enter into a CSA to develop 

a new drug. Immediately before entering into the 

CSA, USP acquires Company X. X is engaged in research 

relevant to the product area, and its only significant 

resources and capabilities are its workforce and 

sole patent. The patent is associated with a compound 

that USP reasonably anticipates will contribute to developing 

the CSA product. The acquisition price 

method, based on the lump sum price paid by USP for 

Company X, is likely to provide a more reliable measure 

of an arm’s-length result than any other method. 

Example 14. Company X is a publicly traded U.S. 

company engaged in pharmaceutical research. Its only 

significant resources and capabilities are workforce and 

its sole patent. Company X has no marketable products. 

Company X enters into a CSA with FS, its newly 

formed foreign subsidiary, to develop a new drug. The 

new drug will be derived from the compound covered 



y USP’s patent. All of Company X’s researchers will 

be engaged solely in research that is related to developing 

that product. Given that Company X’s platform 

contributions covered by PCTs relate to its entire economic 

value, application of the market capitalization 

method provides a reliable measure of an arm’s-length 

result. 

Example 15 describes a U.S. company (MDI) that 

developed a new dental surgical microscope that drastically 

shortens many surgical procedures. MDI entered 

into a CSA with a wholly owned foreign subsidiary to 

develop the next generation of the product. The interests 

are divided on a territorial basis. The rights associated 

with the current product, as well as MDI’s research 

capabilities, are reasonably expected to 

contribute to the development of the next generation 

product and are therefore platform contributions. At 

the time of the PCT, MDI’s only product is the microscope, 

although MDI was developing the next generation 

microscope. Concurrent with the CSA, MDI separately 

transfers exclusive and perpetual exploitation 

rights associated with the existing product to FS in the 

same territory as assigned to FS in the CSA. The example 

states that it is likely to be more reliable to 

evaluate the combined effect of the transactions than to 

evaluate them in isolation. This is because the combined 

transactions relate to all of the economic value 

of MDI. The market capitalization method is likely to 

produce a reliable measure of an arm’s-length payment 

for the aggregated transactions. 

Example 16 states the same facts as in Example 13, 

except that the acquisition occurred significantly in advance 

of the CSA and reliable adjustments cannot be 

made for this time difference. Also, Company X has 

other valuable molecular patents and associated research 

capabilities, apart from Compound X, that are 

not reasonably anticipated to contribute to the development 

of the CSA product and that cannot be reliably 

valued. The CSA divides divisional interests on a territorial 

basis. Under the terms of the CSA, USP will 

undertake all R&D and manufacturing as well as the 

distribution activities for its territory (the United 

States). FS will distribute the product in its territory 

(the rest of the world). FS’s distribution activities are 

routine in nature, and the profitability from its activities 

may be reliably determined from third-party comparables. 

FS does not furnish any platform intangibles. 

At the time of the PCT, reliable financial projections 

associated with development of the CSA product and 

its separate exploitation in each of the markets are undertaken. 

Application of the income method using CPM 

is likely to provide a more reliable measure of an 

arm’s-length result than application of the acquisition 

price method. 

Example 17 states the same facts as in Example 13, 

except that the acquisition occurred some time before 

the CSA, and Company X had some areas of promising 

research that are not reasonably anticipated to con- 


tribute to developing the CSA product. The CSA divides 

divisional interests on a territorial basis. The 

Service determines that the acquisition price stated is 

useful in forming the arm’s-length price, but not necessarily 

determinative. Under the terms of the CSA, USP 

will undertake all R&D and manufacturing associated 

with the product as well as distribution activity for its 

territory (the United States). FS will distribute the CSA 

product in its territory (the rest of the world). FS’s activities 

are routine in nature, and the profitability from 

its activities may be reliably determined from thirdparty 

comparables. It is possible that the acquisition 

price method or the income method using CPM might 

reasonably be applied. Whether the acquisition price 

method or the income method provides the most reliable 

evidence of an arm’s-length price for USP’s contributions 

depends on a number of factors, including 

the reliability of the financial projections, the reliability 

of the discount rate chosen, and the extent to which 

the acquisition price of Company X could be reliably 

adjusted to account for changes in value over the period 

between the acquisition and the formation of the 

CSA and to account for the value of the in-process 

research work done by Company X that does not constitute 

platform contributions to the CSA. 

Example 18 states that the facts are the same in Example 

17, except that FS has a patent on Compound 

Y, which the parties reasonably anticipate will be useful 

in mitigating potential side effects associated with 

Compound X and could thereby contribute to the development 

of the product. The rights in Compound Y 

constitute a platform contribution for which compensation 

is due from USP as a part of the PCT. The value 

of FS’s platform contribution cannot be reliably measured 

by market benchmarks. Under the facts, it is possible 

that either the acquisition price or the income 

method together or the residual profit-split method 

might reasonably be applied to determine the arm’slength 

PCT payment due between USP and FS. Under 

the first option, the PCT payment for the platform contributions 

related to Company X’s workforce, and 

Compound X would be determined using the acquisition 

price referring to the lump sum price paid by USP 

for Company X. Because the value of these platform 

contributions can be determined by reference to a market 

benchmark, they are considered routine platform 

contributions. Accordingly, the platform contribution 

related to Compound Y would be the only nonroutine 

platform contribution, and the relevant PCT payment 

is determined using the income method. Alternatively, 

rather than looking to the acquisition price for Company 

X, all the platform contributions are considered 

nonroutine and the residual profit-split method is applied 

to determine the PCT payments for each platform 

contribution. Under either option, the PCT payments 

will be netted against each other. 

Whether the acquisition price method together with 

the income method or the residual profit-split method 




provides the most reliable evidence of the arm’s-length 

price of the platform contributions depends on a number 

of factors, including the reliability of the determination 

of the relative values of the platform contributions 

for purposes of the residual profit-split method, 

and the extent to which the acquisition price of the 

company can be reliably adjusted to account for 

changes in value over the period between the acquisition 

and the formation of the CSA and to account for 

the value of the rights and in-process research done by 

Company X that does not constitute platform contributions 

to the CSA. It is also relevant to consider 

whether the results of each method are consistent with 

each other, or whether one or both methods are consistent 

with other potential methods that could be applied. 

Transition Rules 

The proposed regulations included transition rules 

for existing qualified cost-sharing arrangements. Grandfather 

treatment would have been terminated in some 

events, including the occasion of a periodic trigger as a 

result of a subsequent PCT, a material change in the 

scope of the arrangement, such as a material expansion 

of the activities undertaken beyond the scope of 

the intangible development area, or a 50 percent or 

greater change in the ownership of interests in costshared 

intangibles. Commentators objected to the 

grandfather termination events. 

The temporary regulations do not terminate the 

grandfather treatment upon a 50 percent change of 

ownership or on account of a subsequent periodic trigger 

or a material change in the scope of the arrangement. 

The temporary regulations instead adopt a targeted 

provision that applies the temporary regulations’ periodic 

adjustment rules to PCTs that occur on or after 

the date of a material change in the scope of a grandfathered 

CSA. A material change in scope would include 

a material expansion of the activities undertaken 

beyond the scope of the IDA. For this purpose, a contraction 

of the scope of the CSA, absent the material 

expansion into one or more lines of research and development 

beyond the scope of the IDA, does not constitute 

a material change in the scope of the CSA. 

Whether a material change in scope has occurred is 

determined on a cumulative basis. Therefore, a series 

of expansions, any one of which is not a material expansion 

by itself, may collectively constitute a material 

expansion. 

An arrangement in existence on January 5, 2009, 

will be considered a CSA if before that date it was a 

qualified cost-sharing arrangement under Treas. reg. 

section 1.482-7, but only if the written agreement is 

amended if necessary to conform with, and only if the 

activities of the controlled participants substantially 

comply with, the provisions of the new rules by July 6, 

2009. Temp. Treas. reg. section 1.482-7T(m) sets forth 

specific rules for how the temporary regulations apply 

to existing CSAs. 

Other Regulations 

Entity Classification 

The IRS finalized regulations to make the federal 

tax classification of the Bulgarian public limited liability 

company (aktsionerno druzhestevo) consistent with the 

federal tax classification of public limited liability companies 

organized in other countries of the European 

economic area: a per se corporation. (For the final 

regs, see Doc 2008-25013 or 2008 WTD 230-26.) 

Conduit Financing Arrangements 

The IRS and Treasury proposed regulations under 

sections 881 and 7701(l) dealing with conduit financing 

structures. (For the proposed regs, see Doc 2008-26696 

or 2008 WTD 246-27.) Treas. reg. section 1.881-3 allows 

the IRS to disregard the participation of one or more 

intermediate entities in a financing arrangement in 

which the entities are acting as conduit entities, and to 

recharacterize the financing arrangement as a transaction 

directly between the remaining parties to the financing 

arrangement for purposes of imposing tax under 

sections 871, 881, 1441, and 1442. 

Since the publication of Treas. reg. section 1.881-3, 

the IRS and Treasury issued the so-called check-thebox 

regulations. The preamble to the newly proposed 

regulations states that Treasury and the IRS are aware 

that issues have arisen regarding the proper treatment 

of disregarded entities under Treas. reg. section 

1.881-3. These proposed regulations clarify that a disregarded 

entity is a person under Treas. reg. section 

1.881-3. Thus, transactions that a disregarded entity 

enters into will be taken into account for purposes of 

determining whether a financing arrangement exists. 

The preamble also states that the IRS and Treasury 

are continuing to study conduit financing arrangements 

and may issue separate guidance to address the treatment 

under those regulations of some hybrid instruments. 

Specifically, the IRS and Treasury are studying 

transactions in which a financing entity advances cash 

or other property to an intermediate entity in exchange 

for a hybrid instrument that is treated as debt under 

the laws of the foreign jurisdiction in which the intermediate 

entity is resident and is not treated as debt for 

U.S. federal tax purposes. 

The issue is whether these instruments should constitute 

a financing transaction under the section 881 

regulations. One possible approach, the preamble 

states, is to treat all transactions involving these hybrid 

instruments between a financing entity and an intermediate 

entity as financing transactions. Comments are 

requested. Another possible approach is to add additional 

factors to consider in determining when stock in 

a corporation (or other similar interest in a partnership 



or trust) may constitute a financing transaction. The 

additional factors would focus on whether, based on 

the facts and circumstances surrounding the stock, the 

financing entity has sufficient legal rights to, or other 

practical assurances regarding, the payment received by 

the intermediate entity to treat the stock as a financing 

transaction. Comments are requested. 

Consolidated Return Regs: Intercompany Debt 

The IRS and Treasury finalized a new version of 

Treas. reg. section 1.1502-13(g), which deals with intercompany 

debt obligations in the context of a U.S. consolidated 

tax return. The regulation involves mostly 

domestic issues, which I will not cover here. However, 

it also addresses two potential international issues. 

The new regulations allow the transfer of intercompany 

debt obligations in a tax-free manner in some 

situations. It also contains antiavoidance rules to preserve 

a proper matching within the consolidated return. 

In one case, the assignment of an intercompany obligation 

by a creditor member under section 351 can be a 

triggering transaction, which means the intercompany 

debt obligation is deemed paid and reissued, with 

whatever consequences that brings. 

One of the situations in which the intercompany 

debt obligation is triggered by the creditor’s transfer 

under section 351 is when the transferor or transferee 

member has a loss subject to a limitation (for example, 

a loss from a separate return limitation or a dual consolidated 

loss that is subject to limitation under Treas. 

reg. section 1.1503(d)-4), but only if the other member 

is not subject to a comparable limitation. 

When debt becomes an intercompany obligation, 

the deemed satisfaction and deemed reissuance are 

treated as transactions separate and apart from the 

transaction in which the debt becomes an intercompany 

obligation, and the tax consequences of the transaction 

in which the debt becomes an intercompany 

obligation must be determined before the deemed satisfaction 

and reissuance occurs. The regulation states 

that ‘‘for example, if the debt became an intercompany 

obligation in a transaction in which section 351 applies, 

any limitation imposed by section 362(e) on the 

basis of the intercompany obligation in the hands of 

the transferee member is determined before the deemed 

satisfaction and reissuance.’’ Section 362(e)(1) provides 

for a limitation on the importation of built-in losses, 

and section 361(e)(2) provides for a limitation on the 

transfer of built-in losses in section 351 transactions. 

The example might involve a foreign parent company 

contributing to its U.S. subsidiary (the parent of the 

U.S. consolidated group) an obligation that thereafter 

becomes an intercompany obligation. 

IRS Rulings and Notices 

Withholding Tax 

The Internal Revenue Service announced that it is 

adding withholding taxes to the tier 1 list of issues. 


Dual Capacity Taxpayers 

LTRs 200850023, 200850024, and 200850025 

granted permission to taxpayers to revoke their previous 

elections to use the dual capacity taxpayer safe 

harbor method described in Treas. reg. section 1.901- 

2A(c)(3) in determining the amount of their foreign 

income taxes paid or accrued to a foreign country. The 

safe harbor method election may not be revoked without 

the consent of the Service. Consent is normally 

given, provided the conditions in the regulations are 

satisfied. The three rulings appear to have been issued 

to the same U.S. consolidated group. 

Subpart F and Partnerships 

In Notice 2009-7, 2009-3 IRB 312, the IRS identified 

as transactions of interest transactions in which a 

CFC owns an interest in a domestic partnership that in 

turn owns interests in lower-tier CFCs. (For Notice 

2009-7, see Doc 2008-27221 or 2008 WTD 250-22.) The 

stated concern is that the lower-tier CFC’s subpart F 

income may not be included in income by the U.S. parent 

company. This would seem to be in accord with 

the statute, in which a domestic partnership is classified 

as a U.S. person. Most interesting, however, is that 

the Service approved just such a structure in a recent 

letter ruling. LTR 200838003, discussed in a previous 

column, approved such a structure in the context of 

the PFIC rules. (For prior coverage, see Tax Notes Int’l, 

Oct. 27, 2008, p. 343, Doc 2008-22362, or2008 WTD 

211-9.) It is curious that the Service was willing to favorably 

rule on just such a structure, yet a couple of 

months later described it as a transaction of interest. 

Restructured Transaction 

CCA 200849012 describes a U.S. parent company 

that in concert with a Country Y bank adopted a tax 

strategy developed and marketed by a promoter. A special 

purpose vehicle was incorporated in Country Y. 

The SPV was formed with funds of the parent and the 

bank. The parent received an equal number of shares 

of preferred stock and common stock. Each share of 

preferred stock was stapled to each share of common 

stock, making a combined unit (referred to as the Class 

B securities). The value of the preferred shares vis-à-vis 

that of the common shares was highly disproportionate 

(1,000-1 ratio). The bank received an equal number of 

Class A securities, which were similarly stapled units. 

SPV purchased accounts receivable at a discount 

from the parent’s subsidiaries and transferred/assigned 

most of the remaining funds to the parent as a loan. 

According to the transactional documents, SPV was to 

purchase monthly accounts receivable from the parent’s 

group with monies repaid to it by the parent on the 

loan. SPV was to simultaneously relend the excess of 

the monthly loan repayments over the monthly purchase 

amounts to the parent’s group. In reality, the 

CCA states, the purchase of accounts receivable, collection 

of loan repayments, and relending to the parent 

never took place other than perhaps as book entries. 




The taxpayer asserts that SPV’s two business activities 

were factoring accounts receivable and lending 

money. The simultaneous lending and alleged purchase 

activities essentially operated with monies contributed 

by the parent to SPV as a circular cash flow, because 

those funds were immediately retransferred to the parent’s 

group as loan proceeds and/or purchase monies. 

The simultaneous lending and alleged purchase activities 

also operated with respect to monies contributed 

by the bank to SPV as loan proceeds (some amount of 

which was purchase money to buy the parent’s accounts 

receivable). SPV (the purported factor) had 

hired the parent’s group to service and collect on the 

accounts receivable that the parent’s group allegedly 

sold to SPV. 

The CCA concludes that SPV did not in effect or in 

substance factor the parent’s accounts receivable. SPV 

never owned the accounts receivable. At no time did 

SPV ever physically possess the accounts receivables 

files or any of the funds collected on the accounts receivable. 

The funds essentially stayed with the parent 

group, and SPV appears to have received only a security 

interest in the accounts receivable and the collections 

thereon. SPV was not given a present possessory 

interest on either the accounts receivable or the funds 

collected on those accounts receivable. 

The steps involved in the transactions, when taken 

together, the CCA states, closely resemble, and have 

many of the same characteristics as a revolving line of 

credit from the bank to the parent, with the parent’s 

accounts receivable being used as collateral for the 

loan. The parent and its subsidiaries maintained lockboxes 

in their own names into which they put the 

monies collected in servicing the accounts receivable 

they allegedly sold to SPV. SPV would acquire dominion 

and control over the contents of those boxes only 

on the occurrence of a termination event. 

The purported factoring transactions permitted the 

parent to deduct on its consolidated federal income tax 

returns both the losses in the aggregate amount of the 

discounts arising from the sale of the accounts receivable 

and the interest payment by the parent’s group 

made on the loans received from SPV. No U.S. income 

tax was paid on the interest or discount income earned 

by SPV. SPV did not treat its discount and interest income 

as attributable to a U.S. permanent establishment, 

nor did the parent withhold 30 percent U.S. tax 

on the interest and discount paid to SPV. Further, the 

parent did not treat SPV as a controlled foreign corporation. 

The Service held that when viewed in substance, the 

series of transactions constituted solely lending activities, 

that is, monies loaned by the bank to SPV for the 

purpose of having SPV relend those same funds to the 

parent. SPV’s main role in the series of transactions 

was merely that of a lender of monies to the parent, or 

a conduit through which the bank passed the loan proceeds 

to the parent. The Service may alternatively ar- 

gue that either the loans were between SPV and the 

parent or that they were between the bank and the parent, 

with SPV acting merely as a conduit through 

which the loan proceeds passed. Either way, the parent 

is not entitled to deduct the purported losses arising 

from the factoring transactions, but should be allowed 

additional interest deductions resulting from the new 

recharacterization of these items. 

As an alternative position to recasting the transaction 

as a direct loan from the bank to SPV, the CCA 

recommends that the Service assert that the bank’s interest 

in SPV is strictly a debt interest with an equity 

kicker, rather than a stock interest in SPV. In that case, 

the parent would be the sole shareholder of SPV, 

which would be a CFC. The CCA states that recharacterizing 

the Class A securities as debt instruments 

would effectively deny the parent’s deduction for the 

factoring discount through the use of section 267. 

The CCA states that recasting the transaction as 

merely a loan between the bank and the parent with 

SPV’s role as that of a conduit provides the correct 

and most satisfactory resolution of the matter. Recharacterizing 

the transaction in this manner more accurately 

captures the true substance of the transaction. It 

also would serve to eliminate any section 267 issue, 

because under this recast, no sale of accounts receivable 

between the parent and SPV would be considered 

to have taken place, and, therefore, the parent would 

not have realized any loss on a purported sale of the 

receivables. 

Publicly Traded Partnerships 

LTR 200852005 described X, which was originally 

organized as a foreign entity that constitutes a per se 

corporation for U.S. tax purposes. (For LTR 

200852005, see Doc 2008-27159 or 2008 WTD 251-17.) 

A acquired all of the outstanding ordinary shares of 

X. X then reregistered as an eligible entity under the 

laws of that foreign country and filed a check-the-box 

election to be treated as a partnership for U.S. tax purposes. 

In addition to its ordinary shares, X has outstanding 

B shares that are nonvoting, noncumulative preference 

shares that are widely held. The B shares previously 

were listed and traded on a stock exchange, although 

they since have been delisted. Holders of B shares have 

the right to sell their shares to X on a certain date each 

year. Also, X implemented an off-market repurchase 

program under which the owners of the B shares may 

sell their shares to X twice per month. X has the right 

to repurchase all outstanding B shares without the consent 

of the B shareholders at a certain time for a specified 

price. X intends to exercise its right to redeem all 

of the B shares at that time. 

The taxpayer sought and obtained a ruling that X is 

not a publicly traded partnership under section 7704(b). 

Section 7704(b) provides that the term ‘‘publicly traded 

partnership’’ means any partnership if: (1) interests in 



the partnership are traded on an established securities 

market; or (2) interests of the partnership are readily 

tradable on a secondary market (or the substantial 

equivalent thereof). The section 7704 regulations provide 

that transfers under a closed end redemption plan 

are disregarded in determining whether interests in a 

partnership are readily tradable on a secondary market 

or the substantial equivalent thereof. 

Interests in X are not traded on an established securities 

market. The repurchase program and the rights of 

B shareholders to sell their B shares to X each year 

qualify as closed end redemption plans under section 

7704 regulations. Therefore, the redemptions under 

those plans are disregarded in determining whether the 

interests in X are readily tradable on a secondary market 

or the substantial equivalent thereof. 

FIRPTA 

LTR 200851023 describes the taxpayers as four foreign 

corporations that raise funds from non-U.S. investors 

to invest in real estate and real-estate-related investments 

located in the United States. (For LTR 

200851023, see Doc 2008-26742 or 2008 WTD 247-32.) X, 

a U.S. partnership, was created at the same time that 

the foreign corporations were created to raise funds 

from U.S. investors to invest in the same real estate and 

real-estate-related investments. The foreign corporations 

and X are collectively referred to as ‘‘feeder funds.’’ As 

funds were periodically raised by one or more of the 

feeder funds, a new domestic corporation was created, 

and those funds were contributed to the new domestic 

corporation. Each of these newly created domestic corporations 

constituted a U.S. real property holding company 

under section 897. The corporations used the 

contributed funds to purchase assets that constituted 

U.S. real property interests. One of these corporations 

is A. A owns interests in a U.S. limited partnership, 

which owns interests in some U.S. real property. 

The taxpayers have proposed to form a new foreign 

partnership (FP) and to contribute all of their equity 

interests in the corporations, including A (transferred 

property), to FP in a transaction qualifying under section 

721. Each of the taxpayers represents that, for purposes 

of section 897(g), the interests in FP that the taxpayers 

receive in exchange for the transferred property 

will be a U.S. real property interest to the extent attributable 

to U.S. real property interests of FP. 

Shortly after the taxpayer’s contribution, the U.S. 

limited partnership will dispose of all of its assets in a 

fully taxable transaction. The partnership will use the 

proceeds to settle any outstanding liabilities and then 

distribute its remaining assets to its partners, including 

A, in a complete liquidation. A will use the proceeds 

received in the liquidation to settle its outstanding 

liabilities and then distribute its remaining assets to its 

shareholders, which will include FP and X, in a complete 

liquidation under section 331. 

Provided that FP adopts the remedial allocation 

method under the section 704 regulations and complies 

with the filing requirements of temp. Treas. reg. section 

1.897-5T(d)(1)(iii), the Service ruled that the taxpayers’ 

transfer of the transferred property in exchange for 

partnership interests in FP will constitute a nonrecognition 

transaction under section 721 and section 897(e). 

The Service also ruled that any gain that FP realizes 

in connection with the liquidation of A is not gain realized 

in connection with the disposition of a U.S. real 

property interest under section 897, provided that A 

satisfies the exclusion described in section 897(c)(1)(B). 

Section 897(c)(1)(B) provides that a taxpayer can establish 

that a corporation was not a USRPHC during the 

five-year period ending on the date of the disposition 

of the interest by showing that the corporation did not 

hold any USRPIs on the date of the disposition of that 

interest and all of the USRPIs held by that corporation 

during the five-year period were disposed of in a transaction 

in which the full amount of gain was recognized. 

Treaties 

CCA 200848032 states that the U.S. competent authority 

has interpreted the mutual agreement procedure 

language in most U.S. treaties to mean that if the foreign 

country raises an adjustment, the U.S. can grant 

relief (a refund) even if it is for a tax year for which 

the statute of limitations has closed. The U.S. would 

not be able to increase a taxpayer’s income under the 

treaty unless the IRS examiners had already assessed 

additional tax. 

Treaties 

Canada, Iceland, and Bulgaria 

Treasury announced on December 15, 2008, that the 

protocol to the Canada-U.S. treaty and the new treaties 

with Iceland and Bulgaria entered into force. (For the 

Treasury announcement, see Doc 2008-26353 or 2008 

WTD 242-30.) 

New Zealand 


Treasury also announced that the U.S. and New 

Zealand agreed to enter into a treaty protocol. (For the 

treaty protocol, see Doc 2008-25303 or 2008 WTD 232- 

15.) The new agreement provides for the elimination of 

source country taxation on some direct dividends and 

on interest paid to banks and other financial enterprises 

when the payer of the interest is not a related party. It 

also reduces the limit of taxation on cross-border payments 

of royalties from 10 percent to 5 percent. 

France 

Treasury announced that the U.S. and France signed 

a treaty protocol providing for the elimination of 

source country taxation of some direct dividends and 




the elimination of source country taxation of crossborder 

royalty payments. (For the protocol and memorandum 

of understanding (MOU), see Doc 2009-670 or 

2009 WTD 8-30; for a U.S. Treasury news release, see 

Doc 2009-671 or 2009 WTD 8-31.) It also provides for 

mandatory arbitration in cases that cannot be resolved 

by the competent authorities within a specified period 

of time. 

Germany 

The U.S. and German competent authorities agreed 

on an MOU to a set of operating guidelines that detail 

how the mandatory binding arbitration provisions of 

the U.S.-German tax treaty will operate. (For the MOU 

on the arbitration process, see Doc 2008-27070 or 2008 

WTD 249-32. For the operating guidelines, see Doc 2008- 

27071 or 2008 WTD 249-33.) 

The MOU was signed on December 8, 2008. It provides 

detailed guidance on several procedural issues 

relating to the arbitration process, including when the 

commencement date of a case is established; when arbitration 

proceedings must begin; how arbitration 

board members are appointed; what information to 

include in position papers; what to do when a case 

involves a permanent establishment issue or was initially 

submitted as a bilateral advance pricing agreement 

request; how to compensate the arbitration board 

members; and how to terminate arbitration proceedings. 

The MOU states that the competent authorities may 

not appoint as an arbitration board member current 

government employees or those who have left the government 

less than two years ago. Board members must 

have significant international tax experience. 

The MOU provides that each competent authority 

will be permitted to submit a proposed resolution paper 

(not to exceed 5 pages) and a supporting position paper 

(not to exceed 30 pages) within 90 days of the appointment 

of the arbitration board’s chair. In a PE case, the 

competent authorities may submit a paper that takes alternative 

positions. That is, the competent authority may 

take the position that no PE exists, but may also propose 

what amount of income should be allocated to the PE 

should the board determine that a PE does exist. 

Future Tax Policy 

In a previous column, I suggested that it might be 

helpful to reinstate section 965 for reasons discussed 

there. (For prior coverage, see Tax Notes Int’l, Nov.24, 

2008, p. 675, Doc 2008-24320, or2008 WTD 229-10.) Section 

965 encouraged repatriation of a huge amount of 

low-taxed foreign earnings and injected the cash into 

the U.S. economy. 

I noted that the American Shipping Reinvestment 

Act of 2008, introduced as H.R. 6374 and S. 3359, 

would provide an incentive to reinvest foreign shipping 

earnings in the U.S. in accordance with a modified section 

965. I also noted that an article in The New York 

Times on December 9, 2008, discussed the benefits of 

reinstating section 965. The U.K. government has announced 

that it is considering such a provision. 

One alternative to section 965 that some taxpayers 

have suggested involves allowing foreign subsidiaries to 

lend funds to their U.S. parent company for up to two 

years without triggering section 965. Reinstating section 

965 seems cleaner, but this is an alternative. ◆ 



February 9 

U.S. International Tax Reporting and 

Compliance — Fort Lauderdale, Fla. 

The Council for International Tax Education 

will sponsor a two-day seminar 

focusing on the latest IRS tax reporting 

requirements for U.S. companies with 

foreign operations. 

• Tel: (914) 328-5656 

• E-mail: info@citeusa.org 

International Tax — New York. Networking 

Seminars will sponsor a oneday 

introduction to international tax 

with topics including expense apportionment, 

earnings and profits, the foreign 

tax credit, and Subpart F income. 

• Tel: (914) 874-5395 

• E-mail: 

elizabeth@networkingseminars.net 

February 10 



international tax update with topics 

including new contract manufacturing 

regulations, recent changes to the foreign 

tax credit, new service rules under section 

482, and treaty developments. 

• Tel: (914) 874-5395 

• E-mail: 


February 11 



advanced international tax seminar 

with topics including inbound and outbound 

transactions, transfers of intangible 

assets, permanent establishments 

under tax treaties, foreign exchange, and 

financing foreign subsidiaries. 

• Tel: (914) 874-5395 

• E-mail: 


February 16 

U.S. International Tax — Houston. 

ATLAS will sponsor a two-day introduction 

to U.S. international tax with topics 

including key issues involving the 

American Jobs Creation Act and the 

U.S. tax effects of generating income or 

losses from operations overseas. 

• Tel: (800) 206-4432 

• Web site: http://www.atlas-sfi.com 

February 18 

U.S. International Tax — Houston. 

ATLAS will sponsor a two-and-a-halfday 

intermediate-level seminar on U.S. 

international taxation. 

• Tel: (800) 206-4432 


February 23 

U.S. Transfer Pricing — New York. The 

Council for International Tax Education 

will sponsor a two-day intermediate- to 

advanced-level seminar focusing on U.S. 

transfer pricing issues. 

• Tel: (914) 328-5656 


Tax Accounting for U.S. Multinationals 

— New York. The Council for International 

Tax Education will sponsor a 

two-day conference on topics including 

computing taxes in assembling the corporate 

tax provision under FAS 109, tax 

accounting requirements for reporting 

domestic production benefits, and how 

FIN 48 rules apply to uncertain tax positions 

for public and nonpublic companies. 

• Tel: (914) 328-5656 


February 25 

Cross-Border Tax Controversies — 

Washington. The Tax Council Policy 

Institute will hold a two-day symposium 

focusing on topics including dispute 

resolution, transfer pricing, indirect taxation, 

and permanent establishment and 

nexus. The keynote speaker will be IRS 

Commissioner Douglas Shulman. 

Contact: Donna Cox-Davies or Roger 

LeMaster. 

• Tel: (914) 686-5599 or 

(202) 822-8062 

• E-mail: dcox-davies@riverinc.com or 

rlemaster@tcpi.org 

• Web site: http://www.tcpi.org 

Global Transfer Pricing — Frankfurt. 

The C5 business information group will 

sponsor a two-day conference on minimizing 

corporate transfer pricing risks, 

with a special focus on regulatory requirements 

in France, Germany, India, 

Russia, the U.K., and the U.S. 

Contact: Susan Jacques. 

• Tel: +44 (0) 20 7878 6888 

• E-mail: s.jacques@C5-Online.com 

• Web site: http://www.C5- 

Online.com/transferpricing 

February 26 

Cyprus Double Tax Treaties — 

Moscow. The Moscow Times and Eurofast 

Global Ltd. will sponsor a seminar 

on confidentiality agreements, tax treaties, 

and exchange of information. 

• Tel: +7 495 232 4774, 232 1769 

International Tax — Washington. The 

U.S. branch of the International Fiscal 

Association will sponsor a two-day conference 

on tax treaties, transfer pricing, 

The calendar is available online as 

Doc 2009-1789. 

Submissions to the Tax 

Calendar may be sent by fax to 

(703) 533-4646 or by e-mail to 

tni@tax.org. 



TAX CALENDAR 

financially distressed companies from a 

Canadian perspective, and tax-effective 

supply chain management. 

• Tel: (866) 298-9464 

• E-mail: info@ifausa.org 

March 2 

International Tax — Miami. Networking 

Seminars Inc. will sponsor a one-day 

introductory course on international 

taxation and taxation of foreign earnings 

of U.S. corporations. 

• Tel: (914) 874-5395 

• E-mail: 

info@networkingseminars.net 

• Web site: http:// 

www.networkingseminars.net 

March 3 



intermediate course on international 

taxation focusing on recent U.S. rulings 

and changes to the international tax 

regulations. 

• Tel: (914) 874-5395 

• E-mail: 




March 4 



advanced course on international taxation 

focusing on recent court decisions 

and U.S. and foreign tax rulings. 

• Tel: (914) 874-5395 

• E-mail: 




March 9 


Compliance — Dallas. The Council for 

International Tax Education will sponsor 

a two-day seminar focusing on the 

latest IRS tax reporting requirements for 

U.S. companies with foreign operations. 

• Tel: (914) 328-5656 


U.S. Infrastructure Investments — New 

York. ATLAS will sponsor a two-day 

seminar of the tax advantages of U.S. 

infrastructure investments, including 

information regarding public-private 

partnerships transactions. 

• Tel: (800) 206-4432 


March 16 

International Tax Forum — San Francisco. 

ATLAS will sponsor a two-day 

forum on topics including new transfer 

pricing regulations, strategies for repatriating 

foreign earnings, and FAS 48 reporting. 

• Tel: (800) 206-4432 


March 23 

U.S. Transfer Pricing — San Francisco. 


will sponsor a two-day introductory 

seminar on the U.S. transfer pricing 

rules. 

• Tel: (914) 328-5656 


China Tax Update — San Francisco. 


will sponsor a two-day technical 

update on the latest legal, tax, and accounting 

issues facing companies with 

operations or business opportunities in 

China. 

• Tel: (914) 328-5656 


U.S. International Tax — Seattle. 







• Tel: (800) 206-4432 


European and U.S. Cross-Border Financial 

Products — London. ATLAS and 

Structured Finance Institute will sponsor 

a two-day conference on the technical 

details of European and U.S. crossborder 

financial products. 

• Tel: (800) 206-4432 


March 25 

U.S. International Tax — Seattle. 

ATLAS will sponsor an intermediatelevel 

three-day seminar on U.S. international 

tax provisions using examples and 

case studies. 

• Tel: (800) 206-4432 


March 30 

U.S. Tax Planning — Chicago. ATLAS 

will sponsor a two-day seminar on tax 

planning in the current economic environment. 

• Tel: (800) 206-4432 


April 2 

Corporate Taxation — Washington and 

Webcast. ALI-ABA and the ABA Section 

of Taxation will cosponsor a twoday 

course on topics including taxable 

merger and acquisition structures, crossborder 

issues, treatment of contingent 

liabilities, executive compensation and 

compensatory interests, and structures to 

accommodate private equity investors. 

• Tel: (800) 253-6397 

April 20 

Taxation of Financial Products — 

Chicago. ATLAS will sponsor a twoday 

introduction to tax and accounting 

issues regarding financial products and 

derivatives. 

• Tel: (800) 206-4432 



Compliance — Atlanta. The Council 

for International Tax Education will 

sponsor a two-day course on IRS tax 

reporting requirements for U.S. companies 

with foreign operations. 

• Tel: (914) 328-5656 


April 26 

Offshore Companies — Miami. 

Offshore Alert will sponsor a three-day 

conference on topics including defense 

against IRS administrative and criminal 

investigations, the limits of Chapter 15, 

Ponzi schemes, anti-money laundering, 

offshore insurance products, and flagship 

tax investigations. Contact: Naomi 

Comerford. 

• Tel: (305) 372-6296 


www.offshorealertconference.com 



April 27 

U.S. International Tax — New York. 







• Tel: (800) 206-4432 


April 29 

U.S. International Tax — New York. 




case studies. 

• Tel: (800) 206-4432 


May 4 

International Tax — Chicago. Networking 


introductory course on international 

taxation and taxation of foreign earnings 

of U.S. corporations. 

• Tel: (914) 874-5395 

• E-mail: 




Foreign Tax Credit — Chicago. ATLAS 

will sponsor a two-day overview course 

on U.S. foreign tax credit mechanics 

under various code sections. 

• Tel: (800) 206-4432 


May 5 



intermediate course on international 

taxation focusing on recent U.S. rulings 

and changes to the international tax 

regulations. 

• Tel: (914) 874-5395 

• E-mail: 




May 6 



advanced course on international taxation 

focusing on recent court decisions 

and U.S. and foreign tax rulings. 

• Tel: (914) 874-5395 

• E-mail: 




May 7 

U.S. International Tax — Philadelphia. 

ATLAS will sponsor a two-day forum 

on topics including cross-border tax 

planning for corporations and U.S. regulatory 

guidance. 

• Tel: (800) 206-4432 


May 13 

Partnerships, LLCs, and Joint Ventures 

— Chicago. The Practising Law Institute 

will sponsor a three-day seminar on 

partnership tax rules. 

• Tel: (800) 260-4754 

• Web site: http://www.pli.edu 

May 18 

Earnings and Profits of Foreign Subsidiaries 

— Philadelphia. ATLAS will 

sponsor a two-day seminar focusing on 

new regulations for earnings and profits, 

subpart F income, and foreign tax credits. 

• Tel: (800) 206-4432 


Latin America Tax Update — Miami. 


will sponsor a two-day conference 

that examines tax issues in doing business 

in Latin America. 

• Tel: (914) 328-5656 


U.S. International Transfer Pricing — 

Miami. The Council for International 

Tax Education will sponsor a two-day 

course on U.S. transfer pricing rules 

under IRC section 482. 

• Tel: (914) 328-5656 

TAX CALENDAR 


Tax Aspects of International Acquisitions 

— Philadelphia. ATLAS will 

sponsor a two-day seminar on crossborder 

business mergers and acquisitions. 

• Tel: (800) 206-4432 


May 27 


— New York. The Practising Law Institute 

will sponsor a three-day seminar on 

partnership tax rules. 

• Tel: (800) 260-4754 


June 4 

International Transfer Pricing — 

Chicago. ATLAS will sponsor a two-day 

seminar on pricing documentation, audits, 

competent authority procedures, 

and advanced pricing agreements. 

• Tel: (800) 206-4432 


June 10 


— San Francisco. The Practising Law 

Institute will sponsor a three-day seminar 

on partnership tax rules. 

• Tel: (800) 260-4754 


June 15 

U.S. International Tax — Boston. 







• Tel: (800) 206-4432 


June 17 

U.S. International Tax — Boston. 




case studies. 

• Tel: (800) 206-4432 




Africa: Zein Kebonang 

Albania: Adriana Civici 

Angola: Trevor Wood 

Anguilla: Alex Richardson 

Antigua: Donald B. Ward 

Argentina: Cristian E. Rosso Alba; Sebastian Lopez-Sanson 

Armenia: Suren Adamyan 

Asia: Laurence E. Lipsher 

Australia: Graeme S. Cooper; Richard Krever; Philip Burgess 

Austria: Markus Stefaner; Clemens Philipp Schindler 

Bahamas: Hywel Jones 

Bangladesh: M. Mushtaque Ahmed 

Barbados: Patrick B. Toppin 

Belgium: Werner Heyvaert; Marc Quaghebeur 

Bermuda: Wendell Hollis 

Botswana: I.O. Sennanyana 

Brazil: David Roberto R. Soares da Silva 

Bulgaria: Todor Tabakov; Lubka Tzenova 

Cameroon: Edwin N. Forlemu 

Canada: Brian J. Arnold; Jack Bernstein; Steve Suarez 

Caribbean: Bruce Zagaris 

Cayman Islands: Timothy Ridley 

Chile: Macarena Navarrete 

China (P.R.C.): Laurence E. Lipsher; Peng Tao; Huiyan Qiu 

Cook Islands: David R. McNair 

Costa Rica: Alvaro Castro Mendez 

Croatia: Hrvoje Šimovic 

Cuba: Cristian Óliver Lucas-Mas 

Cyprus: Theodoros Philippou 

Czech Republic: Niko Härig 

Denmark: Nikolaj Bjørnholm; Jens Wittendorff 

Dominican Republic: Dr. Fernándo Ravelo Alvarez 

Eastern Europe: Iurie Lungu 

Ecuador: Roberto Silva Legarda 

Egypt: Abdallah El Adly 

Estonia: Viktor Trasberg; Inga Klauson 

European Union: Marco Rossi; Clemens Philipp Schindler 

Fiji: Bruce Sutton 

Finland: Marjaana Helminen 

France: Olivier Delattre; Michel Collet; Hervé Bidaud 

Gambia: Samba Ebrima Saye 

Germany: Jörg-Dietrich Kramer; Thomas Eckhardt; Clemens Philipp 

Schindler; Wolfgang Kessler; Rolf Eicke 

Ghana: Seth Terkper 

Gibraltar: Charles D. Serruya 

Greece: Alexandra Gavrielides 

Guam: Stephen A. Cohen 

Guernsey: Neil Crocker 

Guyana: Lancelot A. Atherly 

Hong Kong: Laurence E. Lipsher 

Hungary: Farkas Bársony 

Iceland: Indridi H. Thorlaksson 

India: Nishith M. Desai; Shrikant S. Kamath; Vaishali Mane; Mundachalil 

Padmakshan 

Indonesia: Freddy Karyadi 

Iran: Mohammad Tavakkol 

Ireland: Kevin McLoughlin 

Isle of Man: Richard Vanderplank 

Israel: Joel Lubell; Guy Katz 

Italy: Alessandro-Adelchi Rossi; Gianluca Queiroli; Marco Rossi; Federico 

Pacelli 

Japan: Paul Previtera 

Jersey: J. Paul Frith 

CORRESPONDENTS 

Kenya: Glenday Graham 

Korea: Sangmoon Chang 

Kuwait: Abdullah Kh. Al-Ayoub 

Latvia: Andrejs Birums; Valters Gencs 

Lebanon: Fuad S. Kawar 

Libya: Ibrahim Baruni 

Lithuania: Nora Vitkuniene 

Luxembourg: Jean-Baptiste Brekelmans 

Malawi: Clement L. Mononga 

Malaysia: Jeyapalan Kasipillai 

Malta: Dr. Antoine Fiott 

Mauritius: RamL.Roy 

Mexico: Jaime Gonzalez-Bendiksen; Koen van ’t Hek 

Middle East: Aziz Nishtar 

Monaco: Eamon McGregor 

Mongolia: Baldangiin Ganhuleg 

Morocco: Mohamed Marzak 

Myanmar: Timothy J. Holzer 

Nauru: Peter H. MacSporran 

Nepal: Prem Karki 

Netherlands: Eric van der Stoel; Michaela Vrouwenvelder; Jan Ter Wisch 

Netherlands Antilles: Dennis Cijntje; Koen Lozie 

New Zealand: Adrian Sawyer 

Nigeria: Elias Aderemi Sulu 

Northern Mariana Islands: John A. Manglona 

Norway: Frederik Zimmer 

Oman: Fudli R. Talyarkhan 

Panama: Leroy Watson 

Papua New Guinea: Lutz K. Heim 

Philippines: Benedicta Du Baladad 

Poland: Dr. Janusz Fiszer; Michal Tarka 

Portugal: Francisco de Sousa da Câmara; Manuel Anselmo Torres 

Qatar: Finbarr Sexton 

Russia: ScottC.Antel 

Saint Kitts-Nevis: Mario M. Novello 

Saudi Arabia: Fauzi Awad 

Serbia and Montenegro: Danijel Pantic 

Sierra Leone: Shakib N.K. Basma; Berthan Macaulay 

Singapore: Linda Ng 

Slovakia: Niko Härig 

South Africa: Peter Surtees 

Spain: Florentino Carreño; Sonia Velasco 

Sri Lanka: D.D.M. Waidyasekera 

Sweden: Leif Mutén; Mattias Dahlberg 

Switzerland: Thierry Boitelle 

Taiwan: Yu Ming-i 

Trinidad & Tobago: Rolston Nelson 

Tunisia: Lassaad M. Bediri 

Turkey: Mustafa Çamlica 

Turks & Caicos Islands, British West Indies: Ariel Misick 

Uganda: Frederick Ssekandi 

United Arab Emirates: Nicholas J. Love 

United Kingdom: Trevor Johnson; Nikhil Mehta; Tom O’Shea 

United States: James Fuller 

U.S. Virgin Islands: Marjorie Rawls Roberts 

Uruguay: Dr. James A. Whitelaw; Alberto Varela 

VAT Issues: Richard Ainsworth 

Vanuatu: Bill L. Hawkes 

Venezuela: Ronald Evans; Pedro Palacios Rhode 

Vietnam: Frederick Burke 

Zambia: W Z Mwanza 

Zimbabwe: Prof. Ben Hlatshwayo

tax notes international - Tuck School of Business - Dartmouth College

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