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  • Obama Administration’s Budget Addresses Some BEPS Action Items
    February 2015
    On February 2, 2015 the Obama administration released the description of the revenue proposals in its fiscal 2016 budget, commonly referred to as the “Green Book.”[3] From an international tax perspective, this year’s Green Book is notable because there are several new revenue proposals that align with action items under consideration by the OECD and the G20 as part of the BEPS (Base Erosion and Profit Shifting) initiative.[4] Below we discuss several of the Administration’s latest proposals in the context of the corresponding BEPS action items.
    Group-wide limit on interest deductions
    BEPS Action 4 deals with interest expense and other deductions. The OECD has released a discussion draft which considers various approaches to limiting the interest deduction of multinational groups.[5]  One approach the discussion draft considers is a group-wide approach that limits an entity’s deductible interest expense by reference to the external debt position of its worldwide group. This approach references the group’s actual net third-party interest expense (i.e., total interest paid to third parties less total interest income received from third parties), and allocates that expense among group members based on a measure of relative economic activity.
    The Obama Administration’s proposal follows this approach.  It would apply to an entity that is a member of a group that prepares consolidated financial statements in accordance with U.S. GAAP (Generally Accepted Accounting Principles) or certain other recognized accounting standards. A member’s interest deduction generally would be limited when (i) the member has net interest expense for tax purposes and (ii) the member’s net interest expense for financial reporting purposes (computed on a separate company basis) exceeds the member’s proportionate share of the net interest expense reported on the financial reporting group’s consolidated financial statements. The member’s proportionate share of net financial statement interest expense would be based on the member’s proportionate share of the group’s EBITDA.  Disallowed interest expense for a year could be carried over to future years indefinitely, and a year’s excess limitation would be carried forward three years.  In the case of a non-US group, the limitation would apply to any U.S. subgroup.
    For some groups, the group-wide calculation may be difficult, and the proposal allows a member to elect to use a formula instead: the member’s interest deduction would be limited to the member’s interest income plus 10 percent of the member’s adjusted taxable income (as defined under section 163(j)).[6]
    New minimum tax on foreign income
    BEPS Action 3 is to strengthen CFC rules.  To date, the OECD has issued no report, but over the last several months the US Treasury has been a vocal advocate of the adoption of stronger CFC rules.  For example, in February 2015, Robert Stack , the US Treasury’s deputy assistant secretary for international tax policy, stated that the United States, as part of the OECD’s work on BEPS Action 3 is proposing a CFC rule that is similar to the CFC rule proposed in the Obama administration's budget proposal.[7]
    The Obama Administration’s proposal is a minimum tax on income of CFCs that is not otherwise currently taxable (i.e., under subpart F.). As with subpart F, the minimum tax would apply to a U.S. corporation that is a United States shareholder of a CFC. The tax also would apply to a US corporations’ earnings from a foreign branch or from the performance of services abroad. These earnings would be subject to current U.S. tax at a rate of 19 percent less 85 percent of the “per-country foreign effective tax rate.” The foreign effective tax rate would be computed by aggregating all foreign earnings and the associated foreign taxes assigned to a country for the 60-month period that that ends on the date on which the CFC’s current taxable year ends.[8] In order for foreign income taxes to be included in the rate calculation, they would have to be eligible to be claimed as a foreign tax credit during the 60-month period. 
    The proposed minimum tax does not appear to allow use of losses.  It also is unclear whether the Treasury believes this provision is compatible with the obligation of the United States under most of its income tax treaties to provide a credit for foreign income taxes.
    The Green Book justifies strengthening US CFC rules on several grounds:  First, the current CFC rules provide companies the opportunity to defer U.S. tax on a CFC’s earnings while currently deducting expenses attributable to deferred earnings.  This is believed to provide U.S. multinationals with the incentive to locate production overseas and shift profits abroad. Second, the current system discourages companies from repatriating low-tax foreign earnings, because they would pay significant residual U.S. tax on the repatriated earnings after taking into account any foreign tax credits. The current system also allows “cross- crediting:” using credits from high-tax foreign-source income to reduce U.S. tax on low-tax foreign-source income such as royalties.  Moving to a per-country tax calculation would address all of these issues. It also would significantly raise the US tax bill of US multinationals, while encouraging them to bring cash back to the United States.
    Restricted hybrid arrangements that create stateless income
    BEPS Action item 2 is neutralising the effect of a hybrid mismatch arrangements. The OECD issued two reports on action item 2 in 2014.[9] The reports describes three types of hybrid mismatch arrangements: (i) deduction with no corresponding inclusion, (ii) double deduction, and (iii) indirect deduction with no inclusion. The reports recommend various actions that could be taken to address such mismatches.
    The reports consider arrangements involving hybrid instruments, hybrid entities and reverse hybrid entities. One common example of the use of a reverse hybrid entity to create a deduction with no inclusion is the Dutch CV-BV structure.[10] For example, with respect to reverse hybrid entities the report recommends denying a deduction for amounts paid to such entities to the extent they result in a deduction with no inclusion to the payee.
    The Obama administration has proposed several changes that are consistent with the OECD report. One proposal would deny a deduction for interest and royalty payments made to related parties when the transaction involves a hybrid arrangement, and either (i) as a result of the hybrid arrangement there is no corresponding inclusion to the recipient in the foreign jurisdiction or (ii) the arrangement would permit the taxpayer to claim an additional deduction for the same payment in another jurisdiction. Another proposal would provide that certain “look through rules” that are exceptions to the US subpart F rules would not apply to payments made to a foreign reverse hybrid owned by one or more US persons when the amounts received by the reverse hybrids are from foreign related person’s that claim a deduction for foreign tax purposes. This would address, for example, the CV-BV structure described above.
    These legislative proposals indicate that the Obama administration is fully engaged with the OECD’s BEPS initiative. Tightening US tax rules regarding the taxation of foreign source income and income earned by foreign corporations is probably in the interest of the US fisc given the current worldwide tax climate concerning income located in low-tax jurisdictions. 
    If US tax rules are not tightened, other countries, particularly those that view themselves as source states, will very likely tighten their rules in the near future.[11]  The result will be that the roughly $2 trillion that US multinationals have earned in low-tax jurisdictions will be subject to foreign income tax.
    In the author’s view, the U.S. Congress will eventually enact legislation that will encourage this low-taxed income to be repatriated. To the extent that such income has borne foreign income taxes, the US tax on those repatriated earnings would be reduced by the corresponding foreign tax credit. Moreover, tightening US tax rules may discourage source states from acting unilaterally, perhaps in a manner inconsistent with US treaty obligations and international norms.  Such unilateral action by source states could result in double taxation or taxation inconsistent with US treaty obligations. Such actions also could result in an increase in international tax disputes, including mutual agreement procedures and the denial of foreign tax credits to US multinationals. These are all results that the United States, and most US multinationals, very likely would wish to avoid.
    United States Held Liable for Making False Statements to Foreign Tax Authority
    In a recent case, Aloe Vera of America Incorporated, et al. v. United States of America,[12] the United States was found liable for making false statements to the Japanese tax authority during a joint audit of a group of taxpayers. The opinion also reports that, in connection with the joint audit, the Japanese National Tax Administration (“NTA”) leaked information concerning the audit to Japanese media, which caused the taxpayer’s Japanese subsidiary to experience a decline in sales. This case is notable, not only because it sheds light on the simultaneous examination program authorized by U.S. income tax treaties, but because it shows the potential hazards, to the IRS and U.S. taxpayers, of exchanging taxpayer information with treaty partners.
    The Internal Revenue Code generally prohibits the disclosure of taxpayer information; however, there are numerous exceptions to this general rule.[13]  One of the exceptions is for the exchange of information pursuant to U.S. treaty obligations.[14]
    U.S. income tax treaties include provisions for the exchange of information between tax authorities. Some exchanges are automatic, while others are discretionary. The United States’ income tax treaty with Japan provides for both types of exchange of information. Periodically, the United States and a foreign country, such as Japan, may find it beneficial to jointly audit a multinational taxpayer. This is initiated through a Simultaneous Examination Proposal (“SEP”) issued by one country to the other.
    Facts of the case
    Aloe Vera of America (“AVA”) is a U.S. S corporation wholly owned by a U.S. taxpayer, Rex Maughan (“Maughan”). AVA buys bulk raw aloe vera gel and sells it to affiliated companies. During the years at issue, 1991 and 1992, AVA sold aloe vera gel to Forever Living Products Japan (“FLPJ”), a Japanese company jointly owned by Maughan and Gene Yamagata (“Yamagata”). FLPJ processed the raw gel and resold it to Japanese distributors. FLPJ paid a 3.5% royalty to AVA for certain proprietary processing and bottling processes. In addition, FLPJ paid a “commission/royalty” to AVA which it then paid, directly or indirectly, to Maughan and Yamagata.
    Maughan and Yamagata are wealthy entrepreneurs.  They also previously had engaged in tax planning that attracted the attention of the IRS:  FLPJ had paid a royalty to certain foreign entities for the benefit of Maughan and Yamagata as part of a scheme to defer their U.S. income tax liability with respect to these amounts.  After the scheme had been discovered, both individuals paid taxes due on that income for 1991 and 1992.
    In May 1995, the IRS assigned an international examiner (“Smith”) to investigate whether the taxpayers had employed a similar scheme to avoid U.S. tax on other income for the years at issue. As part of that effort, Smith’s supervisor instructed Smith to draft an SEP to be sent to the NTA. The SEP requires the requesting tax authority to, inter alia, identify issues that could be mutually examined as well as to describe “estimated or potential additional tax” attributable to those issues. Smith’s early drafts of the SEP did not include estimates of additional tax due, and Smith told his supervisor that he could not “really put numbers in there.” Apparently under pressure from his supervisor, Smith showed an estimate of $32,116,000 on the SEP as the amount of unreported U.S. income for the period 1991-1992. The estimate lacked any supporting detail. With respect to FLPJ’s potential Japanese tax liability, the SEP also showed estimates of disallowed royalty expense, disallowed commission expense and withholding tax on dividends.
    The SEP was sent to the NTA, and the IRS and NTA held two meetings as part of the joint audit. In January 1997, the NTA assessed additional tax to FLPJ for the years 1991-1996, including interest and penalties, of approximately $73 million. The tax adjustment was based on the NTA’s characterization of the commission/royalty paid by FLPJ to AVA as nondeductible directors’ bonuses.
    In October 1997, a series of news reports appeared in Japanese media reporting that FLPJ had concealed more than ¥7.7 billion of income by inflating the price of raw aloe vera. FLPJ’s sales in Japan declined materially subsequent to the disclosures.  An expert witness who examined the media reports concluded that the NTA was the source of that information.
    FLPJ paid the assessed taxes, and then contested the assessment. Based on a transfer pricing study, the NTA and the IRS subsequently concluded that FLPJ had paid AVA an arm’s-length price for the raw aloe vera gel. The NTA then refunded the taxes and penalties.
    The taxpayers brought suit in Federal District Court alleging that the United States had disclosed taxpayer information to the NTA contrary to section 6103(a). The taxpayers also asked the court to award $52 million of actual damages.
    The district court’s opinion

    The legal basis for this action is grounded in section 7431, which permits a taxpayer to bring a civil action for damages against United States in the event “any officer or employee of the United States knowingly, or by reason of negligence, inspects or discloses any return or return information with respect to a taxpayer in violation of any provision of section 6103.” In order to find for the taxpayers, the court needed to address several issues.
    The United States disclosed return information
    The government argued that no taxpayer information had been disclosed in the SEP. The District Court found, however, that the SEP contained return information of Maughan and Yamagata for several reasons. First, the statement concerning 32 million of unreported U.S. income was “a determination of the existence, or possible existence, of liability (or the amount thereof)” of tax for Maughan and Yamagata, which was taxpayer information as described in section 6103. The SEP also implied that both individuals had unreported commission income taxable by the United States in the amount of $32 million. Finally, the SEP made the statement that the commission income did not change as the cost of aloe vera gel to FLPJ changed. This also was information regarding the tax liability of Maughan and Yamagata.
    The information disclosed was false
    The government argued that the statements in the SEP concerning unreported income and the lack of variability of the commission were not knowingly false statements. They were simply good-faith estimates of possible unreported income, and an estimate cannot be false. The court found that an estimate carries “an implied assertion that its author knows facts to justify the selection of particular value chosen. Blind guesses are not good-faith estimates.”
    The court concludes that the knowing disclosure of false return information is unauthorized by the income tax treaty with Japan. The United States, therefore, did not satisfy the applicable exception to section 6103(a).
    The taxpayers were entitled to either statutory damages of $1000 per unauthorized disclosure or actual and punitive damages.[15] The taxpayers asked the court to award $52 million in actual damages. The court, however, concluded that the taxpayers were entitled to only statutory damages. The court reasoned that the taxpayers had failed to prove by the preponderance of the evidence that the statement concerning unreported income in the SEP caused the NTA to enter into the simultaneous examinations.
    The facts of the case are inherently interesting because they illuminate the foibles of both taxpayers and tax administrators.  Moreover, the case points out the risks of exchanging information with treaty partners having less stringent rules than the United States concerning the disclosure of taxpayer information. This risk is especially pertinent because one of the OECD’s BEPS’s actions (Action 13 on country-by-country reporting[16]) would require the exchange of significant amounts of a taxpayer’s sensitive transfer pricing information pursuant to U.S. treaty obligations.
    [1] Charles W.  Cope is a U.S. tax attorney who focuses on U.S. cross-border tax planning and tax controversies. He can be reached through his website:
    [2] The information contained herein is of a general nature, is based on authorities that are subject to change, and does not constitute legal advice.  Applicability of information to specific situations should be determined through consultation with your tax adviser.  ©2015 Law Office of Charles W. Cope, PLLC. All rights reserved.
    [3] General Explanations of the Administration’s Fiscal Year 2016 Revenue Proposals, available at
    [4] The OECD’s BEPS action plan is available at
    [6] See section 163(j)(6)(a).
    [7] 39 DTR I-5 (February 26, 2015).
    [8] For a domestic corporation, the end date is the corporation’s current taxable year.
    [9]  See BEPS Action 2: Neutralising the Effects of a Hybrid Mismatch Arrangements (Recommendations for Domestic Law) available at and BEPS Action 2: Neutralising the Effects of a Hybrid Mismatch Arrangements (Recommendations for Domestic Law) available at
    [10] For discussion of that structure see the European Commission's report on the Netherlands's alleged state aid to Starbucks. Available at
    [11] There is already evidence that this activity is beginning. See, e.g., the recent UK proposed tax on "diverted profits."
    [12] No. 2:99-cv-01794 (Feb. 11, 2015).
    [13] See section 6103.
    [14] Section 6103(b)(4)(A)(i).
    [15] Section 7431(c).
    [16]  See Action 13: Guidance on the Implementation of Transfer Pricing Documentation and Country-by-Country Reporting The report is available at