Education

Killer B, Deadly D, Outbound F

MOHAN R. LAVI | Updated on March 12, 2018

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Critics claim that the present tax code of the Internal Revenue Service of the US presents opportunities for corporate entities to skirt the taxman.

After Greece was rescued from a default with an austerity package that jacked up taxes, the United States is teetering on the verge of a default as the politicians there have not seen eye-to-eye to increase the borrowing limit of the Federal Government. Critics claim that the present tax code of the Internal Revenue Service (IRS) presents plenty of opportunities for corporate entities to skirt the taxman. In contrast, the Central Board of Direct Taxes (CBDT), as a part of its revenue-raising action plan, has urged tax collectors to use the decision of the Supreme Court in Vodafone as a benchmark to collect all withholding taxes due — 25 per cent in cash and a bank guarantee for the balance.

Late last year, there was a request to the US President to provide tax-breaks to more than $1 trillion stashed abroad. The request was made with the expectation that this money would kick-start a US economy still wobbling after the financial crisis. In normal circumstances, such repatriations attracted a tax of 35 per cent.

Though the tax-break was never given, it brought into focus the fact that many US corporate entities were already bringing the money back through an innovative use of Article 368(a)(1)(b) of the US Tax Code. This Article provides a tax-break when there is an acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of stock of another corporation if, immediately after the acquisition, the acquiring corporation has control of such other corporation (whether or not such acquiring corporation had control immediately before the acquisition).

TAX PLANNING DEVICES

Like in all other things in the United States, these tax planning devices also acquired names “Killer B” and “Deadly D”. A US company using the technique would sell its shares to an offshore subsidiary, bringing cash back to the US tax-free. The offshore unit could then use the stock to make an acquisition. In 2006, the IRS issued a notice aimed at shutting down the manoeuvre. “Deadly D,” allows a US company to attach the high-tax basis in a newly-acquired company to one of its existing foreign units. In some cases, doing so enables the US parent to pull cash from the subsidiary up to the amount of the recent purchase price tax-free.

In another variant christened “Outbound F”, a US multinational purchases another US company, with the new unit promising to pay the parent a large amount of cash pursuant to a note agreement. Since both parties are US companies, there is no tax bill for the parent under current US law. Then the new acquisition converts to a foreign company. So when the payment pursuant to the note is made, it comes from overseas. That means the foreign cash is treated as a non-taxable payment under the note, instead of a taxable dividend. The newly-converted foreign subsidiary could access the multinational's existing offshore cash by borrowing from a foreign sister unit. There have apparently been many instances of US companies using these schemes or their variants to bring in funds from tax havens.

TAX PLANNING VS EVASION

In 1985, the Supreme Court of India in the landmark McDowell and Co vs. Commercial Tax Officer case, ruled that the proper way to construe a taxing statute, while considering a device to avoid tax, is not to ask whether the provisions should be construed literally or liberally, nor whether the transaction is unreal and prohibited by the statute, but whether the transaction is a device to avoid tax, and whether the transaction is such that the judicial process may accord its approval to it. Much legal sophistry and judicial exposition have gone into the attempt to differentiate the concepts of tax evasion and tax avoidance and to identify the invisible line which distinguishes one from the other.

While the IRS may construe and pass it off as tax planning, Vodafone has shown that tax authorities in India are able to pierce the veil of acquisition agreements. Utilising all the above principles to different agreements could assist in bringing in the moolah from tax havens.

Published on July 31, 2011

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