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DOC# 290186.4 — Cross-Border Arbitrage Connecticut 2009 CROSS-BORDER TAX ARBITRAGE The following are common situations and transactions involving the tax systems of the United States and a foreign country (let’s call it Elbonia). Assume that X is a corporate taxpayer in the United States, and that Y is an entity formed outside the United States that may own X, or be owned by X, or be independent of X, depending on the circumstances. United States Elbonia 1) Dual Resident Corporation X is organized in the United States and hence resident in the United States under its tax laws X is managed and controlled in Elbonia and hence resident in Elbonia under its tax laws Tax benefits: losses or credits of X are potentially available to reduce taxes of related parties under consolidated return or group relief rules in both the United States and Elbonia 2) Hybrid Instrument X extends funds to Y under an instrument considered equity under the tax laws of the United States The instrument is debt under the tax laws of Elbonia Tax benefits: foreign tax credits or dividends received deductions for X in the United States and interest deductions for Y in Elbonia X borrows funds from Y under an instrument considered debt under the tax laws of the United States The instrument is equity under the tax laws of Elbonia Tax benefits: deductible interest for X in the United States and dividends for Y that are either exempt or that make foreign tax credits available to Y in Elbonia 3) Hybrid Branch Y, which is owned by X, is transparent (nonexistent) under the tax laws of the United States Y is non-transparent under the tax laws of Elbonia Tax benefits: the results of Y’s operations, including losses and credits, are attributable to X, and payments by Y to X (or vice versa) have no consequences under the tax laws of the United States; the results of Y’s operations remain confined within Y insofar as the tax laws of Elbonia are concerned and payments between X and Y have Elbonian tax effects - 2 – 4) Reverse Hybrid Y is owned by X and is non- transparent under the tax laws of the United States Y is transparent under the tax laws of Elbonia Tax benefits: deferral of tax on Y’s income in the United States, while foreign tax credits are (arguably) claimable by X in the United States for the Elbonian tax on Y’s income X is owned by Y and a taxable corporation under the tax laws of the United States X is transparent under the tax laws of Elbonia Tax benefits: dividends paid to X by another U.S. corporation are subject to no or reduced taxation in the United States by reason of the dividends received deduction, while foreign tax credits or exemption flow through to Y under the tax laws of Elbonia 5) Repo X sells a security to Y with a contemporaneous agreement to repurchase the security at a designated future date Under the tax laws of Elbonia the transaction is viewed as a sale by X, with an agreement to repurchase at a subsequent date Tax benefits: the transaction is a secured financing under the tax laws of the United States, so distributions on the security belong to X and amounts paid by X to Y in excess of the original sale price are deductible interest; but ownership of the security is transferred to Y for the duration of the transaction under the tax laws of Elbonia, so credits or exemption are available in Elbonia for distributions on the security 6) Taxpayer Use of Arm’s- Length Method Having bought a widget from Y at a cash price of 25, X reports the arm’s- length price as 35 under the tax laws of the United States Y reports a price of 25 under the tax laws of Elbonia Tax benefits: a cost of goods of 35 for X in the United States, but a sale price of 25 reported by Y in Elbonia; and a transfer of 10 from Y to X, with attendant tax consequences, under the tax laws of the United States Having borrowed from Y at a zero rate of interest, X reports deductible interest at an arm’s-length rate under the tax laws of the United States Y reports no income under the tax laws of Elbonia Tax benefits: interest deduction for X in the United States, but zero income to Y in Elbonia - 3 – QUESTIONS: A) Is there commonality among these situations in legal/policy terms? B) Can any of these situations be satisfactorily resolved by “substance-over-form” analysis (an “anodyne for the pain of thinking” per L. Hand, J.)? C) Is there application here of the body of law prohibiting taxpayers from disavowing the form of their transactions? See, e.g., Taiyo Hawaii Company, Ltd., 108 T.C. 590 (1997). D) Is there a tax policy problem here? If so, what is it? OBSERVATIONS: A) There is no general U.S. rule or policy relating to cross-border tax arbitrage. B) There may be no reason for such a general rule, and it would be difficult to administer a general rule. C) There are specific rules in U.S. law aimed at particular arbitrage situations. See, for example, section 1503(d) of the Internal Revenue Code; Treasury Regulation § 1.901-2T(e)(5)(iv); Proposed Treasury Regulation § 1.901-2(f). D) Certain policies expressed in U.S. law presuppose and depend upon the tax laws of other countries (for example, section 954(c)(3)((A)); these policies may be thwarted by cross-border tax arbitrage. E) Arbitrage within a single tax system is arguably more problematic than cross-border arbitrage. H. David Rosenbloom September 21, 2008
