Treaty shoppers are encountering increasing counter-measures. Bart Kruijssen sets out the key issues to be aware of.
How should fund managers arm themselves when talking with potential investors? Likewise, what should institutional investors ask? Worldwide, tax authorities are stepping up their efforts to tackle treaty shopping. For instance, India wonders why it has to lose out on tax revenues simply because foreign funds invest in India through a Mauritius mail box company. The Japanese TK case (first published by a newspaper in 2002), the Lone Star case (2005) and Indofood (UK, 2006), show that this type of tax planning is no longer only a trade off between tax benefits and tax risks. It goes much further than hiring local directors and one annual trip to attend a board meeting.
1. Context - Substance is part of the wider concept of fund governance that also includes tax topics like the location of the investment committee, taxation of management fees, carry arrangements, permanent establishment risks, etc. Fund governance has trumped deal structuring as the primary tax topic of real estate funds. Sufficient knowledge of these topics and how they relate is required to make decisions.
2. Definition - Substance is in fact used in a colloquial sense; it is not a defined term in the tax world. It has connotations as diverse as beneficial ownership, tax residence and transfer pricing. For many countries, the assessment of treaty claims is shifting towards a "substance over form" approach. Complying with the substance imperative is no longer a question of simply implementing a list of formal requirements. Clearly, there should be real activity in holding, financing and management entities rather than mere "rubber stamping". Foreigners who invest into the US encounter a complete substance over form approach. "Limitation on Benefits" provisions in US treaties are so strict that treaty shopping is effectively curtailed in the real estate investment arena, while real estate investments through tax dictated derivative contracts like total return swaps have effectively been banned.
3. Trend - The global trend is unmistakably that substance is gaining even more importance. Court cases arise from an increasingly diverse array of countries. In China, late 2008, two court cases have cast doubt on the tax effectiveness of using off shore SPVs to hold Chinese real estate. The Chongqing tax authorities ruled that the gain derived by a top-tier Singapore holding company, disposing of its Singapore subsidiary, which in turn held an equity interest in a Chinese entity, was chargeable to Chinese withholding income tax. The Xinjiang tax authorities denied the treaty benefits to a Barbados company on disposal of its equity interest in a Chinese joint venture. While Germany has implemented a number of anti-abuse provisions in its tax laws, there are even more in the pipeline. Also, even non-abusive situations are facing consequences due to overkill in the anti-abuse measures.
4. Counter trends - All investee countries, from China to the US, currently wish to attract more foreign direct investment and may accept that tax leakage of several hundred basis points is reasonable on the one hand and the limit on the other. Why would a Hong Kong exempt investor be faced with a 60%-plus tax hit when investing in a New York trophy real estate asset while a US counterpart is exempt? Meanwhile, tax authorities in India, Germany and Canada (particularly in the Prévost case, 2009) continue to find out that judiciaries are sometimes bound by form over substance legislation and interpretation thereof. Finally, EU tax residents have increasingly favourable EU (case) law on their side when investing within the EU.
5. Audits and challenges - Even if sometimes steeped in the same OECD rules, countries have their own policies and practices to challenge structures. While some countries have no resources available, others have invested in an infrastructure. German tax authorities complement the strict laws with standardised questionnaires and potential requests to disclose the funds' ultimate beneficiaries if treaty benefits are claimed. New legislation would enable German tax authorities to collect information from third parties abroad. Switzerland and Liechtenstein faced harsh diplomatic pressure from Germany when they showed reluctance to exchange taxpayers' information. China is likely to issue a circular to deal with the "abusive" use of offshore SPVs to hold investments in China. Foreign investors may be required to provide certain documents and information if those SPVs are disposed of off shore, which may lead the Chinese tax authorities to conclude Chinese taxation is proper. Other factors may influence the risk level, for instance if there is public outcry over foreign investors walking away with big gains without paying their fair share of tax. Try to read the tax leaves and be prepared!
6. Alignment - Best practices involve the use of investment platforms that are fully aligned with the business strategy. A European based platform, for example, may help bridge the time zone gap between Asian investments and US investors. IFRS and language skills may be accessed, while the fund sponsor gains presence in an additional market and access to regional investors and networks. Thus a cost benefit analysis of investing through a third country involves more than the trade off between the mitigation of taxes and the cost of implementing and maintaining the structure.
7. Tax and tax risks policy - What is the level of risk that is acceptable? Is there a good grasp of other related risks: directors' personal liabilities, reputation risk, tax bills that materialize when the fund has already been liquidated? Note that the so called FIN48 provisions (US GAAP) have set the threshold at more likely than not. In other words, if the likelihood of a tax position is less than 50% certain, the reporting entity needs to report a tax liability for the full amount. Even for closed end funds any strategy decision taken at inception has relevance for a decade or more. As tax developments are coming fast, how does one extrapolate the current status? We recommend funds and institutional investors alike create an overall tax policy covering a tax leakage and (tax) risks level that they can accept, as well as a formalized procedure to compare periodically the substance in place against the (new) requirements.
Bart Kruijssen is partner - international real estate and hospitality at PwC