Treasury Targets Global Tax Scamming

A report it sent to Congress examines U.S. weaknesses dealing with abuses in transfer pricing, dealings involving tax treaties, and "earnings strip...
Roy HarrisNovember 29, 2007

The Treasury Department, responding to a Congressional mandate, sent a report to Capitol Hill recommending reforms to catch potential international tax abuses in the areas of transfer pricing, U.S. income-tax treaties, and the practice of “earnings stripping.”

The study’s transfer pricing section called for guidance to be modernized in three areas, and noted that some regulations haven’t been properly updated since 1968. The report cautioned that “rules must be continually monitored to ensure their relevance to changing business conditions and to prevent income shifting from non-arm’s length transfer pricing.”

In detailing the transfer pricing regulation flaws, the report proposed revising the existing guidance relating to cost sharing, specifically that related to “buy-in” payments that involve “contributions for which arm’s length consideration must be provided” in the cost-sharing arrangement. It is in the area of transfer-pricing services, the report said, that related-party regulations need to be completed to reflect legal, business, and economic developments in the nearly four decades since the issuance of the rules. Regulations also still need to be completed to govern global dealing: addressing how taxpayers can determine the amount of income from a global operation is subject to tax in the U.S., “as well as the source of such income and the circumstances under which such income is effectively connected with U.S. trade or business.”

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The section of the report on tax treaties noted that third-country residents sometimes obtain the benefits of U.S. treaties improperly, “in particular by achieving inappropriate reductions in U.S. withholding taxes.” Interest payments from foreign-controlled U.S. corporations to related entities in countries that are a party to a U.S. tax treaty with no “limitation on benefits” (LOB) provisions have surged in recent years. Those arrangements allow “significant reductions in withholding rates,” according to the study. Exploitation of treaties that have no “anti-treaty shopping protections” confirms that LOB provisions “appear to provide significant deterrence against abuse,” the report said. It also noted that Treasury “must continue its ongoing efforts to revise treaties with no or inadequate LOB provisions.”

The cases of earnings stripping targeted in the report involve excessive payments of deductible interest being made by foreign-controlled U.S. corporations “to related persons in whose hands that interest is partially or fully exempt from U.S. tax.” The study said it isn’t possible to quantify the extent of earnings stripping, but “strong evidence exists of earnings stripping by foreign-controlled companies “that have undergone so-called ‘inversion’ transactions….” In those arrangements, the U.S. parent company of a multinational is replaced with a foreign parent in a low-tax or no-tax country.

While the study didn’t find “conclusive evidence of earnings stripping,” the report added that more information is needed for a conclusion to be reached. That will require the tax forms to be modified to require more relevant data. At the same time, the Internal Revenue Service followed up with a proposed new form.