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FINANCE: US IRS provides guidance for examining 'voluntary tax' issues — impact on MNCs with cross-border operations in China
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US IRS provides guidance for examining 'voluntary tax' issues - impact on MNCs with cross-border operations in China

By Kelvin Lee, PwC Tianjin


BT 201604 140 01 Finance 001In brief


The Large Business and International Division of the United States (US) Internal Revenue Service (IRS) issued three International Practice Units (IPUs) several months ago, titled (i) 'Exhaustion of Remedies', (ii) 'Exhaustion of Remedies and Transfer Pricing (TP)' and (iii) 'Exhaustion of Remedies in Non-TP Situations' to intensify the scrutiny on 'voluntary tax' in claiming foreign tax credits (FTC) for US federal income tax purposes by providing IRS tax officials with the general guidelines in auditing 'exhaustion of remedies' in possible 'voluntary tax' situations.


The three IPUs address the requirement in the US tax legislation that foreign income tax payments must be 'compulsory' in order to be creditable. Specifically, they deal with the FTC creditability rule urging a US taxpayer to exhaust all remedies before making a foreign income tax payment. In view of the evolving tax climate in China and the increasing number of tax controversies on complicated transactions around the globe, US-controlled multinational companies (MNCs) operating in China should be aware of the approaches laid out in the IPUs and take prudent actions in handling Chinese tax matters so as to secure their FTC claims. Given the international norm to deny voluntary tax for FTC purposes, the IPUs also provide a good reference for other non-US-controlled MNCs to handle the voluntary tax issue in their home jurisdiction.


In detail

What is the 'voluntary tax'€™ issue?


The voluntary tax issue is not a new concept. As the US taxes income on a worldwide basis, US taxpayers are allowed to claim FTC for the foreign taxes directly paid or indirectly borne by them in overseas jurisdictions to eliminate double taxation. However, like the FTC regime in many other countries, US companies cannot obtain credits for foreign taxes which they are not legally compelled to pay (i.e. 'voluntary tax'). Otherwise they would be shifting improper foreign tax costs to the US. In this regard, the US Treasury Regulations have always asked taxpayers only to settle a 'compulsory payment'.



'Voluntary tax'€™ issue under the US-Chinacontext

Typically under the US-China context, complicated cross-border tax matters such as TP adjustments, inconsistent tax treatment of a transaction / entity (e.g. different views on the recognition of beneficial owners, inconsistent characterisation of service fees and royalties), offshore indirect equity transfers, taxation on permanent establishments (e.g. divergence in deemed profit rate) may give rise to voluntary tax issues. Taxpayers need to prove that they have 'exhausted remedies' to reduce the China tax liability before claiming FTC in the US.

BT 201604 140 01 Finance

How does a taxpayer prove '€˜exhaustion of remedies'€™?

The IPUs reiterate that if a foreign tax authority's position is unreasonable under local law or tax treaties, US taxpayers should exhaust all 'effective and practical' remedies before paying foreign income taxes (even if the tax is due as a result of a foreign tax audit) so as to avoid voluntary tax payment. By 'effective and practical', it should be weighed in light of the tax amount at issue and its likelihood of success. In China, such remedies usually include pursuing administrative appeals, court challenges and a Mutual Agreement Procedure (MAP) between Competent Authorities (CA).


It is worth noting that the IPUs make it clear that a taxpayer not invoking CA in a treaty country tax dispute would likely not be considered to have exhausted its remedies. In addition, if the taxpayer settles the dispute with the foreign tax authority on its own accord, it may prevent the US CA from initiating a MAP to seek a better result, which may also cause the foreign taxes paid to be considered non-compulsory. Thus, the IPU suggests taxpayers consult US CA as to whether the settlement of disputes was reasonable based on prior experience and thus sufficient to exhaust remedies.


The burden to prove the exhaustion of all 'effective and practical' remedies is on the taxpayer and whether all such remedies have been pursued requires detailed analysis, judgement and experience.



BT 201604 140 03 Finance 003The takeaway

Under the US IRS's stricter scrutiny on 'exhaustion of remedies', US-controlled MNCs - especially large MNCs operating in China - should be more prudent in handling tax controversies and dealing with Chinese tax authorities in order to ensure their China tax payment is compulsory for US FTC purposes. Following the examination process suggested by the IPUs, the US taxpayers and their Chinese subsidiaries are recommended to consider the following actions to prove the tax paid in China is compulsory or seek relevant remedies for any tax controversies:


- Conduct a more detailed assessment of their China tax position and the availability of relevant preferential treatments by reasonably interpreting and applying both the substantive and procedural provisions in China tax laws, and decide whether the tax payments are compulsory payments;
- Choose the right strategy and weigh the effectiveness of available remedial channels - i.e. negotiation, administrative review, administrative appeal, MAP, etc - against their costs and seek opinion from tax professionals where needed. It appears from the IPUs that matters which MAP could apply should go through the MAP for the purpose of exhaustion. Given that the provisions of the MAP article in the China-US tax treaty follows the OECD Model Convention which allows a US taxpayer to present the case to the US CA if it considers that the actions of the Chinese tax authorities result or will result for it in taxation not in accordance with the provisions of the tax treaty, irrespective of the remedies provided by the Chinese laws, it might be better to apply for MAP before a conclusion is made in negotiating with the local-level tax authorities, especially where such negotiations do not seemingly lead to a satisfactory solution; and
- Document all tax analyses, any correspondence and agreement with China tax authorities and the CA letters for MAP to substantiate the exhaustion of remedies.


The IPU's impact is not only US tax-related. As an international norm, most jurisdictions that adopt FTC mechanisms would not allow voluntary foreign tax to be creditable for FTC purposes. This is also the case under China's domestic laws. In a post-BEPS era, more cross-border tax controversies may arise and the IPUs give a warning signal that other jurisdictions may also enhance the scrutiny on FTC claims to ensure that the foreign tax payment is not voluntary. All MNCs - including Chinese companies with operations abroad - should be mindful of this voluntary tax issue to ensure that their FTC claim is not disallowed.


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