October 31, 2006

TO: Distribution

FROM: Philip Garlett, Dan Burt

RE: Tax Arbitrage: A Mixed Message¹

Although developed country tax authorities are focusing on tax arbitrage -- transactions that exploit the different treatment of the same cross-border transaction in two or more countries -- the US has not defined acceptable arbitrage versus abusive tax avoidance. We believe the IRS will increasingly apply general anti-abuse concepts, e.g. the § 482 clear reflection of income concept in purely domestic transactions, to define what is or is not abusive tax arbitrage. In addition, taxpayers need to be aware of the impact of recent case law interpretations of common law anti-abuse concepts, such as those in Coltec Industries and Dow Chemical Co.

Coordinated Response To Arbitrage: The US and its major trading partners are working more closely than ever to address cross-border tax arbitrage. For example -- the US, the UK, Canada and Australia formed the Joint International Tax Shelter Information Centre; the OECD is developing a directory of aggressive tax planning; eight OECD countries plus China and India have formed the Leads Castle Group to address cross-border tax issues; and the UK has enacted anti-arbitrage rules, and other countries, including the US, are debating the usefulness of such rules.

Not All Arbitrage Is Bad: While US tax administrators are ramping up efforts to address tax arbitrage, the policy makers seem to accept at least some types of arbitrage. Recent statements by IRS and Treasury Department officials seem to recognize that arbitrage is an inevitable, and not necessarily evil, outgrowth of the interaction of a global economy with national tax systems.

Suspect Transactions: The following types of transactions have the US authorities’ attention:

• Financing transactions involving hybrid entities or hybrid instruments that actually generate foreign tax credits;
• Hybrid entity or hybrid instrument transactions that generate a deduction in more than one country for the same expense;
• Transactions that result in double non-taxation or the tax-free repatriation of income;
• Tax base splitting transactions, in which related income and expenses are separated;
• Hybrid entity or hybrid instrument transactions, or a combination of transactions that change the source or character of income;
  and
• Transactions that inflate the basis of assets or result in non-economic losses.

Recommendations: Government focus on these and similar transactions will be increasing. Given the size of cross-border transactions and the ramifications of unsuccessful tax positions on a company's financial statements, businesses need to carefully analyze transactions that may raise audit concerns and should pay particular attention to 1) general anti-abuse arguments that are often overlooked, such as the application of the clear reflection of income principles under § 482 to purely domestic transactions, and 2) developments in common law doctrines, such as the recent decisions on lack of economic substance in Coltec Industries and Dow Chemical.

¹ Philip Garlett joined Burt, Staples & Maner as a partner in October, 2006. Prior to joining the firm, he was the international tax coordinator for the Office of Associate Chief Counsel (International), IRS, and was involved in analyzing arbitrage and shelter transactions, including those presented to JITSIC. Prior to that position, he was the head of the Harmful Tax Practices Unit at the OECD.