Daniel Pessar

There are many factors a business might consider when deciding where to locate its offices, including proximity to certain pools of labor, suppliers, and customers, regulatory conditions, and the historic roots of the company. But when a company’s operations are spread across multiple jurisdictions—both inside and outside the United States—where is the company actually located for the purpose of receiving specific tax or regulatory treatment? The answer to this important question continues to evolve in both domestic and international contexts, as lawmakers attempt to incentivize economic activity while preventing excessive tax avoidance. This note will present two examples of legal regimes, one domestic and one international, that consider what a company needs to do in order to qualify for a geography-based tax benefit.

I.               Locating a business in a tax-advantaged Opportunity Zone

The Tax Cuts and Jobs Act of 2017 included generous tax benefits in the form of capital gains tax deferral and elimination for certain investments in designated “opportunity zones” throughout the United States. Qualifying investments held for more than ten years can receive, among other benefits, complete exclusion of capital gains. The proposed regulations explain that a geographically-dispersed business would qualify as a Qualified Opportunity Zone Business if: (a) at least half of the hours that employees and independent contractors (and employees of independent contractors) spend working on the business are performed within an opportunity zone; [1] (b) at least half of the amount paid by the business to employees and independent contractors (and employees of independent contractors) is for services performed in an opportunity zone; [2] or (c) both the tangible property of the business that is in an opportunity zone and the management or operations functions of the business that work in an opportunity zone are each necessary to generate at least half of the business’s gross income. [3] Thus a software company that sells to customers around the world could qualify as a Qualified Opportunity Zone Business and enjoy the tax benefits as long as it locates a significant percentage of employees, independent contractors, or management and assets in opportunity zones.

II.              Locating a business in a jurisdiction with advantageous tax treaties while satisfying the Principal Purposes Test (PPT) of the Multilateral Instrument (MLI)

In recent years, the Organization for Economic Cooperation and Development (OECD) has stepped up its efforts to reduce base erosion and profit shifting (BEPS), “tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid.” [4] The OECD’s major initiative to deal with this issue, the (MLI), is an effort to standardize rules that preclude many BEPS activities by taxpayers. [5] This effort to coordinate measures by various countries has been successful and as of June 1, 2019, 88 jurisdictions have signed the MLI. [6] A required element in the MLI is the Principal Purposes Test (PPT) provision, which provides that “a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit…” [7] In short, a company needs to have real, substantial reasons for locating in a jurisdiction, and cannot have its location decisions driven by tax considerations only.

In 2017, the OECD provided preliminary examples of situations in which “it would not be reasonable to deny the benefit” [8] of tax treaties enjoyed by resident investment companies, the kinds of firms that often exploit the benefits of tax treaties when structuring their partnerships and transactions. Factors considered in determining that the PPT is satisfied include whether the company’s location decision was “mainly driven by the availability of directors with knowledge of regional business practices and regulations,” whether the company employs an experienced local management team, whether a majority of its directors are residents of the country and have expertise in investment management, and the legislative landscape for specific types of business in that country (e.g., a real estate investment entity or a securitization company). [9]

III.            Broader lessons for tax-sensitive location planning

As tax authorities become more sophisticated in their attempts to preempt tax planning which reduces their tax receipts, companies need to substantiate their location decisions with better “facts on the ground.” “Substance” considerations are nothing new, but in a changing legislative landscape affected by geopolitics (trade wars, the spectre of Brexit, and legislative attempts to match their tax policies with a increasingly-digital world), companies need to make sure their “substance” is sufficient. Whether that means demonstrating that most of the company’s revenues are earned through the efforts of employees working in the jurisdiction, as under the opportunity zone laws in the United States, or whether that means that experienced directors running the company’s operations live in the jurisdiction as in the OECD MLI guidance, there may be little room for error with significant tax dollars on the line.

[1] I.R.C. Prop. Reg. § 1.1400Z2(d)-1(d)(5)(i)(A)

[2] I.R.C. Prop. Reg. § 1.1400Z2(d)-1(d)(5)(i)(B)

[3] I.R.C. Prop. Reg. § 1.1400Z2(d)-1(d)(5)(i)(C)

[4] OECD, OECD Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, Information Brochure, https://www.oecd.org/tax/treaties/multilateral-instrument-BEPS-tax-treaty-information-brochure.pdf

[5] Id.

[6] Deloitte, OECD Multilateral Instrument status tracker: Current as of 1 June 2019, https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Tax/dttl-global-tax-implementation-of-mli-status-tracker.pdf.

Countries that have signed the MLI include Luxembourg which is “used as a holding company jurisdiction for investments in many European jurisdictions because, in addition to providing access to a range of service providers, it has a good network of double tax treaties and a competitive tax regime.” See Brenda Coleman, Andrew Howard, and Leo Arnaboldi III, Tax issues on private equity transactions, Tax Journal (November 7, 2018).

[7] OECD, Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI), https://www.oecd.org/tax/treaties/multilateral-convention-to-implement-tax-treaty-related-measures-to-prevent-BEPS.pdf

This PPT provision is similar to Article 29 of the OECD Model Tax Convention which bars benefits “in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit…” See OECD Model Tax Convention on Income and on Capital (as it read on 21 November 2017).

[8] OECD, BEPS Action 6 Discussion Draft on non-CIV examples, http://www.oecd.org/tax/treaties/Discussion-draft-non-CIV-examples.pdf

[9] Id.

Although the corresponding final regulations are not yet available, the opportunity zone tax law passed in 2017 has generated significant buzz among investors, business owners, and community groups. The law, codified in Internal Revenue Code Sections 1400Z-1 and 1400Z-2, incentivizes new investment in businesses and real estate in designated low-income communities throughout the United States. The law is expected to unlock significant investment but is also controversial because of the lack of reporting requirements, the open questions surrounding the degree to which low-income people will benefit from the law, and the rich benefits it offers investors. Under the law, investors can receive tax deferral and tax elimination, including the complete elimination of capital gains from qualifying investments held for more than ten years.[i] The law may also provide an added benefit to investors: a way to improve their tax position through the strategic use of debt. Unless regulators restrict the tax benefits available to investors who leverage their opportunity zone equity investments, those investments may produce significant benefits throughout the investment term, not only at disposition.

In the landmark tax case, Crane v. Commissioner (1947),[ii] the Supreme Court held that the amount of a nonrecourse mortgage is included in the basis of a property, a determination significant for calculating a gain on sale or exchange but also for the purpose of determining the amount of depreciation deductions available to a taxpayer. Depreciation deductions allow taxpayers to reduce their income tax liability by deducting from income a portion of an asset’s basis, according to an IRS-allowed depreciation schedule.[iii] But these deductions are not “free”; they are offset by reductions in the property’s basis, increasing the tax liability to the taxpayer upon the disposition of the property. The Crane decision was significant—indeed, opening the door to many forms of tax avoidance—because it allowed taxpayers to obtain major tax benefits by financing investments with debt. By doing so, investors could enjoy depreciation deductions generated by property much more valuable than their own equity investments. Even if a future tax bill were higher because of the reduction in basis, the investors would benefit from years of tax deferral. But the petitioner in the Crane case, Beulah Crane, tried to take this benefit one step further. She used her apartment building’s debt value when calculating depreciation deductions but omitted the debt value when calculating the amount realized when she sold the property.[iv]

While Crane’s attempt to whipsaw the IRS was inconsistent with the Court’s holding—she lost the case—the opportunity zone law may allow investors to accomplish a similar result. Although IRC § 1400Z-2 stipulates that equity investments made in opportunity zone funds shall have a zero basis,[v] the Crane decision suggests that an investor may enjoy a large basis in an opportunity zone investment through the use of debt, since the amount of a mortgage will be included in basis. This is significant because the depreciation deductions would probably not contribute to a higher tax bill in the future, as gains will be excluded as long as the investment is held for more than ten years.[vi] Although the investor’s basis would be reduced each year according to the depreciation deductions taken, the opportunity zone benefit would allow a step up in basis to fair market value at disposition after ten years, [vii] assuming the investor complied with all of the required opportunity zone rules. Assuming investors are able to benefit from leveraged investments in this way, the new law may bring more tax-driven, rather than fundamentals-driven, investment to the designated low-income communities. If this happens, the law’s supposed alignment of interests between investors and communities—through its focus on long-term, fundamentals-driven, equity investments, might be significantly eroded. Final regulations are expected in the coming months. Stay tuned.

[i] See26 U.S.C. § 1400Z-2(c) (2017).

[ii] Crane v. Comm’r of Internal Revenue, 331 U.S. 1 (1947).

[iii] E.g., 26 U.S.C. § 168 (2015).

[iv] Crane, 331 U.S. at 1. Although this was the fact pattern leading up to the case, Crane’s legal arguments to the Court were different; in her brief, she did not defend her attempts to whipsaw the IRS. Brief for Petitioner, Crane v. Comm’r of Internal Revenue, 331 U.S. 1 (1947) (No. 68).

[v] See26 U.S.C. § 1400Z-2(b)(2)(B)(i) (2017).

[vi] See26 U.S.C. § 1400Z-2(c) (2017).

[vii] Id.