Structuring M&As in Uncertain Times

by Gaetano Pizzitola

Reprinted from Tax Notes Int’l, August 19, 2013, p. 709

Volume 71, Number 8 August 19, 2013

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Structuring M&As in Uncertain Timesby Gaetano Pizzitola

G lobalization is compelling more entrepreneurs tolook overseas for expansion and growth, follow-

ing the path of large multinationals and early movers.

Low-tax countries have been used for decades asholding company locations for greenfield investmentsand mergers and acquisitions expansion abroad.

Treaty-protected countries have generally been pre-ferred for M&A deals. Each region has its usual gates:Luxembourg and the Netherlands within the EuropeanUnion, Mauritius for China and India, Singapore forthe wider Asian region, and so forth. Participation ex-emption, foreign investors’ protection, stability of legis-lative environment, and exit strategy have been the keypillars on any foreign investment structuring from a taxstandpoint.

Financing M&A investments has also been based onthe use of low-tax jurisdictions that generate double-dip benefits, either by maximizing return to equity in-vestors or reducing the cost of external borrowing.

Furthermore, intellectual property (IP) companieshave been widely used to consolidate ownership of in-tangibles in low-tax jurisdictions and to shelter incomefrom taxation in high-tax jurisdictions.

Holding, financing, and IP companies all share simi-lar tax attributes: low or nil taxation, legislative stabil-ity, certainty, and protection of foreign investors. Smallcountries have attracted huge amounts of mobile capi-tal but not much human and infrastructure resources.Capital investment management may not require thelevel of staff necessary to conduct manufacturing, serv-ice, or sales activity. Low-tax entities have been struc-tured as passive investment vehicles. The shopping oflocations has damaged the image of tax professionalsand multinational investors. Bad examples are easy tar-gets for complaints, but a majority of investments aresupported by sound business reasoning.

With the beginning of the global financial crisis in2007-2008, the use of passive company structures has

increasingly been front and center on the politicalagenda. The G-20 leaders at the meeting in London onApril 2, 2009, stood against the use of tax havens fornot complying with internationally agreed tax stand-ards.

The G-20 meeting in Moscow on July 17-19, 2013,saw the OECD unveiling its action plan on base ero-sion and profit shifting (BEPS) for the next two tothree years.1

The OECD action plan identified 15 actions pur-porting to:

develop a new set of standards to prevent doublenontaxation. Closer international cooperation willclose gaps that, on paper, allow income to ‘‘dis-appear’’ for tax purposes by using multiple de-ductions for the same expense and ‘‘treaty-shopping.’’2

The underlying goal of the action plan is:

aligning tax with substance — ensuring that tax-able profits cannot be artificially shifted, throughthe transfer of intangibles (e.g. patents or copy-rights), risks or capital, away from countrieswhere the value is created.3

The 15 actions in the plan are the digital economy,hybrid mismatch arrangements, strengthening con-trolled foreign corporation rules, interest deductions,

1Available at http://www.oecd.org/tax/closing-tax-gaps-oecd-launches-action-plan-on-base-erosion-and-profit-shifting.htm.

2OECD, ‘‘Closing tax gaps — OECD Launches Action Planon Base Erosion and Profit Shifting,’’ available at http://www.oecd.org/newsroom/closing-tax-gaps-oecd-launches-action-plan-on-base-erosion-and-profit-shifting.htm.

3Id.

Gaetano Pizzitola is a cross-border tax partner with Crowe Horwath in Rome. E-mail:gaetano.pizzitola@crowehorwath.it

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harmful tax practices, treaty abuse, permanent estab-lishments, intangibles, risks and capital, high-risk trans-actions, BEPS data, mandatory disclosure rules, trans-fer pricing documentation, mutual agreementprocedures, and developing a multilateral treaty.

This is quite a busy agenda — an ambitious plan ofrebalancing the international tax rules to cope with thedevelopment of globalization and the digital economyas the framework of the world financial system. It willcertainly stir a wide debate in the business community.

After the BEPS action plan, any M&A structuringwill have to take into account the increased level ofrisk and uncertainty about foreign investments beingtargeted for tax audits by tax authorities from variouscountries.

We have already seen the Vodafone case in India; theU.S. Senate holding up Apple, Hewlett-Packard, andMicrosoft as examples of bad tax structures; the U.K.’spublic commissions challenging Amazon’s tax plan-ning; Starbucks volunteering a £20 million tax paymentby forgoing some tax reliefs in the U.K.; Google beingaudited in France; and so forth.

The relationship between local politicians and multi-nationals is presented in the media as strained as neverbefore. There is no room in such a hostile environmentto remember the role of multinationals in the industri-alization of countries and regions that would otherwisehave remained undeveloped.

In such a political environment, M&A structuringwill require a more thorough and thoughtful process toidentify the most efficient and safest strategies. Debtpush-down, IP migration, profit maximization in low-tax jurisdictions, withholding tax optimization, and exitstrategies will remain the key pillars of any good taxstructuring. However, careful consideration of the repu-tation of chosen investment countries and of the feasi-bility of an active management structure of financing,IP, and investments will be necessary to prevent an at-tack by the tax authorities of such investment struc-tures within a few years of being set up.

The above is true both for public companies andprivate equity investments. While the former will in-creasingly have to manage pressure from auditors withFIN 48-type accruals for tax risks, the latter may faceprice discount claims at exit by potential buyers be-cause tax due diligences may have identified criticalgray areas of exposure if not a history of tax auditadjustments for lack of substance, treaty shopping,abuse of law, business purpose, transfer pricing, PE,blacklisting, withholding taxes, and all similarly com-plex and sophisticated tax challenges.

In the current environment, business strategies andtheir documentation will be critical factors of successwith any offshore tax structuring. As participation ex-emption methods have been increasingly adopted inmany countries, the use of local holding companiesrather than regional ones may be a good alternative tominimizing risks of treaty-shopping claims. The adop-

tion of regional principal models may still be imple-mented but conversion to those structures will have tobe carefully considered and implemented to minimizerisks.

Recourse to advance ruling clearances and advancepricing agreements will be beneficial to foreign inves-tors to avoid aggressive challenges by tax inspectors.

Attention will be needed to balance the use of spe-cial purpose vehicles for holding investments, equityfunds, and IP in low-tax jurisdictions with the need toensure an adequate level of substance. There will likelybe years of confusion and uncertainty on this point.

The OECD BEPS action plan specifically targets:the involvement of third countries in the bilateralframework established by treaty partners . . . inparticular when done via shell companies thathave little or no substance in terms of officespace, tangible assets and employees.4

It is hoped that the OECD will take a substance-over-form approach on that point. We have seen multi-nationals being unreasonably challenged by tax inspec-tors claiming that their foreign subsidiaries inSwitzerland, for example, are shell companies becausethey do not rent office space directly from landlordsbut instead sublease them from other group companiesusing the same space. Or, even worse, multinationalsmay be challenged because they only have a few em-ployees or none on their payroll and tax inspectorsclaim that secondments or outsourcing of functions donot provide an adequate level of substance for theiroperations.

The BEPS action plan also targets:

tackling the use of intangibles, risks, capital andother high-risk transactions to shift profits.5

Centralized business models will increasingly facequestions from tax authorities claiming that the mainor sole reason for their implementation is tax avoid-ance. The iPhone/iPad can be seen as a paradigmaticexample. They are designed in Cupertino, Calif., andtheir success was driven by the hard work of a genius— one single man. Years of investments were neces-sary to develop the products, and Apple took signifi-cant risks to develop them by investing capital intolow-tax countries. They are manufactured in Asia andsold everywhere in the world. Should Apple stores beallocated most of the profits because customers pur-chase locally? Would the U.S. and the store/customercountries be happy to take the loss if the productswere, or will ever be, unsuccessful under Samsung orothers’ competition? Does anyone remember PalmPilot?Which countries have welcomed and accepted itslosses?

4OECD Publishing, ‘‘Action Plan on Base Erosion and ProfitShifting,’’ p. 13 (2013).

5Id. at 14.

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This is precisely the challenge being presented toAmazon and Google by tax authorities. Their head-quarters are in the U.S., while IP and capital are in-vested in low-tax jurisdictions where profits from IPcontribution to the value chain are taxed at a lowerrate. However, if profits do not arise, the centralizationof tax losses in one low-tax jurisdiction will converselyimply a high effective tax rate.

Meanwhile, in France and other European coun-tries, Amazon may have established logistic centers andcustomers happily purchase products locally at a dis-count. Is there any major difference between Amazon’slogistic centers and the ones established by many busi-nesses to centralizing supply-chain for product deliv-ery?

The adoption of regional principal models may stillbe implemented, but conversion to those structures willhave to be carefully considered and implemented tominimize risks.

Part of the problem is the complexity of a realsubstance-over-form approach, which in our audit ex-perience is often only a recharacterization of form withanother form. The discussion about substance overform may be affected by the risk of misunderstandingson what substance means in a business environment.Tax inspectors often look for quantity and paper evi-dence of it, which may not be the real substance. Inthe modern global and digital economy, substance isnot necessarily a matter of quantity. It is quality of keydecision-making business authority to manage the op-erations. Intangibles, capital, and risk management donot require hundreds or thousands of employees. Con-trol over the functions and risk is the key attribute of asubstance-over-form analysis about the value chain andimplementation of investment strategies. Risks aretaken by decision-makers rather than by those execut-ing strategies. Functions may be executed in differentroles, that is, as a decision-maker or as an advisoryservice supplier or agent executing instructions.

In the current environment, M&A structuringthrough the use of passive vehicles will be more criticalfor the above reasons. Multinationals and private equityinvestors may wish to take into account the need of anactive management of functions as a protective meas-ure to minimize the risk of challenge and advance rul-ing clearances as tools for tax risk management, andseek appropriate professional advice to ensure thatstructures can withstand fiscal audits and challenges.

The qualitative analysis of the level of substanceneeded to get into a safe harbor position will be a nec-essary exercise for tax-effective structuring of any in-vestment.

Given that the current international tax climate isuncertain, as is the economic environment in most re-gions, tax authorities throughout the world are lookingfor extra cash to support public expenditures. Auditorsare striving for profits and, therefore, any strategy bymultinationals to minimize profits locally will be in-creasingly scrutinized.

Case-by-case implementation of the most appropri-ate investment structures based on specialist profes-sional advice together with an active management func-tion are the most critical factors to defend profits fromattack.

Rethinking and reassessing sustainability of existingstructures will also be a top priority in the action planof any multinational.

But what’s next? Maybe the low-tax, small countrieswill start attracting not only capital and intangible as-sets but also human resources and infrastructures. Willhigh-tax countries pushing for the BEPS action planever be able to counteract delocalization and migrationof valuable assets abroad, without developing any posi-tive fiscal policy to attract foreign investors and multi-nationals with benefits and incentives as, indeed, theymay have done in the past? ◆

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