How Easy is Income Shifting?

Oxfam got the signatures of 300 economists on a letter than noted in part:

To counter this, the economists are calling for governments to agree new global rules requiring companies to publicly report taxable activities in every country they operate, and to ensure all territories publicly disclose information about the real owners of companies and trusts. Jeff Sachs said: “Tax havens do not just happen. The British Virgin Islands did not become a tax and secrecy haven through its own efforts. These havens are the deliberate choice of major governments, especially the United Kingdom and the United States, in partnership with major financial, accounting, and legal institutions that move the money. The abuses are not only shocking, but staring us directly in the face. We didn’t need the Panama Papers to know that global tax corruption through the havens is rampant, but we can say that this abusive global system needs to be brought to a rapid end. That is what is meant by good governance under the global commitment to sustainable development.”

Even if we know how multinationals are shifting income to tax havens, can national governments do much about it under current law? President Obama is trying to end earnings stripping by using section 385 to recharacterize intercompany debt as equity. As this law firm explains what this is about, the discussion noted how weak this provision has turned out to be:

Two recent cases highlight the IRS’s approach (although, so far not so successfully) to attack these foreign intercompany lending transactions. In NA General Partnership & Subsidiaries v. Commissioner, T.C. Memo 2012-172, the Service attacked loans made to a U.S. entity from a foreign related entity (Scottish Power, via NA General Partnership & Subsidiaries). The IRS solely relied upon a debt versus equity attack to seek to have the U.S. interest expense deductions recharacterized as dividends and non-deductible in the U.S. The court applied traditional tests to determine if a given security is debt or equity and found for the taxpayer. The material terms of the security were more debt-like and the conduct of the parties (accounting entries, public and securities filings, etc., all treated the security as debt) was consistent with the intention to create debt between the parties. In PepsiCo Puerto Rico, Inc. v. Commissioner T.C. Memo. 2012-269, the IRS was again arguing in court whether a given financial transaction created debt or equity in the U.S. The taxpayer intended to create a security that would be treated as equity in the U.S. and debt by the related holder in the Netherlands. The IRS sought to treat the U.S. equity side of the transaction as a loan. The court, recognizing the intent of the parties and the economic realities of the transaction as the primary factors in deciding whether a given transaction should be characterized as debt or equity, reviewed the traditional debt versus equity factors (those mentioned above). Again, the IRS lost the case, as the intent of the parties and economic realities suggested the U.S. side of the transaction was equity and not debt.

The first case involved the acquisition of PacifiCorp by a UK entity, which was a version of hybrid financing. While the interest expense was deductible in the US, the UK chose not to tax the interest income. Tax free income! Now if you never heard of this entity, it is now owned by Berkshire Hathaway Energy (BHE):

A leading western U.S. energy services provider and the largest grid owner/operator in the West, PacifiCorp serves 1.8 million customers in six western states. The company is comprised on three business units: Pacific Power (serving Oregon, Washington, California), Rocky Mountain Power (serving Utah, Idaho, Wyoming) and PacifiCorp Transmission.

BHE owns several other US energy providers and has approximately $80 billion in tangible assets generating about $6 billion in profits. Let’s imagine for a moment that Warren Buffett gets into one of his corporate inversion moods and decides to relocate corporate headquarters to Edinburgh, Scotland. Let’s also imagine that the Scottish parent had extended a $60 billion 20-year loan on October 1, 2015 with an interest rate equal to 5%. What authority would the IRS have to challenge this aggressive planning? I’m sure Warren’s lawyers could successfully structure its agreements so that section 385 is no problem. I guess some hot shot IRS lawyer might pull out section 163(j):

the term “excess interest expense” means the excess (if any) of the corporation’s net interest expense, over the sum of 50 percent of the adjusted taxable income of the corporation plus any excess limitation carryforward under clause (ii).

Don’t you love the horrific writing of lawyers? What does this mean in our case? Since interest expense is less than 50% of operating profits before depreciation, section 163(j) does nothing for the IRS. So what’s left is to question whether the 5% interest rate is above the arm’s length standard. Alas, on October 1, 2015, the yield on 20-year corporate bonds with credit rating = BBB was over 5.3%. Unless the IRS can argue that the credit rating was something akin to AA, it will get nowhere under current law. I’m not saying Warren Buffett even considered this move but if he had – how would the IRS stop it?