The Aftershocks of Tax Reform
January 16, 2019
2018 saw the aftermath of the U.S. tax reform legislation that was hastily enacted at the end of 2017. Taxpayers processed the law’s extreme changes to the U.S. tax system and the many questions and uncertainties in the statutory language, and the government worked on guidance to resolve and clarify these uncertainties. Outside of the United States, governments got creative in dealing with nexus issues relating to the digital economy and modern tax structures. These developments will have significant implications for companies and may create new risks in the coming year.
- U.S. tax reform advances to the regulatory phase. The U.S. Treasury Department and the Internal Revenue Service (“IRS”) have been hard at work issuing guidance and new tax return forms to clarify and implement the U.S. tax reform law enacted at the end of 2017. Taxpayers and tax advisors have been clamoring for the guidance because of the significant financial impact of the new legislation and the number of ambiguities and uncertainties resulting from the statutory text. While hundreds of pages of proposed regulations have come out in 2018 (and many more are expected in 2019), the process has been complicated by the recent emphasis on ensuring compliance with the Administrative Procedures Act and a new set of procedures requiring Office of Management and Budget review of all proposed regulations prior to release. The certainty that most taxpayers want also takes a backseat to procedural rules as the proposed regulations go through a public comment period after which they can be revised and finalized.
- European Union questions fairness of U.S. tax reform. The European Union has asked the Organisation for Economic Co-operation and Development’s forum on harmful tax practices to review the U.S. tax reform legislation. The European Union is also reportedly considering filing a complaint with the World Trade Organization and possibly adding the United States to the E.U. “blacklist” of tax haven jurisdictions. These developments are not unexpected; several E.U. finance ministers sent a letter before the U.S. tax reform legislation was enacted warning that the law would violate tax treaties and World Trade Organization rules. If the E.U. efforts are successful, the United States could be forced to repeal certain aspects of the tax reform legislation or face sanctions from the European Union.
- Expansion of economic nexus and permanent establishment assertions by governments. The European Union, the United Kingdom and Italy have enacted new laws meant to expand the tax net to capture digital companies. Additionally, France and Italy have taken an expansive view of nexus under audit, asserting that local affiliates or service providers constitute “permanent establishments” and therefore subject foreign companies to local tax. Google and Valueclick were audited on this theory in France, where both taxpayers ultimately prevailed in the courts, and Apple, Amazon and Google all settled similar audits in Italy. Several European jurisdictions have also resorted to criminal investigations or “dawn raids” of companies that are perceived as not paying their fair share of taxes, including Microsoft and McDonald’s (in France), Apple and Amazon (in Italy), and Google (in both France and Italy). Companies operating in Europe should be prepared to deal with these strategies.
- The European Commission’s “State aid” litigation continues. The European Commission ordered Luxembourg in June 2018 to collect $140 million from Engie, the latest in a series of European Commission decisions requiring corporate taxpayers to pay enormous sums to the foreign tax authority which had previously issued a favorable ruling to that taxpayer. Other examples include Fiat (ordered to return €20 to €30 million to Luxembourg), Starbucks (ordered to return €20 to €30 million to the Netherlands), Apple (ordered to return more than €13 billion to Ireland) and Amazon (ordered to return nearly €250 million to Luxembourg). The taxpayers are contesting these judgments, and there is likely to be years of litigation before we have a conclusive determination of whether the European Commission’s expansive interpretation of “State aid” is correct. In the meantime, investigations can be expected to continue. Multinationals that have received private rulings from any European tax authority should review those rulings and assess whether they are at risk and what steps they might take to reduce or mitigate their risks.
- Litigation over the validity of tax rules. Taxpayers are continuing to defend against IRS tax deficiency claims with assertions that the underlying Treasury Regulations are invalid. The asserted grounds for invalidity are usually that the Treasury Regulations are inconsistent with the statutory text or that the process by which the Treasury Regulations were promulgated was flawed. The case that is attracting the greatest interest (Altera v. Commissioner) involves both of these grounds, and has far-reaching implications, in part because the substantive issue in the case is relevant to many U.S. corporations. The substantive issue is whether affiliated entities that jointly develop intangible property are required to share the cost of issuing stock options to the employees involved in that development. The resolution of the substantive issue will have a significant impact, as will the resolution of the issues involving Treasury’s regulatory authority.
Challenges to the validity of tax rules continue to be complicated by the Declaratory Judgment Act and the Anti-Injunction Act, which prohibit pre-enforcement challenges to tax rules – meaning that taxpayers may challenge tax rules only after taking positions contrary to the rules and then having the IRS assert that additional taxes are due (or refusing to issue a refund of taxes paid). In 2018 taxpayers continued to try to convince courts that certain pre-enforcement challenges are permissible, with very limited success. Some see this process as inefficient and unfair, but the policy behind these laws is based upon the importance of tax collections to the operation of the government and the risk of pre-enforcement challenges imperiling the collection of properly due taxes. We anticipate seeing additional litigation over the validity of Treasury Regulations for many years to come, including, eventually litigation over the Treasury Regulations being promulgated now to implement the 2017 tax reform legislation.
- Significant use of insurance in M&A deals. There has been an increase in the use of insurance in the M&A market, rather than traditional indemnification from sellers, to address buyer exposures. Insurance covering breaches of representations and warranties (which include tax representations and warranties) is widespread, with more insurers entering the market and more competitive pricing. Additionally, insurers have recently been willing to expand these policies to cover pre-closing taxes generally. Claims under these policies tend to be subject to limitations that traditional seller indemnification would not, including express carve-outs for known exposures and also for certain substantive issues like transfer pricing risks. Insurance coverage in a transaction changes the deal dynamics and could complicate the diligence process. Additionally, in certain situations (and typically for a higher premium) a buyer or seller can separately purchase insurance against specific tax issues of the target that have been identified in diligence, or the tax treatment of the transaction itself. The portfolio of products offered by insurance companies continues to expand. Companies engaging in M&A activity should consider using insurance (and expect that counterparties may use it) and take into account the cost and the impact on pricing and process.