The World Tax Advisor (June Edition)

This article discusses international tax developments and has been prepared by professionals in the member firms of Deloitte Touche Tohmatsu.

The State Administration of Foreign Exchange (SAFE) recently issued a Circular (Circular 11) that could have a severe impact on PRC individuals who make investments in offshore companies or acquire Chinese companies indirectly through an offshore company.

Before Circular 11, PRC individuals frequently used one of two structures to convert Chinese assets or companies into offshore assets. Under one structure, a PRC individual founder who wanted his Chinese companies or assets to be listed on an overseas stock exchange (e.g. the Hong Kong Stock Exchange) would adopt an "inversion" acquisition structure. The PRC founder would invest in an offshore company that would acquire the Chinese assets or companies from the individual. When the acquisition was completed, the offshore company would be listed on an overseas stock exchange. The second practice was to use an offshore company in a merger and acquisition transaction between a foreign investor and a PRC founder. The foreign investor would invest in a Chinese company through an offshore company and the original PRC owner of the Chinese company would acquire and hold an equity interest in the offshore company. This effectively would allow the PRC founder of the Chinese company to retain part of his interest in the Chinese company through an interest in an offshore company.

First, overseas investments by PRC individuals are now subject to approval procedures similar to those that apply to Chinese companies. Outbound investments by Chinese companies must be approved by the Ministry of Commerce (MOFCOM) according to the 1989 "Measures on Foreign Exchange Administration Related to Overseas Investments" (1989 Measures). Such investments by Chinese companies also must be approved by the State Development and Reform Commission (SDRC) and the SAFE.

In October 2004, the SDRC introduced provisional measures that require all overseas investments by PRC individuals to be approved by the SDRC, a requirement that previously applied only to Chinese enterprises. Circular 11, as a follow-up to the provisional measures, provides that all "PRC residents" investing overseas for the purpose of establishing or controlling an offshore company must obtain the approval of the SAFE and the MOFCOM.

The second approach outlined in Circular 11 restricts foreign exchange registration of certain foreign invested enterprises (FIEs). Circular 11 also requires that all PRC residents who intend to acquire any overseas equity or other property interests in exchange for domestic equity or assets must obtain certain additional SAFE approvals in forming the FIE.

In accordance with the 2003 "Interim Provisions on Mergers and Acquisitions of Domestic Enterprises by Foreign Investors" (M&A Provisions), an FIE’s acquisition of an interest of 25% or more in a Chinese company or any acquisition of Chinese assets must be registered with the SAFE. In addition, as is the case in the M&A Provisions, if (i) the foreign investing company in the acquisition was formed or controlled by PRC residents, and (ii) the foreign investing company has the same management as the Chinese target company, Circular 11 requires that the FIE obtain the approval of the SAFE in Beijing.

Although Circular 11 does not have a retroactive effect, the local SAFE is required to identify any existing FIEs that fall in the above category and to strictly monitor the foreign exchange-related activities of such FIEs.

There are many unresolved practical issues relating to Circular 11, including:

• The term "PRC resident" is not defined. Presumably, the regulation would not apply to PRC citizens who are entirely resident abroad. It is also unclear whether the regulation applies to foreign citizens who are resident in the PRC.
• It is unclear whether the regulation applies to investments made by a PRC individual using offshore assets denominated in foreign currency. Presumably, the SAFE regulations generally do not purport to cover situations where the PRC investor uses such offshore assets to make an offshore investment.
• The SAFE approval refers to the 1989 Measures, which require approval of the outbound investment by MOFCOM. However, currently there is no MOFCOM procedure for approving outbound investments by individuals. We understand that MOFCOM may issue regulations in the near future, but until such guidance is issued, no SAFE approval and registration would be feasible.
• The approval authority for the creation of an FIE currently is shared between the SDRC, which deals with project approval, and the MOFCOM, which deals with contract approval. The additional foreign exchange registration approval by the SAFE could pose a problem for FIEs. If the SAFE in Beijing denies a foreign exchange registration by virtue of Circular 11, the FIE could not operate a foreign currency account at all, including its ability to receive capital.
• Finally, it is unclear whether the SAFE would require a certificate issued by the State Administration of Taxation (SAT) to be provided by the PRC individual founder to demonstrate that individual income tax has been paid in respect of the sale. It is possible that the SAT may issue regulations in this regard in the future.

Circular 11 is a step towards preventing the unmonitored outflow of domestic capital and extending the control on outbound investments to PRC residents. It remains to be seen how Circular 11 will be implemented because it is drafted broadly and loosely. In the meantime, the Circular has introduced a severe restriction on IPOs of domestic companies overseas via an offshore entity.

The Australian government announced on 10 May 2005 that Australia's capital gains tax (CGT) no longer will apply to disposals by nonresidents of many Australian assets, including shares in Australian companies. CGT will continue to apply to disposals of Australian branch assets, and direct or indirect disposals of Australian real property.

The changes were announced as part of the Federal Budget and will take effect after passage of relevant legislation (expected to occur either in the second half of 2005 or in 2006).

Broadly, after the changes take effect, CGT no longer will apply to disposals by nonresidents of shares in Australian companies that are not "land rich" and interests in Australian trusts that are not land rich. CGT will continue to apply to disposals of Australian real property, shares/interests in Australian companies/trusts that are land rich and assets used in the carrying on of a business via an Australian branch.

A company or trust generally will be considered land rich if more than 50% of its value is attributable to Australian real property. "Real property" will extend to interests such as leases and natural resource rights, consistent with Australia's existing tax treaty practice.

To protect the integrity of the above rules, Australian CGT will be extended to disposals by nonresidents of interests in interposed foreign entities that are land rich (as defined above). This rule will apply only if the nonresident owns 10% or more of the interposed foreign entity.

The removal of CGT on many Australian assets owned by nonresidents is a significant change to Australia's current rules, under which nonresidents are taxed on the disposal of a range of assets that have "the necessary connection to Australia," including shares in Australian companies (other than listed companies that the nonresident holds a less than 10% interest in). The change more closely aligns Australia's law with that of other OECD countries, and combined with other recent changes, should make Australia more attractive as a holding jurisdiction, e.g. into the Asia-Pacific region. Foreign dividends can flow through Australia tax free and Australia recently introduced a CGT participation exemption for disposals of foreign subsidiaries with active foreign businesses.

The extension of CGT to disposals of land rich foreign entities is an understandable integrity measure, but details of how this will apply in practice remain to be worked out. This measure may affect investors in the property, resources and (potentially) infrastructure sectors.

Importantly, these proposed changes will not have immediate effect. It is unfortunate that the government did not set a specific effective date for the changes. Making the effective date dependent on the date of Royal Assent for the relevant legislation creates uncertainty for nonresidents contemplating disposals of Australian assets in the next 12 to 18 months.

The 2005 Australian Federal Budget includes an intention to reintroduce previously rejected legislation to provide a four-year income tax exemption for temporary residents on most foreign income and gains.

The proposed measures, which will apply to individuals on temporary resident visas in Australia, will provide a four-year income tax exemption for such temporary residents for most foreign-source income and gains on the disposal of foreign assets. Additionally, interest withholding tax obligations with respect to interest paid on foreign loans will be abolished and the onerous reporting and tax rules of the foreign investment fund regime will not apply, regardless of the period of residence.

The new law is not expected to take effect until 1 July 2006, after the government gains control of the Senate, leaving temporary residents exposed to Australian tax on worldwide income and gains in their June 2005 and 2006 tax returns.

The Austrian Administrative Court has requested a preliminary ruling from the European Court of Justice (ECJ) as to whether Austria’s tax rules relating to the taxation of foreign-source dividends are in accord with the free movement of capital principle as it applies to EU Member States and third countries.

The free movement of capital generally cannot be restricted by treating income from foreign investments less favorably than income from domestic investments if, as a result of such treatment, investments in companies established in other Member States are less attractive to an investor than investments established in the investor’s Member State. This request for a preliminary ruling adds to the number of cases pending before the ECJ on the scope of the free movement of capital principle in the context of third countries.

The case at issue involves an Austrian resident individual that owns 2/3 of a Swiss company. The Swiss company distributed dividends to the Austrian individual from 1992-1996, which were taxed at the ordinary progressive income tax rate (up to 50%). However, during the years at issue, dividends distributed by Austrian companies were taxed at a more favorable rate (25%). The taxpayer claims that the fundamental principle of the free movement of capital that applies between EU Member States and third countries prohibits Austria – from the date (1 January 1995) of its accession to the EU – from taxing dividends distributed by a Swiss company at a rate higher than comparable domestic dividends are taxed. It should be noted that the Austrian Income Tax Act was amended as from 1 April 2003 so that domestic and foreign dividends are now taxed at the same rates. The case at issue concerns assessments for tax periods before 1 April 2003.

The Administrative Court makes reference to the 2004 ECJ decision in the Lenz case, in which the ECJ held that the free movement of capital principle precludes Member States from taxing inbound dividends received from other EU Member States at a rate higher than dividends received from domestic entities. The Administrative Court concluded that this differential treatment also could impair the free movement of capital with respect to a third country. In this connection, article 56 EC prohibits restrictions on the movement of capital between Member States and between Member States and third countries. Article 57 EC, however, contains a provision known as the "standstill clause" that enables Member States to maintain domestic discriminatory restrictions provided the measures were in existence on 31 December 1993 and provided they relate to "direct investment" (or other specifically enumerated activities) in third countries. The Administrative Court considers that these two articles raise questions the answers for which are not obvious. The Administrative Court, therefore, requested a preliminary ruling from the ECJ on whether the free movement of capital principle is violated if dividends distributed by a Swiss company to an Austrian resident are taxed less favorably than dividends distributed by an Austrian company, given that this rule existed at the end of 1993 and after Austria’s accession to the EU on 1 January 1995.

The Administrative Court questioned whether the free movement of capital in the context of a third country is applicable where that country does not tax companies on the same basis as companies are taxed in an EU Member State. The court queried whether a foreign tax burden can become sufficiently relevant to require equal taxation for domestic and inter-community dividend distributions. It further questioned the precise meaning of the term "direct investment." When it rules on the case, the ECJ may clarify whether a distinction is required or justified despite the general principle of nondiscrimination binding only the Member States but not third countries. The Administrative Court did not request guidance on the relationship between article 58(3) EC, which prohibits arbitrary discrimination for tax purposes, and the standstill clause of article 57(1) EC.

Now that the case has been referred to the ECJ, that court will have further opportunity to rule on the conditions under which the free movement of capital principle applies between EU Member States and third countries. The ECJ is expected to hear the case in 2006.

Details of Law 338-Z, amending the Belarus Tax Code and other laws, recently became available. The most significant amendments, which apply from 1 January 2005, are as follows:

• The Law clarifies that dividends received by resident legal entities from abroad are taxable at a rate of 15%;
• The taxable profits of a business entity with foreign investment may no longer be reduced by contributions to the reserve fund of the entity (previously, such contributions were deductible if the entity’s articles of association specifically provided that the reserve fund was created from balance sheet profits);
• The definition of "independent agent" for purposes of the taxation of permanent establishments of nonresidents is amended so that it is no longer necessary that the independent agent act on behalf of several nonresident legal entities, i.e. an agent acting on behalf of one nonresident may qualify as an independent agent;
• The value added tax (VAT) rate for the supply of high-tech goods is increased from 10% to 18%; and
• Nonresident legal entities no longer are subject to VAT on the sale of goods or the provision of services that are deemed to be provided in Belarus if supplied to Belarus legal entities and individual entrepreneurs. The VAT in such transactions is to be calculated and paid by the Belarus business entities purchasing the goods and services from its own funds. Previously, the recipients of such goods and services acted as withholding agents on behalf of the nonresident legal entities and withheld tax at a rate of 15.25% of the amount due to the foreign entities in respect of each transaction. This amendment effectively reinstates provisions that were in effect before 2004.

On 29 April 2005, the Belgian government proposed changes to the draft bill that will introduce a notional interest deduction for companies.

Under the notional interest deduction, a company will be able to take a deduction from its taxable profits for the interest it would have paid in the case of debt financing. The notional interest deduction will be calculated by multiplying the total equity by a percentage that is based on the interest rate for 10-year government bonds (currently 3.5%).

The previous version of the draft bill would have required the applicable percentage to be revised every three years. The government now proposes revising the percentage on an annual basis. The percentage will be equal to the average of the interest rate for 10-year government bonds for the taxable period. The government also decided to set a maximum deviation of 1% from one year to the next and to introduce an absolute maximum of 6.5%. However, both caps can be overruled by Royal Decree.

The notional interest deduction will apply as from tax year 2007 (accounting years ending on 31 December 2006 or later). To prevent companies from changing the closing date of their financial accounts to maximize the benefit from the notional interest deduction, the draft bill provides that any change in the closing date of the financial accounts after 29 April 2005 will not be effective with respect to the notional interest deduction.

The government expects to submit the notional interest deduction bill to the Belgian Parliament in the near future, with a target date for adoption by the end of June 2005. The Belgian State Council has not raised any major objections to the bill.

The State Administration of Taxation (SAT) issued a Notice on 19 April 2005 clarifying the rules relating to the deemed basis of assessment. Certain taxpayers apparently have been issued tax assessments on a deemed basis rather than on the basis of the taxpayer’s actual financial statements, a practice that violates article 35 of the PRC Tax Administration and Collection Law (Law).

The Notice specifies that the tax authorities at the various levels must strictly comply with article 35 and other rules for determining when to use the deemed basis for assessing enterprise income tax, and the authorities are not permitted to expand the scope of the deeming rules. A taxpayer may not be taxed on deemed basis merely because the taxpayer makes a certain amount of sales or because the taxpayer is in a certain industry. Taxpayers that satisfy the requirements to be taxed according to their financial statements must be taxed according to that method, not on the deemed method of assessment. Taxpayers that are assessed to tax on a deemed basis should be taxed according to their actual financial statements once they satisfy the requirements for such taxation. For new enterprises, the tax authorities in charge must conduct a thorough investigation and issue an assessment based on the taxpayer’s actual financial statements if the taxpayer meets the requirements; assessment on a deemed basis is permissible only if the taxpayer fails to meet the requirements.

According to the Notice, the tax authorities at the various levels are required to determine the tax basis for enterprise income tax purposes according to the Law and related regulations. Further, the authorities are to carry out internal examinations and correct any violations in a timely manner.

The Danish Parliament enacted bill No. L 121 on 31 May 2005, which includes a number of significant changes to the Danish corporate tax rules, including the introduction of mandatory national tax consolidation and the reduction of the corporate tax rate from 30% to 28%. The new rules generally take effect for income years beginning 15 December 2004 or thereafter. The most important aspects of the changes are outlined below.

All Danish entities under common control are now subject to mandatory national tax consolidation. Accordingly, national tax consolidation will no longer be subject to an election for qualifying taxpayers. Entities are considered to be under common control if, inter alia, a company controls more than 50% of the voting power of both entities. Both Danish companies and foreign companies with a permanent establishment (PE) or real estate in Denmark qualify for mandatory national tax consolidation, and mandatory consolidation is applicable even if the various entities belong to different business divisions within a multinational.

The ultimate Danish parent company is the administration company of the consolidated group. If there is no ultimate Danish parent company, the group will be required to appoint an administration company from one of the Danish entities. The administration company must pay the total Danish tax for the consolidated group. Each member of the consolidated group is only liable for the taxes relating to the part of the consolidated income that is attributable to that group member. Each member must make a payment to the administration company for the taxes of the income attributable to that individual member. If a loss of one group member is used by another member, the group company utilizing the loss must make a payment to the administration company equal to the tax saving. The administration company, on the other hand, must make a refund of the same amount to the loss-making company.

All entities of a consolidated group are required to use the same income year for tax purposes as the administration company.

The ultimate Danish or foreign parent company of a group may elect for international tax consolidation. Such an election, however, will require that all global companies under common control (including a foreign parent company and foreign sister companies) be covered by the Danish international tax consolidation rules. A foreign tax credit is available for taxes paid by foreign entities covered by the international tax consolidation rules.

An election for international tax consolidation will be binding for 10 years. The ultimate parent company of the group may elect to terminate consolidation but such an election will trigger full recapture of any foreign losses set off against Danish taxable profits.

The new rules on international tax consolidation terminate the cross-border tax consolidation established by many Danish multinationals because including all affiliated entities under tax consolidation will often be disadvantageous and will increase compliance costs dramatically since the taxable income of the foreign entities must be computed according to Danish tax rules. For this reason, many multinationals are expected to terminate tax consolidation with effect from 2005.

If a foreign entity has incurred losses that have not yet been recaptured, termination of tax consolidation will normally require immediate full recapture. However, a grandfathering rule allows for a termination of tax consolidation with foreign loss-making entities without an immediate recapture of losses. Instead, recapture will be postponed until the foreign entity becomes profitable, the shares or the assets are transferred to an affiliated company or the foreign entity is sold to a third party or liquidated.

The Danish tradition of worldwide taxation is replaced by territorial taxation for companies. Accordingly, a Danish company will be fully exempt on profits and losses of a foreign permanent establishment (PE) and foreign real estate. A loss incurred by a foreign PE may be deducted by a Danish company only if an election for international tax consolidation is made. Danish companies will remain subject to worldwide taxation on foreign source income other than profits and losses of PEs and foreign real estate.

The European Court of Justice (ECJ) issued its decision in the RAL case on 12 May 2005, concluding that a VAT avoidance scheme that involved the owner of amusement machine arcades situated in the U.K. relocating the company (but not the slot machines) to Guernsey (outside the EU) does not work.

The RAL group operated numerous amusement arcades in the U.K. and was incurring an annual VAT liability of over GBP 4 million in respect of its income from gaming machines. To mitigate this liability, the group restructured its affairs so that the gaming supplies were provided from offshore by RAL (Channel Islands) Ltd (RAL). RAL leased the gaming machines and contracted with another group company to staff the buildings, and provide such additional services as customer care, promotional services, cleaning and security. RAL also contracted with a wholly independent company for maintenance of the machines and to empty the machines and bank the cash. RAL argued that, under the EU VAT rules, because the supply of gaming machine services was deemed to be at the place where RAL had established its business -- in this case in the Channel Islands -- the supply was outside the EU and, therefore, it was not required to pay VAT on the services supplied to its clients in the U.K. RAL further argued that the principal objective of the recipient of the services was financial gain, rather than entertainment.

The place of supply rules are set out in article 9 of the EC Sixth VAT Directive. The general rule, enunciated in article 9(1), is that the place of supply is the place where the supplier has his business or fixed establishment. However, in the case of a supply of certain services (including entertainment activities), the place of supply is the place where the services are physically carried out.

The ECJ ruled that gaming machines installed in amusement arcades provide an "entertainment" service, which, under article 9(2)(c) of the Sixth VAT Directive, is taxed in the country (in this case the U.K.) where the services are physically carried out. The effect of this is that RAL is liable to U.K. VAT on the income from the gaming machines and the VAT avoidance scheme put into place by the group failed.

The European Court of Justice (ECJ) has decided in favor of the Netherlands government in a case in which the Advocate General (AG) had suggested that tax legislation should normally be prospective only (Goed Wonen). The ECJ did not follow the AG's opinion that the issuance of a press release by the government announcing changes to be back-dated to the date of the press release does not protect legitimate expectations. The ECJ said the principles of the protection of legitimate expectations and legal certainty do not preclude a Member State, in some exceptional circumstances, from giving retroactive effect to a law to combat contrived arrangements designed to avoid VAT. This could be permissible where those carrying out such arrangements were warned of the impending adoption of the change, and of the retroactive effect envisaged, in such a way that they could understand the consequences of the planned change for the transactions they carry out.

On 10 May 2005, the ECJ heard a case concerning the merger between a German public limited liability company as absorbing entity and a Luxembourg public limited liability company that was dissolved without liquidation as a result of the merger (Sevic Systems AG). The German entity’s request to register the merger in the German trade register was denied on the grounds that the German (corporate) merger law allows mergers only if both parties have their registered office in Germany. The merging entity in this case was a Luxembourg entity.

On appeal, the competent German court referred the case to the ECJ in 2003 to issue a preliminary ruling as to whether the refusal to allow the registration that is necessary for the merger to take effect constitutes an infringement of the freedom of establishment principle in articles 43 and 48 EC.

This case has arisen as a result of the inadequate harmonization of the corporate merger rules in the EU. The Third Company Law Directive only governs mergers between public limited liability companies of the same EU member state. The European Company (SE) statute, which entered into force on 8 October 2004, provides for mergers between public limited liability companies formed under the laws of different EU Member States only if the merger results in the formation of an SE. The European Cooperative Society (SCE) statute, which will apply from 18 August 2006, allows cross-border mergers between cooperatives formed under the laws of different EU Member States only for the purpose of forming an SCE.

EU-wide harmonization of the corporate law rules governing ordinary cross-border mergers of limited liability companies is still pending. Based on a proposal of the European Commission, the Council reached a political agreement on 25 November 2004 on a Directive on cross-border mergers of companies with share capital. The European Parliament adopted an amended text of the Directive on 10 May 2005, which still must be formally approved by the Council under the co-decision procedure. It is expected that the Directive will be finally adopted in 2005 and implemented by the EU Member States no later than 24 months after its entry into force.

Since 1992, the Merger Directive has provided for deferral of the taxation of capital gains on certain categories of cross-border mergers. Due to the lack of company law harmonization, tax-neutral cross-border mergers thus far have been rare. This could change if the ECJ concludes later this year that articles 43 and 48 EC require the admission of cross-border mergers even without prior harmonization of the respective company law rules at a European level.

The Finnish Supreme Administrative Court (KHO) referred a case to the European Court of Justice (ECJ) on 23 May 2005 requesting a preliminary ruling on whether the Finnish group contribution regime is compatible with the freedom of establishment principle in the EC Treaty. Specifically, the KHO asked the ECJ to determine whether restricting the tax deductibility of group contributions to situations where recipients are domestic companies violates the EC Treaty.

Under Finnish domestic law, resident group companies may qualify for tax consolidation by way of the group contribution regime, with contributions tax deductible for the contributing company and taxable income for the recipient. Under residency requirements, both the contributing and the recipient company must be Finnish (or Finnish permanent establishments of EU companies or companies resident in a country that has concluded a tax treaty with Finland); and any passive group companies, through which the ownership link is indirectly met, also must be Finnish.

Testing the residency requirement in advance ruling proceedings, the Finnish-based Oy E asked whether the company can make a tax-deductible group contribution to the U.K.-based "E Ltd," having regard in particular to the freedom of establishment principle in article 43 of the EC Treaty. The Central Tax Board ruled that the cross-border group contribution was not tax deductible because the symmetric treatment of the contribution within Finland (tax deductible vs. taxable income) was lacking. On appeal, the taxpayer argued that, under existing ECJ case law, the symmetric treatment of the group contribution must be viewed from the perspective of the entire EU, not just a single Member State. Oy E also stressed that the contribution would be considered taxable income in the hands of E Ltd in the U.K.

At the outset, it would appear that the Finnish system constitutes a discriminatory restriction on the taxpayer's right to exercise its treaty freedoms within the internal market. At first glance, the EC Treaty questions in the case appear identical to those raised and argued by Advocate General (AG) Poiares Maduro in the pending Marks & Spencer (M&S) case. However, even if the ECJ were to follow Poiares Maduro's opinion in M&S, there are certain critical differences between the U.K. group relief system and the Finnish group contribution system.

AG Poiares Maduro concluded in M&S that prohibiting the setoff of losses of foreign subsidiaries against the profits of the U.K. company violates the freedom of establishment principle in the EC Treaty. However, making reference to the potential for the double dipping of losses, AG Poiares Maduro extended the "cohesion" argument that the ECJ thus far has applied only where advantages and disadvantages are linked in the context of the same tax and the same taxpayer by taking into account at least two different corporate taxpayers. AG Poiares Maduro suggested that the ECJ carve out most of the possibilities for cross-border group relief by stating that this route should be applicable only if the losses of the foreign subsidiaries cannot be accorded equivalent treatment in the countries in which they are resident. This approach has been criticized extensively as not complying with the principle of proportionality, which the ECJ historically has recognized as an integral part of EC law. It has been suggested that a preliminary ruling adhering to the principle of proportionality would grant an immediate deduction with a potential recapture to the extent the losses are, in fact, used abroad.

In Finnish domestic cases, a group contribution is tax deductible only if the equivalent contribution is accounted for as income in the profit and loss account and as taxable income by the recipient. There is no reason to believe that this requirement would not have to be met in cross-border situations as well. In fact, AG Geelhoed's opinion in the pending Schempp case concerning the deductibility of cross-border alimony payments would seem to confirm this conclusion. If the cross-border group contribution is treated as taxable income in the hands of the foreign recipient (here U.K. E Ltd), the Finnish system would not give rise to the possibility of double dipping. This would initially seem to dispose of the need for AG Poiares Maduro's carve-out.

Should the group contribution be used as a consolidation tool (rather than as a mechanism to repatriate/shift value between a profitable Finnish and profitable foreign company) and the received contributions not be recognized as taxable income in the hands of the recipient, a valid question might be whether an approach that allows for an immediate deduction in Finland with a potential recapture in later years (to the extent the foreign losses would be utilized) would be a more suitable solution, rather than a complete denial of deductibility.

The compatibility of the Finnish group contribution regime with EC law has been under intense discussion for a number of years. Because Sweden and Norway have similar systems, the case, expected to be heard by the ECJ in 2006, clearly will have implications beyond the Finnish border. The big question is, however, the imminent reaction of the Finnish fisc, i.e. will Finland have any domestic or cross-border tax consolidation regime in the near future?

In a circular issued 18 May 2005, the German Federal Ministry of Finance stated it will not apply a decision of the German Federal Fiscal Court that would prevent application of the ""tainted income" theory" to certain upper tier partnerships. The circular is anticipated to negatively impact private equity funds in particular.

Under the German Income Tax Act, all income received by a partnership that carries on a business activity (the German concept of being engaged in a trade or business) in addition to a non-business activity is deemed to be business income. That is, the business activity taints the whole partnership if the activity exceeds at least 1.25% of the overall activities of the partnership. This provision is applicable to both domestic and foreign partnerships.

As a result of this income reclassification at the partnership level, German partners are deemed to receive business income for German tax purposes. Therefore, negative tax consequences apply to the German partners in comparison to partners in a non-business asset managing partnership. For example, capital gains realized at the partnership level generally will be subject to tax and partnerships located in Germany will be subject to trade tax.

According to the German tax authorities, the tainted income theory also applies if the partnership does not carry on a business activity itself but, instead, holds an interest in an underlying partnership that is engaged in a trade or business.

Deviating from the opinion of the German tax authorities, the German Federal Fiscal Court on 6 October 2004 decided that the tainted income theory does not apply to a partnership that is not engaged in a trade or business but that holds an interest in an underlying partnership engaged in a trade or business.

The 18 May circular issued by the Ministry of Finance, however, states that the German tax authorities will not apply the decision of the Federal Fiscal Court beyond that specific case. Moreover, the Ministry is seeking an amendment to the Income Tax Act that would confirm the application of the tainted income theory in the circumstances described, i.e. where a partnership does not engage in a trade or business but holds an interest in an underlying partnership that is so engaged. Affected individuals should be aware of this amendment and the potential consequences of investments in private equity funds.

The Financial Secretary of the Hong Kong Special Administrative Region (HKSAR) government, in his 2005 budget, proposed abolishing estate duty as an initiative to strengthen Hong Kong’s status as a regional financial and asset management center. The Revenue (Abolition of Estate Duty) Bill 2005 (the "Bill"), which effects the complete abolition, was gazetted on 6 May and tabled for discussion in the Legislative Council on 11 May 2005. The proposed Bill also abolishes all probate fees necessary for the administration of an estate.

Estate duty accounts for about 1% of total government revenue. The government estimates that abolition of the estate duty and probate fees will cost the government around HKD 1.5 billion and HKD 50 million per annum respectively, which would not have a significant impact on the financial situation of the HKSAR government. On the other hand, the abolition will enhance Hong Kong’s attractiveness for local and foreign investors, leading to further development of Hong Kong’s asset-management industry. Together with the growth in related professional service industries, the abolition of the estate duty likely will benefit Hong Kong’s economic development.

The Legislative Council is expected to further examine the effects of the abolition but the Bill is not expected to become an ordinance in the near future. If enacted, the estate of any person who passes away after midnight of the day the Bill is enacted will not be subject to estate duty.

The Italian government has issued a decree providing for immediate implementation of the EC Interest and Royalties Directive. The Directive aims to standardize the tax treatment of interest and royalty payments within the EU, in particular by repealing withholding taxes on payments between related parties.

The Interest and Royalties Directive, approved in June 2003, was to be implemented by each EU Member State no later than 1 January 2004. In January 2005, the European Commission issued a "motivated opinion" (the second stage of the infringement proceedings provided for in the EC Treaty), requesting that the countries that had failed to implement the Directive (i.e. France, Greece, Italy and Portugal) notify the Commission of any measures taken to implement the Directive. Failure to notify the European Commission of the adoption of the required measures within two months from receipt of the opinion could result in referral of the matter to the European Court of Justice (ECJ). The recently issued decree will prevent Italy from going before the ECJ.

Italy’s failure to implement the Directive created considerable uncertainty for Italian companies as to whether they should withhold tax on interest and royalty payments. Moreover, some EU countries, albeit unofficially, stated that they would not grant any tax credit or reimbursement for withholding taxes levied by Italy on interest and royalty payments received by resident companies from Italian related companies.

The decree is expected to confirm taxpayers’ right to claim reimbursement of taxes withheld on royalty and interest payments that should have been exempt under the Directive, since 1 January 2004, thus eliminating the uncertainty that has plagued Italian companies and their related parties in the EU for the last 18 months.

The National Tax Tribunal recently issued a ruling that clarifies when a loan to a related party is deemed to be "unfair" under the Law on the Coordination of International Taxation.

Under the Corporate Income Tax Law, where no interest or interest at a rate lower than the rate set by the Commissioner of the National Tax Service (currently 9%) is charged on a loan to a related party, the loan is deemed to be an unfair loan. As a result, deemed interest income arises to the lender (in the amount of the difference between the rate set by the Commissioner and the amount of the loan) that must be added to taxable income. However, because the Law on the Coordination of International Taxation overrides the Corporate Income Tax Law with respect to international transactions, an arm’s length interest rate is applied to determine whether a loan to a foreign related party is unfair under the coordination law.

The National Tax Tribunal has ruled that a loan provided by a Korean company to a foreign related party at an arm’s length rate (such as LIBOR + x%) will not be deemed to be an "unfair loan" even though the interest rate is lower than the interest rate set by the Commissioner. Such a loan will not be subject to the deemed interest calculation.

The National Tax Service (NTS) in mid-April initiated tax audits of two foreign private equity funds, Lonestar and Carlyle. The audits have generated extensive publicity because they are special tax audits, regarding which the taxpayer receives no advance notice. Instead, the tax auditors appear at the taxpayer's business to collect books and records and remove them to the NTS office for inspection. Both the National Assembly and interest groups condemned the two U.S.-based funds for reaping large profits on which they paid no Korean tax. The NTS special tax audits appear to be in reaction to the protests.

The transactions that triggered the special audits involved the sales by Lonestar and Carlyle of properties that were household names in Korea. Lonestar sold Star Tower, a landmark office building in Seoul, to GIC; Carlyle sold Koram Bank to Citigroup. Both Lonestar and Carlyle acquired the properties during a fire sale at the height of the Asian financial crisis, and both funds made huge profits on the sales. Reports that the two foreign equity funds paid no Korean tax because of tax treaty provisions or some esoteric tax rules angered the public.

The NTS also initiated audits of the purchasers, GIC and Citigroup, in connection with the transactions, and it has expanded its tax audits to other funds that carried out similar transactions. The current audits are scheduled to run through the end of May, but the outcome may not be known until well into the summer.

The NTS is likely to challenge the transactions of the funds on two grounds: (1) that the funds had permanent establishments (PEs) in Korea and should have paid taxes in Korea; and (2) that the funds engaged in treaty shopping.

Should the NTS assert taxing jurisdiction based on the PE argument, it will have to demonstrate that a PE existed and determine the amount of income attributable to the PE of the foreign equity funds. The latter issue in particular is likely to be challenging. Two years ago, a foreign private equity fund that made huge profits from the sale of a Korean company was audited by the NTS, and Korean tax was assessed based on the presence of a PE in Korea. During that audit, the NTS was adamant that the foreign fund had a PE but was lenient in calculating the amount of income attributable to it. Because of the amount of money at stake in the current case, the NTS may adopt a more aggressive stance in protecting the Korean fisc.

Korea generally has not been aggressive in enforcing its anti-treaty-shopping provisions, with the NTS denying treaty benefits only occasionally. One exception concerns tax assessments issued in 2002 regarding investments in Korea through Labuan. Labuan, an island off the coast of Malaysia, offers preferential tax treatment under its offshore business regime and is frequently used as a holding jurisdiction to invest in other countries. The case involved Korean investors that set up a company in Labuan through which they invested in Korea to take advantage of the tax treaty between Korea and Malaysia, which provides for substantially lower withholding tax rates than the domestic Korean rate of 27.5%. The NTS denied the tax treaty benefits claimed by the investors because the investors were Korean. The Korean government began trying to have Labuan removed from protection under the Malaysian treaty, but Malaysia has not agreed to do so.

The NTS recently audited a foreign fund that invested in Korea through Labuan, claiming the fund was not entitled to the benefits of the Korea-Malaysia tax treaty because the Malaysian entity was not a beneficial owner of the income. The NTS argued that the investors in the Labuan entity must be the beneficial owners to qualify for treaty benefits, and that, if those investors are from another treaty country, they would be protected under that other treaty, not under the Malaysia treaty. If the investors are from a country that has not concluded a tax treaty with Korea, there is no treaty protection.

The concept of beneficial owner is consistently applied in anti-treaty-shopping regimes, but typically only in the context of specific income, such as dividends, interest and royalties. Capital gains, the type of income Lonestar and Carlyle derived from their transactions in Korea, normally have no beneficial owner requirements. That income would fall under general anti-treaty-shopping provisions. However, the current audits will shed more light on the Labuan issue, the definition of beneficial owner and the anti-treaty-shopping enforcement policy in Korea.

The stakes are high. The foreign private equity funds claim they followed internationally recognized rules and complied with Korean rules. The NTS feels pressure to collect rightful revenue from foreign funds, and it seems to have all the necessary ammunition to prevail: PE and beneficial owner provisions in tax treaties and domestic law and anti-treaty-shopping provisions.

Effective retroactively from 1 October 2002, the following types of income received by nonresidents from Multimedia Super Corridor (MSC) status companies are exempt from tax in Malaysia:

• Technical advice and technical services;
• Licensing fees relating to technology development; and
• Interest on loans used for technology development.

Accordingly, such payments by MSC status companies to nonresidents are now exempt from withholding taxes.

MSC status is conferred by the Malaysian government on companies that are providers or heavy users of multimedia products and services and that undertake multimedia/information technology activities in the Multimedia Super Corridor, which is an area 15 kilometers wide and 50 kilometers long that starts from the Kuala Lumpur City Centre south to the site of the Kuala Lumpur International Airport. MSC status companies are entitled to various incentives, including: "pioneer status" with an income tax exemption up to the maximum of 10 years or investment tax allowances at the rate of 100% of qualifying capital expenditure; exemption from import duties on multimedia equipment; unrestricted employment of foreign knowledge workers; and no restriction on foreign equity participation.

The Dutch Finance Minister sent a discussion paper to Parliament on 29 April 2005 that would introduce significant improvements to the Dutch tax rules with a view to keeping the Netherlands on the short list of top locations for foreign investment.

The following measures are proposed:

• Reduction of the statutory corporate income tax rate to 20% for profits up to Euro 41,000 and to 26.9% for amounts in excess of that amount;
• Reduction of the tax rate for profits derived from group financing and treasury activities to 10%;
• The introduction of cross-border relief for losses incurred by EU subsidiaries (in anticipation of the European Court of Justice decision in the Marks & Spencer case); and
• Further relaxation of the participation exemption by eliminating the burdensome nonportfolio and "subject to tax" requirements. (For "passive" participations, a "sufficient" tax rate test (possibly 10%) would be introduced.)

The discussion paper also reconfirms the previously announced abolition of the Dutch capital tax as from 1 January 2006.

These proposals would be financed by the following measures:

• The carryback of losses would be reduced from three years to one year and the carryforward of losses would be limited to eight years (currently unlimited);
• The temporary deduction for losses on newly acquired participations and the loss deduction on the liquidation of participations would be abolished; and
• The depreciation of real estate would be capped to the extent the book value of the property is below the fair market value.

The measures would represent a significant improvement in the Dutch investment climate, which, combined with other recent measures (i.e. the introduction of a favorable regime for headquarter activities and the 0% withholding on certain dividends under the Protocol to the tax treaty with the U.S.), underscore the Dutch tradition for offering a state of the art fiscal policy and its continued efforts to be among the most attractive investment climates for the international business community.

Should the draft paper be converted to a bill and approved by Parliament (with or without subsequent amendments), the changes would enter into effect on 1 January 2007.

The New Zealand 2005 budget delivered by the Minister of Finance on 19 May 2005 includes relief for returning New Zealanders and new migrants, savings incentives and changes to the rules governing securities lending transactions. A discussion document introducing the new limited partnership regime, following the 2004 venture capital tax reforms, is expected later this year.

A major taxation bill introduced into Parliament on the same day introduces the changes announced by the budget as well as recently announced measures. Included in the taxation bill, however, is a provision that will require New Zealand companies that migrate to pay tax on their worldwide income earned while resident in New Zealand. When a company ceases to be a New Zealand tax resident, the company will be treated as if it had been liquidated and paid a distribution to its shareholders, thus equalizing the tax treatment of migrating and liquidating companies.

A one-time temporary tax exemption on foreign income will be made available to New Zealanders who return to New Zealand after a stay abroad of at least 10 years and to other individuals who are recruited to work in New Zealand for the first time.

Under the legislation that has been introduced into the House, all returning New Zealanders will enjoy a five-year exemption (three years for those who are not employed). Specifically, the proposed legislation allows for an exemption from all foreign-source income, except dividends, interest, employment income and business income relating to services for a period of five years. The rules will apply from 1 April 2006. The government also is considering exempting all compulsory superannuation schemes from the foreign investment fund regime.

The Minister of Finance also announced proposals intended to improve the availability of saving products and remove disincentives to saving. The announced "KiwiSaver" government-sponsored superannuation scheme will apply to all employees unless they opt out. The government will provide a list of approved investment providers with advisor fees subsidized by the government. Specifically addressing the disincentive to saving via a collective investment vehicle (CIV), the Minister announced two specific policy changes: CIVs will not be required to return for tax purposes gains made on domestic equities and CIVs will be taxed under a standard regime that will provide for the income to flow through to the ultimate investor at the investor’s marginal tax rate. These proposals will apply as from 1 April 2007.

New Zealand’s rules governing securities lending transactions will be updated to bring them into line with current commercial practice and the rules in other countries. In addition to eliminating tax obstacles, the amendments will include measures to prevent the use of securities lending for tax avoidance purposes. Specifically, "qualifying transactions" will be taxed based on their economic substance rather than legal form, meaning the lender will be treated as the owner of the shares for the duration of the transaction and anti-avoidance rules will apply to arrangements where a party that is unable to use imputation credits "lends" the relevant securities to a resident party that is able to utilize the credits.

With a view to making New Zealand more competitive in attracting foreign investment, the government proposes releasing a discussion document on a new limited partnership regime with a bill to be introduced in 2006 (given this timing, any change in law is not likely to be effective until early 2007). The proposal is seen to complement the venture capital tax reforms enacted in 2004, which removed tax barriers to attract private equity and venture capital funds to New Zealand.

The proposed regime would introduce the concept of limited partnerships, which would have a separate legal personality distinct from its members, comprising both general and limited partners. General partners would continue to have unlimited liability as in general partnerships and limited partners would not bear any risk beyond the amount of their investment. However, limited risk means limited involvement in the management of the limited partnership - the limited partner would effectively be a passive investor. Another key aspect of the limited partnership would be flow-through tax status, meaning that each partner is taxed at the partner’s marginal tax rate, tax losses may be claimed by the partner and capital gains would be distributed to the partner without any income tax impost.

The proposal appears to emulate the limited partnership provisions recently introduced in Australia, and those already in place in the U.K. and U.S. The key advantages to the limited partnership regime are perceived to be limited liability and flexibility. The devil will be in the detail and the discussion document will be eagerly awaited for clarity on who can be a general partner, the rights of limited partners, agency considerations and such. To retain competitiveness, the proposal is expected to be closely aligned to the regime in Australia.

Although the 2005 South African Budget was not as dramatic in tax terms as some recent budgets, it does contain a number of significant company tax proposals. In the hope, among other objectives, of increasing foreign direct investment, the South African corporate tax rate has been reduced from 30% to 29% with effect from 1 April 2005. Following suit, the tax rate for South African branches or agencies of a foreign company will be reduced from 35% to 34%. The controversial Secondary Tax on Companies (STC) remains unchanged, triggering debate as to whether it might not have been more effective, in terms of attracting foreign investment, to reduce STC rather than normal company tax.

Since 2004, South Africa has offered fairly wide-ranging exemptions for foreign dividends and some relief in respect of capital gains made on sales of foreign shareholdings. The introduction of these measures was to attract foreign investment to the country. It is noted with some concern that an intention to re-examine these provisions was mentioned in the Budget Review document, in the context of a concern that the rules can be used to shift funds offshore free of tax. It would be unfortunate if these rules, which in certain respects are already less favorable than their counterparts in many other countries, were to be further restricted.

South Africa's CFC rules, introduced in 1997 and expanded in scope every year, will be re-examined. Some of the proposed changes seemed designed to address anomalies or uncertainties triggered by the existing legislation, possibly as a result of the frequency and extent of amendments in recent years. Although no details were provided, reference was made in the Budget Review document to changes needed to the rules governing intragroup loans between related CFCs. These rules provide that interest paid or payable by one controlled group company to another in the same group is tax exempt in the hands of the recipient, but no tax deduction is available to the payor. Certain anomalies arising from these provisions will be addressed (to the benefit of taxpayers) as time permits. Generally, however, the comments relating to CFC changes took the form of ominous rumblings, foreshadowing further tightening of the rules.

The most specific reference made in this regard relates to offshore banking centers. Treasury apparently is of the view that the current exemptions enjoyed by South African parent companies in relation to income earned by their foreign subsidiaries, where those subsidiaries are conducting banking, insurance, dealing or broking activities, are too broad in scope. These rules grant an exemption under the CFC rules in respect of passive income derived by companies with licenses or registrations in their foreign jurisdictions, entitling them to conduct banking, insurance, dealing or brokering businesses with local clients in the same manner as their local counterparts. It was stated in the Budget that the purpose of these rules is to ensure that the foreign operations in question are stand-alone active businesses, "located outside countries that [employ] harmful tax practices in an attempt to poach [the] South African tax base," as opposed to in-house treasury activities. These rules are to be revisited because the Treasury considers them ineffective in preventing South African residents from establishing group finance companies in low-tax jurisdictions and may, in certain instances, be inhibiting "legitimate" offshore financing operations conducted by South African banks.

Reference also was made to changing the definition of participation rights in CFCs. These are defined with reference only to the right of the shareholder to participate in the share capital or accumulated profits or reserves of the company. The definition would be broadened to take factors such as voting rights into account.

The detail of the proposed amendments to the CFC rules will be released later in the year.

It was proposed that the provisional tax system for companies be amended to take account of foreign tax credits claimable by South African companies. The system of provisional (that is, interim) tax payments applicable to individuals already allows this, and it makes little sense that companies previously have been able to claim only foreign tax credits against their final domestic income tax calculations for the year.

With effect from 1 January 2006, the 0.25% duty payable on the issue of shares in South African incorporated companies is to be abolished. Duties arising on the transfer of shares are not affected.

The South African GAAR is to be reviewed and amended after an appropriate discussion process, an announcement consistent with the South African Revenue Service’s (SARS) introduction of specific anti-avoidance measures (e.g. legislation relating to film schemes, share schemes, hybrid instruments and the introduction of reportable arrangements provisions), and increased use by SARS of the media to counter tax avoidance. Although specific proposals have not been released, it is possible that attempts will be made to strengthen the business purpose requirement. Treasury's likely focus will be on targeting transactions, or steps in transactions, that have no real economic substance if their tax benefits are ignored.

The Budget Review document refers to the South African GAAR as being based on "antiquated notions of legal form and intent" and places significant emphasis on the concept of economic substance, thus suggesting a bias in favor of the approach to anti-avoidance legislation found in the U.S. However, tax and treasury authorities need to be cautious in adopting any concept of economic substance. The entire South African tax system, not just the GAAR, is premised on an approach that favors legal form over economic substance. For example, there is no form of group relief or tax consolidation in South Africa. A taxpayer that finances a share acquisition enjoys no deduction for the related interest cost, while a taxpayer that purchases the assets of the target company rather than its shares will be entitled to an interest deduction. There are many instances where, under an economic substance approach required by GAAP, transactions are treated one way for accounting purposes and another for tax purposes. If amendments are to be made to South African tax law that allow the Revenue to invoke economic substance when it suits them, but that (outside of the GAAR) continue to require taxpayers at all times to pay tax according to the legal form of a transaction, no matter how inequitable this may be in terms of economic reality, the South African tax system will be unacceptably one-sided and distorted.

South Africa has seen the introduction of a multitude of new tax laws since 2001, with complex amendments being added on an annual basis. Interpreting these can be a challenge for taxpayers and SARS officials alike. It is important that the GAAR not be seen by SARS as a weapon to compensate for poorly drafted legislation. However, to the extent the GAAR can be re-worded to improve certainty around the likely circumstances of its application, this will be very welcome. SARS will be circulating a discussion paper on this issue later in the year.

The third U.K. Finance Bill (Finance Bill 2005), published 26 May 2005, reintroduces anti-avoidance measures announced in Budget 2005 that were not enacted by Finance Act 2005.

The proposed arbitrage rules will apply only where schemes involving arbitrage have the avoidance of U.K. tax as one of their main purposes. The measures will be debated in standing committee and are likely to become law by 21 July but effective retroactively as from 16 March 2005. Although the provisions are substantially the same as those in the original Finance Bill in many respects, there are some differences:

• The definition of hybrid entity has been revised to have a more sensible application. This provision is now drafted such that an entity is a hybrid entity if (a) under the tax law of any territory, the entity is regarded as being a person; and (b) the entity's profits or gains are, for the purposes of a relevant tax imposed under the law of any territory, treated as profits or gains of a person or persons other than that person.
• Thus, reverse hybrid limited liability partnerships and limited liability companies that are checked open will both now be hybrid entities such that the anti-avoidance rules can apply.
• Taxpayers can now volunteer to make an adjustment without having a notice issued.
• The rules apply in cases where the taxpayer claims a deduction as well as in cases where the taxpayer is in a position to make such a claim.
• There is a clarification such that an entity does not become a hybrid if the entity’s profits are treated as the profits of another person for controlled foreign corporation or (U.S.) subpart F-type purposes only.
• Local rules in respect of branch and tax haven structures need to be understood clearly to ensure they meet the exemptions.

The Guidance Notes released along with Finance Bill 2005 are helpful with respect to the meaning of the main purpose being a U.K. tax advantage, but it would appear that, if the taxpayer can prove that the deduction in the U.K. would have been the same without the hybrid, then the main purpose cannot be a U.K. tax advantage.

A more detailed article will be published in the next edition of World Tax Advisor.

The IRS and Treasury issued Notice 2005-38 on 10 May 2005, which provides the second in a series of detailed guidance for U.S. corporations that intend to repatriate earnings from foreign subsidiaries under §965, the elective temporary repatriation provision introduced in the American Jobs Creation Act of 2004.

The first notice, issued in January, provided guidance on the meaning of a cash dividend and the requirements for a valid domestic reinvestment plan under §965. Issues addressed in the second notice include:

• The income gross-up for deemed paid foreign tax credits ("§78 gross-up");
• Disallowed expense deductions;
• The alternative minimum tax;
• Computing "the base period amount," the "APB 23 limitation" (relating to prior financial statements) and the "$500 million limitation," and the effects of acquisitions and dispositions on the base period amount, the APB 23 and USD 500 million limitations, and domestic reinvestment plans;
• The way in which related party indebtedness reduces the amounts taken into account under §965; and
• The effect of repayments of "disregarded" related-party loans.

Significantly for financial reporting purposes, the notice essentially "fixes" a drafting error in the Code, freeing taxpayers from any requirement to include in income the otherwise applicable "§78 gross-up" relating to foreign taxes that are not creditable because they are attributable to the deductible portion of a dividend. Also, the notice clarifies that deductions will be disallowed only for expenses that are "directly allocable" to the dividends.

Section 965 provides U.S. corporations an opportunity to elect a temporary 85% dividends received deduction for certain dividends paid to them by their controlled foreign corporations, which generally translates into a U.S. tax rate of up to 5.25% on these dividends rather than the normal U.S. rate of up to 35%. The window of opportunity to repatriate CFC earnings under §965 is generally only one year - either the U.S. taxpayer’s last taxable year that began before 22 October 2004 or the first taxable year that began during the one-year period beginning on 22 October 2004.

Another round of guidance is expected in the very near future to address rules that limit the use of foreign tax credits, and the deduction of expenses, by a U.S. corporation that elects the §965 deduction.

On 13 May 2005, the Internal Revenue Service issued final, temporary and proposed regulations (under §1446 and related sections), dealing with withholding by partnerships on U.S. effectively connected income allocable to a foreign partner. The final regulations are based on regulations proposed in September 2003 and take into account public comments. The temporary and proposed regulations make conforming changes and add a few additional substantive provisions.

Section 1446 requires partnerships that are engaged in a U.S. trade or business to obtain documentation from their partners as to whether the partners are U.S. or foreign and whether the partners are corporate, noncorporate or individuals. The partnership must withhold tax on effectively connected allocable income to a foreign partner at the highest tax rate applicable to that person.

Both the temporary and final regulations are effective for partnership taxable years beginning after 18 May 2005 (with an election available for taxable years beginning after 31 December 2004).

Under the new temporary regulations, certain foreign partners may certify their partner-level deductions and losses to a partnership to reduce the §1446 tax required to be paid by the partnership with respect to effectively connected taxable income allocable to such partners. A foreign partner may certify only if it can represent that it timely filed, or will timely file, a U.S. federal income tax return for each of the preceding four taxable years and in the taxable year for which the partner is certifying. The partner also must represent that it has timely paid or will timely pay all tax shown on the returns. A partnership receiving a valid certificate may consider a partner’s certified available deductions and losses in computing its withholding tax liability, but is not obligated to do so. Should the partnership consider the certificate, however, additional reporting and documentation obligations arise.

For withholding rates, a partnership generally is required to use the highest rate of tax under the rate setting provisions for noncorporate and corporate taxpayers (currently 35%) applicable to a partner, but also may consider the type of income or gain allocable to a foreign partner during the taxable year when computing its §1446 tax obligation and use the highest preferential rate for a particular type of income. Where the rates depend upon the status of the person (corporate or noncorporate), the final regulations prohibit using a preferential rate unless status has been established by documentation.

The final regulations also make numerous procedural changes in response to public comments on the proposed regulations.

This article is intended as a general guide only, and the application of its contents to specific situations will depend on the particular circumstances involved. Accordingly, we recommend that readers seek appropriate professional advice regarding any particular problems that they encounter. This bulletin should not be relied on as a substitute for such advice. While all reasonable attempts have been made to ensure that the information contained in this bulletin is accurate, Deloitte Touche Tohmatsu accepts no responsibility for any errors or omissions it may contain, whether caused by negligence or otherwise, or for any losses, however caused, sustained by any person that relies on it.

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