TAX ASPECTS OF CURRENCY REGULATION
| Jurisdiction | United States |
(Feb 1995)
TAX ASPECTS OF CURRENCY REGULATION
Holme Roberts & Owen LLC
Denver, Colorado
TABLE OF CONTENTS
I. Host country taxation
A. Tax as an instrument of currency regulation
1. Tax incentives for investment and reinvestment
a. Reduced tax rates and tax holidays
b. Special tax regimes
c. Guarantees against adverse legislation
2. Tax penalties for repatriation
a. Loss of tax benefit
b. Confiscatory remittance taxes
B. Issues in host country taxation
1. Tax provisions in the agreement
2. Local accounting principles
a. Use of local currency books
b. Marking dollar balances to market
c. Indexing assets and liabilities
3. Delaying tax payments
4. Forced investments
II. United States taxation
A. Blocked income
1. U.S. taxpayer's own income
2. Subsidiary's income
3. Transfer pricing
B. Functional currency
1. Non-functional currency transactions
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2. Hedged transactions
3. Translating income of non-dollar QBUs
4. Dual exchange rates
5. Hyperinflationary accounting
C. Foreign tax credit issues
1. Translating foreign taxes paid
2. Taxes indexed for inflation
3. Tax benefits and subsidies
III. Dealing with blockage
A. Before the fact
1. Protective language in the agreement
2. Effect of grandfather provisions
B. After the fact
1. Biting the bullet
2. Spending or investing blocked funds
3. Swaps
4. Finding the loophole
5. Rate arbitrage: Making a silk purse from a sow's ear
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Currency and exchange controls, and U.S. companies' responses to them, can have a variety of direct and indirect tax consequences for U.S. taxpayers operating abroad. These include both host country and U.S. tax consequences.
I. Host country taxation
A host country may impose burdensome tax consequences on behavior that is contrary to its currency policy. A host country may also provide incentives through its tax system for behavior it wants to encourage, such as investment or reinvestment of funds within the host country.
In addition, non-tax regulations can raise local tax issues, or force the U.S. company to face issues it would not have to deal with if funds were freely convertible and remittable.
A. Tax as an instrument of currency regulation
Most countries, including the U.S., employ taxes as regulatory tools in some circumstances. Indeed, tax provisions can be a powerful carrot or stick to encourage or discourage particular behavior. Special tax rules may be included in generally applicable legislation or regulations, or may be negotiable on a case-by-case basis.
1. Tax incentives for investment and reinvestment
Probably the most benign form of regulation through the tax system is when a foreign government allows the U.S. investor more favorable tax treatment than is available to other persons doing business within the foreign country. At the extreme, these incentives can take the form of complete exemption from some or all of the taxes generally imposed within the country. Partial exemptions can take numerous forms.
The bottom-line benefit of a foreign tax incentive to a U.S. company is a function of the type of tax and of the company's U.S. tax posture. Foreign income taxes (and certain taxes imposed "in lieu" of a foreign country's income tax) are
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creditable against U.S. tax liability, subject to certain limitations. Paying a creditable tax may cost the taxpayer nothing, if the amount paid is within the applicable limitation. Conversely, a foreign income tax concession may provide no net benefit, if the forgone tax would have been creditable in the U.S. (A major reason that the U.S. has not entered into tax treaties with developing countries such as Brazil is the Treasury Department's refusal to include "tax sparing" provisions, under which the U.S. investor would receive credit in the U.S. for the full host country income tax, including taxes that are not paid because of foreign tax incentives.) Finally, to the extent foreign income taxes are paid in excess of the applicable U.S. credit limitation, foreign tax concessions provide the U.S. taxpayer with a dollar-for-dollar bottom-line tax benefit.
Concessions relating to non-income taxes almost always provide a net benefit, although the loss of a U.S. tax deduction for the foreign tax dilutes the incentive effect. In evaluating a tax incentive provided by a foreign country, it is important for the U.S. taxpayer to consider offsetting loss of U.S. tax benefits in order to arrive at a correct understanding of the cash flow or present value benefit of the incentive.
Examples of tax incentive provisions include:
a. Reduced tax rates and tax holidays
In order to encourage investment, the foreign country may offer the U.S. company a full or partial exemption from tax by specifying a tax rate between zero and the generally applicable rate.
Incentives of this type that are embodied in generally applicable legislation usually are limited in time (e.g., five years). An issue that arises with an income tax incentive of this kind is whether the benefit period begins to run at the time of the investment, or only when the investment begins to show a profit. The latter is preferable, since a low tax rate is meaningless as long as the business is running at a loss.
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Incentives are often conditioned on retention of all or a specified part of the affected earnings within the host country for a period of time.
b. Special tax regimes
Instead of an outright reduction in tax rates, foreign law may grant the investor special write-offs or credits for the amount of hard currency capital (or its equivalent in kind) committed to the project.
Another attractive approach could be to negotiate a special tax regime for the U.S. investor that will maximize the U.S. tax benefit of host country taxation (e.g., by converting non-creditable taxes into creditable income taxes, or by converting excess creditable taxes into deductible taxes.)
c. Guarantees against adverse legislation
U.S. companies or industry groups often lobby foreign countries to enact specific guarantees that any investment made in reliance on existing incentives will be protected against repeal of the incentives during the life of the investment. Grandfathering is important because the investment will have been made in reliance on a particular present value estimate, which will be adversely affected if remittances must be delayed or are subjected to increased taxation. However, the added value of blanket prospective grandfather rules is questionable — at least if issued by the same governmental unit that granted the underlying tax concession — since such laws can themselves be repealed.
2. Tax penalties for repatriation
Foreign law may also provide a "stick" in the form of increased taxation as a disincentive to remittance of profits outside the country.
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a. Loss of tax benefit
If a tax benefit was granted on condition that funds remain invested in the host country for a specified period of time, the failure to satisfy that requirement may result in a retroactive loss of the tax benefit.
In some cases the required retention period is indefinite, as when a country imposes a higher rate of income tax on remitted profits than on retained earnings.
b. Confiscatory remittance taxes
In the extreme case, remittance taxes may be so high as to be confiscatory, effectively requiring the indefinite retention of earnings. Brazil at one time imposed a sliding-scale withholding tax, under which remittances in excess of a specified percentage of registered capital were subject to prohibitively high taxes. This barrier, combined with Brazil's chronic hyperinflation, led to many creative attempts to bring money out of the country without running afoul of the remittance rules.
B. Issues in host country taxation
U.S. companies often encounter unexpected tax costs directly or indirectly as a result of operating in a country with a weak currency, currency and exchange controls, and unfamiliar tax rules.
1. Tax provisions in the agreement
In most developing countries it is necessary to enter into an agreement with the government before undertaking an exploration or production project. The company should consider asking for tax concessions if it is in a position to do so; in any event, it should seek protection against current and future foreign tax liabilities that would detract from the economic feasibility of the project.
The government often is the owner of the mineral rights, in addition to its administrative and regulatory roles. As a result, the...
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