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Taxation of Royalties Ceases Under Estonia-UK Tax Treaty | MN Tax Lawyer

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On January 18, 2017, the HM Revenue & Customs announced that the withholding tax on royalties under the 1994 Estonia-UK tax treaty has been eliminated retroactively as of October 16, 2015.

Under the original Estonia-UK tax treaty, the rates had been 5 percent for industrial, commercial, and scientific equipment royalties and 10 percent in other cases. However, paragraph 7 of the Exchange Notes to the Treaty contains the Most Favoured Nation” (MFN) provision relating to royalties (Article 12). Under the MFN provision, UK tax residents only need to pay the lowest tax withholding rate ever agreed by Estonia in a Double-Taxation Treaty (DTA) it later agrees with an OECD member country that was a member when the UK-Estonia tax treaty was signed in 1994.

It turns that Switzerland was an OECD member country in 1994. In 2002, Estonia signed a tax treaty with Switzerland, but the treaty did not impact the UK withholding tax rate at that time. In 2014, however, Estonia and Switzerland signed an amending protocal to the 2002 Estonia-Switzerland tax treaty. Under the protocol, the treaty was revised to provide for only resident state taxation of royalties.

It was this provision in the 2014 protocol to the Estonia-Switzerland tax treaty that triggered the 1994 MFN provision of the Estonia-UK tax treaty. Therefore, when the 2014 protocol entered into force on October 16, 2015, it effectively eliminated tax withholding on royalties not only in Switzerland (wth respect to Estonia), but also in the United Kingdom. While the taxation of royalties under the Estonia-UK tax treaty ceased on October 16, 2015, the HM Revenue & Customs waited for more than a year to announce it on January 18, 2017.

It should be pointed out that MFN provisions, such as the one in Estonia-UK tax treaty, quite often have an important impact throughout the treaty network of a country. This ripple effect of the MFN provisions creates enormous opportunities for international tax planning that is often utilized by international tax lawyers, including US international tax law firms such as Sherayzen Law Office, Ltd.

Belarus-Hong Kong Tax Treaty Signed | MN International Tax Attorney

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On January 16, 2017, the Belarus-Hong Kong Tax Treaty was signed by government officials from both countries – K.C. Chan, Hong Kong’s secretary for financial services and the treasury, and Sergei Nalivaiko, Belarusian minister of taxes and duties. Let’s explore the most important provisions of the new Belarus-Hong Kong Tax Treaty.

Elimination of Double-Taxation Under the Belarus-Hong Kong Tax Treaty

The new tax treaty will provide real benefits to businesses and individuals in both countries. In the absence of the treaty, the profits of Hong Kong companies earned through a permanent establishment in Belarus would be taxed in Belarus and Hong Kong. Similarly, prior to the treaty, the income earned by Belarusian companies in Hong Kong would be subject to both, Belarusian and Hong Kong taxation.

The Belarus-Hong Kong Tax Treaty will now eliminate the risk of double taxation by allowing Belarusian companies to claim a tax credit for taxes paid in Hong Kong. Similarly, Hong Kong companies will be able to claim tax credit for taxes paid in Belarus.

Belarus-Hong Kong Tax Treaty: Taxation of Dividends, Interest and Royalties

The new treaty establishes a 5% maximum tax rate for dividends and interest payments. This is a large reduction from the current highest rate of 13%. Moreover, in certain cases (mainly Hong Kong or Belarusian government-owned entities), dividends and interest are entirely exempt from taxation.

Additionally, under the new treaty, the royalties will generally be taxed also at 5%. However, if the royalties are paid for the use of (or the right to use) aircraft, then the tax withholding rate is further reduced to 3%. Again, this is a major reduction from the current highest rate of 15%.

Belarus-Hong Kong Tax Treaty: Concessions to Hong Kong Airlines

The special reduction for aircraft-related royalties is a major concession to Hong Kong Airlines, but it is not the only one. Additionally, Belarus agreed that Hong Kong Airlines operating flights to Belarus will be taxed at Hong Kong’s corporation tax rate. Furthermore, the profits from international shipping transport earned by Hong Kong residents that arise in Belarus (and which are currently taxed in Belarus) will now fully escape Belarusian taxation.

Belarus-Hong Kong Tax Treaty: Other Provisions and Entry into Force

The new treaty contains a number of other provisions regulating taxation of capital gains, pensions, government salaries and other income. Additionally, Article 25 of the treaty provides for exchange of tax-related information between Belarus and Hong Kong. This provision may have an unintended consequence for US tax residents who operate in Belarus and Hong Kong, because some information exchanged between Belarus and Hong Kong may be further provided to the United States under Hong Kong’s FATCA tax information exchange obligations.

The Belarus-Hong Kong Tax Treaty will enter into force once both sides complete their own ratification procedures.

IRS Civil Penalties and Voluntary Compliance | US International Tax Lawyer

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There has been a spectacular growth in the number of the IRS civil penalties. In 1955, there were about 14 penalties in the entire Internal Revenue Code (“IRC”); on the other hand, today, there are over 150 penalties. The most recent growth in penalties has been driven mostly by offshore compliance concerns and the appearance of new requirements to address these concerns. FATCA Form 8938 is just the most recent example of this trend.

Does this growth in the IRS civil penalties mean that our tax system is shifting its focus from encouraging voluntary compliance to punishing abusive behavior? Let’s explore this issue from a historical perspective and try to answer the question.

The Stated Purpose of the IRS Civil Penalties

The US tax system is based on the taxpayers’ voluntary compliance with US tax laws. As I explained in a previous article, “voluntary compliance” really means the self-assessment of tax and the filing of tax returns by US taxpayers; the actual compliance with US tax laws is compulsory.

In other words, the Congress burdened the taxpayers with all of the hassle and complexity of US tax compliance and it still wants them to do it accurately, timely and in direct opposition to their self-interest of paying the least amount of tax. How can such a system function?

The solution lies in the creation of a system of the IRS civil penalties (a discussion of criminal penalties is outside of the scope of this article). The threat of the imposition of the IRS civil penalties during a random audit is meant to “encourage” voluntary compliance. This is the official purpose of the IRS penalties.

How exactly do the IRS civil penalties encourage voluntary compliance according to Congress? First, the penalties establish the standard of compliant behavior by defining noncompliance. Second, the penalties are meant to define the “remedial consequences” for noncompliant behavior. Finally, the IRS civil penalties impose monetary sanctions against the taxpayers and tax professionals who fail to comply with the aforementioned standard.

IRS Civil Penalties Must be Viewed as Precise and Proportional

Yet, in order to properly function and accomplish their goal of encouraging voluntary compliance, the IRS Civil Penalties must be viewed by the taxpayers as precise and proportional to the fault committed and the harm that resulted from that fault. In other words, the taxpayers must view the IRS Civil Penalties as a deterrence of improper conduct rather than punishing innocent taxpayers. If these penalties are viewed as excessive, the goal of voluntary compliance will be undermined.

Unfortunately, with respect to many IRS Civil Penalties, the taxpayers feel that they are disproportionate and imprecise. This is especially true with respect to international information tax returns, such as FBAR, Form 8938, Form 5471 and so on. The FBAR penalties are especially abhorred by the taxpayers because they apply to even non-willful conduct.

IRS Past Efforts to Change Taxpayers’ Perspective on the IRS Civil Penalties

The IRS has been trying to battle this impression of unfairness of the IRS civil penalties, though we cannot say that it has been entirely successful in this respect.

Already in February of 1989, the IRS Commissioner’s Executive Task Force issued a “Report on Civil Tax Penalties” which emphasized the complexity and perceived unfairness of the IRS Civil Penalties. This Report remains one of the key documents which has not been substantially modified for past twenty some years.

The report established a philosophy of penalties, provided a statutory analysis of the three broad categories of penalties (filing of returns, payment of tax and accuracy of information), and proposed a list of action items to resolve the inconsistencies between civil penalties.

Among these recommendations, the IRS proposed to:

(1) develop and adopt a single-penalty policy statement emphasizing that civil tax penalties exist for the purpose of encouraging voluntary compliance;

(2) develop a single consolidated handbook on penalties for all employees. The IRS emphasized that the handbook should be sufficiently detailed to serve as a practical everyday guide for most issues of penalty administration and provide clear guidance on computing penalties;

(3) revise existing training programs to ensure consistent administration of penalties in all functions for the purpose of encouraging voluntary compliance;

(4) examine its communications with taxpayers to determine whether these communications do the best possible job of explaining why the penalty was imposed and how to avoid the penalty in the future;

(5) finalize its review and analysis of the quality and clarity of machine-generated letters and notices used in various divisions within the IRS;

(6) consider ways to develop better information concerning the administration and effects of penalties; and

(7) develop a Master File database to provide statistical information regarding the administration of penalties. That IRS envisioned that the information would be continuously reviewed for the purpose of suggesting changes in compliance programs, educational programs, and penalty design and penalty administration.

1989 IMPACT’s Effect on the IRS Civil Penalties

The IRS efforts did not go unnoticed. The Congress responded by enacting the Improved Penalty and Compliance Tax Act (“IMPACT”) as part of its Omnibus Budget Reconciliation Act of 1989.

It appears IMPACT had an overall salutary effect on the IRS civil penalties with respect to domestic activities. However, IMPACT’s role in curbing the perceived unfairness with respect to US international tax penalties has been minimal.

The Restructuring and Reform Act of 1998 Changed the Way the IRS Civil Penalties Are Imposed

At the end of the 1990s, the Congress made one more effort to solidify the image of fairness with respect to the imposition of the IRS civil penalties. The Restructuring and Reform Act of 1998 made a valuable contribution to maintaining the focus on encouraging voluntary compliance by creating the IRC Section 6751(b). IRC Section 6751(b) states that most of the IRS Civil Penalties (other than those automatically calculated by a computer) imposed after June 30, 2001, require a written managerial approval by the immediate manager or higher-level official of the employee who initially proposed the penalty.

The idea behind Section 6751(b) is to bring some restrain in the imposition of penalties by the “trigger-happy” employees. The extra level of review is further meant to promote the image of fairness of process during the imposition of the IRS Civil Penalties.

Conclusion: Encouragement of Voluntary Compliance Remains A Priority in General but the Emphasis on Abusive Transactions Dominates International Tax Law Compliance

Now that we have analyzed the IRS Civil Penalties from a historical perspective, let’s return to the original questions that I posed at the beginning of this article: does the growth in the number of the IRS civil penalties mean that our tax system is shifting its focus from encouraging voluntary compliance to punishing abusive behavior?

Based on the IRS past efforts to improve the taxpayer’s perception of the tax system and civil penalties and the Congress’ effort to encourage voluntary compliance through laws like IMPACT, one can say that, in general, the encouragement of voluntary compliance remains the main purpose of the IRS civil penalties.

There is one area, however, where the application of civil penalties has been driven not by only voluntary compliance considerations, but also by the desire to punish certain modes of behavior. This area is international tax law and, more precisely, abusive offshore transactions.

In fact, it appears more and more that the focus of the current tax policy is on punishing abusive offshore transactions irrespective of how it may affect innocent taxpayers. Since 2001, millions of taxpayers found themselves potentially facing draconian FBAR penalties solely for not reporting their foreign accounts. Thousands of small businesses also face large penalties associated with Forms 5471 and 8865 as well as other US international information return penalties. Finally, FATCA Form 8938 created with a new array of penalties and an added compliance burden to US taxpayers.

The fact that all of these forms may be necessary is not the issue. The problem is that the application of these forms has been indiscriminate almost irrespective of the actual income tax impact and the net worth of the taxpayer. For example, small businesses now have to comply with the burden of US GAAP compliance (normally applied only to publicly-traded companies) on Form 5471 or face severe IRS civil penalties for noncompliance. One non-willfully unreported foreign account which could have produced a few dollars of interest may be subject to a $10,000 FBAR penalty.

Naturally, the disproportionate and imprecise application of the IRS civil penalties in the area of the US international tax compliance has generated a great amount of discontent and resentment among the affected US taxpayers. This is precisely what IMPACT tried to avoid in order to encourage voluntary compliance.

This is why the IRS and Congress should work together to make the application of the IRS civil penalties more precise with respect to who should be paying these penalties and more proportionate to the actual fault (i.e. the damage sustained by the US treasury).

UK Tax Haven May Be the Result of Brexit | US International Tax Attorney

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In her January 17, 2017 speech, the British Prime Minister Theresa May confirmed that the United Kingdom (“UK”) will leave the European Union (“EU”) and seek a free trade deal with the EU. The Prime Minister also appears to have made the threat of creating a UK Tax Haven if the deal is not struck.

UK Tax Haven: UK is Leaving the EU

Since the ground-breaking referendum vote to leave the EU in June of 2016, many analysts have predicted that the UK will not leave and seek some sort of a partial participation in the EU.

On January 17, 2017, the Prime Minister’s response to these doubters was clear: “No, the United Kingdom is leaving the European Union.” She also stated: “We do not seek to hold on to bits of membership as we leave.”

She also outlined the procedural roadmap to how the UK will leave the EU. In particular, the Prime Minister stated that the government would bring the final withdrawal agreement to the Parliament for a vote before the Agreement comes into force. Furthermore, the UK government will repeal the European Communities Act. Surprisingly, the Prime Minister further said that the existing body of the EU law will be converted into British law.

UK Tax Haven: The Freedom to Set Competitive Tax Rates

The Prime Minister’s speech also contained something of great interest to international tax lawyers. She stated that, once the UK leaves the EU, it will “have the freedom to set the competitive tax rates and embrace the policies that would attract the world’s best companies and biggest investors to Britain.”

Not surprisingly, the reporters, the opposition and some foreign leaders had interpreted this statement as a threat of converting the UK into a major tax haven for the European companies. It appears that the UK government plans to materializes this threat of the UK tax haven only if the UK is excluded from the EU single economic market as a result of a punitive EU action.

This threat of creating a major UK tax haven echos a similar threat made by the Chancellor of the Exchequer Philip Hammond. In his interview with a German newspaper “Welt am Sonntag”, Mr. Hammond stated that, if the UK is excluded from the EU market, the government will try to contain the damage of such a move by switching away from the European model of taxation.

Is the UK Tax Haven Likely to Become a Reality?

So, is the UK Tax Haven a certainty at this point? Probably not. I view this threat more as a negotiation tool rather than the certainty of enacting a certain plan. The UK economy is one of the most important and complex economies in the world; it is very unlikely that the British government will be even able to pursue a course of action of turning the UK into a full tax haven.

On the other hand, it is obvious that the British government will take advantage of the situation and seek to improve the country’s competitiveness through enaction of certain tax strategies. There is a high likelihood that the corporate tax rate may be lowered to a level where it is better than in most other EU countries, but cannot yet be considered as that of a tax haven.

Furthermore, it is possible that the UK tax haven will materialize only with respect to certain classes of taxpayers from certain countries. For example, the United States can be readily considered as a tax shelter for foreign individuals. The UK may be tempted to adopt a similar approach.

Finally, it is important to remember that the UK is already an attractive country from tax perspective. Its corporate rate is not high (it can even be called relatively low), there is no dividend withholding tax, favorable rules for expats, wide treaty network, and so on. Furthermore, the UK did not enact certain beneficial ownership transparency rules that other European countries already have in place.

Most likely, the UK just wishes to keep its options open for now and there is not going to be a UK tax haven in a traditional sense of this word, despite its threats to do so. International tax lawyers, however, should closely follow the UK developments for any tax opportunities that may become available to their clients.