On January 16, 2015 the European Commission (“EC”) released its report that certain favorable tax rulings Luxembourg granted Amazon (circa 2003) have been preliminarily deemed to constitute illegal state aid under European law. State aid occurs when a European Union country grants advantages (e.g. grants, interest and tax reliefs, guarantees, government holdings of all or part of a company, or provides goods and services on preferential terms, etc.) on a selective basis to a business, thereby distorting competition among EU member countries in a manner which will likely affect trade among EU member countries. Although the EC Amazon report is in substance a transfer pricing opinion , the underlying tax strategy employed by Amazon was the use of a hybrid entity This article examines the hybrid aspects of the Amazon case.
General Theory of Hybrids
A hybrid entity is one that is taxed as a partnership in one country and as a corporation in another.
A partnership is generally tax/fiscally transparent – i.e. if one thinks of profits from a company as physical light – the “light” passes through the partnership without impacting the partnership. Instead the partners are deemed to receive partnership profits as the “light” passes through to them. The partners bear any tax consequences the “light” carries.
A corporation is generally tax/fiscally opaque – the profits, or using our analogy the “light”, are “stopped” by the company – and the company is subject to any tax on them. There is no tax to the equity holders until the profits are distributed to them. The flow of “light” has been blocked by the fact that the company is a corporation.
Each country gets to determine whether an entity is tax transparent or tax opaque under its tax laws. In the US under so-called “check-the-box” rules a company, other than a US corporation or the non-US equivalent of the same, can elect to be taxed in the US as either opaque (like a corporation) or transparent (like a partnership). An entity for which a US check-the-box election may be made is known as an eligible entity.
From a U.S. tax perspective, a hybrid entity is an entity that is “fiscally transparent” for U.S. tax purposes but not fiscally transparent for foreign tax purposes. A reverse hybrid entity is the “reverse” of a hybrid entity in that the entity is fiscally transparent for foreign tax purposes but not fiscally transparent for U.S. tax purposes.
A Hypothetical Hybrid Example
Company A, an eligible entity, is formed under the laws of Country X and is tax transparent in Country X. If the equity owners are US persons they may elect for US tax purposes to have Company A treated as a corporation (tax opaque). From a US point of view our hypothetical hybrid is a reverse hybrid entity. From the view point of Country X, it is a hybrid entity.
Let’s look at the tax consequences.
- In Country X: In general a country will tax non-residents only on income sourced from that country. So, generally, Country X would not tax the US equity owners of Company A who were not tax resident in Country X if the income from Company A were not to be deemed as sourced from Country X. The fact that Company A was formed in Country X would not mean that its income would ipso facto be sourced to Country X. The general rule is that even income generating activity of Company A would not be sourced to Country X if it were not to arise out a permanent establishment (PE) of Company A in Country X. The PE concept is explained a bit more below.
- In the US: Since a check-the-box election is to be made to have Company A taxed as a corporation, the general rule is that US tax on the net income of Company A would be deferred until distributed to the US shareholders. One does need to be aware of so-called “Subpart F Income” (generally passive income) which will be currently taxed in the US, regardless of whether distributed, if Company A is deemed to be a Controlled Foreign Corporation (“CFC”) under US law. Generally, a CFC is a non-US corporation of which 10 or fewer US persons directly or indirectly own over 50% of the voting shares or equity. Of some interest here is that companies formed in US territories (e.g. Puerto Rico, US Virgin Islands, Guam, etc.) are generally considered as non-US corporations under the CFC rules.
Amazon – Use of a Luxembourg Société en Commandite Simple (“SCS”) as a Hybrid
Amazon adopted a hybrid strategy in Europe – more particularly in Luxembourg. It set up an eligible entity (“Lux SCS” – which was roughly a Luxembourg limited partnership) in Luxembourg which was tax transparent in Luxembourg. Thus, the Lux tax consequences passed through to the US equity holders – essentially Amazon US. However, in Luxembourg these tax consequences were nil since Lux SCS had no PE in Luxembourg, that is, no bricks and mortar office in Luxembourg, no employees in Luxembourg, etc. Put differently, although non-residents of Luxembourg are subject to Luxembourg tax on Luxembourg source income, the lack of a PE effectively rendered the income from Lux SCS to Amazon US as non-Luxembourg source. To use our “light” analogy the lack of a PE meant that light flowed to Amazon US but carried no data that rang the tax cash register in Luxembourg.
But what about US tax? That’s where the hybrid treatment came in. For US tax purposes Amazon US, which owned Lux SCS , through check-the-box, elected to have the Lux SCS taxed in the US as a corporation. Hence, barring CFC problems, there would be no taxation to Amazon US until repatriation to the US of the income via actual distribution.
As noted CFC status generally creates current taxation for passive but not active income. Here the Lux SCS was a CFC and it received income in the form of intellectual property (IP) royalties which sounds passive. However there is an “active royalties” exception. Here Lux SCS functioned as an intangibles holding company and assisted in the ongoing development of certain intangible property used in the operation of the Amazon European websites through a buy in license and cost sharing agreement with Amazon US and other affiliates of the Amazon group. All seemingly enough to meet the active royalties exception.
Back to the EC Report – Transfer Pricing
In essence the EC report is that the royalties paid to Lux SCS by a related Luxembourg company were excessive, i.e. not justifiable under any lawful application of arm’s length pricing principles that could be expected between unrelated parties. Needless to say, in the Amazon case, the related Luxembourg company would have been subject to very high Luxembourg taxes had it not been able to reduce its taxable income by deducting the royalty payments to Lux SCS.
While the driver for the EC report was an attack on the Amazon Luxembourg transfer pricing analysis, the motivating factor for the Amazon structure was to take advantage of the hybrid “mismatch” between the US tax rules and those of Luxembourg.
The EC really had no power to undo the US check-the-box laws without an utter disregard for the sovereignty of the US. Hence, it arrived at its finding arguably based, on a somewhat technically unsound and largely irrelevant transfer pricing analysis.
However, the days of check-the box statutes-and hybrids for US corporations may be numbered because the Obama Administration as part of its 2016 budget has proposed that all profits accumulated over the years by US corporations and held in foreign subsidiaries be subject to an immediate 14% US tax whether repatriated to the US or not. And, prospectively, the Obama budget proposals call for an ongoing minimum 19% US tax on foreign subsidiary profits as earned regardless of repatriation. Stay tuned.
Robert Kiggins‘ finance practice is international in scope and involves clients in such diverse countries as Ireland, Argentina, Brazil, South Africa and Taiwan. He has gained extensive experience in corporate finance and tax matters involving securities broker-dealers, investment advisors, investment companies, life insurance companies, hedge funds, medical practice purchases and sales, insurance agencies and bank expansion into insurance and securities fields.