The Crossborder Tax Solution

?Falling share prices, commodity volatility and the continued demand for energy appear to be driving consolidation in the oilfield sector. Multiples have recently dipped from low double-digit numbers to single digits for many companies. Until the smoke clears from the credit crisis, low valuation multiples will likely remain. Those low multiples will entice many players to consolidate, and due to the fragmented nature of the industry and the availability of targets, acquisitions will continue.

The oilfield industry is highly fragmented and geographically diverse. There are thousands of companies in the U.S. alone. For many would-be U.S. target companies, prospective buyers are located abroad as well. Private transactions and joint ventures also frequently draw investors from multiple jurisdictions. Acquisitions frequently involve target companies and assets in non-U.S. jurisdictions.

These crossborder transactions suffer from increased complexity, adding to the risks and rewards of undertaking them. Avoiding risks means buyers must be aware of some of the common issues arising in such transactions.

Further, whether buyers succeed in fulfilling their strategic objectives in crossborder acquisitions depends in no small part on how successfully they implement an effective acquisition structure. Obviously, any crossborder transaction implicates a plethora of tax issues and related regulatory concerns, which influence the form of acquisition structure.

There are generally two types of crossborder acquisition structures. The first follows the organic flow of property, services, cash flow and product flow throughout the business. Oftentimes, however, companies utilize “synthetic” flows to create tax or regulatory advantages within those different jurisdictions.

Common issues

The acquisitive activity currently under way is far from a free-for-all. Potential buyers are being very selective in their efforts to ensure that target entities are complementary to their corporate and strategic objectives. Sophisticated buyers understand the critical role proper due diligence and effective structuring play in that process.

Multiple layers of taxation and capital restrictions. The tax impacts on the oilfield industry are somewhat unique when compared with that of other multinational businesses. The industry has little freedom to choose the locations in which to conduct much of its business. Extraction can only occur where resources exist and where extraction activity is permitted.

Extracted product must then be transported to a market that typically does not exist in the country of extraction. Since many reserves are restricted by federal and state government policies—something unlikely to change for the next four years—accessible oil and gas reserves are increasingly outside the U.S.

Those remaining reserves within the U.S. are the target of non-U.S. buyers taking advantage of currency fluctuations and, until recently, the relative stability of the U.S. market. Thus, even many domestic transactions are subject to taxing regimes of several countries.

In particular, regardless of jurisdiction, tax rules create the most common, and significant, risk that an income stream will be subject to multiple layers of taxation. Buyers must therefore be aware of this when evaluating an opportunity and make the potential use of a tax-advantaged holding-company structure part of their acquisition due diligence.

One of the most common potential tax issues involves a buyer and a target company in two different countries. There is often potential for double taxation on the same income stream because one country may view an income stream differently than the other country, creating the risk of taxation in both jurisdictions.

Multiple layers of taxation can also occur with withholding taxes on payments of dividends and interest. Recipients of those dividends are then subject to taxation in their own jurisdiction (e.g., Subsidiary A in Country A pays withholding tax to Country A on dividend paid to Parent B in Country B and Parent B pays income tax in Country B).

As a part of the due-diligence process, therefore, it is important to understand how funds move through the target organization. This “flow-of-funds” analysis will serve as the basis for the creation of a tax-advantaged holding-company structure, since such “synthetic” structures rely on the use of various jurisdictions to alter the “organic” flow for a tax or regulatory advantage.

nother common issue for targets is the build-up of funds in a jurisdiction due to capital expatriation restrictions in the target country. This is the case in many developing countries with highly restrictive banking regulations designed to prevent capital flight. Careful planning can often leverage this cash by allowing for expatriation or use of funds to secure financing outside the target country.

Oftentimes buyers may find sophisticated legacy tax planning where target entities have used creative financing structures to allow for deductions in one country without a corresponding withholding or income tax in the recipient jurisdiction. This means the buyer may need to establish a special-purpose acquisition company or establish an intermediary holding company in a third jurisdiction to either preserve the existing structure or conform that structure to the buyer’s existing arrangements.

This is the case, for example, where the buyer’s parent is organized in a jurisdiction blacklisted as a tax haven by the target country’s government. Payments to such blacklisted countries may be singled out for severe tax treatment and/or restrictions on capital expatriation.

Transfer pricing. Transfer pricing implicates how a company prices those transactions between each of its affiliated companies in different jurisdictions. Proper transfer pricing involves substantial tax planning and significant risk. Oftentimes, because of the quick pace of due diligence, buyers are not allowed sufficient time to properly evaluate the target’s transfer-pricing structure.

Different jurisdictions often do not agree on the transfer-pricing method the target has used, resulting in not only competing post-closing adjustments in different jurisdictions for the same transaction, but litigation costs in those jurisdictions due to disputes with taxing authorities. It is important that the buyer and the seller plan for the integration of transfer-pricing regimes.

Permanent establishment. A company’s presence, even temporarily, in a jurisdiction can sometimes subject it to various taxes there. If a company has a presence in a jurisdiction for long enough or of the right type—even if it is only by virtue of the presence of equipment—that presence can create “permanent establishment.” Permanent establishment is a significant taxable presence in a jurisdiction, subjecting a company to the full burden of the host country’s tax regime.

This is a common issue in oilfield acquisitions due to the large number of mobile assets, including people. In many cases, a target’s field personnel do not communicate with their tax and accounting cohorts, so such issues do not show up on the target’s financial statements. To further exacerbate this issue, field personnel who a purchaser needs to access to determine whether the target company should have paid tax in each of those different regimes are often in far-flung corners of the world.

The real key in any of the foregoing scenarios is an understanding of the organic flow of funds in the target company versus where buyers and investors want cash to wind up. The acquisition team must model possible structures as part of the due diligence process to accomplish the investor or buyer’s goals.

The non-U.S. holding company

The use of offshore holding companies in a multinational corporate structure can reduce tax inefficiencies for multinationals that desire to reinvest cash from non-U.S. subsidiaries. Under the most basic holding-company structure, non-U.S. operating subsidiaries are held by a holding company in an appropriate jurisdiction. That holding company may be owned by a U.S. parent or individual shareholders.

Under other circumstances, the ultimate parent may be in a favorable jurisdiction with operating subsidiaries in the U.S. and other jurisdictions, with the stock being held by both U.S. and non-U.S. shareholders. The structure itself will depend on the individual situation of the particular company or investor group. The principal benefits of a successfully implemented structure are that non-U.S. operating income can be reinvested abroad without being taxed in the U.S. and, upon repatriation, the minimization of U.S. taxes.

The key to choosing a jurisdiction in which to organize a holding company is to use a jurisdiction that has treaty relationships that minimize or eliminate withholding taxes on dividends paid by operating subsidiaries; impose little or no tax on the receipt of dividends or little or no withholding tax on dividends paid to a U.S. parent or shareholder; or minimize or eliminate withholding taxes on certain payments to affiliated non-U.S. finance companies.

It may be necessary to create intermediary holding companies between the ultimate parent and operating subsidiaries to take advantage of favorable tax treaties and reduce or eliminate the overall effective tax rate on income.

Use of finance and royalty company structures. One significant market development spurring domestic acquisition activity in the oilfield sector is the rise of foreign buyers. For example, as onshore oil and gas production from conventional sources continues to decline in the U.S., competition for acreage in an effort to secure unconventional sources, such as gas from shales, coalbed methane and tight sands, has become heated, and involves numerous non-U.S. competitors and investors.

For investments made in the U.S. from countries with which the U.S. does not have a tax treaty, investing through a Hungarian corporation may be a very effective tax-minimization tool. For legitimate business reasons, many existing non-U.S. holding companies are in so-called tax-haven jurisdictions with which the U.S. does not have a tax treaty, such as Panama and Bermuda.

Dividends paid from a U.S. operating subsidiary to the parent company in a non-treaty country are subject to a 30% withholding tax. Under the U.S.-Hungary tax treaty, dividend withholding, for example, is reduced to only 5% when the recipient owns at least 10% of the stock of the U.S. company. These treaty benefits are available even where the ultimate owners are not Hungarian or U.S. residents.

A non-U.S. taxpayer, including legal entities such as corporations with some U.S. shareholders, may be able to eliminate U.S. withholding tax on payments outside the U.S. by financing acquisitions with debt instead of equity.

Current U.S. treaties with Hungary, Norway and Poland completely exempt U.S.-source interest and contingent interest from U.S. withholding tax. Assuming the underlying instrument is respected as debt by the IRS, this structure potentially allows a non-U.S. taxpayer to receive dividend-like payments in the form of deductible interest—unlike non-deductible dividends—on a tax-free basis.

When using such jurisdictions, investors must also consider local taxes. For example, Hungary’s current corporate income tax rate is 16%. To lower this tax, investors may use a finance branch office in a third, low-tax jurisdiction to reduce the local tax in Hungary. For example, Hungary has treaties with jurisdictions such as Ireland, Luxembourg and Switzerland. All of these countries have favorable finance-branch regimes that can have an effective tax rate as low as 2%.

This result is obtained by allocating the debt held by the Hungarian company “home office” to the branch in the third country’s jurisdiction. This allocation to the branch office exempts the interest income from corporate tax in Hungary.

A non-U.S. holding company, therefore, could, by way of example, indirectly finance the acquisition of properties in Texas through debt issued by a Hungarian affiliate, and dramatically reduce payments made on that debt since they could be characterized as “return of principal” and “exempt interest payments.” The Hungarian lender could then reduce or eliminate Hungarian taxes by allocating the original debt to a foreign branch office.

Similar results can be obtained through the use of licensing structures for intangible property. U.S. tax treaties with Greece, Hungary, Norway and Pakistan completely exempt U.S.-source royalties from U.S. withholding tax. Thus, the same investor above could also hold intangibles in its Hungarian corporation and then license the property to the U.S. in exchange for royalty payments.

The royalty payments from the U.S. to Hungary would be exempt from U.S. withholding tax and subject to a rate of only 8% in Hungary. As with the interest income, the intangibles and royalties may be allocated to a branch office in a third country and result in a similar reduction in Hungarian tax. The end result, again, is a significant reduction in the overall effective tax rate for the company’s income.

For companies with multinational operations outside the U.S., there are a number of holding-company jurisdictions that provide significant advantages, depending on the circumstances of the particular transaction. Luxembourg, for example, is frequently used in European operations since it has a treaty network with many countries—increasing the amount of possible planning opportunities. After obtaining a ruling, a Luxembourg holding company can exempt foreign-source dividend and capital-gains income from domestic taxation.

Cyprus is often considered one of the best holding-company jurisdictions from a pure tax perspective and is ideal for use by U.S. investors making investments in numerous third countries. Cyprus, however, remains on the blacklist of some countries, such as Russia, subjecting it to unfavorable tax treatment.

Sometimes this blacklist status depends on the nature of the business being conducted there. For example, Poland blacklists financial or administrative services performed in Cyprus. While the rules for blacklisting are sometimes ambiguous and a country’s presence on a blacklist completely arbitrary, it is a frequent trap for the unwary and warrants examination in a multi-jurisdictional structure.

The lesson here is that opportunities abound for highly effective planning, but investors must find the right fit for their transactions.

The silver lining to the current economy, for those who believe in buying low and selling high, is that there is an imminent opportunity for strategic acquisitions. Careful planning and thoughtful due diligence will allow healthy companies to lay the groundwork for success when the market rebounds.

Aaron Ball is a Houston-based attorney with Looper, Reed & McGraw who focuses on international transactions and planning for the oilfield and manufacturing industries.