Arthur Andersen Article: Tax Challenges in Investing Cross Border

Any hospitality company contemplating a cross-border investment should begin by developing a tax strategy that reflects a careful examination of tax laws of the home country, host country and any intermediary countries. Each country's domestic tax law (including any special tax structures) must be considered. At the same time, however, tax treaties between the relevant countries may otherwise override the applicable tax law.

A hospitality investor who is confused by the complexity of international tax law must stay focused on a specific short-term and long-term strategy. For instance, an investor operating under a build-and -sell philosophy should implement a different tax strategy than an investor making buy-and-operate investments. An investor looking to sell property will be primarily concerned with the tax treatment of the capital gain. In contrast, an investor looking to operate the property will be primarily concerned with the tax treatment of operating profits. The tax analysis must be broad. To minimize tax exposure and thus improve overall investment returns, a tax analysis must cover three areas: the home country rules, any intermediary jurisdictions chosen because of preferential tax rules. and the country in which the investment is made. We begin at home.

Tax Issues in the Home Country
Although most sophisticated hospitality investors understand the tax laws of their own country, international investors must go one step further. They need to consider the application of those tax laws to income earned from sources outside the home country (i.e., foreign source income). Most countries tax foreign income differently than domestic income. Hong Kong. for example, exempts foreign source income from taxation. Other countries, including the United States, apply taxes only to the extent that income is taxed at a lesser rate outside the home country. Since foreign source income is generally given special treatment, the home country may restrict the ability of the investor to deduct expenses associated with foreign source income. Interest paid on debt incurred to make a foreign investment, for example. may not be deductible against domestic source income.

The hospitality investor should consider any special tax regimes of the home country and evaluate how the foreign source income will be treated for local country tax purposes. For instance, many U.S. investors strive to generate qualified capital gains to obtain a lower tax rate. Those U.S. investors are often surprised to learn that all of their gain from the sale of a foreign investment will be re-characterized as ordinary income from dividends. Alternatively, the hospitality investor may qualify for a tax exemption in the home country. In this case, maintaining the exemption and minimizing foreign country tax liability becomes a priority. For example, U.S. pension funds are allowed to earn passive income such as dividends, interest, rents, royalties and capital gains without incurring any U.S. tax. Those pension funds, however, are taxed on any active income. Therefore, qualifying the income of a U.S. tax-exempt pension fund as "passive" should be a pivotal requirement in the overall tax strategy of pension fund investors.

In many cases, the tax treatment of an item of income can be affected by what seem to be insignificant modifications in the terms of a contract. For example, franchise fees can be transformed from technical services to royalties with only a slight modification of the language in a franchise agreement. If the home country allows preferential tax treatment of foreign source income, royalties might be preferable since they are typically sourced according to where the intangible is used. In contrast, technical services are typically sourced according to the location where they are performed.

Generally, income earned by an entity formed outside the home country will not be taxed in the home country until it is distributed in the home country. Increasingly, however, home countries are enacting laws to tax income generated in tax haven jurisdictions as it is earned. Some countries-among them the United States-have adopted a system that taxes certain types of passive income (i.e., interest, rents, royalties, or capital gains) as it is earned. Other countries, such as Mexico, have adopted a system that taxes income earned from certain blacklisted countries, which are notorious tax havens. During 1996 and 1997, many Mexican companies were moving the domicile of their holding companies from "tax haven" jurisdictions, such as Bermuda, to "tax favored" jurisdictions, such as The Netherlands.

Holding Companies in Intermediary Countries
Hospitality investors may use intermediary holding companies located in jurisdictions that have preferential tax regimes. An intermediary holding company may effectively serve to block the income from accrual in the home country. In other cases, an intermediary holding company is used to obtain a preferential treaty benefit for interest, dividends, royalties or capital gains that would not otherwise be available between the home country and host country. For many years, investors used a Dutch holding company to make investments into the United States as a way to obtain a reduced rate of withholding on dividends and interest. For non-treaty investors, the United States levies a 30 percent withholding tax on payments of dividends and interest. The income tax treaty between the United States and The Netherlands provided for a 5 percent and 0 percent rate of withholding for dividends and interest respectively. Since The Netherlands generally allows for an exemption for dividends and capital gains, the popularity of The Netherlands holding company was tremendous. However, in 1993, the United States and The Netherlands entered into a new treaty, which limits the ability of investors to "treaty shop" into the United States via the Dutch holding company.

Tax Issues in the Host Country
Host country taxation-the location of the investment-will most likely represent the most significant tax cost to the hospitality investor. There are several reasons for this. As discussed above, first (and probably most significant), the home country will usually limit its taxation of income earned abroad. Second, the host country will probably not reciprocate any special tax privileges that the investor enjoys in its home country. For example, a pension fund that benefits from a tax-exemption in its home country will probably not be given the same tax-exempt status in the host country, unless a special treaty provision exists. Thus, the tax paid in the host country on profits earned will likely represent a significant tax cost.

To minimize the profits earned in the host country, the hospitality investor will want to push as many expenses into the host country as possible. For example, a hotel owner/operator may want to charge its host country subsidiary a royalty for having access to its name and worldwide reservation system. In addition, the hotel owner/operator may want to charge a management fee for strategic management services rendered by the home office.

To further minimize host country income tax liability, the investor should maximize the amount of debt incurred by the company holding the host country investment. The entire amount of interest paid on debt owed to a third party is typically deductible by the host country company, while deductibility of interest on debt owed to a related non-resident investor may be subject to limitations. As a result, the investor may want to fund a host country company mostly with debt acquired from a third party. In this way. the taxable profit of the host country company can be reduced by the entire amount of interest paid on the debt. If the interest at the time of distribution is subject to a low withholding tax by the host country, then the host country tax liability could be reduced overall. Because of the significant reduction in taxable net profits caused by the acquisition of debt, the host country typically limits the amount of debt in comparison to the amount of equity of the host country company where the debt is acquired from a related party. For example, if a U.S. pension fund were seeking to acquire the shares of a target company resident in the United Kingdom, that pension fund would want to loan some of the acquisition funds to a newly created acquisition company resident in the United Kingdom. Interest paid by the acquisition company would be deductible against the operating profits of the target company. while the interest income would be tax-exempt to the U.S. pension fund. The tax authorities of the United Kingdom would typically limit the interest deductions to an amount that is commercially feasible.

In some cases, interest deductions in the home country may reduce tax liability more than an interest deduction in the host country. In those cases, the hospitality investor might not want to incur a debt at the host country level. Rather, the investor might benefit most by borrowing in the home country and contributing funds as equity to a holding company located in the host country to be used for the investment. Factors to consider in acquiring debt include relative tax rates (including host country withholding), foreign currency issues, interest withholding tax, host country capital tax, home country controlled foreign corporation legislation and deductibility of interest in the home country.

Income earned by a non-resident of the host country in the form of dividends, interest, rents, royalties or capital gains will likely be subject to withholding tax at the time of payment to the home country. However, tax treaties may reduce the amount of withholding tax levied on the payment.

Most host countries will tax a non-resident hospitality investor on capital gains realized from investments in real estate - or investments in host country companies that primarily invest in real estate. Typically, the seller of the property or the company owning the property will have an obligation to withhold some percentage of the sales proceeds and remit them to the host country's tax authorities. To avoid host country capital gains, investors may want to use a holding company in an intermediary country to hold each host country investment. When the hospitality investor is ready to dispose of a host country property, the investor would sell its stock of the holding company in the intermediary country to another investor. The sale of the holding company stock will almost always avoid taxation of host county capital gains.

For example, if an investor resident in Hong Kong were to sell its investment in a wholly owned French company, the French tax authorities would levy tax on any capital gain realized on the sale. However, if the Hong Kong investor were to sell a Bermuda company that owned the shares in the French company, then French capital gains tax could be avoided. In this case, the purchaser of the property would inherit the capital gains. A well-advised purchaser, as a result, would discount the value of the French company accordingly, even though the discount is generally less than the tax savings. If the investor planned to operate the property, however, this strategy might be disadvantageous, if the income and expenses of separate properties could not be consolidated for host country tax purposes. Consider this example of a Canadian investor using a Dutch holding company to own the shares of several U.S. property companies. In this case, the loss-producing companies in the United States could not transfer their tax losses to the profit-making companies in the United States. To achieve consolidation, all of the U.S. companies would need to be owned by a single U.S. company. Any sales of the separate U.S. companies would be subject to tax in the United States.

Conclusion
Going cross border with any type of international investment, as a result, can be immensely complex from a tax perspective with participation in each country governed by a unique set of rules and regulations. Trade policies, tax treaties and domestic rules and regulations also change over time, often creating unexpected problems and opportunities for companies. Without question, hospitality organizations can limit their tax exposure and optimize revenue with careful cross-border planning. The time to start is before you make an investment or launch a development. A tax strategy should be part of the earliest planning phases when it comes to cross-border investments.

by W. Todd Garrett, W. Todd Garrett is a Senior Manager in the Dallas International Tax Services group.