M E M O R A N D U M
June 1, 2009
TO: Distribution
FROM: Burt, Staples & Maner LLP
RE: GlaxoSmithKline Case Shows Importance of Withholding Tax Issues
The IRS has made cross-border withholding taxes a Tier I issue and has said it will focus on these issues as never before. A recently published Tax Court petition filed by the U.S. group of GlaxoSmithKline shows how an IRS determination on the merits of a transaction can lead to substantial increases in withholding tax, interest and penalties.
As part of the merger of GlaxoWellcome with SmithKlineBeecham at the end of 2000, a Swiss affiliate of GlaxoWellcome exchanged its 100% ownership of GlaxoWellcome’s U.S. operations for new shares in the combined GlaxoSmithKline U.S. holding company and $13.5 billion in deferred payments. The payment schedule called for seven annual payments of $500 million and a final $10 billion payment in 2008.
For U.S. tax purposes, the new U.S. holding company treated the deferred payment arrangement as an original issue discount (“OID”) obligation and took deductions for OID of about $500 million per year in 2002 and 2003 (and somewhat less in 2001). The U.S. holding company did not withhold U.S. tax on the payments to the Swiss affiliate.
The IRS asserts that the payments by the U.S. holding company during 2001-2003 should be considered dividends, eliminating the OID deductions. The IRS also has held the U.S. holding company liable for withholding tax on the “dividends” at a 5% rate, apparently under the U.S.-Switzerland tax treaty. The withholding tax due is allegedly $75 million, not including penalties and interest.
The withholding tax issue gains even more prominence in the later years of the deal. If GlaxoSmithKline continued in 2004-2008 to not withhold U.S. tax, and the IRS were to assert that all $13.5 billion paid were dividends subject to withholding at 5%, the deficiency in withholding tax alone, not including interest and penalties, would be $675 million. By comparison, GlaxoSmithKline’s 2008 annual report estimates that, if the IRS’s position is sustained for all eight years of the structure, the total amount of tax (income and withholding), penalties and interest would be approximately $1.9 billion “net of federal tax relief.”
The GlaxoSmithKline case demonstrates that it is critical to understand the potential withholding tax and information reporting implications of alternative interpretations of transaction structures, and to factor those risks into the analysis. It is important to know what can happen if the IRS recharacterizes a transaction (not only on the debt-equity issue), and to consider alternatives that reduce or eliminate potential withholding tax exposure while still achieving the parties’ other goals. Such issues may materially affect the economics of the transaction.
We have advised on numerous cross-border transactions and can assist clients evaluating international transaction structures.