The Education Jobs and Medicaid Assistance Act of 2010 ("H.R. 1586"), signed into law on August 10, 2010, enacted a number of new provisions impacting taxation of international operations. These new provisions primarily target foreign tax credit ("FTC") planning, with a particular emphasis on indirect credit planning by U.S. multinationals. Some of the provisions will also have relevance to portfolio companies of private equity funds. This Alert will cover five of the provisions: foreign tax credit splitters, covered asset acquisitions, the Section 956 hopscotch rules, Section 304 deemed redemptions and the repeal of the special rules for 80/20 companies.
To claim an FTC, a taxpayer must incur a liability for foreign tax. Current law treats foreign taxes as being paid by the person or entity with the legal liability to pay the tax, as determined by foreign law. In some situations, the person responsible for paying the tax is different from the person realizing the underlying income under U.S. tax rules. Taxpayers have affirmatively used this "technical taxpayer rule" by implementing structures designed to "split" foreign taxes from the related foreign income. In particular, a taxpayer in an excess limitation position can use splitters to increase the amount of its FTCs without having to take the related foreign income into account currently. For example:
• Foreign consolidation: Some foreign consolidation rules treat the consolidated parent as the person legally liable for the group's taxes, even though the income for U.S. purposes is recognized only by the subsidiaries.
• Hybrid and Reverse Hybrid structures: A foreign entity treated as a partnership for foreign tax purposes may elect to be treated as a corporation for U.S. tax purposes with the result that the owners are treated as the technical taxpayers entitled to claim FTCs for any foreign taxes imposed on the entity's income, even though the corresponding income is deferred in the foreign entity under U.S. rules. Splitting can also result without affirmative planning, often as a result of differences in the way U.S. and foreign tax rules interact. Unlike proposed regulations issued in 2006, which would have targeted only the planning techniques summarized above, the new legislation covers a broader range of transactions.
New Section 909
The new legislation is designed to match foreign taxes paid with the foreign income on which those taxes are imposed. If a foreign tax credit splitting event occurs, the foreign tax will not be treated as having been paid (and thus will not be creditable) until the year the related income is taken into account by the person who paid the tax. A "foreign tax splitting event" with respect to a payment of foreign tax will occur if the related income is (or will be) taken into account by a covered person. "Related income" is defined somewhat circularly as the income, calculated under U.S. rules, to which a foreign tax relates. A "covered person" includes a broad class of related persons and any other person as specified by the IRS.
The Joint Committee on Taxation report gives the following example of a splitting event, illustrative of the scope of the new provision.
U.S. Corp., a domestic corporation, wholly owns CFC1, a country A corporation. CFC1 wholly owns CFC2, also a country A corporation. CFC2 earns $100 of active income and issues a hybrid instrument to CFC1; the instrument is treated as equity for U.S. tax purposes but is treated as debt for country A tax purposes. Under the terms of the instrument, CFC2 accrues and deducts (but does not pay currently) $100 of interest owed to CFC1; CFC1 includes the same amount in income for foreign tax purposes. As a result, CFC2 has no income for country A tax purposes and CFC1 has $100 of income, taxed at a 30 percent rate by country A.
For U.S. tax purposes, even though CFC1 is still treated as the payor of the $30 tax, the accrued interest is ignored because the instrument is treated as equity, with the result that CFC2 has $100 of income and earnings and profits ("E&P") and CFC1 has no E&P. For purposes of claiming an indirect credit, CFC1 is treated as paying $30 of foreign tax, but it has no E&P for U.S. tax purposes. Under the new legislation, the $30 of tax paid by CFC1 is treated as related to the income earned by CFC2. Accordingly, U.S. Corp. will not be able to utilize the tax paid by CFC1 as an indirect credit until the related income is taken into account by CFC1. Presumably, this will occur when CFC2 makes an actual payment to CFC1, which U.S. tax law would view as a dividend.
In general, the new FTC splitter rules will be effective for foreign taxes paid or accrued in taxable years beginning after December 31, 2010. There is a special effective date rule applicable to taxes paid by a "Section 902 corporation" that would be eligible for the indirect FTC under Section 902. Under this rule, the new splitter provisions will apply to taxes paid by a Section 902 corporation prior to December 31, 2010 if such taxes would otherwise be taken into account after December 31, 2010. Taxpayers should consider causing their CFCs or other Section 902 corporations to declare a dividend (or undertake other repatriation transactions) to claim FTCs before January 1, 2011.
Due principally to the novelty of a regime that requires item-by-item tracing of taxes to income, a number of open questions exist as to how these new rules will be applied. The legislative history indicates that mere timing differences resulting from normal tax accounting differences between U.S. and foreign tax rules are not intended to give rise to foreign tax splitting events. However, it is unclear as to whether timing differences will be a broad safe harbor, or whether the legislative history was simply confirming that timing differences within an entity resulting in a split are not covered by Section 909. In addition, it remains unclear how the IRS will define what is a normal timing difference and what is taxpayer-driven postponement. Further, it is unclear how Section 909 will be applied to group returns: when one subsidiary has earnings and another has losses, when do the losses become part of the related income? Also, will transfer pricing differences create foreign tax splitting events?
Taxpayers will need to keep track of additional tax attributes whenever a foreign tax splitting event occurs, in order to track both foreign taxes and related income so that they may claim a foreign tax credit when the related income is taken into account. As a precedent, the existing tracing rules for pre-1986 credits provide some insight into how the IRS may approach the mechanics. The IRS has indicated that it expects to issue guidance under Section 909 before the end of 2010.
Reduction of Foreign Tax Credits In Covered Asset Acquisitions
Taxpayers can step up the basis of assets in connection with certain transactions that do not give rise to a step-up under foreign law. This is commonly achieved by making a Section 338(g) election with respect to the qualified stock purchase of a foreign target; a similar result can be achieved using a Section 754 election for the purchase of a partnership interest. One benefit of making a Section 338(g) election for a foreign target is that the election, by deeming a sale of assets to occur to a new target, wipes out the target's E&P history and other tax attributes. The buyer therefore does not take historic E&P into account, and can avoid the often burdensome task of reconstructing the E&P history of a corporation that may never have kept records capable of being reconciled to U.S. E&P accounting principles.
Another benefit of making the election is that the resulting discrepancy between U.S. and foreign tax basis can result in enhanced FTC benefits. A U.S. corporation that owns at least 10 percent of the shares of a foreign corporation can claim a deemed paid foreign tax credit under Section 902 for foreign taxes paid by that foreign corporation on the E&P out of which a dividend is paid (or a subpart F inclusion is made). If a Section 338(g) election is made for the foreign target, the depreciable basis of the foreign assets will generally be higher for U.S. tax purposes than for foreign tax purposes, and foreign net income will be higher than the net income and E&P as calculated for U.S. tax purposes. The effect is to "turbocharge" FTCs, where more foreign taxes are creditable than would be if a Section 338(g) or Section 754 election had not been made.
New Section 901(m)
The new legislation will limit the foreign tax credit in the case of any "covered asset acquisition," including (a) the qualifying purchase of a corporation's stock that is treated as a purchase of assets through a Section 338(g) election, (b) the purchase of a partnership interest resulting in a proportionate part of the partnership's assets receiving a fair market value basis through a Section 754 election, (c) any transaction treated as the acquisition of stock for foreign income tax purposes but treated as the acquisition of assets for U.S. tax purposes and (d) any other similar transaction to the extent provided by the IRS. The new legislation does not eliminate Section 338(g) and Section 754 elections with respect to foreign targets, but instead denies a portion of the FTCs attributable to the step-up. The disqualified portion of foreign income taxes is equal to the ratio of aggregate basis differences allocable to such year with respect to all relevant foreign assets, divided by the income on which the foreign income tax is determined. The basis difference, calculated under U.S. rules, is the adjusted basis of assets after a covered asset acquisition over the adjusted basis of assets before the acquisition.
The covered asset acquisition rules make it less beneficial to make a Section 338(g) (or Section 754) election. However, because the provision is limited to reducing FTCs, the other benefits of making a Section 338(g) election remain. Particularly for private equity buyers, who generally cannot use indirect FTCs, the new legislation is not expected to change behavior.
Because the legislation does not preclude making an election with respect to a foreign target, following a Section 338(g) election the basis of the foreign target's assets will be stepped up. Thus, the foreign target's E&P will be reduced by enhanced depreciation deductions. A U.S. buyer can cause a profitable foreign subsidiary to acquire the foreign target and make a Section 338(g) election for the target. If the target is subsequently liquidated for U.S. tax purposes (e.g. by making a check-the-box election), its enhanced basis, depreciation and amortizations deductions flow to the foreign subsidiary purchaser. The additional basis provided by the Section 338(g) can still reduce U.S. taxable income, even if it no longer provides for turbocharged FTCs.
It remains to be seen what transactions, other than those specifically identified in the legislation, the IRS will decide should be covered by this new provision. For example, when a Section 338(g) election cannot be made for a foreign target, it is not uncommon for a U.S. acquirer to create two foreign subsidiaries to purchase foreign target stock, and then liquidate the target in a taxable liquidation. The result is a basis step-up without the incurrence of foreign tax, the same result that the new legislation targets. It is unclear whether this transaction is covered by the terms of the legislation, but it likely would be covered when and if the IRS issues regulations, at least where the liquidation is effected by a check-the-box election made pursuant to a plan in existence at the time of the acquisition.
Unless it is indifferent to FTCs, a buyer that makes a Section 338(g) election will have to compute the allocable basis difference each year to determine the disqualified portion of foreign taxes. Purchasers of foreign targets will need to increase their diligence budgets, because the purchaser will need to apply U.S. tax principles to compute the foreign target's historic asset basis and such numbers may not have been relevant or available before the purchase.
Section 909(m) will be effective for covered asset acquisitions occurring after December 31, 2010, with transition rules limiting the application of Section 909(m) to certain transactions announced or entered into prior to December 31, 2010. Making a 338(g) election used to be a relatively easy decision for buyers of foreign targets, but now buyers will have to weigh the more limited benefits of covered asset acquisitions with the bookkeeping nightmare that such acquisitions will create.
Limits on Deemed Paid Foreign Taxes Accessed Via Section 956
Section 956 requires a U.S. shareholder of a controlled foreign corporation (a "CFC") to include in income its share of the CFC's investment in U.S. property. An investment in U.S. property includes a loan made by the CFC to a related U.S. person, as well as the CFC's guarantee or pledge of a third-party loan to a related U.S. person.
A U.S. parent may use Section 956 affirmatively to selectively pull up deemed paid FTCs, particularly from high-taxed CFCs, without the need for the CFC to pay an actual dividend (which might be subject to foreign withholding tax). This technique takes advantage of the manner in which Section 956 operates, commonly known as the "hopscotch rule." Under the prior statutory scheme, the U.S. parent's inclusion, as well as the amount of FTCs brought up, is calculated as if the CFC declared a dividend directly to the parent, "hopscotching" around any higher-tier foreign subsidiaries between the CFC and the U.S. parent.
The new provision will eliminate the benefit of the hopscotch rule by deeming a CFC (that makes an investment in U.S. property) to pay a dividend up through an intervening chain of higher-tier CFCs if the result would be a reduction in the amount of the deemed paid FTC. It does this by limiting the amount of foreign taxes deemed paid to the lesser of the foreign taxes deemed paid with respect to the investment in U.S. property as currently calculated (the "tentative credit") and the amount of foreign taxes deemed paid calculated by assuming the Section 956 inclusion had been distributed through the foreign ownership chain of the entity investing in U.S. property (the "hypothetical credit"). Taxpayers will therefore be required to do a separate calculation to compute the amount of FTCs brought up by a Section 956 investment.
The new provision will apply to investments in U.S. property made after December 31, 2010. After that date, the ability of taxpayers to take advantage of the hopscotch rule to maximize their FTCs by selectively repatriating income from high-taxed foreign subsidiaries will be limited. There is no upside for taxpayers in this provision; taxpayers get the lesser of the two calculations and must deal with the burden of making both calculations before determining their FTCs for a year and keeping track of disallowed credits and presumably any deficits that reduced the Section 956 inclusion. Taxpayers who wish to use Section 956 affirmatively should therefore plan to do so before the end of this year.
New Rules for Certain Section 304 Deemed Redemptions
Under Section 304, if a subsidiary corporation purchases stock of its parent, the purchase is recast as a distribution in redemption of the stock of the acquiring corporation, normally giving rise to a dividend out of the acquiring corporation's E&P to the seller. Foreign controlled groups have made use of Section 304 to address a problem that arises when a foreign corporation acquires a U.S. target that owns a subsidiary that is a CFC. Using Section 304, the CFC can purchase stock of its U.S. parent from a foreign grandparent, pulling earnings out of the CFC directly to the foreign grandparent, without such earnings passing through the U.S. parent and becoming subject to U.S. tax.
Under the new provision, found in Section 304(b)(5)(B), the E&P of an acquiring CFC in a Section 304 transaction will not be taken into account if more than 50 percent of the dividend that would arise from the transaction would not be subject to tax. The unreduced E&P will remain available to support taxable dividends from the CFC to its U.S. parent if and when the CFC actually pays a dividend to its U.S. parent. The effective date of this provision is August 10, 2010.
To the extent the "sales proceeds" in a Section 304 transaction exceed an acquiring CFC's E&P, such excess is treated as a dividend to the extent of the target's E&P. The portion of the 304 dividend treated as sourced from a U.S. target may be subject to U.S. withholding tax. If the 304 dividend is subject to a 30 percent U.S. withholding tax, this portion of the dividend should be considered "subject to tax" for purposes of Section 304(b)(5) (B). But what about the situation where the dividend is subject to a reduced treaty rate of 0 percent? If still considered "subject to tax" under Section 304(b)(5)(B), then a narrow exception to Section 304(b)(5)(B) would exist.
For example, assume a simple structure where foreign grandparent wholly owns U.S. parent, which wholly owns CFC.
Further assume that CFC has $45 of E&P and U.S. parent has at least $55 of E&P that would be subject to a 0 percent withholding rate if distributed to foreign grandparent.
If CFC purchases $100 of U.S. parent stock from foreign grandparent, $45 of the deemed 304 dividend will be treated as coming from CFC and $55 from U.S. parent. Arguably, new Section 304(b)(5)(B) does not apply to this transaction, because the $55 deemed dividend from U.S. parent would be more than 50 percent of the total 304 dividend, and such dividend is "subject to tax" (even though no tax is in fact incurred).
The result would be that the E&P of CFC is eliminated without incurring any U.S. tax. Even if the treaty withholding rate were greater than 0 percent, taxpayers might still benefit from such a 304 transaction.
80/20 Company Rules Repealed
Interest paid by a domestic corporation meeting an 80 percent active foreign business test (an "80/20 company") was treated as foreign source income and was generally exempt from U.S. withholding tax if the interest was paid to an unrelated party. Dividends paid by an 80/20 company were partially exempt from U.S. withholding tax.
Subject to a fairly extensive grandfathering exception, interest paid by 80/20 companies will no longer be treated as foreign source income, and dividends will no longer be partially exempt from U.S. withholding tax.
Companies that currently own an 80/20 company should review the details of the transition rule to determine if such company still qualifies as an 80/20 company thereunder.
Published November 2, 2010.