International Tax Provisions in the Education Jobs and Medicaid Assistance Act of 2010
On Tuesday, August 10, the House passed and the President signed the Education Jobs and Medicaid Assistance Act of 2010 (H.R. 1586, the “Act”). The Senate passed H.R. 1586 on August 5, 2010.
The essence of the bill is funding for Medicaid and education which is paid for with a set of international tax provisions. The provisions will generally be effective either for tax years beginning after the date of enactment or tax years beginning after December 31, 2010.
Many of the “loophole closers” included in the bill as revenue offsets would modify existing international tax provisions related to the foreign tax credit, subpart F, and repatriation. Some of these provisions were expected, some unexpected. The international tax provisions are discussed below.
I. Tax Credit Splitting
The bill includes a provision that would delay the recognition of foreign tax credits until the related income is taken into account for U.S. tax purposes. This suspension rule would apply when there has been a “foreign tax credit splitting event,” which occurs when one person pays the foreign income tax and another person, related to the payor of the foreign taxes (including through a 10% ownership interest, by vote or value), takes the income into account under U.S. law. In such case, the foreign taxes will not be taken into account by the taxpayer until the related income is also taken into account by the taxpayer for U.S. federal income tax purposes. This provision would apply to group relief in the U.K. which is evidently considered a foreign-tax credit splitting event. The substance of the provision is similar to regulations proposed in 2005 but never finalized.
The provision also applies to foreign income taxes paid or accrued by a section 902 corporation in taxable years beginning on or before December 31, 2010 (and not deemed paid under section 902(a) or section 960 on or before such date), but only for purposes of applying sections 902 and 960 with respect to periods after such date (the “deemed-paid transition rule”). Accordingly, the deemed-paid transition rule applies for purposes of applying sections 902 and 960 to dividends paid, and inclusions under section 951(a) that occur, in taxable years beginning after December 31, 2010. However, no adjustment is made to a section 902 corporation’s earnings and profits for the amount of any foreign income taxes suspended under the deemed-paid transition rule, either at the time of suspension or when such taxes are subsequently taken into account under the provision.
One such tax splitting structure was illustrated in Guardian Industries Corp v. U.S. as follows:
- Tax Splitting Technique
- Lux Holdco checks the box for U.S. tax to be disregarded entity
- Lux Holdco and operating companies file group return in Luxemburg reporting operations of group
- Lux Holdco pays tax and is deemed the legal obligor under Lux Law
- Since Lux Holdco is disregarded, U.S. Parent is deemed to pay tax
- Lux profits are not taxed in U.S. until distributed to Lux Holdco or otherwise repatriated or deemed repatriated to U.S.
- U.S. parent has foreign tax credits available to offset U.S. tax on other low tax foreign source income.
II. Limitation on Foreign Taxes Deemed Paid with Respect to Section 956 Inclusions
If a U.S. corporation includes an amount in income under section 956 because a lower-tier controlled foreign corporation has made an investment in U.S. property, the U.S. corporation is treated as if it received a direct dividend from the lower-tier subsidiary (and, for foreign tax credit purposes, is deemed to have paid foreign taxes paid by such subsidiary). Thus, under current law, the dividend (and the associated foreign taxes) “hopscotches” over any upper-tier foreign corporations that reside in the chain between the lower-tier controlled foreign corporation and the U.S. corporation, avoiding a blending of tax rates with any such foreign corporations that are located in low-tax jurisdictions. The bill prevents this result by providing that the amount of foreign taxes deemed paid by a U.S. corporation with respect to any section 956 inclusion will not exceed the amount of foreign taxes that would have been deemed paid if the amount of such inclusion was distributed in cash through the chain of entities to the U.S. corporation (determined without regard to any foreign taxes that would have been imposed on an actual cash distribution). Treasury is directed to issue such regulations as are necessary or appropriate to carry out the purposes of these rules, including to prevent the inappropriate use of the foreign income taxes not deemed paid. This provision would apply to acquisitions of U.S. property after December 31, 2010.
- CFC 1 has earnings and profits (E&P) of $100,000 and tax credits of $10,000
- CFC 2 has E&P of $100,000 and tax credits of $30,000
- CFC 2 has loan to U.S. parent which is treated as an investment in U.S. property under 956
- U.S. Parent records $130,000 of income including $30,000 gross up for tax and takes a FTC of $30,000
- New Provision IRC Section 960(c)
- IRS would limit the amount of foreign taxes deemed paid under IRC Section 960 to the amount that would have been deemed paid had the income of the lower tier subsidiary been paid as a dividend through the chain of ownership
E&P Foreign Tax CFC 1 $100,000 $10,000 CFC 2 $100,000 $30,000 $200,000 $40,000
- If CFC 2 had paid $100,000 dividend to CFC 1, the E&P of CFC 1 would be increased to $200,000 and would have available $40,000 of foreign taxes
- If CFC 1 had the paid the $100,000 to U.S. Parent, the deemed credit would be limited to $20,000
III. Foreign Tax Credits in the Context of Covered Asset Acquisition
The bill would limit U.S. taxpayers’ ability to claim foreign tax credits when engaging in certain acquisitions that result in a tax basis step-up for U.S. federal income, but not foreign, tax purposes (a “covered asset acquisition”).
- Denial of Foreign Tax Credits with Respect to Foreign Income Not Subject to U.S. Tax by Reason of Covered Asset Acquisitions
- Covered asset acquisitions include:
- qualified stock purchases to which Section 338 applies
- any transaction treated as an asset acquisition for U.S. tax purposes and as a stock acquisition (or is disregarded) for foreign tax purposes of the relevant tax jurisdiction
- an acquisition of an interest in a partnership that has an election under Section 754 in effect
- or to the extent provided by the IRS
- Covered asset acquisitions include:
In effect, a covered asset acquisition is where there is a step up in basis of assets for U.S. tax purposes but not foreign tax purposes whereby the foreign income recomputed under U.S. tax rules for purposes of computing foreign source income will be reduced by the amortization or depreciation of the stepped up basis
- U.S. corporation acquires 100% of foreign corporation and makes a check-thebox election to treat the acquisition as an asset acquisition for U.S. tax purposes
- Assets had zero basis in hands of foreign corporation and are stepped up to $1,500 attributable to good will
- For U.S. tax purposes, the good will is amortizable over 15 years or $100 per year
- Year 1 foreign corporation has net income before tax of $150 and a 30% foreign tax rate
- Assume U.S. tax rate also 30%
|Foreign Jurisdiction Income||U.S. Income|
|NI Before Tax and amortization||150||150|
|Amortization of Good Will||0||100|
- The U.S. corporation would report $50 income from year 1 operations of foreign corporation and would have a $45 foreign tax credit to offset U.S. tax on the $50 of foreign source income and other low tax foreign source income
- Under new Section 901(m) the tax attributable to the $100 of amortization resulting from the difference in basis between U.S. and foreign would be disallowed (30% of $100 = $30) and the U.S. corporation would have $15 foreign tax credit
- The taxpayer would be allowed a deduction for the unallowed foreign tax credit
In general, the provision is effective for covered asset acquisitions after December 31, 2010. However, the provision does not apply to any covered asset acquisition with respect to which the transferor and transferee are not related if the acquisition is (1) made pursuant to a written agreement that was binding on January 1, 2011, and at all times thereafter, (2) described in a ruling request submitted to the IRS on or before July 29, 2010, or (3) described in a public announcement or filing with the SEC on or before January 1, 2011.
For this purpose, a person is treated as related to another person if the relationship between such persons is described in section 267 or 707(b).
IV. Certain Redemptions by Foreign Subsidiaries
Under section 304, a sale of stock between related parties may be treated as a deemed distribution instead of a sale for U.S. federal income tax purposes. For example, if a parent corporation (“Parent”) sells stock of its first-tier subsidiary (“Issuing Sub”) for cash to a subsidiary of Issuing Sub (“Acquiring Sub”), the transaction generally would be treated as a distribution of cash from Acquiring Sub to Parent. In general, the distribution would be treated as a dividend first to the extent of the earnings and profits of Acquiring Sub and then to the extent of the earnings and profits of Issuing Sub. The bill would modify section 304 for certain transactions involving a foreign acquiring corporation (i.e., Acquiring Sub in the above example). Under this provision, the foreign acquiring corporation’s earnings and profits would not be taken into account for purposes of applying section 304 if more than 50% of the deemed dividend would not (i) be subject to federal income tax in the year of the stock sale or (ii) be includible in the earnings and profits of a controlled foreign corporation. The provision is designed to prevent a direct deemed dividend from a foreign lower-tier subsidiary (Acquiring Sub) to a foreign parent corporation that bypasses a U.S. upper-tier subsidiary (Issuing Sub). The earnings and profits would remain preserved in the Acquiring Sub, and therefore would be subject to subsequent inclusion by the U.S. upper-tier subsidiary. This provision would be effective for acquisitions after date of enactment.
- New provision in the case of an acquisition to which section 304 applies in which the acquiring corporation is foreign, no E&P will be taken into account if more than 50% of the dividends arising from the transaction would not be subject to tax or be included in the E&P of the acquiring foreign corporation
V. Foreign Tax Credit Limitation on Income Resourced Under Treaties
Many U.S. tax treaties resource income to a foreign source to allow U.S. tax payors to obtain a U.S. foreign tax credit for income that would otherwise be considered U.S. source and ineligible for foreign tax credits.
The Act provides that the direct and indirect foreign tax credit provisions will be applied separately (in a new “basket”) with respect to each item of income that would be U.S. source but for the taxpayer choosing the benefits of a U.S. treaty that treats such item as foreign source. This provision is in response to a concern that taxpayers are shifting income-producing assets from U.S. corporations to foreign disregarded entities located in treaty jurisdictions, with the result that the foreign jurisdiction taxes the associated income at low rates and the taxpayer is permitted to treat the entire amount of the income as foreign source under the applicable treaty. The Act allows Treasury to issue regulations, including regulations which provide that related items of income may be aggregated for purposes of these rules.
The provision would apply to taxable years beginning after the date of the Act’s enactment.
VI. Repeal of the “80/20” Rules
Under current law, interest paid by a U.S. corporation that, during an applicable period, derives at least 80% of its gross income from foreign sources in an active business conducted offshore (an “80/20 Corporation”) is foreign source, and therefore not subject to U.S. withholding tax. In addition, dividends paid by an 80/20 Corporation are exempt from U.S. withholding tax to the extent attributable to foreign source income, although the dividend remains U.S. source. The bill would repeal these 80/20 rules for taxable years beginning after December 31, 2010 (subject to certain grandfathering provisions).
The repeal of the 80/20 company provisions relating to the payment of interest does not apply to payments of interest to persons not related to the 80/20 company (applying rules similar to those of section 954(d)(3)) on obligations issued before the date of enactment. For this purpose, a significant modification of the terms of any obligation (including any extension of the term of such obligation) is treated as the issuance of a new obligation.
VII. Correction to Statute of Limitation in HIRE Act
Commentators have pointed out that an unintended effect of the HIRE Act was to possibly extend the statute of limitations for a taxpayer’s entire return if the taxpayer fails to file certain forms related to cross-border transactions. The Act would make technical corrections to the provision to clarify that the statute will be tolled if the failure to comply with the filing requirements is due to reasonable cause not willful neglect.
The provision is effective as if included in section 513 of the Hiring Incentives to Restore Employment Act. Thus, the provision applies for returns filed after March 18, 2010, the date of enactment of that Act, as well as for any other return for which the assessment period specified in section 6501 had not yet expired as of that date.
VIII. Modification of Affiliation on Rules – Interest Allocation
The United States employs a worldwide tax system under which U.S. resident individuals and domestic corporations generally are taxed on all income, whether derived in the United States or abroad; the foreign tax credit provides relief from double taxation. The foreign tax credit generally is limited to the U.S. tax liability on a taxpayer's foreign-source income, in order to ensure that the credit serves its purpose of mitigating double taxation of foreign-source income without offsetting the U.S. tax on U.S.- source income.
To compute the foreign tax credit limitation, a taxpayer must determine the amount of its taxable income from foreign sources by allocating and apportioning deductions between items of U.S.-source gross income on the one hand, and items of foreign-source gross income on the other. There are no specific rules for most types of deductions. Specific provisions govern the allocation and apportionment of interest.
For interest allocation purposes, all members of an affiliated group of corporations generally are treated as a single corporation (the so-called "one-taxpayer rule") and allocation must be made on the basis of assets rather than gross income.
The term "affiliated group" in this context generally is defined by reference to the rules for determining whether corporations are eligible to file consolidated returns. These rules exclude all foreign corporations from an affiliated group. Thus, while debt generally is considered fungible among the assets of a group of domestic affiliated corporations, the same rules do not apply as between the domestic and foreign members of a group with the same degree of common control as the domestic affiliated group.
Under Treasury regulations, however, certain foreign corporations are treated as affiliated corporations, in certain respects, if (1) at least 80 percent of either the vote or value of the corporation's outstanding stock is owned directly or indirectly by members of an affiliated group, and (2) more than 50 percent of the corporation's gross income for the taxable year is effectively connected with the conduct of a U.S. trade or business (also known as effectively connected income).
In the case of a foreign corporation that is treated as an affiliated corporation for interest allocation and apportionment purposes, the percentage of its assets and income that is taken into account varies depending on the percentage of the corporation's gross income that is effectively connected income. If 80 percent or more of the foreign corporation's gross income is effectively connected income, then all the corporation's assets and interest expense are taken into account. If, instead, between 50 percent and 80 percent of the foreign corporation's gross income is effectively connected income, then only the corporation's assets that generate effectively connected income and a percentage of its interest expense equal to the percentage of its assets that generate effectively connected income are taken into account.
The new provision treats a foreign corporation as a member of an affiliated group, for interest allocation and apportionment purposes, if (1) more than 50 percent of the gross income of such foreign corporation for the taxable year is effectively connected income, and (2) at least 80 percent of either the vote or value of all outstanding stock of such foreign corporation is owned directly or indirectly by members of the affiliated group (determined with regard to this sentence). Thus, under the provision, if more than 50 percent of a foreign corporation's gross income is effectively connected income and at least 80 percent of either the vote or value of all outstanding stock of such foreign corporation is owned directly or indirectly by members of the affiliated group, then all of the foreign corporation's assets and interest expense are taken into account for the purposes of allocating and apportioning the interest expense of the affiliated group.
The provision applies to tax years beginning after the date of enactment.
Questions? For more information, please contact Harold Adrion or Gerard O’Beirne.
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