International Tax Provisions and Planning under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010
Adnan Islam and Richard Sackin
EisnerAmper LLP continues coverage of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (“the Act”) signed into law by President Obama on December 17, 2010. Our initial Alerts dated January 13, 2011 and January 25, 2011 summarized and provided observations on, respectively, key Estate & Gift Tax provisions and key Individual Income Tax provisions of the Act.
This Alert provides highlights and observations regarding key International Tax provisions of the Act.
1. Look-through Treatment for Payments between Related CFCs Extended through 2011
Under Subpart F of the Internal Revenue Code (IRC), U.S. persons who are 10% or greater shareholders (U.S. shareholders) of a controlled foreign corporation (CFC) are required to include in income their pro rata share of the CFC’s subpart F income, whether or not this income is distributed to the shareholders. Subpart F income includes foreign base company income (FBCI), which in turn includes foreign personal holding company income (FPHCI). For subpart F purposes, FPHCI includes dividends, interest and income equivalent to interest, rents and royalties. However, under a special so-called look-through rule, FPHCI generally does not include such payments from a related corporation if allocable to income of the paying corporation which itself is not subpart F income. This rule was set to expire at the end of 2009.
The Act generally extends look-through treatment for payments of dividends, interest, rents and royalties between related CFCs for 2010 and 2011.
- The above rule will apply to tax years of foreign corporations beginning before January 1, 2012, and tax years of U.S. shareholders with or within which any tax year of such foreign corporation ends.
- This temporary extension generally permits continued payments of FPHCI between CFCs, where the payor is deriving its own active income from which the payments are made, without triggering current U.S. taxation of the recipient CFC’s U.S. shareholders under subpart F.
2. Active Financing Exception to FPHCI for CFCs Extended through 2011
Another exception to treatment as FPHCI applies to income of a CFC derived in the active conduct of a banking, financing or similar business. This was also set to expire at the end of 2009.
The Act generally extends this exception for 2010 and 2011, similarly to the look-through extension described above.
- This temporarily extended exception is limited to a CFC which is predominantly engaged in the active conduct of a banking, financing or similar business and conducts substantial activity with respect to such business but – if strict tests are met – its interest and other FPHCI generally will not be taxed currently to its U.S. shareholders under subpart F.
- Treatment of insurance income of a CFC, as subpart F income taxed to its U.S. shareholders, has also generally been subject to an exception for income from insuring non-U.S. risks if, inter alia, more than 30% of such income comes from non-related parties – this exception has been temporarily extended for 2010 and 2011, similarly to the active financing exception.
3. Withholding Tax Exemption for RIC Income Paid to Foreign Persons Extended through 2011
The 2004 Jobs Act added a provision that allowed a regulated investment company (RIC) to designate and pay (i) interest-related dividends out of interest that would generally not be taxable when received directly by a nonresident alien individual or foreign corporation and (ii) short-term capital gains dividends out of short-term capital gains. RIC dividends designated as interest-related dividends and short-term capital gains dividends were generally not taxable when received by a nonresident alien individual or foreign corporation, and were not subject to the withholding tax imposed on nonresident alien individuals and foreign corporations. Originally, these provisions didn't apply to dividends for RIC tax years beginning after 2007, but the provisions were extended for dividends for RIC tax years beginning in 2008 and 2009.
Effective for tax years beginning in 2010 or 2011, the Act extends the exemption for RIC interest-related dividends and short-term capital gains dividends.
4.RICs as Qualified Investment Entities for FIRPTA Purposes Extended through 2011
Foreign investors are generally not subject to U.S. tax on U.S. source capital gains, unless effectively connected with a U.S. trade or business or realized by an individual who meets certain U.S. physical presence requirements. Gain from the disposition of a U.S. real property interest (“USRPI”), however, is treated as income effectively connected with the conduct of a U.S. trade or business under the Foreign Investment in Real Property Tax Act (“FIRPTA”). This FIRPTA gain is subject to U.S. tax and withholding.
Stock or another beneficial interest (other than solely as a creditor) in a U.S. real property holding corporation (“USRPHC”) is also treated as a USRPI. However, stock that is regularly traded on an established securities market is a USRPI only when a foreign person holds more than 5% of that class of stock at any time during the five-year period ending on the disposition date or the taxpayer's shorter holding period (the “regularly traded exception”). Moreover, stock of a domestically controlled qualified investment entity is generally not a USRPI (the “domestically controlled exception”).
A look-through rule requires that a qualified investment entity must generally withhold U.S. tax on a distribution to a foreign person or to another qualified investment entity to the extent it is attributable to FIRPTA gain. However, similarly to the disposition gain exception noted above, withholding is not required if the distribution relates to an interest that is regularly traded on an established U.S. securities market and the foreign recipient held no more than 5% of that class of stock or beneficial interest within the one year period ending on the distribution date.
The inclusion of RICs within the definition of qualified investment entities expired at the end of 2009. The Act temporarily extends the treatment of a RIC as a "qualified investment entity" through December 31, 2011, and thus, as noted above, allows the RIC to qualify for limited exceptions to withholding under the FIRPTA rules.
Observation: The retroactive inclusion of RICs within the definition of qualified investment entities does not apply to withholding obligations on payments made on or before date of enactment of the Act. Thus, if a RIC withheld on a distribution made after 2009 and on or before December 17, 2010 when the Act became law, the recipient of the reduced payment cannot recover from the RIC any amount that was withheld and paid to the Internal Revenue Service (IRS) by the RIC.
5.IRS Authority to Reduce Withholding Rate on U.S. Real Property Gains Extended through 2012
A U.S. partnership, trustee of a U.S. trust, or executor of a U.S. estate must deduct and withhold income tax on distributions attributable to the disposition of a U.S. real property interest (USRPI) to the extent it is includible in the income of a foreign partner, foreign beneficiary or, in the case of a trust, a foreign person under the so-called grantor trust rules.
However, for amounts paid after May 28, 2003 and in tax years beginning not later than 2010, the IRS has been authorized to reduce, by regulation, the amount of income tax required to be withheld on such a foreign person's gain from the disposition of a USRPI from 35% to 15%.
The Act extends IRS authority to provide such a 15% withholding rate for two additional years, to tax years beginning in or before 2012.
Observation: Because the IRS has not provided for the 15% rate by regulation, domestic partnerships, estates and trusts have had to continue to withhold tax at 35%.
6. Deduction for Puerto Rico Activities Extended through 2012
The domestic production activities deduction under IRC Section 199 is allowed for various trade or business activities. Generally, those activities must be conducted in the U.S. in order to qualify for the deduction. However, under special rules for any taxpayer with gross receipts from sources within Puerto Rico, the U.S. includes Puerto Rico, but only if all of the taxpayer's Puerto Rico-sourced gross receipts are subject to Federal income tax for individuals or corporations. (In computing the 50% wage limitation, the taxpayer is permitted to take into account wages paid to bona fide residents of Puerto Rico for services performed in Puerto Rico.)
The special rules for Puerto Rico applied only with respect to the first four tax years of a taxpayer which began during 2006-2009.
The Act amends the above expiration by replacing “first four taxable years” with “first six taxable years,” and replacing “January 1, 2010” with “January 1, 2012.”
Observation: The Act thus allows the special domestic production activities rules for Puerto Rico to apply for the first six tax years which begin during 2006-2011.
7.Possessions Tax Credit for American Samoa Extended through 2011 for Existing Claimants
Although the possessions tax credit under IRC Section 936 has generally expired for tax years beginning after 2005, prior law extended the credit for U.S. corporations operating in American Samoa that (i) were existing credit claimants (generally, corporations that qualified for the possessions tax credit on October 13, 1995 and had an election to take the credit in effect on that date) and (ii) elected the application of Section 936 for their last tax year beginning before 2006.
The amount of the credit for such a qualifying domestic corporation was generally based on the tax on the corporation's income from the active conduct of a business within the possession or from the sale or exchange of substantially all of the assets used in the business, up to the economic-activity-based limitation amount. This limitation amount generally was equal to 60% of qualified wages and fringe benefit expenses and various percentages of short, medium and long-term depreciable tangible property.
However, the extended credit was only allowed for the first four tax years of a corporation which began during 2006-2009.
Similarly to the Puerto Rico deduction described above, the Act extends the possessions tax credit for American Samoa.
Observation: Thus, the credit is allowed for the first six tax years of a corporation which begin during 2006-2011.
8. Nonresident Aliens Remain Subject to U.S. Estate Tax on Property in Excess of $60,000
We noted in our Alert dated January 13, 2011, on the Estate & Gift Tax impacts of the Act several Observations on the estate taxation of nonresident aliens (NRAs), which we repeat here as part of this Alert on International Tax provisions:
- A special provision of prior and continuing law allows an NRA to invest in stock issued by a domestic RIC and not be completely exposed to U.S. estate tax if the underlying investments are situated outside the U.S.
- However, the estate of an NRA holding U.S. property in excess of $60,000 remains subject to Federal estate tax up to a maximum rate of 35% through 2012.
- While the Act does not modify the statutory unified credit equivalent for NRAs, nor adjust the credit equivalent for inflation, certain U.S. treaties with foreign countries may provide partial relief by a credit which is equivalent to the exemption available to the estate of a U.S. citizen or resident, multiplied by that proportion of the worldwide estate which is situated in the U.S.; therefore, the increased credit equivalent due to the Act’s increased estate tax exemption for U.S. citizens and residents – which is extensively described in our Alert of January 13, 2011 – will benefit an NRA entitled to the benefits of such a treaty.
9. Gain Recognition for 2010 Transfers to Nonresident Aliens and Foreign Grantor Trusts Repealed
Under prior law, the expansion of gain recognition referred to above under IRC Section 684 was to be effective only for transfers in 2010.
Under the Act, whether a transfer made to a nonresident alien or foreign grantor trust is made before, or during, or after 2010, the gain recognition rule doesn't apply to the transfer.
- Apparently the Act amendments are intended to discourage transfers that avoid the effects of the modified carryover basis rules that were to apply for estates of decedents dying in 2010 and that are also being, in effect, retroactively repealed by the Act. These are explained more fully in our Alert of January 13, 2011, on the general Estate & Gift Tax impacts of the Act.
- Since the Act’s provisions generally are effective through 2012, the repeal of the gain recognition rule discussed above doesn't apply to transfers in or after 2013. However, because the repeal itself affects only transfers during 2010, the Act’s 2012 sunset rule appears to have no practical effect here.
For further information on these provisions, please contact the principal author of this Alert, Adnan Islam, or Richard Sackin.
This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.