Congress Restricts Foreign Tax Credit Planning.

Transcription

1 August 2010 Congress Restricts Foreign Tax Credit Planning. On August 10, 2010, President Obama signed into law The Education Jobs and Medicaid Assistance Act of 2010 (the Act ), which restricts a number of international tax planning techniques in order to provide revenues that offset the costs of funding state education and Medicaid programs. Some of the most significant changes include: > preventing the use of hybrid entities and instruments to generate credits for foreign taxes on income that is not subject to US tax; > disallowing enhanced foreign tax credits that can result when a US acquirer of shares of a foreign target treats the acquisition as an asset purchase for US tax purposes; > repealing the long-standing 80/20 rule that reduces or eliminates withholding on dividends and interest paid by US corporations that conduct most of their business outside the United States; and > several other more targeted international tax provisions: - creating a new foreign tax credit basket for re-sourced income, - limiting deemed paid foreign tax credits for Section 956 inclusions, - adding a special sourcing rule for intra-group stock purchases by foreign subsidiaries, - extending the interest allocation rules for groups with foreign affiliates, and - modifying the statute of limitations for failure to disclose certain foreign transactions. Splitting of Income and Tax Credits Contents Splitting of Income and Tax Credits... 1 Restrictions on Foreign Tax Credits in Covered Asset Acquisitions... 2 Repeal of 80/20 Rule... 3 Targeted International Tax Provisions... 4 New Foreign Tax Credit Basket for Re-sourced Income... 4 Limitation on Deemed Paid Foreign Tax Credits for Section 956 Inclusions... 4 Special Sourcing Rule for Intra-Group Stock Purchases by Foreign Subsidiaries... 5 Extension of Interest Allocation Rules for Groups with Foreign Affiliates... 5 Modification of Statute of Limitations for Failure to Disclose Certain Foreign Transactions... 5 The Act implements a proposal (discussed in our Tax Flash of May 6, 2009 as part of President Obama s international tax proposals) to deny foreign tax credits when the credit is split from the underlying income through the use of certain Congress Restricts Foreign Tax Credit Planning August

2 hybrid instruments and entities. Under current rules, the person that is legally subject to the foreign tax is entitled to claim a tax credit for the tax, even if the income to which the tax relates is earned by a different person for US tax purposes. For example, foreign tax on income earned through an entity which is transparent for foreign tax purposes but opaque for US tax purposes (a reverse hybrid ) is considered to be paid by the owners of the entity, because the tax is legally imposed on these owners for foreign tax purposes, even though the income is earned by the entity itself for US tax purposes. Thus, US taxpayers could use reverse hybrids to claim foreign tax credits on income that had not been subject to US tax. Under the Act, US taxpayers will only be able to claim a direct foreign tax credit if, under US tax principles, the US taxpayer also recognizes the income that is subject to the foreign tax. So, for a reverse hybrid, the owner will not be allowed a credit until the income is distributed to the owner. The IRS had proposed regulations in 2006 that contained a similar rule. The Act would also apply to indirect foreign tax credits. Under current law, a domestic corporation that is a 10% shareholder of a foreign corporation is permitted to claim an indirect foreign tax credit with respect to non-us taxes paid by the foreign corporation in the year in which the foreign corporation s earnings and profits are distributed to the US shareholder. Under the Act, a domestic 10% shareholder of a foreign corporation cannot claim an indirect foreign tax credit with respect to these taxes unless, and until, that foreign corporation or the domestic 10% shareholder recognizes the income for US tax purposes. This new provision applies to direct credits for foreign taxes paid or accrued after December 31, 2010, and to indirect credits that are taken into account after that date, even if the underlying foreign tax was paid or accrued on or before December 31, US taxpayers will only be able to claim a direct foreign tax credit if, under US tax principles, the US taxpayer also recognizes the income that is subject to the foreign tax. Restrictions on Foreign Tax Credits in Covered Asset Acquisitions US acquirers of shares of foreign targets can find it advantageous to treat the share purchase as an asset purchase for US tax purposes (e.g. by making a Section 338 election or causing the target to check the box ). Treating the share purchase as an asset purchase allows the basis of the target s assets to be stepped up for US tax purposes, but not for foreign tax purposes. The target then takes into account this higher basis when computing its earnings and profits. The overall effect is to increase the effective foreign tax rate and enhance the amount of indirect foreign tax credits available when the target s income is distributed to the US shareholder or is subject to US tax under the US controlled foreign corporation ( CFC ) rules. Congress Restricts Foreign Tax Credit Planning August

3 The Act disallows foreign tax credits for a disqualified portion of foreign taxes paid in connection with a covered asset acquisition. A covered asset acquisition is defined to include: (i) (ii) a purchase of shares of a corporation when the purchaser makes a Section 338 election to treat the purchase as an asset acquisition for US tax purposes, the purchase of stock in a hybrid entity that is treated as a partnership or a disregarded entity for US tax purposes but as a corporation for foreign tax purposes, (iii) the acquisition of an interest in a partnership that has made a Section 754 election to adjust the basis of partnership assets to reflect the purchase price of the interest, (iv) (v) a deemed liquidation of a foreign corporation as a result of a "check the box" election to be treated as transparent for US tax purposes, and any other transaction that is treated as the acquisition of stock of a corporation for purposes of foreign tax law but is treated as an acquisition of assets for US tax purposes. The Treasury is given authority to expand this definition to include other transactions that have a similar effect. The disqualified portion of foreign taxes each year is a percentage equal to the enhanced US tax deductions caused by the step-up in asset basis, divided by the foreign taxable income. Thus, in a year in which the target has 100 in foreign taxable income, and 20 in depreciation or other deductions caused by the stepup, then the Act will disallow US tax credits for 20% of that year s foreign taxes. This provision generally applies to covered asset acquisitions after December 31, However, the provision does not apply to covered asset acquisitions after December 31, 2010 if the parties are not related, and the acquisition was (i) subject to a binding written agreement as of January 1, 2011, (ii) described in an IRS ruling request submitted on or before July 29, 2010, or (iii) described on or before January 1, 2011 in a public announcement or SEC filing. Repeal of 80/20 Rule The Act repeals the rule that treats interest paid by a US corporation as foreign source if the US corporation earns at least 80% of its gross income from an active foreign trade or business (an 80/20 company ), as well as the rule that exempts all or a part of the dividends of an 80/20 company from US withholding tax. The repeal applies to taxable years beginning after December 31, 2010, except that it does not apply to debt obligations issued by an 80/20 company to unrelated persons before August 10, The Act repeals the rule that treats interest paid by a US corporation as foreign source if the US corporation earns at least 80% of its gross income from an active foreign trade or business. Congress Restricts Foreign Tax Credit Planning August

4 A grandfather rule will apply to an existing 80/20 company, provided that the company (i) satisfies the existing 80/20 test for its last taxable year beginning before January 1, 2011, (ii) satisfies a new 80/20 test in future years, and (iii) has not added a substantial line of business after August 10, Under the new 80/20 test, for purposes of determining if the 80/20 company satisfies the 80% active foreign business income test, the 80/20 company and all of its 50%-owned subsidiaries will be treated as a single corporation. If the grandfather rule applies, interest and dividends will be wholly or partially exempt from US withholding as under the previous rules, but they will be treated as paid from US sources. Targeted International Tax Provisions New Foreign Tax Credit Basket for Re-sourced Income US taxpayers must calculate their foreign tax credits separately for their passive foreign source income basket and their active foreign source income basket. Taxpayers can only claim foreign tax credits to the extent of their US federal income tax liability for each basket of foreign source income. Some US treaties provide that income that otherwise would be US source is treated as foreignsource income if the treaty permits the other country to tax that income. Under current law, US taxpayers can increase the amount of their foreign source income by shifting assets to a branch or disregarded entity located in a foreign country with a treaty that re-sources income. The resulting increase in the taxpayer s foreign tax credit limitation is beneficial if the foreign country only lightly taxes the income. The Act creates a new separate basket for income re-sourced under a treaty, which will prevent US taxpayers from using that re-sourced income to increase their foreign tax credit limitation for income in their passive or active baskets. The provision applies to taxable years beginning after August 10, Limitation on Deemed Paid Foreign Tax Credits for Section 956 Inclusions A CFC that invests in US property causes its US parent to recognize income under Section 956 as if the CFC had distributed the amount of the investment to the parent as a dividend. This income inclusion also generates a credit for foreign taxes paid by the CFC on that income. Under current law, this rule allows the US parent to directly access the foreign tax credits of CFCs that are not directly owned by the parent, effectively hopscotching over any intermediate CFCs. This hopscotching technique allows the US parent to avoid blending the income of the indirectly-owned CFC with the income of those intermediate CFCs that was taxed at a lower rate. The Act creates a new separate basket for income re-sourced under a treaty, which will prevent US taxpayers from using that resourced income to increase their foreign tax credit limitation. Under the new provision, the deemed paid foreign tax credit that results from a Section 956 inclusion will be limited to the amount of a foreign tax credit that the US parent would receive if a dividend was paid by the lower-tier CFC through the Congress Restricts Foreign Tax Credit Planning August

5 intermediate CFCs to the US parent. The provision applies to investments in US property after December 31, Special Sourcing Rule for Intra-Group Stock Purchases by Foreign Subsidiaries The Act eliminates tax planning techniques for foreign-based multinational corporations that want to distribute earnings from a lower-tier foreign subsidiary while bypassing an intermediate US subsidiary. Any dividend paid by the lowertier subsidiary would be subject to income tax in the hands of the US subsidiary, and US withholding tax would apply to dividends paid by the US subsidiary to the foreign parent. If, instead of paying a dividend, the lower-tier foreign subsidiary purchases the stock of the US subsidiary from the foreign parent, the foreign subsidiary is treated under Section 304 as if it paid a dividend directly to the parent, bypassing the intermediate US subsidiary. Under the Act, when a foreign corporation acquires stock of a related party, the resulting deemed dividend will not be treated as paid by the foreign subsidiary unless more than 50% of the deemed dividend would be: (i) subject to US tax or (ii) included in the earnings of a CFC. Instead, the deemed dividend would be treated as having been paid by the target US subsidiary, and subject to a 30% withholding tax unless reduced or eliminated by treaty. This rule applies to acquisitions after August 10, Extension of Interest Allocation Rules for Groups with Foreign Affiliates Certain affiliated groups of US corporations must allocate their interest expense against US and foreign source income based on the location of the group s assets. Under the new rule, all of the interest expense and assets of an affiliated foreign corporation will be included in the allocation of interest expense if (i) at least 80% of the vote or value of the foreign corporation s stock is owned directly or indirectly by members of the affiliated group and (ii) more than 50% of the foreign corporation s gross income is treated as effectively connected income subject to US federal income tax. Currently, if the effectively connected income of the foreign corporation is less than 80% of its gross income, only a portion of the foreign corporation s assets and interest expense are included. This new provision applies to taxable years beginning after August 10, The Act eliminates tax planning techniques for foreign-based multinational corporations that want to distribute earnings from a lower-tier foreign subsidiary while bypassing an intermediate US subsidiary. Modification of Statute of Limitations for Failure to Disclose Certain Foreign Transactions Generally, taxes must be assessed within three years after a taxpayer s return is filed. However, if the taxpayer fails to provide required information to the Internal Revenue Service regarding cross-border transactions or foreign assets at the time the return is filed, the statute of limitations does not expire until three years after the information is provided. Congress Restricts Foreign Tax Credit Planning August

6 Contacts The Act modifies the scope of the extended statute of limitations by providing that if the taxpayer can show that the failure to provide the required information was due to reasonable cause, then the extended statute of limitations applies only to the item or items related to that failure, and not to the entire return. The provision applies to returns filed after March 18, 2010, as well as for any other return for which the three-year statute of limitations had not yet expired as of that date. For further information please contact: Stephen Land Partner +1 (212) Jon Van Loo US Associate +44 (0) Sarah Stein US Associate +1 (212) Patrick Fasoro US Associate +1 (212) Author: Stephen Land This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All rights reserved 2010 Linklaters in the U.S. provides leading global financial organizations and corporations with legal advice on a wide range of domestic and cross-border deals and cases. Our offices are located at 1345 Avenue of the Americas, New York, New York Linklaters LLP is a multinational limited liability partnership registered in England and Wales with registered number OC The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com Avenue of the Americas New York, NY Telephone +1 (212) Facsimile +1 (212) Linklaters.com Congress Restricts Foreign Tax Credit Planning August