August 16, 2010
Foreign and Other Tax Reforms Signed into Law
On August 10, President Obama signed into law an education and Medicaid funding bill that included a $9 billion package of international tax reforms as well as other tax reforms. This was in response to concerns expressed by the administration and Congress that U.S. multinational corporations are reducing their U.S. taxes by shifting income abroad to affiliates in low-tax jurisdictions.
Some of the main international tax elements of the reform package are as follows:
- Eliminates foreign tax credit splitting
- Reduces foreign tax credits on stepped-up assets
- Restricts treaty use to resource U.S. income
- Limits use of foreign tax credits from Sec. 956 deemed dividends
- Revises certain foreign tax credit interest apportionment rules
- Repeals 80/20 rules and reinstates withholding
- Eliminates U.S. tax avoidance on certain foreign Sec. 304 transactions
- Corrects statute of limitations rule for foreign information filing delinquencies
The following is a summary of the main international tax provisions of the new legislation. This summary does not address the non-international tax reforms. Further details regarding these international tax reforms will be provided in subsequent Tax Flashes.
FOREIGN TAX CREDIT REFORMS
Splitting Foreign Tax Credits
The new bill prevents the separation of creditable foreign taxes from the associated foreign income and suspends the recognition of foreign tax credits until the related foreign income is taken into account for U.S. tax purposes.
The administration aims to prevent inappropriate separation of creditable foreign taxes since the separation does not relieve double taxation. It also attempts to eliminate the use of the foreign tax credit to reduce foreign corporations’ earnings and profits.
The new rules enacted by the passage of this bill will apply to foreign income taxes paid or accrued in tax years beginning after December 31, 2010.
Covered Asset Acquisitions
Taxpayers will now be prevented from claiming foreign tax credit on foreign income that is never taxed in the U.S.
This law attempts to fix an issue related to asset acquisition that allows for more foreign tax credits than are needed to prevent double taxation. This can occur when a US taxpayer acquires a foreign entity and the foreign entity receives a stepped-up basis for US tax purposes but not for foreign tax purposes. Typical scenarios include an acquisition for which a Code Sec. 338(g) election is made or where a hybrid entity is acquired.
These rules apply to transactions occurring after December 31, 2010.
Treaties and Foreign Source Income
Foreign branches and disregarded entities will now be subject to the same treatment as foreign corporations. A separate foreign tax credit limitation is applied to each item that would ordinarily be U.S.-sourced but that the taxpayer treats as foreign source under a treaty.
The Obama administration wants to eliminate taxpayer use of treaties to artificially inflate foreign-source income beyond what is needed to avoid double taxation. By shifting certain assets to foreign branches or disregarded entities, the treaty categorizes the income as foreign-source, thereby allowing the use of foreign tax credits beyond the maximum that U.S. tax could apply.
These rules apply to tax years beginning after the date of enactment.
Section 956 Rule
The new law limits foreign tax credits claimed on a deemed dividend under Code Sec. 956 to the amount that would have been allowed on an actual dividend.
Code Sec. 956 restricts or eliminates tax-deferral for foreign subsidiaries upon their use of earnings to acquire certain tainted property. It recharacterizes earnings used to acquire the tainted property as a direct payment of a dividend from a foreign subsidiary to its U.S. shareholder, effectively deeming the dividend to “hopscotch” over intermediary tax-haven-based subsidiaries in a multi-tier chain of companies. This law attempts to close the loophole presented by the anti-abuse/hopscotch rule so that the foreign tax credit on a deemed dividend cannot be greater than the foreign tax credit on an actual dividend.
The new law applies to U.S. property acquired by a CFC after December 31, 2010.
This new law requires that foreign corporations be treated as members of an affiliated group if certain requirements are met for purposes of allocating and apportioning interest expense.
Existing Treasury regulations aim to prevent taxpayers from excluding foreign interest expense from the foreign tax credit limitation by placing the expense in foreign subsidiaries. The new law aims to prevent taxpayers from artificially inflating foreign-source income in order to receive additional foreign tax credits.
This provision applies to tax years beginning after the date of enactment.
REPEAL OF 80/20 RULES
This law repeals the rule that treats dividends and interest paid by certain U.S. corporations with foreign operations as foreign source and may result in US withholding being required on those payments.
If at least 80% of a U.S. corporation’s gross income is foreign-source during a three-year test period and is attributable to the active conduct of a foreign trade or business, the dividends and interest may be excluded from U.S. withholding. Such dividends and interest received can also increase foreign source income and the foreign tax credit for a U.S. multinational company.
The general repeal applies to tax years beginning after December 31, 2010, although the provision includes a transition rule and a grandfather rule.
REDEMPTIONS BY FOREIGN SUBSIDIARIES
This law requires a foreign subsidiary’s earnings to remain subject to U.S. tax when repatriated to the foreign parent in a Code Sec. 304 transaction. It eliminates the use of hopscotching by preventing the reduction in the foreign subsidiary’s earnings.
Companies have devised a way to avoid U.S. taxation of a foreign subsidiary’s earnings by selling stock in the U.S. company to its foreign subsidiary and recharacterizing the gain as a dividend paid directly to the foreign subsidiary. This rule aims to prevent foreign subsidiaries’ earnings and profits from permanently escaping U.S. taxation.
This provision applies immediately to acquisitions after the date of enactment.
HIRE ACT FOREIGN ACCOUNT DISCLOSURES
This new law pertains to the Hiring Incentives to Restore Employment Act and clarifies when the limitations period will be tolled for corporations failing to provide certain information on cross-border transactions or foreign assets.
This technical change to the Hiring Incentives to Restore Employment Act was deemed necessary by the administration.
The provision applies to returns filed after March 18, 2010 (the date of enactment of the HIRE Act) and to any other return for which the assessment period had not yet expired on that date.
If you have any questions concerning this Tax Flash, please contact your MarcumRachlin Tax Professional.