January 13, 2011
Foreign Tax Credit Reforms - Covered Asset Acquisitions
On August 10, 2010, President Obama signed into law an education and Medicaid funding bill that included a $10 billion package of international tax provisions. Our Tax Flash of August 13 highlighted those international tax changes. In this Tax Flash, we focus on one of these changes - the new rule applicable to “covered asset acquisitions.”
Under current law, certain elections or transactions can result in the creation of additional asset basis eligible for amortization or depreciation for U.S. tax purposes without a corresponding increase in the basis of those assets for foreign tax purposes. These include:
These transactions are known as covered asset acquisitions under the new law. The IRS may add similar transactions in regulations.
- a qualifying stock purchase of a foreign corporation or domestic corporation with foreign assets for which a Code Sec. 338 election is made;
- an acquisition of an interest in a partnership holding foreign assets for which a Code Sec. 754 election is in effect; and
- certain other transactions involving an entity classification (check-the-box) election, such as the acquisition of stock of a foreign entity that is treated as a corporation for foreign tax purposes but as a partnership or disregarded entity for U.S. tax purposes.
In a covered asset acquisition, the increase in the basis of assets for U.S. tax purposes, but not for foreign tax purposes, results in greater depreciation and amortization deductions under U.S. tax law and therefore reduces. U.S. taxable income or foreign corporations’ Earnings and Profits, but results in no corresponding adjustment for foreign income tax purposes. The net result is a permanent difference between U.S. taxable income (or earnings and profits) for purposes of calculating the foreign tax credit for US purposes and foreign taxable income upon which the foreign income tax is levied. This difference, according to Congress, distorts the effect of the foreign tax credit in covered asset acquisitions in favor of taxpayers.
The new law permanently disallows a foreign tax credit for a “disqualified portion” of any foreign income tax paid or accrued with respect to income or gain attributable to foreign assets in a covered asset acquisition. Thus, for example, the disallowance applies to any foreign taxes of a foreign corporation used in the computation of a deemed-paid foreign tax credit under Code Sec. 902.
The disqualified portion of the foreign taxes is equal to the ratio of the aggregate basis difference of the assets in a covered asset acquisition divided by the income on which the foreign income tax was determined. The aggregate basis difference is the adjusted U.S. tax basis of the assets immediately after the covered asset acquisition less the adjusted U.S. tax basis of those assets immediately before the covered asset acquisition. Although this provision permanently disallows a foreign tax credit for the disqualified portion of foreign taxes, those taxes may be deductible.
The new law is effective for covered asset acquisitions occurring after December 31, 2010.