Significant and Immediate Impact on U.S Companies with International Operations

On August 10, 2010, the House passed, without change, the Senate's version of H.R. 1586, sending the bill to President Obama. The President signed the legislation later that day.

The bill generally provides aid to State and local governments. As offsets for its spending provisions, however, the bill has several revenue raisers, including significant limitations on the foreign tax credit, aimed squarely at U.S. multinational corporations.

The Statement of Administration Position called the international revenue raisers "proposals to close international tax loopholes that currently allow multinational corporations to inappropriately lower their U.S. taxes." Although these changes were billed as "loophole closers" by the Administration and the proposal's sponsors, that moniker belies their complexity and the fact that several of the provisions reflect significant changes in the underlying policy of taxation of foreign source income.

Moreover, the new international revenue raisers were developed without public input and have not received much technical scrutiny prior to enactment. Several of the proposals, especially the foreign tax credit "matching" provision, raise a host of technical issues. Because neither the Ways and Means Committee nor the Finance Committee ever formally considered the revenue raisers and no conference was held, there is almost no legislative history other than Joint Committee on Taxation technical explanations.

Several of the provisions are effective upon enactment, which is August 10, 2010. Others become generally effective on January 1, 2011, or in the first taxable year beginning after December 31, 2010. There will therefore be significant and immediate pressure on the Treasury Department and the IRS to publish interpretive guidance regarding these new provisions.

International Tax Provisions in the Bill

Changes to the Foreign Tax Credit

The bill makes changes to the foreign tax credit rules that will require U.S multinational groups to reconsider their current operations and organizational structure.

"Matching" Rule to Prevent Separation of Creditable Foreign Taxes from Associated Foreign Income (raises $4.25 billion over 10 years)

Although the foreign tax credit is intended to relieve the double taxation that would otherwise occur on foreign source income, the foreign tax credit rules and income recognition rules do not always match up for foreign and U.S. tax purposes. The foreign country may tax the income before or after the United States, and the two countries may see different entities as the taxpayer. The foreign tax credit carryback and carryforward are intended to address these timing differences.

The bill, however, addresses this potential timing problem, but only in the government's favor. New section 909 of the Internal Revenue Code provides that if there is a foreign tax credit splitting event, the taxpayer cannot take a foreign tax credit until the taxable year in which the related income is recognized for U.S. tax purposes by the taxpayer. This is simple in concept but very complicated in practice.

A foreign tax credit splitting event occurs if the income to which the foreign income tax relates is taken into account by a covered person (any entity in which the payor of the foreign tax holds at least a 10 percent ownership interest, any person which holds at least a 10 percent ownership interest in the payor, any person that is related to the payor, and anyone else added by regulation).

The new rules apply whether one directly pays the foreign tax (i.e., as the partner in a partnership or as the owner of a disregarded entity) or whether one is eligible for deemed paid credits from a subsidiary corporation (i.e., taxes of a "section 902 corporation" are not eligible for the deemed paid credit until the related income is distributed to the person eligible for the deemed paid credit).

New section 909 applies generally to foreign income taxes paid or accrued in taxable years beginning after December 31, 2010.

Limitation on Foreign Tax Credit in Covered Asset Acquisitions (raises $3.645 billion over 10 years)

This provision denies a foreign tax credit for the disqualified portion of any foreign income tax paid or accrued in connection with a covered asset acquisition. A covered asset acquisition is

  • a qualified stock purchase that is treated under section 338(a) as an acquisition of assets,
  • any transaction which is treated as an acquisition of assets for U.S. tax purposes but which is treated as the acquisition of stock of a corporation (or is disregarded) for foreign tax purposes,
  • any acquisition of an interest in a partnership which has an election in effect under section 754, or
  • to the extent provided by the Secretary, any other similar transaction.

The provision is generally effective for covered asset acquisitions after December 31, 2010, with "binding contract" relief.

Separate Foreign Tax Credit Basket for Income Resourced under a Tax Treaty (raises $250 million over 10 years)

The provision applies a separate foreign tax credit limitation for each item that (a) would be treated as U.S. source under U.S. domestic law, (b) would be treated as foreign source under a treaty obligation of the United States, and (c) the taxpayer chooses the benefits of such treaty. The provision is effective for taxable years beginning after the date of enactment (August 10, 2010).

Limitation on Amount of Foreign Taxes Paid in Section 956 Inclusions ("Hopscotch Rule") (raises $704 million over 10 years)

The provision limits the amount of foreign taxes creditable when section 956 of the Internal Revenue Code requires an inclusion of income. For section 956 inclusions attributable to U.S. property acquired by a controlled foreign corporation ("CFC") after December 31, 2010, the amount of foreign taxes deemed paid is determined by comparing the foreign taxes deemed paid with respect to the U.S. Shareholder's section 956 inclusion (the "tentative credit") to a hypothetical credit.

  • The hypothetical credit is the amount of foreign taxes the U.S. shareholder would have been deemed to have paid if a dividend had been distributed up through the chain (ignoring any withholding taxes that would have been incurred in an actual distribution).
  • If the hypothetical credit is less than the tentative credit, then the amount of foreign taxes deemed paid with respect to the section 956 inclusion is limited to the hypothetical credit.

Other International Tax Provisions

Special Rule regarding Redemptions by Foreign Subsidiaries (raises $250 million over 10 years)

The provision generally imposes an additional limitation on the earnings and profits ("E&P") of a foreign corporation that is taken into account in determining the amount (and source) of a distribution that is treated as a dividend. If more than 50 percent of the dividends arising from an acquisition (before taking into account the provision) would not be (1) subject to U.S. tax in the year in which the dividend arises or (2) includible in the E&P of a CFC, then the E&P of the foreign acquiring corporation is not taken into account.

The special rule is intended to prevent a foreign acquiring corporation's E&P from permanently escaping U.S. taxation. It applies to acquisitions after the date of enactment (August 10, 2010).

Change to Interest Expense Allocation Rules for Certain Foreign Subsidiaries (raises $390 million over 10 years)

For interest expense allocation purposes, the provision treats a foreign corporation as a member of a U.S. affiliated group, if (a) more than 50 percent of its gross income is effectively connected income, and (b) at least 80 percent of its stock is owned directly or indirectly by members of the affiliated group. If so, 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 taxable years beginning after date of enactment (August 10, 2010).

Repeal of 80/20 Company Rules (raises $153 million over 10 years)

The provision repeals the present law rule that (a) treats as foreign source all or a portion of any interest paid by a resident alien individual or domestic corporation that meets the 80/20 test and (b) exempts from U.S. withholding tax all or a portion of any dividends paid by a domestic corporation that meets the 80/20 test. The provision generally applies to taxable years beginning after December 31, 2010. It provides, however, a grandfather rule for existing 80/20 companies that meet a new 80/20 test for each taxable year beginning after December 31, 2010, as long as the grandfathered company does not add a substantial line of business.

Modification to Recently-Enacted Extension of Statute of Limitations for Undisclosed Transactions (no revenue effect)

The bill does include one item of good news for taxpayers. The Hiring Incentives to Restore Employment (HIRE) Act, enacted March 18, 2010, modified Internal Revenue Code section 6501(c)(8) to extend the statute of limitations for taxpayers who fail to provide information about certain cross-border transactions or foreign assets. If the taxpayer fails to provide the required information, the taxpayer's entire tax return remains open until three years after the required information is provided. The provision provides a reasonable cause exception, retroactive to enactment of the HIRE Act.

Conclusion

These changes, especially those to the foreign tax credit, will have a significant impact on international businesses. Taxpayers need to reconsider current cross-border structures and contemplate restructuring or, in some cases, accelerating planned transactions.

Because of the stealth in which many of these proposals were developed and the speed in which all of them were passed by Congress, they have not received much detailed scrutiny. Some of them, especially the foreign tax credit "matching" provision, will require significant administrative guidance as to details. In light of the effective dates, it is important for affected companies to analyze quickly but thoroughly the impact of these provisions to identify where guidance is needed and where regulatory relief should be sought.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.