United States: Outbound Acquisitions:Holding Companies Of Europe – A Guide For Tax Planning, Or A Road Map For Difficulty?

Last Updated: August 23 2017
Article by Stanley C. Ruchelman

INTRODUCTION

In General

When a U.S. company acquires foreign targets, the use of a holding company structure abroad may provide certain global tax benefits. The emphasis is on "global" because standard U.S. benefits such as deferral of income while funds remain offshore may not be available without further planning once a holding company realizes dividends and capital gains. In addition, the operative term is "may provide" because of steps that have been taken by the Organization for Economic Cooperation and Development ("O.E.C.D."), the European Commission, and the European Parliament to impede tax planning opportunities that have been available to multinational groups for many years.

If we assume the income of each foreign target consists of manufacturing and sales activities that take place in a single foreign country, no U.S. tax will be imposed until the profits of the target are distributed in the form of a dividend or the shares of the target are sold. This is known as "deferral" of tax. Once dividends are distributed, U.S. tax may be due whether the profits are distributed directly to the U.S. parent company or to a holding company created under the laws of a different foreign jurisdiction. Without advance planning to take advantage of the entity characterization rules known as "check-the-box," the dividends paid by the manufacturing company will be taxable in the U.S.1 If paid to a holding company that is a controlled foreign corporation ("C.F.C.") for U.S. income tax purposes, the dividend income in the hands of the holding company will be viewed to be an item of Foreign Personal Holding Company Income, which generally will be taxed to the U.S. parent company or any other person that is treated as a "U.S. Shareholder" under Subpart F of the Internal Revenue Code.2

Benefits Of Holding Companies

Nonetheless, the use of a holding company can provide valuable tax-saving opportunities when profits of the target company are distributed. Historically, the use of a holding company could reduce foreign withholding taxes claimed as foreign tax credits by the U.S. parent. This could be achieved through an income tax treaty, or in the case of operations in the E.U., through the Parent-Subsidiary Directive (the "P.S.D."). This can result in substantial savings if the operating and tax costs of maintaining the holding company are significantly less than the withholding taxes being saved.

However, as will be described below, the E.U. has taken steps to modify the P.S.D. so that it does not apply when the parent is in turn owned by a company based outside the E.U. and the structure is viewed to be abusive. In addition, all of the European countries discussed in this paper signed the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (the "Multilateral Instrument") on June 7, 2017. Once the Multilateral Instrument comes into force in a particular European jurisdiction, it will take effect on the first day of the following calendar year or taxable period. Under Article 7 ("Prevention of Treaty Abuse") of the M.L.I. benefits enjoyed by a European holding company in connection with dividends paid by a European operating company may be limited when

it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.3

It remains to be seen how this provision will play out for holding companies that are used to channel dividends to U.S. parent companies. Presumably, where the holding company conducts active headquarters operations through its own staff of employees and executives, treaty abuse may be a conclusion that is difficult to reach.

Although the foreign tax credit is often described as a "dollar-for-dollar reduction of U.S. tax" when foreign taxes are paid or deemed to be paid by a U.S. parent company, the reality is quite different. Only taxes that are imposed on items of "foreign-source taxable income" may be claimed as a credit.4 This rule, known as "the foreign tax credit limitation," is intended to prevent foreign income taxes from being claimed as a credit against U.S. tax on U.S. taxable income. The U.S., as with most countries that eliminate double taxation through a credit system, maintains that it has primary tax jurisdiction over domestic taxable income. It also prevents so-called "cross crediting," under which high taxes on operating income may be used to offset U.S. tax on lightly-taxed investment income. For many years, the foreign tax credit limitation was applied separately with regard to eight different categories of baskets of income designed to prevent the absorption of excess foreign tax credits by low-tax foreign-source income. In substance, this eviscerated the benefit of the foreign tax credit when looked at on an overall basis. The problem has since eased because the number of foreign tax credit baskets has been reduced from eight to two: passive and general.

The benefit of the foreign tax credit is reduced for dividends received from foreign corporations that, in the hands of the recipient, benefit from reduced rates of tax in the U.S. A portion of foreign dividends received by U.S. individuals that qualify for the 0%, 15%, or 20% tax rate under Code §1(h)(11)(B)(i) are removed from the numerator and denominator of the foreign tax credit limitation to reflect the reduced tax rate.5 This treatment reduces the foreign tax credit limitation when a U.S.-resident individual receives both qualifying dividends from a foreign corporation and other items of foreign-source income within the same basket that are subject to ordinary tax rates.

As a result, a U.S.-based group must determine the portion of its overall taxable income that is derived from foreign sources, the portion derived in each "foreign tax credit basket," and the portion derived from sources in the U.S. This is not an easy task, and in some respects, the rules do not achieve an equitable result from management's viewpoint.

Allocation And Apportionment Regulations And Self-Help Options

U.S. income tax regulations require expenses of the U.S. parent company to be allocated and apportioned to all income, including foreign dividend income.6 The allocation and apportionment procedures set forth in the regulations are exhaustive and tend to maximize the apportionment of expenses to foreign-source income. For example, all interest expense of the U.S. parent corporation and the U.S. members of its affiliated group must be allocated and apportioned under a set of rules that allocates interest expense on an asset-based basis to all income of the group.7 Direct tracing of interest expense to income derived from a particular asset is permitted in only limited circumstances8 involving qualified nonrecourse indebtedness,9 certain integrated financial transactions,10 and certain related C.F.C. indebtedness.11 Research and development expenses, stewardship expenses, charitable deductions, and state franchise taxes also must be allocated and apportioned. These rules tend to reduce the amount of foreign-source taxable income in a particular category and may even eliminate that category altogether. The problem is worsened by carryovers of an overall foreign loss account.12 This is an "off-book" account that arises when expenses incurred in a particular prior year are allocable and apportionable to foreign-source income and those expenses exceed the amount of foreign-source gross income of the year. Where that occurs, the loss is carried over to future years and reduces the foreign-source taxable income of the subsequent year when computing the foreign tax credit limitation.

The pressure that has been placed on full use of the foreign tax credit by a U.S.-based group has resulted in several public companies undergoing inversion transactions. In these transactions, shares of the U.S. parent company that are held by the public are exchanged for comparable shares of a newly-formed offshore company to which foreign subsidiaries are eventually transferred. While the share exchange and the transfer of assets may be taxable events, the identity of the shareholder group (i.e., foreign persons or pension plans) or the market value of the shares (i.e., shares trading at relatively low values) may eliminate actual tax exposure in the U.S. Thereafter, the foreign subsidiaries are owned directly or indirectly by a foreign parent corporation organized in a tax-favored jurisdiction and the foreign tax credit problems disappear.

Anti-Inversion Rules

This form of "self-help" is no longer easily available as a result of the anti-inversion rules of Code §7874. In some circumstances, Code §7874 imposes tax on inversion gains that cannot be reduced by credits or net operating loss carryforwards. In other circumstances, Code §7874 treats the foreign corporation as if it were a U.S. corporation. In Notice 2014-52, the I.R.S. described regulations it intends to issue that will address transactions structured to avoid the purposes of Code §§7874 (involving inversion transactions), 367 (involving reorganizations or spin-offs), and 956 (investments in U.S. property by a C.F.C.):

  • Regarding Code §7874, the regulations will disregard certain stock of a foreign acquiring corporation that holds a significant amount of passive assets. The potential abuse is that because the passive assets reflect an asset-stuffing transaction in the acquiring company, it has the effect of avoiding the triggers for the application of the anti-inversion provisions.
  • Also regarding Code §7874, the regulations will provide guidance on the treatment of certain transfers of stock of a foreign acquiring corporation through a spin-off or otherwise that occur after an acquisition.
  • Regarding Code §§7874 and 367, the regulations will provide guidance for disregarding certain distributions that are not made in the ordinary course of businesses. Again, because the potential abuse is that the distribution reduces the assets in the U.S. entity, it has the effect of avoiding the triggers for the application of the anti-inversion provisions.
  • Regarding Code §956, the regulations will prevent the avoidance of the investment in U.S. property rules when a C.F.C. acquires obligations of or equity investments in the new foreign parent corporation or certain foreign affiliates.
  • Regarding Code §956, the regulations will target the investment of pre-inversion earnings and profits of a C.F.C. through a post-inversion transaction that terminates the C.F.C. status of foreign subsidiaries or that substantially dilutes a U.S. shareholder's interest in those earnings and profits.

Finally, regarding Code §956, the regulations will limit the ability of a group to

remove untaxed foreign earnings and profits of C.F.C.'s through related-party stock sales subject to Code §304 (which converts a stock sale of controlled stock into a dividend payment).

In 2016, the Treasury Department adopted updates to the U.S. Model Income Tax Convention (the "2016 U.S. Model"), which serves as the basic document that the U.S. submits when negotiating an income tax treaty. The draft provisions propose, inter alia, to reduce the tax benefits that may be enjoyed by an expatriated group by imposing full withholding taxes on key payments such as dividends,13 interest,14 and royalties15 made to connected persons that are residents of a treaty country by "expatriated entities" as defined under the Internal Revenue Code. This lasts for ten years and goes to the heart of the bargain between the U.S. and its treaty partners, because the full withholding tax reduces the tax in the country of the recipient.

In Notice 2015-79, the I.R.S. outlined forthcoming guidance on corporate inversions in response to perceived abuse. The abusive plans and the I.R.S. responses include the following:

  • Manipulating Substantial Activity Rules: The I.R.S. is aware of transactions in which a taxpayer asserts that the expanded affiliated group ("E.A.G.") has substantial business activities in the relevant foreign country, but the foreign acquiring corporation is not subject to income taxation in the relevant foreign country as a resident. According to the I.R.S., this is abusive.
  • Third Country Transactions: The I.R.S. is aware that certain acquisitions in which a domestic entity combines with an existing foreign corporation are structured by establishing a new foreign parent corporation with a tax residence that is different from that of the existing foreign corporation. In these transactions, the stock or assets of the existing foreign corporation are acquired by the new third-country parent and the U.S. shareholder group owns less than 80% of the parent in the third country. The I.R.S. is concerned that a decision to locate the tax residence of a new foreign parent corporation outside of both the United States and the jurisdiction in which the existing foreign corporation is tax resident generally is driven by abusive tax planning.
  • Disregard of Stock Transferred in Exchange for Nonqualified Property: Stock of the foreign acquiring corporation that is sold in a public offering related to the acquisition is excluded from the denominator of the ownership fraction. Disqualified stock includes stock of the foreign acquiring corporation that is transferred in exchange for "nonqualified property." Nonqualified property includes (i) cash or cash equivalents, (ii) marketable securities, (iii) certain obligations, and (iv) any other property acquired with a principal purpose of avoiding the anti-inversion rules. The I.R.S. is concerned that some taxpayers are narrowly interpreting the definition of avoidance property, contending that it is limited to stock that is used to transfer indirectly specified nonqualified property to the foreign acquiring corporation.
  • Post-Acquisition Transactions: The I.R.S. is concerned that certain indirect transfers of stock or other property by an expatriated entity, rather than direct transfers by the expatriated entity itself, have the effect of removing foreign operations from the U.S.'s taxing jurisdiction. This is because under current law, the income from these indirect transfers is not inversion gain. Consequently, attributes can be used to reduce the tax.
  • Code §1248 Toll Charges: Current §367(b) regulations require a shareholder that exchanges stock in a transaction which results in a loss of C.F.C. status and future exposure under Code §1248 to include the Code §1248 amount in its income as a deemed dividend. The I.R.S. is concerned that the toll charge is not a sufficient deterrent.

On April 4, 2016, the Treasury Department issued a third round of new rules under Code §7874 aimed at halting the wave of inversions that have allowed U.S.-owned multinational groups to restructure their global organization in order to lower U.S. taxes. The Treasury sought to close down a planning strategy used by some foreign companies in which multiple acquisitions of unrelated U.S. target corporations are made over time. This strategy allowed the foreign companies to avoid the application of §7874, since each acquisition was analyzed on its own.16 The prevention of this strategy is accomplished under a multiple domestic entity acquisition rule set forth in Treas. Reg. §1.7874-8T.17

The Treasury was concerned that certain taxpayers were targeting foreign corporations with a value that was attributable to substantial passive assets rather than business assets. Treas. Reg. §1.7874-7T incorporates a rule that identifies certain foreign corporation stock which has substantial value and is attributable to passive assets. When triggered, this rule will skew the ownership fraction in the direction of the former shareholders of the domestic acquired corporation so that Code §7874 may apply.

A so-called "anti-skinnying" rule of the First Notice would disregard any non-ordinary course distribution ("N.O.C.D.") made by the domestic entity during the 36-month period ending on the acquisition date.18

Other rules apply Code §§956, 367, and 304 in a manner that imposes tax on typical transactions that occur after an inversion.

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Footnotes

1 Treas. Reg. §301.7701-3(a). If an election is made for a wholly-owned subsidiary, the subsidiary is viewed to be a branch of its parent corporation. Intra-company distributions of cash are not characterized as Foreign Personal Holding Company Income, discussed later in the text.

2 There are exceptions to the general characterization of a dividend as an item of Foreign Personal Holding Company Income that might apply. One relates to dividends received from a related person which (i) is a corporation created or organized under the laws of the same foreign country as the recipient C.F.C., and (ii) has a substantial part of its assets used in its trade or business located in that foreign country. See Code §954(c)(3)(A)(i). For a temporary period of time, a look-through rule is provided in Code §954(c)(6), under which dividends received by a C.F.C. from a related C.F.C. are treated as active income rather than Foreign Personal Holding Company Income to the extent that the earnings of the entity making the payment are attributable to active income. This provision is regularly adopted for two-year periods after which it must be re-enacted. The latest version was terminated at the conclusion of 2014.

3 Paragraph 1 of Article 7 of the Multilateral Instrument.

4 Code §904(a).

5 See Code §§1(h)(11)(C)(iv) and 904(b)(2)(B).

6 See Treas. Reg. §§1.861-8 through 17.

7 Treas. Reg. §1.861-9T(f)(1) and (g).

8 Treas. Reg. §1.861-10T(a).

9 Treas. Reg. §1.861-10T(b).

10 Treas. Reg. §1.861-10T(c).

11 Treas. Reg. §1.861-10T(e).

12 Code §904(f).

13 Paragraph 5 of Article 10 (Dividends) of the 2016 U.S. Model.

14 Id., ¶2(d) of Article 11 (Interest).

15 Id., ¶2 of Article 12 (Royalties).

16 T.D. 9761, Explanation of Provisions, I(B)(3). (April 8, 2016); Treas. Reg. §1.7874-12T(a)(17).

17 Treas. Reg. §1.7874-8T(b).

18 Treas. Reg. §1.7874-7T(h). Because it is a temporary regulation, this regulation expires in three years.

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.

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