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Don’t Get Left Out in the Cold — the FY 2011 Proposed Budget and Its Blizzard of Changes

15 Mar 2010

With life in the US Capitol grinding to a halt from record-breaking snowfalls, reaction to the Obama Administration's release of its fiscal-year 2011 proposed budget has been tepid. It seems the administration that promised to bring great change to "politics as usual" in Washington has decided to leave major corporate tax reform for a warmer day. The budget re-proposes mostly the same-old provisions that have circulated in recent years or have carried over from the Obama Administration's FY 2010 budget. Only a few patches of bright white snow merit additional review -- proposals that are either new or modified significantly from their last iteration. Taxand US discuss the key elements of the proposed budget and identify for multinationals what to expect.

Notably absent from the 2011 proposed budget is last year's game-changing proposal on entity classification that would have required significant restructuring to most multinationals using check-the-box planning in the cross-border context. This absence should be viewed by most corporate officials as a temporary breath of relief in today's shaky economic climate.

Nonetheless, let's pause to consider the withdrawal of the foreign disregarded entity scale-back and the limitation on the deferral of deductions allocable to unremitted foreign earnings to interest expense only. Do these changes truly address concerns over the competitiveness of US companies abroad? If the administration were serious, taxpayers would have expected to see systemic reform proposals to address the need for jobs and US competitiveness through lower corporate tax rates and the adoption of at least a limited form of territorial or exemption system, as it exists with the vast majority of the US OECD trading partners? The push for additional stimulus spending to spur job growth in the US and the recent reinstatement of the "pay as you go" deficit reduction rules, are prime indicators that costly corporate tax overhauls are unlikely. Instead, US Congress may look for revenue raisers as part of legislative initiatives.

This article addresses the most broadly applicable and significant proposals in the 2011 proposed budget, in an attempt to help US multinational corporations understand how the changes may affect their operations regarding:

  • Offshore value transfers
  • Foreign tax credits
  • Reporting, compliance and withholding with respect to offshore accounts

Relocating Business Operations Offshore: Is Now a Good Time?
In light of our current national unemployment rate, it is not surprising that the 2011 budget proposal contains provisions that would increase the cost of moving and operating businesses offshore.

A new provision in the 2011 budget would cause a US person that transfers intangibles to a related controlled foreign corporation that is subject to low or no foreign tax, to have a current income inclusion equal to the "excessive return" where circumstances evidence "excessive income shifting." Moreover, the provision would prevent the cross-crediting of taxes on such low-taxed income. The benchmark for determining what constitutes a low effective tax rate is 10 percent, and a 30 percent return is considered "excessive."

Areas of concern include the fact that it might apply to income from intangibles that companies transferred in past years and essentially negate a large portion of taxpayers' pre-existing deferral planning. One reading of the proposal, however, would exempt the intellectual property developed after the initial buy-in because the foreign participant would be considered to have developed the property itself. In addition, it is unlikely that the provision would exempt transfers that had solid business purpose, such as transfers as part of a supply chain restructuring.

The second proposal attempts to subject the entire value transferred in an outbound business relocation to future US taxation. This provision clarifies the definition of intangible property to include workforce in place, goodwill and going-concern value. Moreover, the proposal specifically permits the IRS to value multiple properties on an aggregate basis and to compare the profits and prices that the controlled taxpayer would have realised by choosing "realistic alternatives." This appears to be a departure from the arm's length standard.

Continuing with the theme of lessening the benefit of off shoring value and earnings, the administration again proposes that expatriated entities be subject to stricter limits on deducting interest paid to related persons. The definition of "expatriated" entity (enacted in 2004), would apply for taxable years beginning after 10 July 1989. Therefore, companies must determine if the rules would apply at any time during the period of 1989 to 2004. This can translate into significant work for corporate tax departments and advisors.

Reducing the Attractiveness of Foreign Investment through Changes to the Foreign Tax Credit System
The budget proposes deferring interest deductions allocable to unremitted foreign earnings. This proposal will disproportionately affect taxpayers that borrow in the US to fund offshore investments. Under present law, expenses incurred by a domestic corporation that are related to its subsidiaries' foreign operations may be deductible long before the resulting foreign-source income becomes taxable in the United States. According to the Joint Committee on Taxation (JCT), this upfront deduction on the US return -- for income that is essentially tax-exempt until repatriated -- creates an incentive to invest overseas in low-taxed jurisdictions.

A second provision would require taxpayers to pool all of their repatriated Earnings and Profits ("E&P") and certain foreign taxes. This provision is intended to limit taxpayers' ability to pull earnings from high- or low-taxed pools, as needed, to manage their foreign tax credit utilisation and thereby reduce their residual US taxation on foreign repatriated earnings.

Another foreign tax credit proposal adopts a matching rule to require a taxpayer to repatriate its foreign E&P before allowing associated foreign taxes to be credited. The administration's proposal aims to prevent the separation of creditable foreign taxes from the income upon which the taxes were imposed, particularly in the instance of hybrid arrangements.

Given these foreign tax credit proposals, taxpayers should watch for guidance on how far pooling and matching will extend. Also, they would need to carefully consider and model the movement of high-taxed versus low-taxed earnings and the conversion of high-taxed foreign subsidiaries into branches or partnerships.

Curbing Individual Tax Shelters and Under-Reporting of Offshore Income
In an ongoing effort to prevent US taxpayers from using offshore accounts to hide income and assets, the proposed budget also includes measures to support information reporting, compliance and withholding with respect to offshore accounts. These provisions evidence a certain frustration within the government regarding recent enforcement actions in this arena. They generally require increased disclosure of foreign financial assets in the US tax return, impose additional requirements on withholding agents and tighten the rules on foreign trusts. For registration-required obligations, one proposal would eliminate the foreign-targeted obligation exception. Thus, most corporate bonds would only qualify for the portfolio interest exception if the obligor maintains a book-entry system in a manner approved by Treasury.

Note that these provisions were enacted into law on March 18, 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act, H.R. 2847. The majority of these provisions will be effective starting 2013.

Taxand's Take

Domestic and foreign financial institutions and others regularly making payments to foreign persons need to review their current withholding procedures and infrastructure to conform to their new obligations in connection with the HIRE Act. Moreover, US corporate taxpayers and foreign investors relying on the portfolio interest exception should review their support for the position and consider how to incorporate, if not already so doing, a proper book-entry system.

While other systemic changes are likely to be delayed until later this year or 2011, selected revenue raisers may appear in legislative proposals in the upcoming weeks.

Your Taxand contacts for further queries are:
Juan Carlos Ferrucho
T. +1 305 704 6670

Lisa Askenazy Felix
T. +1-415-490-2149

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