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International Tax Reform Has Unexpected Consequences
On 10 August 2010, President Obama signed the Education Jobs and Medicaid Assistance Act (H.R. 1586), which changes the foreign tax credit regime as a way to help pay for a temporary increase in funding for Medicaid and education. These provisions were largely unvetted as of 20 May 2010, when they were introduced by the House in the extenders legislation, and many are complex and fraught with uncertainty. This legislation is now law. Taxand US examines the impacts of the new law across corporate America in 2011 (with some impacts to certain filers as early as fiscal years beginning after enactment).
Some of the most significant changes are aimed at specific planning techniques employed by US multinationals to enhance foreign tax credit utilisation. The full complement of changes is designed to:
- prevent the "bailout" of foreign earnings free of US tax
- disallow the splitting of earnings and associated foreign taxes
- shut down specific foreign-source income-generation techniques
- ensure all foreign assets are included in determining the foreign asset ratio for interest expense apportionment purposes.
The new legislation aims to prevent taxpayers from utilising foreign tax credits beyond what is needed to prevent double taxation. However, some of these legislative changes may have unintended consequences.
The changes anticipated were adopted in final form by this Bill and will now apply to transactions after 31 December 2010. Your corporate tax department will need to be ready for complex new calculations for each and every foreign entity acquired after that date for which a step-up is available under US tax law. Acquisitions from foreign buyers routinely include Section 338 elections for a host of reasons and would now be subject to these additional requirements.
Limitation on Deemed-Paid Taxes from Section 956 -- Unintended Consequences
As an illustration of possible unintended consequences, the new legislation limits the deemed-paid taxes that are available when a controlled foreign corporation (CFC) subsidiary makes a loan that causes an income inclusion under Section 956. The aim of the legislation is to prevent US taxpayers from "hop scotching" over pools of low-taxed earnings and profits.
Prior to this change, a US taxpayer with a highly taxed CFC could elect to loan earnings to a US member of the group to gain access to the foreign cash and possibly avoid an incremental tax in the US. The loan created an income inclusion of the highly taxed foreign subsidiary's earnings without requiring the entity to declare a dividend of its earnings (possibly incurring foreign withholding tax and blending its highly taxed earnings with lower-tax earnings of a CFC holding company). This simple planning technique is used by many US based multinationals to avoid double taxation on income that has already been subject to substantial foreign taxation.
The new legislation limits the deemed-paid taxes available for credit in the US return to the credit that would have been available if the foreign subsidiary had distributed the funds up the chain to the US shareholder. Essentially, this legislation forces the taxpayer to blend the effective tax rate of each foreign earnings pool that exists between the foreign lender and US shareholder. The tax blending consequence is intended to stop perceived abuses, but this legislation may have an unintended result when earnings deficits or previously taxed income pools exist within the chain.
In addition to requiring yet another set of complicated calculations (any Section 956 inclusion now requires a "with and without" analysis), there are many other unforeseen outcomes of the overlaid fiction. Note that a taxpayer may have a lower credit under the fiction, but not a higher credit. If there is a deficit company in the chain, does the dividend stop there and become a return of capital? If so, does the distribution spring back into a dividend when it passes in and out of a pool of earnings higher up the chain? That result would effectively orphan the taxes in a deficit company.
Taxes could also get "hung up" when there is a pool of previously taxed income (PTI) between the debtor and the US shareholder. The distribution would come out of PTI first, delaying the inclusion of foreign taxes.
With the current lapsed status of the "look through" rule, does the fictionalised distribution cause the intermediate recipient to recognise foreign personal holding company income, thereby stopping the distribution up the chain with the deemed-paid taxes coming entirely from that entity's earnings pool?
When the limitation applies, are we to treat the "fiction" as fact? Are the earnings and profits (E&P) and tax pools of all intermediate entities to be adjusted for the fiction after we determine that the Section 956 fictional limit applies? How do we apply the rules when there are loans from multiple CFCs?
The new Section 956 will require a careful and thoughtful analysis, possibly creating one more roadblocks for US based multinationals to access foreign cash without an increase to their US tax burden.
Rules to Prevent Splitting Foreign Tax Credits from Income -- Unintended Consequences
The new legislation may also cause unintended consequences through the required deferral of foreign tax credits until the related foreign income is taxed in the US. The new legislation does not address the possible mismatch between US and local country tax law that ensues from a foreign tax credit splitting event. The mismatch may create unintended legal restraints that would make it difficult or impossible to access the earnings related to the separated foreign tax credits.
Assume a situation in which CFC 1 makes a hybrid loan to CFC 2 and the loan is considered equity for US tax purposes and debt for local country purposes. Further assume that $100 of interest income is accrued (not paid) at CFC 1. Under this scenario, CFC 2 has no income and CFC 1 has $100 of income and associated taxes for local country purposes. For US tax purposes, CFC 2 is considered to have $100 (the accrued interest is ignored because the US views the hybrid loan as equity) and CFC 1 is considered to have the associated taxes (assume $30).
This mismatch between local law and US law related to whether the $100 of income exists at CFC 2 could be problematic in attempting to either access the $30 of taxes deemed paid and/or subjecting the $100 of income to US tax. There may be local country legal restraints that would preclude the repatriation of the $100 from CFC 2 (given that it has no earnings for local country purposes). In addition to the mismatch issue, one must consider the foreign currency implications related to aligning earnings and related taxes (assuming subsidiaries have different functional currencies), as required by the new legislation.
The new rules create overly burdensome compliance requirements for companies to maintain earnings and related taxes on both a pre- and post-2010 basis and also on a US and local country basis (for the same pool of earnings). The presence of every hybrid loan (and entity) in the company's structure will have to be evaluated to determine whether there is a tax splitting event. In addition, the fiction created by Section 956 loans will require a thorough analysis and quite a few "positions" on how to apply the rules in practice.
The scenarios above are only two examples of how the new international tax legislation aims to achieve one goal while creating a host of unintended consequences. Taxpayers may now be left with fewer opportunities to optimise their foreign tax credit profile, with repatriation of foreign earnings riddled with unforeseen consequences.
With careful analysis and thoughtful application of the rules, there may be an opportunity before the enactment date to lessen the impact to the corporate tax posture. These rules are more complex than they appear at first blush, and decisions must be made on how to apply them based on sound reasoning.
Now that the law is signed, every corporate taxpayer impacted by these rules should do the following:
- Prepare your company's disclosure of any changes the new legislation will have on its financial statements (this may be required for 2010 year end financials).
- Analyse how the new tax legislation impacts your company's cash tax cost (the impact will be a part of first quarter 2011).
- Determine the impact that the new legislation will have on your company's effective tax rate (the impact will be a part of first quarter 2011).
- Establish your procedures for applying the new rules and a process for capturing and maintaining the necessary data.
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