University of Chicago Law School 64th Annual Federal Tax Conference November 11-12, 2011 The Future of the Foreign Tax Credit Philip R. West Steptoe & Johnson LLP 2 Overview of Foreign Tax Credit Rules 3 Basic Overview • U.S. taxpayers are generally subject to U.S. tax on their worldwide income, but may be provided a tax credit for foreign income taxes paid or accrued. Direct credit: taxpayer receives the credit for taxes it paid itself “Indirect” or “deemed credit”: U.S. corporation that owns at least 10 percent of the voting stock of a foreign corporation may receive a credit for the foreign taxes paid by its subsidiaries when the related income is distributed as a dividend or included in the U.S. corporation’s income under subpart F • Alternatively, a taxpayer may deduct foreign taxes. 4 Brief Foreign Tax Credit History FTC allowed is lesser of FTC under overall limitation or new per country limitation Foreign tax credit enacted* 1919 1921 Overall FTC limitation 1932 Taxpayers may elect to use overall or per country limitation** 1954 Overall limitation repealed 1960 Section 909 “splitter” and other FTC rules enacted FTC baskets introduced 1976 Per country limitation repealed * Enacted in the Revenue Act of 1918, which passed in 1919 ** A separate limitation for non-business interest income was added in 1962 1986 2004 FTC baskets reduced from nine to two 2010 5 Who Is the Taxpayer Entitled to the Credit? • “Technical taxpayer” rule: The taxpayer entitled to the credit is the taxpayer legally liable for the foreign tax under foreign law Biddle What happens where taxpayer that is legally liable for the foreign tax is different from the taxpayer that takes the associated foreign income into account? o Guardian o Proposed Legal Liability Regulations o Section 909 6 What Foreign Taxes Are Creditable? • Must be a tax Compulsory payment Levied pursuant to the authority of a foreign country to levy taxes Not a tax to the extent a person receives a specific economic benefit in exchange for payment • Two main types of taxes Section 901: Foreign taxes on “income, war profits or excess profits” o “Predominant character” of the tax must be of an income tax in the U.S. sense Tax must be “likely to reach net gain in the normal circumstances in which it applies” Imposed on or subsequent to realization Imposed on the basis of gross receipts Base of the tax must be computed by reducing gross receipts to permit recovery of significant costs an expenses Liability must not be dependent on the availability of a credit for the tax in another country (i.e., must not be a “soak-up” tax) Section 903: Foreign taxes imposed “in-lieu-of” an income tax o Must be imposed as a substitution for an income tax o Must not be a “soak-up” tax 7 What Foreign Taxes Are Creditable? Recent Case Law • In companion decisions in PPL Corp. v. Commissioner, 135 T.C. No. 15 (Sept. 9, 2010) and Entergy v. Commissioner, T.C. Memo. 2010166, the Tax Court recently concluded that a 1997 windfall profits tax imposed by the U.K. government is a creditable tax for purposes of section 901. • In the early 1990s, the U.K. government privatized what had previously been government-owned utilities. Once privatized, the companies became very profitable. In 1997, the new government announced a “windfall profits” tax on the companies. The tax was a one-time 23% tax on the “windfall” to the companies, which was calculated as the difference between the current value of the company (calculated by reference to average book profits of the company over the first four years following privatization multiplied by a price-to-earnings ratio of nine) and the value placed on the company upon privatization. 8 What Foreign Taxes Are Creditable? Recent Case Law • The IRS argued that only the terms of the windfall tax statute itself could be considered and that, considering only the words of the statute, the tax failed the predominant character test. • The taxpayer argued that extrinsic evidence of the purpose and effect of the tax should be considered in determining creditability. The taxpayer cited expert testimony that the windfall tax was, in substance, a tax on income, and that the tax could be restated algebraically to make clear that it operated as an excess profits tax imposed at an approximately 51.7% rate. • The court held for the taxpayer. The court stated that cases predating the current “predominant character” regulations (and cited in the preamble to those regulations) were relevant. Those cases considered the form and effect of the foreign taxes in determining creditability. The court then concluded that the tax met the “predominant character” standard, stating that “a foreign levy [can] be directed at net gain or income even though it is, by its terms, imposed squarely on the difference between the two values.” • The cases have been appealed to the U.S. Court of Appeals for the Third (PPL) and Fifth (Entergy) Circuits. 9 When is a Tax Compulsory? • Payment is not compulsory to the extent that the amount paid exceeds the amount of liability under foreign law for tax An amount does not exceed liability if amount is determined by the taxpayer in a manner that is “consistent with reasonable interpretation and application of the substantive and procedural provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer’s reasonably expected liability under foreign law for tax” Must “exhaust all effective and practical remedies,” including invocation of competent authority procedures 10 When is a Tax Compulsory? Recent Case Law • In the recent case Procter & Gamble Co. v. United States, 106 A.F.T.R.2d 2010-5311 (S.D. Ohio 2010), a federal district court held that a taxpayer must initiate competent authority proceedings even where double taxation arises because of conflicting claims by two foreign countries (as opposed to between the United States and a foreign country). Royalties associated with products sold P&G (U.S.) P&G NEA (Singapore) Products Japanese and Korean Customers • P&G NEA’s principal office was located in Japan • P&G withholds and pays tax to Japan 10% of royalty payments relating to all sales • Korean tax authorities claim the royalties paid with respect to sales to Korean customers are Korean-source and subject to Korean withholding tax at a 15% rate, as well as a local surcharge 11 When is a Tax Compulsory? Recent Case Law • Procter & Gamble (“P&G”) claimed a credit for Japanese taxes paid in several taxable years. In a later year, the Korean tax authorizes determined that the income with respect to which the Japanese taxes had been paid was also subject to tax in Korea. • The IRS disallowed P&G’s claim for a foreign tax credit for the Korean taxes. • The court held that “[a]lthough P&G was required to pay Korean tax, and was reasonably advised as to the legality and accuracy of the Korean claim by its Korean counsel, P&G failed to ‘exhaust all effective and practical remedies including invocation of competent authority procedures available under applicable tax treaties. . .’ to reduce the tax liability owed to Japan.” Although the IRS had challenged the creditability of the Korean tax and not the Japanese tax, the court determined that the Japanese payments were not compulsory and that P&G was entitled to a credit for only the payments made to Korea. • Although the court ultimately did not permit a credit for both taxes, it stated: “[i]t may well be that multiple countries can claim tax on a single source of income and that the IRS is required to grant credits for these claims.” 12 What Amount of Foreign Taxes is Creditable? • A foreign tax credit generally is limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income (computed under U.S. tax accounting principles). • Foreign Tax Credit Limitation: Pre-Credit U.S. Tax Liability Foreign Source Taxable Income Worldwide Taxable Income • Limitation is applied separately to baskets: Passive Category Income General Category Income • Source rules and allocation/apportionment rules key in calculating foreign tax credit 13 What Amount of Foreign Taxes is Creditable? Interest Allocation Rules U.S. Group U.S. Group: $1,000 interest expense $1,000 U.S.-source taxable income after interest expense CFC CFC: $1,000 interest expense $1,000 foreign-source income after interest expense $300 foreign taxes • Interest allocation under current law: Under section 864(e), an affiliated group must allocate and apportion its interest expense based on a fraction computed by reference to the assets (measured by fair market value or basis) of the entire group Recognizes money is fungible, but extends this principle only to the water’s edge (i.e., obligations and assets of foreign affiliates are excluded; stock of foreign affiliates is treated as a foreign asset) $700 • Assume 50% foreign assets • CFC’s interest expense is allocated entirely against its foreign source income • U.S. Group’s interest expense is allocated in part against U.S. source income and in part against foreign-source income Because U.S. Group has 1/2 foreign assets, 50% of the $1,000 interest expense is allocated to foreign source income For purposes of the FTC limitation, U.S. Group has $500 foreign source income ([$700 + $300 gross-up] -$500) and will have a $175 FTC limitation ([35% x $2,000] x [$500/$2000]), giving it $175 in credits and $125 carryover 14 What Amount of Foreign Taxes is Creditable? Interest Allocation Rules • In 2004, Congress enacted a worldwide interest allocation rule, which would allow the interest expense and assets of foreign affiliates to be taken into account. Interest expense of domestic members of worldwide affiliated group is allocated and apportioned to foreign-source income only to the extent that (1) the total interest expense of the worldwide affiliated group, multiplied by the ratio which the foreign assets of the group bear to the total assets of the group, exceeds (2) the interest expense of the foreign members of the worldwide group that they would have allocated and apportioned to foreign source income had they formed their own separate group • The effective date of this rule (originally taxable years beginning after December 31, 2008), however, has since been delayed until taxable years beginning after December 31, 2020. U.S. Group U.S. Group: $1,000 interest expense $1,000 U.S.-source taxable income after interest expense CFC CFC: $1,000 interest expense $1,000 foreign-source income after interest expense $300 foreign taxes $700 • Assume 50% foreign assets • Step 1: Total interest expense ($2,000) x 50% foreign assets = $1,000 • Step 2: Interest expense that would be allocated to CFC if CFC were only entity: $1,000 x 100% foreign assets = $1,000 • Result in Step 1 minus result in Step 2 = $0 interest expense of U.S. group is allocated to foreign source income • For purposes of the FTC limitation, U.S. Group has $1,000 foreign source income ([$700 + $300 gross-up] - $0 interest allocation) and will have a $350 FTC limitation ([35% x $2,000] x [$1,000/$2,000]) and thus can fully credit the $300 in foreign taxes 15 Recent Developments 16 “Splitting” of Foreign Tax Credits: Guardian Industries See Guardian Industries v. United States, 77 F.3d 1368 (Fed. Cir. 2007), aff’g 65 Fed Cl. 50 (2003). Guardian (U.S.) IHC (U.S.) GIE (Lux) Lux Subsidiaries Lux Subsidiaries Legally liable for the foreign taxes paid on the subsidiaries’ income under Luxembourg law (so entitled to a foreign tax credit for taxes paid on the subsidiaries’ income). As a result, in this structure, if the operating subsidiaries do not generate subpart F income or distribute dividends to the holding company, the U.S. holding company is entitled to foreign tax credits on foreign income not subject to U.S. tax. Lux Subsidiaries 17 Proposed Legal Liability Regulations • In 2006, Treasury and the IRS proposed regulations (the “Proposed Legal Liability Regulations”) amending the technical taxpayer regulations. With respect to foreign consolidated-type regimes in which foreign tax is imposed on the combined income of two or more persons, including those where the members of the group are not jointly and severally liable for the group’s tax (as was the case in Guardian), the proposed regulations provide that the foreign tax must be apportioned among all the members pro rata based on the relative amounts of net income of each member as computed under foreign law. o The regulations provide, however, that the foreign tax would not be considered imposed on combined income merely because foreign law (a) permitted one person to surrender a loss to another under a group relief regime, (b) required shareholders to include amounts in income attributable to corporate taxes under an integrated tax system, or (c) required shareholders to include in income amounts under an anti-deferral regime. • The regulations also would revise the technical taxpayer regulations to provide that a reverse hybrid (i.e., an entity that is a corporation for U.S. tax purposes but a flow-through for foreign tax purposes) is considered to have legal liability under foreign law for foreign taxes imposed on the owners of the reverse hybrid in respect of each owner’s share of the reverse hybrid’s income. The reverse hybrid’s foreign tax liability would be determined based on the proportion of the owner’s taxable income (computed under foreign law) that is attributable to the owner’s share of the reverse hybrid’s income. 18 Recent Foreign Tax Credit Legislation • P.L. 111-226 (officially the “______ Act of _____”), signed into law August 10, 2010, contained several international tax-related provisions affecting foreign tax credits to offset education and Medicaid spending: Rules to Prevent Splitting of Foreign Tax Credits Denial of Certain Foreign Tax Credits for Covered Asset Acquisitions Separate Foreign Tax Credit Limitation for Certain Items Resourced Under Treaties Limitation on Foreign Taxes Deemed Paid with Respect to Section 956 Inclusions 18 19 “Splitting” of Foreign Tax Credits: Section 909 • Enacted in August 2010, section 909 creates a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income. In general, where there is a “foreign tax credit splitting event” with respect to foreign income tax paid or accrued by the taxpayer, the foreign income tax is not taken into account for U.S. tax purposes before the taxable year in which the related income is taken into account by the taxpayer. o Rule also applies for indirect credits: Foreign income tax paid by a section 902 corporation (i.e., a corporation with respect to which a U.S. corporation can claim a deemed paid foreign tax credit) as part of a splitting event is taken into account in the taxable year in which the related income is taken into account by that section 902 corporation 19 20 “Splitting” of Foreign Tax Credits: Section 909 • A “foreign tax credit splitting event” arises with respect to a foreign income tax if the related income is (or will be) taken into account for U.S. tax purposes by a “covered person.” A “covered person” is: o Any entity in which the payor holds, directly or indirectly, at least a 10% ownership interest (determined by vote or value); o Any person that holds, directly or indirectly, at least a 10% ownership interest (by vote or value) in the payor; o Any person that bears a relationship to the payor described in section 267(b) or 707(b); and o Any other person specified by the Secretary. • Effective Date: Applies to foreign income taxes paid or accrued after December 31, 2010 20 21 “Splitting” of Foreign Tax Credits: Section 909 – Reverse Hybrid Example • US Co, a domestic corporation, wholly owns CFC 1. CFC 1 is organized in Country A and is treated as a passthrough entity for Country A purposes. CFC 1 is treated as a corporation for U.S. tax purposes. CFC 1 is engaged in an active business that generates $100 of income. Country A has a 30% tax rate. • For Country A tax purposes, CFC’s earnings pass to US Co. Under Country A law, US Co is treated as having paid $30 of Country A tax. • Under the old law, the United States views CFC 1 as having $100 of E&P not subject to current U.S. tax and US Co as having $30 of foreign taxes for which US Co may claim a direct foreign tax credit. • Under the new law, the $30 direct foreign tax credit is suspended until the related income is recognized for U.S. tax purposes. CFC 1 must distribute its net income of $100 to US Co before the $30 direct foreign tax credit is allowed. 21 US Co $50 Tax CFC 1 $100 E&P 22 “Splitting” of Foreign Tax Credits: Section 909 – Other Situations Affected? • Disregarded Payments • Group Relief • Liquidation of Person Who Pays or Accrues the Foreign Income Tax • Transfer Pricing Adjustments? • Contributions of Inventory Resulting in Shift of Deductions? • Differences in the Timing of When Income is Taken into Account for U.S. and Foreign Tax Purposes? 22 23 “Splitting” of Foreign Tax Credits: Section 909 – Notice 2010-92 • On December 6, 2010, Treasury and the IRS released Notice 2010-92, "the first of several items of published guidance“ concerning the foreign tax credit provisions of section 909. The guidance primarily addresses the application of section 909 to foreign income taxes paid or accrued by a section 902 corporation in taxable years beginning on or before December 31, 2010. Future guidance will address the application of section 909 to foreign income taxes paid or accrued in post-2010 tax years. • The notice provides an "exclusive list of arrangements" that will be treated as giving rise to foreign tax credit splitting events for purposes of applying section 909 to foreign income taxes paid or accrued by a section 902 corporation in pre-2011 taxable years ("pre-2011 taxes"). These arrangements include: Certain reverse hybrid structures; Certain foreign consolidated groups to the extent that the taxpayer did not allocate the foreign consolidated tax liability among the members of the foreign consolidated group based on each member’s share of the consolidated taxable income included in the foreign tax base under the principles of Treas. Reg. § 1.901-2(f)(3); Certain arrangements involving group relief and disregarded debt instruments; and Certain other arrangements involving hybrid instruments. 24 Denial of Certain Foreign Tax Credits for Covered Asset Acquisitions: Section 901(m) • The new rules are intended to prevent certain U.S. tax elections or transactions from resulting in the creation of additional asset basis eligible for cost recovery for U.S. tax purposes without a corresponding increase in the basis of such assets for foreign tax purposes. • Section 901(m) 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” means: o A qualified stock purchase (i.e., transactions under section 338(g) and (h)(10); o Any transaction that is treated as the acquisition of assets for U.S. tax purposes and as the acquisition of stock (or is disregarded) for foreign income tax purposes; o Any acquisition in a partnership that has an election in effect under section 754; o Any similar transaction to the extent provided by Treasury. The “disqualified portion” of any foreign income taxes paid or accrued with respect to a covered asset acquisition is: o The aggregate basis differences allocable to such taxable year with respect to all relevant foreign taxes, divided by o The income on which the foreign income tax is determined The term “basis difference” means, with respect to any relevant foreign asset, the excess of (1) the adjusted basis of such asset immediately after the covered asset acquisition, over (2) the adjusted basis of such asset immediately before the covered asset acquisition. 25 Denial of Certain Foreign Tax Credits for Covered Asset Acquisitions: Section 901(m) • • • Assume the excess of the purchase price of Foreign Target stock over the basis of Foreign Target’s assets results in an aggregate basis difference of $200. Asset A: $150 basis difference and 15-year recovery period ($10 annual basis difference) Asset B: $50 basis difference and 5-year recovery period ($10 annual basis difference) Under prior law, US Co has additional asset basis eligible for cost recovery for U.S. tax purposes (with no corresponding increase in the tax basis of such assets for foreign tax purposes). Assume Target’s foreign income for year 1 is $100 and foreign taxes are $25. Under new section 901(m), the “disqualified portion of foreign income taxes paid” is aggregate basis differences / income on which foreign income tax is determined • = $20 / $100 = 20% Of the $25 that could be creditable, 20% ($5) will be disallowed as a foreign tax credit, but may be deductible. US Co Foreign Target Foreign Target stock Target shareholders Foreign Target 26 Denial of Certain Foreign Tax Credits for Covered Asset Acquisitions: Section 901(m) • Provision is effective for covered asset acquisitions after December 31, 2010 But does not apply for covered asset acquisitions where transferor and transferee are not related (under section 267 and 707(b)) if the acquisition is: (1) made pursuant to a written agreement that was binding on January 1, 2011; (2) described in a ruling request submitted to the IRS on or before July 29, 2010; or (3) described in a public announcement or filing with the SEC on or before January 1, 2011. • Treasury is given regulatory authority and may issue regulations or other guidance “necessary to carry out the purpose of the provision,” including: An exemption for certain covered asset acquisitions, and An exemption for relevant foreign assets with respect to which the basis difference is de minimis. 27 Separate Foreign Tax Credit Limitation for Certain Items Resourced Under Treaties: Section 904(d)(4) • Certain U.S. tax treaties provide a “re-sourcing” rule, under which a U.S. taxpayer may treat as foreign source any income that the other contracting state may tax under the treaty. • Section 904(h)(1), however, provides a special rule for income earned through a majority U.S.-owned foreign corporation that is attributable to U.S. source income of the foreign corporation, treating such amounts as U.S. source. • In 1986, Congress enacted section 904(h)(10) to coordinate section 904(h)(1) with the treaty rule. Under section 904(h)(1), if o any amount derived from a U.S.-owned foreign corporation would be treated as U.S-source income under section 904(h)(1); o a U.S. treaty obligation would treat such income as arising from sources outside the United States; and o the taxpayer chooses the benefits of the coordination rule, then the amount will be treated as foreign source. However, for foreign tax credit limitation purposes, a separate limitation applies to such amount and the associated foreign taxes. This coordination rule applied only to amounts derived from a U.S.-owned foreign corporation, and not to amounts derived from a foreign branch or disregarded entity. 28 Separate Foreign Tax Credit Limitation for Certain Items Resourced Under Treaties: Section 904(d)(4) • Section 904(d)(6) extends the coordination rule to amounts earned through branches and disregarded entities. • Under the new rule, a separate foreign tax credit limitation basket for any item of income and associated foreign taxes is created if any item of income would be treated as U.S. source (without regard to a treaty re-sourcing rule), under a treaty rule, such item is treated as foreign source, and the taxpayer elects to claim the benefits of the treaty. • Section 904(d)(6) is effective for taxable years beginning after the date of enactment (August 10, 2010). 29 Limitation on Foreign Taxes Deemed Paid With Respect to Section 956 Inclusions • Under sections 951 and 956, a CFC’s increase of its investment of earnings in U.S. property may be subpart F income to the U.S. parent. In the example to the right, US Parent may be allowed a deemed paid credit for taxes paid or accrued on the earnings of CFC 1. US Parent will be treated under section 960 as having paid its pro rata share of the foreign taxes paid by CFC 1 on those earnings, generally to the same extent as if it had received a dividend distribution of those earnings, and may claim foreign tax credits for those taxes. US Parent Loan CFC 1 30 Limitation on Foreign Taxes Deemed Paid With Respect to Section 956 Inclusions • Under prior law, the deemed distribution from the CFC 2 loan would be taxed to US Parent as if CFC 2 paid a dividend directly to US Parent without regard to the income of CFC 1. • As a result, if CFC 1 is in a lower-tax jurisdiction, the tax credit resulting from the section 956 investment in U.S. property is higher when CFC 2 makes the loan than if the amount had been distributed up the chain. In the example, US Parent would have a section 956 inclusion of $100 and a foreign tax credit of $50. US Parent E&P $200 CFC 1 Taxes $10 E&P $100 Taxes $50 CFC 2 $100 Loan 31 Limitation on Foreign Taxes Deemed Paid With Respect to Section 956 Inclusions • Under the new rule (new section 960(c)), for section 956 inclusions attributable to U.S. property acquired by a CFC after December 31, 2010 , the amount of foreign taxes deemed paid is limited to the lesser of: The foreign taxes deemed paid with respect to the U.S. shareholder’s section 956 inclusion (without regard to the provision) (the “tentative credit”), or The hypothetical amount of foreign taxes deemed as computed under the provision (the “hypothetical credit”). o The “hypothetical credit” is the amount of foreign taxes that would have been deemed paid if an amount equal to the section 956 inclusion had been distributed through the chain of ownership that begins with the CFC that holds an investment in U.S. property and ends with the U.S. shareholder. Any withholding/income taxes that would have been paid are not taken into account. 32 Limitation on Foreign Taxes Deemed Paid With Respect to Section 956 Inclusions • The tentative credit would be $50 (100% x $50). • The hypothetical credit would be calculated as follows: CFC 2 to CFC 1: o o o o o CFC 2 tax pool = $50 CFC 2 E&P pool = 100 Hypothetical Dividend = 100 Hypothetical Dividend as % of E&P = 100% Taxes Distributed to CFC = 100% of $50 = $50 CFC 1 to US Parent o CFC 1 tax pool = $10 + $50 in taxes from CFC 2 =$60 total adjusted tax pool o CFC 1 E&P pool = 200 + 100 hypothetical distribution from CFC 2 =300 adjusted E&P o Hypothetical Dividend = 100 o Hypothetical Dividend as % of E&P = 33% o Hypothetical Credit = 33% of 60 = $20 • Because the hypothetical credit is less than the tentative credit, the amount of taxes deemed paid will be limited to the hypothetical credit. US Parent Hypothetical distribution E&P $200 CFC 1 Taxes $10 Hypothetical distribution E&P $100 Taxes $50 CFC 2 $100 Loan 33 Foreign Tax Credit “Pooling” Proposal • The Obama Administration has included a proposal to calculate indirect foreign tax credits on a “pooling basis” in its FY 2010, 2011, and 2012 budget proposals. A similar proposal was included in then-House Ways and Means Committee Chair Rangel’s Tax Reduction and Reform Act of 2007, although the Rangel bill proposal would require blending of foreign tax credits for both direct and indirect credits. • Legislative language was released in conjunction with the Obama Administration’s deficit reduction plan, which includes the pooling proposal as a revenue raiser. 34 Foreign Tax Credit “Pooling” Proposal • Under proposed section 910(a), the amount of foreign taxes deemed paid under section 902 or 960 and allowed as a credit “shall not exceed the amount which bears the same ratio to the sum of the aggregate amount of post-1986 foreign income taxes for that taxable year and the suspended post-1986 foreign income taxes as the current inclusion ratio.” “Suspended post-1986 foreign income taxes”: The portion of the aggregate amount of post-1986 foreign income taxes for any taxable year not allowed as a credit due to the pooling mechanism. “Current inclusion ratio”: o the sum of all dividends received from section 902 corporations during the taxable year plus subpart F inclusions from section 902 corporations (without regard to the section 78 gross-up), over o the aggregate amount of post-1986 undistributed earnings. 35 Foreign Tax Credit “Pooling” Proposal: Example 1a • Under section 910, the deemed paid foreign tax Year 1 credit is not allowed to the extent it exceeds: Aggregate amount of post1986 foreign taxes for year and suspended post-1986 taxes Sum of all dividends and subpart F inclusions with respect to section 902 corporations in the taxable year US Parent Dividend: $100 Aggregate amount of post-1986 undistributed earnings • For Year 1, US Parent’s deemed paid foreign tax credit may not exceed: = ($30 + $30) x [$100/($300 + $100)] = $60 x ($100/$400) = $15 • US Parent has $15 “suspended post-1986 foreign income taxes” because only $15 out of the $30 otherwise allowable under section 902 is allowed under section 910. CFC 1 CFC 2 Undistributed post1986 earnings: $300 Undistributed post1986 earnings: $100 Post-1986 taxes: $30 Post-1986 taxes: $30 36 Foreign Tax Credit “Pooling” Proposal: Example 1b • In Year 2, US Parent has $15 suspended post-1986 Year 2 foreign income taxes from Year 1. CFC 1 earned $30 in Year 2 and paid $1 in foreign tax. CFC 2 earned $10 in Year 2 and paid $3 in foreign tax. CFC 1 pays a dividend of $100. • For Year 2: = ($15 + $31 + 3) x [$100 / ($330 + $10)] = $49 x $100/$340 = $14 • In the absence of section 910, US Parent would have been deemed to have paid $31 x ($100/$330), or $9 • The $9 that would have otherwise been allowable will be creditable, along with $5 of the $15 suspended post-1986 foreign income taxes from Year 1. Dividend: $100 US Parent Low-tax CFC High-tax CFC Undistributed post1986 earnings: $330 Undistributed post1986 earnings: $10 Post-1986 taxes: $31 Post-1986 taxes: $3 37 Ways and Means Discussion Draft: Overview • On October 26, Ways and Means Chairman Camp (R-MI) released a draft international tax reform plan, which would: Reduce the corporate tax rate to 25% Provide a deduction equal to 95% of foreign-source dividends received by a 10% U.S. corporate shareholder from a CFC Exclude 95% of capital gains from the sale of shares in a CFC by a 10% shareholder Generally retain the subpart F rules Adopt a transition rule applying an 85% dividends-received deduction (i.e., a 5.25% rate) to all existing foreign earnings held offshore, regardless of whether they are repatriated Adopt thin capitalization rules for U.S.-owned worldwide groups Adopt special rules for intangibles, providing three options: o (1) President Obama’s “excess returns” proposal, which would create a new category of subpart F income for income attributable to use of intangibles that has not been subject to a specified minimum foreign income tax and that exceeds 150% of costs attributable to such income; o (2) a proposal that would treat low-taxed foreign income not earned from the active conduct of a trade or business as subpart F income; and o (3) an option that would lower the corporate tax rate for all foreign intangible income (whether earned by a U.S. parent or its CFCs) to 15%, but would treat a CFC’s foreign intangible income as subpart F income if it is taxed at a rate less than 13.5% (90% of the U.S. rate). 38 Ways and Means Discussion Draft: Foreign Tax Credit Provisions • Would repeal section 902, including for taxes paid by noncontrolled 10/50 corporation (though shareholders could elect to treat 10/50 corporations as CFCs) • Would retain deemed paid foreign tax credit for income inclusion under subpart F Credit restricted to foreign taxes “attributable to the subpart F inclusion” For purposes of calculating foreign source income under FTC limitation, only directly allocable deductions are subtracted from gross foreign source income • Would allow foreign tax credits for taxable portion of deemed repatriated income • Would remove certain rules relating to deemed-paid foreign tax credits • Would eliminate baskets • Would eliminate section 909 foreign tax credit “splitter” rule 39 FTC “Generator” Transactions: Pritired 1 v. United States (Principal Life) Principal Life Citibank 50% 50% French Banks Pritired 1, LLC $300 million $930 million $291 million PCs and $9 million Class B shares (stapled) The PCs pay floating interest of 3-month LIBOR plus 1%; the Class B shares pay dividends At the beginning of the transaction, the B shares have 2% of the voting rights (may increase to over 50% after 5 years) and a 1% interest in the distributable profit of SAS SAS $475 million in 1% Convertible Notes and $455 million in Class A (common) shares The Convertible Notes pay 1% interest; the Class A shares pay dividends At the beginning of the transaction, the B shares have 98% of the voting rights and a 99% interest in the distributable profit of SAS 40 FTC “Generator” Transactions: Pritired 1 v. United States (Principal Life) Principal Life Citibank 50% 50% French Banks Pritired 1, LLC PC Swap: Pritred pays LIBOR plus 1% (the amount owed by SAS on the PCs) and SAS pays LIBOR plus approximately 5% minus the French tax attributed to SAS SAS High quality debt securities (the majority of which are sold, the rest are transferred under sale and repurchase agreements) French Banks provide interest rate floors to SAS, guaranteeing a minimum level of income to SAS even if LIBOR rates dropped 41 FTC “Generator” Transactions: Pritired 1 v. United States (Principal Life) • The U.S. District Court for the Southern District of Iowa held that the foreign tax credits were disallowed because: Principal Life Citibank 50% 50% French Banks Pritired 1, LLC Pritired was not a partner in SAS (PCs and Class B shares are debt, not equity) Transaction lacks economic substance Transaction violates partnership anti-abuse rule Foreign taxes SAS Foreign taxes paid by SAS are primarily allocated to Pritired 42 The Future of the Foreign Tax Credit 43 What is the Purpose of the Foreign Tax Credit? • To alleviate double taxation? • To help U.S. businesses compete internationally? “In most cases American firms operating abroad think of their foreign business as a single operation and in fact it is understood that many of them set up their organizations on this basis. It appears appropriate in such cases to permit the taxpayer to treat his domestic business as one operation and all of his foreign business as another and to average together the high and low taxes of the various countries in which he may be operating by using the overall limitation.” S. Rep. No. 86-1393 (1960). o Does cross-crediting allow U.S. business to be more competitive abroad? o Is country “competitiveness” a relevant concept? 44 Cross-Crediting: More Generous Than an Exemption System? • Is the following correct? “A foreign tax credit system that allows excessive crediting of foreign taxes is more generous to investment in high-tax countries than an exemption system. This is because under an exemption system excess tax credits from high-tax countries cannot be used as credits against tax on other income. The U.S. tax rules already allow substantial cross-crediting . . . . Cross-crediting is one of several reasons why the U.S. rules are more generous to investment in high-tax countries than under an exemption regime.” ABA Tax Section, Report of the Task Force on International Tax Reform (2006) 45 Evaluating Policy Options Policy Neutrality/ Economic Efficiency Simplicity/Administrability Alleviation of Double Taxation Revenue Exemption of Would promote foreign capital import income neutrality Simpler than current regime? But increase pressure on transfer pricing, sourcing, and allocation of deduction rules; likely need credit for passive income Yes, but potential for but double nontaxation depending on system design Would depend on design of exemption system Unlimited foreign tax credit Would promote capital import neutrality Would appear to be simpler than current regime Yes Potential for erosion of the U.S. tax base Overall limit Would promote capital import neutrality Would appear to be simpler than current Potentially not regime because would not require taxpayers entirely to assign foreign income and deductions to separate categories (but would still require sourcing rules and allocation and apportionment of deductions) Would likely reduce revenue 46 Evaluating Policy Options Policy Neutrality/ Economic Efficiency Simplicity/Administrability Alleviation of Double Taxation Revenue Per-country Promote capital export limit neutrality with respect to low-tax country investment? Would add complexity for taxpayers Potentially not with operations in many countries; entirely would likely need a look-through rule and loss rules Would likely raise revenue because of effect on crosscrediting? Pooling Would appear to promote capital export neutrality Would add further complexity Item-byitem Would promote capital export neutrality Would add complexity as compared Yes to current regime; administrative feasibility? Would likely raise revenue because would prohibit crosscrediting/averaging Deduction only Would promote “national neutrality" Would be simpler than current system; need for renegotiation of U.S. tax treaties? Would likely raise. revenue Potentially not Would raise revenue entirely Not entirely 47 Where Should We Be on This Spectrum? Exemption No Limitation on Credit Overall Limitation Baskets • Where should we be? • Is this spectrum in the right order? Per Country Limitation Per Item Limitation Deduction 48 Is There a Policy Trend Behind Recent FTC Legislation and Proposals? Ways and Means Discussion Draft (2011) Exemption 904(d)(4) (re-sourcing) (2010) No Limitation on Credit Overall Limitation Baskets Fewer Baskets (2004) Per Country Limitation ? ? Proposed Section 910(a) Pooling Per Item Limitation ? Deduction 901(m) (covered asset acquisitions) (2010) 49 Is There a Policy Trend Behind Recent FTC Legislation and Proposals? Less Restrictive More Restrictive • Fewer Baskets (2004) • Recharacterization of Overall Domestic Loss (2004) • Worldwide Apportionment (2004) • • • • Section 901(m) (2010) Section 960(c) (2010) Section 909 (2010) Delay of Worldwide Apportionment (2008, 2009, 2010) • Pooling Proposals (2007-2011) 50 The Foreign Tax Credit Under an Exemption System • Could we repeal the foreign tax credit under an exemption system? Direct credits? Section 902 indirect credit for dividends? Need credit for passive income that is subject to U.S. tax? o Would an overall limitation be sufficient? o How to allocate foreign taxes and deductions between exempt and non-exempt income? Role of foreign tax credits in transition rules?