The Future of the Foreign Tax Credit

Report
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repealed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repealed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?

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