With life in our nation’s 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.
Much like gray snow trudged through many times before, the budget re-proposes mostly the same-old provisions that have circulated for a few years running (going back to Chairman Charles Rangel’s self-proclaimed “mother of all tax bills” from 2007) 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.
Just like black ice when you are driving in a snowstorm’s aftermath, sometimes what is not visible is more dangerous than what is seen. Notably absent from the 2011 proposed budget is last year’s game-changing proposal on entity classification that would have required significant restructuring for most multinationals using check-the-box planning in the cross-border context. Unlike black ice, however, the “unseen” here should be viewed by most corporate officials as a temporary breath of relief in today’s shaky economic climate.
Nonetheless, we pause to consider the dropping 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 U.S. companies abroad, as Treasury Secretary Tim Geithner would have us believe in his recent testimony? If the administration were serious, wouldn’t we see systemic reform proposals to address the need for jobs and U.S. competitiveness through lower corporate tax rates and the adoption of at least a limited form of territorial or exemption system, as exists with the vast majority of our OECD trading partners? Or, will the administration and Congress continue to take an approach targeted at curbing what it perceives as abuses or gaps in the tax code? For example, how likely is it that the proposal to scale-back the check-the-box rules will be revived in future legislation or through regulatory action?
The push for additional stimulus spending to spur job growth and the recent reinstatement of the “pay as you go” deficit reduction rules are prime indicators that costly corporate tax overhauls are unlikely. Instead, Congress may look for revenue raisers as part of legislative initiatives. Indeed, selected tax offset provisions in the proposed budget have surfaced in the pared-down first Senate jobs bill. It is widely believed that others may be added, as subsequent alternatives no doubt will circulate through Congress over the upcoming weeks. Yet, with Congressional elections looming this November, all this begs the question: will tax reform go the way of the seemingly failed healthcare legislation?
This article addresses the most broadly applicable and significant proposals in the 2011 proposed budget, in an attempt to help U.S. multinational corporations understand how the changes may affect their operations. Also, as a result of the administration’s ongoing effort to prevent U.S. taxpayers from using offshore accounts to hide income and assets, the budget includes measures to support the information reporting, compliance and withholding with respect to offshore accounts. This article outlines steps U.S. multinationals should take to ensure that they are up to speed:
- The article’s first section deals with offshore value subject to attack by way of Internal Revenue Code Section 482 provisions as well as proposals regarding expatriated entities.
- Second, the article analyzes the foreign tax credit proposals that aim to tighten the reins on and reduce the attractiveness of offshore investments.
- Last, but of no less importance in this era of increased government efforts to use compliance reporting to bridge the revenue gap, are the measures to support the information 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. Two provisions are directed at rectifying Section 482’s perceived failure to rein in outbound property transfers. A third reaches back in time to entities that have made the ultimate outbound transfer and have expatriated. With all of these proposals, companies should reconsider the cost-benefit for pending organizational restructurings in light of the potential for additional exit tax costs.
Backstopping Section 482
A new provision would cause a U.S. 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 by segregating this new category of Subpart F income in its own foreign tax credit limitation basket. (According to the revenue projections’ methodology, the benchmark for determining what constitutes a low effective tax rate is 10 percent, and a 30 percent return is considered “excessive.”)
Some traps for the unwary in this proposal concern the fact that it might apply to income from intangibles that companies transferred in past years (with no limit on how far back it could go) and essentially negate a large portion of taxpayers’ pre-existing deferral planning. 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. One reading of the proposal, however, would exempt intangibles developed in a qualified cost-sharing arrangement, for lack of an outbound transfer. In other words, the intellectual property developed after the initial buy-in would not be considered “transferred” because the foreign participant would be considered to have developed the property itself.
As this proposal progresses, and unless Congress moves towards an exemption for foreign-source dividends, we may hear calls for a revival of Section 965 (i.e., a temporary rate reduction on dividends from foreign subsidiaries) to allow companies to clean out their low-taxed earnings and profits (E&P) prior to the proposal’s implementation.
The second proposal attempts to subject the entire value transferred in an outbound business relocation to future U.S. taxation through a refinement of the scope of the bundle of rights transferred and the methodology of pricing such rights. This provision clarifies the definition of intangible property to include workforce in place, goodwill and going-concern value within the scope of Sections 367(d) and 482. 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 realized by choosing “realistic alternatives.” This departs from last year’s proposal, which valued the intangibles at their “highest and best use” in a non-controlled sale. Moreover, like the proposed cost-sharing regulations, it appears to be another departure from the arm’s length standard.
Continuing with the theme of lessening the benefit of offshoring value and earnings, the administration again proposes that expatriated entities be subject to stricter limits on deducting interest paid to related persons. The proposal would eliminate the debt-to-equity safe harbor (currently 1.5:1) and lower the adjusted taxable income threshold for the limitation from 50 percent to 25 percent. The carryforward for disallowed interest would be limited to 10 years, and the carryforward of excess limitation would be eliminated.
The definition of “expatriated” entity, as provided in Section 7874 (enacted in 2004), would apply for taxable years beginning after July 10, 1989. Accordingly, multinationals may need to assess whether they fell under this definition at any point between 1989 and 2004 in order to determine whether they are subject to the proposed rules. This can translate into significant and challenging work for corporate tax departments and advisors.
Broader reform momentum of past years aimed at modifying the U.S.’s thin cap equivalent, i.e., the Section 163(j) earnings stripping provision for all foreign-owned entities is noticeably absent from recent budgets.
Reducing the Attractiveness of Foreign Investment through Changes to the Foreign Tax Credit System
Among the latest proposals, three are particularly significant to multinationals because they fundamentally alter the computation of foreign tax credits and, consequently, affect the corporation’s current tax expense and deferred tax assets.
Under present law, expenses incurred by a domestic corporation that are related to its subsidiaries’ foreign operations (e.g., interest, research & experimentation, stewardship, and general and administrative expenses) 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 U.S. return — for income that is essentially tax-exempt until repatriated — creates an incentive to invest overseas in low-taxed jurisdictions. The JCT noted that similar rules are required in an exemption/territorial system to allocate income between exempt and non-exempt income. Thus, tightening the current allocation rules can be seen as a step toward the eventual adoption of some form of exemption provisions.
The budget proposes deferring only interest deductions allocable to unremitted foreign earnings. This proposal will disproportionately affect taxpayers that borrow in the U.S. to fund offshore investments. The proposal’s effect will be even greater if, as appears likely, the worldwide allocation rules for interest expense, passed as part of the 2004 Jobs Act, do not take effect as scheduled. If enacted, groups with offshore borrowings would be able to apportion less of their interest expense at the U.S. level to foreign-source income, and thus increase their potential U.S. foreign tax credit. Most believe, however, that the worldwide allocations rules will be delayed again, if not scrapped altogether.
A re-proposed provision would require taxpayers to pool all of their repatriated E&P and certain foreign taxes (i.e., Section 902 credits and 10/50 company credits). Mechanically, the U.S. taxpayer would compute its Section 902 credit by multiplying its aggregate foreign tax pool for the eligible foreign corporations (including the indirectly held subsidiaries up to six tiers down) by a fraction — the numerator of which would be the repatriated dividend, and the denominator of which would be the aggregate E&P pool of all these eligible foreign subsidiaries. In effect, the effective tax rate in the blended pool would be the weighted average of the taxes paid or accrued by all of the foreign subsidiaries for which the taxpayer may take a deemed paid credit.
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 utilization and thereby reduce their residual U.S. 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. Consistent with the pooling proposal discussed above and anti-Guardian Industries proposed regulations issued in 2006, the administration’s proposal is intended 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, if this proposal gains traction, watch for guidance on how far pooling and matching will extend — meaning, will the proposals change the Section 904 character? Be sure your foreign tax credit pools are in order as we consider whether post-1986 pools will get caught up in this proposal. Also, 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 U.S. taxpayers from using offshore accounts to hide income and assets, the proposed budget also includes measures to support the 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, notably the UBS case and the offshore credit card initiative. The majority of these provisions would be effective starting 2013. They generally require increased disclosure of foreign financial assets in the U.S. 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 these provisions have largely been adopted from the Foreign Account Tax Compliance Act of 2009 (known as FACTA). FACTA was introduced to the House in October and subsequently became part of the Tax Extenders Act of 2009. The House passed the Extenders bill in December 2009. The first Senate version of a jobs creation bill, cited above, also included these tax offsets. Consequently, these offshore account reporting, compliance and withholding measures are more likely than the other international tax proposals to be enacted. Moreover, these FACTA rules carry hefty penalties.
Alvarez & Marsal Taxand Says:
We expect to see movement on the various tax bills in the upcoming weeks, and the FACTA disclosure and reporting requirements are nearly certain to be included in the bill that moves forward. Thus, financial institutions and others regularly making payments to foreign persons will need to review their current withholding procedures and infrastructure to conform with their obligations under the legislation. Moreover, all corporate taxpayers 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, keep an eye out for selected revenue raisers to appear in legislative proposals in the upcoming weeks.
Also released to provide commentary on the 2011 budget proposal was the “General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals” (better known as the Greenbook).
Officially known as the Tax Reduction and Reform Act of 2007, H.R. 3970, 110th Cong. (2007).
On Friday, February 12, 2010, President Obama signed into law the Statutory Pay-As-You-Go Act of 2010, H.J.Res. 45, 111th Cong. (2010), which increases the public debt limit from $12.394 trillion to $14.294 trillion, and establishes a statutory Pay-As-You-Go procedure that requires that new non-emergency legislation affecting tax revenue or mandatory spending cannot increase the federal deficit.
S. Amendment 3310, Substituting Text of Hiring Incentives to Restore Employment Act for House Amendment to H.R. 2847, Commerce Justice Science FY 2010 Appropriations Bill, by Sen. Reid.
This is one of two proposals that would begin to expand again the number of Section 904(d) baskets, which were reduced from nine to two only six years ago. This proposal is also reminiscent of the now-repealed Section 956A, which required a U.S. shareholder of a controlled foreign corporation to include in its gross income its pro rata share of the CFC’s earnings invested in excess passive assets.
An expatriated entity would be defined by applying the rules of Code Section 7874 and the regulations thereunder as if Section 7874 were applicable for taxable years beginning after July 10, 1989. This special rule would not apply, however, if the surrogate foreign corporation is treated as a domestic corporation under Section 7874.
American Jobs Creation Act of 2004, H.R. 4520, 108th Cong. (2004) (enacted).
See S. Amendment 3310, supra, which proposes extending its application an additional two years to tax years beginning after December 31, 2019.
Guardian Indus. Corp. v. United States, 65 Fed. Cl. 50 (Fed. Cl. 2005).
United States v. UBS AG, S.D. Fla., No. 09-60033-CR-MARRA, information unsealed 2/18/09.
Juan Carlos Ferrucho
Managing Director, Miami
Lisa Askenazy Felix, Senior Director and Rosann Torres, Senior Director contributed to this article
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