2015-Issue 21—A common structure for U.S.-based multinationals entails the use of holding companies in certain jurisdictions such as Ireland, the Netherlands, Switzerland or Luxembourg. A properly structured holding company along with an affirmative assertion to permanently reinvest earnings has provided many of these companies with a significant financial statement benefit with respect to their effective tax rates. This coupled with the economic downturn during the “Great Recession,” favorable rules related to depreciation (i.e., bonus depreciation) as a way to spur capital investment, and the low interest rate environment resulted in many companies generating a net operating loss (NOL) for U.S. tax purposes while continuing to defer foreign earnings. During a period that a company is generating NOLs, and perhaps for the periods of initial utilization of those NOLs, companies have not had the need to focus on the ability to utilize their foreign tax credits (FTCs).
Many companies are now utilizing the NOLs created during the economic downturn. As a result, many tax departments are now analyzing the ability to utilize FTCs prospectively, including amending prior returns to claim an FTC carryforward.
The Internal Revenue Code provides for an FTC and/or an indirect FTC (also known as a "deemed paid” FTC where a domestic C corporation owns 10 percent or more of the voting stock of a foreign corporation). From a policy standpoint and to preserve the purpose of the FTC, the amount of FTC that can be utilized in any particular year is limited to the amount of U.S. tax payable on foreign source income. The FTC should only reduce the U.S. taxes payable on the foreign source income and not reduce the U.S. taxes payable that are associated with U.S. source income. A taxpayer must have both net foreign source income (i.e., gross foreign source income after apportioned and allocable expenses) and worldwide taxable income in a particular year in order to claim an FTC. Accordingly, where a taxpayer is utilizing its NOL carryforward, it generally does not have worldwide taxable income.
Generally, the largest item to be apportioned to gross foreign source income is often interest expense, given the presence of leverage in many organizations. Operating under the general principle that debt is fungible, the regulations provide for the apportionment of interest expense against foreign source income. Interest expense is generally apportioned to all gross income based on average asset value using one of three methods: tax book value, alternative tax book value, or fair market value.
The default method for apportioning interest is tax book value method (TBV). Under the TBV, assets are measured by averaging the taxpayer’s current and prior year tax basis in its U.S. assets. Where a taxpayer has availed itself of bonus depreciation, it has reduced the basis of its U.S. assets. For purposes of determining the taxpayer’s foreign assets, if the taxpayer owns 10 percent or more of stock of a nonaffiliated U.S. or foreign corporation, the TBV of the stock must be adjusted by its earnings and profits. The result of this adjustment is intended to approximate the fair market value of the stock. Accordingly, where a taxpayer has implemented a tax deferral structure and accumulated a significant amount of earnings offshore, the tax basis in taxpayer’s investment in the foreign holding company is adjusted upward for the unremitted earnings & profits (E&P). As result, the value of the taxpayer’s U.S. assets relative to the adjusted value of the taxpayer’s foreign assets maybe unfavorable (i.e., the adjusted basis in the stock of the foreign holding company increased by its E&P is significant when compared with the adjusted basis of the U.S. assets post bonus depreciation).
An alternative valuation method is fair market value (FMV). The FMV method may help a taxpayer mitigate the unintentional skewing of interest expense that would be allocable to foreign source income under the TBV method. Such skewing occurs when the economic value of the U.S. income-producing assets would not otherwise be reflected in, for example, the TBV method. The FMV method is designed to adjust the relative values of the U.S. and foreign assets to reflect their real economic income-producing value to the worldwide enterprise.
A taxpayer may elect to use the FMV with respect to any taxable year for which the statute of limitations is open. (See Rev. Proc. 2000-37, 2003-21 IRB 950.) By electing the FMV method, a taxpayer may be able to reduce the amount of interest expense apportioned to its foreign source income, maximizing its FTC limitation (or reducing its overall foreign loss).
Preliminary considerations for making the FMV election include, but are not limited to:
- Does the company have foreign operations?
- Is there a high level of interest expense?
- Is there a taxable position in the U.S.?
- Is the company likely to be in an excess foreign tax credit position?
- Could the company benefit from additional foreign source net taxable income?
If so, the next step is to consider the indicators of a potential benefit. Potential indicators of making the election include:
- Is the fair market value of U.S. tangible assets, as a percentage of total company tangible assets, greater than the tax basis of U.S. tangible assets?
- Is there a substantial intangible asset value based on the FMV method? If so, is there a high domestic percent component that leads to a higher percent using the FMV method?
If the above indicators appear to potentially provide a favorable position, rather than immediately moving forward with a full FMV election analysis, a prudent approach is to first conduct a diagnostic analysis to better understand the potential economic benefit of a full analysis. This will allow for a more informed decision-making process prior to undertaking a more time-consuming process. The steps involved in a diagnostic approach include:
1. Estimate the business enterprise value of the company, utilizing a stock price approach for public companies and a high-level valuation analysis for non-public companies.
2. Perform a high-level estimate of the FMV of the company’s domestic versus international assets.
3. The focus of the above step is the tangible assets, given that these are the assets that require a subjective analysis instead of a mechanical calculation (which is the case when allocating other assets, i.e., intangible assets). We typically recommend one or two approaches to conducting this high-level valuation:
a) Identify a representative sample of tangible assets that reflects the company’s overall tangible asset composition, valuing the sample assets and extrapolating to the remaining assets;
b) Conduct a high-level “trend analysis” utilizing available fixed asset ledgers.
4. Estimate the preliminary cost/benefit estimate of electing the FMV method through comparison to the percentage allocation derived from the TBV method. This analysis should incorporate a sensitivity analysis using a range of assumptions.
5. Assess the risk associated with electing the FMV method.
It is important to note that that the results of the diagnostic approach are designed only to provide a potential range of indicated values, and will not provide sufficient analysis nor documentation to support a FMV election. It is also vital to understand that the diagnostic approach provides a much more refined analysis and result than some cursory “back of the envelope” approach, which we caution against using given the frequent accuracy-related issues when implemented.
Finalized regulations issued on July 16, 2014, provide a six-step formulaic approach to determine the amount of interest expense to be apportioned between the statutory and residual groupings. (See Treas. Reg. Section 1.861-9T(h); note: The Treasury issued final regulations under Treas. Reg. Section 1.861-9(h)(4) in July 2014.) We are not going to address all six steps but only provide a couple of observations:
1. Valuation of tangible assets: The key to an efficient approach is in the planning phases.
i. What is the condition of the fixed asset ledger?
ii. Is there a central fixed asset ledger?
iii. Are ledgers maintained separately at each location?
iv. Are original costs actual or, in some cases, fair market value (due to being purchased as part of acquiring another business)?
v. Are fully depreciated assets removed from the fixed asset ledgers?
2. Apportionment of the intangible: The allocation under the regulations does not necessarily take into account the location of where the value was created.
3. Valuation of related-party debt & stock: The finalized regulations clarify that related-party debt is an asset in the hands of the creditor; therefore, it is included in the valuation of the stock of a related person (e.g., CFC).
In our experience, companies that elect the FMV method achieve a greater benefit in maximizing their FTC limitation than those using the TBV method, particularly given the presence of factors including usage of bonus depreciation in the U.S., high basis/E&P in the stock of CFCs, etc.
The taxpayer must establish the fair market value of its assets to the satisfaction of the Commissioner for each taxable year. (See Treas. Regs. Section 1.861-9T(g)(1)(iii).) As a reminder of the importance of properly documenting the valuation of assets under the FMV election, the IRS released administrative guidance in 2010 (FFA 20100502F). In this release, the IRS made clear that an FMV method election will only be respected if the taxpayer can prove the values of a substantial portion of the assets. Use of skilled valuation professionals, therefore, is an important factor when considering the FMV election. However, the IRS National Office has advised IRS examiners that if there are only minor factual changes in a taxpayer’s business, it may not be necessary to re-evaluate all of a taxpayer’s assets each year (1996 FSA LEXIS 205), or conduct a new detailed study each year, even though a taxpayer is legally obligated to conduct such a study. (See 1997 FSA LEXIS 201.)
Electing the FMV method is a decision that should not be taken lightly due to the additional administrative burdens associated with the election and the fact that it is a binding election requiring permission of the Commissioner to change from the FMV method to another method. (See Treas. Reg. Section 1.861-8T(c)(2); Rev. Proc. 2006-42, 2006-47 I.R.B. 1093 (automatic consent to change from alternative tax book value or fair market value method to a different method under certain circumstances); Rev. Proc. 2005-28, 2005-21 I.R.B. 1093 (special two-year automatic consent to adopt alternative tax book value method); PLR 201024042 (domestic corporation permitted to change to tax book value method because of costs and uncertain results associated with fair market value method).)
Alvarez & Marsal Taxand Says:
- Use of the TBV can create a skewed result due to low basis in U.S. assets versus high basis/E&P in the stock of CFCs.
- Interest expense usually is the largest expense apportioned against gross foreign source income. (Note: Do not forget the interest netting rule.)
- Conducting a diagnostic to assess the potential benefit is a prudent approach.
- The FMV election doesn’t have to be viewed as a daunting task; an efficient, organized approach can readily be applied to streamline the process and minimize the time spent by the company. See, e.g., FAA 20100502F, where the establishment of value for a substantial portion of assets should be sufficient.
- FMV generally can be elected for open years. See Rev. Proc. 2003-37, Section 4.01, 2003-21 IRB 950.
About the Author
Managing Director, New York
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Philip Antoon and Nicolaus McBee contributed to this article.
Managing Director, New York
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Kristina Dautrich Reynolds
Managing Director, Washington DC
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Managing Director, New York
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Director, New York
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The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.