Almost two years ago, we wrote in these pages about the importance of companies taking a fresh look at their foreign tax credit profile as many began to eat through loss carryforwards and emerge as cash taxpayers once more.
2015 was a simpler time: “border adjustments” sounded like a Middle East peace plan, a 35 percent corporate rate was part of the fabric of America, and territorial regimes just seemed, well, European. All that has changed in a few short months, and with the potential for comprehensive tax reform occurring sometime in the current year, multinational companies are waiting eagerly for any morsel of detail about what shape reform will take.
While many companies are cautiously taking a “wait and see” approach, at least one tried-and-true tax savings mechanism is as valuable as ever: the foreign tax credit. Of course, a foreign tax credit is typically not generated until a repatriation event, which begs the question: “Why on Earth would we repatriate today?”
It’s a fair question: if tax reform moves the U.S. onto a so-called “territorial” system, then repatriation from foreign subsidiaries will be exempt from U.S. tax — shouldn’t we wait and see if that happens before we bring any earnings back to the U.S.? On the surface, it would appear to be a no-brainer. But foreign tax credits may throw a wrench into the equation, which is why many companies have maintained or even increased their repatriation in recent months. Further, many companies may be sitting on pockets of offshore earnings that offer unique foreign tax credit potential under current law. Simply put, both because of and in spite of tax reform, foreign tax credits continue to offer a valuable tax savings opportunity.
Historical E&P Tax — Cashing In on Highly Taxed Earnings
Lockstep with any shift to a territorial regime under proposed tax reform may be a one-time deemed repatriation of all deferred foreign earnings. Both the House Republicans’ Blueprint and President Trump’s campaign tax plan called for such a tax, albeit at reduced rates (3.5 percent or 8.75 percent under the House plan, depending on the makeup of the earnings; 10 percent for all earnings under the Trump plan). A one-time tax has also garnered support among Democrats, who see it as a revenue source for infrastructure spending.
The exact mechanics of a one-time tax are still very much unknown — specifically, whether the deemed repatriation tax allows for a foreign tax credit. Our most recent reference point is the 2004 American Jobs Creation Act, which allowed for a repatriation holiday, whereby 85 percent of foreign repatriation could be exempt from tax, with a pro-rata reduction for any foreign tax credit benefit. As of the time of this writing, whether or not a one-time mandatory tax would follow suit and allow for a ratable foreign tax credit was unknown.
While the mechanics of the one-time tax are blurry at best, companies with high-taxed foreign earnings should be analyzing today whether they can achieve a better result by repatriating before any such one-time tax is levied. For example, a company with a pool of non-U.S. earnings subject to a 30 percent foreign tax rate may only be subject to an incremental 5 percent of U.S. tax after foreign tax credit upon an actual repatriation of those earnings. Conversely, if those earnings are subjected to a one-time tax, they may be taxed in the U.S. at rates as high as 10 percent. By triggering a U.S. income inclusion on such earnings before a one-time tax is levied, a taxpayer in this scenario may be able to reduce the tax associated with those earnings by half.
As if paying more tax than may have been necessary on the one-time deemed repatriation wasn’t bad enough, a shift to a territorial regime could mean that existing foreign tax pools might become worthless from a U.S. perspective. Companies should be analyzing right now whether the combination of a one-time tax on historical earnings and profits (E&P) and the U.S.’s adoption of a territorial regime would be more or less costly than the tax associated with a current repatriation. As we discussed in a recent Tax Advisor Minute, building this knowledge today will equip multinationals to make fast, educated decisions once the mechanics of the one-time tax become clearer.
Making American Dollars Great Again
As mentioned, there is a great deal of uncertainty as to what form foreign tax credits will take in a post‑reform landscape. And as if making a final pitch for self-preservation, many foreign tax pools are as valuable as ever thanks to the recent strengthening of the U.S. dollar. In the past 12 months, the dollar has risen 5 percent against the euro and 10 percent against the pound (in no small part due to post-Brexit concerns). The relative strengthening of the dollar has, for many companies, generated a curious growth in their foreign tax pool rates because of a mismatch in the underlying mechanics of how companies are required to track E&P pools and related foreign tax pools.
Foreign E&P pools are maintained in their functional currency, typically the local currency. Generally, only a repatriation event warrants (for tax purposes) a conversion of that E&P pool into U.S. dollars. That conversion is generally made at the spot rate on the date of the repatriation. However, foreign tax pools are maintained in U.S. dollars — when a payment is made to a local taxing authority, the payment is converted to U.S. dollars on that date. This results in a mismatch — E&P pools fluctuate in value based on the underlying currency values, while foreign tax pools are static. The result is that historical foreign tax pools paid in currencies that have weakened against the dollar have risen in value relative to their underlying E&P as the dollar has strengthened.
Recall the formula for the amount of foreign tax credits carried by a distribution from a foreign subsidiary: [(Earnings Distributed / Total E&P Pool) x Foreign Tax Pool]. If an entity’s underlying E&P pool reduces in value against the U.S. dollar, each dollar of repatriation from that entity carries a greater portion of its foreign tax pool. Given the recent increase in U.S. dollar value relative to many other currencies, many companies’ foreign tax pools may be more valuable than ever.
Review Your Profile Today
Foreign tax credits remain one of the most valuable tax savings mechanisms available to multinationals, which of course means that mountains of complex rules exist to limit their utilization. These obstacles include the overall foreign loss, anti-splitter and anti-hopscotch rules (to name just a few). Rapidly approaching tax reform is forcing multinationals to make decisions today about what actions they should take (both before and after potential legislative action) to efficiently utilize foreign tax credits. These decisions should be made with a proper analysis of what amount of credits might be available.
If such an analysis has not been prepared recently, there may be traps for the unwary that could severely limit the availability of foreign tax credits. Take, for example, the overall foreign loss (OFL) rules. OFLs reflect historical U.S.-source income that has been offset by foreign-source losses. Companies with substantial deferred foreign earnings may have generated OFLs without even realizing it. When calculating your foreign tax credit limitation, an OFL balance may significantly reduce the amount of credits available by recharacterizing foreign-source income as U.S.-source.
If and when reform is enacted, many companies may lack the time or resources to prepare a comprehensive study of their foreign tax credit profile, especially if any legislative changes have retroactive applicability. Traps like the OFL rules require thorough, multi-year analyses — ones that should not be performed at the last minute. Rather, tax departments should equip themselves now with the tools to execute within a short window as the tax reform efforts progress.
These efforts should include examining existing attributes and whether they can be utilized both before and after reform. Under the current foreign tax credit carryover and ordering rules, credits can be carried back one year and forward ten, and current year credits must be utilized before carryovers. However, companies’ ability to utilize foreign tax credit carryovers under a territorial system is a significant unknown under the House Blueprint. With tax reform casting doubt on the creditability of foreign taxes in the future, taxpayers should examine their prior year returns to identify any capacity for foreign tax credit carrybacks.
In addition to understanding their pre-reform planning opportunities, companies preparing audited financial statements will be required to reflect the impact of reform on their first set of post-reform financials. For many companies, this means that the entire weight of tax reform will have to be analyzed and reflected on a quarterly tax provision. This includes analyses of foreign E&P and tax pools, identification of deferred balances that may be revalued, and determinations of the need for valuation allowances on existing deferred tax assets (i.e., foreign tax credit carryforwards). Having those exercises completed today will save considerable headaches at provision time.
Alvarez & Marsal Taxand Says:
Until tax reform becomes a reality, foreign tax credits will continue to be one of the most effective mechanisms for tax savings available to multinationals. While some of the reform proposals from the White House and Congressional Republicans cast uncertainty as to what form foreign tax credits will take in the future, a robust analysis today will help companies identify opportunities to maximize the benefit from existing foreign tax pools in the short term and execute on those opportunities within a potentially narrow window afforded by tax reform.
A&M has assisted numerous clients in identifying these opportunities and analyzing companies’ foreign tax credit profiles under both current law and various reform proposals. Our modeling tools allow for ease of analysis of the various complex rules surrounding foreign tax credits, including overall foreign losses and overall domestic losses.
Regardless of what shape tax reform takes (if any), now may be the best time to review your foreign tax credit profile to understand what attributes your company may have available and what opportunities currently exist to capitalize on them.