Printable versionSend by emailPDF version
August 25, 2010

On August 10, 2010, President Obama signed the Education Jobs and Medicaid Assistance Act (H.R. 1586), which changes the foreign tax credit regime as a way to help pay for a temporary increase in funding for Medicaid and education. These provisions were largely unvetted as of May 20, 2010, when they were introduced by the House in the extenders legislation, and many are complex and fraught with uncertainty. This legislation is now law and will impact corporate America in calendar year 2011 (with some impacts to certain filers as early as fiscal years beginning after enactment).

Some of the most significant changes are aimed at specific planning techniques employed by U.S. multinationals to enhance foreign tax credit utilization. The full complement of changes is designed to:

  • prevent the “bailout” of foreign earnings free of U.S. tax;
  • disallow the splitting of earnings and associated foreign taxes;
  • shut down specific foreign-source income-generation techniques; and
  • ensure all foreign assets are included in determining the foreign asset ratio for interest expense apportionment purposes.

The new legislation aims to prevent taxpayers from utilizing foreign tax credits beyond what is needed to prevent double taxation. However, some of these legislative changes may have unintended consequences.

We addressed one major area of compliance headache (and complexity) in Issue 30 of Tax Advisor Weekly (30-Jul-2010): . The changes anticipated in that article were adopted in final form by this Bill and will now apply to transactions after December 31, 2010. Your corporate tax department will need to be ready for complex new calculations for each and every foreign entity acquired after that date for which a step-up is available under U.S. tax law. As we described in Issue 30 of Tax Advisor Weekly, acquisitions from foreign buyers routinely include Section 338 elections for a host of reasons and would now be subject to these additional requirements.

Limitation on Deemed-Paid Taxes from Section 956 – Unintended Consequences

As an illustration of possible unintended consequences, the new legislation limits the deemed-paid taxes that are available when a controlled foreign corporation (CFC) subsidiary makes a loan that causes an income inclusion under Section 956. The aim of the legislation is to prevent U.S. taxpayers from “hopscotching” over pools of low-taxed earnings and profits.

Prior to this change, a U.S. taxpayer with a highly taxed CFC could elect to loan earnings to a U.S. member of the group to gain access to the foreign cash and possibly avoid an incremental tax in the U.S. The loan created an income inclusion of the highly taxed foreign subsidiary’s earnings without requiring the entity to declare a dividend of its earnings (possibly incurring foreign withholding tax and blending its highly taxed earnings with lower-tax earnings of a CFC holding company). This simple planning technique is used by many U.S. based multinationals to avoid double taxation on income that has already been subject to substantial foreign taxation.

The new legislation limits the deemed-paid taxes available for credit in the U.S. return to the credit that would have been available if the foreign subsidiary had distributed the funds up the chain to the U.S. shareholder. Essentially, this legislation forces the taxpayer to blend the effective tax rate of each foreign earnings pool that exists between the foreign lender and U.S. shareholder. The tax blending consequence is intended to stop perceived abuses, but this legislation may have an unintended result when earnings deficits or previously taxed income pools exist within the chain.

In addition to requiring yet another set of complicated calculations (any Section 956 inclusion now requires a “with and without” analysis), there are many other unforeseen outcomes of the overlaid fiction. Note that a taxpayer may have a lower credit under the fiction, but not a higher credit. If there is a deficit company in the chain, does the dividend stop there and become a return of capital? If so, does the distribution spring back into a dividend when it passes in and out of a pool of earnings higher up the chain? That result would effectively orphan the taxes in a deficit company.

Taxes could also get “hung up” when there is a pool of previously taxed income (PTI) between the debtor and the U.S. shareholder. The distribution would come out of PTI first, delaying the inclusion of foreign taxes.

With the current lapsed status of the “look through” rule, does the fictionalized distribution cause the intermediate recipient to recognize foreign personal holding company income, thereby stopping the distribution up the chain with the deemed-paid taxes coming entirely from that entity’s earnings pool?

When the limitation applies, are we to treat the “fiction” as fact? Are the earnings and profits (E&P) and tax pools of all intermediate entities to be adjusted for the fiction after we determine that the Section 956 fictional limit applies? How do we apply the rules when there are loans from multiple CFCs?

The new Section 956 will require a careful and thoughtful analysis, possibly creating one more roadblock for U.S. based multinationals to access foreign cash without an increase to their U.S. tax burden.

Rules to Prevent Splitting Foreign Tax Credits from Income – Unintended Consequences

The new legislation may also cause unintended consequences through the required deferral of foreign tax credits until the related foreign income is taxed in the U.S. The new legislation does not address the possible mismatch between U.S. and local country tax law that ensues from a foreign tax credit splitting event. The mismatch may create unintended legal restraints that would make it difficult or impossible to access the earnings related to the separated foreign tax credits.

Assume a situation in which foreign subsidiary 1 makes a hybrid loan to foreign subsidiary 2 and the loan is considered equity for U.S. tax purposes and debt for local country purposes. Further assume that $100 of interest income is accrued (not paid) at foreign subsidiary 1. Under this scenario, foreign subsidiary 2 has no income and foreign subsidiary 1 has $100 of income and associated taxes for local country purposes. For U.S. tax purposes, foreign subsidiary 2 is considered to have $100 (the accrued interest is ignored because the U.S. views the hybrid loan as equity) and foreign subsidiary 1 is considered to have the associated taxes (assume $30).

This mismatch between local law and U.S. law related to whether the $100 of income exists at foreign subsidiary 2 could be problematic in attempting to either access the $30 of taxes deemed paid and/or subjecting the $100 of income to U.S. tax. There may be local country legal restraints that would preclude the repatriation of the $100 from foreign subsidiary 2 (given that it has no earnings for local country purposes). In addition to the mismatch issue, one must consider the foreign currency implications related to aligning earnings and related taxes (assuming subsidiaries have different functional currencies), as required by the new legislation.

Avarez & Marsal Taxand Says...

The new rules create overly burdensome compliance requirements for companies to maintain earnings and related taxes on both a pre- and post-2010 basis and also on a U.S. and local country basis (for the same pool of earnings). The presence of every hybrid loan (and entity) in the company’s structure will have to be evaluated to determine whether there is a tax splitting event. In addition, the fiction created by Section 956 loans will require a thorough analysis and quite a few “positions” on how to apply the rules in practice.

The scenarios above are only two examples of how the new international tax legislation aims to achieve one goal while creating a host of unintended consequences. Taxpayers may now be left with fewer opportunities to optimize their foreign tax credit profile, with repatriation of foreign earnings riddled with unforeseen consequences.

With careful analysis and thoughtful application of the rules, there may be an opportunity before the enactment date to lessen the impact to the corporate tax posture. These rules are more complex than they appear at first blush, and decisions must be made on how to apply them based on sound reasoning.

Now that the law is signed, every corporate taxpayer impacted by these rules should do the following:

  • Prepare your company’s disclosure of any changes the new legislation will have on its financial statements (this may be required for 2010 year end financials).
  • Analyze how the new tax legislation impacts your company’s cash tax cost (the impact will be a part of first quarter 2011).
  • Determine the impact that the new legislation will have on your company’s effective tax rate (the impact will be a part of first quarter 2011).
  • Establish your procedures for applying the new rules and a process for capturing and maintaining the necessary data.


For More Information on this Topic, Contact:

Juan Carlos Ferrucho
Managing Director, Miami

Albert Liguori
Managing Director, New York

Ernesto Perez
Managing Director, New York

Other Related Issues:



We would like to hear from you.


As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

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.

About Alvarez & Marsal Taxand

Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.

Alvarez & Marsal Taxand is a founding member of Taxand, the first global network of independent tax advisors that provides multinational companies with the premier alternative to Big Four audit firms. Formed in 2005 by a small group of highly respected tax firms, Taxand has grown to more than 2,000 tax professionals, including 300 international partners based in nearly 50 countries.

To learn more, visit or

© Copyright 2010 Alvarez & Marsal Holdings, LLC. All Rights Reserved.

Alvarez & Marsal | 6th Floor | 600 Lexington Avenue | New York | NY | 10022