By David Shakow
If you haven’t memorized the 433 pages of the latest version of the American Jobs and Closing Tax Loopholes Act of 2010 (undoubtedly named to allow for the euphonious acronym, AJACTLA), you are denying yourself a unique treat. (To get the true flavor, don’t forget the fifteen pages of amendments included with the House passage of the bill on May 28.) We will allow others to give you a full rundown of the 206 sections of the bill and content ourselves with a summary of the highlights.
Much of the bill is taken up with extensions of provisions that are soon set to expire (or already have), including:
- the expensing of environmental remediation costs (section 198(h));
- the deduction allowable under section 199 with respect to income attributable to domestic production activities in Puerto Rico (section 199(d)(8));
- the exceptions for active financing income under subpart F (sections 953(e)(10) and 954(h)(9)); and
- the look-thru treatment of payments between related controlled foreign corporations under the foreign personal holding company rules (section 954(c)(6)).
Seeking revenue to offset the cost of many of these extenders, Congress has added a number of new provisions that require a bit more explanation.
Prevention of Foreign Tax Credit Splitting
New section 909 would attack “foreign tax credit splitting events,” where a foreign entity pays a foreign tax, but the related income is taken into account by another related party. Under the new provision, when such a splitting event occurs, the foreign tax is not taken into account for foreign tax credit purposes until the related income is recognized for U.S. tax purposes. The target of the provision is situations where a U.S. taxpayer takes the benefit of a foreign tax credit although the U.S. taxpayer has not recognized the related income. As currently drafted, the new provision would apply to foreign taxes paid or accrued after May 20, 2010. Thus, it will apply to transactions that occurred before this provision was proposed. [Section 401 of the bill]
Denial of Foreign Tax Credits for Covered Asset Acquisitions
New section 901(l) denies foreign tax credits to the extent they relate to basis differences resulting from a “covered asset acquisition.” The provision targets any transaction in which the basis of an asset is increased for U.S. tax purposes but not for foreign tax purposes, for example, when a section 338 election is made with respect to the acquisition of a foreign corporation. As a result of the asset having higher basis for U.S. tax purposes, the foreign jurisdiction’s income, with respect to which the foreign tax credit is generated, would be greater than the income recognized for U.S. purposes, and the foreign tax credits that are generated could be used to offset U.S. taxes on other foreign income. [Section 402]
Separate Foreign Tax Credit Limitations on Resourced Items
Section 904(d)(6) is amended so that, in any case where a treaty transforms U.S.-source income into foreign-source income, the limitation on the use of foreign tax credits is applied separately to each such item. This is intended to prevent taxpayers from using foreign tax treaties to identify lightly-taxed income as foreign-source to absorb other foreign tax payments. [Section 403]
Limitation on Deemed Payment of Foreign Taxes on Section 956 Inclusions
Under section 956, when a CFC makes certain investments in the U.S., the CFC is deemed to have paid a dividend to the U.S. parent. If there are intervening companies in the corporate chain between the CFC and the U.S. parent, the dividend is treated as paid directly from the CFC to the parent, pulling up foreign taxes at the rate paid by the CFC. In some cases, if the CFC had paid the dividend directly up the chain, a lower amount of foreign taxes would have been creditable, and the deemed payment by the CFC is said to have “hopscotched” over the intervening entities.
New section 960(e) is added to limit the amount of taxes deemed paid by a foreign corporation in the case of a section 956 inclusion to the amount that would actually have been paid if cash in the amount of the inclusion in income of the domestic corporation had been distributed through the chain of corporations starting with the foreign corporation that is deemed to have paid the tax up to the domestic corporation. Note that this limitation applies without reference to any tax-avoidance intention of the parties. [Section 404]
Redemption of U.S. Entity by Foreign Subsidiary
New section 304(b)(5)(B) is inserted in section 304(b)(5). This amendment targets a perceived abuse that arises when the U.S. subsidiary of a foreign corporation in turn controls a foreign corporation. If the foreign grandchild’s earnings are paid up through the U.S. subsidiary to the foreign parent, a U.S. tax applies to the dividend paid to the U.S. subsidiary, and a withholding tax applies to the dividend paid by the U.S. subsidiary. To avoid this withholding tax, the foreign parent could sell stock of its U.S. subsidiary to the foreign grandchild. Under section 304, this would draw up earnings and profits from the foreign grandchild, and those earnings and profits would avoid U.S. tax. Under the proposed amendment, where a section 304 acquisition occurs, and the acquiring corporation is a foreign corporation, no earnings and profits will be shifted under the normal section 304 rules if more than 50 percent of the dividends that would otherwise arise under section 304 would either
- not be subject to tax in the year the dividends arise, or
- would not be included in the earnings and profits of a CFC.
Accordingly, the foreign grandchild’s earnings and profits are not reduced, and they remain available to be taxed in the U.S. [Section 405]
Inclusion of Foreign Corporations in Affiliated Groups for Interest Expense Allocation
Because money is fungible, the tax law worries that multinational corporate groups will shift interest expenses to minimize taxes. Interest deductions are allocated within an affiliated group of corporations based on the relative size of their assets, rather than on the basis of their income. For purposes of allocating the interest deduction, not all affiliated foreign corporations are taken into account. Section 864(e)(5)(A) is amended to make a foreign corporation part of an affiliated group for purposes of the interest allocation regulations if
- more than 50% of the foreign corporation’s gross income is effectively connected with a U.S. trade or business, and
- at least 80% (vote or value) of the foreign corporation is owned by members of the affiliated group [Section 406]
Under the current regulations, if between 50% and 80% of the foreign corporation’s income is effectively connected income, only a portion of the assets would be taken into account for purposes of allocating the interest deduction.
Repeal of the 80/20 Rules
Section 861(a)(1)(A), the so-called 80/20 rule, is repealed. Under the 80/20 rule, dividends and interest paid by a domestic corporation with at least 80% foreign source gross income are treated as foreign source. Accordingly, they are not subject to withholding and could be treated as foreign-source income for purposes of the foreign tax credit. The repeal was prompted by perceived abuses by some 80/20 companies. In order to provide relief for certain existing 80/20 companies, there are six-pages of grandfather rules associated with this repeal. [Section 407]
Sourcing Rules for Guarantee Fees (Reversal of Container Corp.)
Section 861(a)(9) is added to the Code. It sources guarantee fees like interest, so guarantee fees paid by a U.S. resident would be U.S. source (and subject to withholding when paid to a foreign entity). Congress was concerned that, if guarantee fees are sourced like services, U.S. subsidiaries of foreign corporations could pay deductible guarantee fees to foreign affiliates, which was viewed as an income-stripping transaction. This provision reverses the result in Container Corp. v. Commissioner, 134 T.C. No. 5 (Feb. 17, 2010). [Section 408] For our prior discussion of the decision in Container Corp., see here and here.
Extension of Statute of Limitations For Failure to Report Information
Sections 6038, 6038A, 6038B, 6046, 6046A and 6048 contain reporting rules relating to foreign entities and transactions. If a taxpayer fails to timely comply with these reporting rules, section 6501(c)(8) extends the statute of limitations in respect of “any event or period to which such information relates” so that it expires three years after the IRS finally is given the information. Section 6038(c)(8) is amended so that if the failure to furnish the information is due to reasonable cause and not willful neglect, the statute is extended only with respect to the items related to the failure to report. (If you look at this provision long enough, you can see that it isn’t a revenue raiser.) [Section 409]
Limitation on Distributions in Leveraged Spin-Offs
A new section 361(d) affects the treatment of divisive D reorganizations. Congress was concerned that a subsidiary could distribute its debt to its parent prior to a spin off transaction, and the debt would not be treated like cash or other property that the subsidiary distributed. To avoid this problem, for purposes of divisive D reorganizations, securities of the subsidiary can no longer be distributed tax-free. Instead, they will be treated like other property distributed, and will cause the parent to recognize gain to the extent they exceed the parent’s basis. [Section 421]
Repeal of the Boot Dividend Rule
The boot dividend rule of section 356(a)(2) is amended to eliminate the somewhat illogical rule that limited dividends to the gain recognized in the transaction. Instead, if there is a boot dividend, the amount of the dividend will equal the amount of earnings and profits of the corporation. Further, in the case of a non-divisive D reorganization, the earnings and profits of all the parties to the reorganization are taken into account, and rules similar to those in section 304(b)(2) and (5) are used to aggregate the earnings and profits. [Section 422]
All of this is not law, yet. We will keep you informed of any changes as the bill continues through Congress.