“Reforming” the U.S. system of taxing the international activities of U.S. businesses has been a strong theme of the Obama administration since the 2009 inauguration. On May 4, 2009, the Obama administration publicly unveiled its proposal to significantly change the U.S. tax system of the foreign activities of U.S. businesses. The 2009 proposal contained many provisions that have appropriately been viewed as strongly anti-business. Since the administration’s 2009 announcement, Congress has enacted in a piece-meal fashion several of its proposals that impact the offshore activities of U.S. businesses. Some of the new laws that are aimed at legitimate abuses of the U.S. tax laws have been less controversial measures.1
The Education Jobs and Medicaid Assistance Act, H.R. 1586 was signed into law on Aug. 10, 2010. The act contains several provisions that are ostensibly intended to close perceived “loopholes” related to the use of the foreign tax credit (FTC). Many of these provisions, however, cast a wide net that may operate to deny or delay tax benefits arising from legitimate business transactions that are not the product of “tax planning” devices intended solely to game U.S. tax laws. The new tax measures contained in the act that are worthy of the attention of U.S. businesses with offshore activities that include:
• Rules that prevent splitting the FTC from foreign income;
• Denying the FTC for “covered asset acquisitions;”
• Limiting the use of the “hopscotch rule” to maximize the FTC; and
• Eliminating deemed distributions from foreign subsidiaries with regard to certain redemption transactions.
Understanding the impact of the new rules contained in the Education Jobs and Medicaid Assistance Act begins with a basic understanding of the U.S. international tax regime. The U.S. largely pioneered the now broadly accepted notion of taxing the global income of its residents, including corporations, rather than only their earnings arising from U.S. sources. This expanded notion of the U.S. tax system to reach worldwide income of U.S. taxpayers has been tempered with a general tax policy of taxing income only once.2 Thus, an early challenge became addressing the situation of business operations in foreign countries that imposed their own taxes on activities within their borders, to which the U.S. responded with the FTC, which is a credit against U.S. income for foreign taxes paid by the U.S. entity.
The U.S. system of global tax then came to face further challenges when a U.S. resident corporation owned a foreign domiciled subsidiary. It is axiomatic that the U.S. legal system cannot directly impose tax on foreign citizens. Thus, an apparent inequity developed between the tax treatment of a U.S. corporation that engaged in business offshore through a foreign branch and an identical business that engaged in business offshore through a wholly owned subsidiary. In the former situation, the U.S. could subject the foreign income to tax (subject to possible offset by the FTC), whereas in the latter circumstance, the income of the foreign subsidiary could not legally be subject to U.S. taxation.
When foreign subsidiaries were organized in an industrial country that imposed a corporate tax at a level not too disparate from the U.S. corporate income tax, the system worked equitably enough and the principle of business entities paying a single level of tax was not violated. Nonetheless, problems arose if dividends were paid by a foreign subsidiary that had paid its foreign corporate income taxes and then included in the U.S. parent corporation’s taxable income. The result would be double taxation (compared with use of a branch) prior to a possible triple tax upon ultimate distribution to U.S. shareholders. Thus, in a further early refinement to the basic U.S. approach, and also in furtherance of the notion that corporations should bear a single level of corporate tax, the U.S. tax law came to provide for a credit against U.S. income for foreign taxes paid by both foreign subsidiaries at the time dividends were remitted to the U.S. parent.
The catch in the basic tax structure described above was that it led to tax “gaming.” Specifically, to the extent a U.S. corporation could structure its offshore activities or transactions in or to use tax havens, its foreign subsidiaries might pay little or no taxes. If the earnings were not needed for U.S. operations, the funds could remain offshore, having been subject to neither foreign nor U.S. taxation.
The Kennedy administration decided to attack this abuse by adding Subpart F to the Internal Revenue Code (IRC) in 1962. Subpart F respected the principles of international law that precluded directly subjecting non-U.S. entities to U.S. income tax, but innovatively created the concept of “deemed dividends” from foreign corporations to their U.S. shareholders in certain circumstances, primarily where insufficient foreign taxes were being paid. Such deemed dividends were includable in the U.S. parent corporation’s federal taxable income and, thus, made the amount of the deemed dividends subject to U.S. taxation. Subpart F was largely structured to respect and conform to the one level of tax principle and avoided the conundrum that if the income of a foreign subsidiary is significantly taxed by both the foreign jurisdiction and indirectly by the U.S. (under Subpart F), the imposition of U.S. taxation on top of foreign tax results in double taxation at the corporate level even prior to imposition of any taxes on dividends.
Over time, both the Subpart F and the U.S. tax law FTC provisions have become increasingly complex, and where there is complexity, CEOs, CFOs and other business executives began to develop sophisticated—and legal—corporate and transactional structures to minimize U.S. taxation and take advantage of the basic U.S. tax regime, notwithstanding the provisions of Subpart F.
While the Education Jobs and Medicaid Assistance Act contains several measures that effect U.S. taxation of offshore activities, four key provisions of the act are worthy of discussion. These measures have the potential to affect existing organizational and operational structures of gaming businesses with offshore activities. In many instances, the provisions will become effective beginning in 2011. Thus, now is an appropriate time for gaming businesses with offshore activities to begin to examine existing operations and assess the extent to which the provisions of the new law may impact existing offshore operations.
U.S. taxpayers with foreign operations, prior to the enactment of the Education Jobs and Medicaid Assistance Act, could effectively split the time when a FTC could be claimed and the time related foreign income earned by related entities was taken into account for U.S. tax purposes. The act adopts a matching rule intended to prevent the FTC from being separated from related foreign income. Under the new rule, if there is a “foreign tax credit splitting event,” foreign taxes may not be taken into account by the U.S. taxpayer until the related income is taken into account for U.S. tax purposes.
A “foreign tax credit splitting event” occurs when related foreign income is taken into account by a “covered person.” The act defines a “covered person” as a person who bears certain relationships with another person who pays or accrues foreign tax. The relationships include: (1) any entity that the person paying the foreign tax holds, directly or indirectly, at least a 10 percent ownership interest; (2) any person that holds, directly or indirectly, at least a 10 percent ownership interest in the person paying the foreign tax; (3) any person that is a related person, pursuant to certain provisions of federal tax law, to the person paying foreign tax;3 or (4) any other person specified by the secretary of the Treasury.
The legislative history illustrates the application of the new rule through an example of an offshore lower-tiered subsidiary (Sub 2) issuing a hybrid instrument (treated as equity for U.S. tax purposes and debt for foreign tax purposes) to an upper-tiered offshore subsidiary (Sub 1). The hybrid instrument results in Sub 2 accruing, but not actually paying, interest to Sub 1. Sub 1 pays foreign tax, while Sub 2 pays no tax but retains all earnings and profits. Under the new rule, the U.S. shareholder of Sub 1 cannot claim a FTC with respect to the foreign taxes paid by Sub 1 until the earnings and profits of Sub 2 are taken into account for U.S. tax purposes.
The scope of the new rules preventing FTC splitting may have a wide application, beyond just perceived abusive tax motivated transactions. As an example, the new rule grants the secretary of the Treasury regulatory authority to identify “covered persons” to potentially include unrelated third parties. Moreover, the effective date of the new rules may present problems with the indirect FTC. As a general matter, the indirect FTC may be tested in the year foreign taxes are repatriated to the U.S, rather than the year in which foreign taxes are accrued. Thus, the new provision has the potential to reach pre-2011 transactions.
Denial of the FTC
The Education Jobs and Medicaid Assistance Act denies the FTC for the “disqualified portion” of any foreign income taxes paid or accrued in connection with a “covered asset acquisition.” The perceived abuse of the new rule is directed at preventing involves transactions that result in the underlying assets of the foreign entity being increased for U.S. tax purposes but not for foreign tax purposes. The act, as a result, defines a “covered asset acquisition” to mean certain types of transactions that can produce such a result under U.S. tax law. Specifically, a “covered asset acquisition” includes: (1) a qualified stock purchase within the meaning of Section 338(d)(3) of the Internal Revenue Code of 1986, as amended;4 (2) any transaction that is treated as an asset acquisition for U.S. tax purposes and either a stock purchase or disregarded transaction under foreign law; (3) an acquisition of a partnership interest when the partnership has an IRC § 754 election in place; or (4) any similar transactions identified by the secretary of the Treasury.
The disqualified portion of a covered asset acquisition under the new rule is equal to the foreign taxes paid multiplied by the “basis difference” in the assets. The basic difference is determined by using a ratio comparing the adjusted basis of the covered assets pre- and post-acquisition. The formula can be expressed mathematically as follows:
Foreign Taxes Paid x [(adjusted basis of the assets immediately after the covered acquisition)/(adjusted basis of the assets immediately before the covered acquisition)]
As with other provisions contained in the act, the covered asset acquisition rule has the potential for broad application. For example, the rule could be used to deny a FTC arising from an internal restructuring that is not motivated by tax savings. Further, taxpayers may very well face a substantial burden in attempting to determine the basis of assets immediately prior to the covered asset acquisition. Therefore, the covered asset acquisition rule of the act is not without controversial aspects.
Limiting the “Hopscotch Rule”
A common organizational structure for businesses with a multinational presence involves the use of tiered entities, some of which may be located in low tax jurisdictions. When a multinational business distributes dividends up through a chain of entities to a U.S. shareholder, the FTC on the dividend is determined using the blended tax rates applicable to the entities within the corporate chain. A U.S. shareholder could “hopscotch” this result by deeming a dividend from a lower-tiered foreign entity to be paid directly to the U.S. shareholder. The net result is that a higher FTC could be produced in comparison to what the FTC would be on an actual upstream dividend.
The Education Jobs and Medicaid Assistance Act adopts a rule designed to limit the ability of U.S. taxpayers to implement the hopscotch rule. Under the act, the foreign taxes deemed to have been paid cannot exceed the amount that would be included in gross income if the funds were distributed in a series of distributions up through the corporate chain. Hence, limiting the hopscotch rule operates to equalize the FTC between two alternative approaches: upstreaming funds through dividends versus a deemed dividend directly to a U.S. shareholder.
Eliminating Deemed Distributions
Foreign companies with U.S. operations often conduct business activities through a U.S. corporation. The foreign business is often faced with a dilemma when making an outbound distribution of earnings. The U.S. tax law, absent a treaty provision, imposes a 30 percent withholding tax on earnings distributed to a foreign shareholder. Should, however, the foreign shareholder sell stock in the U.S. corporation to another foreign subsidiary, the sale is treated as a redemption for U.S. income tax purposes and, hence, a dividend from the foreign subsidiary. For U.S. income tax purposes, the 30 percent withholding tax does not apply to the redemption transaction. Consequently, the foreign shareholder is effectively able to repatriate earnings outside of the U.S. without incurring U.S. income tax.
The Education Jobs and Medicaid Assistance Act limits the ability to engage in redemption transactions by limiting the amount of earnings and profits (E&P) of the foreign corporation that may be taken into account to determine the amount and source of the constructive dividend.5 Specifically, under the act, if more than 50 percent of the dividends would not be subject to U.S. tax in the year of the dividend or includible in the E&P of a controlled foreign corporation, then the E&P of the foreign corporation is not taken into account. Thus, the new rule under the act is designed to prevent the use of redemption transactions to bail out earnings from the U.S. without subjecting the earnings to U.S. taxation.
The Obama administration vowed in its early days to close perceived “loopholes” in the U.S. system of taxing offshore business activities. The administration’s proposal embraces several rules that can be viewed as strongly anti-business. As discussed above, some of the administration’s proposals have begun to be enacted into law. As a result, all businesses with offshore activities, including those within the gaming industry, should examine existing international business activities to assess the extent to which the new rules of the Education Jobs and Medicaid Assistance Act impact U.S. tax exposure and what, if any, steps may be implemented to minimize potential negative consequences as a result of the structure of existing offshore operations.
Author’s Note: In response to IRS Circular 230 requirements, any discussions of federal tax issues in this article are not intended to be used and may not be used by any person for the avoidance of any penalties under the Internal Revenue Code, or to promote, market or recommend any transaction or subject addressed herein.
1 Examples of less controversial changes in U.S. tax law relating to offshore activities of U.S. taxpayers include requiring greater disclosure of offshore assets and the emphasis placed on compliance with existing rules for the reporting and disclosure of interests in offshore financial accounts. These initiatives may be associated with broader enforcement efforts to combat money-laundering and other fraudulent activities.
2 The notion of taxing once applies only to a given taxpayer’s own income and thus a notable exception is the “C corporation” tax regime, which de facto imposes two layers of tax: once when income is earned by a corporation and, twice, when earnings are distributed to shareholders.
3 The act cross-references Section 267(b) and 707(b) of the Internal Revenue Code of 1986, as amended, to define related parties. A person is treated as a related party under these rules, for example, when the parties are members of the same family, the same controlled group of corporations or meet certain common ownership tests.
4 A purchaser that acquires stock of a target that elects, or is deemed to elect, under IRC § 338 is treated as acquiring the assets of the target. Thus, the form of the transaction is essentially recharacterized by the IRC to in substance be treated as an asset acquisition for federal income tax purposes.
5 The significance of this rule is that under the federal tax law, stock redemptions by certain affiliated corporations that meet prescribed federal tax law requirements are treated as dividend to the extent of E&P.