Foreign Tax Credit Reform
How these reforms expect to generate more than $9 billion over the next 10 years.
Mary Bernard, CPA
Published August 26, 2010
In order to fund education and Medicaid relief, foreign tax credit reform measures were incorporated into HR 1586 signed into law on August 10, 2010. The changes address the concern of the administration and Congress that U.S. multinational corporations are reducing their U.S. taxes by shifting income abroad to affiliates in low-tax jurisdictions.
The foreign tax credit is intended to prevent double taxation of foreign income earned by U.S. multinational corporations. The credit is generally limited to a taxpayer’s U.S. tax liability on its foreign source taxable income. The credit is not intended to offset U.S. tax on U.S. source income. The Obama administration maintains that corporations have been using devices to avoid U.S. tax on foreign income and applying foreign tax credits to offset U.S. tax due on other income. In addition, by reinvesting foreign source income offshore, corporations are permanently avoiding U.S. tax.
New Law Highlights
The international tax reform measures incorporated in the new law resemble the proposed changes included in the tax extenders bill of last May, except that they are effective prospectively.
- Foreign tax credit splitting. In order to prevent the separation of the creditable foreign taxes from the associated foreign income, the new law imposes a matching rule. The recognition of foreign tax credits is suspended until the related foreign income is taken into account for U.S. tax purposes. Timing disparities created by tax accounting differences in U.S. and foreign tax rules are not affected. These new rules apply to partnerships at the partner level and to S corporations and will apply to foreign taxes paid or accrued in tax years beginning after December 31, 2010.
- Asset acquisitions. Under certain scenarios, a stock acquisition treated as an asset acquisition could result in a stepped up basis in assets of the acquired entity only for U.S. taxes, not foreign taxes. This causes more foreign tax credits to be generated than needed to prevent double taxation. A foreign tax credit will now be disallowed on income eliminated from U.S. tax base in an asset acquisition, for acquisitions after December 31, 2010.
- Inflated foreign source income. In some cases, taxpayers have artificially inflated passive foreign source income by using tax treaty provisions to shift the source of certain assets to foreign branches and disregarded entities. The income is then treated as foreign source income, which allows the use of foreign tax credits beyond the maximum U.S. tax that would otherwise apply. The new law applies a separate foreign tax limitation to each item ordinarily be U.S. sourced that the taxpayer treats as foreign income under a treaty. This provision conforms to the treatment of taxpayers operating abroad through foreign branches and disregarded entities to the treatment of those using foreign corporations, effective for tax years beginning after August 10, 2010.
- “80/20 company” rules. Currently,withholding of up to 30 percent is required when a U.S. company pays a foreign person dividends or interest, unless at least 80 percent of the U.S. corporation’s gross income is foreign source during a three-year test period and is attributable to the active conduct of a foreign trade or business. This type of company is called an “80/20 company.” Interest received from an 80/20 company can increase foreign source income and the foreign tax credit for a U.S. multinational company. The new law repeals the rule that treated the interest as foreign source and requires withholding on dividends paid by a U.S. corporation. There is a transition rule as well as a grandfather rule, but generally the repeal applies to tax years beginning after December 31, 2010.
- Controlled foreign corporation rules. Under Internal Revenue Code section 956, the controlled foreign corporation (CFC) rules allow for the re-characterization of income from the sale of property as a direct payment of a dividend from a foreign subsidiary to its U.S. shareholder by deeming the dividend to “hopscotch” over intermediary tax haven based subsidiaries in a multi-tier chain of companies. By taking advantage of this anti-abuse rule, the foreign tax credit on the deemed dividend could be greater than the credit would be on an actual dividend. The new law limits the foreign tax credit claimed on a deemed dividend to the amount that would have been allowed on an actual dividend, effective for property acquired by a CFC after December 31, 2010.
- Interest expense. Notwithstanding existing anti-abuse rules, it is possible for taxpayers to minimize foreign interest expense by placing interest expense in foreign subsidiaries, thereby effectively increasing foreign source income and foreign tax credits. The new law strengthens anti-abuse laws by treating foreign corporations as members of an affiliated group for purposes of allocating and apportioning interest. This will ensure that all of a foreign corporation’s assets and foreign source interest expense are included in the calculation of the foreign tax credit limitation, effective for tax years beginning after the date of enactment.
- Foreign subsidiaries redemptions. Some companies have employed a scenario that allows for the avoidance of U.S. tax of a foreign subsidiary’s earnings. The foreign parent sells stock in the U.S. company to its foreign subsidiary and re-characterizes the gain as a dividend paid directly to its foreign subsidiary. This allows the subsidiary’s earnings to completely and permanently avoid U.S. taxation. The new law requires the subsidiary’s earnings to remain subject to U.S. tax when repatriated to the foreign parent as a dividend. This requirement is effective for acquisitions after the date of enactment.
- Technical correction to HIRE Act. The Hiring Incentives to Restore Employment (HIRE) Act included foreign account disclosure, reporting and compliance rules. With respect to failure to provide certain information on cross-border transactions or foreign assets, H.R. 1586 clarifies that if reasonable cause (and not willful neglect) exists for the failure to notify the Internal Revenue Service (IRS), the extended three-year statute of limitation for the IRS to assess tax will apply only to the items related to the failure to disclose and not to the whole tax return. This provision applies to returns filed after March 18, 2010, the date of enactment of the HIRE Act and to any other return for which the assessment period had not yet expired on that date.
These reforms to the foreign tax credit rules are expected to generate more than $9 billion over the next 10 years. The new law is aimed at curbing the ability of multinational companies to shift income to affiliates overseas, thus escaping U.S. taxation.
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Mary F. Bernard, CPA, is director — income/franchise tax, at the Dallas, Texas-headquartered tax services firm of Ryan. Bernard formerly worked as principal, director of State & Local Tax Services, at Providence, RI-based Kahn, Litwin, Renza & Co., Ltd.