New Repatriation Dividend Deduction

Under American Jobs Creation Act of 2004 (AJCA) Section 422(a), corporate taxpayers can elect to claim a deduction for 85% of cash dividends received from controlled foreign corporations (CFCs) in excess of a base amount; see new Sec. 965. This item summarizes this new deduction and discusses pending technical corrections that may clarify the Sec. 965(c)(1) term applicable financial statements, which comes into play when computing the deductions upper limit.

Repatriation DRD

For dividends to qualify for the new repatriation dividends-received deduction (repatriation DRD), they must be invested in the U.S. under a properly approved domestic reinvestment plan; see Sec. 965(b)(4). Under Sec. 965(f), eligible taxpayers can elect to claim the deduction, for either the taxpayers last tax year that begins before Oct. 22, 2004 or the first tax year that begins during the one-year period commencing on Oct. 22, 2004. Thus, for calendar-year taxpayers, the election is available for tax years 2004 and 2005.

Under Sec. 965(a)(1), the election only applies to actual cash dividends, not to any deemed dividends or foreign tax credit (FTC) gross-ups. Distributions of previously taxed income are also excluded. There are a number of additional limits:

• The dividend eligible for the deduction is limited to the greatest of: (1) $500 million; (2) the earnings shown as permanently invested outside the U.S. on the taxpayers most recently audited financial statements, certified before July 1, 2003; or (3) in the case of an applicable financial statement that fails to show a specific earnings amount, but does show a specific tax liability attributable to such earnings, the amount of such earnings determined by grossing up the tax liability at a 35% rate (Sec. 965(b)(1) and (c)).

• The dividend must be extraordinary; i.e., it cannot exceed the excess of all dividends received during the tax year from CFCs over (1) dividends received during each base-period year from CFCs; (2) amounts included in the U.S. shareholders gross income for each base-period year under Sec. 951(a)(1)(B) for increases in investments in U.S. property by CFCs; and (3) amounts that would have been included for each base-period year for CFCs, but for Sec. 959(a). Sec. 965(c)(2) defines base-period years as three of the most recent five tax years ending before July 1, 2003, excluding the years with the highest and lowest of actual and deemed dividends (Sec. 965(b)(2)).

• The dividend cannot be financed by related-party loans. For example, a U.S. shareholder may not loan the cash to a CFC to make the dividend distribution (Sec. 965(b)(3)).

Under Sec. 965(d)(1), the nontaxable portion of dividends for which an election is made (i.e., nontaxable due to the repatriation DRD) is not eligible for the FTC. Expenses allocated and apportioned to the nontaxable portion of dividends are disallowed, under Sec. 965(d)(2).

According to Sec. 965(e), the dividends taxable portion can be offset only by allowable foreign tax and alternative minimum tax credits. Net operating losses cannot offset the taxable portion. In no event can the taxpayers taxable income be less than the taxable portion.

Planning: When full FTCs are available, the repatriation DRD should be compared to repatriation without the election. The elective dividend treatment should generally be preferable when the dividends come from low-tax jurisdictions. To maximize the deductions value, detailed projections and advance planning may be required, due to the details of computing the deduction and the complexity of FTC computations. Further, a repatriation dividend should not be taken without first considering the state tax treatment.

Applicable Financial Statements

As noted above, Sec. 965(b)(1) limits the dividend amount eligible for the repatriation DRD. To determine the limit, it is necessary either to know the earnings permanently reinvested abroad, as disclosed on applicable financial statements, or, if not provided, to determine earnings reinvested abroad from tax information disclosed on such statements.

If there is no applicable financial statement, or if such statement does not show specific earnings or the tax liability amount, then, according to the AJCA Conference Report, the $500 million limit applies. This amount is divided among controlled group members, using a 50% standard of common control. For a U.S. corporation that is not very large, a $500 million upper limit may be more than enough to cover any level of dividend that the taxpayer might receive. For large corporations, however, it may be important to rely on applicable financial statements.

Probable technical corrections: Technical corrections, which may pass during 2005, will probably clarify the definition of applicable financial statements for Sec. 965 purposes. In the case of a U.S. shareholder required to file a financial statement with the Securities and Exchange Commission (or included in such a statement filed by another person), they will most likely clarify that the applicable financial statement is the most recent audited annual statement filed and certified before July 1, 2003. For purposes of this rule, the technical corrections will probably indicate that a restatement of previously filed and certified financial statements that occurs after June 30, 2003 does not alter the statements status as having been filed and certified before July 1, 2003.

In addition, technical corrections may provide that the term applicable financial statement includes the notes that form an integral part of the financial statement, while other materials (including workpapers or materials that may first be filed for some purposes with the financial statement, but do not form an integral part of such statement), may not be relied on for purposes of producing an earnings or tax number under Sec. 965. Technical corrections may also indicate that if an applicable financial statement does not show a specific earnings or tax amount, the taxpayer cannot rely on underlying workpapers or other materials, not a part of the financial statements that derive such an amount. They may indicate that if an applicable financial statement states that earnings or a tax amount is indeterminate (or that the determination of specific earnings or tax is not feasible), the earnings or tax so described will be treated as zero for purposes of the repatriation DRD limit.

Conclusion

The new repatriation DRD provides a significant tax planning opportunity for U.S. corporations with interests in CFCs. Because the deduction is elective and reduces FTC eligibility, advance planning will generally be beneficial. Complex calculations may be required to properly assess how best to employ this opportunity. Large corporations that wish to claim a repatriation DRD in excess of $500 million should bear in mind the technical corrections proposed on the meaning of applicable financial statements, as these might affect the deductions upper limit.

From Bill Zink, CPA, and Stefan Gottschalk, CPA, J.D., LL.M., Washington, DC