On Tuesday, August 10, Congress passed and the President signed a jobs bill (HR 1586). The bill contained some international tax provisions designed to tax the big evil multinationals. Two provisions may also have an impact on mid market companies. The rules are fairly technical, as with many things international payroll
Summary of Jobs Bill International Tax Provisions
- Foreign tax credit may be disallowed in part following certain acquisitions of foreign companies. The disallowed amount is in proportion to the U.S. “step up” of basis in excess of foreign step up.
- The benefit of two tax planning techniques will be limited.
a. Deemed dividends under section 956 may have less benefit, and
b. Use of “splitter” structures is out.
- The rules on cross chain sales of subsidiaries have changed. Some international tax planning benefits may be gone.
- All assets of 80% foreign subsidiaries are now included in the base for interest expense apportionment of a consolidated corporate return group if the subsidiary does over half its business in the U.S.
- Foreign tax credit can’t be improved for items “re-sourced” under U.S. treaties as foreign source.
- There’s a technical correction to one statute of limitations item.
Mid Market Concerns
The two key provisions impacting mid-market companies are the asset acquisition and 956 changes. Each of these may affect fairly common international tax planning for mid market companies. Careful planning can reduce the impact of these changes.
U.S. taxpayers get a credit reducing their U.S. tax for foreign taxes paid. The credit is limited to that part of U.S. tax caused by foreign source taxable income. The jobs bill changes attempt to limit this credit in some situations.
Asset acquisitions subject to these provisions are only those that result in an increase in basis of acquired assets under U.S. tax rules as compared to foreign tax rules. For example, assume Smith LP acquires a UK company that is treated as a flow-through entity for U.S. purposes. Smith LP allocates its purchase price to the assets of the UK company. For UK purposes, the company shares were acquired, not the assets, so the asset basis stays the same. Smith LP and its partners get higher U.S. depreciation than they would if the basis had not been stepped up. The new provision prevents use of part of the UK tax as a foreign tax credit for Smith’s partners.
This has an impact under each of the following situations common in mid market international acquisitions and formation of joint ventures:
- Acquisitions of “check the box” entities treated for U.S. tax purposes as asset acquisitions.
- Stock acquisitions for which a 338 election is made to step up basis of assets.
- Contributions of assets to partnerships for which a 754 election is made to step up basis of assets.
The new provision reduces foreign tax credit in the ratio of the depreciation or amortization of U.S. basis step up to the foreign taxable income. Thus, if assets with a 10 year life were acquired with a $500,000 step up, foreign tax on $50,000 of income each year would be effectively disallowed. The disallowance is permanent, not a timing difference.
This alters how to plan international acquisitions. It may be better after this to pay some foreign tax to get a foreign step up. This planning should be before the deal is structured.
This change affects only U.S. corporations with foreign subsidiaries. One technique often used in planning is known as a “super-charged dividend.” A C corporation owning 10% or more of the shares of a foreign corporation gets a credit for taxes paid by the foreign corporation when the foreign corporation pays a dividend. The amount of tax credit depends on the amount of tax the foreign corporation has paid in relation to earnings. If a foreign subsidiary had losses recently but paid lots of tax in the past, a dividend may cause more foreign tax credit than the U.S. tax the dividend causes. The U.S. corporate shareholder of the foreign corporation can thus get a U.S. tax refund when the foreign corporation pays a dividend.
Another aspect of U.S. tax law (section 956) requires U.S. shareholders of controlled foreign corporations (CFCs) to pick up a deemed dividend if the foreign corporation loans the U.S. person money. This was designed to prevent U.S. owners of CFCs from getting the benefit of the money without picking up the income. When such a deemed dividend happened, it was direct from the CFC, hopscotching over any intervening foreign corporations. Good tax planning often resulted in low tax foreign holding companies owning both high tax and low tax foreign subsidiaries. When lower tier subsidiaries pay dividends up the chain, the tax rates are effectively blended at the upper tier. By contract, the hopscotch effect of section 956 prevented the foreign taxes on the deemed dividend from being diluted in the holding company. This allowed companies to create high foreign tax credit deemed dividends from lower tier subsidiaries.
Under the new provision, the foreign tax credit on a section 956 deemed dividend is limited to the amount that would have resulted if the amount had been an actual dividend up the chain. Thus, if an upper tier foreign corporation had lower taxes in relation to earnings than the foreign corporation loaning money to the U.S. corporation, the U.S. corporation’s foreign tax credit would be reduced. This can result in increased cost of repatriation, or decreased benefit of the hopscotch effect.
But the provision does not completely kill planning. Super-charged dividends are still available, and careful structuring can preserve tax pools.
The other changes in the bill likely will have minimal impact on mid market companies.
Splitter techniques have been used in international tax planning for well over a decade. The idea is to separate foreign taxes from foreign income. The taxes are taken as foreign tax credits before the income is recognized for U.S. tax purposes. Alternatively, the splitter could be used to create low and high tax pools of earnings so the section 956 deemed dividend could be used to access more credits, and pay less U.S. tax. The implementation costs of these structures generally prevented mid market companies from using them. The new bill prevents the present form of structures from being effective after 2010.