House lawmakers approved a package of tax extenders and unemployment benefits on May 28. This bill, dubbed “The American Jobs and Closing Tax Loopholes Bill of 2010” (H.R. 4213), includes several provisions applicable to multi-national corporations. These provisions are designed to close certain foreign tax loopholes perceived to be abused by taxpayers with respect to foreign tax credit system and other targeted abuses. The international provisions of the bill were developed jointly by the Treasury Department, the Ways and Means Committee, and the Senate Finance Committee.
Changes to the Foreign Tax Credit System
The foreign tax credit system is intended to ensure multi-national companies are not subject to double taxation, but taxpayers have been taking advantage of this system. Specifically, taxpayers’ use of “splitting” techniques, covered asset acquisitions, tax treaty abuses and the section 956 “hopscotch” rule to reduce U.S. tax due on unrelated foreign income or foreign income that has not actually been subjected to double taxation in the U.S. are the perceived $14.451 billion of loopholes Congress intends to close.
The bill calls for the following changes to the current foreign tax credit related rules:
- “Splitting” techniques: Adopt a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income;
- “Covered asset acquisitions”: Deny taxpayers from claiming the foreign tax credit for foreign income that is not subject to U.S. taxation due to a stepped-up basis for U.S. depreciation, but does not reduce the foreign tax base;
- Use of treaty sourcing rules: Segregates certain foreign source income earned by foreign branches and disregarded entities on U.S. assets so the income is not the basis for claiming foreign tax credits directly, but is treated as earned through a foreign corporation;
- Affirmative use of section 956 deemed dividend: Limit the amount of foreign tax credits that may be claimed with respect to a deemed dividend under section 956 to an amount that would have been allowed with respect to an actual dividend from the foreign subsidiary in order to prevent a larger foreign tax credit by “hopscotching” over a chain of subsidiaries in lower-tax jurisdictions;
- Certain redemptions by foreign subsidiaries: Prevent the reduction in earnings of a foreign subsidiary who transfers cash to its foreign parent to buy stock in a U.S. company (which is treated as dividend from the foreign sub). This provision would result in the earnings remaining subject to U.S. tax (and U.S. withholding tax) when repatriated to the foreign parent as an actual dividend;
- Allocating interest expense: Modify the affiliation rules to include certain foreign subsidiary’s interest expense in the allocation rules.
Repeal of 80/20 Rules
Under current law, if at least 80% of a corporation’s gross income is earned from an active foreign trade or business, dividends and interest paid by the corporation will not be subject to the gross basis withholding rules. The bill proposes to repeal these rules, providing relief for existing 80/20 companies that meet specific requirements.
Changes to Sourcing of Guarantee Fees
The treatment of guarantee fees under the source rules has not been clear under current law. Taxpayers have treated such fees as both services and interest, which result in a different treatment for sourcing rules. A recent court case determined that guarantee fees should be treated like services, and sourced where the services are performed (the residence of the guarantor). The bill provides that guarantee fees will be sourced like interest, thus sourced based on the residence of the payor. Hence, if the fees are paid by a U.S. taxpayer to a foreign person, the payment will be subject to U.S. withholding taxes at 30%, unless a lower rate applies by treaty.
The package of extenders and unemployment benefits moves to the Senate for consideration early this month. With deficit concerns on the minds of fiscally conservative members of Congress, the complete bill faces uncertainty without the offset of these loophole-closing measures. The international tax rules targeted in this bill can be quite complicated and the proposed changes are also complex. Taxpayers should review their current structures to ascertain how these proposed changes may impact them.
This advice is not intended or written to be used for, and it cannot be used for, the purpose of avoiding any federal tax penalties that may be imposed, or for promoting, marketing or recommending to another person, any tax-related matter.