In a much publicized event, the U.S. House returned in the middle of summer recess on Aug. 10 to pass HR 1586, funding for teachers and first responders and helping states pay for Medicaid shortfalls. Receiving relatively little notice, however, are the bill’s sweeping tax changes to the foreign tax-credit regulations that provide the bulk of the revenue offsets needed under congressional “pay-go” rules.
Every company doing business overseas needs to be aware of these new rules, since signed into law, because the tax consequence for not knowing could prove an unpleasant surprise.
Foreign tax-credit reforms
The foreign tax credit is intended to prevent double taxation of foreign income earned by U.S. multinational corporations. It is generally limited to a taxpayer’s U.S. tax liability on its foreign-source taxable income. It is not supposed to offset U.S. taxes on U.S.-source income. However, according to the Obama administration, corporations have been using devices that avoid U.S. tax on foreign income and apply the foreign taxes to offset U.S. tax due on other income. Corporations have also permanently avoided U.S. taxes by reinvesting the foreign- source income offshore, according to the administration.
Below are some of the major provisions of the bill:
Splitting foreign tax credits
The new law adopts a matching rule proposed by the Obama administration to prevent the separation of creditable foreign taxes from the associated foreign income. The new law suspends the recognition of foreign tax credits until the related foreign income is taken into account for U.S. tax purposes.
This reform aims to prevent inappropriate separation of creditable foreign taxes.
The rules will apply to foreign income taxes paid or accrued in tax years beginning after Dec. 31, 2010. The change is estimated to raise $4.25 billion over 10 years. The provision also includes special rules for Section 902 corporations (that is, a foreign corporation in which a domestic corporation owns at least 10 percent of the voting stock).
If an acquisition of corporate stock is treated as an asset acquisition, such as through a Code Sec. 338(g) election, the assets acquired obtain a stepped-up basis. This also occurs when a taxpayer obtains an entity that is treated as a corporation for foreign tax purposes but as a partnership, disregarded entity, or other noncorporate entity for U.S. purposes. These hybrid arrangements for covered asset acquisitions, however, typically result in a step-up in basis in the assets of the acquired entity to fair market value only for U.S. taxes, not foreign taxes. As a result, there are more foreign tax credits than are needed to prevent double taxation.
The new law prevents taxpayers from claiming the foreign tax credit on foreign income that is never taxed in the U.S. under this scenario. The rules apply to transactions occurring after December 31, 2010. Transition rules exempt any covered asset acquisition between unrelated parties.
Treaties and foreign source income
The foreign tax credit is limited to the maximum U.S. tax rate (35 percent) that could apply to foreign-source income of a U.S. taxpayer. According to the Obama administration, some taxpayers use treaties to artificially inflate foreign-source income, such as dividends and interest, beyond what is needed to avoid double taxation, by shifting the source of certain assets (for example, U.S. securities) to foreign branches and disregarded entities. The treaty then categorizes the income as foreign source, increasing the taxpayer’s foreign-source income and allowing the use of foreign tax credits beyond the maximum U.S. tax that could apply.
The new law conforms the foreign tax-credit treatment of taxpayers operating abroad through foreign branches and disregarded entities to the treatment of those using foreign corporations.
Interest expenses
Taxpayers use various techniques to minimize foreign-source interest expense, artificially boosting foreign-source income and providing more foreign tax credits than would otherwise accrue. Existing Treasury regulations aim to prevent taxpayers from excluding foreign interest expense from the foreign tax-credit limitation by placing the expense in foreign subsidiaries, according to the Obama administration. The new law modifies the affiliation rules and strengthens the anti-abuse rules by treating the foreign corporation as a member of an affiliated group when allocating and apportioning interest.
The new law will ensure that all the foreign corporation’s assets and foreign-source interest expense are taken into account when allocating and apportioning the interest expense of the affiliated group and determining the foreign tax-credit limitation. The provision applies to tax years beginning after the date or enactment. •
Michael F. Corrente is a managing director at CBIZ Tofias, a provider of tax/consulting services. CBIZ Tofias operates in association with Mayer Hoffman McCann P.C.. They have offices in Providence, Newport, New Bedford and Boston. He can be reached at
mcorrente@cbiztofias.com
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