Tax Executives Institute, Inc.
Kalamazoo Chapter
New Foreign Tax Credit Legislation
Peter M. Daub, Baker & McKenzie LLP
Thursday, March 17, 2011
Your Trusted Tax Counsel®
Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional
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Presenter
Peter M. Daub (Washington, D.C.)
peter.daub@bakermckenzie.com
(202) 452-7081
©2011 Baker & McKenzie
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Recent Foreign Tax Credit Rules
– Repeal the benefit of the “hopscotch rule” for section
956 inclusions
– Suspend foreign tax credits that are split from the
income to which they relate
– Disallow foreign tax credits in the case of a covered
asset acquisition
©2011 Baker & McKenzie
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Repeal of Hopscotch
Rule Benefit for
Section 956
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©2011 Baker & McKenzie
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Repeal of Section 956 Hopscotch Rule
– Deemed-paid taxes from section 956 inclusions limited to the
lesser of:
– Foreign taxes deemed paid using hopscotch rule or
– Foreign taxes that would be deemed paid if a hypothetical
distribution was made through chain of ownership, without
regard to any foreign taxes that would be imposed on an
actual distribution
– The rule is thus a one-way street
– The rule is a problem for higher-taxed CFCs trapped under a
lower-taxed CFC or under a CFC with an E&P deficit
©2011 Baker & McKenzie
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Repeal of Section 956 Hopscotch Rule
– Not a permanent disallowance – excess foreign taxes remain in
CFC’s tax pool
– Applies to acquisitions of U.S. property after Dec. 31, 2010
– Normal hopscotch rule still applies to subpart F income
inclusions
©2011 Baker & McKenzie
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Hopscotch: Example
Tentative Credit
Hypothetical Credit
USP
(US)
USP
(US)
UE&P: $200
FT: $10
CFC1
(A)
UE&P: $100
FT: $50
CFC2
(B)
$100 loan over
all four quarters
$100 / $100 x $50 = $50 deemed-paid
foreign income taxes
CFC1
(A)
UE&P: $300 ($200 + $100)
FT: $60 ($10 + $50)
CFC2
(B)
$100 / $300 x $60 = $20 deemedpaid foreign income taxes
©2011 Baker & McKenzie
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Hopscotch: Grandfathered Section 956 Loan
– Section 956 loans that were made on or before Dec. 31,
2010 are grandfathered
– Normal hopscotch rule applies to inclusions for the duration
of the loan, even after Dec. 31, 2010
– A single grandfathered loan could generate section 956
inclusions year after year through recurring PTI distributions
– Inclusions limited to E&P, so grandfathered loan could allow
for growth in annual earnings over time without inclusions
greater than earnings in the meantime
©2011 Baker & McKenzie
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Hopscotch: Grandfathered Section 956 Loan
– Must be bona-fide loan respected as debt – probably not an
issue in most cases where size of loan was based on
expected annual earnings
– Must consider how the loan was funded – section 956 antiabuse rule effectively prevents funding from other CFCs
©2011 Baker & McKenzie
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Hopscotch: Grandfathered Section 956 Loan
USP
– USP wholly owns CFC1, which wholly owns
CFC2.
– CFC has an overall E&P deficit of <1000>.
– CFC2 does not have any accumulated E&P
through 2010 and has zero in its taxes pools.
CFC1
– In 2010, CFC2 has an average investment in
U.S. property under section 956(c) of 100.
– During 2011, CFC2 has current year E&P of 100
and pays foreign taxes of 20.
CFC2
– CFC2 maintains its section 956 investment from
2010 and, at the beginning of 2011, CFC2
acquires another investment in U.S. property
under section 956(c) of 100.
– USP will have a section 951(a)(1)(B) income
inclusion of 100 for 2011.
©2011 Baker & McKenzie
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Hopscotch: Subpart F Income
– How to calculate the hypothetical distributions
–
–
–
–
954(c)(6)
Current year E&P limitation rules under section 952(c)
The “de minimis” and “full inclusion” rules under section 954(b)(3)
High-tax exception under section 954(b)(4) (and, if so, will the taxpayer be treated
as making the election)
– Same-country exception under section 954(c)(3)
– Other rules and exceptions?
– Normal hopscotch rule applies to any subpart F inclusions resulting from
subpart F income rather than from section 956 investments in U.S. property
– Possibility of extension of anti-hopscotch rule to subpart F inclusions resulting
from subpart F income?
©2011 Baker & McKenzie
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Hopscotch Example: Section 956 Loan with SkipCo
– Section 956 loan should generate
hypothetical dividend distribution
to SkipCo
U.S.
Parent
PTI
CFC-1
(Low-tax)
PTI
Foreign
Taxes with
Hypothetical
Subpart F
Income
Inclusion
SkipCo
(Ctry C)
Hypothetical
Distribution
PTI
Loan
CFC-2
(High-tax)
(Ctry B)
– If look-through rule were not in
force, hypothetical SkipCo
dividend income should be
hypothetical subpart F income
because no same-country match –
same as with actual dividend to
SkipCo
– Use of section 956 loan could
avoid WHT on actual distribution
©2011 Baker & McKenzie
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Hopscotch Example: Dividend to SkipCo
U.S.
Parent
PTI
Distribution
CFC-1
(Low-tax)
PTI
Distribution
SkipCo
(Ctry C)
Dividend
CFC-2
(High-tax)
(Ctry B)
Foreign
Taxes with
Subpart F
Income
Inclusion
– SkipCo dividend income will not be
subpart F income while section
954(c)(6) look-through rule is in
force
– If look-through rule were not in
force, SkipCo dividend income
would be subpart F income
because no same-country match
– Look-through rule has been
extended through 2011 for
calendar year taxpayers; through
FY2012 for fiscal year taxpayers
©2011 Baker & McKenzie
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Hopscotch: Additional Possible Planning
Responses
– Out-from-under transactions for trapped CFCs
– Spin-offs
– Internal inversions
– Movement of E&P out of trapped CFCs
– Section 304 sales
– Requires a transfer of stock, which may produce
unwanted complexity in the post-transaction structure
– Cash D reorganizations
©2011 Baker & McKenzie
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Hopscotch Example: Section 304 Sale
Advantages
– Section 304 deemed dividend from CFC2 earnings direct to US parent
– No GRA needed. Treas. Reg. §1.367(a)9T
U.S.
Parent
CFC-1
(Low-tax)
CFC-2
(High-tax)
CFC-3
$
CFC-3
shares
However…
– Dividend constrained by value of CFC-3
– CFC-2 may not be desirable HoldCo
– CFC-3 now under CFC-1
Variations…
– Recap of CFC-3 shares into preferred?
– Establish CFC-3 as newco prior to sale?
– Consider Treas. Reg. § 304-4T
©2011 Baker & McKenzie
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Matching (Anti-Splitting) Rule
for Foreign Income Taxes
and Related Income
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©2011 Baker & McKenzie
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Matching Rule
– New section 909 suspends the U.S. foreign tax credit for
creditable foreign income taxes that have been split from the
income to which they relate
– If there is a “foreign tax credit splitting event” with respect to a
foreign income tax paid or accrued:
– By a U.S. taxpayer (section 901): Tax not taken into account for
U.S. tax purposes until the taxpayer takes into account the “related
income”
– By a section 902 corporation: Tax not taken into account for
indirect FTC or E&P purposes until the section 902 corporation or
its domestic corporation owner takes into account the “related
income”
©2011 Baker & McKenzie
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Matching Rule
– There is a “foreign tax credit splitting event” with respect to a
foreign income tax if the “related income” is (or will be) taken
into account by a “covered person”
– “Related income”: with respect to any portion of any foreign
income tax, the income (or, as appropriate, earnings and profits)
to which such portion of foreign income tax relates
– Income is calculated under U.S. tax principles per the JCT
Explanation
– “Covered person”: certain related parties, broadly defined, of
the person who pays or accrues the foreign income tax
©2011 Baker & McKenzie
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Matching Rule: Operating Rules
– Application with respect to section 902 corporations
– Suspended foreign taxes are not included in Post-1986
foreign tax pools
– Suspended foreign taxes do not reduce Post-1986
undistributed earnings and profits
– Applies to partnerships at partner level
– Foreign taxes are translated into US dollars in year taxes are
actually paid or accrued
©2011 Baker & McKenzie
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Matching Rule: Effective Date
– Applies to foreign income taxes paid or accrued in taxable years
beginning after Dec. 31, 2010
– Pre-2011 Taxes: Applies to foreign income taxes paid or
accrued by a section 902 corporation in taxable years beginning
on or before Dec. 31, 2010 which have not been deemed paid
under section 902(a) or section 960 on or before such date, but
only for purposes of applying sections 902 and 960 with respect
to periods after [taxable years beginning after] such date
– Thus has potential retrospective reach despite nominal prospective
application
– No E&P adjustment required with respect to pre-2011 taxes
suspended under section 909
– Guidance issued in Notice 2010-92 (see following slides)
©2011 Baker & McKenzie
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Pre-2011 Taxes Not Subject to Matching Rule
1. Not paid or accrued in connection with a pre-2011 splitter
arrangement;
2. Pre-2011 split taxes deemed paid under section 902(a) or 960 on or
before the last day of the section 902 corporation’s last pre-2011
taxable year
3. Pre-2011 split taxes and either:
– The section 902 corporation took the related income into account in a
pre-2011 taxable year
– A section 902 shareholder took the related income into account before
the last day of the section 902 corporation’s last pre-2011 taxable year
4. Pre-2011 split taxes paid or accrued in taxable years before January
1, 1997
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements
–Notice 2010-92 provides an exclusive list of arrangements that
will give rise to a foreign tax credit splitting event with respect to
pre-2011 taxes:
1. Reverse Hybrid Structures
2. Certain Foreign Consolidated Groups
3. Loss Sharing Group Relief with Disregarded Debt
4. Hybrid Instruments
–Future guidance identifying additional transactions to which
section 909 applies will only apply to taxes paid or accrued in
post-2010 taxable years
©2011 Baker & McKenzie
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Matching Rule: Post-2010 Splitter Arrangements
–Notice 2010-92 provides no direct guidance on post-2010 splitter
arrangements
–Future guidance will identify transactions to which section 909
applies with respect to taxes paid or accrued in post-2010
taxable years
–Will include at least the four pre-2011 splitter arrangements
–May well include more
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Reverse Hybrid Structures
– Reverse Hybrid: An entity treated as a
corporation for US tax purposes but as a
pass-through entity or branch for foreign
tax purposes. The owner of the reverse
hybrid is subject to tax on the income of
the entity under foreign law.
US Parent
Sect. 902
Corp’n
P/S Reverse
Hybrid
– Reverse Hybrid Structure: A section 902
corporation owns an interest in a reverse
hybrid.
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Reverse Hybrid Structures
– Pre-2011 Split Taxes: Taxes paid or accrued by the
section 902 corporation with respect to income of the
reverse hybrid.
– Related Income: The E&P of the reverse hybrid
attributable to the activities of the reverse hybrid that gave
rise to the income included in the foreign tax base with
respect to which the pre-2011 split taxes were paid or
accrued.
©2011 Baker & McKenzie
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Matching Rule: Reverse Hybrid
• FS1 accrues split tax of 20 with respect to FS2’s
US Parent
related income in Year 1
• FS2 distributes 1 to FS1 in Year 2
• FS2 and FS3 generate income from different
activities in different countries.
FS1
E&P
Case 1
FS2
Year 1
Year 2
FS2
100
(99)
FS3
0
0
FS2
100
0
FS3
0
(99)
FS3
Case 2
Year 1
Year 2
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Certain Foreign Consolidated Groups
– Foreign Consolidated Group: Exists
when a foreign country imposes tax on
the combined income of two or more
entities.
– Whether through consolidation or
attribution of income.
– Not created by loss surrender group
relief, section 78-type gross-up income,
or anti-deferral regimes.
US Parent
Sect. 902
Corp’n
(Country A)
Sect. 902
Corp’n
(Country A)
Sect. 902
Corp’n
(Country A)
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Certain Foreign Consolidated Groups
– Splitter Arrangement: Exists to the
extent that the payor of taxes does not
allocate the foreign consolidated tax
liability among the members of the
consolidated group based on each
member’s share of the consolidated
taxable income under the principles of
section 1.901-2(f)(3).
US Parent
Sect. 902
Corp’n
(Country A)
Sect. 902
Corp’n
(Country A)
Sect. 902
Corp’n
(Country A)
– Section 909 applies even if the payor of
taxes has a deficit in E&P for a
particular year.
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Certain Foreign Consolidated Groups
– Pre-2011 Split Taxes: Taxes paid or
accrued by one member of the foreign
consolidated group that are imposed on a
covered person’s share of the
consolidated taxable income included in
the foreign tax base.
– Related Income: The E&P of such other
member attributable to the activities of
that other member that gave rise to
income included in the foreign tax base
with respect to which the pre-2011 split
taxes were paid or accrued.
US Parent
Income
Sect. 902
Corp’n
(Country A)
Liability for
foreign tax on
consolidated
group income
Sect. 902
Corp’n
(Country A)
Sect. 902
Corp’n
(Country A)
Income
Income
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Loss Sharing with Disregarded Debt
– Splitter Arrangement: Exists if one entity with a loss permits the
loss to be used to offset income of one or more other entities (a
“shared loss”) and:
1. There is a debt instrument that is regarded for foreign tax
purposes but disregarded for US tax purposes (a “disregarded
debt instrument”); and
2. The owner of the disregarded debt instrument pays foreign
income tax on a payment or accrual on the instrument; and
3. The payment or accrual on the instrument gives rise to a foreign
tax deduction and the issuer incurs a shared loss that is taken
into account under foreign law by one or more foreign persons.
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Loss Sharing with Disregarded Debt
– Pre-2011 Split Taxes: Pre-2011 taxes
paid or accrued by the owner of the
disregarded debt instrument with
respect to amounts paid or accrued
on the instrument, up to the amount
of the shared loss.
– Related Income: The related income
of a covered person is an amount
equal to the shared loss, determined
without regard to the actual amount
of the covered person’s E&P.
US Parent
Interest
UK-1
High-tax
E&P pool
UK-3
UK-2
Low-tax
E&P pool
Surrender
of loss
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Loss Sharing with Disregarded Debt
– Disregarded debt instruments include
obligations between:
1. Two disregarded entities owned by the
same section 902 corporation
Section 902
Corporation
Disregarded
Entity
2. A section 902 corporation and a
disregarded subsidiary
Section 902
Corporation
3. Two disregarded entities owned by a
partnership with a section 902
corporation partner
4. A partnership with a section 902 corp’n
partner and its disregarded subsidiary
Disregarded
Entity
Partnership
Disregarded
Entity
Disregarded
Entity
©2011 Baker & McKenzie
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Matching Rule: Loss Sharing
Case 1
US
UK 1
Year 1
Income
Tax
UK1
1000
200
UK2
(2000)
UK3
3000
0
200
Year 2
UK2
Income
Tax
UK1
0
0
UK2
2000
200
UK3
0
0
UK3
Case 2
US
• 20% tax rate
• UK2 can surrender loss to either
UK1 or UK3
UK 1
• UK2 chooses to surrender loss to UK3
UK2
UK3
• Does it make a difference whether UK2 can
carry over Yr 1 loss to other years?
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Hybrid Instruments
– US Equity Hybrid Instrument:
Equity for US tax purposes but debt
for foreign tax purposes.
– Splitter Arrangement: Exists where
a section 902 corporation owns a
US Equity HI issued by a covered
person, to the extent amounts on
the instrument are deductible by
the issuer for foreign tax purposes
but not included in income of the
owner for US tax purposes.
US Parent
Accrual on
hybrid
instrument
No dividend
income for
US tax
Interest income
for foreign tax
Sect. 902
Corp’n
Equity for US tax
Debt for foreign tax
Foreign Corp’n
(Covered Person)
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Hybrid Instruments
– Pre-2011 Split Taxes: Total pre-2011
foreign taxes paid by the section 902
corporation less the amount of pre-2011
foreign taxes that would have been paid
or accrued had the section 902
corporation not been subject to foreign
tax on income from the US Equity HI.
– Related Income: The related income of
the issuer is an amount equal to the
amounts that are deductible by the
issuer for foreign tax purposes,
determined without regard to the actual
amount of the issuer’s E&P.
US Parent
Accrual on
hybrid
instrument
No dividend
income for
US tax
Interest income
for foreign tax
Sect. 902
Corp’n
Other
foreign
taxable
income
Equity for US tax
Debt for foreign tax
Foreign Corp’n
(Covered Person)
©2011 Baker & McKenzie
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Matching Rule: Example: Hybrid Instrument
Luxembourg
perspective
US perspective
USP
USP
Lux1
Lux1
E&P: $0
FTC: $29
Lux2
E&P: $100
FTC: $0
Lux1 has loaned
money to Lux 2
Lux1 has made
equity investment
in Lux2
Accrued but unpaid
interest: $100
Lux2
Active Income $100
Lux1:
Lux2:
Net Income: $100
Lux Tax:
$29
Net Income: $0
Lux Tax:
$0
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Hybrid Instruments
– US Debt Hybrid Instrument: Debt
for US tax purposes but equity for
foreign tax purposes.
– Splitter Arrangement: Exists where
a covered person owns a US Debt
HI issued by a section 902
corporation, to the extent amounts
on the instrument are deductible for
US tax purposes but not deductible
for foreign tax purposes.
US Parent
Accrual or
payment on
hybrid
instrument
Deductible
interest for
US tax
Non-deductible
dividend for
foreign tax
Sect. 902
Corp’n
(Covered Person)
Debt for US tax
Equity for foreign tax
Sect. 902
Corp’n
©2011 Baker & McKenzie
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Matching Rule: Pre-2011 Splitter Arrangements:
Hybrid Instruments
– Pre-2011 Split Taxes: Pre-2011 foreign
taxes paid or accrued by the section
902 corporation on income that would
have been offset by the interest paid or
accrued on the US Debt HI had such
interest been deductible for foreign tax
purposes.
– Related Income: The related income of
the owner is the gross amount of the
interest income recognized by the
owner for US tax purposes, determined
without regard to the actual amount of
the owner’s E&P.
US Parent
Accrual or
payment on
hybrid
instrument
Deductible
interest for
US tax
Non-deductible
dividend for
foreign tax
Sect. 902
Corp’n
(Covered Person)
Debt for US tax
Equity for foreign tax
Sect. 902
Corp’n
Other
foreign
taxable
income
©2011 Baker & McKenzie
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Matching Rule: Further Examples for Discussion
– Foreign-taxable sale of shares that is treated as a section
351 exchange or section 368 reorganization for U.S. tax
purposes due to circular flow of the sale proceeds
– Timing difference?
©2011 Baker & McKenzie
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Matching Rule:
Example: Foreign Taxable / U.S. Non-Taxable
CFC1
2
1
CFC1 contributes
the sale proceeds
to CFC2
–
For US purposes, tax-free section 351
contribution b/c of circular cash flow
–
For foreign country purposes, taxable
sale – CFC1 recognizes gain and pays
tax ($1000 gain * 30% = $300)
–
CFC1 has no E&P from the sale and
$300 of foreign taxes
–
For US purposes, tax-free non-divisive D
reorganization of Target CFC b/c of
circular cash flow
–
For foreign country purposes, taxable sale
– Target CFC recognizes gain and pays
tax ($1000 gain * 30% = $300)
–
Target CFC has no E&P from the sale and
$300 of foreign taxes – CFC2 succeeds to
Target CFC’s E&P and foreign taxes
Sale of CFC1
assets for cash
CFC2
2 Target CFC distributes
CFC1
3
the sale proceeds to
CFC1
CFC1 contributes
the sale proceeds
to CFC2
4
CFC2
1
Target CFC
Sale of Target CFC
assets for cash
Target CFC elects
disregarded entity
status / liquidates
©2011 Baker & McKenzie
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Matching Rule: Further Examples for Discussion
– Foreign-taxable transfer of assets between members of a
single check-the-box entity
– No income for U.S. tax purposes, therefore no “related
income”?
©2011 Baker & McKenzie
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Matching Rule: Mid-Year Change in Classification
During Year 1
December 31,
Year 1
USP
USP
CFC1
COUNTRY X
CFC1
COUNTRY X
FC2
COUNTRY Y
FC2
COUNTRY Y
• USP, CFC1, and FC2 each have a calendar taxable year
for U.S. federal tax purposes as well as for purposes of
their respective local foreign tax jurisdictions.
• Near the end of Year 1 (i.e., prior to December 31), FC2
makes an election for U.S. federal tax purposes to change
its classification to an association taxable as a corporation
for U.S. federal tax purposes.
• During Year 1, FC2 earns $100 and pays 20 of foreign
income tax to Country Y.
• Foreign taxes for purposes of the foreign tax credit rules
generally would accrue December 31 of Year 1. FC2 is a
CFC on that date.
• CFC1 includes almost all of FC2's income for the year (i.e.,
during the period when it was a disregarded entity).
• Are all the Year 1 foreign taxes allocated to FC2, a CFC?
•
For certain limited situations involving the allocation of foreign
taxes when there is an acquisition, see e.g., Rev. Rul. 75-532
and Treas. Reg. section 1.338-9(d). For proposed regulations
addressing these types of transactions, see Prop. Reg.
section 1.901-2(f)(3).
©2011 Baker & McKenzie
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Matching Rule: Mid-Year Change in Classification
During Year 1
December 31,
Year 1
USP
USP
CFC1
COUNTRY X
CFC1
COUNTRY X
– Assuming that the Year 1 foreign taxes are
allocated to FC2 (a CFC) under current
law, does FC2's entity classification
election result in a foreign tax credit
splitting event for FC2's income up to the
date of the entity classification election?
–
–
FC2
COUNTRY Y
FC2
COUNTRY Y
If yes, suppose FC 2 has 1 of subpart F general
limitation income from the same activity in year 2
resulting in a section 951(a)(1)(A) inclusion for
USP.
Is USP's ability to claim under section 960 the
respective portion of the foreign taxes in FC2
from year 1 suspended until CFC1 makes a
distribution to USP of the related income/E&P?
©2011 Baker & McKenzie
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Matching Rule: Operating Rules – Related Income
– Distributions of Related Income
– General Rule: If the E&P of a covered person includes both
related income and non-related income, distributions from the
covered person are made from related income and nonrelated income on a pro rata basis
– Exception: A section 902 shareholder may elect to treat all
distributions, deemed distributions, and inclusions out of E&P
of a covered person as first attributable to related income
– Election must be made on the tax return for the first post-2010
taxable year
©2011 Baker & McKenzie
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Matching Rule: Operating Rules – Related Income
–Taking into account related income
– Section 902 corporation: if:
1. Reflected in the income of the section 902 corporation; or
2. The section 902 corporation and the covered person are
combined in a section 381 transaction
– Section 902 shareholders: if included in the gross income of
1. The section 902 shareholder; or
2. An affiliated corporation
©2011 Baker & McKenzie
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Matching Rule: Operating Rules – Pre-2011 Split
Taxes
– Distributions
– If a section 902 corporation has pre-2011 split taxes and
other taxes, foreign taxes deemed paid under sections 902 or
960 shall be treated as attributable to pre-2011 split taxes
and other taxes on a pro rata basis
– Pre-2011 split taxes deemed paid in pre-2011 taxable years
in connection with a distribution to a section 902(b)
shareholder retain their character as pre-2011 split taxes
– The section 902(b) shareholder is considered the payor of taxes
with respect to the pre-2011 split taxes
©2011 Baker & McKenzie
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Matching Rule: Operating Rules – Pre-2011 Split
Taxes
– Related income taken into account
– As related income is taken into account, a ratable portion of
the associated pre-2011 split taxes will no longer be treated
as pre-2011 split taxes
– Special rule for pre-2011 splitter arrangements involving reverse
hybrids and foreign consolidated groups: if aggregate related
income is zero or negative, pre-2011 taxes retain character until
aggregate related income becomes positive and such income is
taken into account by the payor or a section 902 shareholder
©2011 Baker & McKenzie
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Covered Asset
Acquisitions
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©2011 Baker & McKenzie
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Covered Asset Acquisitions
– Section 901(m) denies FTCs for “disqualified portion” of
foreign taxes paid after a “covered asset acquisition”
– Covered asset acquisition:
(i) qualified stock purchase (section 338(d)(3)) to which
section 338(a) applies;
(ii) transaction treated as an asset acquisition for U.S. tax
purposes but as a stock acquisition (or is disregarded) for
foreign tax purposes;
(iii) acquisition of partnership interest if section 754 election
is in effect;
(iv) to the extent provided, any similar transaction
– Theme is transactions that result in basis increase for U.S.
tax purposes but not foreign tax purposes
©2011 Baker & McKenzie
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Covered Asset Acquisitions
Disqualified portion of foreign taxes equals:
foreign taxes determined
with respect to the income
or gain attributable to the
“relevant foreign assets”
X
aggregate “basis differences”
that are allocable to the year
the income or gain attributable to
the relevant foreign assets
– Relevant foreign asset includes any asset (including intangibles) with
respect to a covered asset acquisition if income, gain, deduction, or loss
attributable to the asset is taken into account for foreign income tax
purposes
– Basis difference is excess of (i) U.S. tax basis of assets immediately after
acquisition over (ii) U.S. tax basis immediately before acquisition
– Basis difference allocated to years based on applicable cost recovery
method
– Disqualified portion of foreign taxes allowed as deduction
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Covered Asset Acquisitions
– Example: Section 338 qualified stock purchase
– USP acquires foreign target (FT) and makes a section 338(g)
election
– Aggregate basis difference of $200
– Asset A: $150 basis difference and 15-year recovery
period  $10 annually
– Asset B: $50 basis difference and 5-year recovery period
 $10 annually
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Covered Asset Acquisitions
– Example: Section 338 qualified stock purchase
– Year 1: FT earns $100 and pays $25 of tax
– Disqualified portion of foreign tax = $5
– ($10 + $10) / $100 x $25 = $5
– Year 2: FT earns $100 and pays $25 of tax
– Disqualified portion of foreign tax = $5
– ($10 + $10) / $100 x $25 = $5
– Year 3: FT earns $140, incl. income from disposition of Asset
B, and pays $35 of tax
– Disqualified portion of foreign tax = $10
– ($10 + $30) / $140 * $35 = $10
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Covered Asset Acquisitions: Example:
Acquisition Following Covered Asset Acquisition
Year 1
Sellers
300
FT
Year 3
USP
FT
USP
FT
400
USB
–
Purchase price of FT stock is 300
–
338(g) election in year 1
–
FT has a single asset with a 10 year
recovery period and a basis of 100
–
FT organized in Country F, tax rate of
25%
–
FT has 100 of taxable income for
Country F purposes in years 1 and 2
(300-100)
10
100
x 25 =
5 of tax
disallowed in
years 1 and 2
FT
–
–
USB purchases FT in year 3 for 400
No 338(g) election in year 3
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Covered Asset Acquisitions: Basis Step-up
Under Foreign Law
Sellers
FT
300
USP
FT
–
FT organized in Country F
–
USP acquires FT for 300
–
USP makes 338(g) election
–
FT has a single asset with a 10-year
recovery period and a basis of 100 for
US and Country F purposes
–
Basis stepped up to 300 for both
purposes
–
FT has 100 of taxable income for
Country F purposes in years 1
(300-100)
10
x 25 or 5 disallowed in year 1?
100
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Covered Asset Acquisitions
– Section 338(g) election for a foreign target may still make
sense in circumstances where benefits (reduction of E&P,
elimination of unfavorable U.S. tax attributes) outweigh
detriment of disallowed FTCs, depending on a number of
factors
–
–
–
–
–
Amount of depreciation resulting from basis step-up
Deductibility of foreign taxes
Amount of leverage introduced upon acquisition
Foreign income tax rate
Uncertainty regarding target’s U.S. tax attributes
– Sale of shares of disregarded foreign company may still
make sense in circumstances where subpart F benefit
outweighs the FTC detriment
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Covered Asset Acquisition/Matching Rule Overlap
–
–
Sellers
300
USP
–
–
–
–
FT
FT
–
FT organized in Country F
FT treated as a pass-through for Country F
purposes and as a corporation for US purposes
USP makes 338(g) election
FT has a single asset with a 10-year recovery
period and a basis of 100 for US purposes
Basis stepped up to 300 for US purposes
FT has 100 of taxable income for Country F
purposes in year 1 currently recognized by USP
FT has 80 of E&P from US purposes in year 1
(300-100)
10 x 25 or 5 of USP’s tax disallowed in Yr 1
100
–
Is 20 of USP’s tax deferred until a dividend of
80 from FT?
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Thank You
Pursuant to requirements relating to practice before the Internal Revenue Service, any tax
advice in this communication (including any attachments) is not intended to be used, and
cannot be used, for the purpose of (i) avoiding penalties imposed under the United States
Internal Revenue Code, or (ii) promoting, marketing, or recommending to another person any tax-related matter.
Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common
terminology used in professional service organizations, reference within the organization to a “partner” means a person who is a
partner, or equivalent, in a member firm or its affiliate. Similarly, reference to an “office” means an office of any such law firm.
©2011 Baker & McKenzie
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