FY 2016 Budget international tax proposals have implications for inbound investors

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1 17 February 2015 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date FY 2016 Budget international tax proposals have implications for inbound investors Executive summary On 2 February 2015, the Obama Administration (the Administration) released its fiscal year 2016 budget proposals (the Budget). At the same time, the Treasury Department released its General Explanations of the Administration s Fiscal Year 2016 Revenue Proposals (the Treasury Green Book or Green Book) and the related revenue estimates. The Budget includes seven significant international tax proposals in particular that would affect non-us multinational investors (Inbound Investors) in the United States. One of these international tax proposals reflects revisions to a proposal included in the Administration s budget for fiscal year 2015 (the FY2015 Budget). The rest of these proposals are substantially similar to the FY2015 Budget proposals. Collectively, these proposals are estimated to raise $78.4 billion over 10 years. For a comprehensive summary of all the international tax proposals, see EY International Tax Alert, New minimum tax on foreign earnings and one-time tax on accumulated foreign earnings featured in Administration s fiscal year 2016 Budget, dated 5 February International tax proposals that may be relevant to Inbound Investors include the following: Restrict deductions for excessive interest of members of financial reporting groups (revised proposal, estimated to raise $64 billion over 10 years) Restrict the use of hybrid arrangements that create stateless income (estimated to raise $1.1 billion over 10 years) Exempt foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA) (estimated to cost $2.4 billion over 10 years)

2 Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act (FATCA) (not estimated to affect revenue) Tax gain from the sale of a partnership interest on a lookthrough basis (estimated to raise $2.9 billion over 10 years) Repeal gain limitation for dividends received in reorganization exchanges (estimated to raise $632 million over 10 years) Disallow deduction for excess non-taxed reinsurance premiums paid to affiliates (estimated to raise $7.4 billion over 10 years) Other international tax proposals, including three new proposals, that would primarily affect US multinationals, but also may be relevant to Inbound Investors with US holding companies that own non-us affiliates, include the following: Impose a 19% minimum tax on foreign income (new proposal, estimated to raise $206 billion over 10 years) Impose a one-time 14% tax on previously untaxed foreign income (new proposal, estimated to raise $268 billion over 10 years) Amend the CFC attribution rules of Section 958(b) (new proposal, estimated to raise $3.4 billion over ten years) Create a new category of Subpart F 1 income for transactions involving digital goods or services (estimated to raise $8.7 billion over 10 years) Limit the application of exceptions under Subpart F for certain transactions that use reverse hybrids to create stateless income (estimated to raise $1.4 billion over 10 years) Remove foreign taxes from a corporation s foreign tax pool when earnings are eliminated (estimated to raise $317 million over 10 years) Finally, the following international tax proposals from the FY2015 Budget (and earlier budgets) have not been included in the FY 2016 Budget: Determine the foreign tax credits on a pooling basis Defer deduction of interest expense related to deferred foreign income of foreign subsidiaries Tax currently excess returns associated with transfers of intangibles offshore The release of the Administration s FY 2016 Budget proposal is only the start of the process and merely represents an identification of the Administration s tax priorities. The congressional tax-writing committees, the House Ways and Means Committee, and the Senate Finance Committee, will play a key role in the development of any international tax legislation. As lawmakers continue to work on the development of legislative approaches to tax reform, the international tax proposals contained in the Budget, which are scored as raising significant revenue in the aggregate, likely will be part of the dialogue. Detailed discussion This discussion is divided into two parts. The first part provides an overview of certain international tax proposals in this year s Budget that have particular implications for non-us multinationals with US investments. The second part provides an overview on this year s Budget proposals that are of particular interest to non-us multinationals with a US subholding company for other non-us subsidiaries. FY 2016 Budget International tax proposals with particular implications for Inbound Investors 1. Restrict deductions for excessive interest of members of financial reporting groups The Administration again proposes to restrict deductions for interest expense for certain members of financial reporting groups. The formula for calculating the restriction in this year s proposal differs slightly from last year s formula. Section 163(j) disallows a deduction for a specified portion of interest expense paid by a domestic corporation to a related person where, inter alia, the corporation s debt-to-equity ratio is greater than 1.5:1. The Green Book states that Section 163(j) does not consider the leverage of a multinational group s US operations relative to the leverage of the group s worldwide operations in limiting deductions. 2 International Tax Alert

3 According to the Green Book, this allows foreign-parented multinational groups to inappropriately reduce US tax on income from US operations by over-leveraging US operations relative to those located in lower tax jurisdictions. The Administration proposes to restrict deductions for excessive interest of members of a financial reporting group, which is any group that prepares consolidated financial statements in accordance with US Generally Accepted Accounting Principles, International Financial Reporting Standards, or another method authorized by regulations. The interest expense limitation would be determined under a new relative leverage rule. In general, a financial reporting group member s interest expense deduction would be limited if (i) the member has net interest expense for tax purposes (computed on a separate-company basis); and, (ii) the member s net interest expense for financial reporting purposes (computed on a separate-company basis) exceeds the member s proportionate share of the net interest expense reported on the financial reporting group s consolidated financial statements. A member s proportionate share of the financial reporting group s net interest expense would be determined based on the member s proportionate share of the group s earnings (computed by adding back net interest expense, taxes, depreciation, and amortization) reflected in the group s financial statements. Alternatively, under the proposal, if a member fails to substantiate its proportionate share of a group s net interest expense, or if a member so elects, the member s interest deduction would be limited to the sum of the member s interest income and 10% of the member s adjusted taxable income, as defined in Section 163(j). The proposal, which would be subject to a number of important exceptions, would permit disallowed interest to be carried forward indefinitely and excess limitation for three years. If a member of a financial reporting group is subject to the rules under this new limitation provision, the member would not be subject to the application of Section 163(j). The proposal would not apply to financial services entities or to financial reporting groups that report less than $5 million of net interest expense, in the aggregated, on one or more US income tax returns for the tax year. To the extent that this proposal does not apply to a particular entity, the earnings stripping rules under Section 163(j) would still apply. Budget and is estimated to raise $64 billion over 10 years. It is proposed to be effective for taxable years beginning after 31 December Restrict the use of hybrid arrangements that create stateless income Under current law, interest and royalty payments by US persons to non-us persons are generally deductible in the United States, regardless of whether the payments are subject to tax in the recipient jurisdiction. According to the Green Book, there has been a proliferation of tax avoidance techniques involving cross-border hybrid arrangements that result in deductions in one jurisdiction without any corresponding income inclusions in the other jurisdiction (the so-called stateless income), or multiple deductions for the same payment in different jurisdictions. The Administration thus proposes to deny deductions for interest and royalties paid to related persons in certain circumstances involving a hybrid arrangement. For this purpose, hybrid arrangements include hybrid entities, hybrid instruments, and hybrid transfers (such as a sales-repurchase or repo transactions, in which the parties take inconsistent positions in respect of the ownership of the same property). For example, the proposal would disallow a deduction in the United States where a taxpayer makes an interest or royalty payment to a related party and either (i) as a result of the hybrid arrangement there is no income inclusion to the recipient in the foreign country, or (ii) the hybrid arrangement would allow the taxpayer to claim an additional deduction for the same payment in another country. The Administration s proposal would also grant the Secretary of the Treasury the authority to issue regulations necessary to carry out the purposes of the proposal, including provisions that would deny deductions from certain conduit arrangements involving a hybrid International Tax Alert 3

4 arrangement between at least two of the parties; deny interest and royalty deductions arising from transactions such as structured transactions involving unrelated parties, as appropriate; and deny deductions where such payment is subject to inclusion in the recipient s jurisdiction under a preferential regime that reduces otherwise generally applicable statutory rates by 25% or more. Budget and is estimated to raise $1.1 billion over 10 years. The proposal would be effective for tax years beginning after 31 December Exempt certain foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA) Under current law, gains of foreign investors from the disposition of US real property interests are generally subject to US tax under the FIRPTA provisions. Gains of US pension funds, retirement trusts, or similar arrangements whose purpose is to provide pension or retirements benefits from the disposition of US real property interests are generally exempt from US tax. The Green Book notes that a US real property interest gain of a similar pension fund created or organized outside the United States from the disposition of that same property would be subject to US tax under the FIRPTA provisions. The Administration s proposal would provide an exemption from US tax under the FIRPTA provisions for gains of foreign pension funds from the disposition of US real property interests. For this purpose, a foreign pension fund generally means a trust, corporation, or other organization or arrangement that is created or organized outside of the United States, that is generally exempt from income tax in the jurisdiction in which it is created or organized, and substantially all of the activity of which is to administer or provide pension or retirement benefits. The Administration s proposal would provide the Secretary of the Treasury the authority to issue regulations necessary to carry out the purposes of the proposal, including whether for this purpose an entity or arrangement is a foreign pension fund or a benefit is a pension or retirement benefit. The proposal was in last year s Budget and is estimated to reduce revenue by $2.4 billion over 10 years. It is proposed to be effective for dispositions of US real property interests occurring after 31 December Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act (FATCA) Under current law, the FATCA provisions require foreign financial institutions to report to the IRS certain information about foreign financial accounts of US persons in order to avoid the imposition of a new US withholding tax. The Green Book states that the broad information exchange network relationships that the Treasury Department has established contributes to the recent success of the IRS enforcement efforts against offshore tax evasion and the success of those information exchange relationships depends on cooperation and reciprocity. The Green Book notes that intergovernmental agreements under which a foreign government agrees to provide the information required by FATCA to the IRS are necessary to overcome the obstacles to such information exchange imposed by the laws of some foreign jurisdictions. Furthermore, it notes that requiring US financial institutions to report similar information to the IRS with respect to nonresident accounts would facilitate such intergovernmental cooperation by enabling the IRS to reciprocate in appropriate circumstances by exchanging similar information with cooperative foreign governments to support their efforts to address tax evasion by their residents. The Administration proposes that certain financial institutions would be required to report the account balance for all financial accounts maintained at a US office and held by foreign persons. The proposal also would expand the current reporting required with respect to US source income paid to accounts held by foreign persons to include similar non-us source payments. Authority to issue regulations would be granted that would require 4 International Tax Alert

5 financial institutions to report the gross proceeds from the sale or redemption of property held in, or with respect to, a financial account, information with respect to financial accounts held by certain passive entities with substantial foreign owners, and such other information that the Secretary or his delegate determines is necessary to carry out the purposes of the proposal. The proposal would also require financial institutions that are required under FATCA or under the proposal to report to the IRS information with respect to financial accounts also to furnish a copy of the information to the account holders. The proposal would not extend to financial institutions in jurisdictions that have an intergovernmental agreement with the United States where the jurisdiction reports FATCA information directly to the IRS. Budget and is not estimated to impact the US fisc. It is proposed to be effective for returns required to be filed after 31 December Tax gain from the sale of a partnership interest on a lookthrough basis Under current law, the sale or exchange of a partnership interest is treated as the sale or exchange of a capital asset, and gain on the sale of a capital asset by a nonresident alien individual or foreign corporation is subject to US tax only if such gain constitutes US effectively connected income (ECI). The IRS has taken the position in Revenue Ruling ( C.B. 107) that a foreign partner s gain or loss from the disposition of an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States is ECI gain or loss to the extent attributable to ECI property of the partnership and such amount is therefore subject to US tax. There is no explicit rule, however, in the Internal Revenue Code that expressly supports this position. According to the Green Book, taxpayers may take a position contrary to Revenue Ruling because of the absence of an explicit code provision treating gain from the sale of a partnership interest as US ECI. The proposal would provide that gain or loss from the sale or exchange of a partnership interest is effectively connected with the conduct of a trade or business in the United States to the extent attributable to the transferor partner s distributive share of the partnership s unrealized gain or loss that is attributable to ECI property. Thus, a nonresident individual or foreign corporate partner in a partnership engaged in a US trade or business would be required to look through to its share of the partnership s assets in determining whether any gain on the disposition of its partnership interest is subject to US tax. As a means of enforcement, the proposal would require the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange unless the transferor certified that it was not a nonresident alien individual or foreign corporation. If a transferor provided a certificate from the IRS that established that the transferor s federal income tax liability with respect to the transfer was less than 10% of the amount realized, the transferee would withhold such lesser amount. The partnership would be liable for the amount of any under-withholding and would satisfy the withholding obligation by withholding on future distributions that otherwise would go to the transferee partner. Budget and is estimated to raise $2.9 billion over 10 years. It is proposed to be effective for sales or exchanges after 31 December Repeal of the boot within gain limitation of Section 356(a) Under current law, if a target shareholder receives boot in exchange for target stock in a Section 368(a) reorganization, the shareholder generally must recognize gain equal to the lesser of (i) the gain realized in the exchange, or (ii) the amount of the boot received (the boot-withingain limitation). Furthermore, where the exchange has the effect of the distribution of a dividend, then all or part of the gain recognized by the exchanging shareholder is treated as a dividend to the extent of the shareholder s ratable share of the corporation s earning and profits (E&P). Outside the reorganization context, the amount treated as a dividend is by reference to all of a corporation s current and accumulated E&P. International Tax Alert 5

6 The Green Book states that there is no significant policy reason to vary the tax treatment of a distribution received in a reorganization (and currently subject to the boot-within-gain limitation) with the treatment afforded ordinary distributions under Section 301. The proposal would repeal the boot-within-gain limitation. Moreover, the proposal would align the available pool of earnings and profits to test for dividend treatment with the rules governing ordinary distributions. The proposal applies to all reorganizations, including transactions where the acquirer is foreign; the amount of boot received in a reorganization that is potentially subject to 30% US dividend withholding tax (or as reduced by treaty) would no longer be gain-limited. Consider the following example: In the above picture, Foreign Target has a basis of $100 in its US subsidiary (US Target Sub). US Target Sub merges with and into the US Group. Foreign Target receives from the US Group cash of $75 (boot) and stock with a fair market value of $50. Under current law, US tax is levied on $25 of the boot, the amount of Foreign Target s gain in the US Target Sub shares. Because the US group has E&P of $100, the full amount of the gain, $25, is taxed as a dividend. As such, it is subject to US dividend withholding tax at a rate of 30%, unless eligible for reduction by treaty, resulting in a tax of $7.5. Under the proposal, however, the amount of boot subject to taxation would no longer be gain limited. Thus, the full $75 of boot would be subject to dividend withholding tax, resulting in a tax of $22.5. Budget and is estimated to raise $632 million over 10 years. It is proposed to be effective for tax years beginning after 31 December Disallow the deduction for excess non-taxed reinsurance premiums paid to affiliates Under current law, insurance companies generally may deduct premiums paid for reinsurance. If the reinsurance transaction results in a transfer of reserves and reserve assets, tax liability for earnings on those assets shifts to the reinsurer. However, insurance income of a foreign company that is not engaged in a US trade or business generally is not subject to US income tax. The Administration s proposal would deny an insurance company a deduction for reinsurance premiums paid to affiliated foreign reinsurance companies to the extent that the foreign reinsurer (or its parent company) is not subject to US income tax with respect to the premiums received. The proposal also would exclude from the insurance company s income (in the same proportion that the premium deduction was denied) any return premiums, ceding commissions, reinsurance recovered, or other amounts received with respect to reinsurance policies for which a premium deduction is wholly or partially denied. Similar to a provision in FIRPTA, the proposal provides that a foreign corporation that is paid a premium from an affiliate that would otherwise be denied a deduction under this provision could instead elect to treat those premiums and the associated investment income as effectively connected with a US trade or business. Such income 6 International Tax Alert

7 would be treated as attributable to a permanent establishment for tax treaty purposes. Consequently, the deduction for reinsurance premiums would not be disallowed. The proposal further provides that the reinsurance income treated as effectively connected under this elective rule would be treated as foreign source income and would be put in a separate basket for foreign tax credit purposes. Budget and is estimated to raise $7.4 billion over 10 years. The proposal would be effective for policies issued in tax years beginning after 31 December Other tax proposals In addition to the international tax proposals discussed above that may affect Inbound Investors, this year s Budget also repeated several proposals from the FY2015 Budget that may affect a foreign investor s US business. These proposals include, among others: Repeal the last-in, first-out (LIFO) method of accounting for inventories (estimated to raise $76.1 billion over 10 years) Repeal the lower-of-cost-or-market (LCM) method of accounting for inventory (estimated to raise $7.6 billion over 10 years) Enhance and make permanent the research incentives (estimated to cost $127.7 billion over 10 years) Eliminate many oil, gas, and coal company preferences (e.g., repeal percentage depletion, expensing of intangible drilling costs, and the domestic manufacturing deduction for oil and gas production) (estimated to raise $49.8 billion over 10 years) Repeal the non-qualified preferred stock designation (estimated to raise $326 million over 10 years) 2 FY 2016 Budget implications for foreign multinationals with US holding companies This year s Budget also includes proposals that would affect Inbound Investors with foreign subsidiaries held by US subsidiaries (so-called sandwich structures). For example, this could occur when the United States acts as a sub-holding company for subsidiaries incorporated in the Americas (e.g., Canada, Mexico, Central and South America) or for other foreign entities. Six of the budget proposals that are particularly relevant to sandwich structures are: (i) imposition of a 19% percent minimum tax on foreign income; (ii) imposition of a onetime 14% tax on previously untaxed foreign income; (iii) amend CFC attribution rules of Section 958(b); (iv) creation of a new category of Subpart F income for certain relatedparty transactions involving digital goods or services; (v) limitation of Subpart F exceptions to the current US taxation of income resulting from transactions that use reverse hybrids to create stateless income ; and (vi) removal of foreign taxes from a corporation s foreign tax pool when earnings are eliminated. 1. Impose of a 19% minimum tax on foreign income In general, and subject to the rules of Subpart F, US multinational companies generally are not subject to US tax on the profits earned by their foreign subsidiaries (known as controlled foreign corporations, or CFCs) until these profits are repatriated to the United States. According to the Green Book, the ability to defer US tax on CFC earnings until the profits are repatriated provides an incentive for US multinationals to shift profits abroad and thereby erode the US tax base. The Green Book asserts that the current system also discourages US-owned foreign subsidiaries from repatriating foreign earnings (due to the significant residual US tax payable). Additionally, the Green Book states that the current foreign tax credit system allows companies to reduce US tax on low-tax foreignsource income. The Administration proposes to supplement the existing Subpart F regime with a per-country minimum tax on the foreign earnings of US corporations and their CFCs (the proposed minimum tax regime). The minimum tax would apply to a US corporation that either (i) is a United States shareholder of a CFC; or (ii) has foreign earnings from a branch or from the performance of services abroad. The foreign earnings of the CFC or branch or from such services would be subject to current US taxation at a rate (not below zero) of 19% less 85% of the per-country foreign effective tax rate (the residual minimum tax rate). International Tax Alert 7

8 The minimum tax for a particular country would be computed by multiplying the applicable residual minimum tax rate by the minimum tax base for that country. A US corporation s tentative minimum tax base with respect to a country for a taxable year would be the total amount of foreign earnings for the taxable year assigned to that country for purposes of determining the effective tax rate for the country. In assigning earnings to countries, both for purposes of determining the foreign tax rate as well as for determining the tentative minimum tax base for a particular year, rules would be implemented to restrict the use of hybrid arrangements to shift earnings from a low to a high-tax country for US tax purposes without triggering tax in the high-tax country. The tentative minimum tax base could be reduced by an allowance for corporate equity. The minimum tax would be imposed on current foreign earnings regardless of whether they are repatriated to the United States, and all foreign earnings could be repatriated without further US tax. No US tax would be imposed on the sale by a United States shareholder of stock of a CFC to the extent any gain reflects the undistributed earnings of the CFC, which generally would have already been subject to tax under the proposed minimum tax, Subpart F, or the one-time 14% tax (described in the next section) on previously-untaxed income. Any stock gain that is attributable to unrealized (and therefore untaxed) gain in the CFC s assets would be subject to US tax in the same manner as would apply to the future earnings from those assets. Interest expense incurred by a US corporation that is allocated and apportioned to foreign earnings on which the minimum tax is paid would be deductible at the residual minimum tax rate applicable to those earnings. No deduction would be permitted for interest expense allocated and apportioned to foreign earnings on which no US income tax is paid. Finally, current-law rules regarding CFC investments in US property and previously taxed earnings would be repealed for US shareholders that are US corporations. The proposal is estimated to raise $206 billion over 10 years and is proposed to be effective for taxable years beginning after 31 December Impose of a one-time 14% tax on previously untaxed foreign income Under the proposed minimum tax regime, no US tax would be imposed on dividend payments from a CFC to a US shareholder. As a transition measure, the Administration is proposing a one-time 14% tax on accumulated earnings of CFCs that were not previously subject to US tax. A credit would be allowed for the amount of foreign taxes associated with such accumulated earnings multiplied by the ratio of the one-time tax rate to the maximum US corporate tax rate for The one-time tax would be payable ratably over five years. The accumulated income would not be subject to further US tax on repatriation. The proposal is estimated to raise $268 billion over 10 years and is proposed to be effective on the date of enactment with respect to earnings accumulated for taxable years beginning before 1 January Amend CFC attribution rules of Section 958(b) For purposes of determining whether a US person may be considered to be a US shareholder of a foreign corporation and, therefore, whether the foreign corporation is a CFC, Section 958(b) applies the constructive ownership rules of Section 318, with certain modifications. One of these modifications turns off downward attribution of stock ownership from a foreign person to a US person. For example, if a US corporation is a wholly-owned subsidiary of a foreign parent corporation, and the US corporation and the foreign parent corporation each directly own 50% (by vote and value) of the stock of another foreign corporation, the US corporation is considered to own only 50% (by vote and value) of the stock of such other foreign corporation and is not considered to own the stock that is owned by the foreign parent corporation for purposes of determining whether the US corporation is a US shareholder of the foreign corporation. 8 International Tax Alert

9 The Green Book states that the modified constructive ownership rules under Section 958(b) may allow a foreign acquirer of a USparented group that also acquires a sufficient amount of the stock of one or more foreign subsidiaries of the former US-parented group to cause such foreign subsidiaries to cease to be CFCs for US tax purposes, thereby avoiding the application of subpart F with respect to the continued ownership interest of the US shareholders. The Administration s proposal would amend the ownership attribution rules of Section 958(b) to allow downward attribution of stock ownership in a foreign corporation owned by a foreign parent to a related US person for purposes of determining whether the foreign corporation is a CFC. The proposal is estimated to raise $3.4 billion over 10 years and would be effective for taxable years beginning after 31 December Create a new category of Subpart F income for certain related-party transactions involving digital goods or services As stated above, in general, US persons are not taxed on certain active trade or business income earned by their CFCs until that income is repatriated a dividend. The Subpart F rules provide exceptions to this general rule, and require US persons to include in income on a current basis certain types of CFC income. The Green Book states that the existing categories of subpart F income, and the threshold requirements for applying Subpart F, rely on technical distinctions that may be manipulated or circumvented contrary to Subpart F s policy of requiring current US taxation of passive and other highly mobile income earned by foreign corporations controlled by US taxpayers. Furthermore, the Green Book asserts, by choosing different forms for substantially similar transactions, taxpayers may be able to avoid the application of subpart F. The Green Book asserts that the existing categories of Subpart F income are not adequate to tax properly the mobile income generated from digital goods and services. The Administration proposes to create a new category of Subpart F income, foreign base company digital income that would generally consist of income from the lease or sale of a digital copyrighted article or from the provision of a digital service. Specifically, income from the lease or sale of a digital copyrighted article, or from the provision of a digital service, would be foreign base company digital income if the CFC uses intangible property developed by a related person (including property developed pursuant to a cost-sharing arrangement) to produce the income and the CFC does not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income. An exception would be provided for income earned by the CFC from customers that are located in the country in which the CFC is created or organized and that use the digital articles or services in such country. Budget and is estimated to raise revenue of $8.7 billion over 10 years. It is proposed to be effective for tax years beginning after 31 December Limit the application of exceptions under Subpart F for certain transactions that use reverse hybrids to create stateless income Subpart F income of a CFC generally includes, inter alia, certain dividends, interest, rents and royalties unless the CFC qualifies for an exception, such as the same country exception. Under the same country exception, dividend, interest, rent or royalty income will not be subject to current US tax if the CFC has received the income from a related person organized under the laws of the same foreign country as the CFC. 3 In addition, the so-called CFC look-through rule, which currently applies to foreign corporations with tax years beginning before 1 January 2015, provides that certain dividends, interest, rents and royalties received from a related CFC are not Subpart F income. 4 According to the Green Book, stateless income can arise when a reverse hybrid (an entity that is treated as a corporation for International Tax Alert 9

10 US tax purposes but is fiscally transparent under the laws of a foreign jurisdiction) earns dividends, interest, rents or royalties that are not Subpart F income because of the same country exception or CFC look-through rule. The income is not subject to tax in the foreign jurisdiction in which the reverse hybrid is created or organized because that jurisdiction views the reverse hybrid as fiscally transparent and therefore treats the income as derived by its owners, including its US owners. The proposal would deny the same country exception and CFC lookthrough (proposed to be extended permanently) to payments made to foreign reverse hybrids held directly by a US owner where such amounts are considered as deductible payments received from foreign related persons. Budget and is estimated to raise revenue of $1.4 billion over 10 years. It is proposed to be effective for tax years beginning after 31 December Remove foreign taxes from a corporation s foreign tax pool when earnings are eliminated Under current law, a domestic corporation owning at least 10% of the voting stock of a foreign corporation is allowed a foreign tax credit for taxes paid by that corporation if it receives a dividend or a deemed dividend from the foreign corporation. The Green Book notes that certain transactions result in a reduction, allocation, or elimination of a corporation s E&P other than by reason of a dividend or deemed dividend or by reason of the Section 381 carryover rules in a tax-free restructuring transaction. As examples, the Green Book refers to redemptions and certain Section 355 distributions that each can result in the reduction of the redeeming or distributing corporation s E&P, respectively. According to the Green Book, the reduction, allocation, or elimination of E&P without a corresponding reduction in the associated foreign taxes paid results in a taxpayer claiming an indirect credit under Section 902 for foreign taxes paid with respect to earnings that will no longer fund a dividend distribution for US income tax purposes. The Administration s proposal would reduce the amount of foreign taxes paid by a foreign corporation in the event a transaction results in the elimination, reduction or allocation of a foreign corporation s E&P, other than by reason of a dividend or deemed dividend or by reason of a carryover in a non-recognition transaction. The amount of foreign income taxes that would be reduced in such a transaction would equal the amount of foreign taxes associated with the eliminated E&P. Budget and is estimated to raise $317 million. The proposal would be effective for transactions occurring after 31 December Implications The international tax proposals in the Administration s FY 2016 Budget would represent dramatic changes in key elements of the US international tax regime. Similar to the FY2015 Budget, several of the international tax proposals are aimed at addressing tax base erosion concerns that are similar to the concerns that are the target of the OECD in its BEPS project, particularly those proposals addressing hybrid entities and arrangements, digital economy, and excessive interest expense. Foreign-owned groups should focus on both qualitative and quantitative assessment of the business and competitive ramifications of the proposed changes. Additionally, Inbound Investors should consider involvement in the legislative process in order to provide information to lawmakers to assist in their understanding of the full range of implications of the tax reforms being debated. 10 International Tax Alert

11 Endnotes 1. Subpart F is a US tax regime that currently taxes the non-us income of foreign subsidiaries of a US multinational or holding company. 2. Current law treats non-qualified preferred stock (NQPS) as taxable income (boot) in certain transactions. NQPS is defined as stock that: (i) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent; and (ii) has a dividend rate that varies by reference to an index, or, in certain circumstances, a put right, a call right or a mandatory redemption feature. The proposal would repeal the provision that treats NQPS as boot. While not an international provision, the repeal of the NQPS designation may affect international merger and acquisition transactions some foreign investors may undertake. 3. The exception requires that such related person has more than 50 percent of its assets used in a trade or business in that jurisdiction. 4. The FY 2016 Budget would make permanent the CFC look-through provision. International Tax Alert 11

12 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, New York Steve Jackson Ernst & Young LLP, International Tax Services, Washington, DC Barbara Angus Yuelin Lee Andreia Leite Verissimo International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Israel - Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mexico - Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City Central America - Ernst & Young, S.A. Rafael Sayagues, San José South America - Ernst & Young Serviços Tributários S.S. Gil F. Mendes, São Paulo 12 International Tax Alert

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