Advisory. International Tax. Special Alert. International Provisions of the American Jobs Creation Act of 2004 (the JOBS Act )

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1 NOVEMBER 15, 2004 Atlanta Charlotte New York Research Triangle Washington, D.C. International Tax Advisory Insights Into Recent Regulatory, Judicial and Legislative Developments Special Alert International Provisions of the American Jobs Creation Act of 2004 (the JOBS Act ) President Bush signed the American Jobs Creation Act of 2004, H.R. 4520, ( Act ) into law on October 22, 2004 ( date of enactment ). Many of the substantial changes to the international tax rules made by the Act are summarized below. Replacement of Extraterritorial Income Regime with Reduction in Tax Rate on U.S. Manufacturing Income Repeal of ETI The Act is hopefully the final chapter in a long running dispute between the U.S. and the European Union ( EU ) over U.S. income tax breaks for export income. In February 2000, the World Trade Organization ( WTO ) ruled against the Foreign Sales Corporation ( FSC ), which was designed to replace the domestic international sales corporation or DISC after it was held to be an illegal export subsidy by a GATT panel in The WTO ruling held that the FSC was an export subsidy inconsistent with U.S. obligations under international trade agreements because it provided exceptions to the subpart F anti-deferral regime and other rules for export related income. Jack Cummings Editor 601 Pennsylvania Avenue, N.W. North Building, 10th Floor Washington, D.C Fax: One of Fortune magazine s 100 Best Companies to Work For In 2002, Congress replaced the FSC with the extraterritorial income exclusion regime ( ETI ). Under ETI, certain income realized by U.S. persons from foreign trading activities is excluded entirely from gross income, thereby excluding such income from the corporate income tax base at a threshold level. Even though ETI was carefully crafted to comply with the WTO s FSC ruling, in January 2002 the WTO held that ETI was a prohibited export subsidy because it applied only to companies with export income. In addition, the WTO found fault with the definition of ETI eligible income because it gave more favorable treatment to goods manufactured or produced in the U.S. over those produced outside the U.S. The WTO and GATT panels rejected the argument that the U.S. suffers from an unfair disadvantage because international trade agreements generally permit export-contingent refunds of indirect taxes such as a value added tax, but not direct taxes such as the income tax, and the U.S. alone among major countries, has no indirect tax regime. The WTO authorized approximately $4 billion in annual sanctions against the U.S. (in the form of retaliatory tariffs). On December 8, 2003, the EU began gradual implementation of this ruling by raising tariffs on certain imports from the U.S. effective March 1, The Act repeals the ETI effective for transactions after December 31, Under the provision, the ETI benefit is phased out in 2005 and 2006 so that 80% of the ETI benefit is allowed in 2005 and 60% of the benefit is allowed in The ETI regime also remains in effect for transactions occurring in the ordinary course of a trade or business as long as the transactions are pursuant to a binding contract that was in effect on September 17, 2003 and at all times thereafter.

2 Deduction for Domestic Manufacturing Income In place of ETI, the Act adds new I.R.C. 199, which provides a deduction from taxable income for a percentage of the taxpayer s income derived from certain production or manufacturing activity occurring in the U.S. (defined as qualified production activities income ). For taxable years beginning in 2005, U.S. taxpayers can deduct the lesser of 3% of qualified production activities income or 3% of taxable income from all sources (determined before applying this provision). For taxable years beginning in 2007 through 2009, the deduction is the lesser of 6% of qualified production activities income or 6% of taxable income. For taxable years beginning after 2009, the deduction is the lesser of 9% of qualified production activities income or 9% of taxable income The I.R.C. 199 deduction is limited to 50% of the wages paid by the taxpayer during the calendar year that ends in the taxable year in which the deduction is claimed. For purposes of this rule, all members of an affiliated group of corporations are treated as a single taxpayer. The provision applies at the S corporation shareholder or partner level. Qualified production activities income is net income attributable to domestic production gross receipts. Deductions are allowed for the cost of goods sold, costs and expenses directly attributable to domestic production activities and a pro rata share of costs and expenses not directly attributable to any activity. It is expected that deductions for selling and marketing expenses will also be allowed. The critical term in new I.R.C. 199 is domestic production gross receipts. It is defined as gross receipts from (i) the sale or exchange of tangible personal property, computer software or sound recordings that were manufactured, produced, grown or extracted in significant part within the U.S., (ii) the sale, exchange, lease or rental of any film if at least 50% of the total compensation expense paid or incurred in connection with the production of the film was paid in the U.S. (including compensation paid in the form of residual payments); (iii) the sale or exchange of electricity, natural gas or potable water produced in the U.S.; (iv) construction activities performed in the U.S.; or (v) engineering or architectural services performed in the U.S. for construction projects located in the U.S. Domestic production gross receipts include income from agricultural activities. However, the term does not include income derived from the transmission or distribution of electricity, natural gas or potable water. A vertically integrated producer of electricity will be required to allocate gross receipts between production and transmission or distribution activities. The repeal of ETI and the enactment of the deduction for income from domestic production activities will present many planning challenges and opportunities for U.S. taxpayers. In the short term, taxpayers currently taking advantage of ETI may consider accelerating the recognition of income eligible for the ETI exclusion to 2004 (or to 2005 when 80% of the ETI benefit will be available). In the long-term, taxpayers will need to take the deduction for income from domestic production activities into account in tax planning for manufacturing activities. One-Time Dividends Received Deduction for Certain CFC Dividends Overview The Act adds new I.R.C. 965 as an incentive to reinvest earnings of a controlled foreign corporation ( CFC ) in the United States, through a temporary 85% dividends received deduction resulting in a 5.25% effective rate of tax on dividends covered by the provision. It is effective for a single taxable year, which the dividend-recipient taxpayer may elect as either its first taxable year beginning on or after the date of enactment, or its last taxable year beginning before such date. The provision is designed to encourage repatriation and domestic reinvestment of income earned in CFCs that has not been subject to regular U.S. income tax under subpart F. CFCs earn certain foreign source income that normally is free of U.S. tax in the year of recognition (although such income is subject to U.S. income tax when repatriated to the U.S.). It is thought that the deferral of U.S. income tax on earnings of foreign corporations has resulted in the parking of significant amounts of foreign income in foreign subsidiaries of U.S. corporations, to the detriment of the U.S. economy. Thus I.R.C. 965 is intended to induce repatriation of foreign earnings by the actual payment of cash dividends. 2

3 New I.R.C. 965 applies only to dividends from CFCs on a one-time basis that satisfy each of the following requirements: The corporation paying the dividend must be a CFC at the time of payment; The taxpayer receiving the dividend and claiming the deduction must be a corporation that is U.S. shareholder of the CFC paying a dividend; The taxpayer must make the I.R.C. 965 election effective for the taxable year of the payment; The taxpayer must receive the dividend in cash during the taxable year; The dividend must be extraordinary; and The taxpayer must use the dividend in accord with its domestic reinvestment plan. Under I.R.C. 965(f) the election must be made before the due date (including extensions) for filing the tax return for the taxable year for which the deduction is claimed. The language on the timing of the election is unusual in that it does not use the typical words on or before the due date. If the return is filed early, then presumably the election could be enclosed with it, but if it is filed on the due date it apparently would not be timely. Distribution Requirements The distribution must be in cash and it must constitute a dividend under general tax rules. For this purpose, dividends do not include cash dividends of previously taxed Subpart F income, even though such a distribution may be in cash and would otherwise be treated as a dividend under the I.R.C. These distributions are excluded from income under I.R.C. 959(a) to the extent the distribution was made out of income that was previously included in the taxpayer s gross income under Subpart F. An exception to this rule holds that previously taxed dividends may count under I.R.C. 965 if in the same year of the election for the Section 965 deduction, the shareholder has an inclusion of Subpart F income on account of dividends actually received by one or more of the taxpayer s CFCs from other CFCs. I.R.C. 965(c)(3) generally excludes deemed dividends under I.R.C. 78, 367 and 1248 from favorable treatment under I.R.C However, I.R.C. 965(c)(3) does recognize a deemed dividend resulting from a liquidation of a CFC to the extent the liquidating CFC makes a cash distribution to a U.S. corporation. The Conference Report states that a liquidation resulting from a check the box election does not involve the receipt of cash and will not generate a I.R.C. 965 dividend. Cap on Deduction for Qualified Dividends The I.R.C. 965 dividends received deduction is limited by a cap and the requirement that the dividend be extraordinary. The cap is the greater of (i) $500 million, (ii) the amount of earnings shown as permanently invested outside the U.S. on the taxpayer s most recent financial statement prepared on or before June 30, 2003, or (iii), if the taxpayer s financial statement does not show earnings invested outside the U.S., the amount of deferred tax liability attributable to the earnings shown on that financial statement. All U.S. shareholders that are members of a consolidated return group are considered to be a single shareholder for purposes of this rule. The $500 million cap must be shared within a broader group of related companies. The other requirement is that the dividend be extraordinary which generally means that the dividend must be significantly greater than an average of the aggregate dividends that the taxpayer received from CFCs over three base period years. The base period years are three of the five taxable years ending on or before June 30, The three years are identified by eliminating the ones with the largest and smallest amounts of CFC dividends. If the taxpayer does not have five taxable years ending on or before that date, then the smaller number of actual years is used without eliminating the high and low dividend years. Short taxable years are not specifically addressed. I.R.C. 965(b)(2)(C) states that rules similar to the rules of I.R.C. 41(f)(3) will apply for measuring extraordinary dividends if the dividend paying corporation has been involved in an extraordinary transaction within the base period. In general, under I.R.C. 41(f), if a taxpayer acquires a business, then the acquirer 3

4 will include various attributes relevant in determining the research credit limits from the target business (such as research expenditures and gross receipts). The converse applies if the taxpayer disposes of a substantial part of its business (under I.R.C. 41(f) attributes attributable to the transferred business must be reduced). The cross reference to I.R.C. 41 is somewhat puzzling because the issues addressed in the research credit limitations are very different from the issues addressed in the measurement of extraordinary dividends. It is not clear how this general guidance will be incorporated into workable rules. If the U.S. shareholder of a CFC is spun off and it receives an I.R.C. 965 dividend after the spin off, the spun-off corporation (referred to as the controlled corporation ) shares its former parent s history for purposes of the extraordinary dividend rules. Where the rule applies, the controlled corporation will be treated as having been in existence as long as the distributing corporation was in existence, and the dividends and other amounts counted for purposes of the analysis that were received or includible by each corporation will be allocated between the two companies in proportion to their respective interests as United States shareholders of the CFCs immediately after the I.R.C. 355 distribution. It is likely that IRS guidance will be necessary in this area. A CFC may borrow to obtain the cash to pay an I.R.C. 965 dividend, but not from related persons. The prohibition on related party borrowing is intended to prevent the U.S. shareholder from directly or indirectly financing an I.R.C. 965 dividend, which undermines the purpose of the repatriation rule. Domestic Reinvestment Plan The I.R.C. 965 dividend must be described in a domestic reinvestment plan approved by the taxpayer s senior management and board of directors. I.R.C. 965(b)(4) requires the actual investment of the cash dividend in the U.S. pursuant to a domestic reinvestment plan. The domestic reinvestment plan must (i) have been approved by the taxpayer s president, CEO, or comparable official before the distribution and later by the taxpayer s board, management committee, executive committee or similar body, and (ii) provide for reinvestment of the dividend in the U.S. Permissible uses for the dividend proceeds include funding for worker hiring and training, infrastructure, R&D, capital investments, and the financial stabilization of the corporation for the purposes of job retention or creation. The domestic reinvestment plan cannot be used to fund executive compensation. Neither the provision itself nor the accompanying legislative history says much about how the IRS will ensure that taxpayers comply with the reinvestment plan. Foreign Tax Credit Implications and Denial of Deductions No foreign tax credit is allowed for foreign taxes attributable to the deductible portion of any I.R.C. 965 dividend. A foreign tax credit may be allowed for the foreign income taxes associated with the portion of the dividend that is not deductible under I.R.C The taxpayer may specify which dividends meet the average annual base amount and which are in excess. There appears to be nothing that would prevent a taxpayer from earmarking dividends that have borne high foreign taxes for the base amount dividends and earmarking low tax dividends for the I.R.C. 965 dividend. The interaction between the I.R.C. 78 gross up dividend relating to the I.R.C. 902 deemed paid foreign tax credit and I.R.C. 965 is unclear. There does not appear to be any policy justification for requiring foreign income tax associated with the portion of the dividend eligible for the I.R.C. 965 dividends received deduction to be included in gross income under I.R.C. 78. However, the statutory language is ambiguous and could be read to require inclusion of all foreign income taxes in the I.R.C. 78 gross up, even foreign taxes that are ineligible for the foreign tax credit because they are associated with dividends earmarked for the 85% dividends received deduction. It will be interesting to see how far the Treasury Department and the IRS are prepared to go to fix this problem. Deductions are disallowed for any expenses that are properly allocated and apportioned to a deductible Section 965 dividend. 4

5 Anti-Inversion Provisions When a U.S. corporation reincorporates in a foreign jurisdiction the transaction is usually called an inversion transaction. Under prior law, the transformation of the U.S. company into a foreign corporation in the inversion transaction was recognized even if the shareholders of the U.S. corporation recognized gain on the exchange of their stock in the domestic corporation for stock in the foreign corporation (i.e., at the end of the day the new structure with a foreign corporation as parent was recognized). In an inversion transaction, U.S. corporations typically transfer certain assets (such as foreign subsidiaries or foreign assets) to the new foreign parent corporation in order to remove those assets from U.S. income tax jurisdiction. Although the U.S. corporation generally must recognize gain in these transactions, under prior law there were no restrictions on its use of net operating losses and other tax attributes to offset income or gain recognized on those transfers. New I.R.C defines two types of inversion transactions and applies a set of rules to each type. The first type of inversion occurs when (i) pursuant to a plan or series of related transactions, (ii) a U.S. corporation ( expatriated corporation ) either becomes a subsidiary of a foreign corporation ( surrogate foreign corporation ) or transfers substantially all its assets to the surrogate foreign corporation, (iii) after the transaction the former shareholders of the expatriated corporation hold by reason of holding stock in the expatriated corporation at least 80% of the voting power and value of the surrogate foreign corporation, and (iv) the surrogate foreign corporation (including any affiliates connected by a greater than 50% chain of ownership) does not have substantial business activities in its country of incorporation. I.R.C treats the surrogate foreign corporation in the first type of inversion transaction as a domestic corporation for all purposes of the I.R.C., thus denying the benefits of the inversion transaction. The second type of inversion transaction occurs when (i) pursuant to a plan or series of related transactions, (ii) the expatriated corporation either becomes a subsidiary of the surrogate foreign corporation or transfers substantially all its assets to the surrogate foreign corporation, (iii) after the transaction the former shareholders of the expatriated corporation hold by reason of holding stock in the expatriated corporation at least 60% of the voting power and value of the surrogate foreign corporation, and (iv) the surrogate foreign corporation (including any affiliates connected by a greater than 50% chain of ownership) does not have substantial business activities in its country of incorporation. The second type of inversion transaction also includes transactions in which the foreign corporation acquires substantially all of the assets of a U.S. partnership (provided the other elements of the definition are satisfied). In the second type of inversion the surrogate foreign corporation is recognized as a foreign corporation, but the expatriated corporation (and certain affiliated companies) is not permitted to use certain tax attributes such as net operating losses to offset income or gain (called inversion gain ) it recognizes on account of the transfer or license of any asset as part of a plan that includes the inversion transaction. Although foreign tax credits are in theory available to offset U.S. income tax on inversion gain, in practice they are not likely to be of much use because I.R.C. 7874(e)(1) treats inversion gain as U.S. source income for purposes of the I.R.C. 904 foreign tax credit limitation rules. These rules will require substantial guidance from the IRS. For example, what is a plan or series of related transactions in determining whether a transaction is related to an inversion transaction? When will the surrogate foreign corporation and its affiliates be considered to conduct substantial business activities in a foreign country? The Act also imposes a 15% excise tax on specified stock compensation received by certain officers, directors and 10% shareholders in the expatriated corporation within the 12-month period the midpoint of which is the date of the inversion transaction. Specified stock compensation includes any payment granted by the expatriated corporation (or any member of its expanded affiliated group) to any person in connection with the performance of services if the amount or value of the payment is contingent in any way on the value of the stock of the expatriated corporation (or any member of its expanded affiliated group). Specified stock compensation includes stock grants, stock options, stock appreciation rights and phantom stock. 5

6 The provisions affecting the surrogate foreign corporation and the expatriating corporation are effective in taxable years ending after March 4, The excise tax on specified stock compensation is generally effective as of March 4, 2003 except periods before that date are not taken into account for purposes of measuring stock based compensation held or cancelled in the six-month period ending on the date of the inversion transaction. Foreign Tax Credit Provisions Under the foreign tax credit regime, U.S. persons generally are entitled to a dollar-for-dollar credit for foreign income taxes paid. The maximum foreign tax credit that can be claimed in any year is determined under the foreign tax credit limitation formula in I.R.C The Act makes numerous changes to the foreign tax credit rules. Interest Expense Allocation Rules The basic foreign tax credit limitation formula provides that the maximum foreign tax credit cannot exceed the U.S. income tax that would be imposed on the taxpayer s foreign source taxable income (if there were no foreign tax credit). The taxpayer must apportion deductions (including interest expense) between U.S. source gross income and foreign source gross income to compute its foreign source taxable income for purposes of the limitation formula. Interest is allocated between foreign and U.S. sources under a special rule that applies only under the foreign tax credit limitation formula. This rule assumes interest expense is properly attributable to all of the taxpayer s property and business activities and that all members of an affiliated group of corporations are a single corporation. An affiliated group does not include foreign corporations and interest expense of the foreign corporation is not taken into account under the foreign tax credit limitation formula. However, stock in a foreign corporation held by a member of the U.S. affiliated group is a foreign asset to which interest expense can be allocated. Because of the exclusion of affiliated foreign companies, the interest allocation rules may generate distortions. While interest expense of a foreign affiliate is not taken into account in the foreign tax credit limitation formula, it is taken into account for purposes of determining the taxable income of the U.S. group that is derived from the foreign affiliate (interest expense is taken into account in determining the foreign affiliate s taxable income for purposes of subpart F or in determining earnings and profits of the foreign affiliate). When interest expense of the domestic affiliated group is allocated to the stock of the foreign corporation, there may be in effect a double counting of interest expense against the foreign income resulting in an understatement of the foreign tax credit limitation (because foreign source taxable income is too low). Thus, the U.S. taxpayer may be denied the benefit of some of the foreign tax credits because of the understatement of its foreign source taxable income. The Act provides a one-time election for U.S. companies beginning in 2009 to expand the affiliated group for purposes of the interest allocation rule to include certain foreign corporations (this rule will generally apply to certain controlled foreign corporations that would be members of the taxpayer s affiliated group if they were domestic corporations). Under the new approach the interest will be allocated between foreign source and U.S. source gross income by applying a look through rule to the foreign affiliates (i.e., the assets and income of the foreign group member, not its stock, would be taken into account under the interest allocation formula). If the expanded affiliated group is elected, there will no longer be a risk of allocating excessive interest against foreign source income under the foreign tax credit limitation formula. This one-time election is effective for taxable years beginning after December 31, Notwithstanding this delayed effective date, U.S. companies with significant foreign affiliates will need to understand the ramifications of this new regime in the context of structuring long-term financing. 6 Extension of Foreign Tax Credit Carryforward Period The Act increases the foreign tax credit carryforward period for excess foreign tax credits (the foreign tax credits for a taxable year that exceed the applicable foreign tax credit limitation) from five years to ten years

7 and decreases the foreign tax credit carry back period from two years to one year. The provision extending the carry forward period applies to any excess foreign tax credits that may be carried to any taxable year ending after the date of enactment. The provision reducing the carry back period is effective for excess foreign tax credits arising in taxable years beginning after the date of enactment. Reduction of Foreign Tax Credit Limitation Baskets Under prior law, the foreign tax credit limitation is applied separately to nine categories or baskets of income, including (i) passive income, (ii) high withholding tax income, (iii) financial services income, (iv) shipping income, (v) certain dividends from non-controlled Section 902 corporations, (vi) certain dividends from domestic international sales corporations, (vii) certain foreign trade income, (viii) certain distributions from foreign sales corporations or former foreign sales corporations, and (ix) a general limitation or residual category. The Act reduces the number of baskets to two, passive category income and general category income. This provision is effective for taxable years beginning after December 31, It will apply to all foreign tax credit carryovers to such years even if the provision did not apply to the taxable year in which the taxes were accrued. This change is perhaps not as significant as it appears at first glance because four of the nine baskets, Section 902 dividends and baskets (vi), (vii) and (viii) relating to special benefits for foreign trade income have been repealed by the Act. Putting shipping income aside, the Act eliminates a separate category for financial services income and for high withholding tax interest. Nonetheless, any reduction in the number of foreign tax credit limitation baskets will increase the ability of U.S. taxpayers to average high taxed foreign income against low taxed foreign income under the foreign tax credit limitation formula. Election to Use Spot Rate to Translate Foreign Taxes into Dollars Under the general rule, taxpayers must translate foreign income taxes denominated in a foreign currency into U.S. dollars using an average exchange rate for the taxable year in which the taxes were paid or accrued. The Act adds a new I.R.C. 986(a)(1)(D) to permit taxpayers to elect to translate foreign currency denominated taxes into U.S. dollars using the exchange rate on the date of payment (this is also called the spot rate ). The provision is effective for taxable years beginning after December 31, The election, however, applies to all subsequent years and can only be revoked with the permission of the IRS. Base Differences under the Foreign Tax Credit Under current regulations, if foreign income tax is imposed on a base amount that does not constitute income under U.S. income tax law, the tax is allocated to the general limitation basket. The Act codifies this rule in new I.R.C. 904(d)(2)(H). The new rule is effective for taxable years beginning after December 31, The Act also contains a special transition rule intended to benefit corporations with significant financial services income. This provision allows these corporations to allocate taxes paid or accrued after December 31, 2004 and before January 1, 2007 on an income base that does not constitute income under U.S. principles to their financial services income foreign tax credit limitation basket instead of the general limitation basket. The election applies to all years until 2007 unless the IRS permits a revocation of the election. The provision is no longer necessary beginning in 2007 because the financial services income limitation basket will be eliminated beginning in that year. Financial services income will then be included in the general limitation basket. Treatment of Overall Domestic Losses If a taxpayer s overall foreign loss exceeds its overall foreign income, the excess loss may offset domestic source income. However, to prevent a double benefit under the foreign tax credit, when foreign source income is earned in a later taxable year, the loss from the prior year must be recaptured by treating foreign source income in the later year as domestic source income for purposes of the foreign tax credit limitation formula. The effect is to reduce the foreign tax credit limitation amount when an overall foreign 7

8 loss reverses possibly preventing the taxpayer from claiming a full foreign tax credit in the later year. Under prior law there was no recapture rule when overall domestic losses offset foreign income. The Act adopts a symmetrical recapture rule for overall domestic losses. The rule treats certain U.S. source income as foreign source income for purposes of the foreign tax credit limitation formula if a taxpayer s foreign tax credit limitation was reduced in prior years on account of an overall domestic loss (defined as the amount by which U.S. source income for a taxable year is exceeded by deductions properly allocable to U.S. source income). The provision is effective for taxable years beginning after December 31, Loss Recapture on Sale of CFC Stock Under the overall foreign loss recapture rule discussed above, a taxpayer that incurred foreign source losses that were used to offset U.S. source income is also subject to a special recapture rule upon the transfer or disposition of assets used in the foreign business. If the taxpayer transfers assets it uses in a foreign business before the overall foreign loss has been recaptured, it must recognize income in an amount equal to the overall foreign loss (or the aggregate gain recognized in the transaction if smaller) even if the transaction otherwise qualifies as a tax-free transaction. The income recognized under this rule is treated as domestic source income for purposes of the foreign tax credit limitation rules. Under prior law, there is no recapture of overall foreign loss on the disposition of stock in a controlled foreign corporation (a CFC ). The Act amends I.R.C. 904(f)(3), effective on the date of enactment, to require recapture of overall foreign losses on the disposition of certain CFC stock. The rule may require recognition of gain in what is otherwise a tax-free transaction. However, this rule does not apply to the acquisition by the taxpayer of the assets of a CFC in a tax-free reorganization or liquidation and if CFC stock is transferred to a corporation or partnership in a tax-free transaction if the taxpayer s percentage interest in the transferred does not change. Look Through Rules for Indirect Foreign Tax Credit In general under the I.R.C. 902 indirect foreign tax credit, a U.S. corporation that owns at least 10% of the voting stock of a foreign corporation is entitled to claim a foreign tax credit for foreign taxes paid by the foreign corporation in respect of earnings distributed by the foreign corporation as a dividend. A 10/50 company is a foreign corporation that is 10% owned by a U.S. corporation but is not a CFC (the technical term under the I.R.C. is a noncontrolled Section 902 corporation ). Under prior law, special foreign tax credit limitation rules apply to foreign tax credits attributable to 10/50 companies. Dividends of 10/50 companies paid out of pre-2003 earnings and profits comprise a separate foreign tax credit limitation basket and they were not subject to a look through rule. Dividends of 10/50 companies paid out of post-2002 earnings and profits are assigned to foreign tax credit limitation baskets based on the character of the 10/ 50 company s earnings and in proportion to the ratio of the 10/50 company s earnings and profits that are assigned to the foreign tax credit limitation basket. The Act extends the look through rule to all dividends from 10/50 companies, effective for taxable years beginning after December 31, Complex transition rules may be needed to apply the new rule to preeffective date taxes. Attribution of Stock Owned by Partnerships Prior law was unsettled on whether a U.S. corporation can qualify for the indirect foreign tax credit under I.R.C. 902 if it owned at least 10% of the voting stock of a foreign corporation indirectly through a limited partnership, a limited liability company or a foreign partnership. In Rev. Rul , the IRS held that stock in a foreign corporation owned by a general partnership was considered owned by a U.S. corporation that was a general partner in the partnership for purposes of I.R.C. 902, but the application of the ruling to other types of partnerships was unclear. 8

9 The Act provides that a U.S. corporation is entitled to the I.R.C. 902 indirect foreign tax credit with respect to a foreign corporation that is held indirectly through any type of partnership (including a limited partnership, limited liability company or a foreign partnership), provided that the U.S. corporation owns indirectly through the partnership at least 10% of the foreign corporation s voting stock. The provision is effective for taxes incurred by foreign corporations in taxable years beginning after the date of enactment. The legislative history states that no inference is intended as to the treatment of foreign corporations held by partnerships under prior law. Minimum Holding Period for Foreign Tax Credit for Gross Base Foreign Taxes Under I.R.C. 901(k) a taxpayer is not eligible to claim a foreign tax credit for any withholding tax on a dividend if the taxpayer has not held the stock on which the dividend was paid for a minimum period (15 days within a 30-day testing period for common stock and 45 days within a 90-day testing period for preferred stock). Under prior law, there was no comparable rule for other types of property that generate income subject to withholding tax. The Act adds new I.R.C. 901(l) to disallow foreign tax credits for withholding taxes with respect to any item of income or gain from property (other than dividends) if the taxpayer has not held the income generating property for more than 15 days within the 31-day testing period, the midpoint of which is the day the taxpayer became entitled to receive the income. In general, a taxpayer that has eliminated the risk of loss with respect to income generating property will not be considered to own the property for purposes of this rule. In this regard, the Conference Committee Report indicates that regulations will permit taxpayers to eliminate risk of loss from interest or currency rate fluctuations without being treated as having disposed of the underlying property. The provision is effective for amounts that are paid or realized 30 days after the date of enactment. Repeal of Limitation on Foreign Tax Credit under the Alternative Minimum Tax Under prior law, taxpayers can reduce their alternative minimum tax liability by the alternative minimum tax foreign tax credit (the AMT foreign tax credit ). The AMT foreign tax credit is determined under principles similar to those used in determining the regular foreign tax credit except that the AMT foreign tax credit may not offset more than 90% of AMT for any year. The Act eliminates the 90% limitation on the AMT foreign tax credit effective for taxable years beginning after December 31, Source Rule for I.R.C. 367(d) Deemed Royalty Payments Under I.R.C. 367(d) certain transfers of intangible property by U.S. persons to foreign persons in transactions that would otherwise be tax free are treated as a sale of the intangible property for a contingent stream of payments. Initially, these payments were treated as U.S. source income, but in an amendment contained in the Taxpayer Relief Act of 1997, the payments were treated as foreign source income, but they were not specifically classified as royalties. As a consequence, the treatment of I.R.C. 367(d) payments under the foreign tax credit limitation regime was unclear (in particular whether such payments were subject to look through rules applicable to certain royalties). The Act clarifies this issue by providing that I.R.C. 367(d) contingent payments are treated as royalties for purposes of the foreign tax credit limitation regime. The provision is effective for amounts treated as received on or after August 5, 1997 (the effective date of the Taxpayer Relief Act of 1997). Changes to Subpart F In general, the subpart F regime requires U.S. 10% shareholders of a controlled foreign corporation ( CFC ) to report and pay tax on certain income of the CFC ( subpart F income ), whether or not the income is distributed to the shareholders of the CFC. The subpart F rules are complex and highly technical. The Act makes numerous changes to the subpart F regime. 9

10 Look-Through Treatment for Sales of Partnership Interests in Determining Foreign Personal Holding Company Income Subpart F income includes foreign personal holding income ( FPHCI ). Under prior law, FPHCI is generally defined to include the following items, (i) dividends, interest, royalties, rents and annuities, (ii) net gains from the sale or exchange of property that gives rise to the preceding categories of income, property that does not give rise to income and interests in trusts, partnerships and REMICs, (iii) net gains from commodities transactions or foreign currency transactions, (iv) income equivalent to interest, (v) income from notional principal contracts, and (vi) payments in lieu of dividends. The Act excludes from FPHCI income derived from the sale of partnership interests by partners owning directly, indirectly or constructively at least 25% of the capital and profits of the partnership. Instead, the Act provides that gain realized on the sale of a partnership interest by a 25% partner is treated as FPHCI only to the extent a sale by the partnership of its assets would generate FPHCI. The provision is effective for taxable years of foreign corporations beginning after December 31, Determination of FPHCI with Respect to Commodities Transactions Under prior law, FPHCI generally includes net gains from dealings in commodities. However, FPHCI does not include gains or losses in commodities that arise from bona fide hedging transactions reasonably necessary to the normal conduct of business by a producer, processor, merchant, or handler of commodities in a manner in which such business is customarily conducted by others. FPHCI also does not include gains or losses arising from commodity transactions by a CFC that is substantially engaged in business as an active producer, processor, merchant or handler of commodities. To qualify as being substantially engaged in the commodities business, at least 85% of the CFC s gross receipts for the taxable year must be attributable to sales of the commodity or hedging transactions with respect to the commodity. The Act expands the exception from FPHCI for gains and losses from commodity transactions for hedging type transactions. Gains and losses from commodity transactions will be excluded from FPHCI if the transaction satisfies the general definition of a hedging transaction under I.R.C modified to include any transaction with respect to a commodity entered into by a CFC to manage price changes or currency fluctuations with respect to ordinary income property (or to mange other risks as are described in regulations). In addition, gains or losses from commodities transactions are not included in FPHCI if substantially all of the CFC s commodities consist of (i) stock in trade that would be properly includible in inventory, (ii) property subject to an allowance for depreciation, or (iii) supplies regularly used by the CFC in its trade or business. Overall, it is expected that these provisions will substantially increase the amount of gains and losses from dealings in commodities of a CFC that are excluded from FPHCI. The provision is effective for transactions entered into after December 31, Modification of Subpart F Exceptions for Active Financing Income In 1997 Congress enacted I.R.C. 954(h), exempting qualified banking or financing income of an eligible CFC from FPHCI (and thus from subpart F income inclusion). This provision was in response to arguments of U.S. based financial services businesses that after the removal in the Tax Reform Act of 1986 of exceptions to the definition of FPHCI for income derived from a banking, financing or similar business or derived from certain investments made by an insurance company they were at a disadvantage against foreign competitors allowed to defer home country tax on foreign income. President Clinton vetoed the provision using authority granted under the Line Item Veto Act; however I.R.C. 954(h) was reinstated when the Supreme Court held the Line Item Veto Act unconstitutional. As initially enacted, the 1997 amendment adding I.R.C. 954(h) to the I.R.C. had a one-year life. In 1998 the provision was extended for one year, in 1999 for two years and in 2002 the provision was extended for five years. Although the Act does not make permanent or further extend I.R.C. 954(h), it does loosen it by adding a new I.R.C. 954(h)(3)(A) to reduce the requirements of direct conduct of the foreign banking or financial 10

11 activities that is required to qualify for the exception of I.R.C. 954(h). Specifically, the CFC can satisfy the active financial business requirement through employees of a related person if (i) the related person is an eligible CFC with the same home country as the CFC, (ii) the activity is performed by the employees of the related person in that home country, and (iii) the related person is compensated on an arms-length basis and the home country tax laws treat that compensation as earned in the home country. The provision is effective for taxable years of foreign corporations beginning after December 31, 2004 and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end. Modification of I.R.C. 956 Rules on Investments in U.S. Property In general, a U.S. shareholder of a CFC is subject to tax on its pro rata share of earnings of the CFC that are invested in U.S. property. For this purpose, U.S. property includes tangible property located in the U.S., stock of certain U.S. corporations or an obligation of a U.S. person and intangible property acquired or developed by the CFC for use in the U.S. There are numerous exceptions and special rules that limit the definition of U.S. property for this purpose. One exception under prior law held that U.S. property did not include deposits with persons carrying on the banking business, but the term banking business was loosely defined. In The Limited Inc. v. Commissioner, 286 F. 3d 384 (6th Cir. 2002), the court held that activities related to the administration of a private credit card constituted carrying on a banking business. The Act reverses the result in The Limited by providing that the exception to the definition of U.S. property for deposits with persons carrying on the banking business only applies to deposits with a bank holding company or a financial holding company (or any subsidiary of either of those entities) as defined in the Bank Holding Company Act of The provision is effective on the date of enactment. The Act also adds two new exceptions to the definition of U.S. property in I.R.C The first holds that U.S. property does not include securities held by a CFC that is a dealer in securities (provided the securities are held in the ordinary course of its business). The second holds that U.S. property does not include obligations of a non-corporate U.S. person provided the obligor is not a U.S. shareholder of the CFC or is not related to the CFC (in the case of an obligor that is a partnership, estate or trustee). The provision is effective for CFCs for taxable years beginning after December 31, 2004 and for U.S. shareholders for taxable years that end with or within such CFC taxable years. Repeal of Foreign Personal Holding Company and Foreign Investment Company Regimes Since foreign corporations not engaged in a U.S. trade or business are not subject to U.S. income tax, U.S. taxpayers and tax planners have attempted to avoid or defer U.S. income tax by placing income generating assets in foreign corporations. The goal is to defer U.S. income tax on earnings of the foreign corporation and perhaps pay future tax at favorable capital gains rates upon the sale of stock in the foreign corporation. To combat this, various anti-deferral regimes have been added to the I.R.C. over the years, including subpart F relating to controlled foreign corporations (I.R.C ), the passive foreign investment company regime or PFIC (I.R.C ), the foreign personal holding company rules (I.R.C ), and the foreign investment company rules (I.R.C ). In addition the personal holding company rules (I.R.C ) and the accumulated earnings tax (I.R.C ), designed to deter accumulation of excessive passive assets in any corporations (whether domestic or foreign), apply to foreign corporations. There is significant overlap between these sets of rules and the interaction of the regimes is subject to complex rules. The Act repeals the foreign personal holding company rules and the foreign investment company rules and excludes foreign corporations from the application of the personal holding company rules. The Act also expands the definition of foreign personal holding company income under subpart F to include certain personal service income received by a CFC that is at least 25% owned by the individual service provider. Foreign personal holding company income now includes income received by a CFC from a personal 11

12 12 services contract if the contract designates the person who will perform the services or provides that a third person has the right to designate the individual that is to perform the services. These provisions are effective taxable years beginning after December 31, Limitation on Importation of Built-in Losses Under prior law, when one or more foreign persons transfer property that is not used in a U.S. trade or business or an interest in U.S. real property to a U.S. corporation in exchange for stock in a tax-free reorganization, liquidation or I.R.C. 351 transaction, the basis of property received by the transferee corporation, is under the general rule, equal to the transferor s basis adjusted for gain or loss recognized on the transfer. The transferor s basis in the stock of the transferee corporation is the same as its basis in the transferred property immediately prior to the transfer increased by the gain recognized by the transferor in the exchange and reduced by the cash received in the exchange. The Act provides that if property with an aggregate net built-in loss (i.e., the aggregate basis of the property exceeds the aggregate fair market value of the property) is transferred to a U.S. corporation from persons not subject to U.S. income tax, the basis of each transferred item of property to the transferee corporation is the property s fair market value at the time of the transfer. A similar rule is added for a tax-free subsidiary liquidation of a foreign subsidiary by a U.S. corporation. The provision applies to transactions after the date of enactment. Limit Tax Free Outbound Subsidiary Liquidations In general, 30% withholding tax is imposed on dividends paid by U.S. corporations to foreign persons to the extent the dividends are not effectively connected with a U.S. trade or business conducted by the foreign person. The 30% withholding tax may be reduced or eliminated under U.S. income tax treaties. The U.S. also imposes a branch profits tax on the deemed repatriation of profits earned by the U.S. branch of a foreign corporation. No withholding tax is imposed if a U.S. corporation distributes cash to foreign shareholders in a complete liquidation because the distribution is treated as made in exchange for stock not as a distribution in respect of stock. Similar rules apply under the branch profits tax for remissions of profits by U.S. branches in connection with deemed repatriation of earnings in connection with the termination of the branch. In general, I.R.C. 367(e) requires a U.S. subsidiary of a foreign parent corporation to recognize gain on the distribution of appreciated property to the foreign parent corporation in a complete liquidation contrary to the rules that apply to a subsidiary liquidation into a U.S. parent. One exception to this rule provides that no gain is recognized by the U.S. subsidiary on the distribution of stock in a lower tier U.S. corporation to its foreign parent in the liquidation. However, this exception is subject to an anti-abuse rule, which provides that gain must be recognized by the liquidating corporation on the distribution of stock in a U.S. subsidiary if a principal purpose of the liquidation is the avoidance of U.S. income tax. For this purpose, avoidance of income tax includes the distribution of earnings and profits of the liquidating company in order to avoid withholding tax on dividends. The Act amends I.R.C. 332 to treat a liquidating distribution of earnings by a U.S. holding company as a distribution described in I.R.C. 301 unless the holding company has been in existence for at least five years. The provision recasts the transaction as a distribution to a shareholder in respect of stock (potentially subject to withholding tax). The provision applies to liquidating distributions that occur after the date of enactment. Modification of Source of Interest Paid by a Foreign Partnership Under prior law, interest paid by a foreign partnership is U.S. source income if the foreign partnership is engaged in a trade or business in the U.S. at any time during the year in which the interest is paid regardless of whether the interest is connected to the U.S. trade or business or the relative size of the partnership s U.S. trade or business.