Chairman Camp s Discussion Draft of Tax Reform Act of 2014 and President Obama s Fiscal Year 2015 Revenue Proposals

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1 Chairman Camp s Discussion Draft of Tax Reform Act of 2014 and President Obama s Fiscal Year 2015 Proposals Relating to International Taxation SUMMARY On February 26, 2014, Ways and Means Committee Chairman Dave Camp released a discussion draft of tax reform legislation entitled the Tax Reform Act of 2014 (the Discussion Draft ). Although the Discussion Draft is unlikely to be enacted in its current form, some or all of the proposals may serve as a template for future legislation. In addition, on March 4, 2014, the Obama Administration (the Administration ) released the General Explanations of the Administration s Fiscal Year 2015 Revenue Proposals (commonly known as the Green Book ). Although the Green Book does not include proposed statutory language, the Green Book contains significant detail about the fiscal year 2015 revenue proposals. Many of these proposals were made previously by the Administration but were not enacted into law. This memorandum discusses key aspects of the Discussion Draft and the Green Book relating to international taxation that we anticipate may be of interest to our clients. We will be distributing separate memoranda addressing the Discussion Draft and Green Book proposals relating to (i) domestic business taxation, and (ii) individuals, retirement plans and estate and gift taxation, both of which may be obtained by following the instructions at the end of this memorandum. The Discussion Draft proposes comprehensive changes to the existing international taxation regime, and includes the following specific proposals: shifting toward a territorial tax system by establishing a 95 percent deduction for the foreign-source portion of dividends received by domestic corporations from specified 10 percent owned foreign New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 corporations, but requiring that shareholders of such corporations include as income (with up to a 90 percent deduction) their share of the corporations accumulated untaxed income; making the look-through rule for related controlled foreign corporations permanent; taxing foreign intangible income at the reduced rate of 15 percent but subjecting such income to Subpart F (i.e., taxing a U.S. shareholder of a controlled foreign corporation earning such income on a current basis whether such income is distributed or not) unless such income qualifies for the high taxed exclusion); extending the exemption from Subpart F of qualified banking or finance income and qualified insurance income, but limiting the exemption to only 50 percent of the income earned if the income is not subject to tax at a rate that is at least 50 percent of the U.S. maximum rate of corporate tax; denying interest deduction for members of worldwide affiliated groups with excess domestic indebtedness; making the high-tax exception to Subpart F non-elective and creating an exception to foreign base company sales income for income earned by a foreign subsidiary incorporated in a country that has a comprehensive income tax treaty with the United States; restricting the insurance business exception to passive foreign investment company rules; tightening limitations on earnings stripping; and limiting treaty benefits for certain deductible related party payments. The Green Book proposals relating to international taxation include: providing for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act ( FATCA ); creating a new category of Subpart F income for transactions involving digital goods or services; preventing avoidance of foreign base company sales income through manufacturing services arrangements; restricting the use of hybrid and reverse hybrid arrangements that create stateless income; imposing additional limitations on inversion transactions; exempting foreign pension funds from the application of the Foreign Investment in Real Property Tax Act ( FIRPTA ); deferring interest deductions related to deferred foreign income; determining foreign tax credit pools on an aggregate basis; currently taxing some types of income from intangible property transferred to offshore related parties and clarifying (or broadening) the definition of intangible property; modifying the foreign tax credit rules for dual capacity taxpayers; taxing some gain from the sale of a partnership interest as effectively connected to a U.S. trade or business and requiring withholding in certain circumstances; taxing certain leveraged distributions from related foreign corporations; placing additional limits on the use of foreign tax credits in the case of certain asset acquisitions; and removing foreign taxes from the foreign tax pool in the case of certain domestic shareholder corporations when earnings are eliminated from a foreign subsidiary. -2-

3 Finally, both the Green Book and the Discussion Draft propose disallowing deductions for non-taxed reinsurance premiums paid to offshore affiliates. ANALYSIS A. DISCUSSION DRAFT PROPOSALS 1. Shifting Toward a Territorial Tax System The Discussion Draft proposal would establish a participation exemption system by means of a 95 percent deduction for the foreign-source portion of dividends received by domestic corporations from specified 10 percent owned foreign corporations. 1 A specified 10 percent owned foreign corporation would be any foreign corporation in which a domestic corporation owns, directly or indirectly, 10 percent or more of the voting stock of that foreign corporation. The 95 percent participation exemption would be allowed only if the domestic corporation satisfies a sixmonth holding period requirement with respect to the stock on which the dividend is paid under rules similar to those currently in effect for the existing dividends-received deduction. No foreign tax credit or deduction would be allowed for any tax in respect of any dividend for which the 95 percent participation exemption is allowed. A foreign tax credit or deduction would be allowed for foreign tax imposed on income included under Subpart F (which would continue to be fully taxable) 2 for foreign tax paid directly by a domestic corporation on foreign-source income (e.g., income from foreign operations), and for foreign withholding tax levied on non-dividend payments such as payments of royalties or interest. A special loss limitation rule would require, solely for the purposes of determining the amount of loss on disposition of stock, a domestic corporation to reduce its basis by the amount of the dividend received with respect to stock of a specified 10 percent owned foreign corporation. 3 In addition, losses incurred in a foreign branch after the effective date of the 95 percent participation exemption would, upon the transfer of substantially all assets of the foreign branch to a foreign subsidiary, be required to be included in See Section 4001 of the Discussion Draft and new Section 245A of the Internal Revenue Code of 1986, as amended (the Code ). Under the Subpart F rules, a 10 percent U.S. shareholder (taking into account a number of attribution and constructive ownership rules) of a controlled foreign corporation (a CFC ) is generally subject to current U.S. tax on dividends, interest, royalties, rents, and other types of passive income earned by the CFC, regardless of whether the CFC actually distributes such income to the U.S. shareholder. See Section 4002 of the Discussion Draft and Sections 367(a)(3)(C) and 961 and new Section 91 of the Code. -3-

4 income to the extent the domestic corporation receives exempted dividends from any of its foreign subsidiaries. A transition tax would be imposed on all previously untaxed foreign earnings and profits of a specified 10 percent owned foreign corporation immediately prior to the effective date of the 95 percent participation exemption system, with earnings and profits retained in the form of cash, cash equivalents and other short-term assets taxed at a rate of 8.75 percent and the remaining earnings and profits (that have been reinvested in the foreign subsidiary s business) taxed at a rate of 3.5 percent. 4 The transition tax could be paid in installments over a period of up to eight years. These proposals are intended to eliminate the lock-out effect that results from the U.S. residual tax which is imposed under current law on repatriated earnings to the extent that foreign tax credits are insufficient to offset the U.S. tax liability on the repatriated earnings. According to the Discussion Draft, this residual tax discourages companies from bringing their foreign earnings back into the U.S. 5 According to the Draft proposals, instituting the participation exemption system described above would reduce revenues by $42 billion over the 10-year period between 2014 and 2023 (when taking into account the additional revenue from the transition tax). 6 These proposals would be effective for tax years of foreign corporations beginning after 2014, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. The special loss limitation rule would be effective for transfers after Permanent Look-Through Rule for Related Controlled Foreign Corporations Under current law, a 10 percent U.S. shareholder (taking into account a number of attribution and constructive ownership rules) of a CFC generally is subject to current U.S. tax on its dividends, interest, royalties, rents, and other types of passive income earned by the CFC, regardless of whether the CFC distributes such income to the U.S. shareholder. However, for tax years of CFCs beginning before January 1, 2014, and tax years of U.S. shareholders in which or with which such tax years of the CFC end, Section 954(c)(6) of the Code provided a look-through exception under which such passive income will generally not be subject to Subpart F rules if the income was received by a CFC from a related CFC See Section 4003 of the Discussion Draft and Sections 965 and 9503 of the Code. The tax would be implemented by a mandatory Subpart F inclusion (regardless of whether the foreign corporation were a CFC) by U.S. shareholders owning at least 10 percent of a foreign subsidiary of the amount of all previously untaxed foreign earnings and profits, with a 75 percent deduction for earnings and profits retained in the form of cash or cash equivalents (for an effective tax rate of 8.75 percent based on a corporate tax rate of 35 percent) and a 90 percent deduction for the remaining earnings and profits (for an effective tax rate of 3.5 percent based on a corporate tax rate of 35 percent). See Section 4001 of the Discussion Draft. See id. -4-

5 (provided such income was not subject to current U.S. tax or effectively connected with a U.S. trade or business). The Discussion Draft proposes to make the look-through rule permanent, effective for tax years of foreign subsidiaries beginning after January 1, 2014, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end Foreign Intangible Income Taxed under Subpart F Under current law, a foreign subsidiary that owns intangible property in a foreign jurisdiction may, in certain circumstances, be allocated profits, consistent with transfer pricing rules, without resulting in an inclusion of Subpart F income by the U.S. parent of such foreign subsidiary, thus deferring U.S. tax on those profits until they are distributed to the U.S. parent. According to the Discussion Draft, the adoption of a participation exemption system could, without appropriate safeguards, exacerbate this incentive by creating a path through which shifted profits could be repatriated with minimal U.S. tax consequences. The Discussion Draft proposes to create a new category of Subpart F income, foreign base company intangible income ( FBCII ), equal to the excess of the foreign subsidiary s gross income over 10 percent of the foreign subsidiary s adjusted basis in depreciable tangible property (excluding income and property related to commodities). 8 FBCII would generally be subject to an effective tax rate of 15 percent. This effective tax rate would also be available for domestic corporations that earn foreign intangible income directly (rather than through a foreign subsidiary). Although the proposal seems to target the activities of companies that develop digital software or other forms of mobile intellectual property, the proposal is stated broadly enough to also reach the activities of service-based businesses and financial companies (each of which will have minimal depreciable tangible property) for which the proposal does not provide specific exceptions. FBCII would, however, only be subject to current taxation in the U.S. under Subpart F to the extent it is subject to a foreign effective tax rate lower than the 15 percent effective U.S. tax rate imposed on FBCII. With regard to the treatment of FBCII as subject to current U.S. tax, the proposal would be effective for tax years of foreign corporations beginning after 2014, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. The lower effective tax rate that would generally be imposed on FBCII would be effective for tax years beginning after See Section 4004 of the Discussion Draft and Section 954(c)(6) of the Code. See Section 4211 of the Discussion Draft and Section 954 of the Code. -5-

6 4. Denial of Interest Deduction for Members of Worldwide Affiliated Groups with Excess Domestic Indebtedness Under current law, corporations generally can deduct all of their interest expense even if the debt was acquired to capitalize foreign subsidiaries. However, expense allocation rules may require that interest expense be allocated against foreign source income, which may limit the amount of foreign tax credits that the U.S. parent can claim. According to the Discussion Draft, in conjunction with the adoption of the participation exemption system it is important to provide measures to discourage excessive leveraging, and deny an interest deduction to borrowings deemed attributable to largely tax-exempt income from foreign participations. 9 Under the Discussion Draft proposal, the deductible net interest expense of a U.S. parent of one or more foreign subsidiaries would be reduced by the lesser of the extent to which (i) the indebtedness of the U.S. parent (including other members of the U.S. consolidated group) exceeds 110 percent of the combined indebtedness of the worldwide affiliated group which is the U.S. parent and its domestic and foreign subsidiaries but does not include foreign parents or other related foreign entities, 10 or (ii) net interest expense exceeds 40 percent of the adjusted taxable income of the U.S. parent. 11 Any disallowed interest expense could be carried forward to a subsequent tax year but would remain subject to similar limitations in subsequent years. This proposal would be effective for tax years beginning after Subpart F Income: High Tax and Treaty Exceptions Under current law, a U.S. parent of a foreign subsidiary is subject to current U.S. tax on Subpart F income of the foreign subsidiary, regardless of whether or not the income is distributed to the U.S. parent. If, however, the Subpart F income has been taxed at a rate that is at least 90 percent of the U.S. tax rate, then the U.S. parent may elect to treat that income as non-subpart F income. The 90 percent threshold is the same regardless of whether the category of Subpart F income is foreign personal holding company income ( FPHCI ) (generally interest, dividends, rents, royalties and gains on property that produced any of the foregoing) or foreign base company sales income ( FBCSI ) (income from the sale of goods involving a related party) or some other category. Under the Discussion Draft, the high tax exception would no longer be elective. 12 Further, the Discussion Draft proposes to increase the threshold for the high tax exception from 90 percent to 100 percent for See Section 4212 of the Discussion Draft. This is because this proposal is focused on preventing abuse of the participation exemption system. See Section 4212 of the Discussion Draft and Section 163 of the Code. See Section 4202 of the Discussion Draft and Sections 954 and 960 of the Code. -6-

7 FPHCI (i.e., 25 percent under the proposed corporate tax rate), and to establish a threshold of 50 percent for FBCSI (i.e., 12.5 percent under the proposed corporate tax rate) and 60 percent for FBCII (i.e., 15 percent under the proposed corporate tax rate). The proposal would also create an exception to FBCSI for income earned by a foreign subsidiary that is incorporated in a country that has a comprehensive income tax treaty with the United States. This proposal would be effective for tax years of foreign corporations beginning after 2014, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. 6. Extension of the Active Finance Exemption from Subpart F with Limitation for Low- Taxed Foreign Income Under a provision originally enacted in 1997 and extended several times thereafter, there is an exclusion from Subpart F income for income derived in the active conduct of banking, financing, or similar businesses, or in the conduct of an insurance business ( active financing income ). 13 The most recent extension in 2013 was effective for taxable years of foreign subsidiaries beginning before 2014 and U.S. shareholders in which or with which such taxable years of the foreign subsidiary end. The Discussion Draft proposes to extend the exception for active financing income for five years. However, the exception will be limited only to active financing income that is subject to a foreign effective tax rate of at least 12.5 percent (i.e., 50 percent of the new maximum corporate tax rate). Active financing income that is subject to a foreign tax that is lower than 12.5 percent would not be exempt, but would be subject to a reduced U.S. tax rate of 12.5 percent, before application of foreign tax credits. 14 This proposal would be effective for tax years of foreign corporations beginning after 2013 and before 2019, and for tax years of U.S. shareholders in which or with which such tax years of foreign subsidiaries end. 7. Restriction on Insurance Business Exception to Passive Foreign Investment Company Rules Under current law, U.S. shareholders investment in a passive foreign investment company ( PFIC ) is subject to adverse tax consequences. A PFIC is defined as any foreign corporation (i) 75 percent or more of the gross income of which is passive, and (ii) at least 50 percent of the assets of which produce passive income. Among other exceptions, passive income does not include any income that is derived in the active conduct of an insurance business if the foreign corporation is predominantly engaged in an insurance business and would be taxed as an insurance company were it a U.S. corporation See Sections 953(e), 954(h), and 954(i) of the Code. See Section 4204 of the Discussion Draft. -7-

8 Under the Discussion Draft proposal, the insurance business exception would be modified to replace the test based on whether a foreign corporation is predominantly engaged in an insurance business with a test based on the gross receipts of the corporation consisting of premiums. Specifically, the PFIC exception for insurance companies would apply only if (i) the foreign corporation would be taxed as an insurance company under Subchapter L of the Code if it were a domestic corporation, (ii) more than 50 percent of the foreign corporation s gross receipts for the tax year consist of premiums, and (iii) specific insurance liabilities (such as loss and loss adjustment expenses, unearned premiums, and certain reserves) constitute more than 35 percent of the foreign corporation s total assets. 15 The proposal would be effective for tax years beginning after Modification of Limitation on Earnings Stripping Rule Under current law, a U.S. corporation generally may deduct interest payments, including payments to a related party. However, if the taxpayer s debt-to-equity ratio (calculated in accordance with rules set out in the relevant Code section) exceeds 1.5 to 1, a deduction for interest payments to certain related parties that are not subject to U.S. tax (e.g., foreign corporations) is disallowed to the extent the taxpayer has excess interest expense. Excess interest expense is the amount by which the taxpayer s net interest expense (i.e., interest expense less interest income) exceeds 50 percent of the taxpayer s adjusted taxable income (generally taxable income computed without regard to deductions for net interest expense, net operating losses, certain cost recovery, and domestic production activities). Any disallowed interest deductions may be carried forward indefinitely, while any excess limitation (the excess of 50 percent of the corporation s adjusted taxable income over the corporation s net interest expense) may be carried forward three years. Under the Discussion Draft proposal, the threshold for excess interest expense would be reduced to 40 percent of adjusted taxable income. 16 In addition, corporations would no longer be permitted to carry forward any excess limitation. The proposal would be effective for tax years beginning after Limitation on Treaty Benefits for Certain Deductible Payments Under current law, certain payments of fixed or determinable, annual or periodical ( FDAP ) income such as interest, dividends, rents, and annuities to foreign recipients are subject to a statutory 30 percent withholding tax. Income tax treaties between the United States and other countries, however, often reduce or eliminate this withholding tax for payments from residents of one treaty country to residents of the other treaty country See Section 3703 of the Discussion Draft and Section 1297 of the Code. See Section 3704 of the Discussion Draft and Section 163(j) of the Code. -8-

9 Under the Discussion Draft proposal, if a payment of FDAP income is deductible in the United States by the payor and if both payor and payee are controlled by the same foreign parent corporation, then the statutory 30 percent withholding tax on such income would not be reduced by any treaty unless the withholding tax would have been reduced under a tax treaty if the payment were made directly to the foreign parent corporation. 17 The proposal would be effective for payments made after the date of enactment. B. COMMON PROPOSALS 1. Disallowance of Deduction for Non-Taxed Reinsurance Premiums Paid to Affiliates Under current law, insurance companies are generally permitted to deduct premiums paid for reinsurance, including premiums paid to foreign affiliates. While Subpart F limits the ability of domestic insurance companies to use reinsurance with foreign affiliates to avoid current U.S. taxation (because the foreign affiliate s reinsurance premium income is Subpart F income), foreign insurance companies with foreign parents are not subject to the Subpart F regime. Current law does, however, impose a one percent excise tax on reinsurance premiums paid to foreign reinsurance companies with respect to U.S. risks. The Green Book and the Discussion Draft 18 provide substantially similar proposals that would deny an insurance company deductions for premiums and other amounts paid to an affiliated foreign company with respect to reinsurance of property and casualty risks to the extent that neither the foreign reinsurer nor its parent company is subject to U.S. income tax with respect to the premiums. The denial of the deduction would not apply if the foreign reinsurance company elected to treat the premium (and the associated investment income) as income effectively connected with a U.S. trade or business and attributable to a permanent establishment for tax treaty purposes. If the election is made, the income would be foreign source and in a separate foreign tax credit limitation basket. Under the Discussion Draft proposal, unlike the Green Book proposal, the denial of the deduction would not apply if the taxpayer demonstrates to the Internal Revenue Service ( IRS ) that a foreign jurisdiction taxes the reinsurance premiums at a rate as high as or higher than the U.S. corporate rate See Section 3705 of the Discussion Draft and Section 894(d) of the Code. See Section 3701 of the Discussion Draft and new Section 849 of the Code. -9-

10 The Green Book proposal would be effective for policies issued in taxable years beginning after December 31, 2014, and thus would apparently not apply to any policies issued before December 31, The Discussion Draft proposal would be effective for taxable years beginning after December 31, C. GREEN BOOK PROPOSALS 1. Provide for Reciprocal Reporting of Information in Connection with the Implementation of the Foreign Account Tax Compliance Act ( FATCA ) The Foreign Account Tax Compliance Act ( FATCA ) generally requires foreign financial institutions that wish to avoid imposition of a new U.S. withholding tax to report to the IRS comprehensive information about U.S. account holders of financial accounts. This includes, for example, account balances, amounts of dividends, interest and gross proceeds credited to a U.S. account, and, with respect to accounts held by passive foreign entities, information about any substantial U.S. owner of such entity. The Green Book states that the ability to exchange information reciprocally with other jurisdictions is key to the successful implementation of FATCA and that, in many cases, the law of foreign jurisdictions would prevent foreign financial institutions from complying with the FATCA reporting provisions. 19 Intergovernmental agreements have been entered into in order to mitigate such legal impediments and the Green Book asserts that such intergovernmental cooperation would be facilitated if the IRS could provide equivalent levels of information to foreign governments to support their efforts to address tax evasion by their residents. 20 The Green Book proposal would require certain financial institutions to report to the IRS the account balance (including the cash value or surrender value of cash value insurance or annuity contracts) for all financial accounts maintained at a U.S. office and held by foreign persons. The Green Book proposal would also expand the reporting required with respect to U.S. source income paid to accounts held by foreign persons to include similar non-u.s. source payments. The Green Book proposal would grant the Secretary of the Treasury authority to issue Treasury regulations that will require financial institutions to report information with respect to gross proceeds from the sale or redemption of property, accounts held by passive entities with substantial foreign ownership, as well as other types of information. The IRS could, in turn, share such information with foreign governments with which the United States has entered into information sharing agreements. The proposal would be effective for tax returns to be filed after December 31, See Green Book, page 203. On its website, the U.S. Treasury Department provides a list of jurisdictions which are treated as having an intergovernmental agreement in effect. See

11 2. Create a New Category of Subpart F Income for Transactions Involving Digital Goods or Services Under current law, Subpart F income includes several categories of income which, when earned by a CFC, are currently included in the income of the CFC s 10 percent U.S. shareholders. These categories include, among others, foreign personal holding company income, foreign base company sales income, and foreign base company services income, all of which are intended to ensure that tax is not deferred on income that is not generated by an active trade or business of the CFC. The Green Book asserts that taxpayers are able to avoid the Subpart F rules by choosing different forms for substantially similar transactions involving digital goods and services (such as cloud computing), thereby eroding the U.S. tax base. 21 The Green Book proposal would create a new category of Subpart F income, foreign base company digital income, which generally would include income of a CFC from the lease or sale of a digital copyrighted article or from the provision of a digital service, in cases where the CFC uses intangible property developed by a related party (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. Income earned by a CFC directly from customers located in the CFC s country of incorporation that use or consume the digital copyrighted article or digital service in such country will be excluded from this rule. 22 The proposal would be effective for taxable years beginning after December 31, Prevent Avoidance of Foreign Base Company Sales Income through Manufacturing Services Arrangements Under current law, a 10 percent U.S. shareholder of a CFC is required to include its share of foreign base company sales income generated by the CFC, which generally includes income earned with respect to a purchase and subsequent sale of personal property where such property is purchased from (or on behalf of), or sold to (or on behalf of), a related person, provided the property is manufactured outside the CFC s country of organization and sold for use or consumption outside that country. The Green Book states that taxpayers have taken the position that foreign base company sales income does not include the provision of manufacturing services to the CFC by a related party (as opposed to the purchase of property by the CFC from a related party). 23 The proposal would expand the category of foreign base company sales income to include income of a CFC from the sale of property manufactured on behalf of the CFC by a related person. It is not clear how See Green Book, page 58. See Green Book, page 59. See Green Book, page

12 this proposal would interact with the current exception from foreign base company sales income for property manufactured or produced by a contract manufacturer but where the CFC substantially contributes to the manufacturing. 24 December 31, The proposal would be effective for taxable years beginning after 4. Restrict the Use of Hybrid and Reverse Hybrid Arrangements that Create Stateless Income Under current law, interest and royalty payments made or incurred in carrying on a trade or business are generally deductible without regard to the tax treatment of such payments in other jurisdictions (subject to certain exceptions and limitations). According to the Green Book, this has resulted in the development of tax avoidance techniques involving a variety of cross-border hybrid arrangements, 25 such as hybrid entities, hybrid instruments, and hybrid transfers. The Green Book asserts that these arrangements enable taxpayers to claim deductions in the United States without a corresponding inclusion of income in the payee s tax jurisdiction (i.e., the income is not subject to tax in any jurisdiction, and hence the name stateless income ), or to claim multiple deductions for the same payment in several jurisdictions. 26 The Green Book also asserts that taxpayers make use of reverse hybrid entities (i.e., an entity treated as a corporation for U.S. federal tax purposes and as transparent in the jurisdiction in which the entity is organized) to take advantage of exceptions to the Subpart F rules in order to create stateless income which is not subject to tax in any jurisdiction. Specifically, the Green Book asserts that such reverse hybrid entities would generally not be subject to U.S. federal income tax on a current basis unless the Subpart F rules apply and would generally not be subject to tax in the foreign jurisdiction because the foreign jurisdiction takes the view that the entity is transparent and the income earned by the entity is thereby derived by its U.S. owners. Even if a reverse hybrid entity is treated as a CFC, interest and royalty income earned from certain related persons (which would otherwise qualify as Subpart F income) may not be subject to current U.S. tax due to certain exceptions available under current law (e.g., exceptions that exempt payments between related parties from Subpart F treatment). The Green Book proposes to deny deductions for interest and royalty payments made to related parties under certain circumstances involving hybrid arrangements where there is no corresponding inclusion of income to the recipient or if the arrangement would permit the taxpayer to claim an additional deduction for the same payment in another jurisdiction. 27 In addition, the proposal would grant the Treasury See Treas. Reg (a)(4)(iv). The Green book apparently uses hybrid as an adjective to refer to arrangements that are treated differently for U.S. and foreign tax purposes. See Green Book, page 61. See Green Book, page

13 authority to issue any regulations necessary to carry out the purposes of this proposal, including regulations that would: (i) deny interest or royalty deductions arising from certain hybrid arrangements involving unrelated parties in appropriate circumstances, such as structured transactions; (ii) deny deductions from certain conduit arrangements that involve a hybrid arrangement between at least two of the parties to the arrangement; and (iii) deny a deduction claimed with respect to an interest or royalty payment that, as a result of the hybrid arrangement, is subject to a reduced tax rate (which is at least 25 percent lower than the statutory rate) in the recipient s jurisdiction. Second, the Green Book also proposes that the related party exceptions will not apply to payments made to a foreign reverse hybrid held directly by a U.S. owner when such amounts are treated as deductible payments received from foreign related persons. 28 These proposals would be effective for taxable years beginning after December 31, Limitations on Inversion Transactions Under current law, certain inversion transactions (whereby a domestic corporation is replaced by a foreign corporation as the parent company of a multinational affiliated group of companies) result in adverse tax consequences. 29 These consequences depend on the level of shareholders ownership. If the ownership of shareholders of the domestic corporation in the new foreign parent corporation is 80 percent or more (by vote or value), the new foreign parent corporation is treated as a domestic corporation for all U.S. federal tax purposes (the 80-percent test ). If, however, the continuing shareholder ownership is less than 80 percent but at least 60 percent, the foreign status of the foreign parent is respected but certain other adverse tax consequences apply (the 60-percent test ). According to the Green Book, domestic companies have been engaging in inversion transactions that trigger the 60- percent test and still manage to reduce substantially the U.S. federal tax liability of the multinational group with only a minimal change in operations. 30 The Green Book proposal would broaden the definition of an inversion transaction by reducing the 80- percent test to a greater than 50-percent test, and eliminating the 60-percent test. In other words, if the ownership of shareholders of the domestic corporation in the new foreign parent corporation is more than 50 percent (by vote or value), the foreign parent would be treated as a U.S. corporation. The proposal would also add a special rule whereby, regardless of the level of shareholder continuity, an inversion transaction would occur if the affiliated group that includes the foreign corporation has substantial business activities in the United States and the foreign corporation is primarily managed and controlled in See Green Book, page 63. See Section 7874 of the Code. See Green Book, page

14 the United States. The proposal also provides that an inversion transaction can occur if there is an acquisition either of substantially all of the assets of a U.S. partnership (regardless of whether such assets constitute a trade or business) or of substantially all of the assets of a trade or business of a domestic partnership. December 31, The proposal would be effective for transactions that are completed after 6. Exempt Foreign Pension Funds from the Application of the Foreign Investment in Real Property Tax Act ( FIRPTA ) FIRPTA generally requires nonresident alien individuals or foreign corporations to pay U.S. federal income tax on gain from the sale of a direct, or indirect, interest in U.S. real property. 31 FIRPTA is intended to subject foreign investors to the same U.S. federal income tax treatment that applies to U.S. investors on gains from the disposition of U.S. real property interests. This rule, however, may result in unequal treatment of U.S. and non-u.s. pension funds: U.S. pension funds are generally exempt from U.S. federal income tax, including any U.S. federal income tax on the gain from a disposition of a U.S. real property interest, while foreign pension funds would be required under FIRPTA to pay U.S. federal income tax on any gain from a disposition of a U.S. real property interest. The Green Book proposal would eliminate this disparity and exempt foreign pension funds from the application of FIRPTA gains. To qualify for this exemption, a foreign pension fund would have to be (i) a foreign organization or arrangement, (ii) generally exempt from income tax in the jurisdiction in which it is created or organized, and (iii) substantially all of its activity would have to consist of administering or providing pension or retirement benefits. The proposal does not, however, address the taxation of rent or similar income. The proposal would be effective for dispositions of U.S. real property interests occurring after December 31, Defer Deduction of Interest Expense Related to Deferred Foreign Income Under current law, a U.S. person s total interest expense is generally allocated and apportioned between the person s U.S. assets and foreign assets, and the interest allocated to the foreign assets is treated as a foreign source expense. That foreign source interest expense may be currently deducted even if the foreign assets to which it was allocated did not currently generate any foreign income subject to U.S. tax. 32 The Green Book proposal would defer the deduction of interest expense that is allocated and apportioned to stock of a foreign corporation that exceeds an amount proportionate to the taxpayer s pro rata share of See Section 897 of the Code. See generally Treas. Regs through

15 income from such subsidiaries that is currently subject to U.S. tax. For this purpose, foreign-source income earned by a taxpayer through a branch would be considered currently subject to U.S. tax. The Green Book provides that while current Treasury regulations would generally continue to govern the sourcing of interest expense, it is anticipated that the Treasury Department will continue to revise existing Treasury regulations and propose such other statutory changes as necessary to prevent inappropriate decreases in the amount of interest expense that is allocated and apportioned to foreignsource income. 33 Deferred interest expense would be deductible in a subsequent taxable year to the extent that the amount of interest expense allocated and apportioned to stock of foreign subsidiaries in such subsequent year is less than the annual limitation for that year, subject to Treasury regulations that may modify the manner in which such deferred interest expenses may be deducted. 34 The proposal would be effective for taxable years beginning after December 31, Foreign Tax Credit Pooling Under current law, a domestic corporation that owns 10 percent or more of the voting stock of a foreign corporation from which the domestic corporation receives a dividend may claim a deemed paid foreign tax credit for a portion of the income taxes paid to foreign jurisdictions by such foreign corporation. 35 The Green Book proposal would require a domestic corporation to determine its deemed paid foreign tax credit by looking at the aggregate earnings and profits of all of the domestic corporation s foreign subsidiaries. The domestic corporation s deemed paid foreign tax credit would then be limited to an amount proportionate to the taxpayer s pro rata share of the aggregate earnings and profits repatriated to the United States in that year that are currently subject to U.S. tax. Under this proposal, foreign taxes deferred in prior years would be creditable in a subsequent taxable year to the extent that the current year deemed paid foreign taxes do not exceed the limitation for that year. The proposal would be effective for taxable years beginning after December 31, Proposals Relating to the Transfer of Intangible Property Current law provides that if intangible property is transferred or licensed to a related person, the income recognized by the transferor must be commensurate with the income derived by the transferee from the intangible; 36 similarly, if intangible property is transferred by a U.S. person to a foreign corporation in a See Green Book, page 42. The Green Book does not elaborate on how the amount of foreign income deferred would be determined for this purpose or how the portion of total foreign source interest expense allocable to that deferred income, as opposed to currently taxed foreign source income, would be determined. See generally Section 902 of the Code. This foreign tax credit is subject to certain limitations. See generally Section 904 of the Code. See Section 482 of the Code; Treas. Reg

16 transaction that would otherwise be tax-free under Section 351 or 361 of the Code, the transfer is recharacterized as a sale of such property in exchange for a series of contingent payments commensurate with the income derived by the transferee from the intangible. 37 In addition, Section 482 of the Code authorizes the IRS Commissioner to distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses. According to the Green Book, the potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules. 38 This, together with frequent controversies about the scope of intangible property subject to the two commensurate with income rules, has led to inappropriate avoidance of U.S. tax 39 and significant erosion of the U.S. tax base. 40 The Green Book contains two proposals relating to transfers of intangible property by U.S. persons to foreign persons. a. Excess Returns Associated with Transfers of Intangibles Offshore The first Green Book proposal would apply whenever a U.S. person transfers an intangible from the United States to a related CFC. The proposal would expand the reach of the Subpart F anti-deferral regime by treating as Subpart F income any excess intangible income attributable to the intangible if such income is subject to a low foreign effective tax rate. 41 Where the effective tax rate is 10 percent or less, all excess income would be treated as Subpart F income. This treatment would phase out ratably for effective tax rates of 10 to 15 percent. Excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from the intangible, over the costs (excluding interest and taxes) allocable to the income and increased by a percentage markup (emphasis added). 42 A transfer to a CFC for this purpose includes transfers by license, lease, sale, or any shared risk or development agreement (including any cost sharing arrangement). This Subpart F income would be a separate category of income for foreign tax credit limitation purposes See Section 367(d) of the Code (applying to intangible property as defined in Section 936(h)(3)(B) of the Code). See Green Book, page 45. See Green Book, page 47. See Green Book, page 45. The Green Book does not elaborate on how the foreign effective tax rate would be determined, including whether it would be determined using net income as determined under the foreign tax rules or under the U.S. tax rules. See Green Book, page

17 The proposal would apply to any transaction by the CFC connected with or benefitting from the intangible occurring in taxable years beginning on or after January 1, 2015, even if the intangible transfer took place prior to b. Limiting the Shifting of Income through Intangible Property Transfers The second Green Book proposal would clarify that the definition of intangible property for purposes of Sections 367 and 482 of the Code includes workforce in place, goodwill, and going concern value, and any other item owned or controlled by a taxpayer that is not a tangible or financial asset and that has substantial value independent of the services of any individual. Consequently, transfers of such items would be subject to the two commensurate with income rules referred to above. The proposal would also clarify that (i) when multiple intangibles are transferred, or where intangible property is transferred with other property or services, the IRS Commissioner may value such properties or services on an aggregate basis if that achieves a more reliable result, and (ii) the IRS may value intangible property taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken. 43 The proposal would be effective for taxable years beginning after December 31, Modify the Foreign Tax Credit Rules for Dual Capacity Taxpayers Under current law, special foreign tax credit rules apply to taxpayers who pay a levy to a foreign jurisdiction and receive a specific economic benefit, such as the right to extract petroleum or other minerals in exchange for payment of the levy (such a taxpayer, a dual capacity taxpayer ). When a foreign levy applies differently to dual capacity taxpayers as opposed to other taxpayers (other than as the result of a lower rate being applied to dual capacity taxpayers), such levy is treated as a creditable foreign income tax only to the extent established by the taxpayer to be a tax (i.e., not an amount paid in exchange for the specific economic benefit). A dual capacity taxpayer may meet this burden of establishing what portion of the levy is a tax under either: (i) the facts and circumstances test (i.e., the taxpayer must show based on the facts and circumstances that the amount was not paid as compensation for the specific economic benefit; or (ii) the safe harbor test (a formula that derives the amount of the levy that may qualify as a tax). 44 The Green Book asserts that the current law fails to achieve the appropriate split that should exist between a payment of creditable taxes and a payment in exchange for a specific economic benefit in certain cases See Green Book, page 47. See Treas. Reg A. See Green Book, page

18 The Green Book proposal would replace the current regulatory provisions and instead permit a dual capacity taxpayer to treat as a creditable tax the portion of the foreign levy that does not exceed the foreign tax that would be due if the taxpayer were not a dual capacity taxpayer. This aspect of the proposal would defer to U.S. treaty obligations to the extent that they explicitly allow a credit for taxes paid or accrued on certain oil or gas income and would be effective for amounts that, if such amounts were an amount of tax paid or accrued, would be considered paid or accrued in taxable years beginning after December 31, For taxable years beginning after December 31, 2014, this Green Book proposal would also convert foreign oil and gas income credit limitation rules into a separate foreign tax credit limitation basket. 11. Tax Gain from the Sale of a Partnership Interest on a Look-Through Basis In general, capital gain of a nonresident alien individual or foreign corporation from the sale or exchange of property, including a partnership interest, is subject to U.S. federal income tax only if such gain is treated as income that is effectively connected with the conduct of a U.S. trade or business ( ECI ). In Revenue Ruling 91-32, the IRS held that a foreign partner s gain or loss from the sale or exchange of a partnership interest should be treated as ECI to the extent of such foreign partner s share of unrealized partnership gain or loss attributable to property used or held for use in the partnership s U.S. trade or business. The holding in IRS Revenue Ruling has not been codified. According to the Green Book, notwithstanding IRS Revenue Ruling 91-32, foreign taxpayers might take the position that gain from the sale of a partnership interest is not subject to U.S. federal income tax because there is no Code provision explicitly providing that gain from the sale or exchange of a partnership interest by a nonresident alien individual or foreign corporation is treated as ECI. 46 If this position is taken and the partnership has in effect an election under Section 754 of the Code to adjust the basis of its assets upon the transfer of an interest in the partnership, then such gain may escape U.S. federal income tax altogether. The Green Book proposal would codify Revenue Ruling The Secretary would be granted authority to specify the extent to which a distribution from a partnership is treated as a sale or exchange of an interest in the partnership and to coordinate the new provision with the nonrecognition provisions of the Code. Additionally, the proposal would require the transferee of a partnership interest to withhold 10 percent of the amount realized on a sale or exchange of the partnership interest unless the transferor certified that the transferor was not a nonresident alien individual or foreign corporation (if the transferor provided an IRS certificate establishing that its U.S. federal income tax liability with respect to the transfer was less than 10 percent of the amount realized, the transferee would withhold the lesser amount). The partnership would be liable for any underwithholding by the transferee with respect to the transfer and 46 See Green Book, page