Annette Ahlers, Todd Reinstein and Homeira Ghorbani

Transcription

1 Tax Update DECEMBER 2004 Our Corporate Tax Group Has Joined Pepper Hamilton W e are pleased and excited to inform you of our recent move to the Washington, D.C. office of Pepper Hamilton LLP. Pepper s Tax Practice Group assists clients with proactive tax planning, including mergers and acquisitions, dispositions, public offerings, reorganizations, restructurings, liquidations and structured finance transactions. The group handles all areas of tax planning and structuring, including international tax, taxation of securities, state and local tax, and tax litigation. Pepper attorneys are integrally involved in the structure and formation of partnerships, and have significant experience in tax issues common to private equity funds, hedge funds, mezzanine funds, and their investments. A list of Pepper s tax attorneys appears on the last page of this issue. The tax practice encompasses significant international matters, such as inbound and outbound acquisitions Also In This Issue 3 New Law Provides Tax Breaks for Domestic Production Activities 5 Pepper Hamilton LLP Tax Practice Group one of two tax years to be chosen by the U.S. shareholder, to repatriate selected extraordinary cash dividends from the controlled foreign corporation. If the election is made, a taxpayer will be taxed on the basis of an 85 percent dividends received deducand dispositions, foreign tax credit planning and cross-border finance work. In addition to its corporate clients, Pepper represents and advises private foundations and public charities, partnerships, real estate developers, secured and unsecured creditors committees and corporations in bankruptcy. We are extremely excited about the opportunity to offer you more tax resources at our new firm, as well as to continue assisting you with your ongoing corporate tax matters. Happy New Year! Annette Ahlers, Todd Reinstein and Homeira Ghorbani Executive Overview In this issue, we discuss our exciting move to the tax group of Pepper Hamilton. In addition, we discuss the potential financial statement impact and auditor inquiries that may result from the dividend repatriation provisions of the American Jobs Creation Act of Even if you have not yet decided whether or not to repatriate foreign earnings, your auditor my require very specific disclosures and documentation as a result of the potential for repatriating foreign earnings. What Your Auditor May Want to Know About APB 23 Representations and Section 965 Repatriation A much-discussed area of the American Jobs Creation Act of 2004 is the new temporary dividends received deduction in new Section 965. New Section 965 permits a corporation that is a U.S. shareholder of a controlled foreign corporation a one-time election, for APB 23 continued on page 2

2 APB 23, continued from page 1 tion, subject to certain limitations and requirements. The IRS is working on guidance regarding the deduction, including the definition of cash dividend. Because of the uncertainty surrounding qualification for the election, many U.S. corporations have put off the analysis required to take advantage of it until the Treasury issues further guidance. In the meantime, reporting company auditors are beginning to question their U.S. shareholder clients about their plans to repatriate the funds. As a result, the U.S. shareholder may need to record the tax liability associated with the repatriation in the company s financial statements under APB Opinion Number 23, Accounting for Income Taxes (APB 23). 1 APB 23 is a default position that assumes a U.S. shareholder s foreign earnings are repatriated to the United States. This is a subjective test, and if it becomes apparent that some or all of the undistributed earnings will be remitted to the United States in the foreseeable future, a reporting company may need to record an income tax liability equal to the expected taxes that will be incurred upon the repatriation. Paragraph 31 of APB 23 does, however, provide an indefinite reinvestment exception. To qualify for it, the U.S. shareholder needs to provide evidence of specific plans for reinvestment of the undistributed earnings. APB 23, Paragraph 8 establishes six critical factors to evaluate whether the foreign earnings qualify for the indefinite reinvestment plan: Because the indefinite reinvestment exception is subjective, some external auditors have begun to question the validity of past representations because the enactment of new Section 965 has changed the facts and circumstances of companies that previously qualified for the indefinite deferral. 1) financial requirements of the U.S. shareholder 2) financial requirements of the controlled foreign corporation 3) operational and fiscal objectives of the parent company, long-term and short-term 4) remittance restrictions imposed by governments; 5) remittance restrictions imposed by lease or financing agreements of the subsidiary 6) tax consequences of the remittance. Lack of the information necessary to calculate the tax liability is not a viable reason for excluding the deferred tax liability from the balance sheet, although the tax consequences of including the dividend is a factor for qualifying for the exception. To qualify, reporting companies need to document their position with specific examples that satisfy the factors outlined in APB 23. This documentation may include items such as past experience, planned foreign mergers and acquisitions, and overall needs for the undistributed earnings to stay offshore. Satisfactory documentation must reflect a viable plan and rebut the presumption on repatriation. Because the indefinite reinvestment exception is subjective, some external auditors have begun to question the validity of past representations because the enactment of new Section 965 has changed the facts and circumstances of companies that previously qualified for the indefinite deferral. In light of these circumstances, a company may be required to accrue the projected residual tax consequences of a planned Section 965 repatriation when it becomes apparent that profits will be repatriated under Section 965. The Financial Accounting Standards Board (FASB) issued proposed guidance November 15 addressing this issue in FSP FAS 109-b, which is effective immediately. FASB concluded that a company should be allowed time beyond the financial reporting period of enactment to evaluate the effect of this new provision on its plan for reinvestment or repatriation of foreign earnings for purposes of applying Statement 109, due to the need for legislative clarification on some of the provisions in Section 965. The position paper also provides guidance about disclosures for companies that may have started APB 23 continued on page 3 2

3 APB 23, continued from page 2 the evaluation process of whether to repatriate the dividends under the new provision. The Pepper Perspective In light of the proposed FASB statement, reporting companies that intend to keep the funds offshore indefinitely need to properly document their reasoning and support for this position so that it can be provided to their external auditors for review. Reporting companies that have begun evaluating the provision, but have not made a final decision, should prepare a schedule of the status of its repatriation plans and show a range of reasonably possible remittances and income tax effects under the disclosure rules. Reporting companies that have evaluated whether or not to repatriate funds need to disclose the tax liability impact in their financial statements. If the evaluation is completed after year end and before the release of the financial statements, the reporting company also may be required by their external auditor to issue pro forma financial statements taking into account the repatriation. Endnotes 1 FASB Statement No. 109, Accounting for Income Taxes, left intact the provisions of APB 23 that relate to the accounting treatment for unremitted earnings of a foreign investment. Author: New Law Provides Tax Breaks for Domestic Production Activities T he American Jobs Creation Act of 2004 creates a new tax deduction for businesses engaged in domestic production activities. The new deduction replaces the extraterritorial income (ETI) exclusion for U.S. exports. Unlike the ETI exclusion, the new deduction is not limited to exports and is not limited to traditional manufacturing. The new deduction is effective for tax years beginning after December 31, 2004 and will be phased in over the next six years. When fully phased in, the deduction will translate to an effective 3 percent reduction in tax rates for income from domestic production activities. The deduction applies to corporations, partnerships, LLCs and sole proprietorships. What are Domestic Production Activities Eligible for the Deduction? Domestic production activities are significantly broader than traditional manufacturing activities, and include manufacturing, production, growth or extraction (but not the distribution) of: tangible personal property computer software certain sound recordings certain films electricity, natural gas or potable water. Application to U.S. Construction Industry U.S. for U.S. construction projects. Eligible construction includes erection or substantial renovation of residential and commercial buildings. However, cosmetic changes, such as painting, are not eligible. Calculating the Deduction In general, the amount of the deduction is equal to a percentage (see table below) of qualified production activities income. Tax Year Applicable Percentage 2005, percent 2007, 2008, percent percent W-2 Wage Limit The amount of the deduction may not exceed 50 percent of the taxpayer s W-2 wages for the taxable year. Businesses with relatively few employees, or that rely significantly on contractors, may not be able to fully benefit from the new deduction. Affiliated groups will benefit from a rule that treats all corporations in the group as a single taxpayer. For this purposes, the definition of affiliated group is expanded to include 50- percent-owned corporations (but excludes foreign corporations). Todd B. Reinstein reinsteint@pepperlaw.com The deduction also applies to U.S. construction, and engineering or architectural services performed in the Tax Breaks continued on page 4 3

4 Tax Breaks, continued from page 3 Planning Around the W-2 Limitation The limitation of the deduction to 50 percent of W-2 wages may affect a taxpayer s choice of entity and how it compensates its employees. For example, a sole proprietorship may benefit by incorporating as an S corporation so that the sole proprietor can be paid W-2 wages. LLCs and partnerships that pay salaries to members/partners are in a similar situation, because those salaries are considered guaranteed payments and not W-2 wages. Converting to a corporation may result in a larger domestic production activities deduction. However, this benefit needs to be weighed against the disadvantages (including double taxation) of the corporate form. Distinguishing Production Activities From Sales and Services The deduction will not be available for purely sales activities or for purely service activities. The line between what constitutes domestic production activities versus sales or services may not always be obvious. For example, a taxpayer who buys coffee beans and roasts those beans at its facility for sale through unrelated parties is eligible for the deduction, but if the taxpayer also brews coffee at its facility for sale to customers, the brewing activity would not be eligible. A panoply of other activities exist where the distinction between domestic production activities and sales or services will be unclear - the taxpayer will have to carefully The new deduction is effective for tax years beginning after December 31, 2004 and will be phased in over the next six years. analyze whether its activity is eligible for the deduction. Allocation of Expenses to Production Income Qualified production activities income is defined as domestic production gross receipts less allocable cost of goods sold, directly allocable deductions and expenses, and a ratable portion of other deductions and expenses that are not directly allocable. Taxpayers planning to maximize their deduction for qualified production activities income will need to carefully consider the allocation of expenses, especially indirect expenses such as overhead. For activities that combine qualified production activities with nonqualified activities such as services or sales, the taxpayer will have to allocate income and expenses between the two sources. Until regulations are issued, taxpayers may look for guidance to existing rules for determining the costs of goods sold and those that apply for determining source of income and expenses (i.e., U.S. or foreign). Additionally, many more taxpayers will be subject to rules similar to the transfer pricing rules of Section 482 to address allocation of income and expenses. International Planning The new deduction creates incentives for businesses to engage in production activities that employ workers in the U.S. Corporations that operate both in the U.S. and abroad will need to consider the new tax break when planning for the location of new production activities. Existing intercompany agreements and transfer pricing policies may also need to be reevaluated in light of the new tax break. Authors: Joan C. Arnold arnoldj@pepperlaw.com Michiel Muizelaar muizelaarm@pepperlaw.com Joan M. Roll rollj@pepperlaw.com 4

5 Pepper Hamilton LLP Tax Practice Group Partners and Of Counsel JOAN C. ARNOLD is a partner in the Philadelphia office and head of the firm s Tax Group. She focuses her practice on U.S. corporate tax and international tax issues, and she is a fellow of the American College of Tax Counsel. Phone: arnoldj@pepperlaw.com ANNETTE M. AHLERS is a partner in the Washington office. She concentrates her practice in corporate tax matters for large corporations. She counsels clients on structuring transactions, availability of net operating losses, and reporting obligations under the shelter rules. Phone: ahlersa@pepperlaw.com JAMES W. BARSON is a partner in the Pittsburgh office. Mr. Barson assists corporate and individual clients with federal, state, local and foreign tax matters and other corporate matters. Phone: barsonj@pepperlaw.com PHILIP E. COOK, JR. is of counsel in the Pittsburgh office, concentrating on state and local tax matters. Mr. Cook is the co-author of the Guidebook to Pennsylvania Taxes, as well as a contributor to Pennsylvania State Service, published by Matthew Bender. Phone: cookp@pepperlaw.com GORDON R. DOWNING is a partner in the Philadelphia and Berwyn offices. For almost 15 years before coming to Pepper, Mr. Downing was the chief tax counsel at Bell Atlantic Corporation and brings to the firm a unique client-as-customer perspective. Phone: downingg@pepperlaw.com W. RODERICK GAGNÉ is a partner in the Philadelphia office. He concentrates his practice primarily on sophisticated tax planning for corporations, individuals and partnerships. In particular, Mr. Gagné has experience in asset-backed securitizations and the tax issues therein, taxation of pass-through entities, corporate mergers and acquisitions, state and local tax issues (sales and use tax, corporate income tax, capital stock tax, real estate tax and Philadelphia taxes), and succession planning for closely held businesses. Phone: gagner@pepperlaw.com LISA B. PETKUN is a partner in the Philadelphia office. Ms. Petkun concentrates her practice on sophisticated tax planning for individuals, partnerships and corporations. Her areas of concentration include choice of business entity, structuring bankruptcy workouts and reorganizations, taxation of lawsuit payments and recoveries, tax issues associated with nonprofit organizations, and estate, gift and personal planning. Phone: petkunl@pepperlaw.com CHARLES L. POTTER, JR. is a partner in the Pittsburgh office. Mr. Potter s practice includes federal taxation and state and local taxation; he has concentrated in state and local taxation for many years. He is a coauthor of the Guidebook to Pennsylvania Taxes, published annually by CCH Incorporated. Phone: potterc@pepperlaw.com JOAN M. ROLL is of counsel in the Philadelphia office. Ms. Roll advises corporations, partnerships, S corporations and individuals on complex business transactions such as mergers, acquisitions and joint ventures, including cross-border transactions. She provides tax advice in structuring investment vehicles such as oil and gas partnerships, hedge funds, real estate investment trusts and regulated investment companies. Phone: rollj@pepperlaw.com ANDREW J. RUDOLPH is a partner in the Philadelphia office and chairman of the firm s Employee Benefits Practice Group. He advises public and privately held businesses on employee benefits, executive compensation and related tax and corporate law issues. Phone: rudolpha@pepperlaw.com Associates DAVID H. ADAMS is an associate in the Pittsburgh office and practices in the area of tax, concentrating primarily on the resolution of federal and state tax issues for corporations and other types of businesses. Phone: o: adamsd@pepperlaw.com 5

6 PAUL A. GORDON is an associate in the Philadelphia office. Mr. Gordon concentrates his practice in federal income taxation of business entities. Phone: MICHIEL MUIZELAAR is an associate in the Philadelphia office. Before earning his law degree, Mr. Muizelaar worked for five years as a certified public accountant and tax manager at the largest local accounting firm in Richmond, Va. Phone: muizelaarm@pepperlaw.com TODD B. REINSTEIN is an associate in the Washington office. Mr. Reinstein focuses his practice in the overall corporate structuring (domestic and international) of taxable and tax-free transactions, shareholder redemptions, entity selection, deemed asset Subscribe to Future Issues purchases, tax due diligence, corporate loss limitation studies, and the overall tax aspects of bankruptcy and workouts. He has represented taxpayers regarding federal and international tax controversies. Phone: reinsteint@pepperlaw.com Enrolled Agents LINDA M. HARNER is a senior tax accountant in the Philadelphia office. For more than 25 years, she has been the main tax accountant responsible for organizing the preparation of all individual, partnership, corporate and taxexempt returns prepared by the firm. She also has been involved in assisting nonprofit corporations and charitable trusts in obtaining taxexempt status with the Internal Revenue Service. Ms. Harner has been an Please return this form by , facsimile or by mail to be added to our mailing list or to update your information. Send to Pepper Hamilton LLP, Hamilton Square, 600 Fourteenth Street, N.W., Washington, D.C , Attn: Homeira Ghorbani. (Fax or ghorbanih@pepperlaw.com) enrolled agent to practice before the IRS since Phone: harnerl@pepperlaw.com JEANNE STAGLOFF is a senior tax accountant with over 30 years of experience at accounting firms, law firms and corporations. She is experienced in income tax and estate tax returns, and in managing audits and settlements with the IRS. She is an enrolled agent to practice before the IRS. Phone: stagloffj@pepperlaw.com For more information about any of our tax professionals listed, please visit our Web site,. PROMOTIONAL MATERIAL To learn how Pepper Hamilton s Tax Group can assist you please contact Homeira Ghorbani, Director of Business Development - Corporate Tax, at or send an to ghorbanih@pepperlaw.com. Name Title Company Address Phone Fax The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. A Pennsylvania Limited Liability Partnership 2004 Pepper Hamilton LLP ALL RIGHTS RESERVED. 6