Foreign Tax Credit Update

Transcription

1 GW-IRS 29 TH ANNUAL INSTITUTE ON CURRENT ISSUES IN INTERNATIONAL TAXATION Foreign Tax Credit Update December 16, 2016 Brenda Zent Office of International Tax Counsel U.S. Department of Treasury Jeffrey Parry Senior Counsel, Branch 3, ACCI Internal Revenue Service F. Scott Farmer Morgan, Lewis & Bockius LLP Jason Yen Office of International Tax Counsel U.S. Department of Treasury Patrick Brown Vice President, Tax, GE Power General Electric Company Michael Caballero Covington & Burling LLP Agenda Tax Reform and FTC Issues Section 901(m) Regulations Section 704 CFTE Regulations 2

2 Tax Reform and FTC Issues Tax Reform The Big (Trillion Dollar) Questions Will it happen? When? Why does it matter today? Revenue impact? Rate reduction v. infrastructure? Scope? Comprehensive Business Income Corporate Reform International Repatriation Individual Pass-Throughs Corporate International Repatriation 4

3 Tax Reform Structural (Multi-Billion Dollar) Questions? Corporate Tax System Divergent Options Destination Based Tax System Brady/Ryan Blueprint Current System with Territorial Taxation Camp Proposal Corporate Integration Senate Proposal (?) Tax Rate? 20%? 25%? 15%? Expensing of new investment? but no deduction for net interest expense Structure of Subpart F Limited to passive income? Destination-based system? Dramatically limits planning opportunities Other approaches: Focus on intangibles? Minimum tax? Treatment of financial services companies? Blueprint is silent Who will be the winners and losers in reform? What are the dynamic impacts (foreign exchange rates, location of business activity)? 5 Tax Reform Transition Issues Repatriation Mandatory inclusion almost certain if reform moves forward What rate (or rates) apply? Higher rate for cash? How defined? Treatment of FTCs on repatriated earnings Section 965 approach Ratable disallowance (85% DRD) Section 904(b) Adjustment of the limitation for capital gains rates Does it matter how structured? DRD v. reduced rate? Other possibilities: flat (or two-tiered) inclusion rate, no FTCs? What about deficits? Netted against earnings? Globally or within same chain? Different treatment of hovering deficits? Determination of earnings and related taxes JVs, complex capital structures Other issues: FTC carryforwards, OFLs, ODLs, AMT 6

4 Section 901(m) Regulations 7 Section 901(m) Background Enacted on August 10, 2010 as part of the Education Jobs and Medicaid Assistance Act of 2010 (EJMAA) Denies a credit for foreign taxes attributable to the basis step-up for U.S. tax purposes in certain transactions Effectively disallows a credit for the foreign income tax on the seller s built-in gain Disqualified taxes not taken into account for purposes of section 901, 902, or 960 Taxpayers are permitted a deduction for the disallowed taxes and no section 78 gross-up Treatment for other related provisions? o Subpart F high-tax exception o Section 904 high-tax kick-out Prior guidance Notice Addresses timing of when section 901(m) disallows foreign taxes in the case of dispositions Prevents avoidance of section 901(m) through successive CAAs Notice addresses retroactive check-the-box elections 8

5 Section 901(m) Base Case BUYER FT Asset U.S. Stock purchase with section 338 election Foreign FMV = $100 AB = $100 SELLER FT Foreign Foreign Asset FMV = $100 AB = $50 Buyer acquires stock of FT from unrelated foreign Seller for $100 Section 338 election made for FT FT has one asset with 10-year depreciable life (for U.S. tax purposes) Basis difference = 50 ( A/B) FT sells the asset for 150 US gain = 50 ( A/B) Foreign gain = 100 ( A/B) 50 of gain never taxed in U.S. system Foreign tax credit results Foreign tax (and thus credit) is 30 (30% foreign tax rate) U.S. tax on gain is Policy of the Foreign Tax Credit Policy of the foreign tax credit Eliminate double taxation What about U.S. tax exempt income? Service litigated this in the past Clearly the right answer in the case of broad exemptions of income such as a shift to a territorial tax system But in more isolated cases, what is the right policy, and is this a move towards an item-by-item approach to the FTC limitation? Why didn t Congress simply require foreign taxes from these transactions separately basketed? or another alternative? Would have allowed higher effective rate on income from assets but much easier to administer Reverse the trend of reducing the number of baskets 10

6 Policy of Section 901(m) Concern is U.S. tax exempt income Rules apply to the U.S. basis differences before and after the transaction Not about disparity between U.S. and foreign tax basis (though correlated) o Foreign tax basis is not relevant under the statute (except for an election under the regulations) Not just about the resulting hyped foreign taxes Concern is also about assuming the foreign tax liability of another person the seller Should it matter whose liability is assumed? Unrelated foreign seller Unrelated U.S. seller Related person 11 Policy Issues on Scope of CAAs Case 1: Unrelated U.S. seller Sale of foreign DE from one U.S. taxpayer to another US1 may be subject to U.S. tax on the asset gain; US2 obtains a basis step-up Should section 901(m) apply if the basis step-up has been purchased with exposure of gain to U.S. tax? Concern about trafficking of attributes similar to section 382 But this approach encourages buyers to trigger foreign tax immediately, e.g., through as asset transfer, or value is lost in the sale U.S. seller often indifferent from tax standpoint because it can claim a credit U.S. buyer gets step up and no denial of credit U.S. fisc almost always worse off from credit claimed by Seller and no denial of FTC for buyer US1 FDE Case 1 US2 FDE 12

7 Policy Issues on Scope of CAAs Case 2: Related Seller Policy issue in the case of a 901(m) between related persons Policy would suggest that this should be treated as a section 909 splitter o Gain from sale in CFC 1 o Tax on gain incurred by CFC 2 Regulations under section 909 and preamble made clear that related CAAs would be under Section 901(m) Case 2A: Related U.S. Seller Compare if directly under U.S. members of the consolidated group Exemption from section 901(m) more compelling where tax and basis effects are in the same return And the policy concerns of section 909 should be satisfied as gain is income to the same U.S. taxpayer Gain or Income Case 2 Case 2A Gain or Income CFC 1 CFC 2 FDE US1 FDE USP USP FDE US2 FDE Foreign Tax Foreign Tax 13 Why does it matter? Not like section 909, or the PFIC rules (where possible to avoid) Section 338 elections are still advantageous May provide a better after-tax return than no election/step-up Provides administrative simplicity because section 338 election eliminates prior tax history o No need to compute taxes and earnings for prior years o But section 901(m) requires computation of historical U.S. basis (even if only to compare with foreign basis) Increased amortization reduces E&P o May reduce subpart F income o Mandatory repatriation Need to also analyze many factors Look-through on pre-acquisition earnings o No more separate 10/50 baskets o Tax rate and magnitude of earnings (or deficits) Existence of PTI, built-in losses, U.S. property Impact on seller if a U.S. taxpayer(subpart F passive income creating gain limitation, dilution of FTC (CCA )) 14

8 Costs/Benefits of Section 338 Election Is a Section 338 election still advisable? BUYER SELLER U.S. Stock purchase with section 338 election FT Foreign FMV = $100 AB = $100 FT Foreign Foreign FMV = $100 AB = $50 Buyer purchases stock of FT and makes section 338(g) election In post-acquisition Year 1 FT has $15 income Foreign taxes of $6 (40% rate) $5 additional amortization deduction for US tax purposes (10-year recovery period) Also need to consider factors on prior slide 338 Election (no 901(m)) 338 Election (with 901(m)) No 338 Election Year 1 E&P $4 ($15 $5 $6) $4 ($15 $5 $6) $9 ($15 $6) Year 1 Foreign Tax $6 $6 $6 Disallowed Portion N/A $2 $ $ N/A Pre 904 Creditable Foreign Tax $6 $4 $6 E&P $4 $4 $9 Foreign Tax Credit $6 $4 $6 Hypothetical 78 Gross up $6 $4 $6 Foreign ETR 60% After Tax Return Excess Foreign Tax Credit $ $ $11.50 $ % $ $ $10.20 $ % $ $ $9.75 $ New Proposed and Temporary Regulations Temporary Regulations Address the disposition guidance in Notice , including adding successor rules Exclude foreign withholding taxes Effective back to the issue date of Notice Proposed Regulations Expand categories of CAAs (from 3 to 6) Provide de minimis exceptions Permits an election to use foreign basis in computing basis differences Include foreign withholding taxes that are creditable under foreign law against potentially disqualified taxes Comprehensive guidance on operational issues Effective when finalized o Elective back to 2011 o But must apply all proposed regulations on a consistent basis, except expanded CAA list 16

9 Disposition Rules Original Concern and Notice Seller FDE Assets FMV = $100 US A/B = $0 For. A/B = $0 CFC 1 CFC 2 FDE Assets FMV = $100 US A/B = $100 For. A/B = $0 Basis Diff. $100 ($100-$0) US3 FDE Assets FMV = $100 US A/B = $100 For. A/B = $0 Basis Diff. $0 ($100-$100) FDE has assets with $100 FMV, and $0 Adjusted Basis for US and foreign tax purposes CFC 1 acquires FDE stock from Seller for $100 in a CAA U.S. basis step-up section 901(m) applies $100 basis difference CFC 2 acquires FDE stock from CFC 1 Disposition cleanses the original CAA (statute accelerates remaining basis difference) section 901(m) applies to new CAA $0 basis difference, so no effect Notice provides no acceleration of the basis difference which is carried over to CFC 2 17 Temp Regs and Complexity from Successive Transfers The abuse concern of Notice is a subset of broader issue Intersection of the two tax systems creates multiple possibilities Can be taxable, partially taxable, or tax-free in each jurisdiction So 9 possible combinations (or more if multiple countries involved) Temporary regulations adopt Notice four categories Taxable in both jurisdictions section 901(m) disposition rule Tax-free in both jurisdictions section 901(m) taint is transferred to acquiror Other cases look to the reduction in the basis difference o Positive basis difference reduced if US loss or foreign gain is recognized o Negative basis difference reduced if US gain or foreign loss is recognized Temporary Regulations also includes successor rules: Result the section 901(m) taint is an asset level attribute that carries with asset to transferee Including unrelated persons transfer to a p-ship that is 20% owned No de minimis or other exceptions apply Note, section 901(m) itself contains no carryover attribute provision 18

10 Scope of Covered Transactions Three categories of transactions identified in the statute Qualified Stock Purchase (QSP) with a section 338 election Purchase of a partnership interest with a section 754 election Hybrid acquisition asset acquisition for U.S. tax purposes, and stock acquisition (or disregarded) for foreign tax purposes o Section 336(e) Scope of transactions can be unexpectedly broad Can include a U.S. corporation acquiring another U.S. corporation with section 338(h)(10) election, e.g., if the target has a foreign branch Related party transfers of DEs (section 901(m) applies, not section 909) 19 Scope of Covered Transactions Regulatory Authority To apply section 901(m) to similar transactions To exempt (1) certain CAAs and (2) relevant foreign assets with respect to which the basis difference is de minimis Temporary Regulations adopt the three statutory CAA categories Track the statutory language exactly Proposed Regulations add three new categories ship CAA ship Distribution CAA Busted Transaction CAA Similar interpreted as providing a U.S. basis step-up Not intent based 20

11 ship CAA Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as: an acquisition of assets for U.S. income tax purposes the acquisition of an interest in a fiscally transparent entity for foreign income tax purposes FC 1 P-ship Country Z FC 2 USP P-ship Country Z DE FC 1 sells to USP FC 2 sells to DE P-Ship becomes a DE for U.S. purposes as a result of the sale Rev. Rul treats as an asset acquisition by USP o A sale of a partnership interest by FC 1 and 2 21 ship Distribution CAA Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as a partnership distribution of one or more assets either: the U.S. basis of the distributed assets is determined by section 732(b) or 732(d), or the U.S. basis of the partnership s remaining assets is adjusted under section 734(b) transaction results in an increase in the U.S. basis of one or more of the assets distributed or retained by the partnership Includes full or partial gain recognition there is no corresponding increase in the foreign basis of such assets Corresponding does this mean equivalent amount? 22

12 Busted Transaction CAA Any transaction (or series of transactions occurring pursuant to a plan) to the extent: Treated as an asset acquisition for both U.S. and foreign income tax purposes The transaction results in an increase in the U.S. basis in one or more assets There is no corresponding increase in the foreign basis of one or more assets Basically a (full or partially) taxable transaction for U.S. purposes and a (full or partially) nonrecognition transaction for foreign tax purposes Very broad potential trap for the unwary Flips the approach of section 909 o Section 909 general statue limited by regs to a list of identified transactions o Section 901(m) statutory list that regulations expand with a catchall provision De minimis exception 23 Busted Transaction CAA Examples Busted corporate transactions Busted section 351 transaction, reorganization, liquidation o Busted is a misnomer Other corporate transactions Section 301 distribution of appreciated assets by a reverse hybrid Section 351(g) stock Transactions with boot Section 367(a) taxable asset transfers o What happens if tax free due to gain recognition agreement but gain is later triggered? Other transactions Unagreed section 482 adjustment on sale of property Section 475 assets o Taxable asset transfers to non-section 475 taxpayer in otherwise nontaxable transaction o Different result if transfer on Dec. 30 or January 1 Section 704(c)(1)(B) distribution of contributed property to another partner within 7 years Section 737 distribution of other property to partner that contributed property within 7 years Section 707 disguised sales of assets assumption of disqualified liabilities on contribution of appreciated asset contribution followed by distribution of cash or marketable securities pursuant to a plan Section 721 taxable asset transfers under Notice Section 904(f) taxable asset transfers Examples listed only apply if the transaction under foreign law is treated as an asset acquisition resulted in a corresponding basis increase in one or more of the assets acquired Argument that section 301 or partnership distributions in Examples listed are not asset acquisitions even under U.S. law? 24

13 And then the Good News... De Minimis Exceptions Proposed regs exclude certain CAAs where there is a de minimis basis difference General rule section 901(m) does not apply if the basis difference for all RFAs is less than the greater of: $10 million, or 10% of the U.S. basis of all RFAs immediately before the CAA Example: Total U.S. basis before of $1 billion, then threshold is $100 million Related party transactions Threshold is cut in half Necessary to address internal transactions that are covered by section 901(m) and not section 909 Anti-abuse rule if the CAA was entered into between related parties with a principal purpose of avoiding application of 901(m) De minimis rule applied separately for RFA owner under U.S. law with respect to each foreign income tax 25 De Minimis Exceptions Asset Classes De minimis exception for classes of assets if the absolute value of the basis difference for all RFAs in a class is less than the greater of: $2 million, or 10% of the U.S. basis of all RFAs in a class immediately before the CAA Asset classes are the seven classes in Treas. Reg (b) Class I cash & deposits Class II publicly traded property Class III MTM assets Class IV inventory Class V residual category Class VI section 197 intangible other than goodwill and GCV Class VII goodwill and GCV Significantly reduces the administrative burden if step-up is primarily goodwill and GCV basically a single asset with single depreciable life Special rules for related CAAs Reduce thresholds to $1 million and 5% 26

14 De Minimis Exceptions Asset Classes Asset Class US Basis Pre Post Basis Diff. De Minimis Thresh. 901(m) Applies? Class I Cash NO Class II Publicly traded property YES Class III MTM assets NO Class IV Inventory YES Class Vl 3 yr Residual 5 yr yr NO 15 yr Total Class VI 197 intangible other than GW / GCV NO Class VII GW / GCV YES TOTALS De Minimis Exception Aggregation Rule De minimis exception only excludes a CAA that is part of an Aggregated CCA Transaction if: the CAA individually is below the de minimis threshold the Aggregated CAA Transaction is below the threshold Aggregated CAA Transaction is a series of related CAAs occurring as part of a plan (Prop. Reg (m)-1(a)(3)) Almost all transactions will be included in the aggregate rules For example, an acquisition of a target with a subsidiary where a section 338 election is made for both entities Also separate anti-abuse rule that excludes transfers of built-in loss assets in certain circumstances 28

15 De Minimis Exception Aggregation Rule Asset Basis Before 48 After 60 Basis Difference 12 USP CFC 1 CFC 2 Country X Country X Asset Basis Before 100 After 96 Basis Difference (4) Aggregated CAA Transaction Asset Basis Before 148 After 156 Basis Difference 8 USP acquires CFC 1 and CFC 2 in a single transaction, makes a section 338 election for both Both located in Country X Application of De Minimis to CFC 1 Satisfies Aggregate CAA test Fails individual CAA test (12 > greater of 10 or 6) Section 901(m) applies Application of De Minimis to CFC 2 Satisfies Aggregate CAA test Satisfies Individual CAA test Section 901(m) does not apply Not necessarily a good answer Can you merge both CFCs before the sale? * All amounts in millions of USD 29 Relevant Foreign Assets What is a relevant foreign asset? General concept is an asset that has been acquired in a CAA An asset is relevant only if income, deduction, gain or loss attributable to the asset is taken into account in determining the foreign income tax May have either built-in gain or built-in loss Most significant asset by value often is goodwill and other section 197 intangibles Anti-abuse rule also includes assets that was not relevant at the time of the CAA if later become relevant o Per se rule if asset becomes relevant within one year period 30

16 Election to Use Foreign Tax Basis More Good News Basis difference is computed using U.S. basis U.S. tax basis immediately after the CAA, over U.S. tax basis immediately before the CAA Built-in losses can be used as an offset (i.e., a negative basis difference) U.S. basis comparison administratively difficult to implement Foreign targets are unlikely to have computed historical U.S. tax basis 31 Election to Use Foreign Tax Basis More Good News Foreign Basis Election U.S. basis immediately after CAA minus Foreign basis immediately after CAA But foreign basis may be lower due to accelerated depreciation for foreign tax purposes Election is irrevocable once made Flexibility in making election U.S. owners of relevant foreign assets make the election Except for p-ship, which is made by each partner Separate elections with respect to each CAA, each foreign income tax, and each foreign payor (person or entity (including DE) liable for tax), but Aggregate CAAs treated as one CAA for this purpose If foreign payors report on combined basis they are treat as one for this purpose 32

17 Income from RFA and Tax Imposed on Such Income Allocation Questions Foreign taxes subject to the haircut are those that are determined with respect to the income attributable to the relevant foreign assets Raises a question of whether section 901(m) and disqualified taxes should be determined by tracing the taxes to the step-up in specific assets Difficult questions arise if tracing to each assets is required Particularly where additional assets are later acquired Which asset gets the benefit of the lower rate brackets? What if different rates on income from different assets? Statute determines the disallowance of foreign taxes using a formula Aggregate basis and divided by all of the allocable foreign income Proposed regulations implement formula in a practical way Regs use all foreign income and all foreign taxes on the return of each foreign payor (person or entity (including a DE)) that include income from RFAs and subject to foreign tax 33 Disqualified Portion of the Taxes What is the disqualified portion of the tax? Basically equal to the total basis step-up in relevant foreign assets (generally those relevant in determining foreign income) multiplied by the effective foreign tax rate Statute adopts a formula: But the statute implements this in a complicated manner to ensure that the foreign tax disallowance corresponds to the timing of utilization of the basis difference 34

18 Allocation of Basis Differences General allocation rule Use the applicable cost recovery method using U.S. methods Done on an annual basis Difficulties occur where: More than one person subject to section 901(m) Apply the disallowance formula so that basis differences and any disposition amounts must be allocated among the these parties Owner of relevant foreign assets is a partnership Must also account for amounts under successor rules Proposed regulations provide detailed rules to address these issues 35 Basis Difference Carryovers Basis difference is effectively tax-exempt income for which foreign taxes credits are disallowed under section 901(m) Statute s use of a formula can present issues in a specific year: If the aggregate basis difference exceeds foreign taxable income in a given year (e.g., where a CFC has a foreign loss) then there may be insufficient FTCs to disallow under section 901(m) If the aggregate basis difference is negative in a given year (i.e., the allocable basis difference in that year is a net U.S. basis step-down) the statute does not allow a taxpayer to claim more FTCs than the amount actually paid Proposed regulations address this issue with carryover rules Bad News: If basis difference exceeds foreign taxable income, the excess carries forwards and disallows foreign tax credits in a future year Good news: If the aggregate basis difference for a year is negative, it carries forward and offsets positive basis differences in future years (and thus more foreign tax credits) Entity-level attribute Section 901(m) can still apply to an entity even though it has disposed of all of its RFAs, and otherwise taken into account all of total basis difference in earlier years Not provided for in the statute, but may have simplified the rules? 36

19 Every CAA Likely Includes Multiple CAAs Section 901(m) applied separately for each section 901(m) taxpayer (or section 902 foreign corporation) with respect to each foreign income tax imposed on relevant foreign asset acquired in a CAA and a foreign payor (individual or entity (including a DE) subject to foreign tax) An acquisition of a European group involves multiple CAAs Could have multiple section 901(m) computations in the same jurisdiction if multiple creditable income taxes Foreign consolidated groups Election to apply foreign basis is made separately for each CCA with respect to each foreign tax and each foreign payor 37 Acquisition Involving Multiple Jurisdictions CAA Comp. 1 CFC 1 Netherlands FP is acquired in a QSP Section 338 Elections made for all entities CAA Comp. 2 French consol. group CFC 2 France CAA Comp. 4 CFC 3 Switzerland CAA Comp. 6 CFC 4 Spain CAA Comp. 3 CAA Comp. 5 CFC 5 France DE 1 France DE 2 German Business 1 Business 2 Every entity (including DE 1 and 2) has a separate CAA and is a separate foreign payor Spain has one CCA and is a single foreign payor but with respect to two foreign income taxes France has three entities but as one return is filed for all entities, taxes and income are allocated between CFC 2 and CFC 5 CFC 2 and DE 1 are a single foreign payor because CFC 2 and DE 1 file on a combined basis Each ringed group is a separate 901(m) computation CAA Comp. 7 Industry Specific Tax 38

20 Creditable Withholding Taxes Good News / Bad News Third-country withholding taxes (WHT) excluded from section 901(m) But affect computation of disallowed income taxes if creditable against what would otherwise be potentially disqualified taxes Base case example 50 basis difference, 100 foreign income, and 40 foreign tax (40% rate) Base Case with 20 WHT only 20 of foreign tax (20% ETR) Proposed regulations add-back the withholding taxes: Add back of WHT restores base case result 39 Look Back to pre-u.s. Ownership and Prior CAAs CAA defined without regard to whether transaction occurs when relevant for U.S. tax Disqualified tax denied for section 901, 902 and 960, implying that at time the tax is paid or accrued must be relevant for U.S. tax purposes under those sections Proposed regulations confirm that denial only occurs when a U.S. person or section 902 foreign corporation pays or accrues a disqualified tax BUT clarify that section 901(m) applies even if CAA occurs prior to U.S. ownership solely between foreign persons (e.g., among non-section 902 foreign corporations) Due diligence is required on any acquisition of foreign stock to determine if prior CAAs that reduced foreign taxes or have remaining basis differences Busted Transaction CAA most problematic (most other require U.S. nexus) Section 338 election doesn t cure a prior CAA unless there is a foreign basis election Deemed sale not recognized under foreign law; thus not a disposition, so remaining aggregate basis carries over under old CAA with assets Foreign basis election combines impact of prior transactions 40

21 Effective Dates Temporary Regulations Notices and -45 Disposition rules retroactive to the date of the Notice (generally CAAs on or after July 21, 2014) Also covers remaining basis differences from prior CAAs back to 2011 Exclude foreign withholding taxes Also retroactive to July 2014 Proposed Regulations Generally apply to CAAs after regs are finalized Taxpayers can rely on the proposed regulations if: They apply all of the regs consistently to all CAAs on or after Jan. 1, 2011 Except expanded list, which must be applied on or after Dec. 7, 2016 Consistency requirement all related parties treated as one taxpayer Retroactive reliance Proposed regs have favorable rules De minimis exception Exception for withholding taxes Foreign basis election (especially for foreign basis step-up transactions) 41 Effective Dates Examples Simple Case CAA in 2012 Favorable to apply proposed regs for the de minimis rule Timing of making foreign basis election 3 year v. 10 year statute of limitation for foreign tax credits Complicated Case CAA in 2017 that is included in one of the new CAA categories No section 901(m) because no need to apply the proposed regulations But then a second CAA takes place in 2018 that includes an equivalent foreign basis step-up Need to make the foreign basis election and de minimis rules to avoid section 901(m), but this means pulling the first CAA into the rules What is if there is also a 2011 CAA that would be affected by the proposed regs (e.g., the carryover rule) But 2011 is a closed year Do you only lose the credits if they are carried forward to an open year? 42

22 Section 704(b) Regulations on the Allocation of Foreign Income Taxes Sec. 704 Temp Regs Allocations of CFTEs Regulations addressing the allocation of creditable foreign tax expenditures or CFTEs were first issued in April of 2004 Temporary regulations issued in February maintain the approach, but modify the regulations to address certain specific issues Apply to partnership taxable years that begin on or after Jan. 1, 2016 and end after Feb. 4, 2016 CFTEs do not have substantial economic effect Allocated in accordance with the partners interests in the partnership CFTEs are generally allocated consistent with the related income as determined using foreign tax principles The temporary regulations primarily address 3 issues Section 743 adjustments Guaranteed payments and preferential allocations involving differing treatment in different jurisdictions Multiple disregarded payments 44

23 Section 743 Adjustments Base Case Example A 50% interest 100 FMV 0 A/B ABC B Property 200 FMV 0 US A/B 0 Foreign A/B Sale of Property 200 U.S. gain 200 Foreign gain 40 Foreign tax 50% interest 100 FMV 0 A/B ABC is a hybrid partnership (partnership for U.S. purposes but a corporation, and thus a taxpayer, for foreign tax purposes) A and B are 50 / 50 partners of ABC ABC sells the property and has 200 of gain Foreign tax of 40 (20% rate) There is a single CFTE category of income with all 200 of gain Because the 40 of foreign tax is related to the gain, it is allocated to that category 200 of net income in the CFTE category is allocated 50 / 50, or 100 to each of A and B 20 of foreign tax is allocated to each 45 Section 743 Adjustments Temp Regs A B C ABC makes a section 754 election B sells its interest to C for 100 on Jan 1, 2009 (section 901(m) does not apply) 50% interest 100 FMV 0 A/B 50% interest 100 FMV 0 A/B 100 FMV 100 A/B ABC sells the property and has 200 of gain Foreign tax of 40 (20% rate) ABC Property 200 FMV 0 US A/B 0 Foreign A/B Sale of Property 200 U.S. gain 200 Foreign gain 40 Foreign tax 704/743 Analysis: 200 of gain is allocated 50 / 50 to A and C, and then C s gain is reduced from 100 to 0 from the section 743 adjustment CFTE Allocation: Net income in the CFTE category is 200 (section 743 adjustment is not included) and is allocated 50 / 50, or 100 to each of A and C Foreign tax is allocated 50 / 50 (and not only to A), or 20 to each of A and C End result: C has 0 income but 20 of foreign tax 46

24 Section 743 Adjustments Section 901(m) A B C Same as prior example, except sale of partnership interest is post % interest 100 FMV 0 A/B 50% interest 100 FMV 0 A/B 100 FMV 100 A/B Section 901(m) applies; 20 of the foreign tax is not creditable ABC Property 200 FMV 0 US A/B 0 Foreign A/B Sale of Property 200 U.S. gain 200 Foreign gain 40 Foreign tax 704/743 Analysis: 200 of gain is allocated 50 / 50 to A and C, and then C s gain is reduced from 100 to 0 from the section 743 adjustment CFTE Allocation: 200 net income in the CFTE category is 200 (section 743 adjustment is not included) and is allocated 50 / 50, or 100 to each of A and C Foreign tax is allocated 50 / 50 (and not only to A), or 20 to each of A and C Section 901(m): 20 of foreign tax allocated to C is disallowed under 901(m) (Notice ) 47 Section 743 Adj. Section 901(m) Example US Consequences to C Value / Cash Distribution 80 Less US Tax Gain Allocated 100 Section 743 Adj. (100) Foreign tax (20) Net income (20) Tax Cost / Benefit 7 Total Return from Sale 87 Investment 100 Net return (13) US Consequences to B Gain on Sale 100 Less US Tax Gain 100 Foreign tax 0 Net income 100 Tax Cost / Benefit (35) Total Return from Sale 65 Investment 0 Net return 65 Total Return to C and B = 52 48

25 Section 743 Adj. Section 901(m) Example (cont d) C acquires the partnership interest for 80 instead of 100 US Consequences to C Value / Cash Distribution 80 Less US Tax Gain Allocated 100 Section 743 Adj. (80) Foreign tax (20) Net income 0 Tax Cost / Benefit 0 Total Return from Sale 80 Investment 80 Net return 0 US Consequences to B Gain on Sale 80 Less US Tax Gain 80 Foreign tax 0 Net income 80 Tax Cost / Benefit (28) Total Return from Sale 52 Investment 0 Net return 52 Total Return to C and B 52 Section 901(m) loss to aggregate return (65% of 20 foreign tax) or Guaranteed Payments and Preferential Allocations Regulations address guaranteed payments and preferential allocation Deductibility in foreign jurisdiction is the key If deductible, then not part of the foreign tax base Deductible guaranteed payment no adjustments necessary because deductible for U.S. and foreign tax purposes Non-deductible guaranteed payment Include the income in the CFTE category Treat the payment as distributive share of partnership income Deductible preferred allocations Reduce the net income in the CFTE category Do not treat as an allocation of partnership income Multiple jurisdictions 50

26 Preferential Allocations A 7500 Contribution 1000 Preference 50% Residual B 2500 Contribution 50% Residual A and B form ABC by contributing 7500 and 2500 respectively AB is a hybrid partnership A has a 1000 preferred return for excess capital, deductible in Country X, but not Y AB Country X 3000 Net income 1000 Deduction 400 Foreign tax AB has 3000 of net income Foreign tax of 400 (20% rate) in Country X, because 1000 allocation is deductible There is a single CFTE category of income Include the deduction when allocating Country X taxes so 200 to A and B 51 Preferential Allocations (cont d) A B Same facts as above, except that the income is also subject to a withholding tax imposed by Country Y 7500 Contribution 1000 Preference 50% Residual AB Country X 3000 Net income 1000 Deduction 400 Foreign tax 2500 Contribution 50% Residual 300 Additional foreign withholding tax from Country Y AB has 3000 of net income Foreign tax of 400 (20% rate) in Country X Additional Foreign tax of 300 (10% rate) in Country Y, because 1000 allocation is not deductible Still a single CFTE category of income Include the deduction when allocating Country X taxes so 200 to A and B Ignore the deduction when allocating Country Y taxes so 200 to A and 100 to B What if Country Y taxes are creditable so that AB only owes 100 in Country X? Does A get 0 or 50 of Country X taxes? 52

27 Multiple Disregarded Payments -- Example 36 A B C Agreement provides all partnership items allocated as follows A B C DEX 80% 10% 10% DEY 10% 80% 10% DEZ 10% 10% 80% ABC What happens to the cash? is this effectively just 80 / 10 / 10? 120 of tax related to DEX business Tax allocated to 80 / 10 /10 What happens if the W/H tax is imposed by Country Y? 1000 Royalty 0 W/H Tax Unrelated Customers DEX Country X 100 Net Income 30 Income Tax 900 Royalty 90 W/H Tax DEY Country Y 100 Net Income 0 Income Tax 800 Royalty 0 W/H Tax DEZ Country Z 800 Net Income 0 Income Tax 53 Multiple Disregarded Payments -- Example 36 (cont d) Allocations of Income and Tax DEX 1000 income 120 tax DEY 0 income 0 tax DEZ 0 income 0 tax A B C Income Tax Income Tax Income Tax TOTAL

28 Multiple Disregarded Payments -- Example 37 A B C Agreement provides all partnership items allocated as follows A B C DEX 80% 10% 10% DEY 10% 80% 10% DEZ 10% 10% 80% ABC Disregarded payments affect cash distributions 30 tax allocated to 80 / 10 / tax allocated to 10 / 80 / of tax x (100 / 900) 80 tax allocated to 10 / 10 / of tax x (800 / 900) 1000 Royalty 0 W/H Tax Unrelated Customers DEX 900 Royalty 90 W/H Tax 100 Net Income 30 Income Tax DEY 800 Royalty 0 W/H Tax 100 Net Income 0 Income Tax DEZ 800 Net Income 0 Income Tax 55 Multiple Disregarded Payments -- Example 37 (cont d) Allocations of Income and Tax DEX 100 income 30 tax DEY 100 income 10 tax DEZ 800 income 80 tax A B C Income Tax Income Tax Income Tax TOTAL

29 Questions? 57