January 11, Water s-edge Outbound

Transcription

1 Water s-edge Outbound Structure January 11, 2016 BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company BDO KNOWLEDGE limited by guarantee, Webinar Series and forms Water s-edge part of the Outbound Structure international BDO network of independent member

2 CPE AND SUPPORT CPE Participation Requirements To receive CPE credit for this webcast: You ll need to actively participate throughout the program. Be responsive to at least 75% of the participation pop-ups. Please refer the CPE & Support Handout in the Handouts section for more information about group participation and CPE certificates. Q&A: Submit all questions using the Q&A feature on the lower right corner of the screen. At the end of the presentation, the presenter(s) will review and answer all questions submitted. Technical Support: If you should have technical issues, please contact LearnLive: Click on the Live Chat icon under the Support tab, OR call:

3 WITH YOU TODAY Chris Berkness Senior Tax Director BDO USA, LLP One Bush Street Suite 1800 San Francisco, CA Direct: (415)

4 LEARNING OBJECTIVES Determine if filing under the water's-edge method is more beneficial than filing worldwide Identify issues directly related to outbound groups Distinguish intercompany dividends versus dividend deduction under section Describe effectively connected income partial inclusion rules Recall the 20% U.S. apportionment factor full inclusion rule Identify the requirements to properly elect water's-edge Construct forms needed to properly elect water's-edge Recognize issues that directly affect first time water's-edge electors Page 1

5 AGENDA Subpart F Inclusion Ratio Dividend relief Foreign Investment Interest Offset Page 2

6 WATER S-EDGE ELECTION By electing water s-edge, a taxpayer will have to apply a unique blend of multistate and international taxation concepts. The general rule excludes foreign corporations from the combined report. However, there are several exceptions to the general rule. The more common exceptions are the Subpart F inclusion ratio, effectively connected income and the 20% rule. The following presentation will cover the Subpart F inclusion ratio exception along with dividend relief and the foreign investment interest offset. Page 3

7 TOOLS NEEDED TO PROPERLY PREPARE WATER S- EDGE SCHEDULES Organization Chart: Ownership percentage Proper entity classification (corporation, DRE or partnership) Federal forms: 5471 (California conforms to federal penalties)(worksheet A) 926 Transfer of property to foreign entities (California conforms to federal penalties) 8865 Foreign Partnerships (California conforms to federal penalties) Disregarded Entities 1120 Federal consolidated return Page 4

8 OWNERSHIP PERCENTAGE IS IMPORTANT Inclusion ratio If ownership percentage is less than 50%, then the CFC cannot be partially included in the combined report. If the ownership percentage is less than 100%, then for federal purposes the pro-rata Subpart F will be reported but for California it should be 100%. Foreign Investment Interest Offset If ownership percentage is less than 100% but greater than 50%, then the accumulated E&P that is included in the numerator should be adjusted to reflect ownership percentage. If the ownership percentage is less than 50%, then the accumulated E&P of the CFC will not go in the numerator. Section deduction If the ownership percentage is less than 50%, then the dividend paid by that CFC will not qualify for the section deduction. Page 5

9 INCLUSION RATIO FORM 2416 The general rule is that foreign corporations are excluded from the water sedge combined report, however, there are a few exceptions. It is very important to understand that Subpart F income is not included in the combined report. Subpart F income is used to determine what percentage of a CFC to include in the combined report. The CFC must still be considered unitary with the water s-edge group to be partially included. Inclusion ratio = Subpart F income over Current E&P The ratio of Subpart F income over Current E&P is used to determine; (1) What percentage of the CFC will be included in the combined report (income, business income, nonbusiness income, apportionment factors, etc ) (2) What percentage of the CFC s dividends are considered intercompany and qualifying subject to the section deduction. (3) The foreign investment interest offset numerator, denominator and interest expense. Page 6

10 INCLUSION RATIO CFC1 has Subpart F income of $10,000 and current E&P of $100,000. The inclusion ratio is 10% (10,000/100,000) CFC1 has $200,000 of unitary business income and $500,000 of gross sales. The includable income of CFC1 would be $20,000 (200,000x10%) and the includable sales for apportionment factor purposes would be $50,000 (500,000 x 10%). Eliminate any intercompany sales. Page 7

11 INCLUSION RATIO FEDERAL/CALIFORNIA DIFFERENCES The Subpart F income that is included in the numerator of the inclusion ratio may be different than the federal Subpart F income. The pro-rata percentage can result in federal/california differences. (Amount reported on Schedule I should reflect pro-rata.) Section 956 Subpart F income is not included in the numerator. (Line 2 of Schedule I) The recapture & re-characterization rules are not followed for California purposes which can result in federal/california differences. (do not follow IRC 952(c)) (worksheet A for schedule I) The prior year deficit and qualified chain deficit rules are not followed for California purposes which can result in federal/california differences. Page 8

12 INCLUSION RATIO FEDERAL/CALIFORNIA DIFFERENCES Example of recapture/re-characterization. In 2013 CFC1 has current E&P of $60,000 and Subpart F income of $100,000. For federal purposes, the Subpart F income is limited to current E&P and the excess is recaptured. The amount recaptured is $40,000. For California purposes, the inclusion ratio is 100% If in 2014 the current E&P is $100,000 and the Subpart F income is $50,000, then for federal purposes the Subpart F income will be $90,000. The $40,000 recaptured amount is included as Subpart F income in For California purposes the inclusion ratio is 50% (do not include re-characterized Subpart F income. Page 9

13 INCLUSION RATIO FEDERAL/CALIFORNIA DIFFERENCES In general, the adjustment to exclude the re-characterized Subpart F income will benefit the taxpayer (not FTB). However, there may be situations when it is advantageous to the taxpayer to increase the inclusion ratio. Substantial gross receipts but minimal taxable income. (dilute apportionment factor) Could potentially increase intercompany dividends under Page 10

14 INCLUSION RATIO FEDERAL/CALIFORNIA DIFFERENCES In general, the adjustment to reverse the prior year deficit or qualified chain deficit for California purposes will benefit the state and not taxpayer. Only deficits in foreign base sales, foreign base service, foreign base oil and qualified insurance income can be considered qualified deficits. The only time deficits in FPHCI can be carried over to reduce Subpart F income is when the CFC is considered a qualified financial institution. The deficits can only be used against the same qualified activity. Page 11

15 INCLUSION RATIO Previously Taxed Income (PTI) under IRC 959 In the past, FTB would require that the PTI dividends that were excluded from federal Subpart F income under section 959, to be included in the numerator of the inclusion ratio. This created a federal/california difference FTB has since changed its policy and now allows the PTI dividends to be excluded from the numerator of the inclusion ratio. FTB changed its policy as a result of the decision in Fujitsu IT Holdings, Inc. v. Franchise Tax Board (2004) (and TAM ) FTB argued that California did not conform to IRC 959. Page 12

16 INCLUSION RATIO Follow IRC (except 952(c) & 956) In determining the numerator of the inclusion ratio, the Subpart F rules are applied (and any referenced sections) even though California does not conform to these sections for purposes of determining taxable income. Each year California prepares the Summary of Federal Income Tax Changes which lists the federal legislative changes for the year and its implication to California tax law. For 2013, the 2- year extension to the look-thru rules under IRC 954(c)(6) was analyzed for purposes of determining the impact for water s-edge purposes. It stated; When applying provisions of the IRC in connection with a water s-edge election that are otherwise not applicable, such as Subpart F rules, the federal rules-as applicable for federal purposes apply. Thus under California water s-edge rules, the two-year extension of the look-thru rules automatically applies. (Also see section 25116) Page 13

17 INCLUSION RATIO In determining the includable business income of a partially included CFC, there are three separate income items that need to be calculated. Subpart F income (numerator) Current E&P (denominator) Business income after state adjustments multiplied by the inclusion ratio Each item can be a different number since different rules are applied to each income item. Subpart F income is determined under the federal rules (IRC ) Current E&P is determined under IRC 964 Unitary business income is determined using California R&TC Note: 5471 Schedule C is reported in accordance with GAAP Page 14

18 INCLUSION RATIO Example: CFC1 has income from the sale of inventory that qualifies as foreign base sales income (Subpart F) of $60,000 and a foreign currency loss of ($10,000) that qualifies as Subpart F and interest income of $70,000 that does not qualify as Subpart F income. CFC1 paid taxes based on income of $20,000 (applies to interest income). Subpart F income = $60,000 (no-loss rules apply) Current E&P per IRC 964 = $100,000 Unitary business income = $120,000 (taxes based on income) The inclusion ratio is 60% and it is multiplied by $120,000 to determine the includable income of CFC1. Note: the 60% ratio would also be multiplied by the gross sales for apportionment factor purposes (eliminate intercompany sales) Page 15

19 INCLUSION RATIO If a CFC has either sales to or from a corporation that is included in the water sedge combined report, then those intercompany sales must be eliminated from the sales factor. Check schedule M of the form Page 16

20 DIVIDEND RELIEF SCHEDULE H(100W) Once the inclusion ratio has been calculated, the next step is dividend relief. If a CFC pays a dividend to a corporation that is included in the combined report, then a determination must be made as to how much of the dividend should qualify as intercompany under section or qualifying under section (subject to the 75% deduction) Of course it is beneficial to classify the dividend as intercompany (versus qualifying) since intercompany dividends are 100% eliminated whereas qualifying dividends are subject to a 75% deduction. In addition, the foreign investment interest offset applies to the section deduction but it does not apply to intercompany dividends under section Qualifying dividends include both business and nonbusiness income. Qualifying dividends include dividends paid by CFCs that are not unitary. The CFC must be over 50% owned by the water s-edge group and its average property, payroll and sales factor within the U.S. must be less than 20% to qualify. Page 17

21 DIVIDEND RELIEF Intercompany dividends In order for the dividend to qualify as intercompany under section 25106, the dividend must be paid out of unitary earnings and profits. Both the payor and payee of the dividend must be included in the combined report in the year that the earnings and profits were generated. Therefore, a dividend paid by a CFC that is 100% included to a CFC that is also 100% included may not always be classified as intercompany. Page 18

22 DIVIDEND RELIEF Example 1: CFC 2 pays a dividend of $100,000 to CFC1 in Both CFC2 and CFC1 have a 100% inclusion ratio in If the current year earnings and profits are 100,000, then the intercompany portion is $100,000 (100,000 x 100% payor ratio x 100% payee ratio) Example 2: CFC 2 pays a dividend of $100,000 to CFC1 in CFC2 has a 100% inclusion ratio in 2014 and CFC1 has an 80% inclusion ratio in If the current year earnings and profits are 100,000, then the intercompany portion is $80,000 (100,000 x 100% payor ratio x 80% payee ratio) Keep in mind that only $80,000 was actually included in the combined report and $20,000 was excluded because of the payees inclusion ratio. Page 19

23 DIVIDEND RELIEF Example 3: CFC 2 pays a dividend of $100,000 to CFC1 in CFC2 has an 80% inclusion ratio in 2014 and CFC1 has a 100% inclusion ratio in If the current year earnings and profits are 100,000, then the intercompany portion is $80,000 (100,000 x 80% payor ratio x 100% payee ratio) The qualifying portion subject to the section deduction is $20,000. This is very similar to the last example except that $20,000 is subject to the deduction. In the last example, $20,000 was excluded from income since the payee was only 80% included. Example 4: CFC 2 pays a dividend of $100,000 to CFC1 in CFC2 has a 50% inclusion ratio in 2014 and CFC1 has a 80% inclusion ratio in If the current year earnings and profits are 100,000, then the intercompany portion is $40,000 (100,000 x 50% payor ratio x 80% payee ratio) The qualifying portion subject to the section deduction is $40,000 and the amount excluded from the combined report is $20,000. Page 20

24 DIVIDEND RELIEF Example 5: CFC 2 pays a dividend of $100,000 to CFC1 in CFC2 has a 80% inclusion ratio in 2014 and CFC1 has a 100% inclusion ratio in CFC2 has a 10% inclusion ratio in 2013 and CFC1 has a 100% ratio in If the current year earnings and profits are $20,000 and the 2013 earnings and profits are 80,000, then the intercompany portion of the $100,000 dividend paid by CFC2 to CFC1 is $24, % of the dividend is subject to dividend relief since the payee is 100% included in the combined report. Current year E&P is 20,000. The $20,000 is multiplied by the payor s inclusion ratio of 80% to get $16,000. The 2013 E&P is $80,000 which is multiplied by 10% to get $8,000. The total intercompany dividend elimination under section is $24,000. The qualifying portion subject to the section deduction is $76,000 ($100,000 24,000) Page 21

25 DIVIDEND RELIEF ORDERING RULE Example 6: CFC 2 pays a dividend of $60,000 to CFC1 in CFC2 has a 80% inclusion ratio in 2014 and CFC1 has a 100% inclusion ratio in If the current E&P is 100,000, then the intercompany dividend is $60,000 The qualifying portion subject to the deduction is $0. When the dividend paid is less than the E&P layer, the dividend is first considered paid out of E&P attributable to until depleted, then E&P subject to the deduction. This is a priority ordering rule which is in accordance with TAM Both the water s-edge regulations and manual require the use of a pro-rata method, however, this method was changed as a result of Fujitsu IT Holdings, Inc. v. Franchise Tax Board (2004). FTB later issued TAM to reflect the priority ordering rule. Note: see example 2 of regulation 24411(e)(4). If in the following year CFC2 pays a $40,000 dividend and there is no 2015 E&P, then $20,000 will be and $20,000 will be subject to the deduction. This assumes CFC1 has a 100% ratio in Page 22

26 DIVIDEND RELIEF Example 7: CFC 2 pays a dividend of $100,000 to CFC1 in CFC2 has a 0% inclusion ratio in 2014 and CFC1 has a 100% inclusion ratio in Both CFC2 and CFC1 have a 100% inclusion ratio in If the current E&P is $0 and the 2013 E&P is $100,000, then the intercompany dividend is $100,000. Although the payor had a 0% inclusion ratio in the year the dividend was actually paid, the dividend is still considered intercompany under section because the dividend was paid out of the 2013 E&P. The payor was 100% included in Example 8: CFC 2 pays a dividend of $100,000 to CFC1 in Both CFC2 and CFC1 have a 100% inclusion ratio in CFC2 has a 0% inclusion ratio in 2013 and CFC1 has a 100% inclusion ratio in If the current E&P is 0 and the 2013 E&P is $100,000, then the intercompany dividend is $0. It doesn t matter if the payor and payee are both 100% included in the year the dividend was paid, since the dividend was paid out of 2013 E&P. CFC2 had a 0% inclusion ratio in Page 23

27 FOREIGN INVESTMENT INTEREST OFFSET FORM 2424 After the inclusion ratios and dividend relief are both calculated, the foreign investment interest offset (FIIO) can be calculated. FIIO can be the most difficult water s-edge calculation. The purpose of the FIIO is to match the interest expense to the excluded dividends under section The theory is that money is fungible and therefore, a portion of the interest expense of the water s-edge group must be attributable to the foreign investment of the group and since dividend income has been excluded under section 24411, so must the interest expense associated with the deduction. The FIIO is calculated by taking the combined group s foreign investment over the total assets and multiplying this ratio by the group s total interest expense. This amount is compared to the section deduction and the lower of the two is the FIIO (the FIIO cannot exceed the section deduction). The final computation is multiplied by 75% Page 24

28 FOREIGN INVESTMENT INTEREST OFFSET Numerator Foreign investment of the water s-edge group. The foreign investment includes the stock basis and accumulated E&P of certain CFCs. The stock basis is taken into account at the adjusted basis for federal tax purposes. The accumulated E&P is only taken into account if the CFC is over 50% owned. If the CFC is less than 100% owned, then only include the proportionate amount of E&P that represents the ownership percentage. If there is a deficit in E&P it can reduce the stock basis but not below zero. Use the average beginning and year end amounts. The foreign investment (stock basis & accumulated E&P) of certain CFCs is included in the numerator of the FIIO. Only include the foreign investment of the CFCs that are directly owned by the water s-edge group and only to the extent the CFC is excluded from the combined report. Lower tier CFCs excluded from the combined report could be included in the numerator of the FIIO if the direct owner is included in the combined report but only to the extent the owner is included. Page 25

29 FOREIGN INVESTMENT INTEREST OFFSET Numerator example; CFC1 owns 100% of CFC2 and CFC2 s stock basis is $80,000 and its accumulated E&P is $20,000 (assume all numbers are an average of beginning & year end). CFC1 is directly owned by a US corporation included in the combined report. The stock basis of CFC1 is $40,000 and its accumulated E&P is $10,000. If CFC1 s inclusion ratio is 100% and CFC2 s is 0%, then the foreign investment is $100,000. ($80,000 + $20,000) x 100% x 100% plus ($40,000 + $10,000) x 0% x 100% If CFC1 s inclusion ratio is 0% and CFC2 s is 0%, then the foreign investment is $50,000. ($80,000 + $20,000) x 100% x 0% plus ($40,000 + $10,000) x 100% x 100% If CFC1 s inclusion ratio is 80% and CFC2 s is 0%, then the foreign investment is $90,000. ($80,000 + $20,000) x 100% x 80% plus ($40,000 + $10,000) x 20% x 100% If CFC1 s inclusion ratio is 20% and CFC2 s is 60%, then the foreign investment is $48,000. ($80,000 + $20,000) x 40% x 20% plus ($40,000 + $10,000) x 80% x 100% Page 26

30 FOREIGN INVESTMENT INTEREST OFFSET Denominator The total assets of the water s-edge group should reflect federal tax book value. The total asset are averaged (beginning and year end). Intercompany assets are eliminated. Include the assets of partially included CFCs The foreign investment that is reflected on the balance sheet should be eliminated and the amount calculated for numerator purposes should be added. Page 27

31 FOREIGN INVESTMENT INTEREST OFFSET Denominator Example: Assume all assets are an average of beginning and year end amounts. US Corp owns 100% of CFC1. US Corp s total assets are $1,100,000 and of that amount $140,000 is the investment in foreign sub. CFC1 s total assets are $100,000. The stock basis in CFC1 is $20,000 and its accumulated E&P is $30,000. CFC1 s inclusion ratio is 20%. In order to determine the total assets of the group, the numerator must be determined first. ($30,000 + $20,000) x 80% x 100% = $40,000 The total assets of US Corp are $1,100,000 less booked foreign investment plus the foreign investment calculated for numerator purposes. ($1,100,000 - $140,000 + $40,000 = $1,000,000 The total assets of partially included CFCs are also included. CFC1 was partially included based on its 20% inclusion ratio. Therefore 20% of its total assets are also included in the denominator. ($100,000 x 20% = $20,000) The total denominator is $1,020,000. Page 28

32 FOREIGN INVESTMENT INTEREST OFFSET Interest Expense The total unassigned interest expense of the water s-edge group is included in the FIIO calculation. If the interest expense can be directly traced to foreign or domestic activity, it will be excluded from the pool of unassigned interest expense. If the interest expense can be directly traced to foreign activity, then it will be added to the FIIO. Any intercompany interest expense is excluded from the unassigned interest expense of the water s-edge group. Include the interest expense of a partially included CFC. Multiply the total interest expense of the CFC by its inclusion ratio. Page 29

33 FOREIGN INVESTMENT INTEREST OFFSET Example: US parent has total interest expense of $210,000 of which $60,000 is intercompany. CFC1 has total interest expense of $100,000 and a partial inclusion ratio of 50%. The US parent s interest expense is calculated by taking the total interest expense of $210,000 and subtracting the intercompany interest expense of $60,000 which equals $150,000. You would also include the interest expense of the partially included CFC. CFC1 s total interest expense of $100,000 is multiplied by its inclusion ratio of 50% to get $50,000. Therefore, the total interest expense of the water s-edge group for purposes of the FIIO is $200,000. ($150,000 + $50,000) Assume the offset ratio is 10%. The 10% offset ratio is multiplied by the total interest expense of $200,000 ($200,000 x 10% = $20,000). If the group had any interest expense that could be directly traced to foreign activity, it would be added to the $20,000 at this time. Since there is none, the $20,000 is compared to the section deduction. The lower of the two is the FIIO (the FIIO can not exceed the deduction). The final step is to multiply the $20,000 by 75%. Therefore, the total FIIO is $15,000. Page 30

34 FOREIGN INVESTMENT INTEREST OFFSET Per Legal Ruling , the dividend income that is excluded under section 24411, will not be included in the sales factor. Income that is excluded from the tax base, will not be included in the sales factor. The dividend that is included in the tax base (25%) will be included in the sales factor. If for example, a CFC pays a $100,000 dividend to a US corporation in the water s-edge combined report and 75% of this dividend is excluded under section 24411, then only $25,000 will be included in the sales factor. The $75,000 excluded under section should not be included in the sales factor. Since there is a $75,000 section deduction, the foreign investment interest offset must be calculated. The foreign investment interest offset cannot exceed the section deduction. The foreign investment interest offset results in interest expense being matched to dividend income which is excluded from the tax base and therefore, the interest expense is not deductible. Would the foreign investment interest offset have any impact on the amount of dividends excluded from the sales factor? Page 31

35 CFCS WITH SUBPART F INCOME AND ECI CCR 25110(d)(2)(G) Choice of E or F. The United States income and apportionment factors of a foreign corporation which is not an electing taxpayer and which could be included in a combined report pursuant to both subsections (d)(2)(e) or (F) of this regulation shall be determined under subsection (d)(2)(f) and not under (d)(2)(e) of this regulation. CCR 25110(d)(3) - Non-described entities. Any corporation which is a taxpayer which has made a water s-edge election and which is not described in subsections (d)(2)(a) through (d)(2)(d) of this regulation shall determine its income derived from or attributable to sources within California on the basis of its United States located apportionment factors and income and the income and apportionment factors of the other entities included in the water s-edge group of which it is a member. Page 32

36 CFCS WITH SUBPART F INCOME AND ECI Water s-edge Manual section 2.3(g) Senate Bill 663, chaptered in May of 2006, amended R&TC to clarify that if a CFC, which is a California taxpayer or has US sourced income, has both Subpart F income and US sourced income, both types of income are included in the water s-edge combined report. SB 663 is effective for taxable years beginning in or after January 1, Page 33

37 SPEAKER BIOGRAPHY BDO KNOWLEDGE Webinar Series Water s-edge - Outbound Structure

38 BIOGRAPHY CHRIS BERKNESS Senior Tax Director Direct: (415) Chris has over 25 years of experience in multistate/water s-edge tax including ten years at the California Franchise Tax Board as their International Consultant. Over the last twenty years Chris has reviewed hundreds of water s-edge cases involving some of the largest companies in the world including Shell Oil, Apple, Microsoft, Chevron, Pepsi, HP, Coca Cola and more. While at the Franchise Tax Board, he worked directly with the audit staff to ensure that their cases were properly developed and that the law was correctly applied. In addition, he was responsible for providing water s-edge training to both the audit and legal staff. Chris served as a member of the Water s-edge Technical Advisory Team, which was responsible for establishing water s-edge policy and identifying issues that could result in a loss of revenue for the state of California.

39 BDO is the brand name for BDO USA, LLP, a U.S. professional services firm providing assurance, tax, financial advisory and consulting services to a wide range of publicly traded and privately held companies. For more than 100 years, BDO has provided quality service through the active involvement of experienced and committed professionals. The firm serves clients through 58 offices and more than 400 independent alliance firm locations nationwide. As an independent Member Firm of BDO International Limited, BDO serves multi-national clients through a global network of 1,328 offices in 152 countries. BDO USA, LLP, a Delaware limited liability partnership, is the U.S. member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms. For more information please visit: Material discussed is meant to provide general information and should not be acted on without professional advice tailored to your firm s individual needs BDO USA, LLP. All rights reserved. BDO KNOWLEDGE Webinar Series Water s-edge - Outbound Structure