New anti-base erosion and anti-inversion international tax proposals included in the Administration s fiscal year 2015 Budget

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1 28 March 2014 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date New anti-base erosion and anti-inversion international tax proposals included in the Administration s fiscal year 2015 Budget Executive summary On 4 March 2014, the Obama administration (the Administration) released its fiscal year 2015 Budget proposals (the Budget). At the same time, the Treasury Department released its General Explanations of the Administration s Fiscal Year 2015 Revenue Proposals (the Treasury Green Book or Green Book) and revenue estimates. There are a total of 19 proposals related to international tax, 17 of which are estimated to raise revenue by a total of $276 billion according to Treasury and are included in a reserve for revenue-neutral business tax reform. The other two international tax proposals, estimated by the Treasury to reduce revenue by $2.27 billion, are included in the general part of the Budget. The revenue proposals in the Administration s FY2015 Budget include six new international tax proposals. The six new international tax proposals would: Restrict deductions for excessive interest of members of certain financial reporting groups; Create a new category of Subpart F income for certain related party transactions involving digital goods or services; Prevent avoidance of foreign base company sales income through related party manufacturing services arrangements;

2 Restrict the use of hybrid arrangements that create stateless income; Limit the application of exceptions under Subpart F for certain transactions that use reverse hybrids to create stateless income; and Limit the ability of domestic entities to expatriate. The FY2015 Budget includes four international tax proposals that reflect revisions to the proposals included in last year s budget: Limit shifting of income through intangible property transfers; Remove foreign taxes from a Section 902 corporation s foreign tax pool when earnings are eliminated; Prevent use of leveraged distributions from related corporations to avoid dividend treatment; and Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act. The remaining nine international tax related proposals are reintroductions of proposals included in the Administration s FY2014 budget (many of which also appeared in several earlier budgets). The international tax proposals that are substantially identical to proposals from the Administration s FY2014 budget and prior years are the following: Defer the deduction for interest expense related to deferred income of foreign subsidiaries; Determine the foreign tax credit on a pooling basis; Tax currently excess returns associated with transfers of intangibles offshore; Disallow the deduction for excess non-taxed reinsurance premiums paid to affiliates; Modify the treatment of dual capacity taxpayers; Tax gain from the sale of a partnership interest on a lookthrough basis; Extend Section 338(h)(16) to certain asset acquisitions; Provide incentives for locating jobs and business activity in the United Sates and deny tax deductions for activity considered to involve shipping jobs overseas; and Exempt foreign pension funds from the application of the Foreign Investment in Real Property Act (FIRPTA) provisions. In addition, the proposal to tighten the Section 163(j) rules for application to certain expatriated entities from the Administration s FY2014 budget (and earlier budgets) is not included in the FY2015 Budget (but the current Budget does include a new, broader proposal to restrict deductions for certain excessive interest). Detailed discussion New international tax proposals included in the FY2015 Budget Restrict deductions for excessive interest of members of financial reporting groups In general, taxpayers are permitted to deduct interest expense paid or accrued on indebtedness in accordance with Section 163(a). Section 163(j) is an exception to the general rule and disallows a deduction for a specified portion of interest expense paid by a domestic corporation to a related party where the corporation s debt-to-equity ratio is greater than 1.5:1 and its net interest expense exceeds 50% of adjusted taxable income. The Green Book states that while Section 163(j) places a cap on the amount interest expense a corporation can deduct relative to its US earnings, it does not consider the leverage of a multinational group s US operations relative to the leverage of the group s worldwide operations. Thus, according to the Green Book, this allows foreignparented multinational groups to inappropriately reduce US tax on income from US operations by overleveraging US operations relative to those located in lower tax jurisdictions. restrict deductions for excessive interest of members of a financial reporting group. For purposes of the proposal, a financial reporting group would be any group that prepares 2 International Tax Alert

3 consolidated financial statements in accordance with US Generally Accepted Accounting Principles (GAAP), International Financial Reporting Standards (IFRS), or another method authorized by the Secretary of the Treasury under regulations. The interest expense limitation would be determined under a new relative leverage rule. Under the proposal, a financial reporting group member s US interest expense deduction generally would be limited to such member s interest income plus its proportionate share of the group s net interest expense determined under US income tax principles. A member s proportionate share of the financial reporting group s net interest expense would be that amount of the group s net interest expense that bears the same ratio as the member s proportionate share of group earnings bears to total group earnings (computed by adding back net interest expense, taxes, depreciation, and amortization). Alternatively, under the proposal, if a member fails to substantiate its proportionate share of a group s net interest expense, or if a member so elects, the member s interest deduction would be limited to 10% of the member s adjusted taxable income, as defined in Section 163(j). The proposal provides for an indefinite carryforward of disallowed interest and a threeyear carryforward of any excess limitation. If a member of a financial reporting group is subject to the rules under this new limitation provision, such member would not be subject to the application of Section 163(j). The proposal would not apply to financial services entities. It also would not apply to financial reporting groups with less than $5 million of net interest expense in the aggregate on all US income tax returns for a taxable year, determined without regard to the proposal. Such entities would remain subject to Section 163(j). Under the proposal, US subgroups would be treated as a single member of a financial reporting group. The proposal defines a US subgroup as any US entity that is not owned, directly or indirectly, by another US entity and all members (foreign or domestic) that are owned by such entity. Where a US member of a US subgroup owns stock of one or more foreign corporations and the Administration proposal to defer interest expense deductions related to deferred foreign income would be applicable, the excessive interest proposal would apply before the proposal that defers interest expense allocable to deferred foreign income. revenue of $48.5 billion over 10 for taxable years beginning after Create a new category of subpart F income for transactions involving digital goods or services In general, US persons are not taxable on active trade or business income earned by their foreign subsidiaries (known as controlled foreign corporations, or CFCs) until such income is distributed to the US person as a dividend. The Subpart F rules provide exceptions to this general rule and require US persons to include in income on a current basis certain types of income of a CFC. In relevant part, Subpart F income includes foreign personal holding company income, foreign base company sales income, and foreign base company services income. The Green Book states that the existing categories of Subpart F income are not adequate to address mobile income from digital goods and services. As a result, the Green Book asserts that with respect to digital goods and services there is potential for taxpayers to structure digital transactions in a particular form and avoid application of the existing Subpart F rules. The proposal would create a new category of Subpart F income, foreign base company digital income, that would generally consist of income from the lease or sale of a digital copyrighted article or from the provision of a digital service. Specifically, income from the lease or sale of a digital copyrighted article, or from the provision of a digital service, would be foreign base company digital income if the CFC uses intangible property developed by a related person (including property developed pursuant to a cost-sharing arrangement) to produce the income and the CFC does not, through its own employees, International Tax Alert 3

4 make a substantial contribution to the development of the property or services that give rise to the income. An exception would be provided for income earned by the CFC from customers that are located in the country in which the CFC is created or organized and that use the digital articles or services in such country. revenue of $11.6 billion over 10 for taxable years beginning after Prevent avoidance of foreign base company sales income through manufacturing services arrangements Subpart F income includes foreign base company sales income, which generally consists of income earned by a CFC from buying or selling personal property from or to, or on behalf of, related persons if the personal property is both manufactured, produced, grown, or extracted outside of the CFC s country of organization and used, consumed, or disposed of outside of such country. Income derived by a CFC from the sale of products that it manufactures is excluded from the definition of foreign base company sales income. A CFC is treated as manufacturing the property it sells if the CFC makes a substantial contribution to the physical manufacturing of the product by a contract manufacturer. The Green Book asserts that under current law taxpayers have taken the position that a CFC does not have a related party sale, and therefore is not within the foreign base company sales income rules, where the CFC obtains the property sold to customers through a manufacturing service arrangement with a related person, including related persons in the United States. The Green Book states that the policy concerns, including concerns regarding US tax base erosion, addressed by the foreign base company sales income rules apply with respect to income earned by a CFC from the sale of property produced by a related person, regardless of whether such property is treated by the CFC as obtained through a purchase transaction or through a manufacturing service. expand the definition 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 party under a manufacturing service arrangement. The Administration proposal provides that the existing exceptions to foreign base company sales income, including the substantial contribution rules, would continue to apply. revenue of $24.6 billion over 10 for taxable years beginning after Restrict the use of hybrid arrangements that create stateless income The Green Book identifies what it refers to as a proliferation of tax avoidance techniques involving deductible payments and crossborder hybrid arrangements that it asserts can result in deductions claimed in the United States without any corresponding income inclusions in a foreign jurisdiction (referred to as stateless income ) or multiple deductions for the same payment in different jurisdictions. The Administration proposal would deny deductions for interest and royalties paid to related persons under certain circumstances that involve a hybrid arrangement. For this purpose, hybrid arrangements include hybrid entities, hybrid instruments, and hybrid transfers (such as a sales-repurchase or repo transaction, in which the parties take inconsistent positions in respect of the ownership of the same property). For example, the proposal would disallow a deduction in the United States where a taxpayer makes an interest or royalty payment to a related party and either (i) as a result of the hybrid arrangement there is no income inclusion to the recipient in the foreign country, or (ii) the hybrid arrangement would allow the taxpayer to claim an additional deduction for the same payment in another country. also grant the Secretary of the Treasury the authority to issue regulations necessary to carry out the purposes of the proposal, including provisions that would deny deductions from certain conduit arrangements involving a hybrid arrangement between at least two of the parties, deny interest and royalty deductions arising from 4 International Tax Alert

5 transactions such as structured transactions involving unrelated parties, as appropriate, and deny deductions where such payment is subject to inclusion in the recipient s jurisdiction under a preferential regime that reduces otherwise generally applicable statutory rates by 25% or more. revenue of $937 million over 10 for taxable years beginning after Limit the application of exceptions under subpart F for certain transactions that use reverse hybrids to create stateless income Under current law, foreign personal holding company income of a CFC does not include: (1) dividends and interest received from a related person organized under the laws of the same foreign country as the CFC if such related person has more than 50% of its assets used in a trade or business in such country (and with respect to dividends is paid out of income accrued while the CFC owned stock in the related person); and (2) rents and royalties received from a related person for the use of, or privilege of using, property in the country where the CFC is organized ( same-country exception of Section 954(c)(3)). In addition, the so called CFC look-through rule of Section 954(c)(6), which currently applies to foreign corporations with tax years beginning before 1 January 2014, provides that certain dividends, interest, rents, and royalties received from a related CFC are not foreign personal holding company income. According to the Green Book, stateless income can arise when a reverse hybrid (an entity that is treated as a corporation for US tax purposes but is fiscally transparent under the laws of a foreign jurisdiction) earns dividends, interest, rents or royalties that are not subpart F income because of the same country exception or CFC look-through rule. In addition, it is not subject to tax in the foreign jurisdiction in which the reverse hybrid is created or organized because such jurisdiction views the reverse hybrid as fiscally transparent and therefore treats the income as derived by its owners, including its US owners. The proposal would deny the Section 954(c)(3) same country exception and the Section 954(c)(6) CFC look-through rule (if extended) to payments made to foreign reverse hybrids held directly by a US owner where such amounts are considered as deductible payments received from foreign related persons. revenue of $1.34 billion over 10 for taxable years beginning after Limit the ability of domestic entities to expatriate Section 7874 generally applies to expatriation or inversions transactions, including the direct or indirect acquisition by a foreign corporation of substantially all of the trade or business properties of a domestic partnership by a foreign corporation. Under current law, if the former owners of an inverted US entity own at least 60% but less than 80% of the foreign acquiring corporation, the acquired US entity will be denied certain tax attributes for 10 years after the acquisition. If the former owners of the US entity own 80% or more of the foreign acquiring corporation, the foreign acquiring corporation will be treated as a US corporation for all US federal income tax purposes. These rules do not apply, however, if after the acquisition the expanded affiliated group that includes the foreign acquiring corporation has substantial business activities in the foreign country where the foreign acquiring corporation is created or organized, when compared to the total business activities of such group. The Green Book states that there is no policy reason to permit an inversion when the former owners of the expatriated US entity retain a controlling interest in the foreign acquiring entity, often with minimal operational changes and opportunities for substantial US tax base erosion. As a result, the Administration proposal would broaden the definition of an inversion transaction by replacing the 80% test in Section 7874 with a greaterthan 50% test and eliminating the 60% test. The Administration also proposes adding a special rule that would deem an inversion to occur International Tax Alert 5

6 regardless of the level of shareholder continuity where the expanded affiliated group that includes the foreign acquiring corporation has substantial business activities in the United States and is primarily managed and controlled in the United States. Finally, the proposal would provide that the acquisition of substantially all the assets of a US partnership constitutes an inversion transaction regardless of whether such assets constitute a trade or business. revenue of $17 billion over 10 years and is proposed to be effective for transactions completed after International tax proposals that were included in the FY2014 Budget and that have been modified in the FY2015 Budget Limit shifting of income through intangible property transfers Under current law, the transfer (or license) of intangible property to a related party is addressed by Section 482, and the transfer of such property in an outbound nonrecognition transaction is addressed by Section 367(d). Section 482 provides that the income generated from a transfer of intangible property must be commensurate with the income attributable to such property. Section 367(d) generally provides that the US transferor of such property is treated as selling the property for payments contingent on the productivity, use, or disposition of the property commensurate with the transferee s income from the property. Both sections refer to Section 936(h)(3)(B) to define intangible property. The Green Book states that, in both the Section 482 and Section 367(d) contexts, controversy often arises as to whether certain items are considered intangible property. provide that the definition of intangible property under Section 936(h)(3)(B), and therefore Sections 482 and 367(d), includes workforce in place, goodwill, and going concern value. Unlike last year s budget, the FY2015 Budget further provides that intangible property also includes 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. This year s proposal no longer describes the specified definition of intangible property as a clarification. The Green Book this year states that no inference regarding the scope of intangible property under currentlaw Section 936(h)(3)(B) is intended by the definition provided in the proposal. As in prior years, it is not clear if the proposal is intended to include just US goodwill and going concern value and continue the existing exclusions for foreign goodwill and going concern value. The proposal would permit the IRS to value the transfer of multiple intangible properties on an aggregate basis to achieve a more reliable result. It also provides that 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. revenue of $2.73 billion over 10 for tax years beginning after Remove foreign taxes from a Section 902 corporation s foreign tax pool when earnings are eliminated The Green Book notes that certain transactions result in a reduction, allocation, or elimination of a corporation s E&P other than by reason of a dividend or deemed dividend or by reason of the Section 381 carryover rules in a tax-free restructuring transaction. As examples, the Green Book refers to redemptions and certain Section 355 distributions that each can result in the reduction of the redeeming or distributing corporation s E&P, respectively. According to the Green Book, the reduction, allocation, or elimination of E&P without a corresponding reduction in the associated foreign taxes paid results in a taxpayer claiming an indirect credit under Section 902 for foreign taxes paid with respect to earnings that will no longer fund a dividend distribution for US income tax purposes. 6 International Tax Alert

7 reduce the amount of foreign taxes paid by a foreign corporation in the event a transaction results in the reduction, allocation, or elimination of a foreign corporation s E&P other than a reduction of E&P by reason of a dividend or deemed dividend or by reason of a Section 381 transaction. The amount of foreign income taxes that would be reduced in such a transaction would equal the amount of foreign taxes associated with the eliminated E&P. This year s proposal differs from last year s proposal in that this year s proposal is expanded to include transactions that result not only in the elimination but also the reduction or allocation of a foreign corporation s E&P. In addition, this year s Green Book includes a statement that no inference regarding the determination of the amount of foreign taxes deemed paid under current law is intended by the proposal. revenue of $423 million and is proposed to be effective for transactions occurring after Prevent use of leveraged distributions from related corporations to avoid dividend treatment According to the Green Book, the rules for determining whether a corporate distribution is a dividend under current law effectively permit the E&P of one corporation to be repatriated without being characterized as a dividend for tax purposes. This can be accomplished by having such corporation fund a distribution from a second, related corporation that does not have E&P, but in which the distributee shareholder has sufficient tax basis to characterize the distribution (in whole or substantial part) as a return of stock basis under the ordering rules of Section 301. The Administration proposal would modify the manner in which a distribution of property by a corporation to its shareholder is characterized in the case of certain leveraged distributions. In particular, to the extent a corporation (the funding corporation) funds a second, related corporation (the distributing corporation) with a principal purpose of avoiding dividend treatment on distributions to a shareholder, the shareholder s basis in the stock of the distributing corporation would not be taken into account for the purpose of determining the treatment of the distribution under Section 301. In effect, the distribution in such case would be treated as a dividend to the extent of the funding corporation s E&P and the remainder would be treated as gain from the sale or exchange of property pursuant to Section 301(c)(3). The proposal is similar to last year s proposal with one significant change. In this year s proposal, the reference to foreign has been removed which makes the proposal applicable to any corporation, foreign or domestic. For purposes of the proposal, the funding corporation and the distributing corporation would be considered related to the extent they are members of the same controlled group. For this purpose, controlled group would have the meaning given that term by Section 1563(a), but with the modification that the at least 80% ownership threshold would be reduced to more than 50%. Thus, the funding corporation and the distributing corporation would be related if they are members of the same Parent-Subsidiary Controlled Group as defined in Section 1563(a)(1) or the same Brother-Sister Controlled Group as defined in Section 1563(a)(2), but with the caveat that a Parent- Subsidiary Controlled Group is defined more broadly than under the consolidated return rules because the common ownership threshold would be lowered from 80% to more than 50%. The definition of funding for purposes of this proposal is very broad. Funding transactions to which the proposal would apply include capital contributions, loans, or distributions to the distributing corporation. The proposal also provides that the funding transaction may occur before or after the distribution. revenue of $3.55 billion over 10 for distributions made after International Tax Alert 7

8 Provide for reciprocal reporting of information in connection with the implementation of FATCA Under current law, the FATCA provisions require foreign financial institutions to report to the IRS certain information about foreign financial accounts of US persons, in order to avoid the imposition of a new US withholding tax. The Green Book states that the broad information exchange network relationships that the Treasury Department has established contributes to the recent success of the IRS enforcement efforts against offshore tax evasion and the success of those information exchange relationships depends on cooperation and reciprocity. The Green Book notes that intergovernmental agreements under which a foreign government agrees to provide the information required by FATCA to the IRS are necessary to overcome the obstacles to such information exchange imposed by the laws of some foreign jurisdictions. Furthermore, it notes that requiring US financial institutions to report similar information to the IRS with respect to nonresident accounts would facilitate such intergovernmental cooperation by enabling the IRS to reciprocate in appropriate circumstances by exchanging similar information with cooperative foreign governments to support their efforts to address tax evasion by their residents. Last year s Green Book did not provide an explanation of this proposal. The Green Book this year states that the proposal would require certain financial institutions to report the account balance for all financial accounts maintained at a US office and held by foreign persons. The proposal also would expand the current reporting required with respect to US source income paid to accounts held by foreign persons to include similar non-us source payments. Finally, authority to issue regulations would be granted that would require financial institutions to report the gross proceeds from the sale or redemption of property held in, or with respect to, a financial account, information with respect to financial accounts held by certain passive entities with substantial foreign owners, and such other information that the Secretary or his delegate determines is necessary to carry out the purposes of the proposal. This proposal is not estimated to impact the US fisc and is proposed to be effective for returns required to be filed after 31 December International tax proposals that are substantially similar to proposals in the FY2014 Budget Defer deduction of interest expense related to deferred income of foreign subsidiaries In general, taxpayers are permitted to deduct ordinary and necessary expenses incurred in carrying on a trade or business in accordance with Section 162. Currently, such expenses are allocated and apportioned to US- and foreignsource gross income pursuant to Section 861 for purposes of calculating a corporation s foreign tax credit limitation. As described in the Green Book, a US person that incurs interest expense properly allocable and apportionable to foreign-source income may deduct the expense even if it exceeds the taxpayer s gross foreign-source income or if the taxpayer earns no foreign-source income. The proposal would defer the deduction of interest expense that is properly allocated and apportioned to stock of a foreign corporation that exceeds an amount proportionate to the taxpayer s pro rata share of income from such subsidiaries that is currently subject to US tax. The Green Book provides that foreignsource income earned through a branch would be considered currently subject to US tax; thus the proposal would not apply to defer interest expense related to such income. In addition, other directly earned foreign source income, such as royalty income, would be similarly treated. The Administration proposal provides that the amount of interest expense allocated and apportioned to foreign-source income generally would be determined under current regulations. In addition, the Green Book states that Treasury will continue to revise existing 8 International Tax Alert

9 regulations and propose other statutory changes necessary to prevent inappropriate decreases in the amount of interest expense allocated and apportioned to foreignsource income. Interest expense that is deferred under the proposal would be deductible in a subsequent tax 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. However, the Green Book states that regulations may modify the manner in which a taxpayer can deduct previously deferred interest expenses in certain cases. revenue of $43 billion over 10 years and is proposed to be effective for tax years beginning after 31 December Determine the foreign tax credit on a pooling basis Under the proposal, the deemed paid foreign tax credit under Section 902 would be determined on a consolidated basis by aggregating the foreign taxes and earnings and profits (E&P) of all of the foreign subsidiaries with respect to which the US taxpayer can claim a deemed paid foreign tax credit (including lower tier subsidiaries described under Section 902(b)). The proposal would effectively blend the E&P and foreign taxes of these entities into a single pool, thus eliminating the identification of particular dividends with specific pools of foreign taxes on which deemed paid foreign tax credits are determined. The proposal appears not to limit or otherwise defer Section 901 taxes. Although there are few details, the proposal appears to change only the mechanics of the Section 902 calculation, but does not change, for example, the application of Section 959 (relating to ordering and distributions of previously-taxed earnings) or the gross-up for foreign taxes under Section 78. It is not clear how entities with deficits in E&P would be treated for purposes of the consolidated determination. The Green Book states that foreign taxes deferred under the proposal in prior years would be creditable in a subsequent taxable year to the extent that the amount of deemed paid foreign taxes in the current year are less than the annual limitation for that year. revenue of $74.6 billion over 10 for tax years beginning after Tax currently excess returns associated with transfers of intangibles offshore Under Section 482, in order to prevent evasion of taxes or to clearly reflect income, the Secretary is authorized to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control. The regulations under Section 482 provide that the arm s length standard is to be applied. For transfers of intangible assets, Section 482 provides that the income must be commensurate with the income attributable to the intangible assets transferred. According to the Green Book, there is evidence suggesting that transfers of intangibles to low-taxed affiliates have resulted in a significant erosion of the US tax base. The excess returns proposal is aimed at this concern. Under the proposal, if a US person transfers (directly or indirectly) an intangible asset from the United States to a related CFC, then certain excess income from transactions connected with or benefitting from the transferred intangible would be treated as subpart F income if such income is subject to a low foreign effective tax rate (ETR). Such income would be included in a separate limitation category for foreign tax credit purposes. The Green Book specifies what constitutes a low foreign effective tax rate. The proposal provides that if the foreign ETR is greater than 15%, none of the excess intangible income would be treated as subpart F income. If the foreign ETR is 15% or less and greater than 10%, the amount treated as subpart F income would be based on a sliding scale reflecting such rate, and if the International Tax Alert 9

10 foreign ETR is 10%or less, the entire amount would be treated as subpart F income. For purposes of this provision, transfers of intangibles would include transfers by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement). Excess intangible income would be defined as the excess of gross income from transactions connected with or benefitting from such intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. In this regard, the Green Book does not specify what the percentage markup would be for this purpose. revenue of $25.9 billion over 10 years and is proposed to be effective for transactions in tax years beginning after Disallow the deduction for excess non-taxed reinsurance premiums paid to affiliates deny an insurance company a deduction for reinsurance premiums paid to affiliated foreign reinsurance companies to the extent that the foreign reinsurer (or its parent company) is not subject to US income tax with respect to the premiums received. The proposal also would exclude from the insurance company s income (in the same proportion that the premium deduction was denied) any return premiums, ceding commissions, reinsurance recovered, or other amounts received with respect to reinsurance policies for which a premium deduction is wholly or partially denied. The proposal provides that a foreign corporation that is paid a premium from an affiliate that would otherwise be denied a deduction under this provision could instead elect to treat those premiums and the associated investment income as effectively connected with a US trade or business. Such income would be treated as attributable to a permanent establishment for tax treaty purposes. The proposal further provides that the reinsurance income treated as effectively connected under this elective rule would be treated as foreign source income and would be put in a separate basket for foreign tax credit purposes. revenue of $7.5 billion over 10 years and is proposed to be effective for policies issued in tax years beginning after Modify tax rules for dual capacity taxpayers tighten the foreign tax credit rules that apply to taxpayers that are subject to a foreign levy and also receive (directly or indirectly) a specific economic benefit from the levying country, i.e., dual-capacity taxpayers. Under current Treasury regulations, dual-capacity taxpayers are not permitted a foreign tax credit for the portion of the foreign levy paid for the economic benefit. If a foreign country has a generally imposed income tax, the dual capacity taxpayer may treat that portion of the foreign levy considered a generally imposed income tax as a creditable tax. The balance of the foreign levy is considered compensation for the economic benefit. If the foreign country does not generally impose an income tax, the portion of the payment that does not exceed the applicable federal tax rate applied to net income is treated as a creditable tax. Pursuant to Section 907, the amount of creditable foreign taxes imposed on foreign oil and gas income is limited in any year to the applicable US tax on that income. The FY2015 proposal would allow the taxpayer to treat as a creditable tax only the portion of a foreign levy that does not exceed the foreign levy that the taxpayer would pay if it were not a dual-capacity taxpayer. Additionally, the proposal would replace the current regulatory provisions, including the safe harbor, that apply to determine the amount of a foreign levy paid by a dualcapacity taxpayer that qualifies as a creditable tax. The proposal would convert the special foreign tax credit limitation rules of Section 907 into a separate category within Section 904 for foreign oil and gas income. The proposal would not override any US treaty obligations that allow a credit for tax paid or accrued on certain oil or gas income. 10 International Tax Alert

11 The Green Book provides that the aspect of the proposal that would determine the amount of a foreign levy paid by a dual capacity taxpayer that qualifies as a creditable tax is proposed to 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 31 December The Green Book further states that the aspect of the proposal that would convert the special foreign tax credit limitation rules of Section 907 into a separate category within Section 904 is proposed to be effective for tax years beginning after 31 December revenue of $10.4 billion over 10 years. Tax gain from the sale of a partnership interest on lookthrough basis Under current law, the sale or exchange of a partnership interest is treated as the sale or exchange of a capital asset, and gain on the sale of a capital asset by a nonresident alien individual or foreign corporation is subject to US tax only if such gain constitutes US effectively connected income (ECI). The IRS has taken the position in Revenue Ruling ( C.B. 107) that a foreign partner s gain or loss from the disposition of an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States is ECI gain or loss to the extent attributable to ECI property of the partnership and such amount is therefore subject to US tax. There is no explicit rule, however, in the Internal Revenue Code that expressly supports this position. According to the Green Book, taxpayers may take a position contrary to Revenue Ruling because of the absence of an explicit code provision treating gain from the sale of a partnership interest as US ECI. The proposal would provide that gain or loss from the sale or exchange of a partnership interest is effectively connected with the conduct of a trade or business in the United States to the extent attributable to the transferor partner s distributive share of the partnership s unrealized gain or loss that is attributable to ECI property. Thus, a nonresident individual or foreign corporate partner in a partnership engaged in a US trade or business would be required to look through to its share of the partnership s assets in determining whether any gain on the disposition of its partnership interest is subject to US tax. As a means of enforcement, the proposal would require the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange unless the transferor certified that it was not a nonresident alien individual or foreign corporation. If a transferor provided a certificate from the IRS that established that the transferor s federal income tax liability with respect to the transfer was less than 10% of the amount realized, the transferee would withhold such lesser amount. The partnership would be liable for the amount of any under-withholding and would satisfy the withholding obligation by withholding on future distributions that otherwise would go to the transferee partner. revenue of $2.8 billion over 10 years and is proposed to be effective for sales or exchanges after 31 December Extend Section 338(h)(16) to certain asset acquisitions Section 338(h)(16) generally provides that the deemed asset sale resulting from a Section 338 election is disregarded in determining the source or character of any item for purposes of the foreign tax credit rules to the seller. Thus, the deemed asset sale resulting from a Section 338 election made with respect to a qualified stock purchase is not treated as occurring for this purpose and, instead, the gain is generally treated by the seller as gain from the sale of the stock. A covered asset acquisition, as defined in Section 901(m)(2), includes a transaction with respect to which a Section 338 election has been made, but also includes other transactions that are treated as asset acquisitions for US tax purposes and acquisitions of an entity interest for foreign tax purposes. Under current law, transactions that constitute covered asset acquisitions by virtue of a Section 338 election are subject to Section 338(h)(16), but other covered asset acquisitions are not International Tax Alert 11

12 subject to the rule. According to the Green Book, the other types of covered asset acquisitions present the same foreign tax credit concerns as those addressed by Section 338(h)(16) in the case of a Section 338 election transaction. Accordingly, the Administration proposal would extend the application of Section 338(h)(16) to any covered asset acquisition within the meaning of Section 901(m)(2). revenue of $960 million over 10 years and is proposed to apply to covered asset acquisitions occurring after Provide incentives for locating jobs and business activity in the US and deny tax deductions for activity considered to involve shipping jobs overseas According to the Green Book, there are limited tax incentives for US employers to bring offshore jobs and investments into the United States under current law. The Green Book further provides that costs incurred to outsource US jobs generally are deductible for US income tax purposes. The Green Book notes that, despite the recent progress with respect to insourcing of US businesses, the Administration s goal is to create tax incentives to bring offshore jobs and investments back into the United States and to reduce the tax benefits that exist under current law for expenses incurred to move US jobs offshore. create a new general business credit against income tax equal to 20% of the eligible expenses paid or incurred in connection with insourcing a US trade or business. The Green Book provides that insourcing a US trade or business means reducing or eliminating a trade or business (or line of business) currently conducted outside the US and starting up, expanding, or otherwise moving the same trade or business within the United States, to the extent that this action results in an increase in US jobs. It further provides that while the creditable costs may be incurred by the foreign subsidiary of the US-based multinational company, the tax credit would be claimed by the US parent company. A similar benefit would be extended to nonmirror code possessions (Puerto Rico and American Samoa) through compensating payments from the US Treasury. Additionally, the Administration proposal would disallow deductions for expenses paid or incurred in connection with outsourcing a US trade or business. For purposes of this proposal, outsourcing a US trade or business means reducing or eliminating a trade or business or line of business currently conducted inside the United States and starting up, expanding, or otherwise moving the same trade or business outside the United States, to the extent that this action results in a loss of US jobs. It further adds that, in determining the subpart F income of a controlled foreign corporation, no reduction would be allowed for any expenses associated with moving a US trade or business outside the United States. Expenses paid or incurred in connection with insourcing or outsourcing a US trade or business are limited solely to expenses associated with the relocation of the trade or business and do not include capital expenditures or costs for severance pay and other assistance to displaced workers. The proposal would allow the Secretary to prescribe rules to implement the provision, including rules to determine covered expenses. The proposal is estimated to reduce revenue by $212 million over 10 for expenses paid or incurred after the date of enactment. Exempt foreign pension funds from the application of the FIRPTA provisions Under current law, gains of foreign investors from the disposition of US real property interests are generally subject to US tax under the FIRPTA provisions. Gains of US pension funds, retirement trusts, or similar arrangements whose purpose is to provide pension or retirements benefits from the disposition of US real property interests are generally exempt from US tax. The Green Book notes that a US real property interest gain of a similar pension fund created or organized outside the United States from the disposition of that same property would be subject to US tax under the FIRPTA provisions. 12 International Tax Alert

13 provide an exemption from US tax under the FIRPTA provisions for gains of foreign pension funds from the disposition of US real property interests. For this purpose, a foreign pension fund generally means a trust, corporation, or other organization or arrangement that is created or organized outside of the United States, that is generally exempt from income tax in the jurisdiction in which it is created or organized, and substantially all of the activity of which is to administer or provide pension or retirement benefits. provide the Secretary of the Treasury the authority to issue regulations necessary to carry out the purposes of the proposal, including whether for this purpose an entity or arrangement is a foreign pension fund or a benefit is a pension or retirement benefit. The proposal is estimated to reduce revenue by $2.3 billion over 10 for dispositions of US real property interests occurring after 31 December Implications The international tax proposals in the Administration s FY2015 Budget would represent dramatic changes in key elements of the US international tax regime. Many of the proposals in the Administration s Budget are substantially similar to proposals included in the FY2014 budget, but several proposals are new and several others reflect some modifications. Some of the proposals were also included in the international tax reform staff discussion draft released by former Senate Finance Committee Chairman Max Baucus (D-MT) in November In addition, the reinsurance proposal is very similar to a provision included in the comprehensive tax reform discussion draft released by House Ways and Means Committee Chairman Dave Camp (R-MI) on 26 February Several of the new international tax proposals are aimed at addressing tax base erosion concerns that are similar to the concerns that are the target of the Organization for Economic Cooperation and Development (OECD) in its base erosion and profit shifting (BEPS) project, particularly those proposals addressing hybrid entities and arrangements and the digital economy. It should be noted that there also are other proposals in the Budget that are not categorized as international tax proposals but that would have implications for cross-border transactions. Tax executives need to be familiar with these international tax proposals and how the proposals could affect their companies. The release of the Administration s Budget proposals is just the start of the process and at this stage represents only an identification of the Administration s tax priorities. However, given the significance of some of the new international tax proposals, clients should assess the business and competitive ramifications of any such changes. As lawmakers continue to work on the development of legislative approaches to tax reform, the international tax proposals contained in the Administration s Budget, which are scored as raising significant revenue in the aggregate, likely will be part of the dialogue. International Tax Alert 13

14 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC Barbara Angus Eric Oman Yuelin Lee Lisa Findlay International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Craig Hillier, Boston East Central Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Midwest Mark Muktar, Chicago Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Alberto Lopez, New York 14 International Tax Alert

15 EY Assurance Tax Transactions Advisory About EY EY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities. EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com. International Tax Services About Ernst & Young s International Tax Services practices Our dedicated international tax professionals assist our clients with their cross-border tax structuring, planning, reporting and risk management. We work with you to build proactive and truly integrated global tax strategies that address the tax risks of today s businesses and achieve sustainable growth. It s how Ernst & Young makes a difference EYGM Limited. All Rights Reserved. EYG No. CM4310 This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice. ey.com