Tax Executives Institute

Transcription

1 Tax Executives Institute Richmond, VA SEPTEMBER 27, 2011 RECENT DEVELOPMENTS IN DOMESTIC AND INTERNATIONAL CORPORATE TAX Mark J. Silverman Steptoe & Johnson LLP Washington, DC Gregory N. Kidder Steptoe & Johnson LLP Washington, DC Philip R. West Steptoe & Johnson LLP Washington, DC Amanda P. Varma Steptoe & Johnson LLP Washington, DC 2011 Steptoe & Johnson LLP

2 Table of Contents Tax Reform 3 Administration Budget Proposals 18 Stop Tax Haven Abuse Act of International Tax Loophole Closers (P.L ) 58 Container Corp. and Legislative Override 99 Economic Substance 106 Codification 107 Recent Economic Substance Cases 147 Transaction Planning 169 Tax Free Acquisitions 193 Step Transaction Issues 196 Liquidation Reincorporation 204 D Reorganizations 215 2

3 Tax Reform 3

4 Political Environment Divided party government Democrats hold the presidency and a small minority in the Senate Republicans have a majority in the House Significant number of freshmen Strong Tea Party contingent 2012 Elections Presidential election 1/3 of Senate and all of House up for reelection 4

5 Joint Select Committee on Deficit Reduction Created by the Budget Control Act of 2011 (the debt ceiling deal) Must propose $1.5 trillion in deficit reduction by November 23 Congress must vote on the recommendations by December 23 If Congress fails to pass the committee proposal, triggers will spur at least $1.2 trillion in cuts, split between domestic and defense spending 12 members Sen. Baucus (D MT); Sen. Kerry (D MA); Sen. Murray (D WA); Sen. Kyl (R AZ); Sen. Portman (R OH); Sen. Toomey (R PA); Rep. Becerra (D CA); Rep. Clyburn (D SC); Rep. Van Hollen (D MD); Rep. Camp (R MI); Rep. Hensarling (R TX); and Rep. Upton (R MI) Prospect of including tax reform? Roster does include chairmen of both tax writing committees, who would play a crucial role in tax reform But timing is short Joint Committee on Taxation has stated that it would take six months to do a revenue estimate of comprehensive tax reform Speaker Boehner: Can t rewrite the tax code in time, but can certainly lay the groundwork by then for tax reform in the future Possible that a deal could include an instruction for Congress to take up tax reform in the following year? 5

6 Tax Reform Hearings In the past year, the tax writing committees in both the House and the Senate have held hearings examining various aspects of tax reform, including: The role of taxes in business decisions; The role of tax reform in job creation; International taxation, including how other countries have reformed their international tax system and whether the current international tax rules encourage U.S. companies to compete abroad; The role of tax reform in deficit reduction; Impact of taxes on foreign direct investment; The complexity of the tax code; and Consumption taxes 6

7 Significant Issues in Tax Reform: What is the scope of Tax Reform? Close loopholes only? Raise/lower the tax rate? Base broadening/rate lowering? Corporate reform? Individual reform? 1986 style reform? Both individual and corporate reform No major international reform International tax reform? Introduce new revenue source? 7

8 Significant Issues in Tax Reform: Corporate Tax Rate Corporate rate reduction how low, and what are the trade offs? High statutory tax rate (second in the OECD only to Japan) But disagreement about effective tax rates What tax expenditures can be eliminated to get to a lower rate? Significant amount of money in individual tax expenditures, such as the mortgage interest deduction and the exclusion for employer provided health care A 2007 Treasury study concluded that if all corporate tax expenditures were eliminated, the rate could be lowered to 28%, which would still give the United States a relatively high corporate tax rate Likely corporate tax expenditure targets are accelerated depreciation, section 199 deduction Is deferral a tax expenditure? What other aspects of the corporate tax system could be considered to raise revenue? Debt/equity rules International tax rules 8

9 Significant Issues in Tax Reform: International Tax Reform The U.S. has a worldwide system under which U.S. citizens, residents, and corporations pay U.S. tax on income earned around the world. A U.S. corporation can claim credits for foreign taxes paid, which are intended to prevent double taxation. A U.S. corporation may also defer U.S. tax on its active foreign earnings (but not passive/mobile income) until those earnings are repatriated to the United States. Issues with the current system: Lock out effect Income shifting / transfer pricing Complexity Competitiveness 9

10 Significant Issues in Tax Reform: International Tax Reform Territorial / Exemption System Most U.S. trading partners have adopted a territorial system that exempts their corporations foreign earnings (other than passive/mobile income) from home country tax The UK and Japan adopted territorial systems in Main features Exemption (or near exemption) of active foreign income Full U.S. taxation of other foreign income Potential allocation and apportionment of expenses Structural issues Transfer pricing / incentive for income shifting Allocation and apportionment of expenses Transition issues Treatment of previously untaxed earnings Renegotiation of tax treaties Potential economic effects Encourage repatriation? Enhance global competitiveness of U.S. companies? Encourage shipping jobs overseas? 10

11 Significant Issues in Tax Reform: International Tax Reform End Deferral / Full Inclusion Regime Main features Full taxation of income earned by U.S. companies foreign subsidiaries (e.g., worldwide consolidation) Structural issues May require more stringent foreign tax credit limitation rules Likely easier to enforce because less incentives for aggressive transfer pricing or tax haven use Potential economic effects Make U.S. multinationals less competitive? Revenue raiser? 11

12 Significant Issues in Tax Reform: International Tax Reform Country Tax Rate 1 Current International Tax System Japan 41% 95% exemption United States 39% Worldwide with deferral and FTC France 34% 95% exemption Germany 33% 95% exemption Italy 30% 95% exemption United Kingdom 28% 100% exemption Netherlands 25% 100% exemption China 25% Worldwide with deferral and FTC Switzerland 24% 100% exemption Korea 22% Worldwide with deferral and FTC 1 combined (federal and subnational) top statutory tax rate 12

13 Significant Issues in Tax Reform: Choice of Entity More than half of U.S. business is conducted by flow through entities (e.g., S corporations, partnerships, sole proprietorships) Income is taxed at the individual level, while income earned by incorporated entities is subject to tax at the corporate level and then again when distributed to shareholders Is it good tax policy for businesses of similar size and engaged in similar activities to face different tax regimes and different tax rates? Could require firms with certain corporate characteristics (e.g., publicly traded businesses, businesses with income or assets above a certain level, etc.) to pay the corporate income tax But concern about decreasing investment in non corporate businesses Could integrate the corporate tax with the individual income tax to ameliorate double taxation of corporate earnings Lowering the corporate tax rate while keeping the same or raising the individual tax rate may be viewed as hurting small businesses (which are more likely to be flow through) at the expense of big business 13

14 Significant Issues in Tax Reform: Revenue Will tax reform be: Revenue neutral Revenue negative Revenue positive? 14

15 Comparison of Selected Tax Reform Proposals President's National Commission on Fiscal Responsibility and Reform (Bowles Simpson) Illustrative Plan Ryan Roadmap for America's Future Objective Deficit reduction/tax and entitlement reform Tax and entitlement reform Corporate tax rate Lowers corporate tax rate to 28% Corporate income tax repealed; Business tax Eliminates all corporate tax expenditures creates an 8.5% business expenditures consumption tax on goods and services using the subtraction method (liability is total salestotal purchases * 8.5%) Wyden Coats Bipartisan Tax Fairness and Simplification Act Tax reform Lowers corporate tax rate to 24% Reductions in many corporate tax expenditures, including accelerated depreciation and section 199 deduction; limits deductibility of interest by removing value of inflation; makes research credit permanent; directs CBO to identify additional corporate welfare cuts International taxation Territorial system, current taxation of passive foreign income retained, other details not specified Repeals tax deferral for foreign earnings; reinstitutes per country foreign tax credit Individual tax rates Three individual tax brackets of 12%, 22% and 28% Capital gains and dividends Individual tax expenditures Taxed as ordinary income Eliminates or limits most tax expenditures except for the EITC, child tax credit, reformed home mortgage deduction, charitable deduction, employer provided health insurance exclusion Two individual tax brackets of 10% and 25%; eliminates AMT Zero tax rate applied to interest, capital gains and dividends Eliminates all tax expenditures; creates standard deduction of $25,000 for joint filers and $12,500 for single filers Three individual tax brackets of 15%, 25% and 35%; eliminates AMT 35% exclusion for dividends and capital gains Triples standard deduction; retains most credits and deductions, such as deductions for home mortgage interest and charitable donations, EITC and child tax credit 15

16 Obama Administration and Tax Reform On September 19, the Obama Administration released a deficit reduction plan that included both specific tax changes to be made in the short term and tax reform principles that should be considered as part of the longer project of comprehensive tax reform. The Administration states in its deficit reduction plan that the specific tax loophole closers and measures to broaden the tax base offered should begin the national conversation about tax reform. The Administration states that tax reform should draw on the specific items, but that if the Joint Select Committee on Deficit Reduction is unable to undertake comprehensive reform, the measures should be enacted on a standalone basis. 16

17 Obama Administration and Tax Reform Principles for Tax Reform: Lower tax rates for both individuals and corporations Cut inefficient and unfair tax breaks so that the American people and businesses spend less time and less money each year filing taxes and cannot avoid their responsibility by gaming the system Cut the deficit by $1.5 trillion through tax reform, including letting expire the lower rates for single taxpayers making over $200,000 and married couples making over $250,000 Increase job creation and growth in the United States Observe the Buffett Rule No household making over $1 million annually should pay a smaller share of its income in taxes than middle class families pay 17

18 Budget Proposals included in Deficit Reduction Plan 18

19 Defer Deduction of Interest Expense Related to Deferred Income Current law: U.S. businesses may deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business Proposal: U.S. businesses must defer the deduction of interest expense properly allocated and apportioned to foreign source income that is not currently subject to U.S. tax. According to the General Explanations of the Administration s Fiscal Year 2012 Revenue Proposals (the Greenbook ), deferred interest expense would be deductible in a subsequent tax year in proportion to the amount of the previously deferred foreign source income that is subject to U.S. tax during that subsequent year. The amount of a taxpayer s interest expense that is properly allocated and apportioned to foreign source income would generally be determined under current Treasury regulations, but, according to the FY 2012 Greenbook, the Treasury Department will revise existing Treasury regulations and propose such other statutory changes as necessary to prevent inappropriate decreases in the amount of interest expense that is allocated and apportioned to foreign source income. History of Proposal: Included in Administration FY 2012 and 2011 budget proposals FY 2010 budget proposed requiring U.S. businesses to defer the deduction of all expenses (except R&D expenses) allocated to foreign source income not currently subject to U.S. tax Rep. Rangel s 2007 tax reform bill, the Tax Reduction and Reform Act of 2007 (H.R. 3970) also would have required U.S. companies to defer deductions associated with deferred foreign income 19

20 Determine Foreign Tax Credit on Pooling Basis Current Law: A domestic corporation is deemed to have paid the foreign taxes paid by certain foreign subsidiaries from which it receives a dividend. Proposal: A U.S. taxpayer would determine its deemed paid foreign tax credit by determining the aggregate foreign taxes and earnings and profits of all the foreign subsidiaries with respect to which the U.S. taxpayer can claim a deemed paid foreign tax credit. The deemed paid foreign tax credit would be determined based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the United States in that year. History of Proposal Included in Obama Administration FY 2010, 2011, and 2012 revenue proposals 20

21 Determine Foreign Tax Credit on Pooling Basis: Effect on Planning Cross crediting Achieving the lowest overall U.S. tax rate, by using excess credits from taxes imposed by high tax jurisdictions to offset U.S. tax on income repatriated from low tax jurisdictions Selective repatriation Repatriating amounts that carry high foreign tax credits while deferring inclusion of untaxed or low taxed earnings, or repatriating high taxed and low taxed income so as to balance excess credits from the former with excess limitation from the latter 21

22 Determine Foreign Tax Credit on Pooling Basis: Effect on Planning Current law: Under Obama proposal: Dividend with high-income indirect credits US Co CFC 1 CFC 2 Dividend with low-income indirect credits US Co CFC 1 CFC 2 Indirect credit would be determined based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the United States in that year. High-tax Low-tax High-tax Low-tax 22

23 Tax Currently Excess Returns Associated with Transfers of Intangibles Offshore Current Law: In the case of transfers of intangible assets, section 482 provides that the income with respect to the transaction must be commensurate with the income attributable to the transferred intangible. Proposal: If a U.S. person transfers an intangible from the United States to a related CFC that is subject to a low foreign effective tax rate in circumstances that evidence excessive income shifting, then an amount equal to the excessive return would be treated as subpart F income (in a separate foreign tax credit limitation basket). In prior proposals, for purposes of conducting a revenue estimate, the assumed low foreign effective tax rate was 10% and an excessive return was assumed to be a 30% rate of return on the relevant assets. History of Proposal Included in Obama Administration FY 2011 and 2012 revenue proposals 23

24 Limit Shifting of Income Through Intangible Property Transfers Current Law: Sections 482 and 367(d) reference section 936(h)(3)(B) for the definition of intangible property. Section 936(h)(3)(B) provides: The term intangible property means any patent, invention, formula, process, design, pattern, or know how; copyright, literary, musical, or artistic composition; trademark, trade name, or brand name; franchise, license, or contract; method, program, system, procedure, campaign, survey, study, forecast, estimate, customer list, or technical data; or any similar item; which has substantial value independent of the services of any individual. 24

25 Limit Shifting of Income Through Intangible Property Transfers Proposal: Clarify the definition of intangible property to clearly include workforce in place, goodwill, and going concern value The proposal would also clarify valuation issues: In a transfer of multiple intangible properties, the IRS may value the intangibles on an aggregate basis where that achieves a more reliable result. In valuing intangible property, the Commissioner may take into account the prices or profits that could have been realized by the taxpayer if it chose a realistic alternative to the controlled transaction (e.g., if the taxpayer itself exploited the intangible). Treatment of foreign goodwill under current law and under the proposal? History of Proposal Included in Obama Administration FY 2010, 2011, and 2012 revenue proposals 25

26 Limit Earnings Stripping by Expatriated Entities Current Law: Section 163(j) limits the deductibility of interest paid by a corporation to a related person unless (1) the corporation s debt to equity ratio does not exceed 1.5 to 1, or (2) the corporation s net interest expense does not exceed 50% of adjusted taxable income. Proposal: With respect to expatriated entities only: The debt to equity safe harbor would be eliminated; and The 50% adjusted taxable income threshold would be reduced to 25%. History of Proposal Included in Obama Administration FY 2010, 2011, and 2012 revenue proposals 26

27 Current Law Carried Interest Proposal Partners who receive partnership interests in exchange for services may receive interests in future partnership profits, i.e., a profits or carried interest. A partnership is not subject to federal income tax, and an item of income or loss of the partnership retains its character and flows through to the partners, who include the item on their tax returns. Consequently, to the extent a partnership recognizes long term capital gain, partners who provide services reflect their shares of such gain as long term capital gain. Allowing service partners to receive capital gains treatment is viewed by some policymakers as creating an unfair and inefficient tax preference. The increased activity among large private equity firms and hedge funds has increased the cost of this preference. Thus, a service provider s share of the income of a partnership attributable to a carried interest should be taxed as ordinary income and subject to self employment tax because the income is derived from the performance of services. 27

28 Carried Interest Proposal Proposal The proposal would tax as ordinary income a partner s share of income on an investment services partnership interest (ISPI) in an investment partnership, regardless of the character of the income at the partnership level. Gain recognized on the sale of an ISPI would generally be taxed as ordinary income, not capital gain. Under the proposal, an ISPI is defined as a carried interest in an investment partnership that is held by a person who provides services to the partnership. A partnership is an investment partnership if the majority of its assets are investment type assets, but only if over half of the partnership's contributed capital is from partners in whose hands the interests constitute property held for the production of income. To the extent that a partner who holds an ISPI contributes invested capital and the partnership reasonably allocates its income and loss between such invested capital and the remaining interest, income attributable to the invested capital would not be recharacterized. A similar rule would apply to the portion of any gain recognized on the sale of an ISPI that is attributable to the invested capital. Invested capital is defined as money or other property contributed to the partnership, although contributed capital that is attributable to the proceeds of any loan or other advance made or guaranteed by any partner or the partnership is not treated as invested capital. The proposal also includes an anti abuse rule that applies to any person who performs services for an entity and holds a disqualified interest. A disqualified interest is defined as convertible or contingent debt, an option, or any derivative instrument with respect to the entity (but does not include a partnership interest or stock in certain taxable corporations). If the anti abuse rule applies, the person is subject to ordinary income tax rates on any income or gain received with respect to the interest. The proposal would be effective for taxable years beginning after December 31,

29 Carried Interest Proposal Proposal The Administration s carried interest proposal appears to take an approach similar to recent congressional proposals but with an additional requirement aimed at some of the overbreadth issues in those proposals. Recent carried interest proposals in Congress had the potential to capture corporate joint ventures, including joint ventures that involved operating businesses. See, e.g., Job Creation and Tax Cuts Act of 2010, S The additional requirement in the Administration s budget proposal is that, in order for a partnership to constitute an "investment partnership," over half of the partnership's contributed capital must be from partners in whose hands the partnership interests constitute property held for the production of income (i.e., held as an investment asset rather than as a trade or business asset). However, it is not entirely clear what this additional requirement adds. Presumably, this additional requirement is intended to exclude from carried interest treatment interests in partnerships conducting a trade or business (as opposed to investment management operations). This may exclude corporate joint ventures involving operating businesses. However, it seems the additional requirement would not exclude corporate joint ventures involving investment activities. 29

30 Proposal Carried Interest Proposal Job Creation and Tax Cuts Act of 2010 The bill would have enacted new section 710, which is generally intended to treat net income from an investment services partnership interest ( ISPI ) as ordinary income, regardless of the character of the income at the partnership level, except to the extent it is attributable to a return on invested capital. An ISPI is a partnership interest held by any person if it was reasonably expected (at the time the person acquired the partnership interest) that the person would provide, or already has provided, a substantial quantity of certain services with respect to specified assets held by the partnership. Such services include (i) advising as to the advisability of investing in, purchasing, or selling any specified asset, (ii) managing, acquiring, or disposing of any specified asset, (iii) arranging financing with respect to acquiring specified assets, and (iv) any activity in support of any of the foregoing services. For this purpose, specified assets include (i) securities, (ii) real estate held for rental or investment, (iii) interests in partnerships, (iv) commodities, or (v) options or derivative contracts with respect to such securities, real estate, partnership interests, or commodities. The provision provides a narrow exception for items of income, gain, loss, and deduction that are allocated to the portion of an ISPI that is a qualified capital interest. This exception is intended to apply to capital invested in the partnership by the service provider if the investment is made on the same terms as investments of capital by partners not providing services. The exception for qualified capital interests is only applicable if: (i) items are allocated to the service providing partner s qualified capital interest in the same manner as the items are allocated to other qualified capital interests of partners that do not provide any of the identified investment management services and that are not related to the service providing partner, and (ii) the allocations made to the qualified capital interests of unrelated nonservice providing partners are significant compared to the allocations made to the service partner s qualified capital interest. An additional, but equally narrow, exception is contained in the most recent Senate amendment if all distributions and allocations of a partnership are made pro rata based on capital. 30

31 Proposal (cont d) Carried Interest Proposal Job Creation and Tax Cuts Act of 2010 The operative rules of section 710 extend beyond the recharacterization of income as ordinary. Gain on the disposition of an ISPI is treated as ordinary income and is generally recognized notwithstanding any other non recognition provision provided in the Code. Ordinary income is generally triggered on the distribution of property to a holder of an ISPI. Although losses would be ordinary to the extent of aggregate net income, losses in excess of such income would be deferred until a future allocation of income (or a sale or redemption of the ISPI). Some of the rules applicable to ISPIs can also apply if (i) a person performs investment management services for any entity in which such person holds a disqualified interest, and (ii) the value of the interest is substantially related to the amount of income or gain from the assets with respect to which the investment management services are performed. A disqualified interest means (i) any interest in such entity other than indebtedness, (ii) convertible or contingent debt of such entity, (iii) any option or other right to acquire property described above, and (iv) any derivative instrument entered into with such entity or any investor in such entity. A disqualified interest generally does not include a partnership interest or an interest in a corporation. With respect to individual taxpayers, the general rule recharacterizing income and loss as ordinary applies only to the applicable percentage of the net income or net loss. Under the most recent House passed bill, the applicable percentage would initially be 50 percent, but would increase to 75 percent for taxable years beginning after December 31, Under the most recent Senate amendment, the applicable percentage would be 75 percent. However, the applicable percentage is reduced to 50 percent for carried interests that are attributable to the sale of assets held for 5 or more years. The provision provides the Secretary with authority to issue regulations or other guidance as is necessary or appropriate to carry out the purposes of new section 710. The provision was estimated to raise $ billion over 10 years. 31

32 Analysis of Carried Interest Proposal in Job Creation and Tax Cuts Act of 2010 Proposal would apply beyond the classic carry business structure Does not require managing other people s money Not just to individuals Corporations and partnerships Across all industries Expansive application results from: Broad definition of ISPI Narrow exception for Qualified Capital Interests (QCIs) Inclusion of Disqualified Interests 32

33 Investment Services Partnership Interest (ISPI) Definition: any interest in a partnership which is held (directly or indirectly) by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any listed services with respect to the assets held by the partnership 33

34 Definition of ISPI is broad Specified assets Securities, including stock, certain partnership interests, notes, bonds, other debts Real estate held for rental or investment Partnership interests Commodities Options Derivative contracts No de minimis rule for size of holdings Listed services Advising on purchasing or selling specified assets Managing, acquiring, or disposing of specified assets Arranging financing regarding specified assets Reasonably expected that services would be provided at the time partnership interest is acquired Change in services provided can cause an interest to become an ISPI Performance of a substantial quantity of listed services Services can be provided directly with respect to specified assets or indirectly with respect to operating businesses of entities owned by such partnership 34

35 Potential ISPIs in ordinary course business structures Non service providers Services of related persons taint non service providers A partnership solely among members that holds a specified asset if any related party provides a substantial quantity of listed services Tiered structures Lower tier partnership (LTP) treated as a specified asset (of the upper tier partnership) even if LTP holds no specified assets Subsidiary stock treated as a specified asset Partners of operating joint ventures Certain corporate structures with no partnerships 35

36 Tiered structure S1 P S2 P, S1 and S2 are members of a consolidated group PRS s only asset is the stock of OpCo OpCo is a manufacturing company All the officers and directors in OpCo are also the officers and directors of PRS, S1 and S2 PRS OpCo 36

37 Partners of operating joint ventures Corp A Corp B Corp A and Corp B enter into an arrangement to jointly develop technology which is treated as a partnership for federal tax purposes Corp A and Corp B will both be involved in managing the operation of the PRS business PRS Business OpCo 37

38 Qualified capital interest (QCI) exception is narrow QCI generally the portion of an ISPI attributable to cash and property contributions and undistributed net income/gain allocations QCI is not always usable Applies only if allocations attributable to the ISPI holder s QCI are made in the same manner as allocations to other QCI partners: Who do not provide any services Who are not related to the ISPI holder and Whose allocations are significant relative to the allocations made to the ISPI holder s QCI An ISPI is not a QCI if the ISPI holder s capital interest is acquired with proceeds from a loan made, or guaranteed, by another partner or the partnership (or a person related to another partner or the partnership) 38

39 QCI Exception No help without a non service provider Corp A Corp B Corp A and Corp B enter into an arrangement to jointly develop technology which is treated as a partnership for federal tax purposes Corp A and Corp B will both be involved in managing the operation of the PRS business PRS OpCo 39

40 QCI Exception No help for controlled group partnership P S2 is involved in managing the OpCo business S1 S2 PRS Listed Services OpCo 40

41 Consequences relevant to corporations Limits allowable net losses to the extent of post enactment net income Most nonrecognition transfers are taxed Includes pre enactment appreciation Limited exception available for transfers to partnerships, and partnership mergers, divisions and technical terminations Recharacterizes certain amounts of non ordinary items as ordinary items Significant penalties for avoidance transactions 41

42 Loss limitation / suspension S1 P S2 P, S1 and S2 are members of a consolidated group Assume S1 s and S2 s interests in PRS are ISPIs For the year ending 12/31/2010 PRS has $200 of loss PRS Specified Assets 42

43 Nonrecognition transfers are taxed Section 351 transfers S1 P S2 S2 contributes its PRS interest to Newco in a transaction qualifying under Section 351 At the time of the contribution the fair market value of S2 s interest in PRS exceeds its basis PRS Newco PRS 43

44 Tax free acquisition of target P Merger T Other Partner T merges into P with P surviving PRS At the time of the merger, the FMV of T s interest in PRS exceeds its basis therein OpCo 44

45 Recent Budget Proposals Not Included in Deficit Reduction Plan 45

46 Repeal of Boot Within Gain Limitation Current Law In general, gain or loss is not recognized with respect to exchanges of stock and securities in corporate reorganizations. Under section 356, a recipient of money or other property ( boot ) in a tax free reorganization recognizes gain (if any) on the transaction in an amount not in excess of the sum of such money and the fair market value of such other property. Under section 356(a)(2), if the exchange has the effect of the distribution of a dividend, then all or part of the gain recognized by the exchanging shareholder is treated as a dividend to the extent of the shareholder s ratable share of the corporation s E&P. The remainder of the gain (if any) is treated as gain from the exchange of property. Accordingly, if a shareholder receives boot in connection with a corporate reorganization, the amount that the shareholder is required to recognize as income is limited to the amount of gain realized in the exchange (i.e., the boot within gain limitation). This rule applies regardless of whether the property received would otherwise be considered to be a dividend for tax purposes. 46

47 Repeal of Boot Within Gain Limitation Liquidation (2) U.S. Parent Example of Perceived Abuse CFC1 CFC1 Assets Cash In cross border transactions, U.S. shareholders can utilize the boot within gain limitation to repatriate previously untaxed earnings and profits of foreign subsidiaries with minimal U.S. tax consequences. The above transaction should be treated as a valid D reorganization. See Treas. Reg (l). (1) CFC2 U.S. Parent will recognize gain under Section 356 on the lesser of (i) the cash it receives in the liquidation of CFC1 and (ii) its gain in its CFC1 stock. If U.S. Parent s stock in CFC1 has little or no built in gain, U.S. Parent will recognize little or no gain. This is the result regardless of whether the boot is potentially taxable as a dividend or as capital gain under Section 356. This is the result even if CFC2 has previously untaxed earnings and profits equal to or greater than the boot. 47

48 Repeal of Boot Within Gain Limitation Proposal The proposal would repeal the boot within gain limitation in the case of any reorganization transaction (domestic or cross border) if the exchange has the effect of the distribution of a dividend, as determined under section 356(a)(2). The amount of money or other property distributed would generally be treated as a dividend to the extent of the corporation s E&P. The proposal would be effective for taxable years beginning after December 31,

49 Repeal of Nonqualified Preferred Stock Provision Current Law In 1997, Congress added section 351(g), which treats nonqualified preferred stock as taxable boot in corporate organizations and in certain shareholder exchanges relating to a corporate reorganization. Nonqualified preferred stock is stock that (i) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent; and (ii) has a dividend rate that varies with reference to an index, or, in certain circumstances, a put right, a call right, or a mandatory redemption feature. Proposal According to Treasury s explanation of the Administration s proposal, nonqualified preferred stock has become a staple of affirmative corporate tax planning due to its hybrid nature. Treasury states that the issuance of nonqualified preferred stock often occurs in lossrecognition planning, where nonqualified preferred stock is treated as debt like boot, or to avoid the application of a provision that treats a related party stock sale as a dividend. The proposal would repeal section 351(g) and other cross referencing provisions that treat nonqualified preferred stock as boot. The proposal would be effective for stock issued after December 31,

50 Use of Nonqualified Preferred Stock Example 1 Shareholders T Stock $60 cash $40 P NQ P/S T Merger P Facts: T merges into P. In connection with the merger, T s shareholders receive $60 cash and $40 of P nonqualified preferred stock in exchange for their T stock. Result: Can there be a tax-free reorganization? What is the result for T s shareholders? 50

51 Use of Nonqualified Preferred Stock Example 2 T Shareholders P Shareholders T C/S $60 cash P C/S T C/S $40 T NQ P/S T Merger P Facts: P merges into T. In connection with the merger, T s shareholders exchange their T common stock for $60 cash and $40 of T nonqualified preferred stock. P s shareholders exchange their P common stock for T common stock. Result: Can there be a tax-free reorganization? What is the result for T s shareholders? 51

52 Stop Tax Haven Abuse Act of

53 Stop Tax Haven Abuse Act of 2011 Senator Carl Levin (D MI) has introduced a version of this bill in the past three Congresses. The current version (S. 1346) is substantially similar to prior versions, removing provisions that were enacted in some form in other bills and a black list of offshore secrecy jurisdictions and adding provisions to strengthen FATCA and require additional SEC reporting of company financial information on a country by country basis. 53

54 Stop Tax Haven Abuse Act of 2011 In sum, the bill would: Authorize the Treasury Secretary to take special measures against foreign jurisdictions or financial institutions that "impede US tax enforcement," including allowing Treasury to instruct US financial institutions not to authorize credit card transactions involving a designated foreign jurisdiction or financial institution. Strengthen FATCA, including by expanding the types of accounts that must be reported, clarifying that withholding agents must take into account information obtained under anti money laundering, anti corruption, or similar obligations in determining whether an account is directly or indirectly owned by a US person, and allowing the IRS to disclose account information reported under FATCA to federal law enforcement agencies. Create rebuttable presumptions that would presume U.S. taxpayer control of offshore entities that they form or do business with, unless the taxpayer presents clear and convincing evidence to the contrary. Treat corporations whose management and control are located primarily in the United States as domestic corporations for tax purposes. Treat credit default swap ("CDS") payments sent offshore from the United States as taxable U.S. source income. 54

55 Stop Tax Haven Abuse Act of 2011 In sum, the bill would: Deem US dollars and other assets kept offshore by foreign subsidiaries of US corporations and that are deposited into accounts physically located in the United States (e.g., correspondent accounts) as taxable distributions by the foreign subsidiaries to their US parents. Require multinational corporations to include information on a country by country basis in their filings with the Securities and Exchange Commission Strengthen the IRS s ability to use John Doe summons to uncover taxpayers operating in offshore jurisdictions, including allowing a court to presume that a summons involving a class of accounts at an institution that has not entered into a FATCA agreement with the IRS raises tax compliance issues Prohibit tax practitioners from charging fees calculated according to tax savings. Strengthen the Circular 230 tax practitioner standards by instructing Treasury to impose standards applicable to written advice with respect to any listed transaction or plan "which has a potential for tax avoidance or evasion." Strengthen penalties on tax shelter promoters by increasing the maximum penalty to 150% of gross income derived from the relevant activity 55

56 Stop Tax Haven Abuse Act of 2011 Managed and Controlled Provision Would amend Section 7701 of the Code to treat a foreign corporation as a domestic corporation if: The corporation is either publicly traded or has $50 million or more in aggregate gross assets at any time during the tax year or any preceding tax year; and The gross assets test would not apply to a controlled foreign corporation if the U.S. parent corporation has substantial assets (other than cash, cash equivalents, and stock of foreign subsidiaries) held for use in the active conduct of a trade or business in the United States. The management and control of the corporation occurs primarily in the United States. Treasury would have authority to prescribe regulations for determining when management and control is treated as occurring primarily within the United States, including providing the following: Management and control would be treated as occurring primarily within the United States if the executive officers and senior management of the corporation who exercise day to day responsibility for making decisions involving strategic, financial, and operational policies of the corporation are located primarily within the United States; Individuals who are not executive officers and members of senior management of the corporation (including individuals who are officers or employees of other corporations in the same chain of corporations as the corporation being evaluated) would be treated as executive officers and senior management if such individuals conduct the day to day activities described above; and Management and control of a corporation would be treated as occurring primarily in the United States if the assets of such corporation (directly or indirectly) consist primarily of assets being managed on behalf of investors and decisions about how to invest the assets are made in the United States. This provision would apply to tax years beginning on or after the date that is two years after the date of enactment. 56

57 Stop Tax Haven Abuse Act of 2011 Additional SEC Financial Statement Reporting Provision According to Senator Levin, the provision would "increase transparency and facilitate IRS inquiries into transfer pricing, foreign tax credits, and abusive offshore tax shelters." Under the provision, the SEC would issue rules to require a company issuing financial statements (the "issuer") to include information "indicative of financial performance" on a country by country basis. Required reporting would include a list of each country of operation; the country of operation of each member of the issuer group (i.e., the issuer, each subsidiary of the issuer, and each entity under the control of the issuer); the financial performance of each member of the issuer group in each country of operation; and the tax paid by each member of the issuer group in each country of operation. The financial performance of each member of the issuer group would include the following: Total number of employees physically working in the country of operation; Total sales to third parties and to other members of the issuer group; Total purchases from third parties and from other members of the issuer group; Total amount of financing payments made to third parties and to other members of the issuer group; Pre tax gross revenues; Pre tax net revenues; and Any other information the SEC may determine as indicative of the financial performance of the issuer group. This provision would be effective no later than the date on which the issuer must file with the SEC its first annual report that is due no later than one year after the date the SEC issues final rules under this provision. 57

58 International Tax Loophole Closers P.L

59 International Tax Loophole Closers P.L (officially the Act of ) contains several international tax related provisions to offset education and Medicaid spending: Rules to Prevent Splitting of Foreign Tax Credits Denial of Certain Foreign Tax Credits for Covered Asset Acquisitions Separate Foreign Tax Credit Limitation for Certain Items Resourced Under Treaties Limitation on Foreign Taxes Deemed Paid with Respect to Section 956 Inclusions Special Rule with Respect to Certain Redemptions by Foreign Subsidiaries Modification of Affiliation Rules for Purposes of Rules Allocating Interest Expense Modification of 80/20 Rules Limitation on Extension of Statute of Limitations for Failure to Report Certain Foreign Transfers 59

60 Rules to Prevent Splitting of Foreign Tax Credits Current law generally treats foreign taxes as being paid by the person on whom foreign law imposes legal liability (the technical taxpayer rule). In some cases, the person who has legal liability for a foreign tax may be different than the person who realizes the underlying income under U.S. tax principles. As a result, foreign taxes may be separated or split from the foreign income to which the taxes relate. E.g., Guardian Industries structure in which a foreign consolidated rule treats the consolidated parent as the party solely responsible for the taxes of the group and the consolidated parent is thus the technical taxpayer. Hybrid and reverse hybrid structures and hybrid instruments may also cause splitting of foreign income from taxes. 60

61 Rules to Prevent Splitting of Foreign Tax Credits: Guardian Industries Example See Guardian Industries v. United States, 77 F.3d 1368 (Fed. Cir. 2007), aff g 65 Fed Cl. 50 (2003). Guardian (U.S.) IHC (U.S.) GIE (Lux) Legally liable for the foreign taxes paid on the subsidiaries income under Luxembourg law (so entitled to a foreign tax credit for taxes paid on the subsidiaries income). As a result, in this structure, if the operating subsidiaries do not generate subpart F income or distribute dividends to the holding company, the U.S. holding company is entitled to foreign tax credits on foreign income not subject to U.S. tax. Lux Subsidiaries Lux Subsidiaries Lux Subsidiaries 61

62 Rules to Prevent Splitting of Foreign Tax Credits: New Provision The new law (new section 909) creates a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income. In general, where there is a foreign tax credit splitting event with respect to foreign income tax paid or accrued by the taxpayer, the foreign income tax is not taken into account for U.S. tax purposes before the taxable year in which the related income is taken into account by the taxpayer. Rule also applies for indirect credits. 62

63 Rules to Prevent Splitting of Foreign Tax Credits: New Provision A foreign tax credit splitting event arises with respect to a foreign income tax if the related income is (or will be) taken into account for U.S. tax purposes by a covered person. A covered person is: Any entity in which the payor holds, directly or indirectly, at least a 10% ownership interest (determined by vote or value); Any person that holds, directly or indirectly, at least a 10% ownership interest (by vote or value) in the payor; Any person that bears a relationship to the payor described in section 267(b) or 707(b); and Any other person specified by the Secretary. Effective Date: Applies to foreign income taxes paid or accrued after May 20,

64 Rules to Prevent Splitting of Foreign Tax Credits: Example Under New Provision US Co, a domestic corporation, wholly owns CFC 1. CFC 1 is organized in Country A and is treated as a pass through entity for Country A purposes. CFC 1 is treated as a corporation for U.S. tax purposes. CFC 1 is engaged in an active business that generates $100 of income. Country A has a 30% tax rate. For Country A tax purposes, CFC s earnings pass to US Co. Under Country A law, US Co is treated as having paid $30 of Country A tax. Under the old law, the United States views CFC 1 as having $100 of E&P not subject to current U.S. tax and US Co as having $30 of foreign taxes for which US Co may claim a direct foreign tax credit. Under the new law, the $30 direct foreign tax credit is suspended until the related income is recognized for U.S. tax purposes. CFC 1 must distribute its net income of $100 to US Co to release the $30 direct foreign tax credit. US Co CFC 1 $50 Tax $100 E&P 64

65 Rules to Prevent Splitting of Foreign Tax Credits: Example Under New Provision US Co wholly owns CFC 1, a Country A corporation. CFC 1 wholly owns CFC 2, also a Country A corporation. CFC 2 is engaged in an active business that generates $100 of income. CFC 2 issues a hybrid instrument to CFC 1. This instrument is equity for U.S. tax purposes. The instrument is debt for Country A tax purposes. CFC 2 accrues (but does not pay currently) interest to CFC 1 equal to $100. CFC 2 has no income for Country A purposes. CFC 1 has $100 of income, which is subject to Country A tax at a 30% rate. For U.S. tax purposes, CFC 2 still has $100 of E&P (the interest is ignored), while CFC 1 has paid $30 of foreign taxes. Under the new matching rule, the related income with regard to the $30 of foreign taxes paid by CFC 1 is the $100 of E&P of CFC 2 and US Co will not be entitled to the $30 foreign tax credit until it takes the related $100 of income into account for U.S. tax purposes. US Co CFC 1 CFC 2 Hybrid Instrument CFC 2 accrues (but does not pay currently) interest to CFC 1 equal to $100 65

66 Other Situations Affected by Splitter Provision? Disregarded Payments Group Relief Liquidation of Person Who Pays or Accrues the Foreign Income Tax Transfer Pricing Adjustments? Contributions of Inventory Resulting in Shift of Deductions? Differences in the Timing of When Income is Taken into Account for U.S. and Foreign Tax Purposes? 66

67 Other Situations Affected by Splitter Provision? Potential for Guidance The statute grants authority to issue guidance necessary or appropriate to carry out the purposes of the provision. According to the JCT Technical Explanation of the new law, [s]uch guidance may include providing successor rules addressing circumstances such as where, with respect to a foreign tax credit splitting event, the person who pays or accrues the foreign income tax or any covered person is liquidated It is anticipated that the Secretary may also provide guidance as to the proper application of the provision in cases involving disregarded payments, group relief, or other arrangements having a similar effect. The JCT Technical Explanation also states: For purposes of determining related income, the Secretary may provide rules on the treatment of losses, deficits in earnings and profits, and certain timing differences between U.S. and foreign law. Moreover, it is not intended that differences in the timing of when income is taken into account for U.S. and foreign tax purposes (e.g., as a result of differences in the U.S. and foreign tax accounting rules) should crate a foreign tax credit splitting event in cases in which the same taxable person pays the foreign tax and takes into account the related income, but in different taxable period. 67