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1 Number 584 April 4, 2007 Client Alert Latham & Watkins Tax Department Cross-Border Financings: US Tax Authorities Target Structured Finance Arbitrage and Double Dip Losses There are three categories of Structured Passive Investment Arrangements targeted under the new rules: (i) US borrower transactions, (ii) US lender transactions, and (iii) asset holding transactions. In late March 2007, the US Treasury and IRS issued two major sets of rules 1 which have significant implications for crossborder financing structures utilized by US and non-us based multinational corporations, commercial and investment banks and private equity and venture capital funds. Although the rules are not immediately effective, 2 their issuance requires a review and, in certain cases, reconsideration of a number of cross-border financing structures. Structured Finance: Foreign Tax Credit Arbitrage The US has a complex foreign tax credit system, generally designed to prevent US investors and corporations from incurring double taxation on foreign earnings. For several years, government policymakers have expressed concern about structures designed to (i) separate a foreign tax credit from the underlying earnings to which the foreign tax is attributable, or (ii) generate credits using a structured financing transaction, by rearranging the form of what would otherwise be ordinary course lending transactions or portfolio investments. The government has attacked the first category of transactions, most recently with a set of proposed regulations issued in August The proposed rules issued March 29 of this year target the second category of transactions. In the new rules, Treasury and the IRS state that: [we] have become aware that certain US taxpayers are engaging in highly structured transactions with foreign counterparties in order to generate foreign tax credits. These transactions are intentionally structured to create a foreign tax liability when, removed from the elaborately engineered structure, the basic underlying business transaction generally would result in significantly less, or even no, foreign taxes. In particular, the transactions purport to convert what would otherwise be an ordinary course financing arrangement between a US person and a foreign counterparty, or a portfolio investment of a US person, into some form of equity ownership in a foreign special purpose vehicle (SPV). The transaction is deliberately structured to create income in the SPV for foreign tax purposes, which income is purportedly subject to foreign tax. The parties exploit differences between US and foreign law in order to permit the US taxpayer to claim a credit for the purported foreign tax payments while also allowing Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2007 Latham & Watkins. All Rights Reserved.

2 the foreign counterparty to claim a foreign tax benefit. The US taxpayer and the foreign counterparty share the cost of the purported foreign tax payments through the pricing of the arrangement. 3 Very often, these arrangements employ a hybrid entity, i.e., an entity characterized as a partnership for US tax purposes but a corporation for foreign tax purposes (or vice versa, known as a reverse hybrid entity), or a hybrid instrument, i.e., a financial instrument characterized as equity for US tax purposes but debt for foreign tax purposes (or vice versa). Under US law, in order to be a creditable foreign tax, the amount paid to the foreign jurisdiction must be a compulsory payment. In the new rules, Treasury and the IRS target Structured Passive Investment Arrangements, essentially denying a credit for foreign taxes paid by characterizing the payment as noncompulsory. There are three categories of Structured Passive Investment Arrangements: (i) US borrower transactions, (ii) US lender transactions and (iii) asset holding transactions. The following three charts outline in very general terms the types of transactions identified by the government: Structured Passive Investment Arrangements: US Borrower Transactions USP 5-year Repo of SPV $1.5 billion Equity Foreign Lender Sub $1.5 billion Loan SPV 1. USP asserts ownership of SPV for US tax purposes. USP includes dividends from SPV and FTC for foreign taxes paid by SPV. 2. USP claims interest deduction on Repo. 3. Sub claims interest deduction of loan from SPV.

3 Structured Passive Investment Arrangements: US Lender Transactions US Lender Equity for US purposes (Debt for Foreign purposes) $3 billion $1 billion $2 billion Equity SPV 99% RH 1% Foreign Borrower $3 billion Loan 2 Promissory Notes (one of which is zero coupon) 1. US Lender claims FTC on distribution from SPV. 2. Foreign country sees US Lender s interest in SPV as debt, thus foreign borrower owns 100% of SPV. Structured Passive Investment Arrangements: Asset Holding Transactions USP $6 billion Country Z Debt Class A & Class B Shares of DE DE Foreign Borrower Co. $1.5 billion cash Class C Shares of DE Class C Shares allocated all income of DE, but F Co. must contribute distributions back to DE 1. DE immediately redeems USP s Class B shares for $1.5 billion cash 2. USP has forward contract mandating USP buy Class C Shares for $1.5 billion in 5 years 3. USP must pay Foreign Co. interest (below market rate) Result: 1. Foreign Co. reports DE s income in Country Z, but claims credit for taxes paid by DE. Foreign Co. basis is increased by contributions to DE, generating loss on forward sale. 2. USP claims FTC on taxes paid by DE.

4 The government goes on to describe six conditions it views as common to these types of arrangements, conditions which form the definition of a Structured Passive Investment Arrangement: 1. The arrangement utilizes an SPV. There are two requirements: (i) substantially all of the gross income of the entity is attributable to passive investment income and substantially all of the assets of the entity are held to produce passive income, and (ii) there is a purported foreign tax payment attributable to the income of the entity. Passive investment income is generally defined as dividends, interest, rents and royalties. There is an exception to avoid a holding company of operating companies being treated as an SPV. Other special rules apply to certain situations where the entity derives passive income from affiliates; in other words, exceptions (such as the subpart F look-through rules) that might otherwise apply to avoid passive income characterization do not apply for purposes of defining Structured Passive Investment Arrangements. 2. A US person would otherwise be eligible to claim a foreign tax credit for all or a portion of the subject payment. 3. The foreign payments are (or are expected to be) substantially greater than the amount of credits, if any, that a US party would reasonably expect to claim if the US party directly owned its proportionate share of assets held by the SPV. For example, if the SPV holds an interest-generating note with respect to which a foreign payment is made, but foreign law (or a tax treaty) provides a zero rate of withholding on the interest, the US party would not reasonably expect to pay any foreign tax for which it could claim a credit if it directly owned the note. 4. The arrangement is structured in such a manner that it results in a foreign tax benefit (such as a credit, deduction, loss, exemption or disregarded payment) for a counterparty or for a person that is related to the counterparty but not related to the US party. The counterparty is a person (other than the SPV) that is unrelated to the US party and that (i) directly or indirectly owns 10 percent or more of the equity of the SPV under the tax laws of a foreign country in which such person is generally subject to tax on a net basis, or (ii) acquires 20 percent or more of the assets of the SPV under the tax laws of a foreign country in which such person is generally subject to tax on a net basis. The US and an applicable foreign country treat the arrangement differently under their respective tax systems. For this purpose, an applicable foreign country is any foreign country in which either the counterparty, a person related to the counterparty (but not related to the US party) or the SPV is subject to net basis tax. This condition is limited to one of four specified types of inconsistent treatment. The new rules are to be effective for tax years ending after the date that the regulations become final. Thus, if the regulations became final in 2008, they would apply to a calendar year taxpayer s entire 2008 year. The last three conditions will no doubt generate significant commentary, as multinational enterprises consider how these rules can affect their crossborder arrangements. Although the government tried to tailor this antiabuse rule narrowly, whenever a US tax consequence is dependent in whole or part on consideration of foreign tax consequences, the asymmetry in global tax regimes adds considerable complexity to the analysis.

5 Double Dip Losses On March 19, the US Treasury and IRS finalized regulations under section 1503(d) of the Internal Revenue Code (the Code) addressing dual consolidated losses (DCLs). 4 The regulations and several dozen examples provide extensive guidance on the treatment of numerous cross-border financing structures for US and non-us based multinational corporations and private equity owned portfolio companies. The DCL rules are generally designed to prevent the use of a single economic loss (for example, an interest deduction) once to offset income subject to US tax but not foreign tax, and a second time to offset income subject to foreign tax but not US tax (commonly referred to as a double dip structure). The double dip structure is most often accomplished through use of hybrid entities, for example, a Canadian entity treated as a corporation for Canadian tax purposes but as a flow-through entity for US tax purposes, or reverse hybrid entities, for example, a Canadian entity treated as a partnership for Canadian tax purposes but as a corporation for US tax purposes. A basic example of a DCL is depicted below, with FS1 constituting a hybrid entity. Dual Consolidated Loss Example USP Consolidation in Foreign Country FS1 Loan Interest Lender FS2 Operating Income Absent the DCL rules, the interest expense of FS1 would be available to (i) offset income of USP for US tax purposes (because FS1 is treated as a branch of USP) and (ii) offset local income of FS2 for foreign tax purposes (because FS1 and FS2 file a consolidated return in the local country). Technically, the new rules may implicate (i) a dual resident corporation, which is a US corporation which is also taxed in a foreign country on its worldwide income (for example, if the foreign country treats the US corporation as a resident of the foreign country because of the location of its management), (ii) a hybrid entity or (iii) a separate unit of a US corporation, which includes a foreign branch and an interest in a hybrid entity.

6 The new regulations provide much more detailed guidance for purposes of determining (i) whether an entity is a dual resident corporation, (ii) whether a DCL exists and (iii) where a taxpayer has elected to use the loss only in the US, when that loss may need to be recaptured upon the occurrence of certain events. A DCL can exist even if the economic deduction is not actually used in the United States or a foreign country (for example, because there is no income to offset) if the loss is made available to offset the income in the US or foreign country. It is important to note that the foreign use of a DCL can occur where a US person disposes of an interest in a foreign joint venture hybrid entity. As noted, the new regulations provide extensive rules and more than 40 detailed examples regarding their application. Other key highlights to the new regulations include the following: 1. The current regulations provide that if a (g)(2) election is made with respect to a DCL of a dual resident corporation or hybrid entity separate unit, the consolidated group, unaffiliated dual resident corporation or unaffiliated domestic owner, as the case may be, must file with its tax return an annual certification during a 15-year certification period. The proposed regulations reduced the certification period from 15 years to seven years and expanded the annual certification requirement to include DCLs of foreign branch separate units. The final regulations apply a reduced certification period of five years to all current (g)(2) elections as well as closing agreements thereunder. 2. The rule allowing two or more foreign branches, located in the same foreign country and owned by a single domestic corporation, to be combined into a single separate unit is expanded to situations where the branches are owned not by the same domestic corporation but by members of a consolidated return group. 3. Under current law, if a taxpayer fails to include a filing with respect to a DCL in a timely filed tax return, the taxpayer must file a ruling request. The new regulations adopt a reasonable cause procedure, based on that introduced in the proposed regulations and modified by Notice Taxpayers addressing a late request for a closing agreement must continue to seek extensions of time under the Code section 9100 regulations and Rev. Proc The final regulations preserve the dreaded mirror legislation rule that denies the taxpayer the ability to make an election to use a DCL to offset the income of a domestic affiliate when the foreign country has enacted legislation that operates in a manner similar to Code section 1503(d). Thus, the taxpayer is prohibited from claiming the loss in either country. However, the final regulations narrow the scope of the rule to a degree. Although different provisions of these regulations have different effective dates, the regulations generally apply to DCLs incurred in taxable years beginning on or after April 18, However, a taxpayer may apply these regulations in their entirety to DCLs incurred in taxable years beginning on or after January 1, 2007.

7 Endnotes 1 72 FR (Mar. 19, 2007); 72 FR (Mar. 30, 2007). 2 The dual consolidated loss regulations are generally effective next year FR FR (Mar. 19, 2007).

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