Tax Executives Institute Houston Chapter Advanced ASC 740 International Tax Issues. May 4, Ernesto Galvan and Karen Hoffman PwC Houston

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1 Tax Executives Institute Houston Chapter Advanced ASC 740 International Tax Issues May 4, 2016 Ernesto Galvan and Karen Hoffman Houston

2 Ernesto Galvan Partner International Tax Services Group, PricewaterhouseCoopers LLP (Houston). Specializes in international tax consulting for US multinationals and foreign owned US companies. BBA Accounting and Masters in Tax UT San Antonio and Northeastern University, respectively.

3 Karen Hoffman Director Federal Tax Group, PricewaterhouseCoopers LLP (Houston). Specializes in federal tax consulting for multinational companies in the energy industry with an emphasis on accounting for income taxes under US GAAP and IFRS. BBA and MPA The University of Texas at Austin

4 Agenda General international tax considerations Foreign currency considerations Outside basis differences in foreign subsidiaries SEC comment letter trends 4

5 General International Tax Considerations 5

6 General International Tax Considerations Investments in foreign subsidiaries Cash dividends from foreign subsidiaries Deemed dividends subpart F, section 956, QEF inclusions (PFIC) Cross border intercompany sale of assets Cross border loans Outside basis differences / unremitted earnings Foreign branches Foreign tax credit Sourcing of income Expense allocation Section 901(m) and other recent developments 6

7 General International Tax Considerations (cont d) EU tax rulings State Aid considerations Withholding taxes Quarterly ETR estimates 7

8 General Issues Withholding Taxes ( WHT ) Typical cross border flows that may have WHT implications include interest, rents, royalties, dividends and management / service fees Need to understand the facts of all intercompany flows Matching principle expense WHT in the year the intercompany income item accrues Expense of income recipient and WHT liability of the payor Common issue outside of the EU and treaty jurisdictions Also, recent trend of tighter limitations on ability to claim treaty / EU benefits 8

9 General Issues Cross Border Intercompany Sales Deferral provisions under ASC 810 and 740 apply to intercompany transfers of assets involving entities that file separate tax returns Income tax effects resulting from intercompany transfers of assets are generally not recognized immediately in consolidated financial statements Income tax effects are deferred and amortized to income over the period of economic benefit (seller/transferor s jurisdiction) Tax accounting model prohibits the recognition of a DTA for basis differences related to intercompany profits (buyer/transferee s jurisdiction) Frequently arises: - Intercompany profit in ending inventory ( PII ) - Transfer of intangible property - Other transfers of assets 9

10 General Issues Cross Border Intercompany Sales (cont d.) Example U.S. subsidiary manufactures inventory cost of $10 and sells it to foreign subsidiary for $30 U.S. subsidiary pays tax of $8 ($30 - $10 = $20; $20 x 40% = $8) Foreign subsidiary has a tax basis for foreign tax purposes in inventory of $30 Foreign subsidiary has not sold this inventory at year-end balance sheet date U.S. tax paid of $8 is a deferred charge rather than tax expense No deferred tax asset is recorded for excess of foreign subsidiary local tax basis of $30 over U.S. GAAP basis of $10 in consolidated financial statements 10

11 General Issues Cross Border Intercompany Sales (cont d.) Exposure draft of new guidance issued and open for comments: Elimination of the exception for recognizing deferred taxes on certain intercompany transactions under ASC (e) Seller s tax expense on the profit from the transfer of assets and the buyer s deferred tax benefit on the increased tax basis would be recognized when the transfers occur. Modified retrospective transition approach, with a cumulative catch up adjustment to opening retained earnings in the period of adoption Effective for annual and interim periods beginning after December 15, 2016 for public companies and after December 15, 2017 for private companies 11

12 General Issues Quarterly ETR Estimates Expiration of section 954(c)(6) look-through exception to subpart F (and other expired tax provisions) Numerous and frequent foreign law changes in reaction to BEPS Mix of income Loss jurisdictions for which no benefit is recognized 12

13 Foreign Currency Considerations 13

14 Translation of Foreign Currency Financial Statements 3 steps Step 1 Determine the functional currency (FC) of the foreign entity - the currency of the primary economic environment in which the entity operates Step 2 Remeasure local currency (LC) to functional currency (FC) Use current exchange rate for monetary assets and liabilities Use historical exchange rate for non-monetary assets and liabilities Use weighted average or historical rate for revenue and expense items (match to balance sheet exchange rate) Remeasurement of non-monetary accounts - no deferred taxes recognized on certain transaction gains and losses (ASC (f)). Remeasurement of monetary accounts - deferred taxes depending on tax law for particular tax jurisdiction for book to tax differences. 14

15 Translation of Foreign Currency Financial Statements 3 steps Step 3 - Translate functional currency (FC) to reporting currency (RC) the currency in which the financial statements are issued to the public Generates translation adjustments Reported in cumulative translation adjustment (CTA) account CTA in other comprehensive income (OCI) Does not affect cash flows and earnings If Indefinite Reversal Exception under ASC (aka APB 23) then there is not recognition of deferred taxes. 15

16 Price-level related changes Tax bases of assets and liabilities of those entities are often restated for the effects of inflation. Deferred tax expense or benefit shall be calculated as the difference between the following two measures: Deferred tax assets and liabilities reported at the end of the current year, determined based on the difference between the indexed tax basis amount of the assets or liability an the related price-level restated amount reported in the financial statements. Deferred tax assets and liabilities reported at the end of the prior year, remeasured to units of current general purchasing power at the end of the current year. 16

17 ASC 830 Translation process ASC 740 Implications: Remeasurement of Local Currency to Functional Currency Remeasurement of non-monetary accounts no deferred taxes recognized on certain transaction gains and losses (ASC (f)) Remeasurement of monetary accounts deferred taxes recognized depending on tax law for particular tax jurisdiction for book-tax differences ASC 740 Implications: - Tax and U.S. GAAP difference in timing of when gain/loss is recognized - Section 987: Tax gain or loss generally deferred until remittance, sale of assets, or upon liquidation - Proposed regulations under 987 introduce changes (historic rate vs. U.S. spot rate) that may affect the calculation of the unrealized gain or loss 17

18 A foreign entity s functional currency being different from its local currency Remeasurement of an entity s deferred foreign tax liability or asset after a change in the exchange rate will result in a transaction gain or loss that is recognized currently in the statement of profit and loss. Disclosure of the aggregate transaction gain or loss included in determining net income but does not specify how to display that transaction gain or loss or its components for financial reporting. Accordingly, a transaction gain or loss that results from remeasuring a deferred foreign tax liability or asset may be included in the reported amount of deferred tax benefit or expense if that presentation is considered to be more useful. 18

19 A foreign entity s functional currency being different from its local currency (cont d.) The deferred taxes associated with the temporary differences that arise from a change in functional currency when economy ceases to be considered highly inflationary shall be presented as an adjustment to the cumulative translation adjustments component of shareholders equity and therefore shall be recognized in other comprehensive income. 19

20 Outside Basis Differences in Foreign Subsidiaries 20

21 Outside basis differences Governing paragraphs Outside basis differences are addressed in ASC Rules prescribe different considerations for DTAs and DTLs: - DTAs: ASC through 13 - DTLs: ASC , ASC through 7 Starting premise: Record DTAs only if it is apparent that the temporary difference will reverse in the foreseeable future Record all DTLs unless an exception applies 19

22 Outside basis differences Key questions in determining outside basis What type of entity is the investee? - Subsidiary - Corporate JV - Equity method investee - Partnership If subsidiary or corporate JV, is it domestic or foreign? Type of entity affects the rules that apply and the way that the outside basis difference is impacted by earnings, dividends, etc. 20

23 Deferred taxes for outside basis differences Domestic Subsidiary Foreign Subsidiary Domestic Corporate JV Foreign Corporate JV Equity Method Investments Partnerships Book > Tax basis Record DTL, unless Investment can be recovered tax-free without significant cost, and Enterprise expects to ultimately use that means of recovery * For pre 12/15/92 amount, only record DTL if it is apparent it will reverse in foreseeable future Record DTL, unless Parent asserts indefinite reversal (earnings will be indefinitely reinvested or will be remitted without tax consequences) Record DTL (only for pre12/15/92 amount if apparent it will reverse in the foreseeable future) Record DTL, unless Foreign corporate JV is permanent in duration, and Parent asserts indefinite reversal Tax > Book basis Record DTA only if it is apparent that the temporary difference will reverse in the foreseeable future (reversal must be definitely planned such as by a sale of the subsidiary) Record DTA or DTL (certain exceptions exist for equity method investees that had once been subsidiaries or that have no E&P) Generally, record DTAs and DTLs on outside basis differences rather than inside basis 21

24 Outside basis differences Measurement of deferred taxes Foreign Subsidiaries and Foreign Corporate JVs If not indefinitely reinvested, provision for taxes based on estimate of taxes to be incurred upon distribution Consider the following: - Withholding taxes - Foreign taxes, if applicable - U.S. tax, after FTCs Re-evaluate position quarterly Has there been a change in the indefinite reversal assertion? Have other factors changed that will affect the measurement? 22

25 Outside basis differences Measurement of deferred taxes Factors to consider in computing incremental tax upon repatriation: - Years in which repatriations are expected to occur - Blending of tax pools on various dividends - Form of repatriations (dividend, 956 loan, sale proceeds, liquidation, check-the-box election) - FTCs or deductions for foreign taxes paid - Withholding taxes - Domestic source loss in year of repatriation - Impact of 861 expense allocations - Overall foreign loss carryover - Anticipated Subpart F implications if owned by CFC 23

26 Outside basis differences Measurement of deferred taxes What is the significance of E&P in measuring deferred taxes? The basic model requires an evaluation of the outside basis difference in the investment (i.e., earnings is only one component, albeit the most significant, of outside basis difference) Questions to consider: What is the outside basis difference in the investment? How will the difference reverse? What are the expected tax consequences of the reversal? Why is retained earnings different than E&P? Reversal due to repatriation of earnings: Distributions will result in a current income tax provision to the extent it is repatriation of E&P Excess distributions over the amount of existing E&P will be treated as a return of capital and then capital gain 24

27 Indefinite Reversal Exception under ASC (aka APB 23) Sufficient evidence must show that a foreign subsidiary has invested or will invest its undistributed earnings indefinitely or that the earnings will be remitted in a tax-free manner Consider: Cash flow forecasts of parent and the foreign subsidiary Financial requirements of parent (e.g., liquidity needs) Financial requirements of subsidiary (e.g., working capital and capital expenditure needs) Past history of dividends Tax consequences of decision to remit or reinvest Restrictions in loan agreements Restrictions by foreign governments on repatriations Any program designed to influence remittances 27

28 Indefinite Reversal Exception (cont d.) Parent must have the ability to control the foreign subsidiary Assertion must be considered at each level in the legal company organization structure (i.e., foreign-foreign as well as foreign-u.s.) Permanent reinvestment assertion can only be made cross-border (i.e., non domesticdomestic) Criteria for permanent reinvestment assertion Has invested or will invest the undistributed earnings indefinitely or that the earnings will be remitted in a tax-free liquidation Evidence of specific plan of reinvestment Positive assertion from management Re-evaluated at each balance sheet date 28

29 Asserting indefinite reversal exception documentation Specific plans that support the assertion (at sub and parent levels) must be documented and maintained Other facts to consider Repatriation of earnings tax-free through existing intercompany notes No tax E&P Repatriation of earnings tax-free based on treaty exemptions that apply to dividends Absence of cash in subsidiary is not determinative Not sole responsibility of tax department requires involvement of treasury, controller, and senior financial management If the assertion is being made by a subsidiary with respect to its foreign subsidiary, the Parent corporation s plan must also be considered 29

30 Example Impact of Actual Distributions Unremitted Earnings 12/31/ Activity Unremitted Earnings at 12/31/2015 Violation? Earnings CY Distribution (20) No Earnings CY Distribution (40) Yes 30

31 Indefinite Reversal Exception PTI Subpart F income gives rise to PTI to the extent the subpart F income is not distributed How should PTI be considered when applying the indefinite reversal criterion? Distribution of PTI reduces the book and tax bases by equal amounts Distribution of PTI will not generally cause the reversal of any portion of the existing taxable temporary difference However, management must still declare its intensions as to whether PTI is indefinitely reinvested if repatriation will result in additional taxes (i.e., withholding tax and tax on translation gains/losses under section 986(c)) 31

32 PTI Example US Parent Company A Foreign Sub Company B Non-USD FC Company B generated passive interest income Interest income reported on A s US return as subpart F income Company B has non-usd functional currency Company B has not made a distribution so subpart F income is PTI Question: Can US Parent assert permanent reinvestment on tax effects of the unrealized foreign currency gain/loss associated with Company B s PTI? 32

33 Suspended Subpart F Income US Parent Company A Foreign Sub Company B Company B generated subpart F income from interest income Company B does not have current year positive tax E&P Current taxation of subpart F income in the U.S. is deferred until Company B generates positive current year tax E&P Question: Should Company A record deferred taxes on the subpart F income generated by Company B? 33

34 Full Inclusion Subsidiary US Parent Company A Foreign Sub Company B Company B is considered a full inclusion subsidiary because more than 70% of gross income consists of subpart F income Company B has expenses that may give rise to book/tax temporary differences Full Inclusion Sub Question: Should Company A record deferred taxes on the temporary differences of Company B? 34

35 Foreign Holdco Partnership US Parent Foreign HoldCo Check-the-box US Sub Foreign HoldCo is taxed as a partnership for U.S. tax purposes Foreign CFC is Foreign HoldCo s only investment Basis in Foreign HoldCo Book: 600/ Tax: 100 Basis in Foreign CFC Book: 600/ Tax: 100 Foreign CFC Question: Can US Parent look-through Foreign HoldCo and place a permanent reinvestment assertion on outside basis difference in Foreign CFC? 35

36 No or Partial Permanent Reinvestment Assertions Can maintain a full, partial, or no permanent reinvestment assertion with respect to a foreign subsidiary or a type of income Partial reinvestment assertions must be justified by evidence and plans (similar to full permanent reinvestment assertions) Cannot manage income When a permanent reinvestment assertion does not exist, the parent entity must record DTLs on the relevant outside basis difference DTAs are generally not recorded unless the temporary difference is expected to reverse in the foreseeable future 36

37 Change in assertion Reflect change In continuing operations In the period the change in assertion occurs as a discrete period item Rule applies to all assertion changes Foreign ASC (APB 23) Domestic ASC through 13 (FAS 109 par. 33 and 34) Do not backwards trace However, any change in deferred taxes on adjustments to CTA arising in the current year is subject to the rules of ASC (b) and, thus, should be reflected in OCI It is important to distinguish the tax effects of the change in assertion between the current-year and the prior-year changes in CTA 37

38 Plan of Reorganization US Parent owns a foreign subsidiary with historical permanent reinvestment assertion Parent determines historical assertion will not be supportable in the future In current structure, distributions from CFC to parent would be subject to withholding taxes Plan of reorganization started but not completed Reorganization will eliminate the withholding tax on future distributions Question: Does the withholding tax have to be incorporated into the DTL for the outside basis difference? 38

39 Intercompany Loans Should deferred taxes be recorded for foreign exchange gain/loss related to intercompany loans of a long-term-investment nature (that is, settlement is not planned or anticipated in the foreseeable future)? - Loan denominated in FC of subsidiary - Intercompany loan and related gain/loss should be viewed as part of parent s net investment Consider whether CTA is indefinitely reinvested - Loan denominated in FC of parent - Gain/loss on intercompany loan generally reported in OCI Consider whether loan is of a long-term investment nature and whether taxation of exchange gain/loss can be indefinitely deferred Impact of hedges on such loans Accrued interest Debt vs. equity 39

40 Intercompany Loans Loan US Parent Company A Foreign Sub Company B Non-USD FC Company A loans money to Company B The loan is denominated in Company A s functional currency Company B bears the currency risk Company A asserts permanent reinvestment for Company B Question: Should Company A record deferred taxes on outside basis differences created by the currency gain/loss of Company B? Would the answer be different if the loan were denominated in Company B s currency? 40

41 Footnote Disclosures Disclosure of permanently reinvested earnings book earnings versus tax E&P Measurement of deferred tax Book earnings versus tax E&P Enacted rate expected to apply upon realization Character of income Withholding taxes and other distribution-related taxes Deductibility/creditability of foreign taxes 41

42 SEC Comment Letter Trends 42

43 SEC areas of focus in 2016 Valuation allowances/realizability of deferred tax assets Permanent reinvestment assertion/foreign earnings Income tax expense, in particular when tax rates appear unusual relative to the expected statutory rate, effective tax rates are volatile, or effective tax rates do not change because material changes in components are offsetting Disclosures MD&A Effective tax rate Foreign earnings 43

44 SEC Comment Letters common themes Effective Tax Rate Determination of statutory rate Rate differential transparency APB 23 Focus on the accounting and disclosure requirements Ability to assert indefinite reinvestment Cumulative amount of temporary differences related to indefinitely reinvested foreign earnings Impracticability of deferred tax liability quantification 44

45 SEC Comment Letters common themes Valuation allowances Sources of taxable income Positive and negative evidence considered Timing FIN 48 Transparent disclosure of unrecognized tax benefits Changes in assessment 45

46 Comment letters issued by category 46

47 SEC Comment Letters - examples Indefinite reinvestment assertion & liquidity Given the significance of your foreign operations and your plans for future international growth, please revise your future filings to quantify the amount of foreign cash and cash equivalents held outside of the United States as of your most recent period end. Please also disclose the nature of any restrictions on the use or transfer for your foreign cash, if applicable. As a related matter, it appears from your disclosure that you consider your undistributed earnings of foreign subsidiaries to be indefinitely reinvested and therefore, you have not provided for any U.S. income taxes on those earnings. If true, please revise the liquidity section of your MD&A in future filings to disclose that intention and to indicate that if you were to repatriate these funds in the future, you would be required to accrue and pay U.S. taxes at that time. 47

48 SEC Comment Letters - examples Indefinite reinvestment assertion & liquidity We note that you repatriated $x million, $y million, and $z million of current earnings during fiscal years 2014, 2013, Additionally, we note that you have not recognized a deferred tax liability for the undistributed earnings of certain of your foreign operations because those subsidiaries have invested or will invest the undistributed earnings indefinitely. Please tell us the underlying reasons for the repatriation of foreign earnings in 2014, 2013 and Please also provide us with a detailed analysis that supports your conclusion that the remaining undistributed earnings of foreign earnings should be considered permanently reinvested. In this regard, explain why you believe it is appropriate to continue to make this assertion in light of the repatriation of earnings that took place over the last three years. 48

49 SEC Comment Letters - examples Indefinite reinvestment assertion & liquidity We note that you have $170 million of undistributed earnings related to your foreign subsidiaries for the year ended December 31, 2014 and that you intend to reinvest your foreign earnings indefinitely. We further note that your U.S. operations generated a loss before income taxes for each of the last three fiscal years although you have generated foreign earnings for each of the last three fiscal years. If material to an understanding of your liquidity, please revise future filings to discuss the impact of this trend. In this regard, please revise future filings to disclose the portion of your cash that held by foreign subsidiaries and the amount of cash that is available for use in the U.S. without having to repatriate earnings. 49

50 SEC Comment Letters Use of impracticability exception Indefinite reinvestment disclosure The initial SEC comment We note your disclosure on page F-23 that it is not practical to determine the amount of income or withholding tax that would be payable upon remittance of these foreign earnings. Please tell us why it is not practical to determine the amount of tax that would be payable. Describe the complexities involved that make determination of the amount difficult. Alternatively, revise future filings to quantify the effect that repatriation of foreign earnings would have. 50

51 SEC Comment Letters Use of impracticability exception Indefinite reinvestment disclosure The company s response The Company advises the Staff that determination of the potential deferred income tax liability on these undistributed earnings is not practicable because such liability, if any, is dependent on circumstances that exist if and when remittance occurs. The circumstances that would affect the calculations include the source location and amount of the distribution, the underlying tax rate already paid on the earnings, foreign withholding taxes and the opportunity to use foreign tax credits. 51

52 SEC Comment Letters Use of impracticability exception Indefinite reinvestment disclosure The SEC s response We note your response describing why you believe it is impractical to determine the amount of tax that would be payable. We note the factors you cite appear to relate to potential future events that could impact the ultimate amount of tax that would be payable. Please revise future filings to disclose an estimate of the amount of tax that would be payable upon remittance of foreign earnings based on current facts and circumstances. In this regard, we would not object if you also disclosed that the amount of tax that would be payable could be further impacted by the factors that you cite in your response. 52

53 SEC Comment Letters - examples Effective Tax Rate We note from the income tax (expense) benefit reconciliation, that the impact of foreign operations had a significant effect on the income tax expense recognized in the financial statements in Please identify for us the countries that contribute to this amount. We believe that if a significant amount of your profits are generated in countries with significantly low tax rates (such as Ireland), this fact should be disclosed. Please advise or revise accordingly. 53

54 SEC Comment Letters - examples Effective Tax Rate We note the foreign tax rate differential is significantly lower than the federal statutory rate in the income tax rate reconciliation. In light of the significantly lower impact of taxes imposed on foreign earnings to your operating results, in future filings please explain in MD&A the relationship between foreign pre-tax income and the foreign effective tax rate in greater detail. We refer you to Section III.B of SEC Release Please provide us with your proposed revised disclosure. 54

55 SEC Comment Letters - examples Effective Tax Rate Please revise to disclose the components of income before income taxes as either domestic or foreign. See guidance in Rule 4-08(h) of Regulation S-X. Also, we note that in your reconciliation between the federal statutory rate and the effective income tax rate disclosed in Note L, foreign and state income taxes are combined in one line item. Please note that if either of these items (foreign income taxes or state income taxes) affects the statutory tax rate by more than 5% (either positively or negatively) they should be separately presented on the reconciliation. 55

56 SEC Comment Letters - examples Effective Tax Rate We note your effective tax rate decreased to 15% in 2014 compared to 24% in 2013 and your foreign earnings subject to different tax rates line item significantly contributed to the decrease of your effective tax rate during the current period. In future filings, please clarify the nature of the items in the foreign earnings subject to different tax rates line item in your effective tax rate reconciliations. Please also explain to us your consideration of providing additional disclosures, either in the income tax footnote or MD&A, regarding the impact of material component(s) of this reconciling item on your income taxes. Such disclosures should have the objective of providing information about the quality of, and potential variability of, your earnings and cash flow, so an investor can ascertain the likelihood that past performance is indicative of future performance. The disclosures may include identifying your material tax jurisdictions along with their corresponding pre-tax earnings, statutory tax rates, effective tax rates, and whether the mix has changed materially in the past or is reasonably likely to change in the future. 56

57 SEC Comment Letters - examples Uncertain Tax Positions We note your risk factor disclosure regarding the potential for transfer pricing and other taxation adjustments imposed by the Chinese tax authorities that could increase tax liabilities. Please revise to describe the risks and uncertainties and potential impact on your results and financial condition. Please refer to Items 5.D of Form 20-F, codified FRC , Section III.B of SEC Release No and Section III.A of SEC Release No for guidance. 57

58 SEC Comment Letters - examples Uncertain Tax Positions We note a $10 million increase in unrecognized tax benefits related to additions for prior year tax positions. Please describe for us in greater detail the significant components of this increase in unrecognized tax benefits. Please also describe whether this increase relates to the tax audit by the Chinese tax authorities. In this regard, please tell us how you have concluded that no other major jurisdictions outside the U.S. are required to be disclosed under FASB ASC (e). 58