ARNOLD PORTER LLP. Special Edition: International Provisions of the American Jobs Creation Act. Overview INTERNATIONAL TAX HEADLINES DECEMBER 2004

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1 INTERNATIONAL TAX HEADLINES Special Edition: International Provisions of the American Jobs Creation Act Overview The American Jobs Creation Act of 2004 (the AJCA or the Act ) was enacted on October 22nd, It represents one of the most extensive pieces of business tax legislation the United States has seen in two decades not least in the international area. Spurred in large measure by the need to respond to the World Trade Organization s ruling that the export tax rules constituted an illegal trade subsidy, the legislation became a vehicle for many corporate tax provisions that had been under consideration for years. By and large, US multinationals do very well under the Act, while foreign investors in the United States do somewhat worse. The major international tax provisions of the AJCA highlighted in this issue include: DECEMBER 2004 Washington, DC New York London +44 (0) Brussels +32 (0) Los Angeles Northern Virginia Denver the new manufacturing regime for exporters; new expatriation rules for corporations and revisions to the existing rules governing individuals; substantial relaxation of the foreign tax credit rules; rationalization of the anti-deferral (Subpart F, PFIC, foreign personal holding company, etc.) regimes; and modification of miscellaneous rules governing the taxation of nonresident aliens and foreign corporations. These provisions have a wide variety of transition rules and effective dates that must be carefully reviewed as part of taxpayers planning to comply with and take advantage of opportunities created by the Act. Citation: Pub. L , 118 Stat (Oct. 22, 2004) Link to: Legislative Text Link to: Conference Report This summary is intended to be a general summary of various laws and regulations, and does not constitute legal advice. You should consult with competent counsel to determine applicable legal requirements in a specific fact situation. arnoldporter.com

2 Manufacturing Regime Repeal of Export Tax Incentives In response to the adverse World Trade Organization ruling on the legality of the extraterritorial income ( ETI ) regime enacted to replace the foreign sales corporation rules (also invalidated by the WTO), the Act phases in the repeal of the ETI regime for all transactions entered into after December 31, 2004, except for those carried on in the ordinary course of business under binding contracts between taxpayers and unrelated persons that have been in effect continuously since September 17, 2003 ( grandfathered transactions ). Under the repeal, taxpayers retain all ETI benefits for pre-2005 transactions; other transactions generate 80 percent (for transactions during 2005) or 60 percent (for 2006 transactions) of the ETI benefits otherwise available (except for grandfathered transactions, which retain 100 percent of such benefits). Foreign corporations that elected domestic status in order to take advantage of the repealed ETI benefits have one year to revoke those elections on a tax-free basis, subject to anti-abuse rules. Citation: Pub. L , 101 Tax Reduction for Manufacturing Income Effective for taxable years beginning after December 31, 2004, US taxpayers receive a tax deduction expressed as a percentage of their income from qualified production activities (generally, the disposition, license or rental of qualifying production property ). The deduction is limited to the lesser of (i) 50 percent of the taxpayer s wages paid during the year and (ii) the applicable fixed percentage (3 percent in 2005 and 2006, 6 percent from 2007 through 2009, and 9 percent thereafter) of (ii) the taxpayer s gross receipts from qualified production activities carried out to a significant degree in the United States, reduced by (ii) expenses directly allocable to such receipts and the portion of indirect expenses properly allocable to those activities. In general, qualifying production property means tangible personal property, computer software and sound recordings, as well as certain motion picture films or videotapes if more than 50 percent of the production expenses reflect compensation paid for US-based activities. Citation: Pub. L , 102 2

3 Expatriation Rules Corporations In response to significant adverse publicity relating to so-called corporate inversions (i.e., transactions whereby US corporations become subsidiaries of related foreign corporations), the Act treats such foreign subsidiaries as domestic corporations if (i) substantially all of the US corporation s assets, or of its stock, is transferred to a foreign-incorporated entity after March 4, 2003, (ii) the US corporation s former shareholders own 80 percent or more of the stock (by vote or value) of the foreign entity, and (iii) that entity and its 50-percent affiliates do not have significant business activities in the entity s country of incorporation. If, after such a transaction, at least 60 percent, but less than 80 percent, of the foreign entity s shares are owned by the US corporation s former shareholders, the foreign entity is respected as such but no corporate-level income or gain required to be recognized in the inversion transaction may be reduced by tax attributes (such as net operating losses or foreign tax credits). Separately, an excise tax equal to the maximum rate for an individuals net capital gain is imposed on the stock-based compensation of insiders in an expatriated corporation (including any gross-up on account of the excise tax itself). Citation: Pub. L , 801, 802 Individuals Code sections 877, 2107 and 2501 subject nonresident aliens to an expanded alternative tax regime if they are former US citizens or long-term residents who expatriated for tax reasons within ten years prior to the taxable year at issue. The Act replaces the subjective inquiry into the individual s tax-avoidance intent (and the IRS ruling request process that accompanies that inquiry) with objective standards, under which the alternative tax applies unless the taxpayer establishes that (ii) his average income tax liability for the preceding five years did not exceed $124,000 (with a post-2004 inflation adjustment) and his net worth does not exceed $2 million, and (ii) certifies under penalties of perjury, and supplies such proof as the IRS may require, that he has complied with all his US federal tax obligations during that period. A greater than de minimis presence in the United States during the ten-year period will cause the individual to be treated as a US citizen or resident for that year, and in any event an annual return is required during that period. The provision applies to expatriations that occur after June 3, Citation: Pub. L , 801, 802 3

4 The Foreign Tax Credit Reduction in Number of Baskets Under current law, the foreign tax credit limitation of Code section 904(a) is applied separately to creditable foreign taxes imposed on foreign-source taxable income that is allocated to one of nine separate categories (colloquially referred to as baskets ). Effective for taxable years beginning after December 31, 2006, the Act reduces the number of baskets from nine to two: passive category income (includes items currently allocated to the passive basket, financial services income not earned by a financial institution, and the DISC- and FSC-related items); and general category income (includes shipping income and income not otherwise allocated to the passive basket). Foreign taxes imposed on items not constituting income under US tax principles are generally assigned to the general income category, subject to special transition rules. Other separate categories established outside Code section 904 (such as certain oil and gas income under Code section 907 or income from countries described in Code section 901(j)) and treaty-based sourcing rules are unaffected by the Act s changes. Citation: Pub. L , 404 Alternative Minimum Tax Limitation Under existing Code section 59(a)(2), only 90 percent of a taxpayer s alternative minimum tax liability may be offset by foreign tax credits. Effective for taxable years beginning after December 31, 2004, this limitation is repealed. Citation: Pub. L , 421 Holding Periods For Creditable Withholding Taxes Code section 901(k) imposes a minimum holding period for sock on which dividends are paid before foreign withholding taxes imposed on those dividends may be credited. The Act imposes a similar requirement on other payments with respect to which foreign withholding taxes are imposed. Citation: Pub. L , 832 4

5 Look-Through Rules Distributions from controlled foreign corporations are allocated to baskets based on the baskets applicable to the income deemed distributed. The same rule applies to distributions by 10/50 companies out of post-2002 earnings and profits; all other such dividends are allocated to one or more separate baskets under Code section 904(d)(1)(E). The Act extends look-through treatment to all post-2002 dividends from 10/50 companies. Citation: Pub. L , 403 Carryover Periods Under current law, excess foreign tax credits may be carried back two years and forward five years before they expire. The Act reduces the carryback period to one year but extends the carryforward period to 10 years. Citation: Pub. L , 417 Ownership Through Partnerships A US corporation may claim so-called indirect foreign tax credits when it receives dividends from a foreign corporation in which it owns at least a 10-percent voting interest. The Code and Regulations are silent on whether a domestic corporation owning the requisite interest in the distributing foreign corporation through a partnership is entitled to claim an indirect foreign tax credit when the partnership receives a dividend from the foreign corporation. The Act provides that, for taxable years beginning after the date of enactment, indirect foreign tax credits are available in such a case. Citation: Pub. L , 405 Outbound Transfers of Intangibles Code section 367(d) treats certain transfers of intangibles by a US person to a foreign corporation as sales of the intangibles for a stream of contingent payments. The Taxpayer Relief Act of 1997 provided that the source of such payments is determined under the sourcing rules for royalties, but stopped short of characterizing the payments as royalties for other purposes (e.g., the foreign tax credit). The Act provides (retrospectively to the effective date of the 1997 amendment) that payments deemed made under Code section 367(d) will be treated as royalties for purposes of Code section 904(d) (the basket rules). Citation: Pub. L , 406 5

6 Overall Domestic Loss Under existing law, when a US taxpayer generates a foreign loss in a taxable year, foreign-source income earned in a subsequent year will be partly re-sourced to the United States until the amount of the earlier loss is recaptured (Code section 904(f)). The purpose of the provision is to avoid whipsawing the US government, which provides an implied tax subsidy when the loss is generated but would otherwise be unable to compensate itself with tax on later foreign income because of the sheltering effect of foreign income taxes income. Current law does not provide a symmetrical rule when a domestic loss (which reduces the taxpayer s ability to use foreign tax credits in the loss year) is followed by both US- and foreign-source income in another year. The Act introduces such an overall domestic loss rule in new Code section 904(g). For taxable years beginning after December 31, 2008, where a taxpayer s tentative foreign tax credit in a given year is reduced by a domestic loss, up to 50 percent of the taxpayer s US-source income in a later year is recharacterized as foreign-source income to the extent of that earlier domestic loss (thereby increasing the taxpayer s potential foreign tax credit in that later year). That re-sourced income is allocated to the taxpayer s baskets in the same proportion as income in those baskets was effectively reduced by the domestic loss. Citation: Pub. L , 402 Expense Allocation and Apportionment The foreign tax credit limitation is driven by the measure of the taxpayer s taxable income from foreign sources; this requires an allocation and apportionment of the taxpayer s deduction to foreign-source gross income. Under current law, certain deductions (notably for interest expense) are allocated on the basis of the US- and foreignsitus assets of the affiliated group of which the taxpayer is a member. However, certain financial institutions are excluded from the group for this purpose, and certain aspects of the computation exclude foreign affiliates. Effective for taxable years beginning after 2008, the Act provides a pair of elections for taxpayers seeking to mitigate the adverse effects of the foregoing rules. One election permits the taxpayer to include a broader array of financial corporations within the group of companies to which the worldwide allocation and apportionment rules for interest expense apply. The second election allows the US members of the affiliated group to allocate and apportion their interest expense on a truly worldwide basis (as though all of the group s members, domestic and foreign, were a single corporation). Citation: Pub. L , 401 6

7 Subpart F and PFIC Rules Temporary Tax Relief on Certain Repatriations of CFC Earnings In an express effort to provide a one-time incentive for the repatriation of overseas earnings of US multinationals, the Act introduces an elective 85-percent dividends-received deduction applicable to qualifying cash distributions from controlled foreign corporations. The election may be made effective for either (i) the last taxable year of a taxpayer beginning before October 22, 2004, or (ii) the taxpayer s first taxable year beginning within one year after that date. The foreign tax credit and deductions properly apportioned to the deductible portion of the qualifying dividend are denied. To qualify, dividends must be extraordinary as measured against a modified average earnings repatriation level over three of the taxpayer s preceding five taxable years. In addition, They must also be described in a domestic reinvestment plan approved by the US parent s senior management and board, and are limited to the greater of (i) the taxpayer s permanently reinvested overseas earnings, as shown on its most recently certified pre-june 30, 2003 financial statement (or, in default of such a statement, determined by grossing up the deferred tax liability for such earnings at a 35-percent rate), and (ii) $500 million. The qualifying amount is also reduced by any increase in certain post-october 3, 2004 related-party indebtedness. Numerous additional limitations and special rules apply. Citation: Pub. L , 422 Menu of International Anti-Deferral Rules Shortened Historically, US taxpayers with foreign operations or earnings have needed to run the gauntlet of no fewer that four international anti-deferral regimes: Subpart F, the passive foreign investment company ( PFIC ) rules, the foreign personal holding company regime, and the foreign investment company rules. The Act repeals the latter two regimes, effective as of (i) taxable years of foreign corporations beginning after December 31, 2004, and (ii) taxable years of US shareholders with or within which such taxable years of those foreign corporations end. Citation: Pub. L , 413 7

8 Definition of United States Property Narrowed Under Code section 956, one of the items includible in the incomes of US shareholders of controlled foreign corporations ( CFCs ) on an accrual basis is the amount of the CFC s earnings for the year invested in United States property. The Act excludes from the definition of such property (i) certain securities held by the CFC as a dealer and (ii) debt obligations of certain noncorporate US persons. These exclusions are effective as of (i) taxable years of foreign corporations beginning after December 31, 2004, and (ii) taxable years of US shareholders with or within which such taxable years of those foreign corporations end. Citation: Pub. L , 407 Scope of Subpart F Income Reduced The Act introduces a number of special rules that tend to reduce the number of classes of income that must be included in the income of a CFC s US shareholders: Sales of partnership interests which automatically generate Subpart F income under current law are made subject to a look-through rule for 25-percent partners. The hedging exception under which gains from commodities transactions can be excluded from Subpart F income is broadened. The provisions governing foreign base company shipping income are repealed, and a safe harbor is provided for certain rents derived from international aircraft or vessel leasing activities. The home-country nexus requirements for treating income otherwise includible under Subpart F as excludable active financing income are relaxed, specifically by allowing activities of certain related persons to be attributed to the CFC (or its qualified business unit) in question. These modifications are generally effective as of (i) taxable years of foreign corporations beginning after December 31, 2004, and (ii) taxable years of US shareholders with or within which such taxable years of those foreign corporations end. Citation: Pub. L , 412, 414, 415, 416 8

9 Provisions Affecting Foreign Investors Withholding Taxes on Foreign Persons Puerto Rico (which is a foreign country as to the United States for most tax purposes) imposes a 10 percent withholding tax on dividends to non-puerto Rico corporations. In order to achieve parity for US corporations, subject to certain conditions the Act reduces the statutory withholding rates on dividends paid by US corporations to Puerto Rican corporate shareholders from 30 percent to 10 percent for so long as the Puerto Rican dividend withholding rate does not increase. The provision applies to dividends paid after October 22, Separately, the Act repeals the secondary withholding tax that applies under existing law on dividends paid by foreign corporations to non-us shareholders if, over the three preceding taxable years, 25 percent or more of the payor corporation s gross income was effectively connected with its conduct of a trade or business in the United States. The repeal is effective for payments made after December 31, In addition, the Act modernizes the rule for sourcing interest paid by certain foreign partnerships to track the corresponding rule for foreign corporations (i.e., such interest in US-source only if it is properly allocable to income effectively connected with the conduct of a US trade or business). The change takes effect in taxable years beginning after December 31, Furthermore, the Act recharacterizes certain dividends paid by regulated investment companies to foreign shareholders as interest (and therefore eligible for the portfolio interest exception, if the requirements of Code Sections 871(h) or 881(c) are satisfied) to the extent designated by the payor is coming out of its qualified net interest income. Finally, the Act imposes a withholding tax on liquidating distributions by certain foreign-owned US holding companies to the extent of their current and accumulated earnings and profits. This rule, which exempts companies with substantial direct business activities of their own or that have been in existence for longer than five years, is effective for liquidating distributions occurring after October 22, Citation: Pub. L , 420, 409, 410, 411, 893 9