On April 10, 2013, the Obama Administration (the “Administration”) released the General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals (commonly known as the “Green Book”). Although the Green Book does not include proposed statutory language, the Green Book contains some explanations of the Administration’s fiscal year 2014 revenue proposals. This memorandum discusses key aspects of the Green Book relating to international taxation that we anticipate may be of interest to our clients. We will be distributing separate memoranda addressing Green Book proposals relating to (1) domestic business taxation, and (2) individual, retirement plans, and estate and gift taxation, both of which may be obtained by following the instructions at the end of this memorandum.
The Green Book’s international proposals would make significant changes in existing law. The proposals relating to international taxation include:
- exempting foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA);
- deferring interest deductions related to deferred foreign income;
- determining foreign tax credit pools on an aggregate basis;
- currently taxing some types of income from intangible property transferred to offshore related parties and clarifying (or broadening) the definition of intangible property;
- disallowing deductions for non-taxed reinsurance premiums paid to offshore affiliates;
- limiting earnings stripping by expatriated entities;
- modifying the foreign tax credit rules for dual capacity taxpayers;
- taxing some gain from the sale of a partnership interest as effectively connected to a U.S. trade or business and requiring withholding in certain circumstances;
- taxing certain leveraged distributions from related foreign corporations;
- placing additional limits on the use of foreign tax credits in the case of certain asset acquisitions; and
- removing foreign taxes from the foreign tax pool in the case of certain domestic shareholder corporations when earnings are eliminated from a foreign subsidiary.
The Green Book proposals described below would generally become effective for taxable years beginning after December 31, 2013, and the Administration estimates that these proposals would raise more than $157 billion over the 10-year period 2014-2023.1
1. Exempt Foreign Pension Funds from the Application of the Foreign Investment in Real Property Tax Act (FIRPTA)
FIRPTA generally requires nonresident alien individuals or foreign corporations to pay U.S. federal income tax on gain from the sale of a direct, or indirect, interest in U.S. real property.2 FIRPTA is intended to subject foreign investors to the same U.S. federal income tax treatment that applies to U.S. investors on gains from the disposition of U.S. real property interests.3 This rule however, may result in unequal treatment of U.S. and non-U.S. pension funds: U.S. pension funds are generally exempt from U.S. federal income tax, including any U.S. federal income tax on the gain from a disposition of a U.S. real property interest, while foreign pension funds would be required under FIRPTA to pay U.S. federal income tax on any gain from a disposition of a U.S. real property interest.
The Green Book proposal would eliminate this disparity and exempt foreign pension funds from the application of FIRPTA gains. To qualify for this exemption, a foreign pension fund would have to be (i) a foreign organization or arrangement, (ii) generally exempt from income tax in the jurisdiction in which it is created or organized, and (iii) substantially all of its activity would have to consist of administering or providing pension or retirement benefits.4 The proposal does not, however, address the taxation of rent or similar income.
2. Defer Deduction of Interest Expense Related to Deferred Foreign Income
Under current law, a U.S. person’s total interest expense is generally allocated and apportioned between the person’s U.S. assets and foreign assets, and the interest allocated to the foreign assets is treated as foreign source expense. That foreign source interest expense may be currently deducted even if the foreign assets to which it was allocated did not currently generate any foreign income subject to U.S. tax.5
The Green Book proposal would defer the deduction of interest expense that is allocated and apportioned to “stock of a foreign corporation that exceeds an amount proportionate to the taxpayer’s pro rata share of income from such subsidiaries that is currently subject to U.S. tax.” For this purpose, foreign-source income earned by a taxpayer through a branch would be considered currently subject to U.S. tax.
The Green Book provides that while current Treasury regulations would generally continue to govern the sourcing of interest expense, it is anticipated that the Treasury Department will “continue to 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.”6 Deferred interest expense would be deductible in a subsequent taxable year to the extent that the amount of interest expense allocated and apportioned to stock of foreign subsidiaries in such subsequent year is less than the annual limitation for that year, subject to Treasury regulations that may modify the manner in which such deferred interest expenses may be deducted.7
3. Foreign Tax Credit Pooling
Under current law, a domestic corporation that owns 10 percent or more of the voting stock of a foreign corporation from which the domestic corporation receives a dividend may claim a deemed paid foreign tax credit for a portion of the income taxes paid to foreign jurisdictions by such foreign corporation.8
The Green Book proposal would require a domestic corporation to determine its deemed paid foreign tax credit by looking at the aggregate earnings and profits of all of the domestic corporation’s foreign subsidiaries. The domestic corporation’s deemed paid foreign tax credit would then be limited to an amount proportionate to the taxpayer’s pro rata share of the aggregate earnings and profits repatriated to the United States in that year that are currently subject to U.S. tax. Under this proposal, foreign taxes deferred in prior years would be creditable in a subsequent taxable year to the extent that the current year deemed paid foreign taxes do not exceed the limitation for that year.
4. Provisions Relating to the Transfer of Intangible Property
The Green Book contains two provisions relating to transfers of intangible property by U.S. persons to foreign persons. Current law provides that if intangible property is transferred or licensed to a related person, the income recognized by the transferor must be “commensurate with the income” derived by the transferee from the intangible;9 similarly, if intangible property is transferred by a U.S. person to a foreign corporation in a nonrecognition transaction, the transfer is recharacterized as sales of such property in exchange for a series of contingent payments commensurate with the income derived by the transferee from the intangible.10 In addition, Code Section 482 authorizes the IRS Commissioner to “distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses.” According to the Green Book, the “potential tax savings from transactions between related parties, especially with regard to transfers of intangible assets to low-taxed affiliates, puts significant pressure on the enforcement and effective application of transfer pricing rules.”11 This, together with frequent controversies about the scope of intangible property subject to the two “commensurate with income” rules, has led to “inappropriate avoidance of U.S. tax”12 and “significant erosion of the U.S. tax base.”13
a. Excess Returns Associated with Transfers of Intangibles Offshore
The first Green Book proposal would apply whenever a U.S. person transfers an intangible from the United States to a related controlled foreign corporation (“CFC”). U.S. shareholders of a CFC are taxed currently on some types of the CFC’s income (generally, passive income and some intercompany sales and services income) known as “subpart F income”, as if these shareholders had received a dividend of this subpart F income. The proposal would expand the reach of this anti-deferral regime by treating as subpart F income derived by that CFC any “excess intangible income” attributable to the intangible if such income is subject to a “low foreign effective tax rate.”14 Where the effective tax rate is 10 percent or less, all excess income would be treated as subpart F income. This treatment would phase out ratably for effective tax rates of 10 to 15 percent. Excess intangible income is defined as “the excess of gross income from transactions connected with or benefitting from” the intangible, over the costs (excluding interest and taxes) allocable to the income and increased by a percentage mark-up (emphasis added).15
A “transfer” to a CFC for this purpose includes transfers by license, lease, sale, or any shared risk or development agreement (including any cost sharing arrangement). This subpart F income would be a separate category of income for foreign tax credit limitation purposes.
The effective date proposed would apply the provision to any “transaction” by the CFC connected with or benefitting from the intangible occurring in taxable years beginning on or after January 1, 2014, even if the intangible “transfer” took place prior to 2014.
b. Limiting the Shifting of Income through Intangible Property Transfers
The second Green Book proposal would “clarify” that the definition of intangible property for purposes of Code Sections 367(d) and 482 includes “workforce in place, going concern value and goodwill,” meaning that transfers of such items would be subject to the two “commensurate with income” rules referred to above. The proposal would also clarify that (i) when multiple intangibles are transferred, the IRS Commissioner may value them on an aggregate basis if that achieves a more reliable result, and (ii) the IRS may value intangible property “taking into consideration the prices or profits that the controlled taxpayer could have realized by choosing a realistic alternative to the controlled transaction undertaken.”16
5. Disallowance of Deduction for Non-Taxed Reinsurance Premiums Paid to Affiliates
Under current law, insurance companies are generally permitted to deduct premiums paid for reinsurance, including premiums paid to foreign affiliates. While subpart F limits the ability of domestic insurance companies to use reinsurance with foreign affiliates to avoid current U.S. taxation (because the foreign affiliate’s reinsurance premium income is subpart F income), foreign insurance companies with foreign parents are not subject to the subpart F regime. Current law does, however, impose a one percent excise tax on reinsurance premiums paid to foreign reinsurance companies with respect to U.S. risks. According to the Green Book, the Administration believes that this excise tax is not always sufficient to offset the tax advantage of reinsurance with foreign-owned foreign insurance company affiliates, and that this tax advantage “creates an inappropriate incentive for foreign-owned domestic insurance companies to reinsure U.S. risks with foreign affiliates.”17
The Green Book proposal would deny an insurance company deductions for premiums and other amounts paid to an affiliated foreign company with respect to reinsurance of property and casualty risks to the extent that neither the foreign reinsurer nor its parent company is subject to U.S. income tax with respect to the premiums. The denial of the deduction would not apply if the foreign reinsurance company elected to treat the premium (and the associated investment income) as income effectively connected with a U.S. trade or business and attributable to a permanent establishment for tax treaty purposes. If the election was made, the income would be foreign source and in a separate foreign tax credit limitation basket. The proposal would be effective for policies issued in taxable years beginning after December 31, 2013, and thus would apparently not apply to any policies issued before December 31, 2013.18
6. Limit Earnings Stripping by Expatriated Entities
The “earnings stripping” rules of the Code currently limit the ability of a corporation to deduct interest paid to a related person that is not subject to U.S. tax on such interest. This limitation applies only if the corporation paying the interest (i) has a debt-to-equity ratio greater than 1.5-to-1 and (ii) has net interest expense in excess of 50 percent of adjusted taxable income (generally computed by adding back net interest expense, depreciation, amortization, depletion, any NOL deduction, and any Code Section 199 deductions). The interest expense disallowed may be carried forward indefinitely, and the corporation’s excess limitation for a tax year (the excess of 50 percent of adjusted taxable income, over the corporation’s net interest expense for the year) may be carried forward to increase the amount of deductions in future years for up to three years.
Two alternative sets of special rules apply to so-called “expatriated” U.S. corporations and the related acquiring foreign corporations but generally applies only to expatriations taking place on or after March 4, 2003. Additionally, only if there was 80 percent or greater shareholder continuity in relation to the expatriation do the harsher set of rules apply (i.e., the acquiring foreign corporation is treated as a domestic corporation for all purposes of the Code).
The Green Book explains that, despite these rules, a 2007 Treasury Department study found “strong evidence” of the use by expatriated entities of foreign related-party debt to reduce the U.S. tax on income earned from U.S. operations.
The Green Book proposal would apply to any “expatriated entity”, other than an expatriated entity already treated as a domestic corporation. The proposal would tighten earnings stripping rules for such entities by (i) eliminating the debt-to-equity safe harbor, (ii) reducing the 50 percent of adjusted taxable income threshold to 25 percent, (iii) limiting the carryforward of disallowed interest to 10 years, and (iv) eliminating the excess limitation carryforward.
7. Modify the Foreign Tax Credit Rules for Dual Capacity Taxpayers
Under current law, special foreign tax credit rules apply to taxpayers who pay a levy to a foreign jurisdiction and receive a specific economic benefit, such as the right to extract petroleum or other minerals in exchange for payment of the levy (such a taxpayer, a “dual capacity taxpayer”). When a foreign levy applies differently to dual capacity taxpayers as opposed to other taxpayers (other than as the result of a lower rate being applied to dual capacity taxpayers), such levy is treated as a creditable foreign income tax only to the extent established by the taxpayer to be a tax (i.e., not an amount paid in exchange for the specific economic benefit). A dual capacity taxpayer may meet this burden of establishing what portion of the levy is a tax under either: (1) the facts and circumstances test (i.e., the taxpayer must show based on the facts and circumstances that the amount was not paid as compensation for the specific economic benefit; or (2) the safe harbor test (a formula that derives the amount of the levy that may qualify as a tax).19
The Green Book explains that the current law “fails to achieve the appropriate split” that should exist “between a payment of creditable taxes and a payment in exchange for a specific economic benefit” in certain cases.20
The Green Book proposal would replace the current regulatory provisions and instead permit a dual capacity taxpayer to treat as a creditable tax the portion of the foreign levy that does not exceed the foreign tax that would be due if the taxpayer were not a dual capacity taxpayer. This aspect of the proposal would defer to U.S. treaty obligations to the extent that they explicitly allow a credit for taxes paid or accrued on certain oil or gas income and would be effective for amounts that, if such amounts were an amount of tax paid or accrued, would be considered paid or accrued in taxable years beginning after December 31, 2013. For taxable years beginning after December 31, 2013, this Green Book proposal would also convert foreign oil and gas income credit limitation rules into a separate foreign tax credit limitation basket.
8. Tax Gain from the Sale of a Partnership Interest on Look-Through Basis
In general, capital gain of a nonresident alien individual or foreign corporation from the sale or exchange of property, including a partnership interest, is subject to U.S. federal income tax only if such gain is treated as income that is effectively connected with the conduct of a U.S. trade or business (“ECI”). In Revenue Ruling 91-32, the IRS held that a foreign partner’s gain or loss from the sale or exchange of a partnership interest should be treated as ECI to the extent of such foreign partner’s share of unrealized partnership gain or loss attributable to property used or held for use in the partnership’s U.S. trade or business. The holding in IRS Revenue Ruling 91-32 has not been codified.
According to the Green Book, notwithstanding IRS Revenue Ruling 91-32, foreign taxpayers might take the position that gain from the sale of a partnership interest is not subject to U.S. federal income tax because there is no Code provision explicitly providing that gain from the sale or exchange of a partnership interest by a nonresident alien individual or foreign corporation is treated as ECI.21 If this position is taken and the partnership has in effect an election under Code Section 754 to adjust the basis of its assets upon the transfer of an interest in the partnership, then such gain may escape U.S. federal income tax altogether.
The Green Book proposal would codify Revenue Ruling 91-32. The Secretary would be granted authority to specify the extent to which a distribution from a partnership is treated as a sale or exchange of an interest in the partnership and to coordinate the new provision with the nonrecognition provisions of the Code. Additionally, the proposal would require the transferee of a partnership interest to withhold 10 percent of the amount realized on a sale or exchange of the partnership interest unless the transferor certified that the transferor was not a nonresident alien individual or foreign corporation (if the transferor provided an IRS certificate establishing that its U.S. federal income tax liability with respect to the transfer was less than 10 percent of the amount realized, the transferee would withhold the lesser amount). The partnership would be liable for any underwithholding by the transferee with respect to the transfer and would be required to satisfy the withholding obligation by withholding on future distributions to the transferee partner.22
9. Prevent Use of Leveraged Distributions from Related Foreign Corporations
A distribution of property from a corporation to a shareholder is treated first as a dividend to the extent of the distributing corporation’s earnings and profits and then the excess amount, if any, is treated as a reduction in the shareholder’s adjusted basis in its stock of the distributing corporation.23 Any amount of the distribution in excess of both earnings and profits and the shareholder’s basis is treated by the shareholder as gain from the sale or exchange of property.24 There is no provision under current law that limits a foreign corporation from funding a distribution (the “foreign funding corporation”) made by a related foreign corporation that does not have earnings and profits (the “foreign distributing corporation”). In such a case, the distribution would not be treated as a dividend and, if the distributee shareholder has sufficient basis in the foreign distributing corporation, the distributee would not be subject to U.S. federal income tax on the distribution.
To prevent this result, the Green Book proposal would disregard a U.S. shareholder’s basis in the stock of the foreign distributing corporation in cases where a foreign funding corporation funds a related foreign distributing corporation’s distribution with the principal purpose of avoiding dividend treatment. For this purpose, the foreign funding corporation and the foreign distributing corporation would be treated as related if they are members of the same “controlled group” within the meaning of Code Section 1563(a), but replacing references to “at least 80 percent” with “more than 50 percent.”25 Additionally, the proposal would apply whether the funding transaction between the foreign funding corporation and the foreign distributing corporation “occurs before or after the distribution.”26
10. Extend Section 338(h)(16) to Certain Asset Acquisitions
Under Section 338 of the Code, an election may be made to treat certain qualified stock purchases as asset acquisitions (a “Section 338 election”), resulting in a stepped-up basis of the target corporation’s assets. Under Section 338(h)(16) of the Code however, “the deemed asset sale resulting from a Section 338 election is not treated as occurring for purposes of determining the source or character” of the income when applying the foreign tax credit rules. This “prevents a seller from increasing allowable foreign tax credits as a result of a Section 338 election.”27
Section 901(m) of the Code denies foreign tax credits with respect to foreign income that is not subject to U.S. taxation by reason of an acquisition of assets that have a higher tax basis for U.S. tax purposes than for foreign tax purposes (such acquisitions, “Covered Asset Acquisitions” or “CAAs”). A transaction in which a Section 338 election is made is one such CAA to which Section 901(m) applies.
The Green Book explains that other types of CAAs subject to the credit disallowance rule under Section 901(m) “present the same foreign tax credit concerns as those addressed by section 338(h)(16)” but do not have a similar limit on the ability of a seller to increase allowable foreign tax credits by entering into a transaction that is treated as an asset acquisition for U.S. tax purposes but as a stock acquisition for foreign tax purposes. The Green Book proposal would impose such limits by extending the application of section 338(h)(16) to any CAA to which Section 901(m) applies.28
11. Remove Foreign Taxes from a Section 902 Corporation’s Foreign Tax Pool When Earnings Are Eliminated
Under current law, a domestic corporation which owns 10 percent or more of the voting stock of a foreign corporation from which it receives dividends (or, in certain cases, a subpart F income inclusion that is treated as a deemed dividend) is generally deemed to have paid the same proportion of such foreign corporation's foreign income taxes as the amount of such dividends (or deemed dividends) bears to such foreign corporation’s undistributed earnings and profits.29 Following such a dividend (or deemed dividend), the earnings and profits and the associated foreign taxes paid are reduced. However, certain other transactions eliminate a foreign corporation’s earning and profits without a corresponding reduction in the associated foreign taxes paid (e.g., the Green Book cites a partial redemption of corporate stock30 and a tax-free distribution under Code Section 355).31
The Administration argues that the elimination of earnings and profits for certain transactions, without a corresponding reduction in the associated foreign taxes paid, results in a taxpayer claiming a credit for foreign taxes paid with respect to earnings that will no longer fund a dividend distribution.32 The Green Book proposal would reduce the amount of foreign taxes paid by a foreign corporation in the event a transaction results in the elimination of a foreign corporation’s earnings and profits, other than a reduction of earnings and profits by reason of a dividend or deemed dividend, or by reason of a Code Section 381 transaction (generally providing that earnings and profits and other tax attributes of a target corporation carry over to an acquiring corporation in a tax-free restructuring transaction). The amount of foreign taxes that would be reduced in such a transaction would equal the amount of foreign taxes associated with the eliminated earnings and profits.