Two significant pieces of international tax legislation are working their way through Congress this summer.
Corporate Expatriations – H.R. 2937
H.R. 2937, introduced on June 28, 2007, by Rep. Richard Neal (D-MA) and referred to the House Committee on Ways and Means for further consideration, would amend Section 7874 of the Internal Revenue Code (“Code”) to provide that management and administrative activities are not to be taken into account in determining if an entity has “substantial business activities” in a foreign country to avoid treatment as an expatriated entity.
Section 7874 applies if, pursuant to a plan or series of related transactions:
- a foreign corporation acquires, directly or indirectly, substantially all of the properties held a. directly or indirectly by a U.S. corporation (or substantially all of the properties constituting a trade or business of a domestic partnership);
- the foreign acquiring corporation (or any affiliated company) does not have “substantial b. business activities” in the foreign country in which the acquiring corporation is organized; and
- immediately after the acquisition, the former shareholders of the domestic target corporation c. own at least 60 percent of the vote or value of the foreign corporation by reason of holding stock in the domestic target corporation.
If the former shareholders own between 60–79 percent, the U.S. target is prevented for a 10-year period from using tax attributes to offset income realized on the transfer of stock or assets. If the shareholders own 80 percent or more, the acquiring corporation itself is treated as a domestic corporation for all U.S. tax purposes.
Two sets of temporary regulations were issued under the authority of Section 7874. The second set, in Temp. Reg. § 1.7874-2T(d)(1), provides that a “facts and circumstances” test is applied in determining whether “substantial business activities” are conducted by the affiliated group in the acquiring foreign entity’s country of incorporation. A non-exclusive list of factors is provided which includes employee headcount, sales, management activities, etc.
Alternatively, a safe harbor test is provided pursuant to which the “substantial business activities” provision will be complied with if three tests (measuring employees, assets and sales) are met.
H.R. 2937 would add Section 7874(a)(4) to eliminate “management and administrative activities” as a factor in determining whether the affiliated group has “substantial business activities” in the country of incorporation of the acquiring entity as compared with the affiliated group’s business activities worldwide. The genesis for the bill, apparently, was one company’s statement that it was moving its headquarters of the operation to a foreign country with no income tax. According to Rep. Neal, “many have speculated that this is really a two-step process: move some administrative functions abroad to establish a minimal presence and then give up U.S. corporate citizenship.”
The bill is broad and would apply to any management and administrative activities extending beyond top corporate management to include management and administration of operational units and would affect both the “facts and circumstances” test as well as the “safe harbor” test. Interestingly, management and administrative activities are not to be counted in the numerator but are to be counted in the denominator of the analysis.
It is not clear how serious an abuse this is and whether taxpayers can really credibly defend against a Section 7874 attack simply by moving management and administrative services, alone, to the acquiring entity’s country of incorporation. This factor, together with the anti-abuse provision of the regulations, would seem to suggest not.
However, it remains to be seen whether significant opposition will be generated from the tax community and lobbyists. No floor action has yet been taken up on the bill.
Fairness in International Tax - H.R. 3160
H.R. 3160, introduced on July 24, 2007, by Rep. Lloyd Doggett (D-TX) as an offset to a farm reauthorization bill, would amend Section 894 of the Code by providing that U.S. corporations making deductible payments to certain related foreign entities be required to withhold tax at the higher of the withholding rate applicable to payments made directly to the foreign parent and payments made to a foreign affiliate in a treaty country.
Citing a 2002 U.S. Treasury Department report regarding loopholes in the treaty network, Rep. Doggett introduced the “Fairness in International Tax” bill designed to curb abuses in the U.S. international tax treaty network. The bill is intended to prevent foreign multinationals from enabling their U.S. affiliates to make deductible payments to foreign affiliates located in low or no tax countries at reduced withholding rates.
The bill, which would add a new Section 894(d), would provide that if a U.S. entity makes a deductible payment to a foreign entity that is part of the same foreign controlled group of entities as the U.S. corporation, then the withholding tax rate to be applied to the payment shall be the higher of the rate applicable in the case of a payment to the foreign parent corporation (taking into account any relevant tax treaty between the U.S. and the country in which the foreign parent corporation is present) or the rate applicable on the payment to the controlled foreign entity in the treaty country.
Deductible payments include interest on loans made to the U.S. affiliate or royalties charged the U.S. affiliate for the use of intellectual property, e.g., patents, trademarks, copyrights. U.S. corporations will be considered part of the same foreign controlled group (the common parent of which is a foreign corporation) if 50 percent or more of the stock is held by other corporations within the same group.
Taxpayers potentially affected by this bill have already weighed in arguing that the bill runs counter to U.S. treaty policy, effectively abrogating various provisions of our tax treaties, and that the “limitation on benefits” provisions contained in most U.S. tax treaties are already designed to curb the cited abuses. In addition, taxpayers have argued that the bill ignores the commercial and business reasons for why corporations establish separate subsidiaries in different jurisdictions to hold intellectual property. Taxpayers also argue that this bill will further render the United States as an uncompetitive environment in which to do business that will have an adverse affect on employment and business growth in the United States. Finally, fear of retaliation by treaty partners has been cited as a concern.
Whether or not this bill survives remains to be seen. It has already been attached to a farm reauthorization bill, H.R. 2419, which passed the House on July 27, 2007. While there is significant opposition to it, including from the White House, the congressional search for revenue offsets can’t be underscored enough and it is not clear how this will play out.