Effective January 1, 2011, new U.S. legislation limits the foreign tax credits available to a U.S. corporation that directly or indirectly acquires a Canadian corporation in certain basis step-up acquisitions. By limiting foreign tax credits, this rule may increase the effective tax rates of U.S. acquirers of Canadian corporations.
Properly structured stock acquisitions may be treated as asset acquisitions for U.S. federal income tax purposes. Acquirers structuring stock transactions in this manner obtain a step-up in the U.S. tax basis of the target’s assets (including intangible assets) to fair market value, even though the transaction may be otherwise treated as a stock acquisition for Canadian tax purposes. (Although in some transactions a Canadian tax “bump” may increase the tax basis of certain non-depreciable capital property for Canadian income tax purposes, such as shares of subsidiaries or partnership interests, no such basis increase applies to other assets, such as intangible property). In general terms, these acquisitions are referred to as “covered asset acquisitions,” and are subject to special foreign tax credit limitations under recently enacted Section 901(m) of the U.S. Internal Revenue Code of 1986, as amended (the Code).
A “covered asset acquisition” includes (i) a stock acquisition for which an election under Section 338(g) of the Code1 is made, (ii) any transaction that is treated as an acquisition of assets for U.S. tax purposes and an acquisition of stock for non-U.S. tax purposes (e.g., the acquisition of all of the outstanding shares of a Canadian unlimited liability company that is disregarded for U.S. federal income tax purposes but is treated as a corporation for Canadian tax purposes), (iii) an acquisition of the interests in an entity treated as a partnership for U.S. federal income tax purposes for which an election under Section 7542 of the Code is in effect, and (iv) any other similar transaction that is identified in future U.S. Treasury Regulations. A covered acquisition can occur where the target is a non-U.S. entity or where the target is a U.S. entity holding non-U.S. assets, and can result from a third-party acquisition or a related-party acquisition.
Section 901(m) appears to have been motivated by concerns that covered asset acquisitions can create permanent differences between the U.S. and non-U.S. tax basis of non-U.S. assets that can lead to inappropriate cross-crediting of foreign taxes. For example, a covered asset acquisition that results in a step-up in the U.S. tax basis of a target’s depreciable assets may result in greater depreciation and amortization deductions for U.S. tax purposes than would typically be available for non-U.S. tax purposes when there has been no corresponding non-U.S. tax basis step-up. This basis disparity can result in an amount of non-U.S. taxes paid that is disproportionately high compared to the amount of income earned (as computed for U.S. tax purposes), resulting in a higher effective rate of non-U.S. tax. Prior to this new legislation, these “excess” non-U.S. taxes could, subject to certain other limitations, be cross-credited against U.S. tax otherwise payable on other non-U.S. source income of the taxpayer. Section 901(m) restricts this cross-crediting by reducing the amount of non-U.S. taxes eligible for the foreign tax credit.
New Section 901(m)
Following a covered asset acquisition, new Section 901(m) permanently disallows foreign tax credits for a portion of the non-U.S. taxes paid by the target. The “disqualified portion” of non-U.S. taxes is generally equal to:
Example4: U.S. Acquirer (P) acquires Canadian target (T) in a covered asset acquisition that increases T’s basis in its assets by $100 for U.S. federal income tax purposes. Assume the $100 basis is recoverable rateably over five years under the applicable U.S. cost recovery method and T has $40 of Canadian taxable income from operations in year X, taxed at a 30 percent rate. T pays $12 of Canadian taxes. The disqualified portion of the taxes for year X is equal to $6 (the $12 of Canadian taxes paid (x) multiplied by the $20 of U.S. basis attributable to the covered asset acquisition and recoverable in year X under U.S. principles and (y) divided by the $40 of Canadian taxable income). Thus, half of the $12 of Canadian taxes paid would not be creditable to P.
The disqualified portion of non-U.S. taxes relating to the covered acquisition is allowable as a deduction to the U.S. acquirer, subject to the application of general U.S. tax rules.
Example (con.): T distributes $28 of available cash to P ($40 of income, net of $12 of Canadian taxes paid). P has $34 of income for U.S. tax purposes (the $28 dividend, assuming T has sufficient earnings and profits, grossed up by the $12 of Canadian taxes paid and reduced by the $6 deductible disqualified portion). P has $11.90 of U.S. income tax due (assuming a 35 percent rate), against which it can credit the $6 of the Canadian taxes paid that were not disqualified. P has a net U.S. income tax liability of $5.90, compared to the $2 of net U.S. income tax liability it would have owed prior to the enactment of Section 901(m) (in which case, the full amount of Canadian taxes paid ($12) would be creditable).
Subject to limited grandfathering provisions, new Section 901(m) applies to any covered asset acquisition occurring after December 31, 2010.
Transactions treated as covered asset acquisitions are common in international tax planning. Often these transactions are principally motivated by a desire to obtain a “clean slate” for the target for U.S. federal income tax purposes (e.g., to avoid having to determine the target’s historic U.S. tax attributes, which may not have been previously maintained by a non-U.S.-owned target), rather than a desire to obtain a basis step-up. U.S. acquirers may need to weigh the relative benefits of a “clean slate” for U.S. federal income tax purposes against the foreign tax credit cost of such election under Section 901(m), and, in some cases, restructure transactions to avoid the application of the provision. Multinationals with U.S. ownership will also need to be cognizant of the potential application of these rules to internal group restructurings that may be treated as covered asset acquisitions.
In addition, this legislation may impose significant administrative burdens on prospective acquirers. For example, in order to determine the potential impact of Section 901(m) in any given acquisition, purchasers may need to determine the pre-acquisition U.S. tax basis of the target’s assets. In the case of non-U.S. targets, this information may not be available and it may be extremely difficult to reliably derive this information from available records. The legislative history to the provision anticipates that the U.S. Treasury will issue regulations identifying circumstances in which it may be acceptable to use the basis of the target’s assets under non-U.S. law prior to the covered asset acquisition, or another reasonable method, in order to determine the pre-acquisition U.S. tax basis of the assets. Furthermore, if there is a covered asset acquisition, Section 901(m) in its current form is applicable regardless of whether such acquisition actually results in a difference between the U.S. tax basis of the target’s assets and the non-U.S. tax basis in such assets. Section 901(m)(7) does, however, indicate that the U.S. Treasury may issue regulations to exempt covered asset acquisitions where the difference in basis is de minimis, but the U.S. Treasury Department is not required to issue any such regulations.
Application to Canadian Taxpayers
As the example above illustrates, Section 901(m) can substantially limit the U.S. foreign tax credits available to U.S. acquirers following a covered asset acquisition. As a result, potential acquirers of Canadian targets who are either U.S. persons or Canadian entities with U.S. ownership should work with their U.S. tax advisors to determine the effect of the provision on any tax modelling of post-acquisition operations of the Canadian target. Further, because the determination of the disqualified portion of foreign tax credits is a function of the U.S. tax basis of the target’s assets prior to the acquisition, acquirers may be required to engage in rigorous due diligence to verify, or in many cases calculate for the first time, the U.S. tax basis of the Canadian target in its assets. Similar concerns apply to multinationals with U.S. ownership, who will need to be cognizant of the potential application of these rules to internal group restructurings, such as internal transfers of Canadian unlimited liability companies, that may be treated as covered asset acquisitions.
Finally, in cases where a U.S. purchaser, through a Canadian acquisition corporation, acquires a Canadian target corporation and concurrently (i) makes a Section 338(g) election in connection with the acquisition, and (ii) obtains a Canadian tax “bump” in the basis of the Canadian target’s nondepreciable property, the Section 901(m) limitation may apply with respect to Canadian taxes on income attributable to the bumped assets, notwithstanding that there should be no material difference in the U.S. and Canadian tax basis of such assets immediately after the acquisition. While this result may be modified by future U.S. Treasury Regulations, it is not yet clear whether those regulations will be issued.