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IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico

FROM PRINCIPLES TO PLANNING. IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico. IRC 987, Earnings & Profits/Tax Pools, Canadian Paid-Up Capital, and Mexican CUFIN/CUCA Joel Mitchell, Plante & Moran PLLC Randy Janiczek, Plante & Moran PLLC

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IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico

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  1. FROM PRINCIPLES TO PLANNING IRC 987 and Calculation of Earnings & Profits, Tax Pools – Canada PUC & Mexico

  2. IRC 987, Earnings & Profits/Tax Pools, Canadian Paid-Up Capital, and Mexican CUFIN/CUCA Joel Mitchell, Plante & Moran PLLC Randy Janiczek, Plante & Moran PLLC Gerard Roddis, MNP LLP Luis Vazquez, Mazars Mexico

  3. Concept of Earnings and Profits Earnings & Profits (“E&P”) measures the ability of a corporation to make distributions to its shareholders Except for purposes of determining the Accumulated Earnings Tax of § 531, for the most part, E&P does not affect the tax liability of corporations Current and accumulated E&P may result in taxable income to the shareholder/recipient of Actual distributions under §§ 301and 316(a); or Deemed distributions from a controlled foreign corporation (“CFC”) under § 951 or 1248 IRC 987 and Calculation of Earnings & Profits, Tax Pools

  4. Definition of E & P E&P is an economic measure of corporation’s ability to make distributions to shareholders; Conference Report on the Tax Reform Act of 1084, H.R. Rep. No. 98-861, at 835 (1984) The term E&P is not defined in the Internal Revenue Code; instead, its meaning has been developed through case law, IRS rulings and Treasury Regulations IRC 987 and Calculation of Earnings & Profits, Tax Pools

  5. Definition of E & P (cont’d) In Luckman v. Comr. 418 F.2d 381, 383 (7th Cir. 1969), the court defined E&P: “As used in federal taxation, (the concept of E&P) represents an attempt to separate those corporate distributions with respect to stock which represent returns of capital contributed by the stockholders from those distributions which represent gain derived from the initial investment by virtue of the conduct of the business. The crucial issue is whether a given transaction has a real effect upon the portion of the corporate net worth which is not representative of contributed capital and which results from the conduct of business” IRC 987 and Calculation of Earnings & Profits, Tax Pools

  6. Accounting Consistency Rule In general, the method of accounting for federal taxable income is followed in computing E&P, Treas. Reg.§ 1.312-6(a) For example, a corporation using the cash method of accounting for federal taxable income may not use the accrual method to determine E&P IRC 987 and Calculation of Earnings & Profits, Tax Pools

  7. Accounting Consistency Rule (cont’d) The Consistency Rule applies not only to the overall method of accounting, but to the accounting treatment of individual items Examples include: deferring income for federal taxable income, use of the installment method, changes in method of accounting, and timing of inclusion of tax items in E&P IRC 987 and Calculation of Earnings & Profits, Tax Pools

  8. Calculating the E&P of a Foreign Corporation E&P of foreign corporations is determined under very similar rules, as those used for domestic corporations (§ 964) The Three Steps for calculating E&P, per Treas. Reg. § 1.964-1(a)(1) Prepare a Profit and Loss Statement in CFC’s functional currency Make accounting adjustments necessary to P/L to conform with U.S. GAAP Make additional adjustments to GAAP P/L to conform with U.S. tax accounting IRC 987 and Calculation of Earnings & Profits, Tax Pools

  9. Mandatory US GAAP Adjustments Treas. Reg. § 1.964-1(b) contains the following adjustments that must be made to the foreign corporation’s financials, so that it conforms to GAAP principles: Clear reflection of income (i.e. no allocation to an arbitrary reserve) Use of historical cost for physical assets (i.e. no reflection of appreciation or depreciation in value or in the relative value of the currency in which the cost was incurred) Valuation of assets and liabilities (i.e. an accounting adjustment must be made for inventory written down to below its market value, even if not required under foreign law) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  10. Mandatory U.S. GAAP Adjustments (cont’d) Treas. Reg. § 1.964-1(b) contains the following adjustments that must be made to the foreign corporation’s financials, so that it conforms to GAAP principles Equalization of income and expenses (i.e. percentage of completion for long-term contracts is required for E&P) Foreign currency (i.e., for transactions undertaken in currency other than the functional currency of the corporation, translation must be made in a manner similar to U.S. rules for translating foreign currency into USD under § 988) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  11. Basic Concepts of Tax Adjustments to E&P Certain items excluded from book (U.S. GAAP) income must be added back to determine E&P Similarly, certain items deducted for taxable income may not be deducted for E&P The adjustments made to E&P of domestic corporations apply to foreign corporations with few notable exceptions § 952(c)(3): LIFO inventory adjustments Installment sales Completed contract method of accounting IRC 987 and Calculation of Earnings & Profits, Tax Pools

  12. Basic Concepts of Tax Adjustments to E&P (cont’d) Depreciation under § 312(k)(4) for assets placed into service after 1986 Foreign Corporations with 20% or more U.S. source income, 312(k)(4) requires the use of the alternative depreciation system for E&P purposes Foreign Corporations with less than 20% of U.S. source income and property outside of the U.S. must use the alternative depreciation system for all purposes The alternative depreciation system generally requires Property divided into classes Straight line depreciation based on lives specified under the Code IRC 987 and Calculation of Earnings & Profits, Tax Pools

  13. Common E&P Adjustments Foreign Corporations Common adjustments made to E&P include the following 1) Taxes 2) Inventory reserve 3) Bad Debts reserve 4) Stock options IRC 987 and Calculation of Earnings & Profits, Tax Pools

  14. Impact of Distributions with Respect to Stock on E&P § 312(a) provides in part, that distributions to shareholders with respect to their stock shall reduce E&P. The amount of reduction equals the sum of: money debt of the corporation, and adjusted basis of property distributed during the year The reduction cannot create a deficit in E&P IRC 987 and Calculation of Earnings & Profits, Tax Pools

  15. Ordering and Tracing Rules of Distributions § 316(a) provides that a distribution made by a corporation to its shareholders is treated as a dividend to the extent of current and accumulated E&P § 301(c) provides the order and character of corporate distributions First distributions are characterized as dividends to the extent of E&P (as determined under § 316) Once current and accumulated E&P have been exhausted, distributions shall reduce the adjusted basis of stock Distributions in excess of basis shall be treated as capital gains IRC 987 and Calculation of Earnings & Profits, Tax Pools

  16. Example of §§ 301 and 316 Example: Assume that P owns 100% of the stock of S. P has a $ 800 basis in the shares of S. S has accumulated deficit of ($ 6,000) E&P at end of 2010 In May of 2011, S makes a distribution of $ 1,000. At the time of distribution, S has no current year E&P Due to a large sale, S ends up with $ 700 of current year E&P Result: The distribution is sourced for purposes of § 301 as follows: (a) $ 700 of the distribution constitutes a dividend, § 301(c)(1) (b) $ 300 of the distribution represents basis recovery, §301(c)(2) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  17. Nimble Dividend Rule When a foreign corporation with an accumulated deficit in E&P, distributes a dividend out of current E&P, that dividend is commonly known as nimble dividend. Since the foreign corporation does not have a positive pool of E&P, the shareholder is not allowed a § 902 credit Example: M, a domestic corporation, owns 100% of A, a foreign corporation. At Dec. 31, 2010, A has a deficit in post-1986 Undistributed Earnings of ($ 200). At Dec. 31, 2011, A earns $100 net of foreign taxes of $40. A distributes $ 50 to M during 2010 Result: The $ 50 distribution is treated as a dividend per §316(a)(2). However, no foreign tax credit is allowed because of accumulated deficit pool of ($100), per § 902 IRC 987 and Calculation of Earnings & Profits, Tax Pools

  18. Distributions by Controlled Foreign Corporations There are certain differences in the ordering rules of distributions between CFC’s and domestic corporations § 959 alters the distribution rules to avoid earnings from being taxed twice Basic idea behind § 959 is to allow a CFC’s distributions of previously taxed income (“PTI”) to be free of tax Earnings previously taxed under the Subpart F regime or § 956, are tax free when distributed to U.S. Shareholders IRC 987 and Calculation of Earnings & Profits, Tax Pools

  19. Ordering of Distributions Previously Taxed Earnings § 959 Under § 959 three different baskets of E&P are maintained. CFC’s distributions to U.S. Shareholders are deemed to come out E&P in the following order §959(c)(1) – earnings included in income because of Investments in U.S. Property – the § 956 amount §959(c)(2) – earnings included in income because of Subpart F §959(c)(3) – other earnings - those not previously included in income of U.S. Shareholder IRC 987 and Calculation of Earnings & Profits, Tax Pools

  20. Example of Ordering Distribution Example: A domestic corporation (D) owns all the stock of F, a CFC. F has accumulated E&P of 225, which includes 30 of previously taxed § 956 income and 25 of previously taxed Subpart F income. During the calendar year 2011 the following transactions occurred (a) F makes a cash distribution of $ 100 to D. (b) There is an increase in Investment in U.S. Property of $ 10. (c) Subpart F income of $ 15 and other earnings of $ 30 Total current E&P = $ 55 Question: How much of the Distribution is taxable as a dividend? IRC 987 and Calculation of Earnings & Profits, Tax Pools

  21. IRC 987 and Calculation of Earnings & Profits, Tax Pools Example of Ordering Distribution (cont’d)

  22. Example of Ordering Distribution (cont’d) Answer: Portion of cash distribution treated as dividends = $ 20 (the § 959(c)(3) component) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  23. E&P and Tax Pools The E&P and Foreign Taxes are calculated annually, and accumulated into separate pools E&P pools are maintained in the foreign corporation’s functional currency and translated into U.S dollar at the appropriate rate under § 989(b) Foreign Taxes are translated into U.S. dollar at the average currency exchange rate for the year to which they relate under § 986 (a)(1) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  24. E&P “Appropriate Exchange Rate” § 989(b) E&P is translated into US dollar at the “appropriate exchange rate.” This is necessary when a taxable event occurs (i.e. inclusion of earnings in the gross income of U.S. Shareholder) Distributions of earnings – dividends – E&P is translated at the spot rate on the date of distribution, § 989(b)(1) Deemed dividend arising from sale /disposition of stock - § 1248 transaction- E&P is translated at the spot rate on the date of income inclusion, § 989(b)(2) Subpart F inclusions – E&P is translated at the average exchange rate for the year, § 989(b)(3) Investments in U.S. Property - § 956 Amount- E&P is translated at the average exchange rate for the year, § 989(b)(4) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  25. E&P of a CFC must be categorized into baskets, pools, and layers, and characterized by source E&P pools are subdivided into baskets according to the type of income from which it is derived (i.e. Subpart F, general category, passive income, etc.), § 902(c) The identification of E&P by categories is required to determine the following among others 1. Foreign tax credit basket classification of the dividend 2. U.S. or foreign source of the dividend 3. Taxability of actual distributions as dividends 4. Amount of exchange gain or losses on distributions of PTI 5. Subpart F and investments of U.S. property IRC 987 and Calculation of Earnings & Profits, Tax Pools

  26. E&P and Tax Pools: Example Example: Assume the following facts E&P in Local Taxes in Taxes Currency Local Currency in USD 2009 LC 300 LC 300 $ 250 2010 LC 200 LC 200$ 100 LC 500LC 500$ 350 The CFC pays a dividend of LC 250 to its U.S. parent in 2010. The taxes deemed paid are $ 175 (LC 250/LC500 X $ 350). After the dividend, the pool of E&P and taxes is reduced by the payment of LC 250 and by the $ 175 of taxes. E&PTaxes Pools of E&P before payment LC 500 $ 350 Dividend LC (250) $ (175) Undistributed E&P and Taxes LC 250$ 175 IRC 987 and Calculation of Earnings & Profits, Tax Pools

  27. Reorganizations and Similar Transfers §381(c) Carryover Tax Attributes Generally, in an acquisitive type reorganization under § 368, the acquiring corporation succeeds to certain tax attributes of the acquired corporation, per § 381(c) One of the tax attributes that the acquiring corporation succeeds to is the E&P (or deficit) of the acquired corporation,§ 381(c)(2) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  28. Reorganizations and Similar Transfers §381(c) Carryover Tax Attributes (cont.) At the date of reorganization, if both the acquiring and acquired corporations have accumulated E&P (positive earnings), these are simply blended into one account At the date of reorganization, if the acquired corporation has a deficit, and the acquiring has E&P, the two accounts (pools) cannot be blended into one account. The deficit in the acquired corporation can only offset future earnings (post-acquisition earnings) of the acquiring corporation; this is commonly known as, the Hovering Deficit rule, per § 381(c)(2)(B) IRC 987 and Calculation of Earnings & Profits, Tax Pools

  29. E&P Considerations for Various Transactions: Stock Sale - §1248 Related Party Redemption - §304 Check the Box Election - §332 Spinoff - §355 IRC 987 and Calculation of Earnings & Profits, Tax Pools

  30. History Prior to 1972, a return to shareholders from a corporation treated similar to the U.S. system – first out of “E&P” and treated as a dividend Post-1971, corporations may make a tax-free distribution of the corporate paid-up capital (“PUC”) even where “E&P” exists The Income Tax Act, Canada permits payments to shareholders as a reduction of capital up to the PUC of the shares Canadian Paid-Up Capital

  31. Definitions PUC is defined in the context of a class of shares by the applicable corporate jurisdiction and corporate law The corporate jurisdiction will likely use “stated capital” which is a legal term PUC is a tax term based on legal capital PUC is a corporate reference, and is averaged across a class of shares Canadian Paid-Up Capital

  32. Basics Shareholders control their adjusted cost base (“ACB”), but do not control PUC – usually differences between the two Mr. A subscribes for one common share for $1 - PUC and his ACB are $1 Mr. A sells his common share to Mr. B for $10 - PUC is still $1, but Mr. B’s ACB in the common share is $10 Canadian Paid-Up Capital

  33. Application PUC is relevant to many corporate/shareholder transactions, including acquisitions, wind-ups, amalgamations, share redemptions, capital reductions Since PUC may be returned tax-free to shareholders, specific avoidance provisions apply These provisions are directed primarily at limiting artificial increases in PUC Canadian Paid-Up Capital

  34. Planning #1 - acquisition Canadian Paid-Up Capital • USCo intends on acquiring CanTarget for $10M • Existing CanTarget PUC is $1M • CanTarget owns valuable Canadian real property CanTarget CanVendor Canada USA USCo

  35. Planning #1 - acquisition Canadian Paid-Up Capital • USCo acquires shares of CanTarget • USCo has an ACB of $10M in CanTarget shares • CanTarget’s PUC is still $1M • USCo may extract $1M tax-free from CanTarget • Can we do better? CanTarget CanVendor Canada USA USCo

  36. Planning #1 - acquisition Canadian Paid-Up Capital CanTarget • USCo incorporates CanAcqCo and subscribes for $10M in shares • CanAcqCo PUC is $10M • CanAcqCo acquires CanTarget from CanVendor for $10M • CanAcqCo and CanTarget amalgamate to form AmalCo CanAcqCo CanVendor Canada USA USCo

  37. Planning #1 - acquisition Canadian Paid-Up Capital CanTarget • AmalCo’s PUC is $10M • AmalCo may distribute $10M of its after-tax profits or property to USCo tax-free • Amalco may “bump” to $10M the ACB of its non-depreciable property CanAcqCo Canada USA USCo

  38. Planning #2 – ULC repatriation Canadian Paid-Up Capital • USCo owns 100% of CanULC • CanULC wishes to repatriate $10M of earnings to USCo • Article IV(7)(b) of the Treaty applies and USCo not afforded treaty benefits – 25% Canadian withholding tax • Can we use the Canadian PUC rules to our advantage? CanULC Canada USA USCo

  39. Planning #2 – ULC repatriation Canadian Paid-Up Capital • CanULC authorizes a $10M increase in its stated capital • PUC is increased by $10M • The Act treats an increase in PUC as a deemed dividend • A “nothing” for U.S. federal income tax purposes • Canadian withholding tax applies at 5% because the same Canadian and U.S. income tax treatment applies whether or not CanULC is a hybrid entity CanULC PUC increase Canada USA USCo

  40. Planning #2 – ULC repatriation Canadian Paid-Up Capital • CanULC authorizes a $10M reduction in its PUC • CanULC distributes $10M to USCo as a PUC reduction – no Canadian or U.S. income tax effect • $10M of CanULC’s earning have been repatriated to USCo at a 5% Canadian withholding tax rate CanULC PUC decrease Canada USA USCo

  41. Mexico – Calculation of Earnings and Profits • Net Tax Profit of the Year • The Net Tax Profit of the year (UFIN) will be determined as follow: • Net Tax result • (-) Income tax paid • (-) Employee profit sharing • (-) Non-deductible expenses • (=) Net tax profit of the year (UFIN) • If resulting number is negative, it will be reduced from the CUFIN balance

  42. Mexico – Calculation of Earnings and Profits Dividends distribution • Corporate requirements: • Financial statements must be approved by shareholders • Must exist profits in the financial statements • Tax implications: • If shareholder is a Mexican company and dividends < CUFIN, no income tax will be triggered and the income received will not be considered as taxable income by the receiving company • If dividends > CUFIN, the balance will pay income tax. Tax will be calculated by grossing up this balance multiplying it by 1.4286, the result will be multiplied by tax rate (30%) – income tax determined will be paid by the Mexican entity • Income tax paid by the Mexican entity could be credited against its annual income tax and the following tow years, also against advance payments

  43. Mexico – Calculation of Earnings and Profits Dividends distribution • If shareholder is a US entity and dividends < CUFIN, tax free dividends (no need to analyze USA – Mexico Tax Treaty) • If shareholder is a Mexican individual, the dividend received will be taxable on his Mexican annual income tax return. The individual will be able to credit the income tax paid by the legal entity that distributed the dividends

  44. Mexico – Calculation of Earnings and Profits Capital Contributions Account - CUCA • Capital Contribution Account (CUCA) should be determined as follows: • Balance of CUCA last year • (+) Capital contribution (effectively paid) • (+) Net premium of shares subscription • (-) Capital reductions • (=) Capital contribution account • Reinvestments or capitalization of profits or any other item that is part of the legal entity´s shareholders equity should not be consider for the CUCA calculation • Liabilities could be capitalized and should be considered as capital contributions

  45. Mexico – Calculation of Earnings and Profits Capital Reimbursement: • Entity must determine a tax profit, if applicable, considering two procedures: • Section I – Levied shareholders reimbursement • Section II – Levied profit distributed by the entity

  46. Mexico – Calculation of Earnings and Profits Capital Reimbursement (CR) Section I No tax triggered Difference is considered as profit, not exceeding the amount of the reimbursement The difference is considered as profit distributed Section I Such Profit less Profit Section I = Profit Section II Profit Section II> CUFIN Profit Section II < CUFIN = no tax triggered Profit < CUFIN = no tax triggered Profit > CUFIN Profit x 1.4286 x 30% = income tax Section I and Section II Yes No Section II CR < CUCA Equity account < CUCA Yes No

  47. Section 987 - Agenda Overview §987 Taxable Income or Loss §987 Gain or Loss IRC 987

  48. IRC 987 Section 987 - Background Definitions • QBU – Qualified business unit (Prop. Reg. §1.987-1(b)) • Eligible QBU is (1) a trade or business activity (2) with separate books and records, (3) assets and liabilities of the trade or business are reflected on those books and records, and (4) the activities do not operate in hyperinflationary environment. • Does not require a legal entity • §987 QBU – “eligible QBU […] that has a functional currency different from its owner” • Remittance (Prop. Reg. §1.987-5(c)) • Total amounts, in the owner’s functional currency, transferred from §987 QBU to the owner in excess of total amounts transferred from the owner to its §987 QBU

  49. Section 987 - Background §987 provides rules for determining (1) taxable income or loss and (2) §987 gain or loss of a taxpayer owning a §987 QBU. (1) Taxable income is income or loss of the QBU translated into the owner’s functional currency Average exchange rate (1991 regulations) Historical vs. Average approach (2006 regulations) (2) The §987 gain or loss results from appreciation or depreciation in the value of the QBU’s capital and earnings, based on changes in the value of the QBU’s currency relative to the owner’s functional currency. §987 gain or loss is recognized when the taxpayer makes “remittances” from QBU to its owner IRC 987

  50. Section 987 - Background In 1991, proposed 987 regulations were issued providing for the determination of taxable income or loss at the average exchange rate, plus §987 gain or loss based on the recovery of equity and basis pools as remittances are made. The evolution of check-the-box (CTB) regulations subjected more taxpayers to §987. Concern by IRS and Treasury Department that the 1991 proposed regulations permit the recognition of “non-economic §987 losses” because they determine §987 gain or loss with respect to all assets and liabilities, including nonfinancial assets. Remittances are not limited to “dividend” type distributions (Prop Reg. 1.987-5(c)(1)) IRC 987

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