Foreign Tax Credits – Advanced Topics

FROM PRINCIPLES TO PLANNING Foreign Tax Credits – Advanced Topics

Foreign Tax Credits – Advanced Topics Jerry Jonckheere, Plante & Moran PLLC Michael Schwartz, WeiserMazars LLP Bill Henson, Plante & Moran PLLC Tim Bloos, MNP LLP

Agenda • Requirements to claim a foreign tax credit • Limitations • Overall foreign loss • Overall domestic loss • Separate loss limitations • Foreign tax credit splitters • New section 909 • Covered asset acquisitions • New section 901(m) • Planning for excess foreign tax credits • Questions • .

Creditable Taxes • Requirements for a tax to be creditable • It must be a tax • It must be based on income • It must be paid or accrued during the taxable year • It must be paid or accrued to a foreign country or a U.S. possession

Creditable Taxes • What is a tax? • Compulsory payment pursuant to the authority of a foreign country to levy taxes • It does not include payments to a foreign government for which the taxpayer receives a specific economic benefit • It does not include • Penalties, fines, interest, customs duties, etc

Creditable Taxes • Tax must be based on income • The predominant character of the base of the tax must be an income tax • Foreign tax must be likely to reach the net gain in which it applies • Foreign tax must not depend on the availability of a foreign tax credit in another country – aka “soak-up” tax • In lieu of taxes are permissible

Creditable Taxes • Paid or accrued to a foreign country or U.S. Possession • Any foreign state and any political subdivision of any foreign state • U.S. possessions include • Puerto Rico • U.S. Virgin Islands • Guam • Northern Mariana Islands • American Samoa • The amount paid or accrued must be a “reasonable approximation of the final tax liability to the foreign country”

Creditable Taxes • Paid or accrued by the taxpayer • Tax is considered paid by the person who is legally liable for the tax • Person who is required to take the income into account for foreign income tax purposes • Even if another person is obligated to remit the tax, such as a withholding agent • Joint and several liability and tax on the combined income of two or more persons • Each persons foreign tax liability is the amount allocable based on their pro rata share of the combined foreign income

Creditable Taxes • Paid or accrued by the taxpayer • Identity of the technical taxpayer has been the source of substantial controversy and, as a result of taxpayer victories, changes in the law

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Ordering Rules under Reg. §1.904(g)-3T: • Allocate net operating loss and net capital loss carry forward deductions • Allocate foreign losses • Allocate separate limitation losses • Allocate overall foreign losses • Allocate overall US source losses • Recapture overall foreign loss • Recapture separate limitation loss • Recapture overall domestic loss • Allocate net operating loss and net capital loss carryback deductions • Perform steps 2 and 3 again after carryback deductions

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Net Operating Losses – Reg. §1.904(g)-3T(b) • In a year where an NOL is generated, a taxpayer must source and categorize the NOL between U.S. source and the various foreign income categories • If an NOL from a particular taxable year is deducted in its entirety in a carryover year, the U.S. source losses and foreign source losses in separate categories that are part of the NOL are combined with the U.S. income or loss and the foreign source income or loss in the same separate categories in the carryover year

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Net Operating Losses (con’t) • If an NOL from a particular taxable year is partially deducted in a carryover year, the source of the NOL deduction is determined using the following ordering rules from Reg. §1.904(g)-3T(b)(3): • U.S. source NOL to the extent of any U.S. source income in the carryover year • Foreign source NOL in each separate limitation category to the extent of any foreign source income in each separate limitation category • Foreign source NOL in each separate limitation category to the extent of any remaining foreign source NOL after step 2 • U.S. source NOL to the extent of any remaining U.S. source NOL after step 1

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Overall Foreign Losses (OFL) - §904(f) • An OFL is created when a taxpayer has an overall foreign source taxable loss that offsets U.S. source taxable income. • Distinguish between a foreign source NOL carryover which has not yet offset any income and an OFL which has offset U.S. source taxable income • An OFL is carried forward indefinitely to future years where the taxpayer must recapture the OFL as U.S. source income • The OFL recapture does not affect the total amount of taxable income, rather it reclassifies how much of the taxable income is foreign source vs. U.S. source

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Separate Limitation Losses (SLL) - §904(f)(5) • An SLL is created when a taxpayer has a loss one separate limitation foreign income category that offsets income in another foreign income category • An SLL is carried forward indefinitely to future years where the taxpayer must recapture the SLL • There is no 50% income limitation on the recapture of separate limitation losses as there is with OFLs and ODLs

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Overall Domestic Losses (ODL) - §904(g) • The American Jobs Creation Act of 2004 added the ODL provisions of §904(g) effective for tax years beginning after December 31, 2006. For tax years beginning before 2007, there was no ODL recapture provision in effect. • An ODL is created when a taxpayer has an overall U.S. source taxable loss that offsets foreign source taxable income in any year beginning after December 31, 2006 in which the taxpayer elects under §901 to take a foreign tax credit. • Distinguish between a U.S. source NOL carryover which has not yet offset any income and an ODL which has offset foreign source taxable income • An ODL is carried forward indefinitely to future years where the taxpayer may recapture the ODL as foreign source income

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Overall Domestic Losses (ODL) - §904(g) (con’t) • ODL recapture equals the lesser of: • 50% of the taxpayer’s U.S. source income for the year, or • the amount of ODL carry forward to the tax year • Even though the ODL recapture comes after the OFL recapture in the Reg. §1.904(g)-3T ordering rules, the 50% U.S. source income limitation on the ODL recapture is based on the U.S. source income before the OFL recapture.

Section 904(f) and (g) – OFL, ODL, SLL, NOL • Case Study – click on PDF icon to access a case study on OFLs, ODLs, SLLs, and NOLs (case study also provided as separate file)

Splitters Paid or accrued by the taxpayer • Identity of the technical taxpayer has been the source of substantial controversy and, as a result of taxpayer victories, changes in the law

Splitters Guardian Industries Corp & Subs v. United States Luxembourg Fiscal Unity Group US Under Luxembourg law, the Lux parent of the group was responsible for paying taxes for the fiscal unity group Lux Holding Lux Opco 2 Lux Opco 3 Lux Opco 1

Splitters Guardian Industries Corp & Subs v. United States • Both the Court of Claims and the Federal Circuit ruled in favor of the taxpayer • The courts relied on literal reading of regulation section 901-2(f)(1) and Lux law to conclude that the Lux Holding company was responsible for the payment of Lux income taxes • The courts told the government to change the regulations of they wanted a different result

Splitters Government has taken several steps to attempt to eliminate taxpayers ability to split taxes from the income to which they relate • 2006 – regulations proposed under section 901 addressing the technical taxpayer • 2006 – section 704 regulations amended to require that foreign tax credits be allocated among the partners in accordance with their interests in the partnership. • Special allocations no longer permissible • 2008 – Government issued temporary and proposed regulations that provide that a foreign tax payment is not a compulsory payment, and thus not creditable, if the foreign tax payment is attributable to “structured passive investment arrangements” • 2010 – codification of economic substance doctrine • 2010 – codification of anti-splitter statutes in code section 909

Splitters New code section 909 – Suspension of credits and taxes until related income taken into account • If there is a FTC splitting event, such tax shall not be taken into account before the taxable year in which the income is taken into account (section 909(a)) • Also applies for purposes of sections 902 and 960 as well as for earnings and profits • Special rules for partnerships and S corporations • Effective date – applicable to years beginning after 12/31/2010 • But is then effective retroactively • Retro active application requires taxpayers to recompute E&P

Splitters • What is a “foreign tax credit splitting event”? • There is a FTC splitting event with respect to a foreign income tax if the related income is (or will be) taken into account under this chapter by a covered person.

Splitters • What is “related income”? • The term “related income” means, with respect to any portion of any foreign income tax, the income (or as appropriate, earnings and profits) to which such portion of foreign income tax relates.

Splitters • Who is a “covered person”? • With respect to any person who pays or accrues a foreign income tax • Any entity in which the payor holds, directly or indirectly, at least a 10 percent ownership interest (determined by vote or value) • Any person which holds, directly or indirectly, at least a 10 percent ownership interest (determined by vote or value) in the payor • Any person which bears a relationship to the payor described in section 267(b) or 707(b), and • Any other person specified by the Secretary

Splitters Notice 2010-92 • Guidance issued 12/6/2010 • Anticipates it will be the first of several guidance concerning section 909 • Statute provides expansive language with regard to authority to issue regs “as is necessary or appropriate to carry out the purposes of this section…” • Addresses the implications of foreign income taxes paid or accrued in years beginning before 2011 • Provides an exclusive list of arrangements that are treated as FTC splitting events for purposes of section 909 to pre-2011 years

Splitters Reverse Hybrids • Reverse hybrid is a corporation for U.S tax purposes but a flow-through or a branch for local country purposes • Owner of the reverse hybrid is subject to tax on the income of the reverse hybrid • Notice requires a section 902 corporation must own the reverse hybrid • Section 909 would apply if the US person owned the Reverse Hybrid directly but Notice 2010-92 is focused on the application of 909 to pre-2011 taxes US Person Taxes paid by CFC CFC Reverse Hybrid E&P stays in the reverse hybrid

Splitters Foreign Consolidated Groups • A foreign consolidated group is a pre-2011 splitter to the extent that the taxpayer did not allocate foreign consolidated tax liability among members of the foreign consolidated group based on each member’s share of consolidated taxable income under the principles of Reg 1.901-2(f)(3) • Applies even if one or more members has a deficit in earnings CFC Holding is parent of group and pays tax for all the members US Person CFC Holding Opco 1 & Opco 2 have profits. E&P stays in Opco 1 & Opco 2 Opco 1 Opco 2

Splitters Group Relief • Group relief or other loss-sharing regime exists when one entity with a loss permits the loss to be used to offset the income of one or more other entities. • Three conditions must exist • Instrument treated as indebtedness that is disregarded for U.S. purposes • The owner of the foreign disregarded debt instrument pays a foreign income tax attributable to a payment or accrual on the instrument • The payment or accrual on the debt gives rise to a deduction US Person CFC Opco 1 Opco 2

Splitters Hybrid Equity • Hybrid equity where instrument is treated as equity for US purposes but debt for local country purposes • Issuer of hybrid equity must be a covered person • Must involve a 902 corporation US Person CFC1 accrues interest income on the hybrid Instrument. CFC1 pays tax on income. CFC 1 For US purposes, the instrument is equity. No accrual of dividend.CFC2 retains the E&P CFC 2

Splitters Hybrid Debt • Hybrid debt where instrument is treated as debt for US purposes but equity for local country purposes • Issuer of hybrid debt must be a covered person • Must involve a 902 corporation US Person Reduce E&P for interest deduction. No deduction for local country. CFC 1 CFC2 has higher E&P because it the interest income for US purposes CFC 2

Splitters Effect of Rev Rule 2010-92 • Must re-determine income and E&P • Back to years beginning after 1996 • First year of CTB regs • Prior years are unaffected • Must re-determine each category of separate limitation loss • Each covered person and 902 corporation • Related income is deemed to be distributed ratably with other income • However, the taxpayer can make an election so related income is deemed to be distributed first • Do not include PTI • Related income carries over to other corporations • Attribute under section 381

Splitters Effect of Rev Rule 2010-92 • Must re-determine tax pools • Distributions – • Taxes allocated on a pro rata basis • Pre-2011 taxes retain character as pre-2011 taxes • When distributed • Under 381 carryover transaction • As related income is taken into account, pre-2011 taint is removed.

Splitters Effect of Rev Rule 2010-92 • Special rules for partnerships and trusts • Treasury acknowledges that it is possible to comply with 704(b) and still split taxes from the related income (e.g see Reg 1.704-1(b)(5) example 24) • Not a foreign tax credit splitting event for pre-2011 splitter arrangements • But prospective guidance will provide for post-2010 years that such allocations are splitters subject to 909 • Example 24 may be modified

Splitters Effect of Rev Rule 2010-92 • Taxes deferred are treated as paid or accrued in the year (section 904(c)) • Section 909 does not alter carry forwards • Section 909 does not alter general rules for determining when a foreign tax has been accrued or paid • Suspended taxes are taken into account in the year the related income is taken into account • Redeterminations under 905(c) • If redetermination applies to pre-2011 split taxes, the section 909 applies. If redetermination applies to non-split taxes, section 909 will not apply.

Section 901(m) – Covered Assets Acquisitions New Section 901(m) denies a foreign tax credit for taxes applicable to foreign basis differences in assets due to covered asset acquisitions Applies to §901 direct foreign taxes and §902 indirect foreign taxes Any disallowed foreign taxes are permitted as a deduction or a reduction to E&P

Section 901(m) – Covered Assets Acquisitions • Applies to covered asset acquisitions after December 31, 2010 • Transition rule: does not apply to unrelated party covered asset acquisitions if the acquisition is – • Made pursuant to a written agreement which was binding on, and after January 1, 2011, • Described in a ruling request to the IRS on or before July 29, 2010, or • Described in a public announcement of SEC filing on or before January 1, 2011.

Section 901(m) – Covered Assets Acquisitions • A covered asset acquisition includes certain U.S. tax elections or transactions that result in the creation of additional asset basis eligible for amortization or depreciation for U.S. tax purposes without a corresponding increase in the basis of such assets for foreign tax purposes. Examples include: • Qualified stock purchase where a §338 election is made • Acquisition of a partnership interest holding foreign assets where a §754 election is made • Acquisition of stock of disregarded entities • Deemed §331 liquidation from a check-the-box election • Any similar transaction

Section 901(m) – Covered Assets Acquisitions • Disqualified Portion: Calculated as the ratio (expressed as a %) of: • Aggregate basis difference (not below zero) allocable to the taxable year with respect to all relevant foreign assets, divided by • The income on which the foreign income tax is determined.

Section 901(m) – Covered Assets Acquisitions Before After 901(m)901(m) Net Taxable Dividend $600 $600 Section 78 gross-up $300$270 Gross Taxable Dividend $900 $870 US Tax (@34%) $306 $296 Foreign Tax Credit ($300)($270) Net US Tax $6 $26 Cost of 901(m) $100 Basis Adjustment x 30% Foreign Tax Rate x 66% (1 – US Tax Rate) = $20 Annual Cost as a result of Sec 901(m) Section 338(g) Election BasisAmortization Foreign Asset Step Up / Amort $1,500 $100 US E&PLocal Pre-tax Income before E&P adjustments $1,000 $1,000 E&P Adj: §197 Amortization ($100)0 E&P / Local Pre-tax Income $900 $1,000 Foreign Tax (@30%) ($300)($300) E&P / Local Net Income $600 $700 Disqualified Portion = $100 (Basis Diff.) x $300 = $30 $1,000 (Local Tax base) Creditable Taxes = $270 ($300 less $30 disqualified)

Foreign Tax Credit Planning • Know your facts! • Go through the quantitative analysis to determine your position. • Consider simple strategies first • Many client problems can be fixed with relatively simple tweaks to the facts • Changing shipping terms on intercompany sales • Changing shipping terms on major customer shipments • Reviewing/analyzing classes of income • Revisiting expense allocations – high level

Foreign Tax Credit Planning • Then consider more complex planning as appropriate • Structural changes • Sourcing companies • Distribution companies • Partnership holding companies • Expense allocations • Comprehensive expense allocation review • Nitty gritty allocations • Fair market value election

Foreign Tax Credit Planning • War stories • A software client that had turned the corner. It had NOLs, OFLs and ODLs… • A manufacturing company owned by PE that has NOLs and one-time recapture option… • A client with NOLs and anticipated future NOLs in the near term…

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein. IRS Circular 230 Disclosure

Questions?

Jerry Jonckheere, Plante & Moran PLLC Jerry.Jonckheere@PlanteMoran.com Michael Schwartz, WeiserMazarsLLP Michael.Schwartz@WeiserMazars.com Bill Henson, Plante & Moran PLLC Bill.Henson@PlanteMoran.com Tim Bloos, MNP LLP Tim.Bloos@mnp.ca

Foreign Tax Credits – Advanced Topics