On May 11, 2009, the U.S. Treasury Department released details of a major reform to the U.S. international tax rules proposed by President Obama in connection with the Administration's fiscal 2010 budget. Many of these proposals, if enacted into law, will have significant consequences for Canadian entities with U.S. operations, earning U.S.-source income or holding U.S. subsidiaries. Most of these new rules are scheduled to come into force in 2011.
The proposals include the following:
Codifying the "Economic Substance" Doctrine – The U.S. Internal Revenue Code of 1986, as amended (Code) would be amended to clarify that a transaction would satisfy the economic substance test only if it results in a meaningful change in economic position and is supported by a substantial non-tax business purpose. If a transaction does not have economic substance, a taxpayer would not be entitled to the transaction's U.S. tax benefits.
Reforming the Foreign Entity "Check-the-Box" Rules – The ability of a foreign entity to elect to be treated as a disregarded entity for U.S. tax purposes would be restricted to cases in which either (a) the foreign entity is wholly owned by an entity that is organized under the laws of the same foreign country, or (b) except in cases of U.S. tax avoidance, the foreign entity is wholly owned directly by a U.S. person.
Modifying the Earnings Stripping Rules – The earnings stripping rules restricting the deductibility of interest on related party loans would be tightened in the case of interest paid by certain inverted U.S. corporations.
Repealing the 80/20 Company Rules – This proposal would repeal rules which effectively allow a U.S. corporation that qualifies as an "80/20 company" to reduce or eliminate U.S. withholding taxes on cross-border dividend and interest payments.
More Rigorous Qualified Intermediary Rules – This proposal enhances and expands the application of the qualified intermediary (QI) rules including: expanded reporting requirements for QIs; a grant of regulatory authority to impose more rigorous eligibility requirements for QI status; and the imposition of adverse presumptions for certain payments made to foreign intermediaries that are not QIs.
The measures described in The General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals (the so-called "Green Book") are only proposals and may be substantially amended as part of the legislative process. Nonetheless, as elements of a budget proposal, the Green Book tax initiatives can be passed by Congress and signed into law by a simple majority vote in each of the House of Representatives and the Senate (which are both controlled by the Democrats). With some notable exceptions, the provisions generally apply to taxable years beginning after December 31, 2010.
From a tax policy perspective, many of the proposals contained in the Green Book represent an expansion of the extraterritorial reach of U.S. federal income tax rules. From a substantive point of view, these measures reflect and reaffirm the view that the United States has a continuing interest in taxing the foreign earnings of U.S. multinationals and in limiting opportunities to defer tax on such earnings. Many have argued that these changes will make U.S.-owned companies less competitive and more vulnerable to takeovers. In fact, many countries seem to be heading in the opposite direction, proposing changes to make their domestic multinationals more competitive. For example, the Canadian Minister of Finance's Advisory Panel on Canada's System of International Taxation has recommended that Canada expand its exemption regime for income earned by foreign subsidiaries, with no new limitation on related deductions to Canadian shareholders.
Following years of consistent opposition by Treasury and IRS personnel, the Green Book proposals would codify the judicially-created "economic substance" doctrine which has been inconsistently interpreted by U.S. courts. In general, this doctrine provides that if a transaction does not have "substance" from an economic perspective, a taxpayer will be denied any U.S. tax benefits flowing from the transaction. Under the proposal, a transaction would satisfy the economic substance doctrine and accordingly be respected, if
"(i) it changes in a meaningful way (apart from federal tax effects), the taxpayers economic position and
(ii) the taxpayer has a substantial purpose (other than a federal tax purpose) for entering into the transaction" (emphasis added).
The proposal would also clarify that a transaction would not be treated as having economic substance solely by reason of profit potential "unless the present value of the reasonably expected pre-tax profit is substantial in relation to the present value of the net federal tax benefits arising from the transaction." The proposal would add a new 30 percent penalty to understatements of tax attributable to a transaction that lacked economic substance (unless disclosed on the taxpayer's return, in which case the penalty would be 20 percent). In addition, interest on understatements of tax attributable to transactions taxed for failure to comply with the economic substance test would not be deductible.
Reform of the Foreign Entity "Check-the-Box" Rules
Under current U.S. "check-the-box" rules, a foreign "eligible entity" is entitled to elect to be treated as either a corporation or a disregarded entity for U.S. federal income tax purposes. The Green Book proposals would provide that certain foreign entities, which would otherwise be eligible to be classified as disregarded entities for U.S. tax purposes, are no longer entitled to such elective treatment and are required to be treated as corporations. The intent of the provision is to combat perceived abuses of the "check-the-box" rules as illustrated in the following example:
A U.S. company, through its foreign subsidiary holding company, uses a disregarded entity established in a low-tax jurisdiction to make a loan to an entity operating in a high-tax jurisdiction as a means of obtaining a deduction from operating income for purposes of the high-tax jurisdiction's tax regime and, at the same time, avoiding U.S. tax (under Subpart F of the Code) on the interest income on the related-party loan.
To achieve this goal, the proposal provides that an otherwise eligible foreign entity would only be eligible to be treated as a disregarded entity if:
(a) the single owner of the entity is created or organized in (or under the laws of) the same foreign country in which the foreign eligible entity is created or organized, or
(b) except in cases of U.S. tax avoidance, the foreign entity is wholly owned directly by a U.S. person (i.e., disregarded entities treated as foreign branches of a U.S. person would generally not be affected by the proposal).
This proposal, as written, would not affect eligible foreign entities that have elected to be treated as corporations and does not appear to affect foreign entities with two or more owners that elect to be treated as partnerships for U.S. tax purposes. Enactment of this proposal would convert existing disregarded entities that do not meet the criteria into corporations for taxable years beginning after December 31, 2010.
Earnings Stripping by Expatriated Entities
The current earnings stripping rules under Section 163(j) of the Code limit the deductibility of certain related-party interest payments (and interest payments to third parties that are "guaranteed" by certain related parties) to 50 percent of a corporation's "adjusted taxable income" (a concept roughly analogous to EBITDA (earnings before interest, taxes, depreciation and amortization)). The limitation is subject to a debt-to-equity safe harbor of 1.5 to 1. Current-year interest expense disallowed under Section 163(j) of the Code may be carried forward indefinitely for deduction in subsequent years. Additionally, corporations may carry forward any "excess limitation" (the excess of 50 percent of "adjusted taxable income" over net interest expense) for a given tax year to the three subsequent tax years. Presently, special rules under Section 7874 of the Code apply to expatriated entities (formerly U.S. corporations that have merged or migrated into foreign corporations) and their acquiring foreign corporations, depending on the percentage of stock in the acquiring foreign corporation owned by former owners of the expatriated domestic entity.
Under the proposal, Section 163(j) of the Code would be expanded by restricting the deductibility of interest paid by an expatriated entity to related persons by eliminating the debt-to-equity safe harbor and reducing the limitation threshold to 25 percent of adjusted taxable income. (Interest paid on unrelated debt supported by a foreign related-party guarantee would continue to be subject to the 50 percent adjusted taxable income threshold.) The carry-forward for disallowed interest would be limited to ten years and the carry-forward of excess limitation would be eliminated altogether. Under the proposal, expatriated U.S. entities which have been acquired by (or merged with) foreign entities in an expatriation transaction resulting in shareholders of the former U.S. entity obtaining 60 percent (by vote or value) or more of the foreign acquiring company stock (as defined in Section 7874 of the Code) will generally be subject to the new rule. Interestingly, the proposal would apply the new earnings stripping limitations by reference to the statutory tests for an "expatriated entity" in Section 7874 of the Code, but as if Section 7874 of the Code were applicable for taxable years beginning after July 10, 1989 (the Look-Back Rule) even though Section 7874 of the Code was enacted in 2004. Accordingly, if enacted, taxpayers would need to analyze transactions occurring in those taxable years to determine if the domestic entities involved would have been subject to Section 7874 of the Code if it had been in effect at that time. An ambiguously worded exception can be read to exempt expatriated entities where the acquiring foreign corporation is treated as a domestic taxpayer under the inversion rules.
Repeal of the 80/20 Company Rules
For some time, U.S. companies have been able to reduce or eliminate U.S. withholding tax on cross-border interest and dividends if at least 80 percent of the U.S. company's gross income during the three prior taxable years consisted of active foreign source income. The Green Book suggests that these rules can be the subject of manipulation and potential abuse. Accordingly, the proposals would repeal the 80/20 company provisions entirely, effective for taxable years beginning after December 31, 2010.
Changes To Qualified Intermediary Regime
Currently, U.S. withholding agents who make payments to recipients that claim a reduced U.S. withholding tax rate must rely on documents provided by that recipient certifying its eligibility for the exemption or reduction. Fuelled by concerns that some persons may be avoiding U.S. withholding taxes by routing payments through foreign financial institutions, the Green Book proposals establish a presumption that would require withholding agents to assume that payments made to foreign financial institutions that are not QIs further tax avoidance. Under the presumption, withholding agents making payments to non-QIs would be required to withhold 20 percent of the gross proceeds from the sale of certain securities (unless the non-QI is located in a jurisdiction with which the U.S. has a comprehensive income tax treaty with a "satisfactory" exchange of information program) and 30 percent of the amount of any payments of most other types of U.S.-source income, including interest, dividends and royalties (FDAPI) and without a similar exception for institutions in treaty countries. A 30 percent tax would also be required on any payments of FDAPI to non-publicly-traded foreign entities (other than financial institutions) that do not disclose information about their beneficial owners. To the extent tax is withheld but the relevant beneficial owner of the payment is, in fact, entitled to a U.S. tax exemption, the payee could claim a refund, but not without disclosing its identity and other potentially sensitive information to the IRS.
A foreign financial institution that wishes to become a QI to avoid the adverse implications of these withholding tax presumptions would be required to identify its U.S. account holders and report information about these U.S. customers to the IRS as if it were a U.S. financial institution. Importantly, the Green Book proposals would also authorize the Treasury Department to issue new regulations that would exclude foreign financial institutions from QI status if any of their financial institution affiliates are not also QIs (e.g., a Canadian bank with a Barbados insurance subsidiary). Publication of a list of QIs by the IRS would also be explicitly authorized.
Supplementing these changes to the withholding tax and QI rules, the Green Book proposals would further strengthen reporting and enforcement mechanisms with respect to offshore activities, including by creating a number of new reporting obligations for foreign QIs and for certain third parties, increasing penalties for failure to comply with the rules and extending applicable statutes of limitation.
Deferral of Deductions Associated with Income Earned through non-U.S. Subsidiaries
This proposal would provide that deductions allocable to foreign-source income be taken into account currently only to the extent that such deductions are allocable to currently-taxed foreign income. The deductions subject to deferral would be broadly defined to include, among other items, interest expense attributed to non-U.S. operations, but would explicitly exclude deductions for research and experimentation. A portion of previously deferred deductions would be taken into account, as foreign income is repatriated based on the proportion that repatriated foreign income bears to previously deferred foreign income.
Foreign Tax Credit Changes
Deferral of foreign tax credits based on the portion of
non-U.S. income subject to current U.S. tax
The administration is concerned that U.S. taxpayers are inappropriately reducing U.S. tax on non-U.S. earnings by engaging in foreign-tax-credit tax planning techniques known as "cross-crediting" and the selective repatriation of highly taxed foreign earnings. The proposal would require a U.S. taxpayer to determine its available indirect foreign tax credit by consolidating or pooling the earnings of certain foreign subsidiaries. In this way, the proposal would limit the indirect foreign tax credit available to a U.S. taxpayer based on the proportion of foreign earnings that were actually repatriated to such taxpayer during a particular taxable year. Foreign income taxes not taken into account in the current year would be taken into account as foreign income is repatriated based on the proportion that the repatriated foreign income bears to the total amount of previously deferred foreign income.
Prevent splitting of foreign income and foreign
Under current foreign tax credit rules, the person considered to have paid a foreign tax is the person on whom foreign law imposes legal liability for such tax. As a result of hybrid arrangements, taxpayers had previously been able to achieve separation of creditable foreign taxes from the associated income. This proposal would adopt a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income.
Insurance Company Changes
Modify rules that apply to sales of life insurance
Under current law, the buyer of a previously-issued life insurance contract who subsequently receives a death benefit is generally subject to the "transfer-for-value rule" which taxes the difference between the death benefit received and the sum of the amount paid for the contract and premiums subsequently paid by the buyer, subject to certain exceptions.
To facilitate tax compliance, the proposal imposes a reporting requirement on the purchaser of an existing life insurance contract with a death benefit of at least $1 million. The proposal requires the purchaser to report the purchase price, the purchaser's and seller's taxpayer identification numbers (TIN), and the issuer and policy number to the IRS, the issuer and the seller. Further, the proposal imposes an obligation on the insurance company to report the gross benefit paid under the policy, the purchaser's TIN and the insurance company's estimate of the purchaser's basis to the IRS and the payee. The administration also intends to modify the law to ensure that exceptions to the "transfer-for-value rule" would not apply to buyers of policies.
Modify dividends-received deduction for life insurance company separate accounts Currently, life insurance companies benefit from the dividends-received deduction only with regard to the "company's share" of dividends received from other domestic corporations and not the portion of the dividends used to fund its tax-deductible reserves. In an effort to more accurately reflect the insurance company's economic interest in separate account assets, the proposal outlines a specific formula for prorating net investment income between the company's share and the policyholders' share. The aim of this formula is to generate a "company share" which would approximate the ratio of the mean of the surplus attributable to the account to the mean of the account's assets.
Expand pro-rata interest expense disallowance for
Corporate-Owned Life Insurance
In general, interest on policy loans or other indebtedness with respect to life insurance, endowment or annuity contracts is not deductible, subject to an exception for insurance contracts which insure the life of a "key person" of the business. Further, under current law, the interest deductions of a taxpayer which is not an insurance company are disallowed to the extent the interest is attributable to unborrowed policy cash values based on a statutory formula. An exception to the pro-rata interest disallowance applies with respect to contracts that cover individuals who are officers, directors, employees or 20-percent owners of the taxpayer.
The proposal would repeal the exception from the pro-rata interest expense disallowance rule for contracts covering employees, officers or directors, other than 20-percent owners of a business that are the owners or beneficiaries of the contracts. The new rule would apply to contracts entered into after the date of enactment of the proposal.
Changes not included
The Green Book proposals do not include a controversial proposal to deny deductions for excess non-taxed reinsurance premiums paid to offshore affiliates. Congress has previously considered similar legislation.
Intangible property transfers
Under current law, Section 482 of the Code permits the IRS to reallocate income with respect to the transfer or license of intangible property between related parties on a basis "commensurate with the income" subsequently earned from the use of such intangible property. Further, in certain outbound non-recognition transactions governed by Section 367 of the Code, the U.S. transferor is treated as selling the intangible property for a series of royalty payments that are contingent upon the use of such property and "commensurate with the income" earned by the transferee.
The stated purpose of the Obama administration's proposal is to modify current intangible property transfer-pricing rules to prevent the inappropriate shifting of income outside the U.S. The new provision broadens the application of existing rules to include workforce-in-place, goodwill and going-concern value which are items not currently subject to the "commensurate with income" regime. This may block attempts to transfer U.S. marketing intangibles out of the United States. The proposed rules would also allow the IRS to value multiple intangible properties on an aggregate basis where it would achieve a more "reliable" result. Further, the proposal would require that intangible property be valued at its "highest and best use" as determined by willing buyers and sellers, both having "reasonable knowledge of relevant facts."
Preventing avoidance of dividend withholding
Under current U.S. tax law, the source of income from certain notional principal contracts (such as a total return swap) is generally determined based on the residence of the investor. As a result, payments made on a qualifying contract to foreign resident investors are treated as foreign-source income and taxpayers take the position that such payments are not subject to U.S. withholding tax. Although the issue has been debated, the administration notes that taxpayers have similarly taken the position that payments to non-U.S. persons on a total return swap involving U.S. equity securities are also foreign-source income and, therefore, are not subject to U.S. withholding tax, notwithstanding that the foreign investor may be economically benefiting from dividend returns on the underlying U.S. stock.
In addition, taxpayers that engage in securities lending transactions (where securities are loaned and payments on the securities, including dividends, are generally treated for commercial purposes as payments on the loan) have benefited from IRS Notice 97-66, which provides limited exemption from U.S. withholding tax. Under the U.S. rules applicable to securities lending transactions, "substitute dividend payments" are treated as U.S.-source income and are subject to withholding. However, the IRS acknowledged in Notice 97-66 that this rule could "pyramid" withholding taxes where U.S. equities were lent between foreign parties. Notice 97-66 allows these parties to claim a reduced U.S. withholding tax rate in certain cases.
The Green Book states that the Treasury Department intends to revoke Notice 97-66 and issue guidance that eliminates the ability to inappropriately avoid U.S. withholding tax through securities lending transactions. It is not clear how the administration will ultimately attack these foreign-to-foreign securities lending transactions. Further, under the proposal, total return swaps that reference U.S. equities would become subject to new rules that treat income calculated by reference to dividends paid by domestic corporations as U.S.-source. The proposal includes an exception to this sourcing rule that would apply to swap arrangements with specific characteristics and also grants the Treasury Department regulatory authority to provide further exceptions to the rule.
Oil and gas changes
Claiming that certain current tax benefits encourage more investment in the U.S. oil and gas industry than otherwise would occur in a tax-neutral system, and consistent with the Obama administration's long-term energy security and environmental initiatives, the Green Book proposals include several provisions meant to eliminate existing oil and gas company tax preferences. These changes would:
- impose excise taxes on the production of oil and gas on the Outer Continental Shelf (which is currently exempt from U.S. tax);
- repeal the investment tax credit for enhanced oil recovery projects and the production tax credit for oil and gas from marginal wells;
- repeal the exception from the passive loss rules that excludes working interests in oil and gas properties from being categorized as passive activities; and
- repeal special rules that allow preferential expensing, amortization, capitalization and depletion with respect to oil and gas activities, including by:
- disallowing expensing and/or accelerated capitalization of intangible U.S. drilling and development costs, instead requiring such costs to be capitalized as depreciable or depletable property in accordance with generally applicable rules;
- disallowing percentage depletion with respect to oil and gas wells, instead permitting taxpayers to claim only cost depletion on their adjusted tax basis, if any, in such wells,
- increasing the amortization period for geological and geophysical costs from two to seven years; and
- disallowing the current deduction for qualified tertiary injectant expenses, instead placing such expenses on a cost recovery system similar to those employed in other industries.
The Administration also proposes to eliminate the LIFO (last in, first out) method of accounting for taxable years beginning after December 30, 2011. LIFO is an accounting method which permits taxpayers to use the most recent cost of acquired goods in determining the cost of goods sold. When the costs of acquired goods are rising, LIFO generally results in an increase to the cost of goods sold and, therefore, a reduction in gross income. Taxpayers that use the LIFO method, however, can experience a bunching of income in taxable years in which inventory is liquidated and inventories with a lower cost of goods sold from earlier years are sold. The Administration proposal would require a deemed sale of inventory in the first taxable year beginning after December 31, 2011, and many taxpayers currently using LIFO will likely recognize additional income as a result. The proposal would spread the tax cost of this inclusion over an eight-year period.
Tax carried interest
The Administration also proposes to change the long-standing taxation of certain partners who provide services to a partnership, taxing income allocated to those partners as ordinary income, regardless of the character of the income derived at the partnership level. Under current law, the general partners of investment limited partnerships are typically taxed at long-term capital gain rates (or are not taxed at all if they are not subject to U.S. tax) on their allocable share of the partnership's long-term capital gain. The proposal treats this allocation, often referred to as a "carried interest," as ordinary income, subject to self-employment taxation. The proposal would not require service partners to treat their allocable share of capital gain as ordinary income if the partner contributes "invested capital" and the partnership reasonably allocates the partnership's income between this invested capital and other partnership interests.
The Green Book proposals represent a potentially sweeping and dramatic reform of U.S. international tax law. In addition to the Green Book proposals, other substantial changes have been proposed by members of the House of Representatives and the Senate. As with all legislative proposals, these changes may never be enacted into law in the form they have been proposed. However, given the revenue shortfalls in the White House's budget, and the widespread perception that international taxation is a fruitful area to find revenue, most advisors expect the law to change, perhaps dramatically, over the next several years. From a broader perspective, the Green Book proposals appear to illustrate an emerging divergence in international tax policy between Canada and the United States. From the perspective of cross-border tax planning and controversy resolution, it is important to understand whether and to what extent the substantive law and regulatory outlook of closely integrated countries like Canada and the United States deviate, including for the purpose of interpreting and resolving matters under the Canada-U.S. Treaty.
We will keep you updated as further developments unfold.
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