United States: Repatriation Provisions in FSC-ETI Bill

Congress took a major step last week toward completion of the FSC-ETI international tax bill with passage of the long-stalled House version of the bill. This follows Senate passage of a different version in May. The Congressional leadership now will seek to reconcile the two versions in a House-Senate conference committee.

Both versions of the bill include the so-called repatriation legislation, known officially in the Senate as the Invest in the U.S.A. Act and in the House as the Homeland Investment Act. The repatriation legislation, which varies in detail between the two bills, provides for a temporary effective tax rate of 5.25 percent on "extraordinary distributions" from controlled foreign corporations. The legislation enjoys the backing of the leadership in both the House and the Senate and appears highly likely to be included in any final bill to emerge from the conference committee.

This memorandum describes several issues that you should consider if you anticipate taking advantage of the legislation. Attached to the memorandum is a comparison of the two versions of the legislation and the potential impact on state and federal tax issues.

If conference committee negotiations get underway promptly – i.e., shortly after the July 4 Congressional recess – Congress will have a reasonable chance of completing the bill by the Democratic convention and August Congressional recess starting on July 26. Such a compromise bill might go to the President for signature in early August. For planning purposes, companies need to focus on the late July/early August timeframe as the first period for possible completion of the bill, although completion certainly could be delayed into the fall.

If Congress were to succeed in passing a final bill by the end of July, and if the bill were to include the Senate version of the repatriation legislation, calendar year taxpayers would have until the end of 2004 to complete any extraordinary distributions intended to qualify under the legislation. Given that both the CEO and the board of directors must approve a "domestic reinvestment plan," as described in the attachment, that period of time might be uncomfortably short for companies that have not engaged in advance planning. Thus, companies that intend to take advantage of the legislation should consider spending time now analyzing and working through a variety of issues.

The stakes involved in this issue are potentially enormousi.e., the difference between a tax rate of 5.25 percent and a rate of 35 percent on dividend income. Companies presumably will not want to take on any significant risk of repatriating substantial amounts improperly.

Companies will need to prepare a formal plan that documents how the repatriated earnings will be invested in the United States. Both bills require a two step approval process for the plan: the CEO or equivalent must first approve it, followed by the board of directors. Companies should consider developing plans that are as specific as possible, ideally identifying detailed projects and costs. Also, companies need to consider whether proposed investment of the repatriated earnings will qualify as "domestic reinvestment" within the meaning of the legislation.

Drafting of corporate and legal documents will be an important aspect of preparing for repatriations under the legislation. Because both bills require it, companies should draft documentation that clearly demonstrates the CEO’s approval of the plan. Additionally, companies will need to prepare appropriate corporate resolutions to evidence board approval of the plan.

Finally, companies should consider the potential impact of Sarbanes-Oxley on the implementation of the reinvestment plan. Various controls and monitoring procedures should be established for corporate governance purposes and in anticipation of inquiries by the Internal Revenue Service.

It is not too early for companies to start the process of determining the amount of their foreign earnings eligible for the reduced effective tax rate. As described in the attachment, distributions in excess of the annual average of "base period dividends" will qualify for the reduced effective tax rate. A mistake in the calculation could lead to higher than anticipated taxes.

In connection with accurately determining the extraordinary distribution amount, it may be necessary for some companies to conduct an earnings and profits (E&P) analysis of their accumulated foreign earnings. This is particularly the case for companies that have operated abroad for many years and that may desire to repatriate a substantial pool of earnings. Companies that may need to conduct an E&P study should consider starting work as soon as possible.

Similarly, companies need to carefully consider the impact of repatriation on their foreign tax credit position. This analysis is of special concern for companies that have an overall foreign loss, have excess foreign tax credits, or have controlled foreign corporations (CFCs) with pools of E&P that have been subjected to high foreign taxes. Finally, companies should analyze the impact of repatriation on other planning, such as mergers and acquisitions, subpart F mitigation and foreign withholding tax reduction.

Given that the effective federal tax rate on eligible distributions will be only 5.25 percent under the legislation, the state tax implications of the distributions could be an important issue for some companies. In many jurisdictions, the state rate will be as high as or higher than the federal rate.

The aggregate national volume of repatriations contemplated under the legislation – $400 billion by some estimates – undoubtedly will be a tempting target for state tax officials. It is certainly possible that multiple states will claim the right to tax the same amounts. Additionally, one cannot expect states to follow the federal law in allowing the 85 percent dividend received deduction (DRD) as provided in the House bill.

Again, companies contemplating repatriations under the legislation should factor in state tax consequences at an early stage. In particular, companies should consider whether they have flexibility in the choice of entity or entities that will receive the distributions. Entities operating in certain states could be preferable to entities in other states. Additionally, entities with a substantial net operating loss also could be attractive; a provision in the House version of the legislation that precludes the use of NOLs as an offset to the taxable portion of distributions most likely not apply for state income tax purposes.

Lastly, as soon as possible, companies need to start the process of planning for the actual distributions from the foreign affiliates. Given the magnitude of the distributions that some companies may be contemplating, there may be substantial legal and regulatory hurdles to clear in transferring cash out of the foreign jurisdictions. In addition, foreign withholding taxes will need to be considered, particularly in light of the limitations that both bills put on the use of foreign tax credits. It is certainly possible, or even likely, that the final legislation will require that repatriations take the form of cash dividends to the U.S. parent – and not the form of investments in U.S. property or other deemed distributions.

We have assembled a broad team of tax and corporate lawyers to assist clients in taking advantage of the repatriation legislation. We have the capabilities within this team to advise on federal and state tax, corporate law and corporate governance issues that will arise as a result of repatriating foreign earnings under the legislation. Please let me know if we can assist you.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.