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Tax Executives Institute, Inc. Corporate Tax Update Seminar

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1 Tax Executives Institute, Inc. Corporate Tax Update Seminar
Los Angeles Chapter Corporate Tax Update Seminar Selected International and Corporate Tax Provisions of the American Jobs Creation Act of December 16, 2004 Joseph DeCarlo, Jr. Alan W. Granwell 1925 Century Park East Pennsylvania Ave, N.W. Suite Suite 600 Los Angeles, CA Washington, DC 20006 (310) (202)

2 Discussion Overview ETI Repeal and Transition
Domestic Activities Production Deduction Foreign Repatriation Incentive International Tax Reforms ─ Foreign Tax Credits Reduced Foreign Tax Credit (FTC) Limitation Baskets Amended FTC Carryover Periods Repeal of AMT Limitation on FTCs Elective Worldwide Interest Fungibility Look-through Treatment for 10/50 Dividends Re-characterization of Overall Domestic Losses

3 Discussion Overview International Tax Reforms ─ FTCs cont’d
Additional OFL Recapture Translation of Foreign Taxes Indirect FTCs Through Partnerships Minimum Holding Period for Non-dividend FTCs Outbound Transfers of Intangibles International Tax Reforms ─ Other Matters Subpart F Treatment of Sales of Partnership Interests Repeal of FPHC and FIC Regimes Corporate Inversions

4 Discussion Overview International Tax Reforms ─ Other Matters cont’d
Ivins, Phillips & Barker Discussion Overview International Tax Reforms ─ Other Matters cont’d Holding Company Liquidations Interest Paid by Foreign Partnerships Interest and OID Payable to Related Persons Additional Tax Reforms Transfers of Built-in Loss Assets Anti-Loss Duplication Questions

5 ETI Repeal and Transition
The ETI exclusion has been repealed for transactions entered into after 12/31/04 But the repeal is subject to two transition rules, which continue to afford ETI benefits after 2004 a two year phase-out period preserves 80% of the ETI benefits for 2005 transactions and 60% of the ETI benefits for 2006 transactions and transactions entered into at any time in the ordinary course of business pursuant to a binding contract in effect on 09/17/03 with an unrelated person are forever grandfathered

6 ETI Repeal and Transition cont’d
The two-year phase-down of ETI benefits in 2005 and 2006 and the 09/17/03 binding contract exception are both being challenged by the EU in the World Trade Organization A separate transition rule allows foreign corporations that have elected to be treated as US corporations for ETI purposes to revoke those elections without gain or loss recognition Both phased-down ETI benefits and the domestic activities production deduction potentially may be available for many taxpayers

7 Domestic Activities Production Deduction ─ Section 199 of the Code
Described as “tax relief specifically designed to be economically equivalent to a 3-percentage point reduction in [the rate of tax imposed on] U.S.-based manufacturing” Which isn’t fully phased-in until 2010, but which affords benefits to numerous taxpayers that were not eligible for ETI benefits, whose repeal prompted the substitute measure Key concept: calculation of a deduction for qualified production activities (QPA) income

8 Calculation of the QPA Deduction
QPA gross receipts, minus the sum of: Cost of goods sold allocable to QPA gross receipts Other deductions directly allocable to those receipts And a ratable portion of other deductions not directly allocable to another class of income Equals QPA income, times the phased-in percentage 3% for taxable years beginning in 2005 and 2006 6% for taxable years beginning in 2007, 2008, and 2009 9% for taxable years beginning post 2009 Equals the QPA Deduction

9 QPA Gross Receipts ─ 5 categories of production activities
Revenue derived from the lease, sale, exchange, or other disposition of tangible personal property, computer software, and sound recordings (so-called qualifying production property) manufactured, produced, grown, or extracted in whole or significant part within the US motion picture films and video tapes, including television but not including pornography if 50% or more of the total compensation for production costs is for personal services performed within the US

10 QPA Gross Receipts ─ 5 categories of production activities cont’d
Revenue derived from the production, within the US, of electricity, natural gas, and potable water Revenue derived from construction activities performed in the US And revenue derived from engineering and architectural services performed in the US for construction projects located in the US

11 Limitations on the QPA Deduction
QPA income cannot exceed taxable income for the year QPA deduction is limited to 50% of W-2 wages paid to all employees, ostensibly without regard to whether or not such employees are engaged in QPA QPA income does not include income from retail sales of food and beverages QPA income does not include income from the transmission or distribution of electricity, natural gas, or potable water

12 Limitations on the QPA Deduction cont’d
Query receipts attributable to bundled or ancillary services, such as installation, warranties, shipping, financing, maintenance and other items Query what is meant by manufacturing, production, growth, or extraction “in whole or significant part” within the US Query the status of contract manufacturing arrangements Myriad tax accounting issues

13 Foreign Repatriation Incentive ─ Section 965 of the Code
Elective 85% deduction for “extraordinary” cash dividends received during a limited window of opportunity by a corporation that is a United States shareholder of a CFC Equates to a 5.25% effective tax rate But requires the disallowance of any deductions “properly allocated and apportioned” to the dividends in question

14 Foreign Repatriation Incentive ─ Section 965 of the Code cont’d
And a permanent disallowance of 85% of the FTCs associated with the extraordinary dividends however, taxpayers are permitted to cherry-pick which dividends are taken into account a technical correction is needed to confirm that there’s no section 78 gross-up inclusion (nor cross-crediting for the non-deductible 15%) and query treatment of the CFC stock for section 861 allocation purposes

15 Foreign Repatriation Incentive ─ Overview
Four critical components base period dividend amount eligible dividends reinvestment plan benefit period

16 Foreign Repatriation Incentive ─ Base Period Dividend Amount
Only cash dividends that are in excess of a defined base period amount are eligible for the deduction. That base period amount is defined as the annual average of the amount of dividends received from all CFCs during the 5 most recent taxable years ending on or before 06/30/03 (i.e., for calendar year taxpayers) computed by disregarding the 2 years in which the largest and the smallest amount of dividends were received

17 Foreign Repatriation Incentive ─ Base Period Dividend Amount cont’d
In determining the base period dividend amount, all US shareholders included in a consolidated return are treated as one US shareholder, and the items treated as a dividend for such purposes are subject to a number of specific inclusions and exclusions Inclusions Exclusions actual dividends subpart F inclusions PTI distributions section 1248 inclusions section 956 amounts section 78 gross-ups

18 Foreign Repatriation Incentive ─ Eligible Dividends
The amount of extraordinary dividends potentially eligible for the 85% deduction is subject to a cap, which is computed as the greatest of three amounts $500 million the earnings shown as permanently reinvested outside the US on the most recent audited financial statement certified on or before 06/30/03 (i.e., 12/31/02 financial statements for calendar year taxpayers) if that financial statement does not report a specific amount of earnings, but does show a specific amount of tax liability attributable to such earnings, a gross-up computation of the earnings using a 35% rate

19 Foreign Repatriation Incentive ─ Eligible Dividends cont’d
In addition to the overall cap, the amount of extraordinary dividends potentially eligible for the 85% deduction is subject to other limitations and qualifications the cap is reduced by any increase in the amount of the CFCs’ related party indebtedness that arises between 10/03/04 and the close of the taxable year in which the election is made however, all CFCs as to which the distributee is a United States shareholder are treated as one CFC for this purpose, thereby causing debt between related CFCs to be disregarded regulatory authority to address capital contributions

20 Foreign Repatriation Incentive ─ Eligible Dividends cont’d
Moreover, the amount of eligible dividends is subject to specific inclusions and exclusions different from those used in computing the base period amount Qualify as dividends Do not qualify as dividends section 301(c)(1) cash distributions in-kind section 302(d) cash section 1248(a) amounts section 304 cash section 78 gross-ups section 951/959 cash other section 951 amounts section 332/367 cash other section 367 amounts

21 Foreign Repatriation Incentive ─ Eligible Dividends cont’d
A variety of potential funding issues arises as a result of the requirement that eligible dividends be paid in cash parent/affiliate guarantees of third party debt subsequent parent/affiliate refinancing of third party debt CFC’s functional currency may be property in the hands of parent, while US $ may be property in the hands of the CFC assignments of demand deposits, short-term time deposits, and other cash equivalents

22 Foreign Repatriation Incentive ─ Reinvestment Plan
An extraordinary cash dividend will not qualify for the 85% deduction unless the dividend is invested in the US pursuant to a domestic reinvestment plan (DRIP) the taxpayer’s president, CEO or other comparable officer must approve the DRIP before the dividend is paid and the taxpayer’s Board of Directors, Management Committee, or comparable body must approve the DRIP prior to the close of the taxable year in which the election is made

23 Foreign Repatriation Incentive ─ Reinvestment Plan cont’d
The DRIP must provide for the reinvestment of the dividend in the US including as a source for the funding of worker hiring and training infrastructure research and development capital investments financial stabilization of the corporation for the purpose of job retention or creation The DRIP may not be used for executive compensation

24 Foreign Repatriation Incentive ─ Reinvestment Plan cont’d
The lack of more definitive guidance on the detailed requirements for a DRIP, coupled with the fungibility of cash, leaves a host of unresolved issues can the funds be used to fund or increase dividends, to repurchase shares, to repay debt, or make to acquisitions what consequences arise if some portion of the funds is used for an ineligible purpose what interim uses or investments are permitted before the funds are ultimately “reinvested” by when must the reinvestment be made what type of tracing is required or advisable

25 Foreign Repatriation Incentive ─ Benefit Period
Taxpayers have only a limited window of opportunity to take advantage of the repatriation incentive and may elect to apply the deduction to dividends received in one of two periods during the taxpayer’s last taxable year that begins prior to 10/22/04, i.e., 2004 for calendar year taxpayers, or during the taxpayer’s first taxable year that begins on or after 10/22/04, i.e., 2005 is the alternative window for calendar year taxpayers Temporary economic stimulus measure, with no intent to extend or enact it again in the future

26 Reduced FTC Limitation Baskets
Effective for taxable years beginning after 12/31/06, there will only be 2 FTC baskets post pre-2007 passive passive general high withholding tax financial services shipping 10/50 DISC dividends foreign trade FSC distributions general And creditable foreign taxes imposed on amounts that are not income under US tax principles fall in the general basket or electively fall in financial services basket from 01/01/05-12/31/06

27 Reduced FTC Limitation Baskets cont’d
Also applies to taxes accrued prior to 01/01/07 that are carried forward to subsequent years Includes regulatory authority to address carry-backs from pre-effective date years Does not affect other separate limitations, such as those arising under re-sourcing rules in tax treaties or taxes imposed by countries subject to section 901(j)

28 Amended FTC Carryover Periods
Effective for taxable years beginning after 10/22/04 post prior law carry back 1 year carry back 2 years carry forward 10 years carry forward 5 years (even if arising pre-enactment date)

29 Repeal of AMT Limitation on FTCs
Effective for taxable years beginning after 12/31/04 post prior law no limitation AMT FTCs limited to 90% of pre-credit AMT computed without regard to AMT NOL

30 Elective Worldwide Interest Fungibility
Effective for the first taxable year beginning after 12/31/08 one-time, irrevocable election to allocate and apportion interest by reference to the third party interest expense of the entire worldwide affiliated group allocate and apportion to foreign source income the excess of worldwide group’s total third party interest expense times the ratio of foreign assets of worldwide group, divided by total assets of worldwide group over the third party interest expense of the foreign members of the group that otherwise would be allocated to foreign source income

31 Look-through Treatment for 10/50 Dividends
Effective (retroactively) for the taxable years beginning after 12/31/02 dividends from 10/50 companies are subject to look-through treatment regardless of the year in which the E&P was accumulated moreover, look-through treatment also applied to carry forward of 10/50 FTCs from pre-2003 years regulatory authority to address carry back of post-2002 credits to pre-2003 years as well as E&P accumulated prior to the beginning of the taxpayer’s holding period

32 Re-characterization of Overall Domestic Losses
Effective for losses incurred in taxable years beginning after 12/31/06 US-source income is re-sourced as foreign-source income if FTC limitation for prior year was reduced as a result of an overall domestic loss (ODL) only applies if FTC election in effect for the ODL year otherwise re-source the lesser of ODL not previously recharacterized, or 50% of US-source income for the succeeding year regulatory authority to coordinate OFL/ODL “flips”

33 Additional OFL Recapture
Effective for dispositions of stock after 10/22/04 irrespective of whether gain otherwise would be recognized, the disposition of stock of a CFC by a controlling United States shareholder (i.e., more than 50% of the voting power or value) causes the recapture, as US-source income, of an amount equal to the lesser of the amount of gain realized upon the disposition of that CFC stock, or the previously un-recaptured OFL amount subject to exceptions for section 351/721 intra-group transfers, in which there is no dilution of indirect ownership, and intra-group liquidation and reorganization transactions

34 Translation of Foreign Taxes
Effective for taxable years beginning after 12/31/04 taxpayers may elect to translate into US $ the amount of foreign taxes paid in a non-functional currency using the spot rate when those taxes are paid under current law, the receipt of a dividend subject to foreign withholding taxes requires a taxpayer to translate the dividend at the spot rate, but to translate the associated withholding taxes at the average rate for the year

35 Indirect FTCs Through Partnerships
Effective for taxable years beginning after 10/22/04 clarification that a domestic corporation is entitled to a deemed-paid FTC with respect to dividends received from foreign corporations whose stock is owned indirectly through foreign or domestic partnerships provided that distributee proportionately owns 10% or more of the distributor’s voting stock and without treating partnership as an additional tier vis-à-vis the 6-tier limitation

36 Indirect FTCs Through Partnerships cont’d
reaffirms Rev. Rul , notwithstanding ’95 proposed regulations and ’97 preamble without creating any inference as to present law and subject to regulatory authority to address special partnership allocations of dividends, credits, and other incidents of ownership of stock in determining proportionate ownership

37 Minimum Holding Period for non-dividend FTCs
Effective for amounts paid or accrued after 11/21/04 no FTC is allowed to for any withholding tax on any item of income or gain with respect to property if property is held for 15 days or less during the 31-day period that begins 15 days before the right to receive the payment arises, or the recipient of the payment is obligated to make a related payment with respect to positions in substantially similar or related property Exceptions for dealers and pursuant to regulatory authority (e.g., 10-day loan) Copyright example in Notice 98-5

38 Outbound Transfers of Intangibles
Effective (retroactively) for (deemed) payments arising after 08/05/97 outbound transfer of intangibles, subject to section367(d) treatment ─ sale in exchange for payments contingent upon productivity, use, or disposition ─ treated in the same manner as if a royalty ’97 TRA repeal of US-source rule but sale of all substantial rights → passive basket sale of less than all rights → look-through, general limitation

39 Subpart F Treatment of Sales of Partnership Interests
Effective for taxable years of CFCs beginning after 12/31/04 (and for taxable years of United States shareholders with or within which such CFC years end) sale by a CFC of an interest in a partnership in which the CFC owns 25% or more of the capital or profits is treated as the sale of a proportionate share of the partnership’s assets for subpart F purposes but method of allocating gain or loss not prescribed based on relative FMVs of partnership assets based on relative BIGs and BILs and query coordination with section 954(c)(1)(B) netting (excess of gains over losses)

40 Repeal of FPHC and FIC Regimes
Effective for taxable years of foreign corporations beginning after 12/31/04 (and for taxable years of US shareholders with or within which such years end) FPHC provisions are repealed FIC provisions are repealed foreign corporations are excluded from the PHC rules subpart F income includes personal service contract income counterpart to sections 543(a)(7) and 553(a)(5) PFIC rules continue to apply where subpart F rules don’t

41 Corporate Inversions Effective (retroactively) to 03/05/03, 2 new sets of rules govern corporate inversions Under the first, a foreign incorporated entity is, instead, treated as a domestic corporation for all purposes of the Code if a US corporation becomes a subsidiary or transfers substantially all of its assets to a foreign corporation subsequent to 04/04/03 former shareholders of the US corporation own, by reason of their having owned stock in the US corporation, 80% or more of the voting power or value of the foreign corporation’s stock and the foreign corporation’s expanded affiliated (50+%) group does not conduct substantial business activities in its country of incorporation, as compared to the group’s worldwide business activities

42 Corporate Inversions cont’d
Under the second set of rules, a so-called “expatriated entity” is subject to special tax treatment for a 10-year period if a US corporation becomes a subsidiary or transfers substantially all of its assets to a foreign corporation subsequent to 04/04/03 former shareholders of the US corporation own, by reason of their having owned stock in the US corporation, 60% or more of the voting power or value of the foreign corporation’s stock and the foreign corporation’s expanded affiliated (50+%) group does not conduct substantial business activities in its country of incorporation, as compared to the group’s worldwide business activities

43 Corporate Inversions cont’d
Under the second set of rules, the expatriated entity’s status as foreign corporation is respected, but during the 10-year period any income or gain recognized by reason of the transfer of the stock or assets to the foreign corporation may not be offset by NOLs, FTCs, or other tax attributes Both sets of rules are subject to as special rule that overrides any tax treaty obligation “heretofore or hereafter entered into” And both sets of rules are complemented by corresponding provisions that apply to the transfer of substantially all the properties constituting a trade or business of a domestic partnership

44 Corporate Inversions cont’d
In addition, the stock options and stock-based compensation of specified corporate insiders (persons subject to Section 16(a) of the ’34 Act) are subject to an additional excise tax if gains are recognized as a result of the inversion. The tax imposed at the maximum capital gains rate and applies to stock compensation received at any time within the 12-month period that begins 6 months prior to the inversion transaction The reimbursement or payment of the excise tax by the inverted company to or on behalf of the insider also is subject to the excise tax

45 Holding Company Liquidations
Effective for distributions after 10/22/04, the tax consequences, to the distributee, of an outbound parent-subsidiary liquidation of a US parent of a consolidated return group depend upon the period of time that the liquidating US parent has been in existence current law treats the distributee as having participated in a section 331(a) exchange, which ordinarily would be entitled to non-recognition treatment under section 332(a) the new rule instead treats the transaction as a section 301 distribution, and thereby in whole or in part as a US source dividend, if the common parent has been in existence for less than 5 years regulation section 1.367(e)-2(d) anti-abuse rule potentially applies (to the US company) after 5-year period has elapsed

46 Interest Paid by Foreign Partnerships
Effective for taxable years beginning after 12/31/04, the all-or-nothing rule of current law for determining the geographic source of interest paid by a partnership is changed for foreign partnerships under current law, interest paid by a foreign (or domestic) partnership is 100% US source income if the partnership is ETB within the US at any time during the taxable year under the new provision, the geographic source of interest paid by a foreign partnership, that is predominantly engaged in an active trade or business outside the US, will be determined in a manner analogous to the branch interest rule of section 884(f)(1)(A)

47 Interest and OID Payable to Related Persons
Effective for amounts accrued after 10/22/04, the current rules for determining the time at which OID (section 163(e)(3)) and other accruals (section 267(a)(3)) to related foreign persons is modified current regulations use a “when includible” by the payee test new law substitutes a “to the extent includible” by the direct or indirect US owners standard for payees that are CFCs or PFICs takes into account stock ownership by unrelated persons disregards properly allocable deductions and qualified deficits under section 952(c)(1)(B) takes into account E&P limitation of section 952(c)(1)(A) deductions are restored when amounts are paid does not apply to US subsidiaries of foreign multinationals

48 Interest and OID Payable to Related Persons cont’d
United States shareholder owns 60% of stock of CFC, to which it accrues $100 item of expense Unrelated foreign shareholder owns remaining 40% of CFC stock deduction for US shareholder now limited to $60 same result if CFC has $60 of properly allocable deductions (or qualified deficits) even though US shareholder therefore includes only $24 ($40 x 60%) but deduction is limited to $24 if CFC’s total E&P for the taxable year is only $40, due to other deductions or losses, and US shareholder therefore includes only $24 ($40 x 60%) under the limitation of section 952(c)(1)(A)

49 Transfers of Built-in Loss Assets
Effective for transactions occurring after 10/22/04, the carryover basis rules are modified in certain tax-free reorganizations, section 351 transactions, and in-bound liquidations if there is an aggregate BIL in the properties that are acquired from any transferor that is not subject to US tax on the BIG/L with respect to such properties, then the transferee’s basis in each of the assets acquired from that transferor is its FMV the rule applies only to the properties that are received from persons in whose hands gain or loss with respect to such property is not subject to US tax and only where the properties are subject to tax in the hands of the transferee

50 Transfers of Built-in Loss Assets cont’d
where a partnership is a transferor in a section 351 transaction or in a tax-free reorganization, the new rule is applied by treating each partner as holding its proportionate share of the property of the partnership the same rule also applies to an in-bound section 332 liquidation if there is an aggregate BIL in the properties that are acquired by a domestic corporation upon the liquidation of its foreign subsidiary, then the domestic transferee’s basis in each of the assets acquired from that foreign transferor is its FMV

51 Anti-Loss Duplication
Effective for transactions occurring after 10/22/04, the carryover basis rules in section 351 transactions involving solely domestic taxpayers also have been modified if there is an aggregate BIL in the properties that are acquired in a section 351 transaction from any transferor that is subject to US tax, then the transferee’s aggregate basis is limited to the FMV of the properties unlike the anti-loss importation rule, no adjustments are made to the (carryover) basis of BIG assets the aggregate basis reduction is allocated in proportion to the respective BILs

52 Anti-Loss Duplication cont’d
the rule is limited to section 351 transactions and does not apply to tax-free reorganizations in the alternative, where there is an aggregate BIL in the properties that are acquired in a section 351 transaction from a transferor that is subject to US tax, the transferor and transferee can elect to have the transferor step-down the basis of the stock received in the section 351 exchange in lieu of having the transferee step-down the basis of its BIL assets


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