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Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional.

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Presentation on theme: "Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional."— Presentation transcript:

1 Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference within the organization to a “partner” means a person who is a partner, or equivalent, in a member firm or its affiliate. Similarly, reference to an “office” means an office of any such law firm. New Foreign Tax Credit Legislation Peter M. Daub, Baker & McKenzie LLP Tax Executives Institute, Inc. Kalamazoo Chapter Your Trusted Tax Counsel ® Thursday, March 17, 2011

2 ©2011 Baker & McKenzie 2 Presenter Peter M. Daub (Washington, D.C.) peter.daub@bakermckenzie.com (202) 452-7081

3 ©2011 Baker & McKenzie 3 Recent Foreign Tax Credit Rules –Repeal the benefit of the “hopscotch rule” for section 956 inclusions –Suspend foreign tax credits that are split from the income to which they relate –Disallow foreign tax credits in the case of a covered asset acquisition

4 ©2011 Baker & McKenzie 4 [change title in View/Header and Footer] 4 Repeal of Hopscotch Rule Benefit for Section 956

5 ©2011 Baker & McKenzie 5 Repeal of Section 956 Hopscotch Rule –Deemed-paid taxes from section 956 inclusions limited to the lesser of: –Foreign taxes deemed paid using hopscotch rule or –Foreign taxes that would be deemed paid if a hypothetical distribution was made through chain of ownership, without regard to any foreign taxes that would be imposed on an actual distribution –The rule is thus a one-way street –The rule is a problem for higher-taxed CFCs trapped under a lower-taxed CFC or under a CFC with an E&P deficit

6 ©2011 Baker & McKenzie 6 Repeal of Section 956 Hopscotch Rule –Not a permanent disallowance – excess foreign taxes remain in CFC’s tax pool –Applies to acquisitions of U.S. property after Dec. 31, 2010 –Normal hopscotch rule still applies to subpart F income inclusions

7 ©2011 Baker & McKenzie 7 USP (US) CFC1 (A) CFC2 (B) UE&P: $100 FT: $50 UE&P: $200 FT: $10 Tentative Credit $100 / $100 x $50 = $50 deemed-paid foreign income taxes USP (US) CFC1 (A) CFC2 (B) Hypothetical Credit $100 / $300 x $60 = $20 deemed- paid foreign income taxes UE&P: $300 ($200 + $100) FT: $60 ($10 + $50) $100 loan over all four quarters Hopscotch: Example

8 ©2011 Baker & McKenzie 8 Hopscotch: Grandfathered Section 956 Loan –Section 956 loans that were made on or before Dec. 31, 2010 are grandfathered –Normal hopscotch rule applies to inclusions for the duration of the loan, even after Dec. 31, 2010 –A single grandfathered loan could generate section 956 inclusions year after year through recurring PTI distributions –Inclusions limited to E&P, so grandfathered loan could allow for growth in annual earnings over time without inclusions greater than earnings in the meantime

9 ©2011 Baker & McKenzie 9 Hopscotch: Grandfathered Section 956 Loan –Must be bona-fide loan respected as debt – probably not an issue in most cases where size of loan was based on expected annual earnings –Must consider how the loan was funded – section 956 anti- abuse rule effectively prevents funding from other CFCs

10 ©2011 Baker & McKenzie 10 Hopscotch: Grandfathered Section 956 Loan USP CFC2 CFC1 –USP wholly owns CFC1, which wholly owns CFC2. –CFC has an overall E&P deficit of. –CFC2 does not have any accumulated E&P through 2010 and has zero in its taxes pools. –In 2010, CFC2 has an average investment in U.S. property under section 956(c) of 100. –During 2011, CFC2 has current year E&P of 100 and pays foreign taxes of 20. –CFC2 maintains its section 956 investment from 2010 and, at the beginning of 2011, CFC2 acquires another investment in U.S. property under section 956(c) of 100. –USP will have a section 951(a)(1)(B) income inclusion of 100 for 2011.

11 ©2011 Baker & McKenzie 11 Hopscotch: Subpart F Income –How to calculate the hypothetical distributions –954(c)(6) –Current year E&P limitation rules under section 952(c) –The “de minimis” and “full inclusion” rules under section 954(b)(3) –High-tax exception under section 954(b)(4) (and, if so, will the taxpayer be treated as making the election) –Same-country exception under section 954(c)(3) –Other rules and exceptions? –Normal hopscotch rule applies to any subpart F inclusions resulting from subpart F income rather than from section 956 investments in U.S. property –Possibility of extension of anti-hopscotch rule to subpart F inclusions resulting from subpart F income?

12 ©2011 Baker & McKenzie 12 Hopscotch Example: Section 956 Loan with SkipCo U.S. Parent CFC-1 (Low-tax) CFC-2 (High-tax) (Ctry B) SkipCo (Ctry C) –Section 956 loan should generate hypothetical dividend distribution to SkipCo –If look-through rule were not in force, hypothetical SkipCo dividend income should be hypothetical subpart F income because no same-country match – same as with actual dividend to SkipCo –Use of section 956 loan could avoid WHT on actual distribution Hypothetical Distribution PTI Loan Foreign Taxes with Hypothetical Subpart F Income Inclusion PTI

13 ©2011 Baker & McKenzie 13 Hopscotch Example: Dividend to SkipCo U.S. Parent CFC-1 (Low-tax) CFC-2 (High-tax) (Ctry B) SkipCo (Ctry C) –SkipCo dividend income will not be subpart F income while section 954(c)(6) look-through rule is in force –If look-through rule were not in force, SkipCo dividend income would be subpart F income because no same-country match –Look-through rule has been extended through 2011 for calendar year taxpayers; through FY2012 for fiscal year taxpayers Dividend PTI Distribution Foreign Taxes with Subpart F Income Inclusion

14 ©2011 Baker & McKenzie 14 Hopscotch: Additional Possible Planning Responses –Out-from-under transactions for trapped CFCs –Spin-offs –Internal inversions –Movement of E&P out of trapped CFCs –Section 304 sales –Requires a transfer of stock, which may produce unwanted complexity in the post-transaction structure –Cash D reorganizations

15 ©2011 Baker & McKenzie 15 U.S. Parent CFC-1 (Low-tax) CFC-2 (High-tax) CFC-3 $ shares Advantages –Section 304 deemed dividend from CFC- 2 earnings direct to US parent –No GRA needed. Treas. Reg. §1.367(a)- 9T However… –Dividend constrained by value of CFC-3 –CFC-2 may not be desirable HoldCo –CFC-3 now under CFC-1 Variations… –Recap of CFC-3 shares into preferred? –Establish CFC-3 as newco prior to sale? –Consider Treas. Reg. § 304-4T Hopscotch Example: Section 304 Sale

16 ©2011 Baker & McKenzie 16 [change title in View/Header and Footer] 16 Matching (Anti-Splitting) Rule for Foreign Income Taxes and Related Income

17 ©2011 Baker & McKenzie 17 Matching Rule –New section 909 suspends the U.S. foreign tax credit for creditable foreign income taxes that have been split from the income to which they relate –If there is a “foreign tax credit splitting event” with respect to a foreign income tax paid or accrued: –By a U.S. taxpayer (section 901): Tax not taken into account for U.S. tax purposes until the taxpayer takes into account the “related income” –By a section 902 corporation: Tax not taken into account for indirect FTC or E&P purposes until the section 902 corporation or its domestic corporation owner takes into account the “related income”

18 ©2011 Baker & McKenzie 18 Matching Rule –There is a “foreign tax credit splitting event” with respect to a foreign income tax if the “related income” is (or will be) taken into account by a “covered person” –“Related income”: 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 –Income is calculated under U.S. tax principles per the JCT Explanation –“Covered person”: certain related parties, broadly defined, of the person who pays or accrues the foreign income tax

19 ©2011 Baker & McKenzie 19 Matching Rule: Operating Rules –Application with respect to section 902 corporations –Suspended foreign taxes are not included in Post-1986 foreign tax pools –Suspended foreign taxes do not reduce Post-1986 undistributed earnings and profits –Applies to partnerships at partner level –Foreign taxes are translated into US dollars in year taxes are actually paid or accrued

20 ©2011 Baker & McKenzie 20 Matching Rule: Effective Date –Applies to foreign income taxes paid or accrued in taxable years beginning after Dec. 31, 2010 –Pre-2011 Taxes: Applies to foreign income taxes paid or accrued by a section 902 corporation in taxable years beginning on or before Dec. 31, 2010 which have not been deemed paid under section 902(a) or section 960 on or before such date, but only for purposes of applying sections 902 and 960 with respect to periods after [taxable years beginning after] such date –Thus has potential retrospective reach despite nominal prospective application –No E&P adjustment required with respect to pre-2011 taxes suspended under section 909 –Guidance issued in Notice 2010-92 (see following slides)

21 ©2011 Baker & McKenzie 21 Pre-2011 Taxes Not Subject to Matching Rule 1.Not paid or accrued in connection with a pre-2011 splitter arrangement; 2.Pre-2011 split taxes deemed paid under section 902(a) or 960 on or before the last day of the section 902 corporation’s last pre-2011 taxable year 3.Pre-2011 split taxes and either: –The section 902 corporation took the related income into account in a pre-2011 taxable year –A section 902 shareholder took the related income into account before the last day of the section 902 corporation’s last pre-2011 taxable year 4.Pre-2011 split taxes paid or accrued in taxable years before January 1, 1997

22 ©2011 Baker & McKenzie 22 Matching Rule: Pre-2011 Splitter Arrangements –Notice 2010-92 provides an exclusive list of arrangements that will give rise to a foreign tax credit splitting event with respect to pre-2011 taxes: 1.Reverse Hybrid Structures 2.Certain Foreign Consolidated Groups 3.Loss Sharing Group Relief with Disregarded Debt 4.Hybrid Instruments –Future guidance identifying additional transactions to which section 909 applies will only apply to taxes paid or accrued in post-2010 taxable years

23 ©2011 Baker & McKenzie 23 Matching Rule: Post-2010 Splitter Arrangements –Notice 2010-92 provides no direct guidance on post-2010 splitter arrangements –Future guidance will identify transactions to which section 909 applies with respect to taxes paid or accrued in post-2010 taxable years –Will include at least the four pre-2011 splitter arrangements –May well include more

24 ©2011 Baker & McKenzie 24 Matching Rule: Pre-2011 Splitter Arrangements: Reverse Hybrid Structures –Reverse Hybrid: An entity treated as a corporation for US tax purposes but as a pass-through entity or branch for foreign tax purposes. The owner of the reverse hybrid is subject to tax on the income of the entity under foreign law. –Reverse Hybrid Structure: A section 902 corporation owns an interest in a reverse hybrid. US Parent Sect. 902 Corp’n P/S Reverse Hybrid

25 ©2011 Baker & McKenzie 25 Matching Rule: Pre-2011 Splitter Arrangements: Reverse Hybrid Structures –Pre-2011 Split Taxes: Taxes paid or accrued by the section 902 corporation with respect to income of the reverse hybrid. –Related Income: The E&P of the reverse hybrid attributable to the activities of the reverse hybrid that gave rise to the income included in the foreign tax base with respect to which the pre-2011 split taxes were paid or accrued.

26 ©2011 Baker & McKenzie 26 Matching Rule: Reverse Hybrid FS1 accrues split tax of 20 with respect to FS2’s related income in Year 1 FS2 distributes 1 to FS1 in Year 2 FS2 and FS3 generate income from different activities in different countries. E & P Case 1 FS2FS3 Year 1 100 0 Year 2 (99) 0 Case 2 FS2FS3 Year 1 100 0 Year 2 0(99) FS1 FS2 FS3 US Parent

27 ©2011 Baker & McKenzie 27 –Foreign Consolidated Group: Exists when a foreign country imposes tax on the combined income of two or more entities. –Whether through consolidation or attribution of income. –Not created by loss surrender group relief, section 78-type gross-up income, or anti-deferral regimes. Matching Rule: Pre-2011 Splitter Arrangements: Certain Foreign Consolidated Groups Sect. 902 Corp’n (Country A) Sect. 902 Corp’n (Country A) Sect. 902 Corp’n (Country A) US Parent

28 ©2011 Baker & McKenzie 28 –Splitter Arrangement: Exists to the extent that the payor of taxes does not allocate the foreign consolidated tax liability among the members of the consolidated group based on each member’s share of the consolidated taxable income under the principles of section 1.901-2(f)(3). –Section 909 applies even if the payor of taxes has a deficit in E&P for a particular year. Matching Rule: Pre-2011 Splitter Arrangements: Certain Foreign Consolidated Groups Sect. 902 Corp’n (Country A) Sect. 902 Corp’n (Country A) Sect. 902 Corp’n (Country A) US Parent

29 ©2011 Baker & McKenzie 29 –Pre-2011 Split Taxes: Taxes paid or accrued by one member of the foreign consolidated group that are imposed on a covered person’s share of the consolidated taxable income included in the foreign tax base. –Related Income: The E&P of such other member attributable to the activities of that other member that gave rise to income included in the foreign tax base with respect to which the pre-2011 split taxes were paid or accrued. Matching Rule: Pre-2011 Splitter Arrangements: Certain Foreign Consolidated Groups Sect. 902 Corp’n (Country A) Sect. 902 Corp’n (Country A) Sect. 902 Corp’n (Country A) US Parent Liability for foreign tax on consolidated group income Income

30 ©2011 Baker & McKenzie 30 –Splitter Arrangement: Exists if one entity with a loss permits the loss to be used to offset income of one or more other entities (a “shared loss”) and: 1.There is a debt instrument that is regarded for foreign tax purposes but disregarded for US tax purposes (a “disregarded debt instrument”); and 2.The owner of the disregarded debt instrument pays foreign income tax on a payment or accrual on the instrument; and 3.The payment or accrual on the instrument gives rise to a foreign tax deduction and the issuer incurs a shared loss that is taken into account under foreign law by one or more foreign persons. Matching Rule: Pre-2011 Splitter Arrangements: Loss Sharing with Disregarded Debt

31 ©2011 Baker & McKenzie 31 –Pre-2011 Split Taxes: Pre-2011 taxes paid or accrued by the owner of the disregarded debt instrument with respect to amounts paid or accrued on the instrument, up to the amount of the shared loss. –Related Income: The related income of a covered person is an amount equal to the shared loss, determined without regard to the actual amount of the covered person’s E&P. Matching Rule: Pre-2011 Splitter Arrangements: Loss Sharing with Disregarded Debt UK-1 UK-2 UK-3 Interest Surrender of loss High-tax E&P pool Low-tax E&P pool US Parent

32 ©2011 Baker & McKenzie 32 –Disregarded debt instruments include obligations between: 1.Two disregarded entities owned by the same section 902 corporation 2.A section 902 corporation and a disregarded subsidiary 3.Two disregarded entities owned by a partnership with a section 902 corporation partner 4.A partnership with a section 902 corp’n partner and its disregarded subsidiary Partnership Disregarded Entity Disregarded Entity Section 902 Corporation Disregarded Entity Disregarded Entity Section 902 Corporation Matching Rule: Pre-2011 Splitter Arrangements: Loss Sharing with Disregarded Debt

33 ©2011 Baker & McKenzie 33 Case 1 US UK 1 UK2UK3 Year 1 IncomeTax UK11000200 UK2(2000) 0 UK33000200 Year 2 IncomeTax UK1 0 0 UK22000200 UK3 0 0 20% tax rate UK2 can surrender loss to either UK1 or UK3 UK2 chooses to surrender loss to UK3 Does it make a difference whether UK2 can carry over Yr 1 loss to other years? US UK 1 UK3 Case 2 UK2 Matching Rule: Loss Sharing

34 ©2011 Baker & McKenzie 34 –US Equity Hybrid Instrument: Equity for US tax purposes but debt for foreign tax purposes. –Splitter Arrangement: Exists where a section 902 corporation owns a US Equity HI issued by a covered person, to the extent amounts on the instrument are deductible by the issuer for foreign tax purposes but not included in income of the owner for US tax purposes. Matching Rule: Pre-2011 Splitter Arrangements: Hybrid Instruments US Parent Sect. 902 Corp’n Foreign Corp’n (Covered Person) Equity for US tax Debt for foreign tax Accrual on hybrid instrument No dividend income for US tax Interest income for foreign tax

35 ©2011 Baker & McKenzie 35 –Pre-2011 Split Taxes: Total pre-2011 foreign taxes paid by the section 902 corporation less the amount of pre- 2011 foreign taxes that would have been paid or accrued had the section 902 corporation not been subject to foreign tax on income from the US Equity HI. –Related Income: The related income of the issuer is an amount equal to the amounts that are deductible by the issuer for foreign tax purposes, determined without regard to the actual amount of the issuer’s E&P. Matching Rule: Pre-2011 Splitter Arrangements: Hybrid Instruments US Parent Sect. 902 Corp’n Foreign Corp’n (Covered Person) Equity for US tax Debt for foreign tax Other foreign taxable income Accrual on hybrid instrument No dividend income for US tax Interest income for foreign tax

36 ©2011 Baker & McKenzie 36 USP Lux1 Lux2 US perspective Lux1 has made equity investment in Lux2 Luxembourg perspective Lux1 has loaned money to Lux 2 Accrued but unpaid interest: $100 Active Income $100 Lux1: Net Income: $100 Lux Tax: $29 Lux2: Net Income: $0 Lux Tax: $0 E&P: $0 FTC: $29 E&P: $100 FTC: $0 USP Lux1 Lux2 Matching Rule: Example: Hybrid Instrument

37 ©2011 Baker & McKenzie 37 –US Debt Hybrid Instrument: Debt for US tax purposes but equity for foreign tax purposes. –Splitter Arrangement: Exists where a covered person owns a US Debt HI issued by a section 902 corporation, to the extent amounts on the instrument are deductible for US tax purposes but not deductible for foreign tax purposes. Matching Rule: Pre-2011 Splitter Arrangements: Hybrid Instruments US Parent Sect. 902 Corp’n (Covered Person) Sect. 902 Corp’n Debt for US tax Equity for foreign tax Accrual or payment on hybrid instrument Deductible interest for US tax Non-deductible dividend for foreign tax

38 ©2011 Baker & McKenzie 38 –Pre-2011 Split Taxes: Pre-2011 foreign taxes paid or accrued by the section 902 corporation on income that would have been offset by the interest paid or accrued on the US Debt HI had such interest been deductible for foreign tax purposes. –Related Income: The related income of the owner is the gross amount of the interest income recognized by the owner for US tax purposes, determined without regard to the actual amount of the owner’s E&P. Matching Rule: Pre-2011 Splitter Arrangements: Hybrid Instruments US Parent Sect. 902 Corp’n (Covered Person) Sect. 902 Corp’n Debt for US tax Equity for foreign tax Other foreign taxable income Accrual or payment on hybrid instrument Deductible interest for US tax Non-deductible dividend for foreign tax

39 ©2011 Baker & McKenzie 39 Matching Rule: Further Examples for Discussion –Foreign-taxable sale of shares that is treated as a section 351 exchange or section 368 reorganization for U.S. tax purposes due to circular flow of the sale proceeds –Timing difference?

40 ©2011 Baker & McKenzie 40 Sale of Target CFC assets for cash CFC1 CFC2Target CFC Target CFC elects disregarded entity status / liquidates 1 4 3 CFC1 contributes the sale proceeds to CFC2 –For US purposes, tax-free non-divisive D reorganization of Target CFC b/c of circular cash flow –For foreign country purposes, taxable sale – Target CFC recognizes gain and pays tax ($1000 gain * 30% = $300) –Target CFC has no E&P from the sale and $300 of foreign taxes – CFC2 succeeds to Target CFC’s E&P and foreign taxes Sale of CFC1 assets for cash CFC1 CFC2 1 2 CFC1 contributes the sale proceeds to CFC2 –For US purposes, tax-free section 351 contribution b/c of circular cash flow –For foreign country purposes, taxable sale – CFC1 recognizes gain and pays tax ($1000 gain * 30% = $300) –CFC1 has no E&P from the sale and $300 of foreign taxes 2 Target CFC distributes the sale proceeds to CFC1 Matching Rule: Example: Foreign Taxable / U.S. Non-Taxable

41 ©2011 Baker & McKenzie 41 Matching Rule: Further Examples for Discussion –Foreign-taxable transfer of assets between members of a single check-the-box entity –No income for U.S. tax purposes, therefore no “related income”?

42 ©2011 Baker & McKenzie 42 Matching Rule: Mid-Year Change in Classification USP, CFC1, and FC2 each have a calendar taxable year for U.S. federal tax purposes as well as for purposes of their respective local foreign tax jurisdictions. Near the end of Year 1 (i.e., prior to December 31), FC2 makes an election for U.S. federal tax purposes to change its classification to an association taxable as a corporation for U.S. federal tax purposes. During Year 1, FC2 earns $100 and pays 20 of foreign income tax to Country Y. Foreign taxes for purposes of the foreign tax credit rules generally would accrue December 31 of Year 1. FC2 is a CFC on that date. CFC1 includes almost all of FC2's income for the year (i.e., during the period when it was a disregarded entity). Are all the Year 1 foreign taxes allocated to FC2, a CFC? For certain limited situations involving the allocation of foreign taxes when there is an acquisition, see e.g., Rev. Rul. 75-532 and Treas. Reg. section 1.338-9(d). For proposed regulations addressing these types of transactions, see Prop. Reg. section 1.901-2(f)(3). USP CFC1 COUNTRY X CFC1 COUNTRY X During Year 1 December 31, Year 1 USP FC2 COUNTRY Y FC2 COUNTRY Y CFC1 COUNTRY X CFC1 COUNTRY X FC2 COUNTRY Y FC2 COUNTRY Y

43 ©2011 Baker & McKenzie 43 Matching Rule: Mid-Year Change in Classification –Assuming that the Year 1 foreign taxes are allocated to FC2 (a CFC) under current law, does FC2's entity classification election result in a foreign tax credit splitting event for FC2's income up to the date of the entity classification election? –If yes, suppose FC 2 has 1 of subpart F general limitation income from the same activity in year 2 resulting in a section 951(a)(1)(A) inclusion for USP. –Is USP's ability to claim under section 960 the respective portion of the foreign taxes in FC2 from year 1 suspended until CFC1 makes a distribution to USP of the related income/E&P? FC2 COUNTRY Y FC2 COUNTRY Y CFC1 COUNTRY X CFC1 COUNTRY X USP CFC1 COUNTRY X CFC1 COUNTRY X During Year 1December 31, Year 1 USP FC2 COUNTRY Y FC2 COUNTRY Y

44 ©2011 Baker & McKenzie 44 Matching Rule: Operating Rules – Related Income –Distributions of Related Income –General Rule: If the E&P of a covered person includes both related income and non-related income, distributions from the covered person are made from related income and non- related income on a pro rata basis –Exception: A section 902 shareholder may elect to treat all distributions, deemed distributions, and inclusions out of E&P of a covered person as first attributable to related income –Election must be made on the tax return for the first post-2010 taxable year

45 ©2011 Baker & McKenzie 45 Matching Rule: Operating Rules – Related Income –Taking into account related income –Section 902 corporation: if: 1.Reflected in the income of the section 902 corporation; or 2.The section 902 corporation and the covered person are combined in a section 381 transaction –Section 902 shareholders: if included in the gross income of 1.The section 902 shareholder; or 2.An affiliated corporation

46 ©2011 Baker & McKenzie 46 Matching Rule: Operating Rules – Pre-2011 Split Taxes –Distributions –If a section 902 corporation has pre-2011 split taxes and other taxes, foreign taxes deemed paid under sections 902 or 960 shall be treated as attributable to pre-2011 split taxes and other taxes on a pro rata basis –Pre-2011 split taxes deemed paid in pre-2011 taxable years in connection with a distribution to a section 902(b) shareholder retain their character as pre-2011 split taxes –The section 902(b) shareholder is considered the payor of taxes with respect to the pre-2011 split taxes

47 ©2011 Baker & McKenzie 47 Matching Rule: Operating Rules – Pre-2011 Split Taxes –Related income taken into account –As related income is taken into account, a ratable portion of the associated pre-2011 split taxes will no longer be treated as pre-2011 split taxes –Special rule for pre-2011 splitter arrangements involving reverse hybrids and foreign consolidated groups: if aggregate related income is zero or negative, pre-2011 taxes retain character until aggregate related income becomes positive and such income is taken into account by the payor or a section 902 shareholder

48 ©2011 Baker & McKenzie 48 [change title in View/Header and Footer] 48 Covered Asset Acquisitions

49 ©2011 Baker & McKenzie 49 Covered Asset Acquisitions –Section 901(m) denies FTCs for “disqualified portion” of foreign taxes paid after a “covered asset acquisition” –Covered asset acquisition: (i) qualified stock purchase (section 338(d)(3)) to which section 338(a) applies; (ii) transaction treated as an asset acquisition for U.S. tax purposes but as a stock acquisition (or is disregarded) for foreign tax purposes; (iii) acquisition of partnership interest if section 754 election is in effect; (iv) to the extent provided, any similar transaction –Theme is transactions that result in basis increase for U.S. tax purposes but not foreign tax purposes

50 ©2011 Baker & McKenzie 50 Covered Asset Acquisitions –Relevant foreign asset includes any asset (including intangibles) with respect to a covered asset acquisition if income, gain, deduction, or loss attributable to the asset is taken into account for foreign income tax purposes –Basis difference is excess of (i) U.S. tax basis of assets immediately after acquisition over (ii) U.S. tax basis immediately before acquisition –Basis difference allocated to years based on applicable cost recovery method –Disqualified portion of foreign taxes allowed as deduction aggregate “basis differences” that are allocable to the year the income or gain attributable to the relevant foreign assets Disqualified portion of foreign taxes equals: foreign taxes determined with respect to the income or gain attributable to the “relevant foreign assets” X

51 ©2011 Baker & McKenzie 51 Covered Asset Acquisitions –Example: Section 338 qualified stock purchase –USP acquires foreign target (FT) and makes a section 338(g) election –Aggregate basis difference of $200 –Asset A: $150 basis difference and 15-year recovery period  $10 annually –Asset B: $50 basis difference and 5-year recovery period  $10 annually

52 ©2011 Baker & McKenzie 52 Covered Asset Acquisitions –Example: Section 338 qualified stock purchase –Year 1: FT earns $100 and pays $25 of tax –Disqualified portion of foreign tax = $5 –($10 + $10) / $100 x $25 = $5 –Year 2: FT earns $100 and pays $25 of tax –Disqualified portion of foreign tax = $5 –($10 + $10) / $100 x $25 = $5 –Year 3: FT earns $140, incl. income from disposition of Asset B, and pays $35 of tax –Disqualified portion of foreign tax = $10 –($10 + $30) / $140 * $35 = $10

53 ©2011 Baker & McKenzie 53 Covered Asset Acquisitions: Example: Acquisition Following Covered Asset Acquisition – Purchase price of FT stock is 300 – 338(g) election in year 1 – FT has a single asset with a 10 year recovery period and a basis of 100 – FT organized in Country F, tax rate of 25% – FT has 100 of taxable income for Country F purposes in years 1 and 2 (300-100) 10 100 – USB purchases FT in year 3 for 400 – No 338(g) election in year 3 Year 300 FT Year 1 SellersUSP 400 Year 3 USPUSB FT x 25 = 5 of tax disallowed in years 1 and 2

54 ©2011 Baker & McKenzie 54 Covered Asset Acquisitions: Basis Step-up Under Foreign Law – FT organized in Country F – USP acquires FT for 300 – USP makes 338(g) election – FT has a single asset with a 10-year recovery period and a basis of 100 for US and Country F purposes – Basis stepped up to 300 for both purposes – FT has 100 of taxable income for Country F purposes in years 1 (300-100) 10 x 25 or 5 disallowed in year 1? 100 FT SellersUSP 300

55 ©2011 Baker & McKenzie 55 Covered Asset Acquisitions –Section 338(g) election for a foreign target may still make sense in circumstances where benefits (reduction of E&P, elimination of unfavorable U.S. tax attributes) outweigh detriment of disallowed FTCs, depending on a number of factors –Amount of depreciation resulting from basis step-up –Deductibility of foreign taxes –Amount of leverage introduced upon acquisition –Foreign income tax rate –Uncertainty regarding target’s U.S. tax attributes –Sale of shares of disregarded foreign company may still make sense in circumstances where subpart F benefit outweighs the FTC detriment

56 ©2011 Baker & McKenzie 56 Covered Asset Acquisition/Matching Rule Overlap –FT organized in Country F –FT treated as a pass-through for Country F purposes and as a corporation for US purposes –USP makes 338(g) election –FT has a single asset with a 10-year recovery period and a basis of 100 for US purposes –Basis stepped up to 300 for US purposes –FT has 100 of taxable income for Country F purposes in year 1 currently recognized by USP –FT has 80 of E&P from US purposes in year 1 (300-100) 10 x 25 or 5 of USP’s tax disallowed in Yr 1 100 –Is 20 of USP’s tax deferred until a dividend of 80 from FT? SellersUSP FT 300

57 ©2011 Baker & McKenzie 57 Thank You Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference within the organization to a “partner” means a person who is a partner, or equivalent, in a member firm or its affiliate. Similarly, reference to an “office” means an office of any such law firm. Pursuant to requirements relating to practice before the Internal Revenue Service, any tax advice in this communication (including any attachments) is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing, or recommending to another person any tax-related matter.


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