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In May of 2010, the House passed a version of the “extenders bill” that included several revenue raisers implemented through the Internal Revenue Code’s international tax provisions. That bill stalled in the Senate in June of 2010, however, leaving the international tax laws at their status quo. Although the fate of the timing and offsets of the extenders bill remains unclear, Senate Majority Leader Reid recently resurrected the proposed international revenue raisers by including them in a Senate amendment to the Education Jobs and Medicaid Assistance Act, H.R. 1586 (the “Act”). The Senate passed the Act by a vote of 61-39 on August 5, 2010. The House passed the Act by a vote of 247-161 on August 10, 2010, and it was signed into law by the President that same day as Public Law No. 111-226. Interestingly, although the Democrats have informally named the Act, it does not actually have a name and is officially labeled the “_______ Act of _______.”

The Act provides over $26 billion in federal funding for local education and Medicaid and the international tax raisers are estimated to raise over $9.7 billion over the next 10 years to help pay for it. While Democrats are stressing the benefits of the “jobs” portion of H.R. 1586, Republicans are concerned about the revenue-raising additional taxes that U.S. multinationals will now face on account of these changes which, according to them, could stunt needed economic growth. Nevertheless, these changes to international tax law have been enacted. This Alert summarizes the international tax revenue raisers included in the Act.^[1]

Prevent Foreign Tax Credit Splitting

Taxpayers generally are permitted to claim foreign tax credits with respect to foreign taxes paid on income earned in foreign countries. There are certain planning techniques that allow a taxpayer to claim foreign tax credits while not taking into account the income on which those taxes are paid. The Administration’s 2011 Budget includes a proposal to match foreign tax credits to associated foreign income. The Act adopts this proposal by effectively suspending the foreign tax credits until the foreign income related to those tax credits is taxed in the U.S. The provision is generally effective for foreign income taxes paid or accrued in taxable years beginning after December 31, 2010, but is effective for foreign income taxes paid in taxable years beginning on or before December 31, 2010, for purposes of taking deemed-paid taxes into account in taxable years beginning after December 31, 2010.

“Covered Asset Acquisitions”—Denial of Foreign Tax Credit Attributable to Basis Differential

Under present law, taxpayers may treat an acquisition of stock in an entity that is treated as a corporation for foreign tax purposes, but as either a partnership or disregarded entity for U.S. tax purposes, as an asset acquisition for U.S. tax purposes (i.e., a “covered asset acquisition”). As a result of this structure, the taxpayer would obtain a permanent tax-free step-up in basis of the assets of the entity for U.S. tax purposes, but not for foreign tax purposes. Thus, U.S. depreciation and amortization deductions would be higher than the corresponding deductions for foreign tax purposes, resulting in higher foreign tax credits relative to U.S. income (i.e., creating an artificially high effective foreign tax rate). The Act disallows such credits to the extent attributable to differences in asset tax basis as a result of a covered asset acquisition. The provision generally applies to covered asset acquisitions after December 31, 2010, but will not apply to certain pending transactions.

Income Resourced Under Tax Treaties—Separate Foreign Tax Credit Limitation

Foreign tax credits generally are limited to the maximum amount of U.S. tax that could be imposed on foreign-source income (generally 35% for U.S. corporations). Under present law, the limitation applies separately to passive and active income “baskets.” Thus, a certain amount of “cross-crediting” is permissible within each basket. Certain income treated as derived from sources within the United States under U.S. domestic tax law may be treated as derived from sources outside the United States under a tax treaty. The Act segregates each such item of resourced income into a separate limitation basket. The Act does not apply to certain income or gain that is resourced under present law, in a similar manner, with respect to U.S.-owned foreign corporations. The provision targets the sale of certain income-producing assets to foreign branches and disregarded entities located in certain treaty jurisdictions in order to increase foreign-source income without increasing foreign taxes. The provision is effective for taxable years beginning after the date of enactment.

Prevention of Section 956 “Hopscotch”

This provision limits the foreign tax credits that a U.S. shareholder in a controlled foreign corporation (“CFC”) is deemed to pay in the case of an inclusion under Section 956. Section 956 deems a dividend to be paid directly by a foreign subsidiary to its ultimate U.S. parent in the case of certain U.S. investments by the subsidiary, including loans to its U.S. parent (“United States property”). This deemed dividend affirmatively “brings up” foreign tax credits directly from the subsidiary. If the Section 956 income inclusion is from a subsidiary located in a high-tax jurisdiction, the credits will reflect that high tax rate. However, an actual dividend to the U.S. parent from the same subsidiary will bring up foreign tax credits at a tax rate “blended” with the rate of intervening companies, which may be holding companies with low tax rates. This may result in a lower amount of foreign tax credit for the U.S. parent recipient than if the originator of the dividend had “hopscotched” the dividend over its chain of intervening subsidiaries through the use of Section 956. The Act limits the amount of foreign tax credits that may be claimed with respect to a Section 956 income inclusion to the amount that would have been allowed had the dividend actually been paid through the chain of ownership. This provision is effective for acquisitions of United States property after December 31, 2010.

Modification of Section 304(b)—Redemptions of Foreign Subsidiaries

The earnings of foreign subsidiaries of U.S. entities with foreign parents normally are subject to a withholding tax at a rate of 30% (unless reduced by treaty) when they are remitted to the foreign parent through the U.S. entity. Prior to the Act, the foreign parent could avoid this withholding tax by entering into a Section 304 transaction which would result in the earnings being treated as a deemed dividend from the foreign subsidiary directly to the foreign parent. The Act generally eliminates this benefit and is effective for acquisitions after the date of enactment.

Modification of Affiliation Rules for Purposes of Allocating Interest Expense

For purposes of determining the foreign tax credit limitation, taxpayers must allocate and apportion interest deductions between U.S.- and foreign-source income, on the basis of the assets producing such income. In general, all members of an affiliated group of corporations are treated as a single corporation, and Treasury Regulations generally exclude all foreign corporations from the affiliated group. However, a foreign corporation is treated as affiliated if (1) at least 80% of either the vote or value of the foreign corporation’s stock is owned directly or indirectly by members of an affiliated group, and (2) more than 50% of the corporation’s gross income for that taxable year is effectively connected with the conduct of a U.S. trade or business (“ECI”). If 80% or more of the foreign corporation’s gross income is ECI, then all of the foreign corporation’s assets and interest expense are taken into account. If, instead, between 50 and 80% of its gross income is ECI, then only its assets generating ECI and a corresponding percentage of its interest expense are taken into account. The Act strengthens these rules by providing that, if more than 50% of the foreign corporation’s gross income is ECI and the 80% ownership requirement is met, then all of the foreign corporation’s assets and interest expense are taken into account in allocating interest. The provision is effective for taxable years beginning after the date of enactment.

Repeal of 80/20 Rules

Currently, interest paid by a resident individual and interest and dividends paid by a domestic corporation are subject to 30% withholding if paid to a foreign person. However, if at least 80% of a resident alien’s or domestic corporation’s gross income during a three-year period is foreign-source income attributable to the active conduct of a trade or business (the “80/20 test”), such dividends and interest are not subject to the normal gross basis withholding. The Act adopts the Administration’s 2011 Budget proposal to repeal these rules. However, the Act provides relief for certain existing companies meeting the 80/20 test. The provision is generally effective for taxable years beginning after December 31, 2010.

Technical Correction to HIRE Act Statute of Limitations Provision

The HIRE Act (Pub. L. No. 111-147, sec. 513), contains a provision that effectively left open indefinitely the statute of limitations on certain international transactions if certain correct information returns were not furnished. Under the Act, if the taxpayer establishes reasonable cause, the limitations period is suspended only for the item or items related to the failure to disclose. This provision is generally effective as if it was included in the original HIRE Act (i.e., for returns filed after March 18, 2010.)

If you have questions on how any of these tax changes may affect you or your business, or would like to discuss whether advance tax-planning opportunities may be available for you, please contact Paul M. Schmidt, Jeffrey H. Paravano, Allen J. Littman, Michael W. Nydegger, or your regular Baker Hostetler contact.