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David Forst and Adam Halpern
Fenwick & West
United States

The Obama Administration's international tax proposals would amount to a significant overhaul of the US international tax system, believe David Forst and Adam Halpern of Fenwick & West.

The Obama Administration released a series of international tax reform proposals earlier this year that it estimated would raise $210 billion in revenue over 10 years. (The Joint Committee on Taxation later estimated that the proposals would raise $159 billion in the same period.) At the time of writing Congress has largely not acted on the proposals and may not do so until 2010. Some of the more significant provisions are:

Repeal of check-the-box

Under US tax rules a business entity (other than certain business entities treated as per se corporations) can elect whether to be treated as a corporation or as fiscally transparent for US federal tax purposes. A business entity with a single owner that is not treated as a corporation is treated as disregarded from its sole owner. These are the so-called check-the-box rules.

The Obama Administration's proposal would eliminate disregarded entity treatment for foreign entities except in two narrow cases:

• a first-tier entity having a US corporation as its direct owner (this exception would not apply in cases of US tax avoidance, however); and
• an entity having an owner that is not disregarded for US tax purposes and that is organised under the laws of the same foreign country as its owner.

The Administration estimated that this proposal would be the biggest revenue raiser of all the proposed reforms-$86 billion over 10 years. However, the Joint Committee on Taxation estimated that the proposal would raise only $31 billion over 10 years.

Indeed, the Administration's proposal could be more of a boon to foreign treasuries than the US Treasury, given the use of disregarded entity elections in foreign earnings stripping transactions. Substantial repeal of check-the-box could hurt the competitiveness of US companies, and their ability to create and retain jobs. Doing so at the enrichment of foreign treasuries would seem not to be an appropriate US policy goal.

Deferral

The Administration's proposal would also limit US persons' ability to defer earnings of foreign corporations from US tax. Of course, many countries exempt the foreign earnings of resident corporations from home country taxation. The US deferral system is a cousin to an exemption regime, with a significant difference being that foreign earnings cannot be repatriated without US tax.

Under the proposal, deductions for expenses (other than research and experimentation expenses) that are properly allocated and apportioned to foreign-source income would be deferred to the extent the foreign-source income associated with the expenses is not subject to US tax. The proposal would particularly affect companies with large amounts of interest expense allocated to foreign sources, by deferring a deduction for such expenses. The effect would be compounded if implementation of worldwide interest allocation rules are delayed until 2020, as proposed in the House Ways and Means Committee's markup of pending U.S. healthcare legislation.

The Administration's deferral proposal would cause the US to move in the opposite direction from the exemption systems adopted by most industrialised countries. This could cause the US's high corporate income tax rate to act as an even greater drag on competitiveness for US-based companies.

Foreign tax credits

One proposal would prevent the separation of foreign tax credits and income through a matching rule. The Internal Revenue Service (IRS) issued a similar proposal in 2006 regulations. Some commentators, however, questioned whether the IRS had the authority to write such a rule. At the time of writing the proposed regulations have not been adopted.

Another proposal would require a taxpayer to determine foreign tax credits and earnings and profits on a consolidated basis for all controlled foreign corporations. Taxpayers would be subject to a limitation on foreign tax credits based on an average foreign tax rate imposed on the sum of the foreign source income of the taxpayer and unrepatriated income earned by the taxpayer's controlled foreign corporations.

Other proposals

The Administration proposes to clarify the definition of intangible property in instances when a US person transfers intangible property to a foreign corporation. The transfer of foreign goodwill and going concern value by a US person to a foreign corporation is not subject to US tax. The IRS has argued for a narrowing of the definition of going concern value so as not to include workforce in place.

The Administration would repeal the 80/20 rules. These rules exempt all or a portion of interest and dividends paid by a US corporation from US withholding tax if at least 80% of the corporation's gross income is derived from foreign sources in the active conduct of a trade or business.

In another proposal the US affiliates of certain inverted companies could not deduct related-party interest expense.

Xilinx

In a 2-1 decision the US Court of Appeals for the Ninth Circuit reversed the US Tax Court's decision in the Xilinx case (Disclosure: Fenwick & West represents Xilinx). One practitioner was quoted in the Wall Street Journal as stating that Xilinx is "the most important transfer-pricing decision in [the United States] in 20 years." A petition for rehearing en banc has been filed with the Ninth Circuit.

At issue in Xilinx is whether the purported cost of stock-based compensation (ESOs) must be shared pursuant to a cost sharing agreement entered into between a US parent corporation and its Irish subsidiary. The tax court held that the IRS regulations in effect at the time did not require the sharing of any amounts related to ESOs, since parties operating at arm's-length did not and would not share such amounts. All of the three ninth circuit judges who heard the case agreed that it was not arm's length for any amounts associated with ESOs to be shared, that is, included in the pool of costs. Unrelated parties in identical or similar circumstances would not share such items. However, two of the judges interpreted the IRS regulations as nevertheless requiring that such items be shared. Thus, the majority of the panel read the cost sharing regulations as not incorporating or being governed by the arm's length standard, even though the regulations provide that the standard applies in "every case," and has been in the regulations for 75 years. This majority's rationale was never advocated or defended by the IRS in the proceedings.

The decision could have wide ramifications. The majority recognised that the US-Ireland tax treaty, which was applicable, incorporated the arm's-length standard, but believed that the arm's-length standard could be abandoned on the US side due to the Treaty's savings clause. The savings clause, of course, could not have intended that, not least because (under the panel's reading of the treaty) the arm's-length standard would essentially be written out of all the US's bilateral income tax treaties with a savings clause. This would defeat the understandings and expectations of the US's treaty partners and create intractable double taxation issues in competent authority proceedings across the globe. Former senior tax officials from major US treaty partners have written to the ninth circuit expressing substantial concern and supporting a rehearing of the case. At the time of writing the ninth circuit has not yet decided whether to grant a rehearing.

Textron

In a 3-2 decision on rehearing, the first circuit, en banc, reversed the district court's decision in Textron, holding that the attorney work product privilege did not apply to tax accrual work papers because the workpapers were not "prepared for" litigation. The court of appeals stated that

[i]t is not enough to trigger work product protection that the subject matter of a document relates to a subject that might conceivably be litigated . . . nor is it enough that the materials were prepared by lawyers or represent legal thinking.

The court emphasised that the workpapers lacked the "touch and feel" of materials prepared for a current or possible litigation.

The vigorous dissenting opinion stated that the majority's "prepared for" standard was "blatantly contrary" to precedent. It also stated that the decision could have wide ramifications since under the majority's rule, "there is no protection for . . . documents analyzing anticipated litigation, but prepared to assist in a business decision rather than to assist in the conduct of the litigation."

The Textron majority opinion is an unfortunate departure from the last 15 years of US legal developments, which had established the viability of work product claims for so-called "dual purpose" documents in nearly all US appellate circuits.

Anti-inversion rules

In June 2009, the Treasury Department and the IRS issued new temporary regulations under the anti-inversion rules of Section 7874 of the Code to replace 2006 temporary regulations that were expiring. The 2009 temporary regulations tightened the rules in a number of ways, making it more difficult for US companies to switch to a foreign parent corporation structure.

Section 7874 was enacted as part of the 2004 Tax Act after a number of US-based companies completed inversion transactions. Under Section 7874, in the case of an inversion completed after March 4 2003, the new foreign parent corporation will be treated as a US corporation for US tax purposes if:

• 80% or more of its stock is held by former owners of the inverting US entity by reason of holding their ownership interests in the US entity, and
• the overall corporate group does not have substantial business activities in the new parent's country of organisation when compared to its total business activities.

If the ownership percentage is between 60% and 80%, the new foreign parent corporation will be respected as such, but the inverting US entity will be barred from using tax attributes such as net operating losses or foreign tax credits to offset income it recognises in connection with establishing the inverted structure.

The 2006 temporary regulations generally applied a facts-and-circumstances test to determine whether a corporate group had substantial business activities in a particular country. They also included a safe harbour whereby the group would be treated as having substantial business activities if 10% of its employees, 10% of its assets and 10% of its sales were based or located, or occurred, in the relevant country. Importantly, the 2009 temporary regulations removed the safe harbour. Thus, for acquisitions completed on or after June 6 2009, a corporate group will need to satisfy the facts-and-circumstances test to meet the substantial business activities requirement.

Among other changes, the 2009 temporary regulations also addressed certain transactions intended to avoid the application of section 7874. For example, two or more foreign corporations might collectively acquire substantially all of the properties of a US corporation, though neither acquires substantially all of the properties individually. Alternatively, a single foreign corporation might acquire the properties of two or more US corporations, and after the acquisition neither group of shareholders owns 80% (or even 60%) of the foreign corporation's stock. In each case, the 2009 temporary regulations provide that the two or more corporations will be treated as one corporation for purposes of applying section 7874.

Proposed stock basis regulations

In January 2009, the Treasury Department and the IRS issued proposed regulations addressing the allocation of consideration and the allocation and recovery of stock basis in certain corporate transactions. The proposed regulations are far-reaching in scope. For many corporate transactions, they would tax a shareholder based on the consideration the shareholder received for each separate share of stock. If adopted in their form now, the proposed regulations could have significant implications for US-based companies repatriating cash from foreign subsidiaries and would impose significant compliance burdens.

Under section 301 of the Internal Revenue Code, a distribution of property by a corporation to a shareholder in respect of the shareholder's stock is treated as a taxable dividend to the extent of the corporation's earnings and profits. To the extent a distribution is more than earnings and profits, it is treated as recovery of the shareholder's basis in the stock and then as capital gain. Under the proposed regulations, basis would be recovered pro rata, share by share, for each share of stock for which a distribution is made. Thus, a shareholder with high-basis and low-basis shares might recognise capital gain with respect to the low-basis shares while not being able to recover all of his basis with respect to the high-basis shares.

This rule, if adopted, could raise issues for US parent companies repatriating cash from unprofitable foreign subsidiaries. A distribution from the foreign company could be taxable in part, even though the subsidiary has no earnings to support a dividend, and even though the US parent's aggregate basis in the stock is greater than the amount distributed.

A similar rule would apply in the case of stock redemptions and related-party stock sales that are taxed in the same manner as distributions under sections 302 and 304 of the code. In the case of any redemption of stock treated as a distribution, the nondividend portion of the distribution would be applied to reduce the basis of each share held by the redeemed shareholder in the class of stock from which shares were redeemed. For this purpose, a class of stock would be defined with respect to economic rights to distributions rather than labels or corporate governance rights.

In the case of a US parent company's sale of one first-tier foreign subsidiary's stock to another first-tier foreign subsidiary, the proposed regulations would alter the tax results so significantly that the IRS felt it necessary also to issue new temporary regulations under section 367(a) to address such transactions.

Finally, in addition to imposing tax consequences based on a share-by-share approach, the proposed regulations also would require shareholders, including corporations with wholly-owned subsidiaries, to track basis separately for separate blocks of stock following certain common transactions. A merger of two subsidiaries, the transfer of one subsidiary's stock to another subsidiary, or even a simple cash contribution would require the creation by each of a separate block of stock with separately-tracked basis. Separate tracking would be required even if no additional stock is actually issued.

These rules obviously impose substantial administrative burdens on taxpayers, particularly in the context of wholly-owned subsidiaries, where intercompany transfers are common.

David Forst (dforst@fenwick.com) and Adam Halpern (ahalpern@fenwick.com) of Fenwick & West