US
David Forst and Adam Halpern
Fenwick & West
US
Key litigation on the economic substance doctrine, more debate on overhaul of the corporate tax system and rule changes to do with foreign tax credits and controlled foreign companies have taken the headlines in the US since the turn of the year, explain David Forst and Adam Halpern of Fenwick & West
Economic substance doctrine
A US appellate court, in Merck & Co v US, affirmed the district court's decision in Schering-Plough Corp v US. (Schering-Plough was acquired by Merck between the time of the district court case and the time of the appellate court case). The decision concerns section 956 of the US Tax Code, but the appellate decision is more noteworthy for its impact on the recently codified economic substance doctrine.
The case concerned a promoted strategy to effect a repatriation from a controlled foreign corporation (CFC). The US parent assigned future income streams from an interest rate swap with a third party to certain foreign subsidiaries in exchange for lump sum payments from those subsidiaries. The court held that the transactions were in substance loans from the foreign subsidiaries. The taxpayer took the position that the lump sum payments from the foreign subsidiaries were includible in income ratably under notice 89-21. The court was not swayed by the taxpayer's reliance on the notice, focusing on substance over form and step transaction issues. An item of evidence relied on by the court was notes of the taxpayer's director of financial reporting, which stated, "we are really accounting for the net deferred income as a loan, but tax could not have us record it as a loan." The court stated that, in substance, the transactions were loans, and that section 956 applied.
The district court, in a footnote, also stated that as an alternate conclusion the transactions lacked economic substance. The Third Circuit did not adopt this conclusion, stating in a footnote that since it affirmed the Third Circuit's substance over form reasoning, it did not need to reach the economic substance issue. This is important in light of the recent codification of the economic substance doctrine. A transaction deemed to lack economic substance is subject to a strict liability 40% penalty (or a 20% penalty if disclosed on the taxpayer's return). The Third Circuit's decision perhaps reflects a reluctance on the part of courts to find a lack of economic substance given the severity of the statutory penalty.
Legislative activity
Legislative activity in the US has been light in 2011, reflecting a lack of political consensus between the Obama Administration and Congress, where Republicans control one chamber and Democrats control the other chamber. President Obama's proposed 2012 budget (which was voted down unanimously in the US Senate) contained many of the same international provisions he has proposed throughout his term, including paring back deferral, calculation of foreign tax credits on a pooled basis, and extra tax on the outbound transfer of intangibles.
Various bills have been introduced in Congress to treat certain foreign corporations that are managed and controlled in the US as US corporations. Similar bills were introduced, but never enacted, in past Congresses. There is no reason to believe that these bills will have a different fate.
Finally, there have been statements made by certain members of Congress (including House Ways & Means Committee Chairman David Camp) indicating an openness to reinstituting a tax holiday for repatriated foreign earnings. Under one estimate, as much as $1.5 trillion in unrepatriated earnings is held by US-headed corporations offshore. However, there has not been concerted legislative activity in this area. Further, Treasury Secretary Geithner made a point of stating earlier this year that the Obama administration's budget proposals do not include incentives to encourage corporations to bring foreign earnings back into the US.
Foreign tax credit issues: creditability of Puerto Rican excise tax
The IRS announced, in notice 2011-29, that it is evaluating whether a new Puerto Rican excise tax is a creditable foreign income tax under US law, but would not challenge the creditability of the excise tax in the meantime. The Puerto Rican excise tax applies to purchases made by non-Puerto Rican corporations from affiliated entities that manufacture in Puerto Rico if their gross receipts exceed $75 million. The tax is imposed on the purchasing corporation at a 4% rate on the value of purchases made and is collected and remitted by the seller.
The excise tax applies in lieu of a tax imposed when a non-Puerto Rican corporation purchases goods from an affiliate that manufactures in Puerto Rico, and such purchases account for at least 10% of the total gross receipts of the manufacturer or at least 10% of the total cost of the property acquired by the purchaser. When it applies, a portion of the income of the purchaser from the sale outside of Puerto Rico of the products manufactured in Puerto Rico is treated as Puerto Rican source income that is effectively connected with the conduct of a Puerto Rican trade or business.
The notice treats the excise tax as an in lieu of tax that, for now, is creditable under section 903 of the Code (pending resolution of a number of factual and legal issues). Therefore, a final determination has not been made on the creditability of the excise tax.
Further, the tax itself raises issues under the US Constitution, to which Puerto Rico is subject. The issue are similar to the ability of US states to tax out-of-state taxpayers that have no or minimal contacts with that state.
Foreign tax credit splitter rules
Section 909 was enacted into the Code as part of PL 111-226, signed into law on August 10 2010. The provision is intended to prevent the claiming of foreign tax credits arising from splitter transactions, generally meaning transactions, often using hybrid entities, in which foreign taxes are separated from the underlying earnings that give rise to the foreign taxes.
Late in 2010 the IRS released notice 2010-92, 2010-15 IRB 1, which the IRS anticipates is the first of several items of published guidance concerning section 909. The notice focuses on the application of section 909 to split foreign income taxes of a section 902 corporation that were not deemed paid by a US shareholder before 2011. The notice refers to these as pre-2011 splitter arrangements.
The first type of splitter transaction, a reverse hybrid structure, exists when a section 902 corporation owns an interest in a reverse hybrid, meaning an entity that is treated as a corporation for US federal income tax purposes but is a pass-through entity or a branch under foreign law. A pre-2011 splitter arrangement involving a reverse hybrid structure exists when pre-2011 taxes are paid or accrued by a section 902 corporation with respect to income of a reverse hybrid that is a covered person with respect to the section 902 corporation.
The notice provides that a pre-2011 splitter arrangement involving a reverse hybrid structure may exist even if the reverse hybrid has a deficit in earnings and profits for a particular year (for example, due to a timing difference). Such taxes paid or accrued by the section 902 corporation are pre-2011 split taxes. The related income is the earnings and profits (computed for US federal income tax purposes) 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.
The second category of pre-2011 splitter arrangements is a foreign consolidated group, which exists when a foreign country imposes tax on the combined income of two or more entities. Tax is considered imposed on the combined income of two or more entities even if the combined income is computed under foreign law by attributing to one such entity the income of one or more other entities.
A foreign consolidated group is a pre-2011 splitter arrangement to the extent that the taxpayer did not allocate the foreign consolidated tax liability among the members of the foreign consolidated group based on each member's share of the consolidated taxable income included in the foreign tax base under the principles of Treasury regulation section 1.901-2(f)(3). A pre-2011 splitter arrangement involving a foreign consolidated group may exist even if one or more members has a deficit in earnings and profits for a particular year (for example, due to a timing difference). Pre-2011 taxes paid or accrued with respect to the income of a foreign consolidated group are pre-2011 split taxes to the extent that taxes paid or accrued by one member of the foreign consolidated group are imposed on a covered person's share of the consolidated taxable income included in the foreign tax base. The related income is the earnings and profits (computed for US federal income tax purposes) 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.
The third category of pre-2011 splitter arrangements is a foreign group relief or other loss-sharing regime, which exists when one entity with a loss permits the loss to be used to offset the income of one or more other entities (a shared loss). A pre-2011 splitter arrangement involving a shared loss, however, exists only when three conditions are met:
- There is an instrument that is treated as indebtedness under the laws of the jurisdiction in which the issuer is subject to tax and that is disregarded for US federal income tax purposes (a disregarded debt instrument).
- The owner of the disregarded debt instrument pays a foreign income tax attributable to a payment or accrual on the instrument.
- The payment or accrual on the disregarded debt instrument gives rise to a deduction for foreign tax purposes and the issuer of the instrument incurs a shared loss that is taken into account under foreign law by one or more entities that are covered persons with respect to the owner of the instrument.
The fourth category is a hybrid instrument, that is, an instrument which is either (1) treated as equity for US federal income tax purposes and as debt for foreign tax purposes (US equity HI), or (2) treated as debt for US federal income tax purposes and as equity for foreign tax purposes (US debt HI).
If the issuer of a US equity HI is a covered person with respect to a section 902 corporation that is the owner of the US equity HI, there is a pre-2011 splitter arrangement with respect to the portion of the pre-2011 taxes paid or accrued by the owner section 902 corporation with respect to the amounts on the instrument that are deductible by the issuer as interest under the laws of a foreign jurisdiction in which the issuer is subject to tax but that do not give rise to income for US federal income tax purposes. Pre-2011 split taxes paid or accrued by the section 902 corporation equal the total amount of pre-2011 taxes paid by the section 902 corporation less the amount of pre-2011 taxes that would have been paid or accrued had the section 902 corporation not been subject to tax on income from the US equity HI. The related income of the issuer of the US equity HI 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 earnings and profits.
Section 956
In chief counsel advice (CCA) 201106007 the IRS stated that the sale of software by a CFC to US end-user customers does not cause the CFC to hold an investment in US property for purposes of section 956(c)(1)(D). The CFC, pursuant to a cost sharing arrangement with its US parent, held the right to exploit copyrights in the US. The US parent developed the software product and transferred the final version, in the form of a gold master disc, to the CFC. The CFC reproduced and sold copies of the software to end-user customers in the US.
US property for purposes of section 956(c)(1)(D) includes the right to use intangible property in the US that is acquired and developed by a CFC for use in the US. The CCA interprets this provision as defining US property in relation to whether a CFC develops intangible property intended for use in the US or acquires a right to use intangible property in the US. It does not interpret this provision as defining US property in relation to whether that right is actually exercised. Accordingly, an investment in US property arises upon the actual acquisition or development of rights to use intangible property in the US, not upon the actual use of that intangible in the US.
The CCA states that the CFC is treated as making an investment in US property under section 956 when it acquires or develops the rights to use copyright rights in the US pursuant to the cost sharing agreement. However, the actual sales of the computer software copies from CFC to end-user customers in the US do not in themselves give rise to an investment in US property within the meaning of section 956(c)(1)(D). Furthermore, the actual transfer of copies of the software by CFC to the end-user US customers does not affect the calculation of the inclusion amount, if any, under section 956 attributable to the CFC's original investment in US property, because the CFC does not acquire or develop additional rights (or relinquish any rights) to use the software in the US merely as a result of the sale of copies to a US person.
David Forst (dforst@fenwick.com) is the practice group leader of the tax group and
Adam Halpern (ahalpern@fenwick.com) is a partner at Fenwick & West