To pay for newly enacted legislation that temporarily increases federal medical assistance for states and appropriates funds for education and jobs, the Education Jobs Act of 2010 includes a number of international tax provisions―including new restrictions on the use of foreign tax credits by U.S. corporations with foreign operations.
The new foreign tax provisions stem from a concern that U.S. multinational corporations are able to shift income to foreign affiliates and operations in low-tax jurisdictions in order to reduce or avoid U.S. taxes on U.S.-source income.
In general, the Act’s foreign tax provisions are intended to achieve the following:
deny foreign tax credits to U.S. corporations for federal tax purposes until the related foreign income is actually reported by the corporation
prevent artificial inflation of foreign source income, and
modify the resourcing rules to limit foreign tax credits
A number of the Act’s more significant international provisions are described below.
Prevents Splitting of Foreign Tax Credit and Foreign Income
The U.S. foreign tax credit was created to prevent the full taxation of a U.S. corporation’s foreign-source income by both the U.S. and a foreign country―i.e. prevent double taxation on foreign-source income. If a corporation pays taxes to a foreign government based on the income it earns outside of the U.S., it is entitled to claim a federal tax credit on its U.S. tax return.
Under the pre-Act tax rules, however, it was possible for a corporation to claim a foreign tax credit for income that was not required to be reported for U.S. tax purposes―and thereby escape taxation altogether.
The new Act prevents splitting foreign tax credits from related foreign income. It implements a matching rule that denies the foreign tax credit to a U.S. corporate taxpayer until such time as the corporation reports the related foreign income for U.S. tax purposes.
The provision applies to all split foreign taxes that are paid or accrued in tax years beginning after December 31, 2010.
Establishes Separate Foreign Tax Credit Limitations for Foreign-Source Income Established By Tax Treaty
Under certain tax treaties, the income from assets that are owned by foreign branches and disregarded entities are treated for U.S. federal tax purposes as foreign-source income. Without the benefit of the treaty, the income would be considered U.S.-source income, and therefore subject to U.S. tax at a maximum rate of 35 percent.
Because the foreign tax credit that is available to a U.S. corporation is limited to the maximum U.S. tax that could be levied on its foreign-source income, this treaty provision can increase a U.S. corporation’s foreign tax credit limitation.
The new Act prevents U.S. corporations from inflating foreign-source income for tax benefit. It does so by establishing separate foreign tax credit limitations for income that could be treated as U.S. source income under the federal tax code and for foreign-source income that the U.S. taxpayer elects to treat as foreign source based on treaty provisions. Foreign tax credits that stem from treaty-based foreign-source income can only be used to offset that specific foreign-source income and cannot be used to reduce U.S. taxes on other foreign-source income.
Under the new rules, foreign tax credits for U.S. corporations with foreign branches and disregarded entities is essentially the same as for U.S. corporations with foreign affiliates.
The provision applies to tax years beginning after the date of the new law’s enactment, August 10, 2010.
Limits Foreign Tax Credits With Respect to Hopscotched Dividends
Under pre-Act rules for controlled foreign corporations, an anti-abuse rule (the hopscotch rule), actually created another potentially abusive loophole. The hopscotch rule applies to U.S. corporations that own an interest in one or more controlled foreign corporations that, in turn, own other controlled foreign corporations―i.e., the U.S. corporation has a multi-tier chain of foreign subsidiaries.
A U.S. corporation with a controlled foreign subsidiary is generally required to recognize income based on its share of any U.S. property acquired by its foreign subsidiary. If that controlled foreign subsidiary is a lower-tier subsidiary, the hopscotch rule requires the U.S. corporations treat the distribution as if it came directly from the lower-tier subsidiary and did not pass through the upper-tier subsidiary.
The U.S. corporation is also entitled to claim a deemed-paid foreign tax credit based on its share of the foreign taxes paid by its controlled foreign subsidiary. Because the foreign tax credit calculation takes into consideration the earnings and taxes paid by the subsidiary, skipping over an upper-tier subsidiary can result in a larger foreign tax credit for the U.S. corporation than would have been available if the calculation considered the full chain of ownership.
The new law limits foreign tax credits to the maximum amount that the U.S. corporation could claim assuming the dividend did not skip over any upper-tier subsidiaries.
The provision applies to the affirmative use of the deemed dividend rule after December 31, 2010.
Redemptions by Foreign Subsidiaries
Under pre-Act rules, if a foreign company owns a U.S. corporation, and that U.S. company owns a foreign subsidiary, the U.S. company pays tax on the foreign subsidiary’s earnings when they are distributed. When the U.S. company distributes earnings to its foreign parent, the distributions are subject to a withholding tax at the rate of 30 percent.
Under another form of hopscotching technique, it was possible for the foreign parent company to permanently escape U.S. taxes and withholding on the foreign subsidiary’s earnings.
The new Act establishes a limitation on when an acquiring foreign corporation’s earnings and profits may be reduced by a deemed dividend. Under the Act, the foreign earnings remain subject to U.S. income tax when repatriated to a higher-tier U.S. subsidiary and subject to U.S. withholding tax when distributed to the foreign parent as a dividend.
The provision applies to acquisitions after December 31, 2010.
Repeals 80/20 Rules
When a U.S. corporation (or resident alien individual) pays interest and/or dividends to a foreign person, the amount paid is generally subject to a 30 percent withholding tax.
Until now, there was an exception for interest and dividends paid by a U.S. corporation that derives at least 80 percent of its gross income from active foreign business income. While the interest paid by such an 80/20 company was considered foreign-source income, the dividends were considered U.S.-source income not subject to withholding.
The Act repeals the 80/20 company exception for interest and dividends. Regardless of the amount of active foreign business income earned by the U.S. corporation, the dividends and interest it pays to foreign persons are classified as U.S.-source income and are subject to the U.S. withholding.
The Act includes a grandfather provision to provide relief for existing 80/20 companies that meet specific requirements and are not abusing the 80/20 company rules. Subject to this relief for existing 80/20 companies, the provision applies to tax years beginning after December 31, 2010.
Modifies Affiliation Rules for Allocating Interest Expense
For U.S. corporations, the amount of their foreign-source income limits the foreign tax credit they can claim. As a result, certain U.S. corporations have an incentive to reduce foreign-source interest expenses by shifting the interest expense to foreign subsidiaries that are outside of the affiliated group, and thus artificially increasing the U.S. corporation’s foreign-source income.
Temporary Treasury regulations limit the ability of corporations to shift interest expense to foreign subsidiaries. The Act codifies the general rule in these temporary regulations to provide that the assets and interest expense of foreign corporations―satisfying income and ownership tests―are taken into account in allocating and apportioning the interest expense of the affiliated group for purposes of computing the foreign tax credit limitation. It essentially changes the affiliation rules to treat a foreign subsidiary as a member of an affiliated group for allocating and apportioning interest expense.
The provision applies to tax years beginning after the date of the new law’s enactment, August 10, 2010.
