Authored by Jim Alajbegu
On the international side of U.S. tax reform discussions, the focus has been on repatriation of an estimated $2.6 trillion of offshore earnings and the potential end to deferral of tax on such earnings. Beyond tax reform, final, proposed and temporary regulations as well as notices issued by the IRS and Department of Treasury (Treasury) will also have an enduring effect on U.S. companies doing business globally.
Current tax law generally taxes U.S. citizens, residents and corporations on their worldwide incomes. This extraterritorial tax system creates the risk of double taxation which the U.S. attempts to relieve through the foreign tax credit. The initial draft of the House tax reform bill, the Tax Cuts and Jobs Act (TCJA), released Nov. 2, 2017, calls for a territorial tax system, a regime that taxes its resident companies based on the location of its profits (income earned within that jurisdiction), not its residence. The potential move to a territorial tax system is believed to increase competitiveness of U.S. companies in today’s global tax landscape; conversely, territorial tax systems can also be quite complex as companies try to base erode profits by allocating and sourcing profits to other tax jurisdictions. Some of the more controversial provisions of the House tax reform bill are anti-base-erosion measures for transitioning to a territorial international tax system, which are a result of having to set aside the controversial border-adjustment tax, previously proposed.
Whether a major overhaul of the tax code actually results in a move to a territorial system is still being debated; however, most advisors agree that any tax reform or tax cuts will likely result in some form of repatriation tax on foreign earnings. The TCJA imposes a one-time tax of 12 percent on U.S. companies’ accumulated offshore earnings that are held as cash — and 5 percent for noncash holdings. The tax can be remitted over eight years and will be recognized on a corporation’s first tax return for tax years beginning before 2018. As part of the overhaul, the TCJA would establish a participation exemption system where 100 percent of certain foreign-sourced qualified dividends received by U.S. corporations (that own 10 percent or more of foreign corporations) from foreign subsidiaries would be exempt from U.S. federal income tax, effective for distributions after 2017. No foreign tax credit or deduction would be allowed for any taxes (including withholding taxes) paid or accrued with respect to any dividend to which the dividend exemption system of the bill would apply.
Final section 987 regulations
On Oct. 2, 2017, Treasury reported the final regulations under section 987 would likely be modified due to application difficulties by taxpayers. A possible implementation delay to 2019 is expected to be issued soon. Consequently, the rules issued in December 2016, providing guidance to qualified business units (QBUs) operating in a functional currency different from its owner to determine income or loss, are placed on hold. While the final regulations were intended to ease compliance with simplifying elections, taxpayers were struggling with implementation. Modifications to the transition rules are also being considered.
The temporary regulations established loss deferral rules designed to make it difficult for taxpayers to trigger section 987 losses through technical terminations of section 987 QBUs. The temporary regulations also provide certain elections and other rules which, subject to exceptions, track the effective date of the final regulations as described above.
Taxpayers that make remittances (payments to other QBUs) that trigger section 987 gains or losses should consider the impact of these regulations on their financials and tax returns.
Final PFIC regulations
On Dec. 28, 2016, the Treasury and IRS issued final regulations that provide guidance on reporting obligations for U.S. persons who own interests in passive foreign investment companies (PFICs) as well as clarification on PFIC ownership rules. The final regulations retain the basic approach as the temporary regulations issued in 2013, with certain revisions and clarifications. Among these are requiring a U.S. person owning multiple PFICs to file a separate Form 8621, “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund,” for each PFIC and providing exceptions to the section 1298(f) reporting obligations for certain treaty-country residents, foreign pension beneficiaries and shareholders marking PFIC stock to market. Individuals who are treated as U.S. nonresidents under the tiebreaker provisions of an income tax treaty are exempt from filing Form 8621 for the portion of the tax year that the individual is taxed as a nonresident.
Taxpayers should carefully consider analyzing foreign investments to determine whether they are considered a PFIC shareholder. Failure to report under section 1298(f) may result in an extension of the limitation period. The ownership and reporting rules of the final PFIC regulations are broad and onerous. Please contact your Baker Tilly advisor to help you determine whether you are a PFIC shareholder.
Section 7874 regulations
Since the enactment of section 7874 in 2004, the Treasury and IRS continue to limit the number of inversions, transactions in which U.S. companies become foreign parent companies by moving their headquarters offshore. On Jan. 13, 2017, the Treasury and IRS issued final and temporary regulations under section 7874 which adopt T.D. 9654, the 2014 proposed regulations (REG-121534-12), and the 2016 proposed regulations (REG-135734-14). The new regulations exclude intercompany obligations from nonqualified property that gives rise to disqualified stock. The new regulations also expand the scope of the associated obligations rule. Additionally, the new regulations modify certain de minimis exceptions. As such, the new regulations add complexity to an already complex code section and make it difficult for companies to not trigger the inversion rules under section 7874.
Notice 2017-36: IRS and Treasury push back onerous intercompany debt documentation start date
On July 27, 2017, the IRS released Notice 2017-36 delaying the effective date of the documentation requirements under the final and temporary section 385 regulations. The effective date of the documentation requirements now applies to certain intercompany debt interests issued or deemed issued after Jan. 1, 2019. The section 385 regulations, issued by the IRS and Treasury in October 2016, provide the IRS with the authority to treat certain intercompany debt interests as equity, and the resulting deductible interest payment recast as a nondeductible dividend payment.
The section 385 regulations also contain extensive documentation requirements relating to certain intercompany debt interests issued after the date identified in Treas. Reg. section 1.385-2. To satisfy the documentation requirements, a U.S. taxpayer must prepare the following documentation with regard to the applicable debt interest:
- Unconditional obligation to pay a certain sum;
- Creditor rights;
- Reasonable expectation of ability to repay; and
- Evidences of debtor-creditor relationship.
Failure to comply with the documentation requirements will result in the intercompany debt interest being recast as equity. An issuer of the intercompany debt interest is subject to the documentation requirements if stock of any member of the expanded group is traded on an established financial market, total assets exceed $100 million on any applicable financial statement or annual total revenue exceeds $50 million on any applicable financial statement.
Notice 2017-36 and the delay of the documentation requirements is a direct response to concerns expressed by taxpayers regarding inadequate time to “develop the necessary systems or processes to comply with the documentation regulations.” Furthermore, the section 385 regulations were identified in Notice 2017-38 as significant tax regulations requiring additional scrutiny pursuant to Executive Order 13789.
Effect on funding rules
The delay to the implementation of the documentation regulations does not affect the section 385 regulations that treat certain instruments as stock under the funding rules, which are still in effect. Subject to a variety of exceptions, these rules apply to covered debt distributed by an issuer to another group member, covered debt issued in exchange for another member’s stock or covered debt exchanged for property in internal asset reorganizations. The rules also create a presumption that treats debt as equity if, within 36 months before or after covered debt is issued by a group member, the borrowing member uses the funds to engage in any of the specified transactions listed above.
U.S. Tax Court rules that non-U.S. partner’s gain from the redemption of its partnership interest is not effectively connected income
Generally, foreign entities or individuals are required to report gain on sale of U.S. partnership interests on their 1040NR or 1120-F filings. However, the Tax Court in Grecian Magnesite Mining, Industrial & Shipping Co., SA v. Commissioner of Internal Revenue (149 T.C. No. 3, 2017) rejected the IRS position set forth in Revenue Ruling 91-32 that a foreign partner is subject to U.S. tax on gain from the sale of an interest in a partnership to the extent the gain is attributable to U.S. trade or business assets of the partnership. Prior to the Grecian Magnesite decision, Rev. Rul. 91-32 controlled precedent for treating gain on the sale of a U.S. partnership interest by a foreign person as income which is effectively connected to a U.S. trade or business under section 882. Rev. Rul. 91-32 applied the “aggregate” theory of partnerships to deem the sale of partnership interest as the sale of the partner’s share of the partnership’s underlying assets, which is U.S. source income under section 865(e)(2). Therefore, under Rev. Rul. 91-32, gain on sale of a U.S. partnership interest is effectively connected U.S. source income and is taxable to the foreign seller. The ruling has often been criticized as incorrectly applying the principles of section 864 for determining whether gain is considered effectively connected income with a U.S. trade or business.
In Grecian Magnesite, the Tax Court disagreed with Rev. Rul. 91-32, opting instead to treat the sale of the U.S. partnership interest as the sale of a discrete asset pursuant to section 731(a). Under this “entity” approach, the sale of a U.S. partnership interest is not considered a sale of the underlying partnership property and therefore avoids being effectively connected with a U.S. trade or business under section 882. As such, any gain on the sale of a U.S. partnership interest is not subject to U.S. tax.
Given the new authority provided by Grecian Magnesite, practitioners should consider amending any open year 1040NR or 1120-F returns in which gains on sale of U.S. partnership interests were reported.
Transfer pricing — OECD releases further transfer pricing guidelines
On July 10, 2017, the Organization for Cooperation and Economic Development (OECD) released transfer pricing guidelines for multinational enterprise (MNE) groups that provide a number of revisions from its 2010 publication. The guidelines now include Base Erosion and Profit Shifting (BEPS) Actions 8-10 and Action 13 addressing transfer pricing documentation requirements and annual country-by-country (CbC) reporting. On July 18, 2017, the OECD released additional guidance aimed at requiring minimum standards for CbC reporting. Our 2016 year-end tax letter described the final Treasury regulations (TD 9773) that require annual CbC reporting by any U.S. business considered the ultimate parent entity of an MNE group, if annual groupwide revenue meets or exceeds $850 million in the prior reporting period. Form 8975, “Country-by-Country Report,” has been designated for this purpose and will be finalized in the near future for issuance and release. These additional requirements and new U.S. tax compliance requirement are a supplement to existing transfer pricing documentation requirements. Furthermore, the OECD releases described above will only encourage more aggressive audits by foreign tax authorities seeking to apply these standards. As such, U.S. businesses operating globally may also be subject to other foreign transfer pricing compliance requirements under local CbC rules. Any reader of a properly completed CbC report can easily identify where an MNE earns income and incurs expenses, as the report also facilitates the identification of intercompany transactions. That said, MNEs should expect that the CbC report will be subject to scrutiny outside the U.S. Accordingly, the transparency provided by CbC reports will provide foreign taxing jurisdictions with the information needed to initiate additional tax audits.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.