Global Tax Alert | 15 April 2014

FY 2015 Budget Proposals have implications for inbound investors

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Executive summary

In March 2014, the Obama Administration (the Administration) released its fiscal year 2015 Budget proposals (the Budget). At the same time, the Treasury Department released its General Explanations of the Administration’s Fiscal Year 2015 Revenue Proposals (the Treasury Green Book or Green Book) and revenue estimates.

There are at least seven significant international tax proposals in the Budget that would affect non-US multinational investors (inbound investors) in the United States. Two of these proposals are new: (i) a proposal to restrict deductions for excessive interest of members of financial reporting groups, which effectively modifies the earnings stripping rules under Section 163(j); and (ii) a proposal to restrict the use of hybrid arrangements that create stateless income. The rest of the proposals are very similar to last year’s Budget proposals. Collectively, these proposals are estimated to raise $60.8 billion over 10 years.

Tax proposals that may be relevant to inbound investors include the following:

  • Restrict deductions for excessive interest of members of financial reporting groups (estimated to raise $48.6 billion over 10 years);
  • Restrict the use of hybrid arrangements that create stateless income (estimated to raise $.94 billion over 10 years);
  • Exempt certain foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA) (estimated to cost $2.3 billion over 10 years);
  • Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act (FATCA) (not estimated to impact revenue);
  • Tax gain from the sale of a partnership interest on a look-through basis (estimated to raise $2.8 billion over 10 years);
  • Repeal the “boot within gain” limitation of IRC Section 356(a) (estimated to raise $3.1 billion over 10 years); and,
  • Disallow the deduction for excess non-taxed reinsurance premiums paid to affiliates (estimated to raise $7.6 billion over 10 years).

Proposals which would primarily impact US multinationals, but also may be relevant to inbound investors with US holding companies owning non-US affiliates, include the following:1

  • Create a new category of Subpart F2 income for certain related party transactions involving digital goods or services (new proposal, estimated to raise $11.6 billion over 10 years);
  • Limit the application of exceptions under Subpart F for certain transactions that use reverse hybrids to create “stateless income” (new proposal estimated to raise $1.3 billion over 10 years);
  • Remove foreign taxes from a corporation’s foreign tax pool when earnings are eliminated (estimated to raise $423 million over 10 years);
  • Compute deemed paid foreign tax credits on a pooling basis (estimated to raise $74.6 billion over 10 years);
  • Defer interest expense deductions deemed to be related to deferred foreign income (estimated to raise $43 billion over 10 years); and,
  • Impose current US tax on ”excess returns” associated with transfers of intangibles offshore if the intangibles are transferred to a related controlled foreign corporation (CFC) that is subject to a low foreign effective tax rate in circumstances that suggest excessive income shifting (estimated to raise $25.9 billion over 10 years).

The release of the Administration’s FY2015 Budget proposal is only the start of the process, and merely represents an identification of the Administration’s tax priorities. The congressional tax-writing committees, the House Ways and Means Committee and the Senate Finance Committee, will play a key role in the development of any international tax legislation. Senior members of both committees have expressed the view that the policy and economic significance of the Administration’s international tax proposals underscore the need for careful consideration in the context of more fundamental tax reform.

Detailed discussion

This discussion is divided into two parts. The first part provides information about the ramifications of this year’s Budget proposals for non-US multinationals with US investments. The second part provides an overview with regard to this year’s Budget proposals that are of particular interest to non-US multinationals that have a US sub-holding company for other non-US subsidiaries.

FY 2014 Budget – implications for inbound investors

Restrict deductions for excessive interest of members of financial reporting groups

In general, the earnings stripping rules3 limit the deductibility of certain interest (i) paid by a US taxpayer to foreign, related persons if no US tax is imposed on the payment (or the amount of tax is reduced pursuant to an applicable treaty) or (ii) paid on debt that is subject to a foreign, related-party guarantee (disqualified interest). Under current law, no deduction is allowed for disqualified interest in excess of 50% of the adjusted taxable income (ATI) of the taxpayer. The earnings stripping limitations, however, only apply to corporate taxpayers with a debt-to-equity ratio in excess of 1.5 to 1. Disqualified interest that is disallowed in a tax year (disallowed interest) can be indefinitely carried forward and deducted in future tax years. Finally, any excess limitation (i.e., the amount by which a corporate taxpayer’s 50% ATI limitation exceeds its net interest expense) can be carried forward for a three-year period.

The earnings-stripping proposal included in the FY 2015 Budget would create a new set of rules that overlays the existing Section 163(j) earnings stripping rules. The FY 2015 Budget proposal applies to entities that are members of a group that prepares consolidated financial statements in accordance with US GAAP, IFRS or other method authorized by the Secretary of the Treasury under regulations. The proposal limits the US interest expense deduction to the US member’s interest income plus its proportionate share of the group’s net interest expense under US income tax principles.4 The US member’s proportionate share of the group’s net interest expense would be determined based on the member’s proportionate share of the group’s earnings as adjusted for net interest expense, taxes, depreciation and amortization. Alternatively, the US member can elect to limit its interest deduction to 10% of adjusted taxable income (ATI) (as computed under IRC Section 163(j)). Any interest disallowed under either method of calculating interest expense would be carried forward indefinitely and any excess limitation could be carried forward for three years. To the extent that a member of a financial reporting group is subject to this provision, it would be exempt from the application of IRC Section 163(j).

The proposal would not apply to financial services entities or to financial reporting groups that report less than $5 million of net interest expense on one or more US income tax returns for the taxable year. To the extent that this proposal does not apply to a particular entity, the earnings stripping rules under section 163(j) would still be applicable.

The Green Book states that the reason for the change is that the fungibility of money makes it easy to adjust the mix of debt and equity in a controlled entity which allows multinational groups to shift profits to lower tax jurisdictions by overleveraging the higher taxed jurisdictions, such as the US.

The proposal is estimated to raise $48.6 billion over 10 years, and would be effective for taxable years beginning after 31 December 2014.

Restrict the use of hybrid arrangements that create stateless income

Under current law, interest and royalty payments by US persons to non-US persons are generally deductible in the US regardless of whether the payments are subject to tax in the recipient jurisdiction.

However, the Budget proposal would deny the US deduction when a taxpayer makes an interest or royalty payment to a related party and, as a result of a hybrid arrangement, either the recipient is not subject to tax on the income or the taxpayer is eligible to receive an additional deduction for the same payment in another jurisdiction. The Green Book defines hybrid arrangements to include hybrid entities, hybrid instruments, and hybrid transfers, such as repo transactions.

The Secretary would be granted the authority to issue regulations necessary to carry out the proposal including regulations that would deny deductions for: (i) conduit arrangements involving a hybrid arrangement; (ii) certain hybrid arrangements involving unrelated parties, as appropriate (e.g., structured transactions); and, (iii) interest or royalty payments that, as a result of the hybrid arrangement, are subject to a preferential rate of tax in the recipient’s jurisdiction that reduces the statutory rate by at least 25%.

Although the hybrid provision is new to this year’s Budget proposal, it is consistent with other recent tax reform measures including the Organisation for Economic Cooperation and Development’s (OECD’s) Base Erosion and Profit Shifting (BEPS) initiative.

This provision is estimated to raise $.94 billion over 10 years. The proposal would be effective for taxable years beginning after 31 December 2014.

Exempt certain foreign pension funds from the application of the Foreign Investment in Real Property Tax Act (FIRPTA)

Under current law, gains of foreign investors from the disposition of US real property interests are generally subject to US tax under FIRPTA. Gains of US pension funds, retirement trusts, or similar arrangements whose purpose is to provide pension or retirements benefits from the disposition of US real property interests are generally exempt from US tax. The Green Book notes that a US real property interest gain of a similar pension fund created or organized outside the United States from the disposition of that same property would be subject to US tax under FIRPTA.

The Administration’s proposal provides an exemption from US tax under FIRPTA for gains of foreign pension funds from the disposition of US real property interests. The Green Book clarifies that a foreign pension fund generally means a trust, corporation, or other organization or arrangement that is created or organized outside of the United States, that is generally exempt from income tax in the jurisdiction in which it is created or organized, and substantially all of the activity of which is to administer or provide pension or retirement benefits. The proposal would provide the Treasury Department the authority to issue regulations necessary to carry out the purposes of the proposal, including whether an entity or arrangement is a pension or retirement benefit.

The proposal is identical to the same provision included in last year’s Budget and is estimated to reduce revenue by $2.3 billion over 10 years. It is proposed to be effective for dispositions of US real property interests occurring after 31 December 2014.

Provide for reciprocal reporting of information in connection with the implementation of the Foreign Account Tax Compliance Act (FATCA)

The Treasury Green Book notes that foreign law often prevents foreign financial institutions from complying with the FATCA provisions that mandate the reporting to the IRS of information about foreign accounts of US persons, and that such legal impediments can be addressed through intergovernmental agreements under which the foreign government agrees to provide the information required by FATCA to the IRS. Furthermore, it notes that requiring US financial institutions to report similar information to the IRS with respect to nonresident accounts would facilitate such intergovernmental cooperation by enabling the IRS to reciprocate in appropriate circumstances by exchanging similar information with cooperative foreign governments to support their efforts to address tax evasion by their residents.

The Budget proposal would facilitate such reciprocity by requiring certain financial institutions to report the account balance for all financial accounts maintained at a US office and held by foreign persons. It also would expand the reporting required with respect to US source income paid to accounts held by foreign persons to include similar non-US source payments. Finally, the Administration’s proposal would provide the Secretary of the Treasury with authority to prescribe regulations that would require financial institutions to report the gross proceeds from the sale or redemption of property held in a financial account, information with respect to the financial accounts held by certain passive entities with substantial foreign owners and other such information.

This proposal provides explanatory information that was not provided when the proposal was first introduced in last year’s Budget. The proposal is not estimated to impact federal revenues. It is proposed to be effective for returns required to be filed after 31 December 2015.

Tax gain from the sale of a partnership interest on a look-through basis

Under current law, the sale or exchange of a partnership interest generally is treated as the sale or exchange of a capital asset, and gain on the sale of a capital asset by a nonresident alien individual or foreign corporation is subject to US tax only if such gain constitutes income effectively connected to a US trade or business (ECI). For many years, the IRS has taken the position that a foreign partner’s gain or loss from the disposition of an interest in a partnership that is engaged in a trade or business through a fixed place of business in the United States is ECI gain or loss to the extent attributable to ECI property of the partnership, and such amount is therefore subject to US tax. There is no explicit rule, arguably, in the Internal Revenue Code that expressly supports this position.

According to the Green Book, some taxpayers take a position contrary to the IRS position because of the absence of an explicit statutory provision treating gain from the sale of a partnership interest as ECI. The proposal would provide that gain or loss from the sale or exchange of a partnership interest is ECI to the extent attributable to the transferor partner’s distributive share of the partnership’s unrealized gain or loss that is attributable to ECI property. Thus, a nonresident individual or foreign corporate partner in a partnership engaged in a US trade or business would be required to look through to its share of the partnership’s assets in determining whether any gain on the disposition of its partnership interest is subject to US tax.

As a means of enforcement, the proposal would require the transferee of a partnership interest to withhold 10% of the amount realized on the sale or exchange unless the transferor certified that it was not a nonresident alien individual or foreign corporation. If a transferor provided a certificate from the IRS that established that the transferor’s federal income tax liability with respect to the transfer was less than 10% of the amount realized, the transferee would withhold such lesser amount. The partnership would be liable for the amount of any under-withholding and would satisfy the withholding obligation by withholding on future distributions that otherwise would go to the transferee partner.

The proposal is identical to the FY 2014 Budget. It is estimated to raise $2.8 billion over 10 years, and is proposed to be effective for sales or exchanges after 31 December 2014.

Repeal of the “boot within gain” limitation of IRC Section 356(a)

If a shareholder exchanges stock in a target corporation for property other than stock (so-called “boot”), the exchanging shareholder is required to recognize gain equal to the lesser of the gain realized in the exchange or the amount of boot received (the “boot-within-gain” limitation).5 Further, part of the gain recognized by the exchanging shareholder may be taxed as a dividend distribution to the extent of the exchanging shareholder’s share of the undistributed earnings and profits of the corporation. Any remaining gain is treated as gain from the exchange of property.6

This year’s proposal is similar to last year’s proposal. The FY 2015 proposal provides for the repeal of the boot-within-gain limitation of current law in the case of any reorganization that has the effect of the distribution of a dividend, as determined under Section 356(a)(2). In addition, consistent with the rules governing dividend distributions, the proposal would take into account all of the earnings and profits of the corporation, rather than the shareholder’s ratable share of the E&P. The Green Book states that such a repeal would provide more uniform treatment for dividend distributions where there is no significant policy reason to vary the treatment of a distribution that otherwise qualifies as a dividend by reference to whether it is received in the normal course of a corporation’s operations or is instead received as part of a reorganization exchange. Additionally, according to the Green Book, the proposal would prevent US shareholders from repatriating previously untaxed earnings and profits of foreign subsidiaries with minimal tax consequences.

Because the proposal applies to all reorganizations regardless of whether the acquirer is foreign, the proposal is of concern to inbound investors: the amount of boot received in a reorganization that is potentially subject to 30% US dividend withholding tax (unless reduced by treaty) would no longer be gain limited.

The proposal is estimated to raise $3.1 billion over 10 years, and would be effective for taxable years beginning after 31 December 2014.

Disallow the deduction for excess non-taxed reinsurance premiums paid to affiliates

Under current law, insurance companies generally may deduct premiums paid for reinsurance. If the reinsurance transaction results in a transfer of reserves and reserve assets, tax liability for earnings on those assets is shifted to the reinsurer. However, insurance income of a foreign company that is not engaged in a US trade or business generally is not subject to US income tax.

Under the Budget proposal, US insurance companies would not be permitted to deduct reinsurance premiums for property and casualty risks paid to affiliated corporations that are not subject to US tax on the premiums. The Budget proposal also excludes from a US insurance company’s income (in the same proportion in which the premium deduction was denied) any ceding commission, return premium, reinsurance recovered or other amount received by the insurance company with respect to reinsurance policies for which a premium deduction is wholly or partially denied.

Similar to a provision in the Foreign Investment in Real Property Tax Act (FIRPTA rules), the Budget proposal would allow an affiliated non-US reinsurer to elect to be subject to US tax on the reinsurance income. The rationale for the election is to ensure that foreign affiliates are not treated less favorably than US reinsurers. Thus, an affiliated foreign corporation that makes the election would treat the reinsurance income as effectively connected with the conduct of a trade or business (or attributable to a permanent establishment) in the United States. Consequently, the deduction for reinsurance premiums would not be disallowed.

This proposal is identical to a proposal in the FY 2014 Budget and is estimated to raise $7.6 billion over 10 years. The proposal would be effective for policies issued in taxable years beginning after 31 December 2014.

Other tax proposals

In addition to the international tax proposals that affect Inbound Investors, this year’s Budget also proposes a number of other tax changes that may affect a foreign investor’s US business. These proposals include, among others:

  • Repeal the last-in, first-out (LIFO) method of accounting for inventories (estimated to raise $82.7 billion over 10 years);
  • Repeal the lower-of-cost-or-market (LCM) method of accounting for inventory (estimated to raise $7.5 billion over 10 years);
  • Enhance and make permanent the research and experimentation tax credit (estimated to cost $108.1 billion over 10 years);
  • Eliminate many oil, gas, and coal company preferences (e.g., repeal percentage depletion, expensing of intangible drilling costs, and the domestic manufacturing deduction for oil and gas production) (estimated to raise $48.8 billion over 10 years); and,
  • Repeal the non-qualified stock designation - Under current law, non-qualified preferred stock (NQPS) is treated as taxable income (boot) in certain transactions. NQPS is defined as stock that (i) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent; and (ii) has a dividend rate that varies by reference to an index, or, in certain circumstances, a put right, a call right, or a mandatory redemption feature. The proposal would repeal the provision that treats NQPS as boot. While not an international provision, the repeal of the NQPS designation may affect international transactions including transactions that foreign investors may undertake to eliminate sandwich structures (i.e., foreign parent owns a US company that, in turn, owns one or more controlled foreign corporations.) (Estimated to raise $405 million over 10 years).

FY 2015 Budget – implications for foreign multinationals with US holding companies

This year’s Budget also includes proposals that would affect inbound investors that have foreign subsidiaries held by U.S. subsidiaries (so-called sandwich structures). For example, this could occur where the US acts as a sub-holding company for subsidiaries incorporated in the Americas (e.g., Canada, Mexico, Central and South America) or for other foreign entities. Six of the budget proposals that are particularly relevant to sandwich structures are: (i) a new category of Subpart F income for certain related party transactions involving digital goods or services; (ii) limitation of Subpart F exceptions to the current US taxation of income resulting from transactions that use reverse hybrids to create “stateless income;” (iii) the removal of foreign taxes from a corporation’s foreign tax pool when earnings are eliminated; (iv) the calculation of deemed paid foreign tax credits on a pooling basis; (v) the deferral of interest expense deemed to be related to deferred foreign income; and, (vi) the current taxation of excess returns associated with transfers of intangibles offshore.

A new category of Subpart F income for certain related party transactions involving digital goods or services

In general, US persons are not taxable on active trade or business income earned by their foreign subsidiaries (known as controlled foreign corporations, or CFCs) until such income is distributed to the US person as a dividend. The Subpart F rules provide exceptions to this general rule and require US persons to include in income on a current basis certain types of income of a CFC.

The Green Book states that the existing categories of Subpart F income are not adequate to address mobile income from digital goods and services. As a result, the Green Book asserts that with respect to digital goods and services there is potential for taxpayers to structure digital transactions in a particular form and avoid application of the existing Subpart F rules.

The proposal would create a new category of Subpart F income, foreign base company digital income, which would generally consist of income from the lease or sale of a digital copyrighted article or from the provision of a digital service. Specifically, income from the lease or sale of a digital copyrighted article, or from the provision of a digital service, would be foreign base company digital income if the CFC uses intangible property developed by a related person (including property developed pursuant to a cost-sharing arrangement) to produce the income and the CFC does not, through its own employees, make a substantial contribution to the development of the property or services that give rise to the income. An exception would be provided for income earned by the CFC from customers that are located in the country in which the CFC is created or organized and that use the digital articles or services in such country.

The proposal is estimated to raise revenue of $11.6 billion over 10 years and is proposed to be effective for taxable years beginning after 31 December 2014.

Limit the application of exceptions under Subpart F for certain transactions that use reverse hybrids to create “stateless income”

Subpart F income of a CFC generally includes, inter alia, certain dividends, interest, rents and royalties unless the CFC qualifies for an exception such as the same country exception. Under the same country exception, dividend, interest, rent or royalty income will not be subject to current US tax if the CFC has received the income from a related person organized under the laws of the same foreign country as the CFC.7 In addition, the so called “CFC look-through rule,” which currently applies to foreign corporations with tax years beginning before 1 January 2014, provides that certain dividends, interest, rents, and royalties received from a related CFC are not Subpart F income.

According to the Green Book, stateless income can arise when a reverse hybrid (an entity that is treated as a corporation for US tax purposes but is fiscally transparent under the laws of a foreign jurisdiction) earns dividends, interest, rents or royalties. The income is not subject to tax in the foreign jurisdiction in which the reverse hybrid is created or organized because such jurisdiction views the reverse hybrid as fiscally transparent and therefore treats the income as derived by its owners, including its US owners. Further, the income sometimes is not subject to current tax in the US because of the same country exception or CFC look-through rule.

The Budget proposal would deny the same country exception and CFC look-through to payments made to foreign reverse hybrids held directly by a US owner where such amounts are considered as deductible payments received from foreign related persons.

The proposal is estimated to raise revenue of $1.3 billion over 10 years and is proposed to be effective for taxable years beginning after 31 December 2014.

Removal of foreign taxes from a corporation’s foreign tax pool when earnings are eliminated

Under current law, a domestic corporation owning at least 10% of the voting stock of a foreign corporation is allowed a foreign tax credit for taxes paid by such corporation if it receives a dividend or a deemed dividend from the foreign corporation.

The Green Book notes that certain transactions result in a reduction, allocation, or elimination of a corporation’s E&P other than by reason of a dividend or deemed dividend, or by reason of carryover rules in a tax-free restructuring transaction. As examples, the Green Book refers to redemptions and certain spin off transactions8 that each can result in the reduction of the distributing corporation’s E&P.

According to the Green Book, the reduction, allocation, or elimination of E&P without a corresponding reduction in the associated foreign taxes paid results in a taxpayer claiming a credit under Section 902 for foreign taxes paid with respect to earnings that will no longer fund a dividend distribution for US income tax purposes.

This year’s Budget proposal is similar to last year’s proposal. The Administration’s proposal would reduce the amount of foreign taxes paid by a foreign corporation in the event a transaction results in the elimination, reduction or allocation of a foreign corporation’s E&P other than by reason of a dividend or deemed dividend or by reason of a carry-over in a non-recognition transaction. The amount of foreign income taxes that would be reduced in such a transaction would equal the amount of foreign taxes associated with the eliminated E&P.

The proposal is estimated to raise $423 million, and would be effective for transactions occurring after 31 December 2014.

Calculate deemed paid foreign tax credits on a pooling basis

Pursuant to IRC Section 902, a US corporation receives a deemed-paid foreign tax credit upon receipt of a dividend, or certain other payments, from certain foreign subsidiaries. The deemed paid credit offsets US tax by the amount of the foreign tax paid subject to certain limitations, thereby avoiding double taxation of foreign income.

Under the proposal, the deemed paid credit would be determined on a pooled basis rather than an entity-by-entity approach. This would be accomplished by pooling the aggregate foreign taxes and earnings and profits of all the foreign subsidiaries (including lower-tier entities) from which the US taxpayer can claim a deemed paid foreign tax credit. The proposal would effectively ”blend” the earnings and profits and foreign taxes of these entities into a single pool, thus eliminating the identification of particular dividends with specific pools of foreign taxes on which deemed paid foreign tax credits are determined. The deemed paid foreign tax credit that can be claimed would be limited by the amount of consolidated E&P of the foreign subsidiaries that is actually repatriated to the US.

The FY 2015 Budget proposal is identical to the corresponding proposal in the FY 2014 Budget. The proposal is estimated to raise $74.6 billion over 10 years, and would be effective for taxable years beginning after 31 December 2014.

Deferral of interest expense deductions deemed to be related to deferred foreign income

In general, US corporations are subject to US tax on the earnings of any foreign subsidiaries only when such earnings are repatriated as a dividend, unless those subsidiaries have certain income which is taxable under the Subpart F or passive foreign investment company (PFIC) regimes. US tax paid on earnings of a foreign corporation can be offset by a foreign tax credit.

Ordinary and necessary expenses incurred in carrying on a trade or business,9 are allocated and apportioned to US and foreign-source gross income for purposes of calculating a corporation’s available foreign tax credit.10 Under current rules, a US person that incurs interest expense properly allocable and apportionable to foreign-source income may deduct these expenses even if the expenses exceed the taxpayer’s gross foreign-source income or if the taxpayer earns no foreign-source income.

The Administration’s FY 2015 proposal is identical to the corresponding proposal described in last year’s Budget. It would defer deductions for interest expense treated as related to foreign income not subject to current US tax.11 Deferred interest expense could be deducted in a subsequent tax year to the extent that the amount of interest expense allocated to the foreign subsidiaries is less than the annual limitation for that year. The Green Book states that, “the ability to deduct expenses from overseas investments while deferring US tax on the income from the investment may cause US businesses to shift their investments and jobs overseas, harming the [US] domestic economy.”

Although primarily targeted at US-headquartered groups, this measure could potentially impact foreign investors which use the US as a leveraged sub-holding company jurisdiction for foreign subsidiaries.

The proposal is estimated to raise $43 billion over 10 years, and would be effective for taxable years beginning after 31 December 2014.

Current taxation of excess returns associated with transfers of intangibles offshore

Under Section 482, in order to prevent evasion of taxes or to clearly reflect income, the Secretary is authorized to distribute, apportion, or allocate gross income, deductions, credits, and other allowances between or among two or more organizations, trades, or businesses under common ownership or control. The regulations under Section 482 provide that the arm’s length standard is to be applied. For transfers of intangible assets, section 482 provides that the income must be commensurate with the income attributable to the intangible assets transferred.

The Green Book states that there is evidence indicating that income shifting through transfers of intangible assets to low-taxed affiliates has resulted in an erosion of the US tax base. To address this stated concern, the FY 2015 Budget includes a proposal, identical to the provision in the FY 2014 Budget, with respect to the US tax treatment of intangibles that are transferred offshore. If a US person transfers (directly or indirectly) an intangible from the United States to a related CFC that is subject to a low foreign effective tax rate, then certain excess income from transactions connected with or benefitting from the transferred intangible would be treated as subpart F income in a separate foreign tax credit limitation basket. The Green Book further elaborates on what constitutes a “low foreign effective tax rate” by reference to a sliding scale between 10% and 15%.

For purposes of this provision, “transfers of intangibles” would include transfers by sale, lease, license, or through any shared risk or development agreement (including any cost sharing arrangement). “Excess intangible income” would be defined as the excess of gross income from transactions connected with or benefitting from such intangible over the costs (excluding interest and taxes) properly allocated and apportioned to this income increased by a percentage mark-up. In this regard, the Green Book does not specify what the percentage markup would be for this purpose.

Because this provision applies only to transfers from a US person to a related CFC, it primarily targets US multinationals. However, this provision could affect inbound investors in situations where the US is a sub-holding company for controlled foreign subsidiaries. Significantly, it does not apply to transfers from a US person to a related foreign affiliate that is not a CFC (e.g., transfers to the Foreign Parent or the Foreign Parent’s IP–holding non-US subsidiary).

This proposal is estimated to raise $25.9 billion over 10 years, and would be effective for taxable years beginning after 31 December 2014.

Implications

The international tax proposals in the Administration’s FY 2015 Budget would represent dramatic changes in key elements of the US international tax regime. That being said, many of the proposals are substantially similar to proposals included in the FY 2014 Budget as well as other tax reform proposals issued by former Senate Finance Committee Chairman Max Baucus and House Ways and Means Committee Chairman Dave Camp.

Several of the new international tax proposals are aimed at addressing tax base erosion concerns that are similar to the concerns that are the target of the OECD in its BEPS project, particularly those proposals addressing hybrid entities and arrangements, and the digital economy.

The release of the Administration’s FY2015 Budget proposal is only the start of the process, and merely represents an identification of the Administration’s tax priorities. The congressional tax-writing committees, the House Ways and Means Committee and the Senate Finance Committee, will play a key role in the development of any international tax legislation. Senior members of both committees have expressed the view that the policy and economic significance of the Administration’s international tax proposals underscore the need for careful consideration in the context of more fundamental tax reform.

As lawmakers work both on longer-term development of legislative approaches to tax reform and on more immediate legislative priorities, the international tax proposals contained in the Administration’s Budget which are scored as raising significant revenue in the aggregate will be part of the dialogue, and we potentially could see action on one or more of the proposals.

While the Budget proposals have received significant attention in the US tax community regarding their impact on US multinationals, all foreign-owned groups should focus on both qualitative and quantitative assessment of the business and competitive ramifications of the proposed changes. Additionally, inbound investors should consider involvement in the legislative process in order to provide information to lawmakers to assist in their understanding of the full range of implications of the tax reforms being debated.

A more detailed version with diagrams can be found under the download pdf link.

Endnotes

1. Other international proposals include: (i) preventing avoidance of foreign base company sales income through related-party manufacturing services arrangements; (ii) limiting the ability of domestic entities to expatriate; (iii) preventing use of leveraged distributions from related foreign corporations to avoid dividend treatment; (iv) extending Section 338(h)(16) to certain asset acquisitions (treating gain recognized as gain from the sale of the corporation’s stock); (v) limiting shifting of income through intangible property transfers; (vi) providing incentives for locating jobs and business activity in the United States and denying tax deductions for activity considered to involve “shipping jobs overseas;” and (vii) modifying the tax rules applicable to dual-capacity taxpayers.

2. Subpart F is a US tax regime that currently taxes the non-US income of foreign subsidiaries of a US multinational or holding company.

3. Section 163(j).

4. If a US member owns a foreign corporation, this proposal would apply prior to the proposal deferring the deduction of interest expense allocable to deferred foreign earnings (see below).

5. Section 356(a)(1).

6. Section 356(a)(2).

7. The exception requires that such related person has more than 50 percent of its assets used in a trade or business in that jurisdiction.

8. Section 355.

9. Section 162.

10. Section 861.

11. The FY 2010 Budget proposal was more expansive and would have deferred expenses, other than research and experimentation expenses, that were allocated and apportioned to foreign-source income not currently subject to US tax. The FY2011, 2012, 2013, and 2014 Budget proposals, however, would limit the application of the provision to interest expense only.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services – Inbound, New York
  • Steve Jackson, New York
    +1 212 773 8555
    steve.jackson@ey.com
  • Eric Oman, Washington, DC
    +1 202 327 6559
    eric.oman@ey.com
  • Katherine Loda, New York
    +1 212 773 6634
    katherine.loda@ey.com

EYG no. CM4357