Daily Tax Update - July 13, 2011: Regulations Finalized Addressing Foreign Tax Credit Generator Transactions

REGULATIONS FINALIZED ADDRESSING FOREIGN TAX CREDIT GENERATOR TRANSACTIONS:  Today the IRS finalized regulations (T.D. 9535) relating to the determination of the amount of taxes paid for purposes of the foreign tax credit ("FTC").  The regulations address certain structured transactions that produce FTC results deemed inappropriate by Treasury and the IRS, commonly referred to as FTC generator transactions. 

  • The final regulations adopt, with changes, 2008 temporary regulations addressing the treatment of foreign payments attributable to structured passive investment arrangements.  The regulations as finalized apply to foreign payments that, if they were taxes, would be considered paid or accrued on or after July 13, 2011.  
  • The basic approach and structure of the proposed regulations is retained by the final regulations.  Amounts paid to a foreign taxing authority that are attributable to a "structured passive investment arrangement" ("SPIA"), defined as an arrangement meeting six specified conditions, are not treated as an amount of "tax paid" for FTC purposes.  The six conditions can be met even if they are not part of a plan or series of related transactions.  
  • The first condition (the "Special Purpose Vehicle ("SPV") condition") is that the arrangement utilizes an entity that meets two requirements.  First, substantially all of the entity’s gross income must be attributable to passive investment income and substantially all of the entity’s assets must be held to produce such passive investment income (excluding passive investment income attributable to a qualified equity interest in certain lower-tier entities engaged in an active trade or business where certain conditions are met (the "holding company exception")).  Second, there must be a foreign payment attributable to the income of the entity.
  • The final regulations update and clarify numerous aspects of the SPV condition.  With respect to the first requirement of the SPV condition, the final regulations clarify that passive investment income does not include personal service contract income as described in section 954(c)(1)(H), that income attributable to equity interests in pass-through entities is treated as passive investment income unless the holding company exception applies, and that the assessment of opportunity for gain and risk of loss is based on all facts and circumstances.  The final regulations clarify with respect to the holding company exception that in cases involving more than one US party or more than one counterparty, or both, the requirement that the parties share in substantially all of the upper-tier entity’s opportunity for gain and risk of loss with respect to its interest in a lower-tier entity is applied by examining whether there is sufficient risk sharing by each of the groups comprising all US parties and all counterparties.  If there is more than one US party or counterparty, the final regulations do not require each member of the respective groups to share in the investment risk.  Further, the holding company exception is modified under the final regulations to provide that where a US party owns an interest in an entity indirectly through a chain of entities, the exception is applied beginning with the lowest-tier entity before proceeding upward and the opportunity for gain and risk of loss borne by an upper-tier entity that is a counterparty is disregarded to the extent borne indirectly by a US party.
  • With respect to the second requirement of the SPV condition, that there is a foreign payment attributable to the income of the entity, the final regulations remove an exception under the temporary regulations that a foreign payment does not include a withholding tax imposed on distributions or payments made by an entity to a US party.  Further, the second requirement of the SPV condition is updated to reflect that foreign payments by entities that are lower-tier branches or pass-through entities only under US law cannot be attributed to the income of their owners.         
  • The second condition under the temporary regulations is that that a person would be eligible to claim a credit under section 901(a), including a credit for taxes deemed paid under section 902 or 960, for all or a portion of the foreign payment if the foreign payment were an amount of tax paid (the "US party condition").  The final regulations adopt without change the US party condition.
  • The third condition under the temporary regulations is that the US party’s share of the foreign payments(s) is (or is expected to be) substantially greater than the amount of credits, if any, that the US party reasonably would expect to be eligible to claim under section 901(a) for foreign taxes attributable to income generated by the US party’s proportionate share of the assets owned by the SPV if the US party directly owned such assets (the "direct investment condition").  The final regulations adopt without change the direct investment condition. 
  • The fourth condition under the temporary regulations is that the arrangement is reasonably expected to result in a tax benefit to a counterparty or related person under the laws of the foreign country (the "foreign tax benefit condition").  If the foreign tax benefit available is a credit, then it must correspond to 10 percent or more of the US party’s share of the foreign payment.  Other types of foreign tax benefits, such as exemptions, deductions and exclusion of losses must correspond to 10 percent or more of the foreign base with respect to which the US party’s share of the foreign payment is imposed.  Under the final regulations, the 10 percent correspondence requirement compares the aggregate amount of foreign tax benefits available to all counterparties and persons related to counterparties to the aggregate amount of the US parties’ share of the foreign payment, or the foreign base if the tax benefit is not a credit.  The final regulations also revise the foreign tax benefit condition to provide that certain tax benefits claimed by upper-tier entities do not correspond to the US party’s share of the foreign payment. 
  • The fifth condition under the temporary regulations is that the arrangement include a person that, under the laws of a foreign country in which the person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis tax, directly or indirectly owns or acquires equity interests in, or assets of, the SPV (the "counterparty condition").  The counterparty condition is clarified under the final regulations to provide that dual citizens or US residents generally subject to US tax on worldwide income are not treated as counterparties
  • The final condition under the proposed regulations is that the United States and an applicable foreign country treat the arrangement inconsistently under their respective tax systems and that the US treatment results in either materially less income or a materially greater amount of FTCs than would be available if the foreign law controlled the US tax treatment (the "inconsistent treatment condition").  The final regulations clarify that, where an arrangement involves multiple US parties, the condition is satisfied only if the amount of income attributable to the SPV that is recognized for US tax purposes by the SPV and all the US parties is materially less than the amount of income that would be recognized if the foreign tax treatment controlled for US tax purposes or if the amount of FTCs claimed by all US parties is materially greater than it would be if the foreign tax treatment controlled for US tax purposes. 
  • The regulations can be accessed here.
  • For additional information, contact Philip R. West - pwest@steptoe.com

JOINT COMMITTEE HEARING ON TAX REFORM AND THE TAX TREATMENT OF DEBT AND EQUITY: Today, the House Ways and Means and Senate Finance Committees held a joint hearing on the tax treatment of debt and equity.  The testimony and questions and answers session focused on whether the tax code creates a bias for equity financing, the impact of overleverage on the economy, and how the treatment of debt and equity might be equalized.

  • The hearing witnesses were:
    • Dr. Thomas A. Barthold, Chief of Staff, Joint Committee on Taxation;
    • Dr. Mihir A. Desai, Mizuho Financial Group Professor of Finance, Harvard Business School;
    • The Honorable Pamela F. Olson, Former Assistant Secretary of the Treasury for Tax Policy;
    • Mr. Victor Fleischer, Associate Professor of Law, University of Colorado Law School; and
    • Dr. Simon Johnson, Ronald A. Kurtz Professor of Entrepreneurship, Massachusetts Institute of Technology Sloan School of Management, former Economic Counselor and Director of the Research Department at the International Monetary Fund.
  • In his opening statement, Ways & Means Chairman Camp (R-MI) stated, "before we can begin to tackle and craft a plan for comprehensive tax reform, we must take time to better understand how the current code influences our economy and the decisions made by families and businesses.  The issue of debt and equity – the topics of our hearing today – is among the most complex issues we must grapple with and among the most important to get right in moving forward."
  • Finance Chairman Max Baucus (D-MT) said, "Today, we examine the taxation of debt and equity.  Right now, we are confronting a massive debt problem due, in part, to the 2008 financial crisis.  In the year before the crisis, the five major investment banks had a leverage ratio of 40 to 1.  This means for every 40 dollars in assets, there was only one dollar in equity to cover losses.  This raises the question whether excessive private debt played a major role creating that financial meltdown."
  • Ways & Means Ranking Member Levin (D-MI) argued that it would be more appropriate if the committees were gathering to discuss action on the debt limit, stating "I fear that the chances of the discussion at this joint hearing leading to fruitful action have been dimmed immeasurably by the environment created on the overarching issue of action on the debt ceiling."  Levin did state, however, "[t]hat does not mean that the specific topic before us is unimportant.  Indeed, if we are to seriously address tax reform, issues relating to debt and equity must be considered and like other significant issues, done so in depth and with open debate.  As our witnesses’ prepared testimony demonstrates, the subject is complex, and answers do not always automatically fall into usual ideological frameworks."
  • Senate Finance Ranking Member Orrin Hatch (R-UT) said in his opening statement, "Tax reform should be based on the same three principles that led to the enactment of the Tax Reform Act of 1986: fairness, simplicity and economic growth. I am very much looking forward to hearing what our witnesses have to say on these three principles as they relate to the tax treatment of debt and equity."  Hatch continued, "Our tax system encourages the use of debt rather than equity in the area of corporate finance as well as household finance. If a corporation is in need of additional funds, our tax system encourages the corporation to borrow money rather than raising funds by issuing stock. Why? Because any interest payments on the borrowing are deductible while any dividends paid on the stock are not deductible. In addition, many US multinational corporations are sitting on large piles of cash, yet these corporations are borrowing money. One reason is that their cash is trapped offshore, and the corporations will be subject to a 35 percent US tax on repatriating the cash back to the United States. The increased use of debt by both households and corporations makes both more vulnerable to the risks of bankruptcy and other downturns in the economy."
  • Dr. Barthold submitted two new reports prepared by the Joint Committee on Taxation in preparation for the hearing.  In his remarks, Mr. Barthold noted that "debt is not inherently a bad thing" and that there may be many valid reasons for using debt.  Mr. Barthold also noted that there may be reasons for investors to prefer equity investment—for individuals, dividends and capital gains are taxed at lower rates, while corporations may receive the dividends-received deduction.
  • Ms. Olson testified, "The impact of the Internal Revenue Code’s preferential treatment of debt has been a concern of the US Treasury Department for a number of years and has led to proposals to neutralize or equalize the tax treatment of debt and equity. In 1992, for example, the Treasury Department described concerns about high debt service burdens and corporate bankruptcies and noted that '[t]he US corporate tax system discourages corporations from financing investments with equity as opposed to debt. . . . The disparate treatment of debt and equity, particularly the double tax on dividends, has also given rise to corporate governance concerns, which affected the Treasury Department’s design of the dividend exclusion proposal included in the Bush Administration’s fiscal year 2004 budget.'"  Ms. Olson was one of several witnesses noting that one way to reduce the preference for debt financing was to lower the corporate tax rate, stating: "The preference for debt financing is a result of the ability to deduct interest payments from taxable income. Lowering corporate tax rates would reduce the value of the interest deduction to corporations and reduce the disparity in the taxation of debt and equity investments. Besides reducing the distortion as between debt and equity financing, lowering the corporate tax rate would have other important benefits. The US corporate tax system is increasingly out of step with policies adopted by other countries, to the disadvantage of our economy and the jobs that might otherwise be created here. Our corporate tax rate, at 35 percent, is high relative to our economic peers. Foreign countries offer lower tax rates and investment incentives and, as a result, may provide a more attractive location for investment." 
  • Mr. Fleischer said, "There are several different ways one could eliminate the debt/equity distortion, including eliminating the deduction for interest paid, allowing a deduction for corporate equity, or moving to a corporate cash-flow or consumption tax. There has been a great deal of work done on each of these various proposals, which goes beyond the scope of my testimony here. A comprehensive reform to eliminate the debt/equity distortion could take some time to implement and would make the most sense as part of a package that reduces corporate tax rates. Given the focus of this hearing on debt/equity, it might be useful for me to offer a specific, smaller proposal that could be enacted quickly. My proposal is to allow banks and other financial institutions to deduct interest only up to a limit of a 2 to 1 debt to equity ratio. The reason for focusing on financial institutions is that they are the source of most of the externalized social costs of excessive leverage. The tax distortion makes it difficult for bank executives to build equity cushions, as doing so hurts them competitively. Removing the tax distortion at least keeps the tax system from making the problem worse."
  • Dr. Desai testified, "The appropriate solution will, unsurprisingly, depend very much on the diagnosis of the problem. My perspective on these issues is that regulatory approaches are tempting in idealized settings and are politically salient but are also likely to be ineffective pragmatically and rife with unanticipated consequences. Structural approaches are worth pursuing but some variants of structural approaches are at odds with some important current realities. A step toward fundamental tax reform via a comprehensive business income tax or a corporate tax reform that cuts rates, moves toward territoriality, captures more business income and links definitions of income for tax authorities and capital markets is most desirable. Rate solutions are modest by comparison but provide some supplementary benefits. More generally, given the uncertainty over the magnitude of the current financing bias, it is useful to prioritize the promise of fundamental tax reform or modernizing the corporate tax for current global realities rather than the perceived ills of excessive leverage."
  • Dr. Johnson focused on the negative effects of the "tax-induced debt bias," especially in the financial sector.  Dr. Johnson stated, "Arguments that equity is 'expensive' for banks are either incorrect or self-serving. From a broader social perspective, banks and anyone else providing credit should be financed with relatively more equity and less debt. This would not reduce the availability and growth of credit – rather it would ensure that financial institutions have sufficient 'loss-absorbing' capital on their balance sheets. This is what we need for sustainable growth and job creation."  Johnson argued that the United States should tax excessive leverage in the financial sector, noting that a number of European countries have introduced new taxes on financial institutions, including the United Kingdom.
  • The panelists offered different suggestions for ways to neutralize or equalize the treatment of debt and equity.  Ms. Olson recommended some form of integration, Mr. Desai recommended the Comprehensive Income Business Tax, and Mr. Johnson recommended a tax on excessive returns of financial institutions along with a deduction for dividends.
  • Several of the witnesses also discussed hybrid instruments.  Mr. Fleischer observed that companies may structure instruments to be treated as equity for regulatory purposes but debt for tax purposes.  Dr. Barthold also observed that taxpayers have flexibility in determining whether to structure an instrument to be treated as debt or equity for tax purposes.  He noted that, although Congress has given Treasury the authority under section 385 to write regulations to distinguish between debt and equity, Treasury is not presently exercising that authority.  Chairman Baucus also commented on the line between debt and equity, stating that "in today’s tax code, it can be hard to tell what is considered borrowing and what is equity investment.  A business can make an infusion of cash look like either, and naturally, some businesses choose to cast their financing in a light that gets the best tax treatment.  But this requires sophisticated tax planning, which not everyone can afford.…Tax reform should simplify these issues and make our tax code fairer."
  • The hearing also examined the effectiveness of the mortgage interest deduction.  Mr. Fleischer stated that the deduction likely increases home ownership, but that he would design a housing subsidy differently if starting from scratch.  Mr. Johnson argued that the deduction does not encourage home ownership, but rather encourages leverage in the pursuit of home ownership.  Mr. Johnson argued that home ownership might be further encouraged, on a revenue-neutral basis, by reducing the home mortgage interest deduction but increasing other housing subsidies.
  • Testimony can be accessed here.
  • For additional information, contact Philip R. West - pwest@steptoe.com or  Amanda Varma - avarma@steptoe.com

McCONNELL PRESENTS FALLBACK PLAN:  On Tuesday, Senate Minority Leader Mitch McConnell unveiled a backup plan to increase the debt ceiling and cut spending.  Under McConnell's proposal, the President would send a request to Congress that would let President Obama raise the debt ceiling and allow Congress to express its will through a resolution of disapproval.

  • Reaction to McConnell's plan received positive feedback from House and Senate Democratic leaders.  Senate Majority Leader Harry Reid said, "I am glad to hear that the Republican leader has come forward with a backstop proposal to address the debt limit.  I am still studying it and discussing it with Senators.  But I am heartened by what I read.  This is a serious proposal.  And I commend the Republican leader for coming forward.  I believe that the Republican leader’s proposal, combined with ideas he and I have been discussing to force a vote on deficit reduction proposals, could go a long way toward resolving the impasse in which we find ourselves."
  • House Minority Leader Nancy Pelosi said, "What Leader McConnell has put on the table recognizes that we must pass . . . lift the debt ceiling, that we must do that.  So it has that merit in that it says what are we talking about here?  We have to pass this."

TAX BILLS INTRODUCED JULY 12TH:

1. [112nd] H.R.2502 : To amend the Internal Revenue Code of 1986 to expand tax-free distributions from individual retirement accounts for charitable purposes.
Sponsor: Rep Herger, Wally [CA-2] (introduced 7/12/2011)      Cosponsors (1)
Committees: House Ways and Means
Latest Major Action: 7/12/2011 Referred to House committee. Status: Referred to the House Committee on Ways and Means.

2. [112nd] H.R.2506 : To establish the National Commission on Effective Marginal Tax Rates for Low-Income Families.
Sponsor: Rep Petri, Thomas E. [WI-6] (introduced 7/12/2011)      Cosponsors (1)
Committees: House Ways and Means; House Agriculture; House Veterans' Affairs; House Financial Services; House Energy and Commerce; House Education and the Workforce
Latest Major Action: 7/12/2011 Referred to House committee. Status: Referred to the Committee on Ways and Means, and in addition to the Committees on Agriculture, Veterans' Affairs, Financial Services, Energy and Commerce, and Education and the Workforce, for a period to be subsequently determined by the Speaker, in each case for consideration of such provisions as fall within the jurisdiction of the committee concerned.

3. [112nd] S.1346 : A bill to restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid Federal taxation, and for other purposes.
Sponsor: Sen Levin, Carl [MI] (introduced 7/12/2011)      Cosponsors (5)
Committees: Senate Finance
Latest Major Action: 7/12/2011 Referred to Senate committee. Status: Read twice and referred to the Committee on Finance. 

INTERNAL REVENUE SERVICE - CIRCULAR 230 DISCLOSURE:
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