The Internal Revenue Service issued last year guidance on upcoming regulations under Internal Code Section 901(m), introduced in 2011, dealing with the denial of the foreign tax credit for certain foreign stock acquisitions. The proposed rules described in Notice 2014-44 seek to deny the dual benefit of a basis step-up and a foreign tax credit, for certain transactions that are treated as a stock acquisition abroad, and as an acquisition of the underlying assets in the United States. The provision denies credit for a portion of the foreign tax paid by the foreign target.
These types of transactions effectively allow a form of “double-dipping”. The U.S. acquiror obtains depreciation write-offs based on purchase cost. The foreign target pays relatively more foreign tax, by reason of not obtaining a step-up and extra write-offs. This foreign tax normally would be creditable by the US acquiror against US tax on other income in the same income group, or basket.
Under the upcoming regulations, in the case of a “covered asset acquisition”, the disqualified portion of any foreign income tax determined with respect to gain attributable to relevant foreign assets is not taken into account in determining the allowable foreign tax credit, either the direct credit, or the credit for foreign taxes paid by certain foreign subsidiaries.
A “covered asset acquisition” is
– a qualified stock purchase to which Code section
338(a) applies, i.e., a stock acquisition treated for tax purposes as the acquisition of the underlying assets, or
– any other transaction treated as (i) an acquisition of assets for U.S. tax purposes, and as (ii) the acquisition of stock (or disregarded) for foreign income tax purposes. The term also includes the acquisition of an interest in a partnership which has an election in effect under Code section 754, to raise or lower the tax basis of the partnership assets to match the basis of the partners in their partnership interests. A “covered asset acquisition” can also include any other similar transaction by regulation.
Under Code section 338, the purchaser is deemed to form a subsidiary corporation that acquires the assets of the target corporation. This construct results in an increased tax basis for the target’s assets and the elimination of the historic tax attributes associated with the assets.
The “disqualified portion” of the foreign tax means, with respect to any covered asset acquisition, the ratio of
(i) the aggregate basis differences (but not below zero) allocable for the year with respect to all relevant foreign assets, using the applicable cost recovery method, divided by (ii) the income on which the foreign income tax is determined. If the taxpayer fails to substantiate such income to the satisfaction of the Service, the income is determined by dividing the foreign tax by the highest marginal tax rate in the relevant jurisdiction.
Except as otherwise provided by regulation, if there is a disposition of any relevant foreign asset, the basis difference allocated to the taxable year of the disposition is the excess of the basis difference of such asset over the aggregate basis difference of such asset that has been allocated to all prior taxable years (Unallocated Basis Difference).
“Basis difference” means the adjusted basis of the relevant foreign asset immediately after the covered asset acquisition, over the basis before. If the asset has a built-in loss, the negative amount is taken into account.
The disallowed taxes are allowed as a deduction, free from the general limitations in Code sections 275 and 78.
While Code Sec. 901(m) reduces the amount of creditable foreign taxes, a Code Sec. 338(g) election can continue to provide some excess foreign tax credits, just reduced. The effective tax rate generally would be still lower without the election, lower than the US rate, resulting in incremental US tax on a dividend. The 338(g) election also eliminates the foreign target’s tax attribute history, simplifying computations, potentially avoiding subpart F gains or section 1248 deemed dividends. For the seller, the earnings resulting from the target’s deemed sale of assets is taken into account in determining the gain recharacterized as dividend under section 1248. The additional may dilute the seller’s deemed paid foreign
tax credits accompanying the deemed dividend.
Sometimes it is helpful for the foreign target to retain its historic tax attributes, e.g., previously taxed income, which includes amounts taxable to a U.S. seller under section 1248; or a high-taxed earnings pool or a deficit of a foreign target.
Notice 2014-44 announces that the Internal Revenue Service and the Department of the Treasury will issue regulations addressing the application of Code section 901(m) to dispositions of assets following covered asset acquisitions (CAAs), and to CAAs described in section 901(m)(2)(C) (regarding section 754 elections).
The future regulations will emphasize the term Relevant Foreign Assets (RFA). RFA means, with respect to a CAA, any asset with respect to such acquisition, if income or loss attributable to such asset is taken into account in determining the foreign income tax referenced in section 901(m)(1).
Notice 2014-44 provides guidance on the upcoming regulatory exception to the statutory disposition rule. The Code rule is that, if there is a disposition of any relevant foreign asset, the basis difference allocated to the taxable year of the disposition is the excess of (i) the basis difference of the asset, over (ii) the aggregate basis difference allocated to prior years (Unallocated Basis Difference).
Treasury finds that, applying the statutory disposition rule to the disposition of an RFA is appropriate in fact patterns in which the gain or loss is fully recognized for both U.S. and foreign income tax purposes. In certain cases, it may not be the appropriate time for all, or any, of the Unallocated Basis Difference to be taken into account. Section 901(m) should continue to apply to the remaining Unallocated Basis Difference. This includes cases in which the gain or loss from the disposition is recognized for purposes of U.S. tax, but not for foreign tax purposes, or cases in which no gain or loss is recognized for U.S. or foreign tax purposes.
Certain taxpayers are engaging in transactions shortly after a CAA, which are intended to invoke application of the statutory disposition rule under section 901(m)(3)(B)(ii), to avoid the purpose of section 901(m). An example is the target becoming disregarded as an entity separate from its owner, pursuant to an entity classification election under Treas. Reg. § 301.7701-3. The foreign target is deemed for U.S. tax purposes to distribute its assets and liabilities to FSub in liquidation (deemed liquidation) the day before the election is effective. No gain or loss is recognized. The taxpayers take the position that the deemed liquidation constitutes a disposition of the RFAs, and claim all of the basis difference in the final taxable year of the target that occurs by reason of the deemed liquidation.
Treasury is offended that: (i) the disparity in basis of the assets of the foreign target for U.S. and foreign tax purposes continues to exist after the deemed liquidation; and (ii) because no gain is recognized for foreign income tax purposes as a result of the deemed liquidation, there is no foreign income tax subject to disqualification under section 901(m).
Taxpayers have engaged in other variations of this transaction, also offensive to Treasury. Hence, regulations will be issued to create exceptions to the statutory disposition rule.
Treasury opines that, for purposes of section 901(m), a disposition means an event that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax or a foreign income tax, or both, thus not including the tax-free deemed liquidation arising upon the foreign target’s entity classification election.
The portion of a basis difference with respect to an RFA that is taken into account as a result of a disposition will be determined under one of two rules.
If a disposition is fully taxable for both U.S. and foreign income tax purposes, the Disposition Amount is equal to the Unallocated Basis Difference.
If a disposition is not fully taxable for both U.S. and foreign income tax purposes, to the extent that the disparity in the U.S. Basis and the Foreign Basis is reduced as a result of the disposition, all or a portion
of the Unallocated Basis Difference is taken into account.
In the case of a positive basis difference, a reduction in basis disparity generally will occur if (i) gain is recognized for foreign tax purposes (Foreign Disposition Gain), which generally results in an increase in the Foreign Basis of the RFA, or (ii) loss is recognized for U.S. tax purposes (U.S. Disposition Loss), which generally results in a decrease in the U.S. Basis of the RFA.
If the RFA has a positive basis difference, the Disposition Amount equals the lesser of:
(i) any Foreign Disposition Gain plus any U.S. Disposition Loss (expressed as a positive amount), or
(ii) the Unallocated Basis Difference.
In the case of a negative basis difference, a reduction in basis disparity generally will occur if (i) loss is recognized for foreign tax purposes (Foreign Disposition Loss), which generally results in a decrease in the Foreign Basis of the RFA, or (ii) gain is recognized for U.S. income tax purposes (U.S.
Disposition Gain), which generally results in an increase in the U.S. Basis of the RFA.
If the RFA has a negative basis difference, the Disposition Amount equals the greater of the following amounts:
(i) any Foreign Disposition Loss plus any U.S. Disposition Gain (solely for this purpose, expressed as a negative amount), or
(ii) the Unallocated Basis Difference.
Special rules are proposed for a section 743(b) CAA.
Section 901(m) continues to apply to an RFA until the entire basis difference in the RFA has been taken into account using the applicable cost recovery method or as a Disposition Amount (or both), even if there is a change in the ownership of an RFA.
The Internal Revenue Service and Treasury continue to ponder whether and to what extent section 901(m) should apply to an asset received in exchange for an RFA if basis is determined by reference to the basis of the RFA transferred.