RECENT DEVELOPMENTS IN U.S. TAXATION OF INTERNATIONAL TRANSACTIONS
By:
Marco A. Blanco
John Dworkin
New York
Recently, the U.S. Department of Treasury ("Treasury") and the Internal Revenue Service ("IRS") issued three notices dealing with two types of arrangements by U.S. taxpayers that the notices state abuse the intent of the two statutory provisions. The two types of arrangements are: (1) those that are formed primarily to generate foreign tax credits and (2) those with hybrid entities that are used to reduce foreign taxes. The discussion below provides a summary of these notices.
1. Foreign Tax Credit Abuses
On December 23, 1997, Treasury and the IRS released Notice 98-5 announcing that regulations to be issued will disallow foreign tax credits for foreign taxes generated in certain arrangements that are considered "abusive tax-motived transactions." The abusive arrangements are designed to generate foreign tax credits for U.S. taxpayers that have low-taxed foreign-source income. The notice identifies two classes of transactions that create the potential for foreign tax credit abuse.
The first class consists of transactions involving the transfer of tax liability through the acquisition of an asset that generates an income stream subject to foreign gross basis taxes such as withholding taxes. Such transactions include the acquisition of income streams through securities loans and similar arrangements and acquisitions in combination with total return swaps. Thus, the abuse identified is the purchase of foreign tax credits by a U.S. taxpayer in an arrangement where the expected economic profit is insubstantial compared to the foreign tax credits generated.
The second class of transactions identified by the notice consists of cross-border tax arbitrage transactions that permit effective duplication of tax benefits. Such duplication is created when the U.S. grants benefits and, in addition, a foreign government grants benefits to separate persons with respect to the same taxes or income. Because the U.S. and a foreign country treat all or a part of a transaction or amount differently under their respective tax systems, the U.S. taxpayer exploits these inconsistencies where the expected economic profit is insubstantial compared to the foreign tax credits generated.
The notice provides five examples of abusive arrangements. In regulations to be issued, foreign tax credits generated in such arrangements will be disallowed. The notice states that it is expected that the regulations to be issued will include a test comparing economic profit and foreign tax credits to determine if a transaction is abusive. It is expected that the regulations to be issued generally will be effective with respect to taxes paid or accrued on or after December 23, 1997, the same date that the notice was issued.
2. Abusive Hybrid Branch Arrangements
On January 16, 1998, Treasury and the IRS issued Notice 98-11 addressing hybrid branch arrangements designed to reduce foreign taxes without generating a corresponding increase in U.S. tax liability. Notice 98-11 provides that the use of hybrid arrangements in such manner is contrary to U.S. international tax policy and would be the subject of forthcoming regulations. On March 23, 1998, temporary and proposed regulations were issued under Notice 98-11 that provided that payments made pursuant to hybrid branch arrangements may give rise to currently taxable U.S. income if certain conditions are met. On June 19, 1998, Treasury and the IRS issued Notice 98-35 announcing their intention to with-draw the temporary regulations and proposed regulations issued under Notice 98-11. In addition, Notice 98-35 states that it is intended that the proposed regulations on hybrid transactions (whether through a branch or partnership) will not be finalized prior to January 1, 2000 and that such regulations will provide transition relief for payments made under hybrid arrangements before June 19, 1998. Finally, the notice invites comments on the policy objectives of tax provisions dealing with controlled foreign corporations and whether these policy objectives are still appropriate.
Since the introduction of the "check-the-box" regulations in 1996, characterization of certain entities as either pass-throughs (partnerships or branches) or corporations taxable as associations has been greatly simplified. Hybrid branch arrangements have increasingly been used as a means of reducing foreign taxes without creating a corresponding increase in U.S. tax liability. In essence, the "check-the-box" regulations have allowed U.S. multinational corporations to consolidate on an international basis, and therefore to disregard cross-border payments made between related corporations, since the "check-the-box" regulations allow a wholly owned foreign subsidiary to be disregarded as an entity separate from its parent corporation (i.e., the subsidiary is treated as fiscally transparent). For example, assume Country X corporation ("Subsidiary"), a company engaged in a manufacturing business in Country X, is a wholly owned subsidiary of Country Y corporation ("Parent"), and Parent is wholly owned by U.S. persons. As a wholly owned subsidiary, Parent can elect under the "check-the-box" regulations to disregard Subsidiary as an entity separate from itself. Parent will capitalize Subsidiary in the form of loans that generate deductible interest expense for Subsidiary under the laws of Country X. If Country X imposes a low rate of withholding tax on interest paid from Country X corporations to Country Y corporations, and Country Y imposes a low rate of tax on the net income of its resident corporations, then the use of Subsidiary indebtedness successfully reduced the overall foreign tax burden on Subsidiary's manufacturing profits. Prior to the "check-the-box" regulations, the interest payments made by Subsidiary to Parent would have generated U.S. taxable income as payments made to a controlled foreign corporation. However, under the "check-the-box" regulations Subsidiary is not treated as an entity separate from Parent, and therefore the interest payments received by Parent are not treated for U.S. federal income tax purposes as giving rise to U.S. tax consequences (since Parent is, in essence, making a payment to itself). In this way, hybrid branch arrangements have been used to reduce foreign taxes without creating a corresponding increase in U.S. tax liability.
When Notice 98-11 was issued, the private sector and certain members of Congress were critical of the notice's disapproval of U.S. taxpayers entering into transactions that reduce their foreign tax liability. This resulted in the issuance of Notice 98-35 that, as described above, announced the withdrawal of Notice 98-11 and the proposed regulations. We expect this issue will continue to be debated and it would be difficult to speculate on whether Treasury and the IRS will reissue proposed regulations in the same form as were previously issued. Thus, any corporate structures using hybrid entities should be carefully considered.
