Covered Asset Acquisitions Uncovered

By James J. Tobin, Esq.

Ernst & Young LLP 1 , New York, NY


I suspect I've been sounding like a broken record since August of last year when the big three (and assorted other) international "loophole closers," which had taken us all by surprise last May, were enacted into law. My first impression was that §909 was overly broad for the relatively narrow set of foreign tax credit situations that could reasonably be considered to be "abuses" as opposed to merely the inevitable inconsistencies created by applying U.S. tax rules to foreign subsidiaries taxed under the sometimes very different taxable income standards of their home countries. My initial view was reinforced when I read the initial guidance on §909 contained in Notice 2010-92, particularly the last part of the notice which warns of a very (overly) broad list of possible future targets. As for the other two provisions, I never saw the hopscotch result under §956 or the §902 effective foreign tax rate implications of a §338 election as anything but a logical and straightforward outcome of those long-standing statutory rules.

Since the August 2010 enactment of these three new provisions, I've spent the most time thinking about §909, in part because of the guidance that was issued in December and in part because our clients had to deal with year-end consequences of the so-called foreign tax credit "splitter" rules due to their potential retrospective effect on existing earnings and profits (E&P) pools (which, of course, is why Treasury and the IRS had to act so quickly to issue initial guidance). I also have spent a bit of time thinking about §960(c) in large part because of the need to understand how the grandfather rule would work before the grandfather date had passed. Until recently I had spent the least time thinking about the covered asset acquisition rules of §901(m).  But I have been thinking more about this new provision lately in the context of some transactions we are helping our clients to structure.  I'm quickly coming to the conclusion that this provision may well be the most unreasonable of the three: it has real potential for double tax results and in many cases it could cause a change in the structure of an acquisition transaction so as to accelerate foreign tax in order to avoid or reduce the disallowance of future foreign tax credits.  (Having said that, §909 remains in contention for the unreasonableness trophy … and I do have another commentary coming up in a couple of months…).

When thinking about §901(m) and the perceived "abuse" at which it was aimed, the most common example I start with is an acquisition of a foreign target from a foreign seller in which the U.S. purchaser (or an acquiring CFC) makes a §338 election.  The foreign seller typically pays no foreign tax on the gain due to an applicable participation exemption regime and the U.S. acquiring group gets to step up the basis of target's assets to fair market value for future E&P purposes. Often more importantly, the §338 election serves to eliminate the old E&P history of the foreign target and thus the need to determine E&P under U.S. tax principles for a foreign company that never had any reason to think about, much less prepare for, such a determination. My fellow commentator, Lowell Yoder, recently wrote an excellent piece on the §901(m) consequences of this type of transaction and the impact of the new rules on a U.S. acquirer's decision as to whether or not to make a §338 election for a foreign target. Conceptually speaking, one can see at least some policy rationale for a disallowance of a credit for the portion of the foreign tax that is related to the step-up in this case. And fortunately the lawmakers did recognize that new §901(m) represents a true change in policy and appropriately provided a truly prospective effective date. My concern about the provision as applied in this fact pattern is another installment in my ongoing whine about complexity (although we advisors sometimes are accused of seeing a glimmer of silver lining in complexity). The disallowed foreign tax credit is based on the U.S. tax basis difference arising from the §338 step-up. To determine that amount it will be necessary first to determine the U.S. tax basis of all the assets of the foreign target before the acquisition. This would require a full historical E&P study of the foreign target. Thus, the "eliminate the past and start fresh" advantage of a §338 election likely is history, unless Treasury and the IRS come to the rescue in regulations.2

While I could ramble on a lot longer about the complexities and unintended consequences of §901(m) in a foreign target context, I'll move on now to my bigger policy concern, which relates to the impact of §901(m) on the acquisition of a U.S. target with foreign operations or check-the-box branches. The statute and the legislative history seem clearly to contemplate that such a transaction is potentially within the scope of §901(m).3 I hadn't initially focused on this fact pattern — perhaps I was fooled by the title of the subsection "denial of foreign tax credit with respect to foreign income not subject to United States taxation by reason of covered asset acquisitions" (emphasis added). So assume I have an acquisition of a U.S. target for which a §338(h)(10) election is made and assume that U.S. target has a U.K. branch and also has valuable intangibles that generate foreign-source royalties. Further assume there is gain with respect to both the branch assets and the foreign portion of the intangibles. Should §901(m) impact the future credits with respect to foreign taxes to be paid by U.S. target and, if so, to what extent?

In my view a §338 election with respect to a U.S. target corporation should not be considered a covered asset acquisition. While there is a difference in the treatment of the transaction for U.S. and foreign tax purposes, all of the "foreign" income in question will be fully subject to U.S. tax. Indeed, the income recognition of the U.S. seller for U.S. tax purposes is accelerated.  To add insult to injury, based on the §865 sourcing rules, a significant part of the gain recognized with respect to the intangibles and the foreign branch assets will be U.S.-source income which cannot be offset by other foreign tax credits of the selling group. Admittedly, the U.S. buyer in this case would have derived what could be considered somewhat of a "benefit" in the pre-§901(m) world by being entitled to a credit for foreign tax imposed on a net income amount that is greater than its U.S. net income amount. But cumulatively in this case the same amount of income has been taxed in the United States as in the foreign country. Moreover, due to our U.S. sourcing rules, the potential for double tax under the foreign tax credit limitation rules already was a serious risk, even absent any potential disallowance under new §901(m).

If the covered asset acquisition rules are to be applied to the transaction described above, let's consider how the disallowance could be computed. Section 901(m)(3) provides that the disallowed portion of a foreign income tax for a particular year will be equal to the aggregate basis differences for the year with respect to the relevant foreign assets divided by the relevant foreign taxable income amount, multiplied by the foreign tax for the year.  For the foreign operating branch in the above example, this would seem to mean that the increased U.S. tax deductions for depreciation, cost of goods sold, §197 amortization, etc. that are not recognized by the foreign country would be the numerator. The denominator would be the branch taxable income reported on the foreign country tax return converted to U.S. dollars on some basis not specified in the statute or legislative history. Interestingly, the fraction is not based on a comparison of U.S. versus foreign taxable income. Therefore, if there happens to be other deductions that are recognized under local tax rules, ironically such foreign deductions would have the effect of increasing the disallowance percentage. To illustrate, let's assume a first-tier hybrid branch (a first-tier foreign subsidiary treated as a disregarded entity for U.S. tax purposes) that has 100 of operating profit. Assume a prior (but post-effective date) §338 election with respect to the U.S. corporate owner of the hybrid branch, which results in 50 of §197 amortization deduction for U.S. tax purposes for the year. Assume also that the hybrid branch makes interest payments to its U.S. corporate owner of 50, which are deducted for foreign country purposes but are disregarded for U.S. tax purposes. The branch, therefore, has 50 of foreign country taxable income. Assume the branch pays foreign tax at 30%, resulting in 15 of foreign tax for the year. The "disqualified portion" of the foreign tax in this case would be the 50 of basis difference divided by the 50 of foreign taxable income, with the result that all of the 15 of foreign tax of the hybrid branch would be disallowed.

Now, what about the intangible property that produces foreign royalty income? In some foreign countries, this royalty income will be subject to foreign withholding tax. In other foreign countries, there will be no such withholding tax. Because the foreign withholding tax typically will be imposed on gross payments, any §197 amortization that could result from a §338 step-up (or even from a direct purchase of the IP by a U.S. buyer) will not impact the amount of foreign tax paid. It would, therefore, seem especially inappropriate to disallow a portion of this foreign withholding tax because of a step-up that occurs due to the §338 election. In this regard, no disallowance would result from a direct asset purchase because such a transaction would not potentially fall into the definition of a covered asset acquisition. Unfortunately, one cannot find any comfort on this point in the statutory language.

If §901(m) were to apply in this case, one wonders whether the basis difference with respect to the "relevant foreign asset" should be computed based on the full non-U.S. IP value or whether the IP value should be segregated on a country-by-country basis because only some countries will impose a withholding tax on the royalties. An aggregate approach would seem simpler and would avoid the need for a costly country-by-country valuation exercise which would not be required for any other business, accounting, or tax purpose. However, I could foresee some pesky issues in aggregating all foreign country rent and royalty amounts for purposes of computing the denominator of the disallowance fraction (cash versus accrual basis, net versus gross for rents in some countries, forex conversion, transfer pricing adjustments, etc., to name a few).

Section 901(m)(7) provides the Secretary with broad regulatory authority, including the authority appropriately to exclude certain covered asset acquisitions from the application of these foreign tax disallowance rules. The legislative history gives us one example of such an appropriate transaction: a situation where a covered asset acquisition results in a U.S. tax step-up but there is similarly a foreign tax step-up and therefore there is a good likelihood of similar net taxable income results in the United States and in the foreign country. I would strongly encourage Treasury and the IRS to use this broad regulatory authority to exclude from the reach of §901(m) both transactions involving U.S.-held assets that produce foreign-source income, such as royalties, rents, etc., and transactions involving an actual foreign branch or a first-tier hybrid branch. Absent such an exclusion, I would foresee that in many situations a logical self-help solution that buyers and sellers would have to consider pursuing could be to structure an acquisition transaction as a direct foreign asset sale subject to immediate foreign tax. In such case, the seller would be fully entitled to any resulting foreign tax credits and foreign-source income on the sale likely could be increased, better enabling full foreign tax credit utilization.  Future foreign tax imposed on the buyer would be reduced through enhanced amortization and other deductions. Overall, it is the foreign country that would be enriched by the acceleration of the imposition of its tax. The take for the U.S. fisc would be reduced upfront by the foreign tax credit. And the new lower-taxed future foreign income of the purchasing group more likely would be reinvested rather than distributed to the extent possible.

Anyone who works in the international tax M&A area spends a lot of time and energy working hard to defer foreign tax on cross-border sale and restructuring transactions. All else being equal, if in the case of a direct or indirect U.S. seller, a foreign tax paid today on a "covered asset acquisition" would be eligible for a credit but all or a portion of a foreign tax deferred until after closing would not be eligible for a credit to a U.S. direct or indirect buyer, the commercial consequences are fairly obvious. Let's hope the regulation drafters take this into account as they are exercising the authority provided in the statute to exempt transactions as appropriate.

This commentary also will appear in the July 2011 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Chudy, Early-Hubelbank & Reddy, 788 T.M., Stock Purchases Treated as Asset Acquisitions — Section 338, DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes — General Issues, and Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits,  and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.

1 The views expressed herein are those of the author and do not necessarily reflect those of Ernst & Young LLP.

2 The legislative history of §901(m) does allude to the possibility of rules allowing the use of the foreign tax asset basis pre-acquisition rather than having to compute a U.S. tax basis in certain cases. But it doesn't appear to envisage a broad use of foreign basis and in any event I don't know too many countries that have clear rules for computing, maintaining, and reporting a local tax basis balance sheet.

3 The statutory language refers to §338(a), which as noted in the legislative history includes both §338(g) elections and §338(h)(10) elections. A §338(g) election can apply to U.S. or foreign targets but a §338(h)(10) election can only apply to U.S. targets.