Subpart F High-Tax Exception: Impact of Recent Foreign Tax Credit Legislation

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By Lowell D. Yoder, Esq.  

McDermott Will & Emery LLP, Chicago, IL 

Income realized by a controlled foreign corporation (CFC) that would otherwise constitute "Subpart F" foreign base company income is excepted from such treatment (at the option of the controlling United States shareholders) if the income is subject to a "high" foreign tax rate.1  A foreign tax rate is high if it exceeds 31.5%, i.e., 90% of the U.S. 35% corporate tax rate. Thus, for example, the high-tax exception would be available to exclude from Subpart F income $68 of foreign base company sales income (net of associated foreign income taxes) that has $32 of associated foreign income taxes — an effective foreign tax rate of 32%. (The effective foreign tax rate on an item of income is determined by dividing the amount of associated foreign taxes by the sum of the amount of the item of income and the amount of the associated foreign taxes.)

This commentary explores the application of the high-tax exception to "general basket" Subpart F income in light of recent legislative amendments to the foreign tax credit provisions.2  Income that is not Subpart passive F foreign personal holding company income (FPHCI) is subject to the general foreign tax credit limitation. (Passive FPHCI is subject to the passive foreign tax credit limitation.)3  Thus, a CFC's items of "general basket" Subpart F income include foreign base company sales income and foreign base company services income.4  In addition, dividends, interest, rents, and royalties received by a CFC from a related person fall within the general basket except to the extent the payments are allocable to passive income of the payor.5 

While the statute appears to require that the effective foreign tax rate for purposes of the Subpart F high-tax exception be calculated separately for each item of general basket Subpart F income using the foreign income tax directly associated with that item of income, this is not the approach under the regulations.  The regulations provide that the amount of taxes taken into account is the amount of deemed-paid taxes determined under §960 that would accompany the Subpart F income inclusion.6  This calculation is based on the foreign taxes associated with the CFC's post-1986 general basket earnings pool rather than the actual amount of taxes associated with the particular item of income.7  As a result, every item of general basket Subpart F income has the same effective tax rate.

Example. A U.S. parent corporation, USP, owns SwissCo, which in turn owns a Japanese branch and an Irish branch. During 2011 the Japanese branch earns $100 of foreign base company sales income that is subject to a 40% tax rate, and the Irish branch earns $200 of foreign base company services income that is subject to a 12.5% tax rate. As of the end of 2010, SwissCo had $180 of earnings in its general basket post-1986 earnings pool and $20 of associated taxes. As of the end of 2011, the amount in SwissCo's post-1986 earnings pool would be $415 ($180 + $60 + $175) and its corresponding post-1986 general basket taxes pool would be $85 ($20 + $40 + $25), with an effective tax rate for the post-1986 earnings pool of 17% ($85/$500). The pool's effective tax rate would be the effective tax rate for purposes of determining whether the high-tax exception is available for the Japanese sales income8 and the Irish services income,9  and neither item of income would qualify for the high-tax exception.

Basing the high-tax exception on the amount of deemed-paid taxes does not appear to comport with the language of the Code and the legislative history. Both express the intent that the high-tax exception be available for an item of income that is actually subject to a high foreign tax rate (e.g., the Japanese branch's sales income). Under the approach of the regulations, as illustrated above, an item of income may be subject to a high foreign tax (indicating the lack of tax motivation to shift income) and yet not qualify for the high-tax exception.10  In addition, a highly taxed item of income that does not qualify for the high-tax exception may be subject to additional U.S. tax as illustrated by the Japanese branch's sales income above which would bear an incremental tax of 18% when included in the gross income of USP under Subpart F.

Since the regulations provide that, for purposes of applying the high-tax exception, the amount of deemed-paid taxes associated with an item of Subpart F income is the amount of taxes taken into account, the recent foreign tax credit amendments can affect the calculation of the high-tax exception. The new rules generally limit the amount of foreign taxes that may be claimed as a deemed-paid credit.

New §909 suspends taking into account a foreign income tax if there is a "foreign tax credit splitting event" (FTCSE). There is an FTCSE with respect to a foreign income tax if the related income is (or will be) taken into account by a "covered person", e.g., a subsidiary. The suspension continues until the taxable year in which "the related income" (i.e., the income to which the foreign income tax relates) is taken into account by the taxpayer for U.S. tax purposes. In the latter taxable year, the suspended foreign income tax is taken into account as a foreign income tax paid or accrued in such year.

These rules generally apply to CFCs for purposes of the deemed-paid credit rules of §§902 and 960 and for purposes of determining earnings and profits under §964(a). The suspension of foreign income taxes continues until the taxable year in which the related income is taken into account by the CFC or by a domestic corporation meeting the 10% ownership requirements of §902(a) or (b) with respect to the CFC. The suspended foreign income taxes stay with the entity that is legally liable for the taxes, i.e., they are not considered as the taxes of the covered person with the related income. When suspended taxes are released to a CFC, the taxes are placed in the CFC's post-1986 taxes pool (using the exchange rate applicable when the taxes were suspended).

Example. USP owns CFC1, which owns 99.9% of a foreign partnership that is classified as a corporation for U.S. purposes (CFC2). During 2012 CFC2 derives $100 of non-Subpart F sales income subject to a 35% foreign income tax rate. CFC1 is liable for the taxes under foreign law and thus considered as the taxpayer for purposes of §§901 and 902.11  In addition, during 2012 CFC1 derives $100 of Subpart F interest income (assuming §954(c)(6) has sunset) from a related person that is general basket income (which is the only amount in CFC1's post-1986 general basket earnings pool), and pays no foreign income tax on the interest. Prior to §909, CFC1's interest income should have qualified for the high-tax exception because a Subpart F inclusion would have been accompanied with $35 of deemed-paid taxes under §960. Under the new rule, the $35 of taxes paid by CFC1 would be suspended, and therefore not deemed paid, causing the high-tax exception not to be available. The taxes would be added to CFC1's pool once CFC2 distributed the $100 of related income to CFC1. It is noted that the $35 also would not reduce CFC1's earnings and profits for purposes of applying the current year earnings and profits limitation to the amount of Subpart F income.

The $35 of suspended foreign income taxes remain at CFC1; they are not moved to CFC2. As a result, such taxes would not be available to CFC2 for purposes of applying the high-tax exception to its income, even to the related income that gave rise to the taxes.  Thus, if the $100 of sales income derived by CFC2 were Subpart F income, the $35 of taxes paid on that income would not be available for purposes of applying the high-tax exception. Interestingly, under these facts, because USP (a 10% §902 shareholder of CFC1) would include the $100 in its income, the $35 of taxes would not be suspended and would be in CFC1's general basket pool. As a result, the high-tax exception should be available for CFC1's general basket interest income. 

New §901(m) provides that a portion of foreign income tax attributable to income from foreign assets acquired in a "covered asset acquisition" is not creditable. Covered asset acquisitions include a purchase of stock in a target for which a §338 election is made or transactions that are treated as asset acquisitions for U.S. purposes but are treated as acquisitions of stock or are disregarded for foreign tax purposes (e.g., the purchase of interests in an entity disregarded for U.S. tax purposes). The disqualified portion equals the aggregate basis difference allocable to such taxable year with respect to all relevant foreign assets divided by income on which the foreign income tax is determined. In other words, §901(m) denies a credit for foreign taxes paid on foreign income that is not recognized for U.S. purposes because of the covered asset acquisition. Amortization related to a covered asset acquisition remains deductible for earnings and profits purposes as do the non-creditable taxes.

Since the high-tax exception is based on the amount of deemed-paid taxes accompanying a Subpart F inclusion under §960, the amount of taxes disallowed as a credit under §901(m) would not be taken into account, even though actually imposed on the item of income. Nevertheless, the amount of the inclusion should be reduced by such disallowed taxes taken as an expense (and not grossed up).  In addition, the amount of the post-1986 pool of earnings should be reduced by the amount of disallowed taxes for purposes of calculating the amount of deemed-paid taxes under §960.

New §960(c) limits the amount of foreign income taxes that accompany an inclusion in the income of U.S. shareholders under §951(a)(1)(B) for investments in U.S. property held by lower-tier CFCs. This is achieved by modifying the application of the so-called "hopscotch" rule.

As a general rule, the amount of deemed-paid taxes that accompany an inclusion resulting from an investment in U.S. property by a lower-tier CFC (e.g., a CFC operating company owned by a CFC holding company) is determined as if the amount were deemed distributed directly from the lower-tier CFC to the U.S. shareholder.  The limitation provided by new §960(c) is determined by calculating a U.S. shareholder's deemed-paid foreign tax credits as if cash in an amount equal to the amount of the §951(a)(1)(B) inclusion were distributed as a series of distributions through the chain of ownership which begins with the lower-tier CFC and ends with the U.S. shareholder ("hypothetical credit"). If this amount is less than the taxes deemed paid by the U.S. shareholder without regard to the new rule (the "tentative credit"), then the amount of the U.S. shareholder's credit is the hypothetical credit.12 

Section 960(c) should not have a direct impact on the application of the high-tax exception because the high-tax exception is not available for §951(a)(1)(B) inclusions resulting from investments in U.S. property. In addition, §960(c) does not apply to Subpart F income inclusions (i.e., the hopscotch rule continues to apply).

Nevertheless, §960(c) may have an indirect impact. The foreign taxes not deemed paid with the §951(a)(1)(B) inclusion remain with the lower-tier CFC. Such taxes would be included in the post-1986 taxes pool, generally increasing the pool's effective tax rate. As discussed above, the high-tax exception is determined for general basket income based on the effective tax rate of the general basket pool.13 

The new foreign tax credit rules would appear to cause the regulations' reliance on §960 for purposes of applying the high-tax exception to become even more questionable. It may be time to reconsider the approach of using the amount of deemed-paid taxes to determine whether an item of general basket income qualifies for the high-tax exception and provide a rule that achieves a closer relationship to the actual amount of foreign taxes associated with the item of Subpart F income.

This commentary also will appear in the February 2011 issue of BNA's Tax Management International Journal.  For more information, in BNA's Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes -- General Issues, Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, Yoder, Lyon, and Noren, 926 T.M.,CFCs -- General Overview, Yoder, 928 T.M., CFCs -- Foreign Base Company Income (Other than FPHCI), Yoder and Kemm, 930 T.M., CFCs -- Sections 959-965 and 1248 and in Tax Practice Series, see ¶7150, U.S. Persons—Worldwide Taxation.

1 §954(b)(4); Regs. §1.954-1(d).  

2 P.L. 111-226; see Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586, Scheduled For Consideration by the House of Representatives on August 10, 2010(JCX-46-10), Aug. 10, 2010.   

3 §904(d)(2)(B); Regs. §§1.904-4, -4T.  Passive FPHCI includes dividends, interest, rents, and royalties received from unrelated persons that do not qualify for the active rents or royalties exception or qualify for the active financing exception.  It also includes passive gains, income equivalent to interest, and foreign currency gains, to the extent no exception applies. §954(c).   

4 The high-tax exception is not available for foreign base company oil related income. §954(g). 

5 §904(d)(3); Regs. §1.904-5(c), (h), (i). 

6 Regs. §1.954-1(d)(3)(i).  

7 Regs. §1.960-1; Regs. §1.904-6(b)(1).   

8 Deemed-paid taxes under §960: 60/415 × 85 = 12, yielding an effective tax rate of 17% (12/72).  The amount of taxes allocated to the Japanese sales income for purposes of calculating the net amount of Subpart F income should be the $40 paid on the income. Regs. §1.861-8(e)(6). 

9 Deemed-paid taxes under §960: 175/415 × 85 = 36, yielding an effective tax rate of 17% (36/211). 

10 See Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (H.R. 3838, 99th Cong.; P.L. 99-514) (JCS-10-87), May 1987, at 983: "Congress believed that if movable types of income have been moved to a jurisdiction where they in fact bear a low rate of tax when compared to the U.S. tax rate, then it is appropriate to impose current U.S. tax on such income without any inquiry into the subjective motivations of the taxpayer. Thus, taxpayers should be permitted to except income from current taxation under Subpart F only by showing that such income is subject to a foreign tax at a rate substantially equal to the U.S. tax rate." 

11 Regs. §1.901-2(f)(1). Section 909 does not address the determination of the person who paid a foreign income tax for U.S. income tax purposes. Notice 2010-92, 2010-52 I.R.B. 916. 

12 See Yoder, "Section 956 Inclusions: New Limit on Foreign Taxes Deemed Paid," 39 Tax Mgmt. Int'l J. 785 (12/10/10). The new rule is effective for acquisitions of U.S. property after Dec. 31, 2010.  

13 Not electing the high-tax exception for Subpart F income would be a way to directly access foreign tax credits from lower-tier CFCs under the hopscotch rule.