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James J. Tobin, Esq.

By James J. Tobin, Esq. Ernst & Young LLP New York, New York

I'm excited about the prospect of major international tax reform, which is looking more and more likely to me. The House Republican Tax Reform Blueprint would represent massive changes. Border adjustability would be a true disruption and cause many companies to rethink their business models. But if it is projected to raise lots of revenue there will naturally be lots of lobbying and pushback, so I'm not so sure about that proposal. On the other hand, I do think we need to and will move to a territorial tax system, which will likely come with a transition tax on deferred foreign earnings. The transition tax would pay for the move to the territorial tax system and have the added benefit of unlocking large amounts of cash trapped offshore.

Because a logical starting point for drafting a transition tax would be the proposal included in legislation championed by former House Ways and Means Committee Chairman Dave Camp (R-Mich.), the Tax Reform Act of 2014, I decided to revisit that proposal (hereafter referred to as Camp II) to determine what I do and do not like about it. (And maybe I didn't take that proposal seriously enough at that time to appreciate all of its subtleties — but it seems like I need to know them now.)

So let me go through the basics of the Camp II transition tax proposal and then make a few comments. As we all know the proposal calls for a mandatory tax on deferred foreign earnings — not just a tax on optional cash repatriation like old §965. (In fact Camp II uses §965 again for the new provision — no point wasting a good Code section that's available.) The mandatory tax applies to deferred foreign earnings accumulated by controlled foreign corporations and §902 (10/50) companies in tax years ending after December 31, 1986. The taxing mechanism is a one-time subpart F inclusion for the deferred earnings amount. But in order to provide a reduced tax rate for the deemed inclusion, a deduction is allowed. A 75% deduction is allowed with respect to deferred earnings which are represented by cash or other specified liquid assets producing an effective tax rate of 8.75% and a 90% deduction is allowed for remaining deferred foreign earnings producing an effective rate of 3.5%. Any foreign tax credits related to the deductible portion of the deferred earnings inclusion are disallowed but underlying foreign tax credits related to the nondeductible portion of earnings would be available to offset the toll charge. Any existing foreign tax credit carryovers and net operating losses are also available to offset the transition tax, apparently without limitation.

A very positive aspect of Camp II, which had not been in Chairman Camp's previous toll charge proposal, was the offset of deferred foreign earnings deficits (again earned in tax years ending after December 31, 1986) against positive deferred earnings balances, thus reducing the transition tax. The mechanism for doing so is quite complicated. All deficits allocable to the U.S. shareholder in the CFCs or §902 group companies are aggregated and then allocated proportionally to each CFC or §902 corporation of that U.S. shareholder which had positive deferred earnings.

Camp II was released for public comment in February 2014. The earnings and profits measurement date for the toll charge proposal by Camp II was the last day of the last taxable year of each deferred foreign income corporation beginning before January 1, 2015. The total toll charge inclusion would be the aggregate attributable post-1986 E&P net of aggregate attributable deficits. This aggregate net amount would represent the total subpart F inclusion. Note the amount would be unreduced by any dividend distributions during that year — such dividends would essentially be treated as previously taxed income distributions of the subpart F inclusion. If such a quick effective date were chosen for current tax reform and it passed this year, for calendar year companies 2017 would be the E&P measurement and subpart F inclusion year.

There was a deferred payment election available for paying the toll charge. Regular taxpayers could elect to pay in eight installments: 8% of the liability in each of the first five years and 15, 20, and 25% for years 6 through 8. Pretty generous. And Subchapter S shareholders could defer payment indefinitely until there was a triggering event with respect to the S corporation or its shareholder.

So those are the basics. Pretty complicated. Lots of money at stake and a tremendous amount of computational work to do in potentially a very short time. Let's see how close to Camp II the rules turn out to be. Here are some observations on aspects of the proposal, many of which I hope get fixed or clarified before we have a final rule.

  •  Good news that only deferred foreign earnings accumulated in years ending after December 31, 1986, are included in the toll charge. But interestingly the definition of deferred foreign earnings appears as a chronological date, and thus is different from the definition of “post-1986 undistributed earnings” in §902(c), which includes only earnings as of the first taxable year in which the foreign corporation has a §902 shareholder. So unless the definition (which must be unintended) is fixed, there would be a toll charge on E&P earned by acquired non-U.S. corporate targets after 1986 where there was no §338 election made (which based on the complexity and nuances of §901(m) is more common than it used to be). But applying a toll charge to income earned before the CFC was owned can't be an intended result or serious position.
  •  The calculation of the post-1986 deferred earnings or deficit is based on the ownership percentage by the U.S. shareholder as of the last of the CFC's or 10/50 company's transition year, i.e., a snapshot in time. Seems to me the earnings attributable to each share in a §1248-like calculation would be more appropriate and avoid distortions. For example, a U.S. shareholder who owns say 51% of a CFC for years and then increases its ownership to 100% should not pay a toll charge with respect to E&P attributable to the 49% for the period it did not own it. As above, I would submit this can't be intended.
  •  The automatic offset of E&P deficits is quite favorable and would reduce the potential need for companies to try and merge or otherwise reorganize their foreign groups to try and combine profit and loss companies. And it certainly seems “fair.” To simplify, imagine a group that has two CFC's, one of which lost 40 in country 1 and one of which made 100 in country 2. It would seem clear that the “fair” result would be to consider only the net amount of 60 as deferred foreign earnings subject to the toll tax. The press seems quite focused these days on companies paying their “fair” amount of tax so it seems that taxing authorities should also be trying to tax only the “fair” amount. But since this would reduce the revenue raised by the toll charge, and since the toll charge is meant to raise revenue to pay for rate reduction, other reform, infrastructure or other uses, one can't be sure the deal stays “fair.” So if a company has big deficits some interim self-help could be prudent if practical.
  •  Another point on deficits is the impact on the foreign tax credit calculations. In my simple example above, if CFC 2 paid tax at 20% or 20 in country 2, it would seem fair to me that on the net subpart F pickup of 60 that a full 20 of credit be available subject to the scaledown for the dividends received deduction on the toll tax. In essence the full net foreign profit would be included and the full amount of foreign tax incurred would be taken into account. It's not clear that happens under the Camp II proposal.
  •  Under the proposal, allowable deficits of all deferred foreign income corporations are aggregated and then allocated to each deferred foreign income corporation with positive earnings proportionally based on their earnings thereby reducing their subpart F inclusion amounts. Absent this allocation being considered to reduce the post-1986 E&P of each individual foreign corporation, the subpart F inclusion would be less than their full E&P and therefore their deemed paid foreign tax credit amount would be scaled down. In my simple example only 12 of the 20 foreign tax paid might be available for credit (60/100 x 20 tax). And since the deficit is allocated among multiple foreign corporations — perhaps some high-taxed and some low-taxed, the credit scaledown could be difficult to determine.
  •  The deficit offset is still quite favorable overall so hopefully it will be retained. But maybe the foreign tax credit impacts create more reason for self-help to combine deficits with positive E&P subsidiaries where possible. And one needs to consider whether hovering deficits will impact the calculations in some way. I would suggest — and hope — not, because only three people in the world fully understand all of the complex aspects of how hovering deficits are to work. But clarification would be nice, as Camp II is currently silent on this point.
  •  The dual rate structure of Camp II requires definition for cash and cash equivalents which will attract the higher proposed 8.75% tax rate. The proposed definition includes cash, foreign currency, certain marketable securities, net accounts receivable, short-term obligations and any other asset the Treasury Secretary feels is the equivalent of the above. So pretty far-reaching and who knows how wide the definition of accounts receivable and short-term obligations could be. Plus the calculation is done in the aggregate for the foreign corporate group. The aggregate amount is compared with the aggregate subpart F amount to determine the portion of the subpart F inclusion taxed at the higher rate. Not clear how the scaledown of foreign tax credits will work with the two different deduction percentages but seems like this could also be done on an aggregate basis rather than as a proportional calculation by deferred foreign income corporation.
  •   I was hoping that international tax reform would mean the end of our trio of new foreign tax credit anti-avoidance provisions of §909, §960(c) and §901(m), and that they would become obsolete. But perhaps they get to bite one more time in the toll charge calculation. Seems to me there could be some suspended foreign tax credits in the system which should be unsuspended on inclusion of the toll charge — and then scaled down? And of course eligible credits would be impacted by §901(m). Since the toll charge is proposed to be an inclusion under subpart F and the inclusion would be from all deferred foreign income corporations, I don't see any obvious §960(c) implications. But I can imagine its potential application in some unique fact patterns.
  •  The toll charge is presumably the price to pay for a move to a territorial system. (One certainly hopes it's not used as a “pay for” for something else and we continue our non-competitive currently worldwide regime.) So after this likely frenzy of every U.S. multinational (or foreign-owned group with CFCs or §902 companies in the U.S.) needing to do a one-time recalculation of foreign E&P with all the complexities referred to above and more, are we done with foreign E&P forever? Can our E&P team retire? I don't think so!
  •  The new proposed participation exemption system in Camp II (assuming that is the model used) calls for a 95% exemption for qualifying foreign dividends. A distribution which is not a dividend would presumably still be governed by §301(c)(2) and §301(c)(3). Thus we will need to know what E&P is and what tax basis is, and distinguish between dividends and capital. And for non-exempt income in the form of subpart F inclusions there will presumably be a form of foreign tax credit/double tax relief, meaning that deemed paid foreign tax credits likely will not die either. So nobody gets to retire!
  •  Lots of open questions on FTC baskets. Will the subpart F toll charge inclusion be tracked by basket? If so, will the deficit offset also be tracked by basket? What if there is, for example, a passive basket deficit but positive general basket E&P or vice versa? Will the use of credit carryovers be done on a basket-by-basket basis or in the aggregate? My hope is that as a one-time tax-raising provision this will all be kept simple and the whole inclusion in general basket and all FTC carryovers can be available to offset it. Certainly not a technically pure approach but this will all be tough enough so let's just be practical?
  •  How will FTC-related attributes be dealt with? I'm thinking OFL (Overall Foreign Loss), ODC (Overall Domestic Loss) excise tax, AMT (Alternative Minimum Tax) carryovers, among others. Good news is that the proposal states that the inclusion will not be subject to OFL recapture. But I guess, therefore, any OFL balance still remains. But does it? And what effect would it have in a new territorial world? Likewise, any FTC carryovers left after offset against the toll charge inclusion may be of limited value particularly if we have both a territorial regime and border adjustment which exempts export receipts?
  •  Since the toll charge will be in the form of a subpart F pickup, I guess §986 will apply going forward which will create foreign exchange exposure with respect to the Previously Taxed Income amount (assuming the deferred foreign income subsidiary in question had a functional currency in other than the U.S. dollar). Given the fact that the toll charge amount will be for all post 1986 E&P and not just the E&P represented by cash, it could take quite a while before that PTI is remitted up the chain. Given that future earnings should be eligible for a participation exemption in a territorial regime, it doesn't seem like sound policy to have fully taxable forex gains or losses with respect to old earnings. Maybe another area to give more thought to?


So overall one hopes that we get clarification in lots of areas assuming the toll charge does get enacted. Seems that will practically need to happen in the statute or legislative history as it will be awfully hard for the IRS to give guidance on open points quickly enough to help taxpayers since all reporting will likely be required within about one year after the law is enacted.

I complained about the toll charge proposal in Camp I, in part because I didn't see it coming. I know of no other country that extracted a similar entry fee upon converting to territorial. A toll charge at all — even at a reduced rate — on earnings fully redeployed in the foreign business seems like a pure revenue grab and not a principled transition approach. But I am at least thankful for the lower split rate. How about zero for non-cash equivalent E&P?

But it seems to me the revenue targeted from a toll charge is now largely committed or spent so I doubt it will be abandoned. And since it could happen quite quickly companies will need to get prepared. In my experience, permanently reinvested foreign earnings numbers are often a bit “soft.” So lots of effort may be needed to firm them up and start addressing all of the obvious complications. And the IRS will certainly have its hands full in dealing with the complex issues and reviewing the calculations of every multinational company in America!

Thomas S. Bissell, CPA Celebration, Florida David Ernick, Esq.PricewaterhouseCoopers LLPWashington, D.C. Edward Tanenbaum, Esq.Alston & Bird LLPNew York, New York Robert E. Ward, Esq. Ward Chisholm, P.C. Bethesda, Maryland
Kimberly S. Blanchard, Esq.Weil, Gotshal & Manges LLPNew York, New York Gary D. Sprague, Esq. Baker & McKenzie LLPPalo Alto, California James J. Tobin, Esq.Ernst & Young LLPNew York, New York Lowell D. Yoder, Esq.McDermott Will & Emery LLPChicago, Illinois
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