By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
While we wait for attention in Washington to turn to comprehensive U.S. tax reform, taxpayers are going to have to get used to loophole closing and revenue generation as the catch words in tax policy. With the U.S. government struggling to deal with an exploding deficit and the resulting federal debt burden (which recently crossed the $13 trillion threshold), tax "loopholes" are squarely in the crosshairs.
But maybe it's not really about the revenue to be raised – at least not directly. At a recent IFA meeting, economist Martin Sullivan gave a dose of inside-the-beltway reality: "Loophole closing is never going to bring in enough money – it's all for show," said Sullivan. "But there ain't no way in hell there's going to be a broad-based tax increase or a significant cut in Social Security before we try to close every one of these loopholes." The international arena "is the first and most likely place to look for politically necessary loophole closers." (See "Multinational Corporations `Offended' by White House Intangibles Proposals," 2010 TNT 118-3.)
I guess I understand the politics, but I'm a little confused about what's considered a tax "loophole" or an abuse of the tax code. Given what's been tagged with the loophole label lately, I suspect there is many a practitioner out there who has exploited a "loophole" without ever realizing it. According to my dictionary (Merriam-Webster's), the word "loophole" is defined as "an ambiguity or omission in the text through which the intent of a statute, contract, or obligation
may be evaded." Could it be that those who have been using the word "loophole" so liberally have a different dictionary?
I would argue we've moved way down the continuum to a new and dangerous tax paradigm. In this new world, anytime there is an interpretation of an existing statute that could result in a lower U.S. tax liability than a different interpretation of that statute, the application of the statute resulting in a lower U.S. tax liability must be a loophole in need of correction. A corollary to this is that any potential for an unfavorable tax answer – through double taxation or otherwise – must be within the intended scope of the statute.
The latest installment in this new tax world order came on August 10, 2010, when President Obama signed into law, the "Education Jobs and Medicaid Assistance Act of 2010." This Act is paid for in part by numerous international tax changes. I'm going to focus on just one of these changes, a so-called foreign tax credit loophole closer: a new limitation on the use of §956 foreign tax credit planning by modifying what is referred to as the "hopscotch" rule. (As an aside, perhaps we in the tax community should learn a lesson about minding our language: it seems to be the case that the catchier the nickname for a tax provision, the more likely it will come under attack.)
The legislation creates new §960(c), adding a new limitation on the amount of foreign taxes deemed paid with respect to §956 inclusions. The limitation applies if there is included in the gross income of a domestic corporation under §951(a)(1)(B) (a §956 inclusion) any amount attributable to the earnings and profits of a foreign corporation that is a member of a qualified group (as defined in §902(b)) with respect to the domestic corporation. So the provision applies whenever a lower-tier controlled foreign corporation (CFC) makes an investment in U.S. property (such as through a loan to its U.S. parent) which triggers an immediate income inclusion to the U.S. parent under the anti-abuse rule of §956.
A §956 inclusion is treated like a distribution by the CFC directly to the U.S. parent; the U.S. parent's income inclusion is based on the E&P of the CFC and the U.S. parent is treated for foreign tax credit purposes as having paid the foreign taxes of the CFC with respect to that E&P. If the CFC is a lower-tier subsidiary, this direct link between the attributes of that CFC and the U.S. parent's income inclusion, without regard to any intervening upper-tier CFCs, is referred to as the hopscotch rule.
The provision partially repeals the hopscotch rule for purposes of measuring the foreign taxes to be taken into account by the U.S. parent in connection with a §956 inclusion. Under the provision, the amount of the foreign income taxes deemed paid by the U.S. parent by reason of a §956 inclusion, with respect to a lower-tier CFC, would not be allowed to exceed the amount of the foreign income taxes which would have been deemed to have been paid by such U.S. parent if cash equal to the amount of the §956 inclusion had instead been distributed up through the chain of CFCs beginning with the foreign corporation making the §956 investment and ending with such parent. Therefore, any time the foreign tax pool rate for the entity with a §956 investment exceeds the foreign tax pool rate for the intervening entities, this provision has the effect of reducing the amount of foreign taxes that can be taken into account with respect to the U.S. parent's income inclusion. The provision only applies in one direction (i.e., when the effect would be to lower the amount of foreign tax credits that can be claimed by the U.S. parent with respect to a §956 inclusion) apparently because getting more credits is a loophole.
Going back to Webster's definition of a loophole, it's hard for me to see how the hopscotch rule falls into the category of something which has ambiguity or omission. It's been a part of the statutory framework of §956 for about 50 years. It is clearly contemplated in the 1962 legislative history of §956. The Conference Committee Report to the 1962 Act states: "Where a domestic corporation has at least a 10% interest in a foreign corporation which in turn has at least a 50% voting stock interest in a subsidiary, then a foreign tax credit will be allowed the U.S. shareholder with respect to the earnings of this subsidiary when undistributed earnings of the subsidiary are taxed to the U.S. corporate shareholder." It has been the subject of numerous IRS rulings over the years. And there is a specific anti-avoidance rule in the regulations under §956 that is there to prevent circumvention of the hopscotch rule.
Let's consider the anti-avoidance rule of Regs. §1.956-1T(b)(4). This rule gives the IRS the discretion to apply a conduit-type analysis to an investment in U.S. property that is made by one CFC but that is funded by debt or equity from another CFC for the purpose of avoiding having a §956 investment by the funding CFC. Thus, if a low-tax upper-tier CFC made funds available by equity or debt to a lower-tier CFC in order to produce a §956 investment by the lower-tier CFC that will carry with it more foreign tax credits, the involvement of the lower-tier CFC could be ignored and the §956 inclusion could be treated as coming from the upper-tier CFC with a correspondingly lower amount of foreign tax credits. Therefore, in order for the hopscotch rule to apply in the first place, a lower-tier CFC would typically need to fund its investment in U.S. property with cash generated from its own activities; accordingly, the U.S. parent should be unambiguously entitled to foreign tax credits from that lower-tier CFC and its earnings.
So it's clear that I don't buy into this new provision from a policy standpoint. But let's nonetheless play along and analyze how it may work in practice. Take a simple situation where USP owns CFC1, which has 100 of E&P and no foreign taxes in its pool. CFC1 owns 100% of CFC2, which has 100 of E&P and 50 of foreign taxes in its pool. CFC2 loans 100 to USP. In this case, under pre-§960(c) law, USP would be entitled to a 50 foreign tax credit based on CFC2's pool. Under the new provision, USP's foreign tax credit would be limited to 25, which would be the result if CFC2's income were dividended first to CFC1 and then on to USP. The remaining 25 of foreign taxes that would not be allowed as a current foreign tax credit would remain in the foreign tax pool of CFC2. More later about what would happen to those foreign taxes.
Of course, it can get lots worse than this. Assume CFC1 has an E&P deficit of 100. In that case no foreign tax credits would be allowed on the §956 inclusion with respect to CFC2 because, in the case of a hypothetical dividend up the chain, the theoretical distribution from CFC1 to USP would be a so-called nimble dividend but the §902 denominator would not be positive, so no foreign tax credit would be available.
The Joint Committee on Taxation's Technical Explanation takes the bad news to one more level. Assuming instead that CFC1 had previously taxed income (PTI) of 100, then again no foreign tax credit would be allowed for the CFC2 §956 inclusion because the theoretical distribution from CFC1 to USP would constitute a non-taxable distribution of PTI. So if I am understanding the JCT's footnote example correctly, let me review the results. Under pre-§960(c) law, a §956 inclusion from CFC2 would trigger a 100 income inclusion carrying foreign tax credits at a 33% effective rate (100 of E&P after tax which has suffered a tax of 50) resulting in 2% residual U.S. tax. An actual dividend up the chain to CFC1 and on to USP would be tax-free because it would be treated as coming first from CFC1's PTI; because such an actual distribution would be tax-free, it wouldn't carry with it any foreign tax credits. Under the new law, the §956 inclusion from CFC2 is fully taxable but no foreign tax credits are allowed because a hypothetical distribution through CFC1 would be tax-free. So to recap: In this example, if an actual dividend were paid up the chain, no residual U.S. tax would result. Under prior law, a §956 inclusion would result in residual U.S. tax of 2% in addition to the foreign tax of 33% paid on the same earnings. Under the new legislation, the residual U.S. tax would be 35%, which would be in addition to the foreign tax of 33% paid on the same earnings. If that seems unfair, just remember this is an abusive situation. Still doesn't seem fair, does it? Hopefully, I am missing something and this is not what the Technical Explanation intends in the case of PTI.
One might say stop whining and just make sure to avoid this situation by always paying a dividend up the chain in PTI situations such as this. But consider a real world situation where both CFC1 and CFC2 are guarantors on USP debt. This would result in full §956 inclusions from each of CFC1 and CFC2. Based on the above example, the effect of the legislation could be that USP potentially would have a total income inclusion of 200 with no foreign tax credit.
After being subject to an income inclusion without the benefit of the full foreign tax credits associated with that income, how does one ever get access to those "deferred" credits from CFC2? The statutory framework is that the credits stay in the foreign tax credit pool of CFC2 and are available when future earnings are distributed. But the potential to access the credits in the future would be delayed until after the PTI associated with the §956 inclusion is fully remitted. And in principle it would seem that this PTI would need to fully clear the system all the way up to USP before the deferred foreign tax credits could be associated with a new taxable dividend distribution. Further, it seems to me that this potentially long deferral of the foreign tax credits could become a permanent disallowance of the credits in some cases. Two examples that come to mind immediately are where CFC2 has losses in the future and where the §956 inclusion was from pre-1987 E&P which obviously will never be replenished by future earnings.
So what will be the practical effect of the provision? First, it adds even more complexity to international tax rules that are already more than sufficiently complex. And it's worth noting that the same "loophole-closing" act also includes another provision that temporarily "suspends" foreign tax credits using a different construct as well as a third provision that permanently denies foreign tax credits. That's a lot of different computation mechanics to keep track of at the same time for the same purpose.
Second, it is clear that §956 becomes even more of a penalty provision, one to be avoided at all cost. This would result in less repatriation to the United States. Despite the implicit assumption underlying this provision, the reality is that §956 is often an important mechanism for the repatriation of cash to the United States. This is the case when the U.S. group seeks to avoid or defer foreign withholding tax and other foreign income taxes that would apply to a dividend up the chain. This is also the case where cash cannot legally be paid as a dividend due to local law requirements, such as the need to have distributable reserves.
Third, this provision clearly is another step in the further un-leveling of the playing field from a competitiveness standpoint. It should increase the drum beat for fundamental reform of the U.S. international tax regime and the adoption of a territorial system like that of almost all of our trading partners.
Overall, this provision strikes me as a not particularly well-thought-out grab for revenue that in no way should be classified as a loophole closer. To me, it's more in the nature of a game that's fixed in favor of the government: a heads I win/tails you lose approach by the government that will often result in true economic double tax to U.S.-based companies and that will further erode the integrity of our international tax system from an overall policy standpoint. And as is often the case for playground bullies, the government may find that a victory here is not that sweet.
This commentary also will appear in the September 2010 issue of BNA's Tax Management International Journal . For more information, in BNA's Tax Management Portfolios, see Madole, 929 T.M., Controlled Foreign Corporations - Section 956 , and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
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