CliftonDouglas LLP

Feature of the Week—International Tax Reform: Foreign Tax Credit “Reform”.

The plea for substantive international tax reform has been heard from Congress, Treasury, MNEs, and commentators across a wide spectrum of fiscal views for many years. The effective tax rate on U.S.-based MNEs is the second highest in the world after Japan, though Japan is in the process of lowering its own rates to a level competitive with other countries.

The Obama Administration and the current Congress, however, seem hell-bent on making the situation ever worse for U.S.-based MNEs, not only ignoring the fiscal realities of the competitive landscape but lambasting MNEs as shirking their fiscal responsibilities to the United States. The President’s words in his most recent revenue message are stunning. The essence of his views is that MNEs are “shirking” their responsibilities and that the Internal Revenue Code is “a broken system, written by well-connected lobbyists on behalf of well-heeled interests and individuals” [ Lowell, Briger & Martin: U.S. International Transfer Pricing ¶  2.02[23] ].

The agenda for a responsible effort to provide competitive equilibrium for U.S.-based MNEs is familiar [ Lowell, Briger & Martin: U.S. International Transfer Pricing ¶  2.02[22] ]. Is there any reason to hope that such an approach will be forthcoming from the present Administration and Congress? No. Rather, it can be anticipated that there will be stream of revenue-raising projects taken off the proverbial “shelf” to pay for the various stimulus packages that the Administration and Congress seem to throw at the wall, hoping that the economic slide somehow reverses course. Much of this effort is voiced in the rhetoric of creating or saving jobs. The likely impact is to simply continue, perhaps even accelerate, MNE investment in other places to try to cope with the disadvantage of the U.S. system.

This negative anticipation is certainly reflected in the international tax provisions (read revenue-raisers) in the Education Jobs and Medicaid Assistance Act of 2010 (H.R. 1586; P.L. 111-226 ), which the President signed into law on August 10, 2010 [BNA Daily Tax Report, August 11, 2010, page GG-1]. The temporary increase in funding for Medicaid and education will be paid for by a series of changes to the foreign tax credit and other international tax provisions relating to U.S.-based MNEs. President Obama described the provisions as “tax loopholes that encourage corporations that ship jobs overseas.”

The revenue raisers include:

(1.) Prohibition of splitting foreign tax credits from the underlying income.

(2.) Restricting the ability to claim deemed paid taxes under Code Sec. 956 relating to distributions of U.S. property where there is no underlying U.S. income inclusion.

(3.) Limitations on certain covered asset acquisitions, such as under Code Sec. 338(g) .

(4.) Separate foreign tax credit treatment for income re-sourced under treaties.

(5.) Restriction of foreign subsidiary redemptions under Section 304.

(6.) Modification of the affiliation rules for purposes of interest expense allocation.

(7.) Repeal of the 80/20 foreign business provision for U.S. withholding purposes.

(8.) Modification of the exception to the three-year period of limitations for failure to provide information about cross-border transactions or foreign assets in Code Sec. 6501(c)(8) , as amended in the Hiring Incentives to Restore Employment (HIRE) Act ( P.L. 111-147 , March 18, 2010) to include a reasonable cause standard. This, at least, rationalizes a draconian provision.

The proposed sourcing of foreign paid guarantee fees as U.S.-source income was not included in the final package.

Needless to say, the Administration and Congress ignored the persistent pleas of U.S.-based MNEs that their competitive posture vs. foreign-based competitors continues to erode. Thus, it is hard to muster any enthusiasm for the prospect of actual reform that will address the serious issues facing these MNEs. At the very least, a reasonable person might anticipate that Congress would realistically handle this situation. If there is a public policy need to raise revenue to deal with the bulging national debt, it might be responsible to address this via appropriate rate increases as a comprehensive international tax reform package is also prepared. Such an approach would require something beyond simple political grandstanding.

“Check-the-box” election relief provided to foreign entities that mistake the number of their owners.

In a Revenue Procedure, IRS has provided relief to foreign entities that make a “check-the-box” election either to be a partnership (under the reasonable but mistaken assumption that it has more than one owner) or to be a disregarded entity (under the reasonable but mistaken assumption that it has only one owner). Rather than treat the entity as an association taxable as a corporation, in the former case, IRS will treat the original election as an election to be a disregarded entity, and in the latter case, IRS will treat the original election as an election to be a partnership. Rev Proc 2010-32, 2010-36 IRB 320

Presidential Advisory Report wades into tax reform debate with shopping list of proposals.

Click here for the text of the President’s Economic Recovery Advisory Board (PERAB) Report on Tax Reform Options: Simplification, Compliance, and Corporate Taxation.

The President’s Economic Recovery Advisory Board (PERAB) has delivered its long-awaited report on tax reform options, carrying a host of reform options for the Administration to consider in drafting tax policy. The Report covers a wide range of reform proposals in areas such as corporate and international taxation, retirement plan simplification, individual taxation, and small business simplification.

RIA observation: PERAB is an outside advisory panel established by the President and is not part of the Administration. The Report, which doesn’t represent Administration policy, may figure in the upcoming Congressional debate over EGTRRA sunsets and extenders.

Corporate tax reform. The PERAB Report contains a number of proposals for reforming the U.S. corporate tax system, which experts have described as “deeply flawed and in need of reform.” These range from reducing the statutory corporate tax rate (with reduction or elimination of preferential tax breaks, such as the Code Sec. 199 domestic production activities deduction) and allowing all businesses to expense all or a portion of new machinery and equipment purchases to limiting the deductibility of net interest (to provide a more level treatment of debt and equity). As a counterweight against the growth of noncorporate business forms (e.g. LLCs, S corporations) offering the legal benefits of limited liability but only one tax on earnings, one proposal would require firms with certain “corporate” characteristics (e.g., firms that are publicly traded, have a large number of shareholders, or meet certain income or asset sizes) to pay the corporate income tax. An alternative is to eliminate double taxation of corporate income and harmonize tax rates on corporate and on-corporate income through integration with the individual income tax.

International tax issues. The PERAB Report suggests that the U.S. consider making fundamental changes to the way it taxes its multinational corporations (MNCs). One option would be to adopt a territorial approach similar to those used by most other developed economies and exempt from U.S. tax the active foreign income earned by foreign subsidiaries or by the direct foreign operations of U.S. companies. (Transition rules might be imposed to limit the potential windfall from eliminating the tax that would have been paid when and if accumulated and deferred profits currently held abroad are repatriated.) Moving to a territorial system would eliminate the incentives of U.S. MNCs to keep income earned from foreign operations abroad rather than repatriating this income to the U.S.

Another option would be to impose a pure worldwide tax system and end deferral (of overseas active income of foreign subs until it is repatriated) as part of a larger corporate tax reform that lowers the U.S. corporate tax rate to a level comparable to the average of other developed countries. Still another approach would be to limit or end deferral in exchange for reducing corporate rates.

Foreign sub’s gross receipts excluded in computing research credit.

A district court has held that a domestic parent company can properly exclude gross receipts from intercompany transactions with foreign group members when computing gross receipts for purposes of calculating the Code Sec. 41 research credit. Thus, the court granted the parent partial summary judgment. Procter and Gamble (DC OH, 6/25/2010, 106 AFTR 2d 2010-5433).

First Circuit affirms Tax Court’s validation of “check-the-box” regs.

Medical Practice Solutions LLC, Carolyn Britton, Sole Member, (CA 1 8/24/2010) 106 AFTR 2d ¶2010-5239

The First Circuit Court of Appeals has affirmed the Tax Court’s rejection of an attempt to remove liens to satisfy unpaid employment taxes by claiming that the “check-the-box” regs were invalid. The taxpayer was the sole member of a limited liability company (LLC), which the “check-the-box” regs treated as a disregarded entity under its default rule. As a result, the taxpayer was responsible for the LLC’s employment taxes.

The Employment Development Department (EDD) has announced these Important Payroll Tax Changes in 2011: starting with the first quarter of 2011, employers will begin reporting their Unemployment Insurance, Employment Training Tax, and State Disability Insurance contributions, along with the Personal Income Tax withholdings, quarterly on new quarterly Contribution Return and Report of Wages (DE 9) instead of annually on the Annual Reconciliation Statement (DE 7). Detailed wage items for each worker will be reported on new quarterly Contribution Return and Report of Wages (Continuation) (DE 9C) instead of the Quarterly Wage and Withholding Report (DE 6). Employers will still use the DE 6 and DE 7 for years prior to 2011. Employers will continue to make deposits using the Payroll Tax Deposit (DE 88ALL) form. (NOTE: This quarterly reporting change will not affect: (1) deposit and return due dates; and (2) Annual Household employers, Disability Insurance Voluntary Plan filers, or Disability Insurance Elective Coverage filers.) Also, beginning in the spring of 2011, EDD will significantly expand its e-Services for Business—employers will be able to conduct more business online with EDD including: viewing account information, filing reports, and paying tax deposits and liabilities. ( Employment Development Department Announcement—Important Payroll Tax Changes in 2011, 08/01/2010 .)

New Q&As explain longer NOL carryback option for businesses under recent law change (Notice 2010-58, 2010-37 IRB.

In a new Notice, IRS uses a question and answer (Q&A) format to address a number of specialized issues that have arisen under the new optional longer net operating loss (NOL) carryback period that was provided by the Worker, Homeownership, and Business Assistance Act of 2009 (WHBAA, P.L. 111-92 ). Under WHBAA, taxpayers can generally elect to carry back an applicable net operating loss (NOL) for a period of 3, 4, or 5 years to offset taxable income in the preceding tax years.

RIA observation: IRS recently revised the Instructions for Form 1139, Corporation Application for Tentative Refund (Rev. August 2010), to explain how businesses can elect the new optional longer (NOL) carryback period provided by WHBAA.

California — Corporate Income Tax — Coming in 2010—Access Your Account.
Beginning in the Fall of 2010, the Franchise Tax Board (FTB) will provide taxpayers, tax professionals, and businesses a new secure method to log in and access e-services on the FTB’s website. This new secure method, Access Your Account, requires a one-time registration. In the registration process users choose their user name and password. Access Your Account replaces the current customer service number (CSN) based system. To view a client’s account, tax professionals should have their client’s permission and will need to provide information from the client’s tax return. When Access Your Account is implemented, taxpayers and tax professionals can view the following account information: estimated tax payments made; other payments made to the FTB; current account balance; wage, withholding; and FTB-issued 1099 information In the initial implementation, these additional e-Services will be provided: taxpayers will be able to update their address online; businesses will be able to make payments online using the FTB’s new Web Pay service for business entities.

Proposed regs on Circular 230 standards for return preparers also modify standards for all practitioners.

IRS has issued proposed regs that would modify the general standards of practice before IRS (i.e., Circular 230) to provide for competency testing, continuing professional education (CPE), and ethical standards for a new class of practitioner called a registered tax return preparer (RTRP). The proposed regs also would modify the professional standards for all practitioners in Reg. § 10.34(a) to generally be consistent with the civil penalty standards in Code Sec. 6694 for tax return preparers.

RIA observation: The proposed regs would affect a vast potential audience. IRS estimates that there are 600,000 to 700,000 tax return preparers who will apply for RTRP status if the proposed rules are adopted.

Revised Form 1139 Instructions explain longer NOL carryback option for businesses.

In recently revised Instructions for Form 1139, Corporation Application for Tentative Refund (Rev. August 2010), IRS has explained how businesses can elect the new optional longer net operating loss (NOL) carryback period that was provided by the Worker, Homeownership, and Business Assistance Act of 2009 (WHBAA, P.L. 111-92 ).

RIA observation: Although the Instructions for Form 1139 are revised August 2010, they indicate that they are nonetheless to be used with the August 2006 revision of Form 1139.

Click here for the text of Instructions for Form 1139, Corporation Application for Tentative Refund (Rev. August 2010).