07.12.11

2009 Recovery Act – General Information

All references are to the Internal Revenue Code of 1986 as amended and the regulations thereunder unless otherwise noted.

Inbound Tax Issues

A. Guarantee Fees

There has been a change in the law regarding the sourcing of guarantee fees and their subjectivity to withholding at the source.  A foreign bank pays a guarantee fee to a foreign corporation (FC) for FC's guarantee of debt owed to the bank by FC's U.S. subsidiary. The cost of the guarantee fee is passed on to the U.S. subsidiary as additional interest on the debt. The guarantee fee is treated as U.S. source income because it is treated as paid indirectly by the U.S. subsidiary. Joint Comm Staff, Tech Expln of the Small Business Jobs Act of 2010 (JCX-47-10), 9/16/2010. 

For guarantees issued prior to the effective date of the new legislation (i.e., September 28, 2010), the sourcing of such fee is case law driven.  For example, in Container Corp. v. Comm’r, 107 AFTR 2d-2011-XXXX, decided May 2, 2011 and applying the pre-September 28, 2010 law, the court of appeals upheld the tax court’s analogy that the guarantee fee to was the payment for services and considered the service to be provided outside the U.S.; therefore, it was foreign source income not subject to withholding tax.  New sec. 891(a)(9) is a legislative fix to Container Corp.ⁱ

Although not entirely clear, it would appear that under new Sec. 891(a)(9), the guarantee fee would be deemed interest income subject to withholding under sec. 881(a) at the statutory 30% rate, which may be reduced by a treaty.ⁱⁱ   Even if there is reduced withholding there is still reporting and compliance issues that must be adhered to.  Argy can assist in implementing this law change and preparing the applicable tax reporting forms (e.g., W-8BEN).

B. Protective 1120-F and/or “Treaty Based Returns”

“A foreign corporation shall receive the benefit of the deductions and credits otherwise allowed to it with respect to the income tax, only if it timely files or causes to be filed with the Philadelphia Service Center, in the manner prescribed in subtitle F, a true and accurate return of its taxable income which is effectively connected, or treated as effectively connected, for the taxable year with the conduct of a trade or business in the United States by that corporation.”ⁱⁱⁱ   If a foreign corporation is deemed to have a trade or business in the U.S., that trade or business income is “effectively connected” to the U.S. and the foreign corporation has a permanent establishment in the U.S. (either a domestic law analysis or treaty analysis if there is a treaty) then that foreign corporation MUST file a U.S. tax return.  Should it fail to do so, the above referenced regulation would effectively make the tax a “gross basis” tax using the progressive corporate rates versus a tax based on the net profit allocable to the U.S. activities.  There may also be a branch level tax (which is the equivalent to a distribution of earnings tax as a dividend).  This regulation was previously challenged by a taxpayer as unconstitutional (i.e., arbitrary and capricious) and the tax payer won.  However, the IRS appealed and the court of appeals overturned the lower court; therefore, this regulation is still good law and can be extremely costly if the foreign corporation has a U.S. trade or business, ECI and a permanent establishment.  Please note that this is a three prong test in order for taxation to occur on ECI.  This analysis is also very facts and circumstances based.  Argy can add value to our foreign owned clients by discussing with the potential requirement to file a Form 1120-F.  There are some specific rules regarding the filing deadline for a Form 1120-F depending on the facts and circumstances.

Outbound Tax Issues

A.  Dual Consolidated Losses – Missed Elections and/or Certifications?

A dual consolidated loss is a net operating loss of a domestic corporation incurred in a year when the corporation is a dual resident of the U.S. and one or more other taxing jurisdictions.^iv    The domestic corporation does not have to be a member of a consolidated group.  These rules are equally applicable to a FDE (i.e., a foreign disregarded entity that is a corporation for local tax purposes but disregarded for U.S. tax purposes). These losses, despite being directly attached to a U.S. corporation; cannot be used to offset domestic income without a timely filed election. 

The DCL rules will not apply to a corporation who elects to deduct the loss in the U.S. pursuant to an agreement between the U.S. and a foreign country, whereby the loss can be used to offset income in only one of the taxing jurisdictions.^v  The election is required and must be signed under penalties of perjury by the return due date (including extensions) for the year of the loss;^vi  thereafter, for the next five years an annual certification is required. For example, USP has a wholly-owned entity in Italy and a check-the-box election is filed to treat the Italian subsidiary as a FDE.  If the Italian subsidiary generates a loss that flows into the U.S., consideration of the DCL election must be made and if applicable, timely filed with USP’s tax return. 

The following items are needed under the election:
  

1. A signed statement that the document is submitted under Treas. Reg. § 1.1503-2(g).
2. The name, address, indentifying number, and place of incorporation of the dual resident country, and the country or countries that tax the DLC.
3. An agreement by the group/owner/corporation to comply with all of the provisions of Treas. Reg.  § 1.1503-2(g)(2)(iii).
4. The amount of the DLC covered by the agreement.
5. A certification that no portion of the DLCs expenses, deductions, or losses have ever been used to offset income of any other person under the tax laws of a foreign country.
6. A certification that arrangements have been made to ensure that none of the DLC will ever be used to offset income or another person under the tax laws of a foreign country.

Haven’t been filing your election?  Retroactive relief may be available depending on the facts and circumstances.  The ability to deduct the DCL requires an affirmative act by the taxpayer (i.e., filing the agreement and annual certification).  This is not a situation where the election is made by simply deducting the loss in the taxpayer’s U.S. tax return.

It is important to note that under the regulations of this section, possessions of the U.S. are considered foreign countries.^vii    Also note that recapture of a DCL is required under certain circumstances, to prevent abuse.^viii   Finally, as a side note, there may be foreign exchange gains or losses that need to recognized under sec. 987 if there is a FDE making a remittance back to the U.S.

B.  IC- DISC – Permanent Tax Savings for Our Clients

You may be familiar with the FSC, ETI regime and the successor to those export incentives, the DPD under sec. 199.  Although the World Trade Organization was successful in attacking the FSC and ETI regime and causing Congress to change those rules, the IC-DISC is still a viable export incentive.

An IC-DISC can yield the following benefits:

1. A  permanent tax benefit to C Corporations on 50-100% of export profits
2. Allow for substantial income to flow into an IRA or qualified plan at tax rates as low as 15%. (See Swanson v. Commissioner, 106 T.C. 76 (1996)); and
3. No income tax is paid by tax to a DISC and, under recently enacted legislation, the DISC dividend to individuals may be taxed at no more than 15%.^ix

Additional benefits include the ability of the IC-DISC to be a lender to the exporting company whereby the exporting company is charged interest and the IC-DISC earns interest income that is treated as a deemed dividend IC-DISC shareholders.

Export property is property:

1. Manufactured, produced, grown or extracted in the United States by a person other than a DISC;
2. Held primarily for sale or lease in the ordinary course of business to any person for direct use, consumption or disposition outside the United States; and
3. Not more than 50 percent of the fair market value of which is attributable to articles imported into the United States.^x

In addition, certain engineering and architectural services will qualify.  The below reflects the potential benefits of using an IC-DISC:

The following example is taken from the regulations reflecting the daily operations of an IC-DISC:

P Corporation forms S Corporation as a wholly-owned subsidiary. S qualifies as a DISC for its taxable year. S has no employees on its payroll. S is granted a franchise with respect to specified exports of P. P will sell such exports to S for resale by S. Such exports are of a type which produce qualified export receipts as defined in paragraph (b) of this section. P's sales force will solicit orders in the name of S using S's order forms. S places orders with P only when S itself has received orders. No inventory is maintained by S. P makes shipments directly to customers of S. Employees of P will act for S and billings and collections will be handled by P in the name of S. Under these facts, the income derived by S for such taxable year from the purchase and resale of the specified export is treated for Federal income tax purposes as the income of S, and the amount of income allocable to S will be determined under section 994 of the Code.^xi

To summarize, an IC-DISC can provide up to a 20 percent permanent tax savings for qualifying U.S. exports.  It is a “paper” entity that is not required to have substance.  It is merely a conduit for exports.

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i. “Although this provision overturns the opinion in Container Corp. v. Commissioner, supra, no inference is intended with respect to the source of income received for the provision of a guarantee issued before the date of enactment. The Secretary may provide rules for determining the source of other types of payments that are not within the scope of this provision.”  COMREP ¶ 8611.0017 Source rules for income on guarantees. (Small Business Lending Fund Act of 2010, , PL 111-240, 9/27/2010)

ii. A technical correction would be helpful to clarify the appropriate treatment of the guarantee fee for sourcing and withholding tax purposes.  In Container Corp, the IRS was arguing that the guarantee fee was analogous to interest income; therefore, it would seem reasonable to treat the guarantee fee in that manner.

iii. Treas. Reg. § 1.882-4(a)(2)

iv. Treas. Reg. §1.1503-2(c)(1)

v. Treas. Reg. §1.1503-2(g)(2)

vi. The regulation refers to the “year of the loss” not “losses;” therefore, each year there is a loss, the election must be considered.

vii. Treas. Reg. §1.1503-2(c)(7)

viii. The Code provides for recapture of losses under a number of provisions including the DCL rules, where there is a branch termination.

ix. Tax Strategies for Exporters,¶901,Overview—DISC: Strategic Alternative to Closely-held Companies

x. Sec. 993(a)

xi. Treas. Reg. § 1.993-1(l)(3)

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