Proposals would reform, limit tax-planning opportunities

June 1, 2009
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In a May 4 news release, President Obama announced, and the United States Treasury Department outlined, a sweeping tax reform proposal that would, if enacted, affect almost all U.S. taxpayers conducting international activities and/or having international investments.

On May 11, the Treasury Department released General Explanations of the Administration's Fiscal Year 2010 Revenue Proposals ("Green Book"), a document that provides a description of the Obama Administration's budget proposals affecting revenues. The May 4 proposals are explained in further detail in the Green Book. A significant portion of the anticipated tax revenue resulting from the reforms (estimated at more than $210 billion between 2011 and 2019) is proposed to provide an offset for any potential revenue losses from making the research credit permanent. The proposal to make the research credit permanent is widely seen as a positive result of an otherwise controversial package of tax proposals.

The international changes may have an impact on U.S. competitiveness with foreign competition, as many foreign jurisdictions have been simplifying rather than complicating their foreign taxation rules. This has been done, in part, to attract international business investment. In fact, many foreign trading partners have reduced their corporate tax rates, changed their taxation of foreign dividend rules and made other changes in recent years.

The recent U.S. proposals have been targeted at closing various planning strategies that many multinational companies have used to improve their cash flow, profits and taxation on a worldwide basis. The current proposals reverse a trend, begun during the Clinton Administration, that allowed U.S. taxpayers some alternatives in how their foreign operations are structured and reduced their overall worldwide effective tax rates.

A change implemented by the Treasury Department during the 1990s was a change in tax regulations that allowed U.S. owners of foreign entities to make an election of how the foreign entity would be treated for U.S. tax-reporting purposes. The entity classification rules, or "check-the-box" regulations, allowed taxpayers to essentially check a box on a tax form to designate whether a foreign entity was to be treated as a corporation or as a flow-through (disregarded entity/hybrid branch or a partnership). This election simplified matters in some respects and allowed more possibilities in worldwide tax planning for U.S. businesses. This allowed the ability in many respects for smaller U.S. businesses (primarily organized as S corporations or as limited liability companies taxed as partnerships in the U.S.) to obtain foreign tax credits and other benefits that larger C corporations received under the Internal Revenue Code with respect to owning and managing international operations.

At the same time it allowed larger multi-national companies to arrange their activities in a more tax-efficient manner and to offer more alternatives in determining how, when and where to decide where to invest and make repatriations or earnings.

What was seen by some as good tax planning was seen by others as moving jobs and profits offshore. In an effort to curb some of the abuses that may be present, the recent proposals attempt to reform and limit some of the opportunities for planning that many U.S. businesses may have used to manage their worldwide taxes and cash flow. A few of the proposals that may impact West Michigan businesses with international activity include:

Reforming the entity classification rules. If a foreign eligible entity is owned by a single owner, it will be treated as disregarded only if that single owner and its foreign eligible entity are both organized in the same foreign country. If a single member foreign eligible entity is created or organized outside its owner's home country, the disregarded entity would instead be treated as a foreign corporation for federal tax purposes. This rule is not intended to affect elections by a first-tier foreign eligible entity, i.e., owned directly by the United States person, unless it was formed for tax avoidance purposes. The change in classification from a disregarded entity to a corporation would be subject to any existing tax provisions that otherwise apply to a corporate conversion transaction. The proposal makes no reference to foreign eligible entities with multiple owners.

Prevention of foreign tax credit abuse. Rather than continue the application of the foreign tax credit limitation separately to foreign-source income in each of the separate categories under section 904(d), the proposal would determine the deemed paid foreign tax credit for a taxable year based on the amount of the consolidated earnings and profits of the foreign subsidiaries repatriated to the U.S. taxpayer in that particular taxable year.

Restrict or defer certain deductions. These changes would apply to deductions (other than research and experimentation expenditures) such as interest expense and other expenses properly allocated and apportioned to foreign-source income to the extent the foreign-source income associated with the expenses is not currently subject to U.S. tax.

Any proposals will require passage by both houses of Congress before they are enacted into law. The legislative process may take significant time as the proposed changes affect many current Internal Revenue Code provisions, and members of Congress may not support the precise proposals made by the Administration.

The proposed reforms did not state any specific changes to or repeal of the controlled foreign corporation rules and some of its anti-deferral provisions including subpart F, which requires current inclusion as taxable income of certain tainted income. However, the proposed changes to the check-the-box rules may create situations where taxpayers may, in fact, be subject to the application of the subpart F rules in 2011 and thereafter. Many taxpayers had previously avoided creating subpart F exposure by affirmatively using check-the-box tax planning in their offshore structures. Transition rules were provided to allow taxpayers to restructure their operations without triggering a number of adverse consequences related to any change in the U.S. tax status of the foreign subsidiaries. Currently, a decision to uncheck the box by taxpayers may trigger significant tax consequences.

The repeal or major reform of the check-the-box rules may have a significant impact on S corporations and partnerships (including limited liability companies classified as partnerships), which are ultimately owned by U.S. individuals and are taxed on the individual owners' income tax returns.

The tracking of deferred deductions in addition to the change in the deemed paid (indirect) foreign tax credit will require additional recordkeeping and tracking by taxpayers to determine their foreign tax credits and limitation amounts available for future taxable years.

The international changes, coupled with some domestic proposals such as the repeal of last-in first-out inventory method of accounting, will provide some interesting challenges for West Michigan businesses trying to compete in the global marketplace.

William F. Roth III is a tax partner with BDO Seidman LLP. The views expressed above are those of the author not necessarily those of BDO Seidman LLP

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