Chapter 6
International Provisions
A Tax News & Views Special Report:
Promises Kept: The 1997 Tax Law

• Computer software. Produces a tremendous victory for the software industry by modifying the foreign sales corporation (FSC) rules to include computer software in the definition of export property.
• Foreign tax credit. Provides for additional opportunities to use indirect foreign tax credits through additional tiers but also imposes a holding period requirement.
• Improvements in the controlled foreign corporation rules. Provides additional exemptions from U.S. property and subpart F income for the securities, banking, and finance industries and eliminates the overlap between passive foreign investment companies (PFICs) and controlled foreign corporations (CFCs).
• Income tax treaties. Changes the rules for when foreign owners of hybrid entities can claim treaty reduced rates of withholding tax on U.S. source income.
• International joint ventures. Eliminates the 35% excise tax on transfers of property but includes additional reporting requirements for various international entities.
• Other significant international provisions. Increases the foreign earned income exclusion for individuals and simplifies the ability of foreign mutual funds to avoid being engaged in a U.S. business.

Treatment of Computer Software

Computer software licensed for reproduction abroad will qualify as export property entitled to FSC benefits, ending a long-running dispute with the IRS. Gross receipts received or accrued on any such license, regardless of when issued, will be included in computing the portion of the FSC income that is exempt from federal income tax.

This provision is consistent with efforts by the administration to improve the tax climate for the U.S. software and information technology industry. In November 1996, the IRS issued proposed regulations on the classification of income from software transactions, that were largely responsive to the needs of the U.S. software industry. At the same time, the Treasury Department issued a discussion paper on the tax issues of Global Electronic Commerce. Together with the administration's tax policy document A Framework for Global Electronic Commerce, it urges that the Internet and other forms of electronic commerce not be subjected to new or discriminatory forms of taxation. In addition, the administration has called on its trading partners to eliminate tariff and nontariff barriers on the import of information technology goods and services.

Effective date: This provision applies to gross receipts that are attributable to periods after Dec. 31, 1997.

Changes to the Foreign Tax Credit

Expansion of indirect foreign tax credit: The Act eases restrictions on U.S. corporations claiming the indirect foreign tax credit by extending the application of the credit to foreign income taxes incurred by certain fourth-, fifth-, and sixth-tier foreign subsidiaries if the following requirements are met:

• The foreign subsidiary is a controlled foreign corporation (CFC) and the foreign income taxes were incurred during periods when it was a CFC.
• The foreign subsidiary immediately preceding the CFC in the ownership chain owns directly at least 10% of the voting stock of the CFC.
• The U.S. Corporation claiming the credit owns directly, indirectly, or through attribution at least 10% of the combined voting power of the CFC.
• The U.S. Corporation claiming the credit owns indirectly (without attribution) at least 5% of the voting stock of the CFC.

No indirect credits will be allowed for foreign income taxes incurred in taxable years beginning after the effective date by non-CFCs below the third-tier or CFCs below the sixth tier, even if a subsequent liquidation, reorganization, or a similar planning transaction causes those corporations to meet the requirements of this provision.

Effective date: This provision applies to foreign income taxes paid or accrued during the foreign corporation's taxable year beginning after date of enactment.

Holding period: The Act denies a shareholder a credit for foreign withholding or other taxes paid with respect to dividends if the shareholder fails to hold common stock in the paying foreign subsidiary for a minimum period of 15 full days (45 full days for preferred stock) before or after the ex-dividend date and during which the shareholder is not protected from risk of loss. The shareholder is allowed to deduct any credit disallowed. Exceptions for securities dealers meeting certain conditions are provided. This provision is intended to curtail transactions designed to transfer foreign tax credits from persons unable to benefit from them to persons that can use the credits.

Effective date: This provision applies to dividends paid or accrued more than 30 days after the date of enactment.

Translation of foreign income taxes paid or accrued: Taxpayers accruing liabilities for foreign income taxes for the year must currently translate them into U.S. dollars at the exchange rate prevailing on the last day of that year. When actually paid, those taxes are translated into U.S. dollars using the exchange rate on the date of the payment, and the previously claimed foreign tax credit must be redetermined. The Act, however, requires that accrued foreign taxes (including adjustments thereto, such as refunds) must now be translated into U.S. dollars at the average exchange rate for the accrual year unless the accrued taxes are (1) denominated in inflationary currency, (2) paid before the beginning of such year, or (3) paid more than two years after the close of such year. If one of these exceptions applies, such foreign taxes (including adjustments other than refunds) are translated using the exchange rate on the payment date. Refunds are translated at the exchange rate prevailing on the date such taxes were originally paid.

Also, unless regulations provide otherwise, credits previously claimed must be redetermined if (1) accrued taxes when paid differ from the amounts claimed as credits for reasons other than changes in the exchange rate, (2) accrued taxes are not paid within two years after the close of the tax year to which they relate, or (3) any tax paid is refunded. In case an accrued tax is not paid within two years of accrual, this redetermination results in denying a credit for such tax.

Effective date: The translation rules are effective for foreign taxes paid or accrued in tax years beginning after Dec. 31, 1997, and the redetermination rules are effective for foreign taxes that relate to tax years beginning after Dec. 31, 1997.

No credit for certain sales of foreign subsidiaries: Under IRS rulings, if a foreign-owned U.S. corporation sells a foreign subsidiary to a related foreign corporation, the consideration received by the seller may be recharacterized as a foreign-source dividend and an indirect foreign tax credit may be claimed. The Act, however, denies this credit unless the earnings and profits of the foreign acquiring corporation (1) are attributable to the stock of a U.S. shareholder (either the U.S. seller or a related U.S. person), and (2) were accumulated during periods in which the acquirer was a controlled foreign corporation (CFC) and such U.S. shareholder owned its stock.

Effective date: The provision is generally effective for distributions or acquisitions after June 8, 1997.

Simplify foreign tax credit limitation for individuals: The Act allows individuals with no more than $300 ($600 if married filing jointly) of creditable foreign taxes, and no foreign source income other than passive income, to elect to credit these taxes without regard to the foreign tax credit limitation rules. An electing individual meeting certain documentation requirements would report the foreign tax credit directly on Form 1040 and would no longer be required to file a Form 1116 with his or her individual income tax return.

Effective date: This provision is effective for tax years beginning after Dec. 31, 1997.

The Act also makes the following additional changes affecting the foreign tax credit:

• Expands look-through treatment, for foreign tax credit limitation purposes, by recharacterizing a CFC's gain from the sale or exchange of stock in a second CFC (or former CFC) as a dividend to the extent that the second CFC's earnings and profits were not previously taxed by the United States.
• Permits a U.S. shareholder (one owning 10% or more of a CFC's voting stock) to claim look-through treatment for foreign tax credit limitation purposes on dividends from that CFC paid out of profits earned when the payer was a CFC, but the payee was not a U.S. shareholder.
• Permits all foreign-source dividends paid by non-controlled section 902 companies (i.e., a foreign corporation in which a U.S. shareholder owns at least 10%, but not more than 50%) to be averaged in one foreign tax credit limitation basket. This provision does not apply to passive foreign investment companies. It also provides that look-through treatment will apply to dividends paid by non-controlled section 902 companies, but only for dividends paid out of earnings and profits accumulated by such companies in tax years beginning after Dec. 31, 2002.
• Clarifies that high-taxed passive income is not excluded from the separate foreign tax credit limitation for financial services income.
• Provides that a foreign tax credit carryback that reduces or eliminates a prior year underpayment of tax does not stop interest from accruing on that underpayment until the filing date for the year in which such foreign taxes were paid or accrued. A similar rule is provided if a net operating loss or capital loss carryback triggers a foreign tax credit carryback that affects an underpayment.
• Requires that claims for credit or refund of an overpayment caused by a foreign tax credit carryforward must be filed within ten years of the year in which the taxes carried forward were originally paid or accrued.
• Requires that when calculating the indirect foreign tax credit, a foreign corporation's post-1986 foreign income taxes must be reduced by taxes attributable to dividends distributed in a prior year, even if the dividend recipient did not elect to claim a credit for that prior year.
• Permits taxpayers to use regular foreign source taxable income in computing their AMT foreign tax credit limitation, provided an election is made for the first taxable year beginning after Dec. 31, 1997, for which an AMT foreign tax credit is claimed.
• Provides that the foreign tax credit may not reduce AMT tax liability for any taxpayer by more than 90%, thus repealing a special exception.

Effective date: Unless otherwise noted, the above provisions are effective on or after date of enactment. The provisions relating to the calculation of interest on underpayments reduced by foreign tax credit carrybacks, the 10-year period of limitations for claiming a credit or refund caused by a foreign tax credit carryforward, and the repeal of the special exception to the AMT foreign tax credit limitation, are effective for tax years beginning after date of enactment. The rule permitting the use of regular foreign source taxable income in the computation of the AMT foreign tax credit limitation is effective for tax years beginning after Dec. 31, 1997. The rule which allows the merging of all noncontrolled section 902 companies into one foreign tax credit limitation basket and the look-through treatment rule are effective for tax years beginning after Dec. 31, 2002.

Controlled Foreign Corporation (Subpart F) Changes

Elimination of PFIC/CFC overlap: U.S. shareholders of foreign corporations face several anti-deferral regimes that sometimes overlap. One overlap exists when the foreign corporation qualifies as a controlled foreign corporation (CFC) under the subpart F rules and also meets the definition of a passive foreign investment company (PFIC). When this occurs, a U.S. shareholder owning 10% or more of the CFC's stock is taxed currently on its share of certain income of the CFC under the subpart F rules and is also subject to an interest charge on certain distributions received from the CFC under the PFIC rules. Subject to certain restrictions, the Act eliminates this overlap by removing from the PFIC rules on a prospective basis income otherwise subject to the current income inclusion rules of subpart F. The PFIC rules continue to apply to shareholders owning less than 10% of a CFC that also qualifies as a PFIC. The PFIC rules also continue to apply to income earned outside of the overlap periods.

Effective date: This provision applies to tax years of U.S. persons beginning after Dec. 31, 1997, and tax years of foreign corporations ending with or within such tax years.

Exemption from U.S. property treatment for certain security industry assets: U.S. persons owning 10% or more of a CFC must include in income certain earnings of the CFC to the extent the CFC invests those earnings in particular types of U.S. property such as debt obligations of U.S. persons and stock of U.S. corporations. To help facilitate cross-border transactions by securities and commodity dealers, the Act exempts from the types of U.S. property triggering income inclusion: (1) deposits of collateral or margin on commercial terms in the ordinary course of the business made by a securities or commodities dealer that is a CFC or made with a U.S.-based securities or commodity dealer by a CFC; and (2) obligations of a U.S. person acquired in a repurchase transaction by a securities or commodities dealer that is a CFC. This change permits the above CFC to hold stock of U.S. corporations and debt obligations of U.S. persons as collateral or margin, or as part of a repurchase transaction, without causing its U.S. shareholders to pay tax on the CFC earnings equal to those investments.

Effective date: This provision applies to tax years of foreign corporations beginning after Dec. 31, 1997, and tax years of U.S. shareholders ending with or within such tax years.

One-year exemption from foreign personal holding company income status for certain active financing income of banking, financing, insurance, or similar businesses of CFC: U.S. persons owning 10% or more of a CFC must pay tax currently on certain passive income (subpart F income) earned by the CFC, even though the CFC does not currently distribute the income. Prior to the Tax Reform Act of 1986, subpart F income did not include income such as interest and dividends derived by a CFC from the active conduct of a banking, financing, or similar business, or derived from certain investments by a CFC in the active conduct of an insurance business. The Tax Reform Act of 1986 eliminated this exclusion causing such income to be included in subpart F income. The 1997 Act generally restores for one year the exclusion from subpart F treatment of such income, including financial services income as defined for foreign tax credit purposes. The exemption does not apply to investment income allocable to insuring related party risks or insuring risks outside the CFC's country of organization.

This provision helps CFCs involved in these activities compete with foreign-owned companies whose shareholders do not face current taxation on this type of income.

Effective date: This provision applies to tax years of foreign corporations beginning after Dec. 31, 1997, and before Jan. 1, 1999, and to tax years of U.S. shareholders with or within such tax years of the foreign corporations' end.

With one exception the Act makes other changes that are beneficial to U.S. shareholders of foreign corporations:

• Allows PFIC shareholders, including CFCs, to elect to recognize as ordinary income or loss the gain or loss reflected by marking the PFIC stock to market as of the close of each tax year.
• Provides that to the extent gain from the sale of CFC stock is recharacterized as a dividend to the selling U.S. shareholder, it shall be treated as a distribution reducing the purchasing U.S. shareholder's subpart F income from that CFC.
• Provides that U.S. source effectively connected income (ECI) derived by a CFC does not become subpart F income due to a treaty branch tax exemption or reduction. This provision applies retroactively to tax years beginning after Dec. 31, 1986. U.S. shareholders who included a CFC's U.S. source ECI in income based on a treaty branch tax exemption or reduction should file refund claims for all open years.
• Expands the subpart F and PFIC definition of foreign personal holding company income received by a CFC to include generally income from all types of notional principal contracts and payments in lieu of dividends from security lending transactions (equity swaps). The Act provides an exemption for transactions entered into by a CFC in its business as a regular dealer in property and financial instruments including notional principal contracts, forwards contracts, and options.
• Provides for a basis increase to a lower tier CFC's stock, for its earnings previously taxed as subpart F income, when determining an upper tier CFC's gain on the sale of such stock.
• Clarifies that current earnings and profits are not counted twice when calculating a CFC's earnings invested in U.S. property.
• Modifies current law to require the use of fair market value rather than adjusted tax basis when determining if a publicly-traded CFC is a passive foreign investment company.

Effective date: The mark-to-market election applies to tax years of U.S. persons beginning after December 31, 1997, and tax years of foreign corporations ending with or within such tax years of U.S. persons. The rules expanding the subpart F and PFIC definition of foreign personal holding company income are effective for tax years beginning after the date of enactment. The reduction in the purchasing shareholder's subpart F income applies to dispositions of CFC stock occurring after the date of enactment. The basis adjustment applies to tax years of U.S. shareholders beginning after December 31, 1997, but permits regulations to take into account amounts taxed in prior years.

Payments to Hybrid Entities Under Treaties

The Act makes unavailable reduced treaty withholding tax rates on U.S. source passive income derived by a partnership (or other transparent entity) unless (1) the foreign partner's (or other owner's) pro rata share of that income is treated as income of the partner by the partner's treaty country of residence because that country regards the entity as a pass-through, (2) the treaty specifically addresses the availability of treaty benefits on items of income paid to a partnership, or (3) upon the distribution of such items of income the foreign partner is taxed on such income by the partner's treaty country of residence. For example, U.S. source interest received by a U.S. limited liability company (LLC) owned by Canadian investors will presumably be subject to a 30 percent U.S. withholding tax since Canada currently treats the LLC as a corporation and does not tax the Canadian investors as if they directly received their pro rata share of that interest and effectively exempts that income when distributed.

Also, the Act grants Treasury regulatory authority to deny treaty benefits in addition to reduced withholding tax rates when payments are derived by an entity regarded as transparent for U.S. purposes but not transparent by the partner's treaty country of residence. Thus, Treasury would have the authority, for example, to deny by regulation a treaty exemption for business profits. Also, the Act may provide legislative support to regulations already issued on this subject.

Effective date: This provision is effective on the date of enactment, but any regulations issued by Treasury may have a later effective date.

Provisions Affecting International Joint Ventures

U.S. persons that form international joint ventures are subject to a confusing set of income or excise tax rules when they transfer appreciated property to a foreign entity. A 35 percent excise tax is levied on gain realized on transfers of appreciated property by a U.S. person to: (1) a foreign partnership, trust, or estate, or (2) a less than 80 percent owned foreign corporation as paid-in surplus or as a contribution to capital. All other outbound transfers of appreciated property are subject to income tax rules.

To eliminate some of this confusion, the Act repeals the 35 percent excise tax and a complicated penalty provision enacted last year for failure to report transfers subject to that tax. In their place the Act requires any U.S. person transferring appreciated property to a foreign estate or non-grantor trust to pay income tax currently on the built-in gain in that property. Second, it allows Treasury to determine by regulation whether income tax will be currently imposed on built-in gain realized when a U.S. person (or persons) transfers appreciated property to either a less-than-80-percent owned foreign corporation or to a foreign or U.S. partnership having one or more foreign partners. In the case of transfers to partnerships, the Act generally intends that no tax currently be imposed on such built-in gain if the gain, when realized on a later partnership sale of the property, is not allocated to any foreign partner so as to escape U.S. tax. Third, the Act amends existing law to treat as foreign rather than U.S. source income royalties deemed received when a U.S. person contributes an intangible to an 80 percent to 100 percent owned foreign corporation or otherwise transfers the intangible in a reorganization to a foreign corporation. This change will permit some companies to credit more foreign taxes by increasing the low-taxed foreign source income they are deemed to have received. Treasury also is granted authority to issue regulations applying this deemed royalty rule to U.S. persons that transfer intangibles to foreign partnerships.

Effective date: These changes are effective as of the date of enactment.

The Act makes other changes to penalty and reporting provisions that relate to foreign entities and outbound transfers:

• Creates a new class of foreign partnerships, controlled foreign partnerships (more than 50% owned by U.S. persons), and requires the controlling U.S. partners to comply with reporting requirements that are similar to the existing rules applicable to controlling U.S. shareholders in controlled foreign corporations.
• Extends the reporting requirements that currently apply to corporate reorganizations and other transfers of property to foreign persons, to include contributions of property to foreign partnerships by a U.S. person owning 10% of the foreign partnership or contributing more than $100,000 in a 12-month period. It also increases the penalty for failing to report all of the above transfers from 25% of the unreported gain to 10% of the fair market value of the property. Treasury is authorized to write regulations applying these rules to deemed contributions that arise as a result of transfer pricing adjustments.
• Repeals the requirement that all foreign partnerships with U.S. partners file U.S. income tax returns, even if they did not engage in a U.S. business. Under the Act, foreign partnerships must file U.S. income tax returns only if they have income effectively connected with a U.S. business, or U.S. source income such as royalties, dividends, or interest. A failure to file results in the denial of deductions to the partners.
• Increases the penalty for U.S. multinationals that fail to file information returns (Form 5471) on controlled foreign corporations from $1,000 to $10,000, with a penalty of up to $50,000 for continuing failures.
• Increases the threshold for reporting an ownership change in a foreign partnership to any change involving a 10% interest and an ownership change in a foreign corporation to any acquisition of, or reduction below, a 10% interest in the corporation's total voting stock or value.
• Grants Treasury regulatory authority to define whether a partnership is domestic or foreign, without regard to place of organization.
• Grants Treasury regulatory authority to allow non-grantor trusts that were re-classified from domestic to foreign as a result of changes included in the Small Business Job Protection Act of 1996, to elect to be treated as domestic trusts.
  
  

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