The IRS and the Department of the Treasury issued notices and regulations during the first half of 2016 impacting US international tax rules. In addition, the completion of the 15 Action Plans under the Organization for Economic Co-operation and Development (OECD) initiative against “Base Erosion and Profit Shifting (BEPS) means that, going forward, international tax planning will be subject to much greater government scrutiny and transparency requirements than it has been to date.
2016 Model Income Tax Treaty
A new US Model Income Tax Convention (the 2016 Model Treaty) was issued by Treasury on February 17, 2016. The 2016 Model Treaty will be the basis for US tax treaties to be negotiated in the future. The Model Treaty denies treaty benefits for income subject to preferential tax regimes, and incorporates some of the OECD’s anti-BEPS principles. It should be noted that several US income tax treaties or protocols are still pending in the Senate, some of which were submitted to the Senate for signature at the beginning of this decade. Ratification of these treaties and protocols has been held up for principally political reasons.
IRS Proposed Section 385 Debt-equity Regulations
On April 4, 2016, Treasury and the IRS issued proposed regulations under Section 385 of the Internal Revenue Code. The principal reason for these proposed regulations is to “reduce the benefits of and limit the number of corporate tax inversions, including by addressing earnings stripping.” However, as one often finds, the scope of the proposed regulations would have an adverse impact outside the inversion context. As drafted, the proposed regulations would have a significant impact on the determination of the character of an interest in a related party corporation, as debt or equity. The proposed regulations would grant the IRS the power to recharacterize certain intercompany debt instruments as stock, unless such debt is in exchange for cash (or other non-stock property) that increases the (non-stock) assets of the debtor. In such cases the debtor would be denied a tax deduction for the interest on the related party debt, and any interest payments would be re-characterized as dividends instead, for all US federal income tax purposes. Naturally, this would result in tax mismatches when the foreign related party continues to report the income as interest income. In addition, if the debt is characterized as a “hybrid instrument,” it likely would run afoul of the OECD anti-BEPS provisions that are aimed specifically at hybrid debt. The proposed regulations would also have a possibly fatal effect on cash pooling arrangements commonly used by most multinational corporations. There has been a great deal of criticism of the proposed regulations by taxpayers and legislators, and it is quite likely that they will be revised heavily before they are released again in temporary or final form. It’s evident that only a legislative fix, that Congress has declined to provide in the past few years, will be truly effective in defeating “tax inversion” transactions.
International Tax Reminders
The media regularly report on different variations of proposed international tax reform legislation. There are two things we can say with relative certainty: first, whatever you read about today isn’t likely to be the version of tax reform that is enacted; and second, it’s highly unlikely that anything material will be enacted before the next Congress is seated in 2017. So rather than speculate about future tax reform, this section is a reminder for our clients who conduct business internationally. In particular:
- Keep in mind your ability to elect the “entity classification” of foreign business entities in order to obtain, or avoid, flow-through tax results. (This “check-the-box” election is available for many foreign limited liability types of entities, other than those that are considered “per se” public corporate entities). Obtaining flow-through status in a foreign entity can have beneficial features, including:
- Flowing through foreign start-up losses into the income of the US parent entity and offsetting the losses against US income;
- Permitting the use of foreign taxes paid in the foreign country as taxes that may be creditable against US taxes imposed on individual taxpayers with foreign-source income;
- Avoiding the application of disadvantageous US anti-deferral tax rules (such as “Subpart F” and Section 956) that apply to “Controlled Foreign Corporations;”
- Simplifying the US tax reporting requirements with respect to the ownership of foreign entities.
However, there is a trade-off between accessing foreign tax credits on the one hand, and the maximum US tax rate on foreign “qualifying dividends” on the other. Dividends from a foreign corporate legal entity that can make “qualifying dividend” payments to a US individual shareholder, directly or through a US pass-through entity, are subject to a maximum federal tax rate of 23.8% (including the Net Investment Income Tax.) If the effective foreign tax rate, including withholding taxes, on the foreign corporation’s income is relatively low, it is often less expensive to the US individual shareholder to access the 23.8% rate than to obtain a foreign tax credit on flow-through foreign source income that would be taxed in the US at up to 39.6% (not including state taxes). Consult your FGMK tax advisor regarding this trade-off before making a foreign check-the-box election.
- Remember that doing business outside the US entails a variety of tax and treasury reporting requirements. In addition to reporting the ownership of foreign entities on Forms 5471 (corporations), 8865 (partnerships) or 8858 (“disregarded entities”), US taxpayers must report contributions to foreign corporations (Form 926), ownership of foreign financial assets (Form 8938), ownership of an interest in a Passive Foreign Investment Company (Form 8621), transactions with foreign trusts, or foreign gifts (Form 3520), and foreign trusts with a US owner (Form 3520-A), among other Forms. Moreover, the US Department of the Treasury requires the reporting of foreign financial accounts on Form FinCEN 114, an on-line form that is due on April 15th (beginning with 2016 tax filings due in 2017). Failure to follow these and other international reporting requirements frequently entails penalties, and prevents the tax audit statute of limitations from running.
- Finally, note that almost all cross-border transactions come with tax pitfalls, tax opportunities and US and/or foreign tax reporting requirements. To the extent that your business or investment profile has expanded to encompass cross-border transactions or cross-border investments, the “old tax rules” may no longer apply. The international tax portion of the Internal Revenue Code acts as an “overlay” on top of the domestic portions, and frequently overrides simpler domestic provisions to cause transactions to be taxable, subject to reporting, or both, when the domestic rules would not. Be sure to consult your FGMK tax advisor, and advise her or him of any international expansion of your business or your investments.
For questions about this article, please contact Fuad Saba at 312.818.4305 or firstname.lastname@example.org
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