Sao sae Congress of the United States Senisecatewvom Serer stone een Jowr Comrres on TAXATION 1625 LONGWORTH HOUSE OFFICE BUILOING ‘wasiaverox, DC 20818-6453 (202) 225-3621 JUL 2 8 2015 Honorable Bernard Sanders United States Senate SD-332 Washington, D.C. 20510 Dear Senator Sanders: This letter is a partial response to your request of January 7, 2015, as modified by discussions with Steve Wamhoff of your staff. In particular, this letter provides estimates of three components of your request: modifications of the foreign tax eredit rules for dual capacity taxpayers: denial of interest deductions for certain highly indebted taxpayers; and modifications of rules for inverted corporations. Modifications of the foreign tax credit rules for dual eapacity taxpayers Under present law, a taxpayer that is subject to a foreign levy and also receives a specific economic benefit from the foreign country is considered a “dual-capacity taxpayer.” A “specifi economic benefit” is broadly defined as an economic benefit that is not made available on substantially the same terms to substantially all persons who are subject to the income tax that is generally imposed by the foreign country, or, if there is no such generally imposed income tax, an economic benefit that is not made available on substantially the same terms to the population of the country in general. An example of a specific economic benefit includes a concession to extract government-owned petroleum. Other examples of economic benefits include property; a service; a fee or other payment; a right to use, acquire or extract resources, patents, or other property that a foreign country owns or controls (as provided by the regulations); and a reduction or discharge of a contractual obli Treasury regulations addressing payments made by dual-capacity taxpayers were developed in response to the concem that payments which purported to be income taxes imposed on U.S. oil companies by mineral-owning foreign governments were at least partially, in substance, royalties or some other business expense. To the extent that a taxpayer meets the definition of a dual-capacity taxpayer, the taxpayer may not claim a foreign tax credit for the portion of the foreign levy that is paid for the specific economic benefit. Treasury regulations require that a dual-capacity taxpayer, similar to other taxpayers, must establish that the foreign levy meets the requirements of section 901 or section 903, However, the regulations require that a dual-capacity taxpayer use either a facts and circumstances method or a safe harbor metho: establishing the foreign levy is an income tax. Under the facts and circumstances method, a separate levy is creditable to the extent that the taxpayer establishes, based on all the relevant facts and circumstances, the amount of the levyCongress of the United States JOINT COMMITTEE ON TAXATION ‘Washington, BE 20515-6453 Honorable Bernard Sanders Page 2 United States Senate that is not paid as compensation for the specific economic benefit. For purposes of applying the facts and circumstances method, the foreign country need not have a generally imposed income tax. A dual-capacity taxpayer alternatively may choose to apply the safe harbor method on a country-by-country basis to determine whether a levy is a creditable tax. Under the safe harbor method, if the foreign country has a generally imposed income tax, the taxpayer may credit the portion of the levy that application of the generally imposed income tax would yield provided that the levy otherwise constitutes an income tax or an in lieu of tax. The balance of the levy is treated as compensation for the specific economic benefit. If the foreign country does not generally impose an income tax, the portion of the payment that does not exceed the applicable USS. Federal tax rate, applied to net income, is treated as a creditable tax. In general, a foreign tax is treated as generally imposed for this purpose even if it applies only to persons who are not residents or nationals of that country.' ‘Your proposal would allow a taxpayer to treat as a creditable tax the portion of a foreign levy that does not exceed the foreign levy that the taxpayer would pay if it were not a dual- capacity taxpayer. ‘The proposal replaces the current regulatory provisions, including the safe harbor, that apply to determine the amount of a foreign levy paid by a dual-capacity taxpayer that qualifies as a creditable tax. " After the promulgation of the regulations, many dual-capacity taxpayers elected the safe harbor method for determining what portion, if any, of the separate foreign levy they paid would be treated as a creditable income tax. However, in 1999, the Tax Court in Exxon Corp. v. Commissioner determined that the entire amount of the petroleum revenue tax paid by Exxon to the U.K. government did not constitute compensation for a specific economic benefit and would thus qualify as tax for purposes ofthe foreign tax credit. The Court considered that Exxon entered into an arm’s length licensing agreement with the U.K, government to gain access to the North Sea oil fields prior to the enactment ofthe petroleum revenue tax, and determined that Exxon’s right to explore, develop, and exploit petroleum resources was dependent on the licensing agreement and payment of license fees under that agreement and not in exchange for payment of the tax. Subsequent to the decision in Exxon, anecdotal evidence suggests that a significant number of dual-capacity taxpayers revoked their safe harbor elections and adopted the facts and circumstances method to argue for tax treatment forthe entire amount of the qualifying levy.Congress of the United States JOINT COMMITTEE ON TAXATION ‘Washington, BE 20515-6453 Honorable Bernard Sanders Page 3 United States Senate Modifications of rules for inverted corporations U.S. tax treatment of a multinational corporate group depends significantly on whether the parent corporation of the group is domestic or foreign. For purposes of U.S. tax law, a corporation is treated as domestic if it is incorporated under the laws of the United States or of any State." All other corporations (that i, those incorporated under the laws of foreign countries) are treated as foreign.? Thus, place of incorporation determines whether a corporation is treated as domestic or foreign for purposes of U.S. tax law, irrespective of other factors that might be thought to bear on a corporation’s “nationality,” such as the location of the corporation's management activities, employees, business assets, operations, revenue sources, the exchanges on which the corporation’s stock is traded, or the residence of the corporation's sharcholders. Only domestic corporations are subject to U.S. tax on a worldwide basis. Foreign corporations are taxed only on income that has a sufficient connection with the United States. Until enactment of the American Jobs Creation Act of 2004 (AICA™) aU.S. parent corporation could reincorporate in a foreign country, potentially without any exit tax to compensate the United States for the loss of future tax revenue from the departing company. It ‘was not always clear, however, whether the re-incorporations had a significant non-tax purpose or effect, or whether the corporate group had a significant business presence in the new country of incorporation. These transactions were commonly referred to as inversions. Under prior law, inversion transactions could produce a variety of tax benefits, including the removal of a group's foreign operations from U.S. tax jurisdiction and the potential for reduction of U.S. tax on U.S.- source income through, for example, large payments of deductible interest or royalties from a USS. subsidiary to the new foreign parent (subject to certain deduction restrictions such as the section 163(j) earnings stripping rules for some related party interest payments). AJCA included provisions designed to curtail inversion transactions. In particular, AICA section 801 added to the Code the anti-inversion rules of section 7874. These anti-inversion rules deny certain tax benefits of a typical inversion transaction by deeming the new top-tier foreign corporation to be a domestic corporation for all Federal tax purposes, ‘This sanction Sec, 7701(a). * Sec. 77011a\5) Pub. L. No, 108-357, 5 Fora description ofthe possible tax consequences ofa reincorporation transaction before AJC, see Joint Committe on Taxation, Background and Deseription of Present-Law Rules and Proposals Relating 10 Corporate dnversion Transactions (CX-S2-02), June S, 2002, p. 4Congress of the United States JOINT COMMITTEE ON TAXATION ‘Washington, BE 20515-6453 Honorable Bernard Sanders Page 4 United States Senate generally applies to a transaction in which, pursuant to a plan or a series of related transactions: (1) a US. corporation becomes a subsidiary of a foreign-incorporated entity or otherwise transfers substantially all of its properties to such an entity in a transaction completed after March 4, 2003; (2) the former shareholders of the U.S. corporation hold (by reason of the stock they had held in the U.S. corporation) 80 percent or more (by vote or value) of the stock of the foreign-incorporated entity afier the transaction; and (3) the foreign-incorporated entity, considered together with all companies connected to it by a chain of greater than 50 percent ownership (that is, the “expanded affiliated group”), does not have substantial business activities in the entity's country of incorporation, compared to the total worldwide business activities of the expanded affiliated group. Similar rules apply if'a foreign corporation acquires substantially all of the properties constituting a trade or business of a domestic partnership.” ‘Treasury released Notice 2014-52, on September 22, 2014. Among other things, the notice describes regulations that the Treasury Department and IRS intend to issue (1) addressing some taxpayer planning to keep the percentage of the new foreign parent company stock that is held by former owners of the inverted domestic parent company (by reason of owning stock of the domestic parent) below the 80 or 60 percent threshold; (2) restricting the tax-free post- inversion use of untaxed foreign subsidiary earnings to make loans to or stock purchases from certain foreign affiliates; and (3) preventing taxpayers from avoiding U.S. taxation of pre- inversion earnings of foreign subsidiaries by engaging in post-inversion transactions that would end the controlled foreign corporation status of those subsidiaries. ‘Your proposal eliminates the toll charge rules for transactions in which historic shareholders of the expatriated entity own at least 60 percent but less than 80 percent of the stock of the new foreign-ineorporated entity. * AJCA also provides a lesser set of sanctions (the “toll charge rules”) with respect to a transaction that would meet the definition of an inversion transaction described above, except thatthe 80 percent ownership threshold is not met. In such a case, ifat least a 60-percent ownership threshold is met, a second set of rules applies to the inversion. Under these rules, the inversion transaction is respected (that is, the foreign corporation is treated as foreign), but ny applicable corporate-level inversion gain (derined in section 7874(@)(2)) generally may not be off8et by tax: attributes such as net operating losses or foreign tax credits 7 Sec. 7874(a)(2B)().Congress of the United States JOINT COMMITTEE ON TAXATION ‘Washington, DE 20515-6453 Honorable Bemard Sanders Page 5 United States Senate ‘The proposal reduces the historie stock ownership threshold at which the new foreign- \corporated entity is treated for purposes of the Code as # domestic corporation from 80-percent historic ownership to more than 50-percent historic ownership. Consequently, if, in a transaction that otherwise satisties the present law requirements for applicability of the anti-inversion rules, the historic shareholders of the former domestic corporation own more than 50 percent of the stock (by vote or value) of the new foreign- incorporated entity by reason of their ownership of the stock of the former domestic corporation, the new foreign-incorporated entity is considered a domestic corporation for all purposes of the Code: The proposal provides that, if a transaction satisfies requirements for applicability of the anti-inversion rules except for the 50-percent historic ownership test, the new foreign- incorporated entity is treated as a domestic corporation for all purposes of the Code if the expanded affiliated group that includes the new foreign corporation has significant business activities in the United States and the management and control of the expanded affiliated group occurs, directly or indirectly, primarily within the United States, ‘The proposal is effective for taxable years ending after May 8, 2014. For purposes of estimating ‘your proposall, we have assumed that it would be enacted July 1, 2015. In estimating your proposal, we have included a variety of revenue effects: reduced earnings stripping of the U.S. corporation in an inverted corporate structure, increased Subpart F income included in U.S. taxable income, and reduced capital gains to shareholders. Our estimate does not assume that the proposal will eliminate inversion activity on the part of U.S. corporations. Denial of deductions for excess interest expense Under present law, a domestic corporation with a foreign parent may reduce the U.S. tax on the income derived from its U.S. operations through the payment of deductible amounts such as interest, rents, royalties, premiums, and management service fees to the foreign parent or other foreign affiliates that are not subject to U.S. tax on the receipt of such payments. Generating inappropriately large U.S. tax deductions in this manner is known as “earnings stripping.” Although foreign corporations generally are subject to a gross-basis U.S. withholding tax at a flat 30-percent rate on the receipt of such payments if they are from sources within the United States, this tax may be reduced or eliminated under an applicable income tax treaty. The term “earings stripping” applies more broadly to the generation of inappropriately large deductions for interest,Congress of the United States JOINT COMMITTEE ON TAXATION ‘Wiashington, BE 20515-6453 Honorable Benard Sanders Page 6 United States Senate rents, royalties, premiums, management fees, and similar types of payments in the circumstances described above. Present law limits the ability of foreign corporations to reduce the U.S. tax on the income derived from their U.S. operations through earnings stripping transactions. If the payor’ s debt- to-equity ratio exceeds 1.5 to I (a debt-to-equity ratio of 1.5 to 1 or less is considered a “safe harbor”), a deduction for “disqualified interest” paid or accrued by the payor in a taxable year is, generally disallowed to the extent that the payor’s “net interest expense” (ie., the excess of interest paid or accrued over interest income) exceeds 50 percent of its “adjusted taxable income” (generally taxable income computed without regard to deductions for net interest expense, net operating losses, domestic production activities under section 199, depreciation, amortization, and depletion).* Disqualified interest includes interest paid or accrued to (1) related parties when no Federal income tax is imposed with respect to such interes (2) unrelated parties in certain instances in which a related party guarantees the debt (“guaranteed debt”). Interest amounts disallowed under these rules can be carried forward indefinitely and are allowed as a deduction to the extent of excess limitation in a subsequent tax year. In addition, any excess limitation (i., the excess, if any, of 50 percent of the adjusted taxable income of the payor over the payor’s net interest expense) can be carried forward three years. ? or ‘Your proposal restricts the deduction for interest expense for members of applicable financial reporting groups the common parent of which is a foreign corporation, An applicable financial group means, with respect to any corporation, a group of which such corporations is a member and which files a financial statement on the basis of generally accepted accounting principles, international financial reporting standards, or another method specified by the Secretary in regulations. The interest expense deduction for members of an applicable financial reporting group is limited to the greater of (1) the taxpayer's allocable share of the applicable financial reporting group’s net interest expense for the taxable year or (2) 10 percent of the taxpayer's adjusted taxable income for the taxable year, plus any excess limitation carryforwards to the taxable year from any preceding taxable year. The taxpayer's allocable share of the applicable financial reporting group's net interest expense is the amount which bears the same * sec, 163) “Tia tax treaty reduces the rate of tax on interest paid or accrued by the taxpayer, the interest is treated as imerest on which no Federal income tax is imposed to the extent of the same proportion of such interest as the rate cof tax imposed without regard to the treaty, reduced by the rate of tax imposed under the treaty, bears to the rate of tax imposed without regard to the treaty, Sec. 163()XS)B).Congress of the United States JOINT COMMITTEE ON TAXATION ‘Washington, DE 20515-6453 Honorable Bernard Sanders Page 7 United States Senate ratio to such net interest expense as the net earnings of the taxpayer bears to the aggregate net camnings of all members of the applicable financial reporting group. Net earnings are the ccamnings of the taxpayer computed under financial accounting principles without regard 10 any reduction allowable for net interest expense, taxes, or depreciation, amortization, or depletion, Net interest expense is computed under U.S. tax principles on the basis of the applicable financial reporting group’s financial statements. ‘The proposal does not apply to members of financial reporting groups that have an aggregate net interest expense of less than $5,000,000, or any financial service entity. Entities that are exempt from this proposal remain subject to section 163(j). Members of financial reporting groups that are subject to the proposal are exempt from application of section 1634). ‘We estimate that your three proposals would have the following effects on Federal fiscal year revenues. For purposes of estimating your proposals, we have assumed that they would be enacted on October 1, 2015. This estimate is preliminary and subject to change.Congress of the United States Joint COMMITTEE ON TAXATION ‘Washington, DE 20515-6453 Honorable Bernard Sanders Page 8 United States Senate Fiscal Years [Bitions of Doar] tem 20162017 20182019 2020 2021 2022 2023 2024 2025 2016.20 201625 Modication toFTC rule for dual Rp “ME O02 6316 Mositcations toante rules. 17 17 24 2427 33S 39 8k 52a Disallow expense 31 63 66 67 68 69 7173 77S 8S 59 90 98 WS 42 17 BS It M2 1S 64 1133 Details may not add o totals due to rounding U1) Gain oF tess than $50 million [hope that this information is helpful to you, If we can be of further assistance in this matter, please let me know. qe Ale ‘Thomas A. Barthold