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Foreign Taxation Highlights of the Tax Reform Act of 1986

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Foreign Taxation Highlights of the Tax Reform Act of 1986 RAYMOND TURNER* Foreign Taxation Highlights of the Tax Reform Act of 1986 Although overshadowed in the media by the sweeping domestic tax revisions in the Tax Reform Act of 1986,1 the foreign tax provisions in title XII of the Act also make highly significant changes in the Internal Revenue Code 2 and, together with the Congressional Committee Reports, comprise about one-fifth of the Act and its legislative history.3 Moreover, some of the same policy considerations prompted both the domestic and the foreign provisions. For instance, tax neutrality, that much ballyhooed domestic tax policy goal, is equally evident in certain foreign tax provi- sions such as the new branch profits tax, 4 which tends to make more tax- neutral the decision of a foreign corporation to operate in the U.S. either through a U.S. subsidiary or a branch. By contrast, the tightening up of the U.S. foreign tax credit, 5 combined with the significantly reduced do- mestic tax rates,6 will provide many U.S. companies having foreign op- *Partner, Moore & Peterson, Dallas, Texas. The author wishes to express his gratitude for the assistance and advice given by Jay M. Vogelson in the preparation of this article. 1. Pub. L. No. 99-514, 100 Stat. 2085 [hereinafter the Act]. 2. The Act renames the Internal Revenue Code of 1954, together with all amendments to it, including those made by the Act, as the Internal Revenue Code of 1986 [hereinafter the Code]. Act § 2. The Internal Revenue Code of 1954, as it existed just prior to the enactment of the Act, will be referred to as the Prior Code. 3. The committee reports accompanying the Act are the reports of the House Committee on Ways and Means. H.R. REP. No. 426, 99th Cong., 2d Sess. (1986) [hereinafter House Report]; the Senate Committee on Finance, S. REP. No. 313, 99th Cong., 2d Sess. (1986) [hereinafter Senate Report]; and the Committee of Conference, CONF. REP. No. 841, 99th Cong., 2d Sess. (1986) [hereinafter Conference Report]. 4. See infra notes 106-22. 5. See infra notes 7-27. 6. After the 1987 phase-in period, the top individual rate will be 28 percent (compared with 50 percent in 1986), and the top corporate rate will be 34 percent (compared with 46 percent in 1986). Act §§ 101 & 601. 487 488 THE INTERNATIONAL LAWYER erations with a tax motive for rearranging their businesses in order to decrease their foreign source income and increase their U.S. source income. This article will survey, with some background discussion, the more significant provisions of the Act and the legislative history relating to the U.S. taxation of international transactions and operations. The main sec- tion headings used below correspond generally to the subtitle headings of title XII of the Act. While the majority of these provisions are effective beginning after December 31, 1986, many of the new rules contain different effective dates and detailed transition rules largely beyond the scope of this article. I. Foreign Tax Credit Modifications A. NEW SEPARATE LIMITATIONS Because the U.S. taxes the worldwide income of U.S. citizens or res- idents, 7 a U.S. citizen or resident may be taxed by both the U.S. and a foreign country on foreign source income arising in the foreign country. The foreign tax credit alleviates this tax burden by effecting a subtraction from U.S. tax of an amount attributable to the foreign tax paid or accrued on foreign source income. 8 The amount of foreign taxes, however, that may be credited is limited to an amount equal, in effect, to the U.S. tax on the taxpayer's foreign source income. 9 Expressed as a formula, the overall foreign tax credit limitation amount equals the following product: foreign source taxable income worldwide taxable income The foreign tax credit is allowed with respect to foreign taxes paid directly by the taxpayer. Moreover, a "deemed-paid" credit is allowed a domestic corporation with respect to dividends it receives from a foreign corpo- ration that pays foreign taxes and that is at least ten percent owned by the domestic corporation. 10 Such domestic corporations are deemed to have paid a ratable share of the foreign taxes paid by the foreign corpo- ration and first and second tier foreign subsidiaries of the foreign corporation. 7. Treas. Reg. § 1.871-1(a) (as amended in 1980). 8. See Code §§ 901-908. The foreign tax credit must be elected by the taxpayer. If the election is not made, foreign taxes paid or accrued may be deducted. Id. §§ 901(a), 275, & 164(a). 9. Id. § 904(a). To the extent that foreign taxes paid or accrued in a particular year exceed the limitation they may be carried back to the second preceding year and first preceding year and then carried forward to the first through fifth succeeding years. 10. Id. § 902. VOL. 21, NO. 2 FOREIGN TAXATION HIGHLIGHTS-TAX REFORM ACT 1986 489 In addition to the overall foreign tax credit limitation, Congress has created certain separate limitations with respect to certain types of foreign source income that can give rise to abuse of the foreign tax credit. Ac- cording to the House Report, separate limitations have been applied for one of three reasons: the income's source (foreign or U.S.) can be ma- nipulated; the income typically bears little or no foreign tax; or the income often bears a rate of foreign tax that is abnormally high or in excess of rates on other types of income. 11 Accordingly, a foreign tax credit limi- tation is calculated separately, for example, for passive interest income and certain dividends from domestic international sales corporations and foreign sales corporations. 12 The new law creates more such separate categories (sometimes called "baskets") of income that are subject to a separate limitation calculation. In general, these new separate limitation categories are as follows: (1) passive income; (2) financial services income; (4) highly taxed interest income; and (5) (3) certain shipping income; 13 certain dividends from noncontrolled foreign corporations. The new passive income basket replaces the old separate limitation for interest, an- passive interest income and includes, generally, dividends, 1 4 nuities, rents, royalties, and gains from the sales of noninventory assets. Passive income does not, however, include certain foreign oil and gas extraction income, interest derived from financing certain export sales and highly taxed passive income on which the (except financial interest), 1 5 effective foreign tax rate exceeds the highest U.S. rates for such income. Financial services income generally means the nonpassive investment income earned in an active banking or financing business and certain investment income earned by an insurance company. 16 The shipping in- come category includes any income of a kind that would be foreign base company shipping income, which generally means income from the use, or from hiring, or leasing of any vessel or aircraft in foreign commerce 7 the performance of services directly related to such use, hiring, or leasing. ' The high withholding tax interest category encompasses interest income subject to a foreign withholding tax of at least five percent. 18 This category does not include export financing interest; and, if interest qualifies as high 11. H.R. REP. at 331. 12. Prior Code § 904(d). 13. Act § 1201 (amending Code § 904(d)). If a U.S. taxpayer incurs a foreign loss in one of the separate limitation categories, it must be applied to reduce proportionately the income in the other separate limitation categories before being applied to reduce U.S. income. Act § 1203(a) (adding paragraph (5) to Code § 904(f)). 14. Code § 904(d)(2)(A)(i) & (ii). 15. Id. § 904(d)(2)(A)(iii). 16. Id. § 904(d)(2)(C). 17. Id. § 904(d)(2)(D) & 954(f). 18. Id. § 904(d)(2)(B). SPRING 1987 490 THE INTERNATIONAL LAWYER withholding tax interest, it is not included in the passive income basket. The Secretary is to prescribe regulations providing that amounts not oth- erwise qualifying as high withholding tax interest are to be treated as such in order to prevent tax avoidance.19 Lastly, the fifth new item of income subject to a separate limitation computation is dividends paid by noncontrolled foreign corporations to domestic corporations owning at least ten percent of the voting stock of the payor foreign corporation.20 Such domestic corporations are deemed to have paid a proportion of any income taxes paid or deemed to have foreign corporation and are, accordingly, entitled been paid by the payor 2 to the deemed-paid foreign tax credit. ' B. OTHER FOREIGN TAX CREDIT CHANGES An amendment of the rules for computing the deemed-paid credit pro- vides that dividends paid by a foreign corporation to a ten percent or more domestic corporate shareholder are considered as paid first out of earnings and profits accumulated by the foreign corporation after Decem- ber 31, 1986, rather than, as under prior law, from all undistributed ac- cumulated earnings and profits on the books in the year the dividend is paid. 22 Furthermore, for purposes of computing the foreign tax credit of a ten percent or more U.S. corporate shareholder of a controlled foreign corporation, new "look-through" rules are provided. Under these rules dividends, interest, rents, and royalties received by the domestic cor- poration from the controlled foreign corporation, as well as subpart F income of the controlled foreign corporation that is included in the income of the domestic corporation, is allocated to one or more of the five new the extent the income of the controlled separate limitation categories to 23 foreign corporation is itself attributable to one or more of these categories.
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