On May 17, 2006, the President signed into law the Tax Increase Prevention and Reconciliation Act of 2005 (the Act). Touted as a $70 billion dollar "tax-cut package", the Act amends the Internal Revenue Code of 1986, as amended (the Code) by, among other things, extending certain temporary tax reductions and also implementing several new substantive provisions. This update provides a summary of some of the most noteworthy provisions of the Act, some of which are noteworthy cross-border developments.
1. Extension of 15% Tax Rates on Capital Gains and Certain Dividends
One of the most prominent aspects of the Act is the two year extension of the 15% tax rate on net capital gains and certain dividends (including dividends from certain non-U.S. entities). The 15% rate, which would have expired at the end of 2008, is extended through 2010.
2.
Controlled Foreign CorporationsExtension of statutory exceptions from Subpart F Income.
Prior to the adoption of the Act, the Code provided that certain types of income were not treated as "Subpart F Income" (the U.S. analogue of Canada’s "foreign accrual property income" or FAPI regime). In particular, assuming certain requirements are satisfied, income earned in the active conduct of an insurance business or of a banking, financing or similar business (so-called "active financing income") was temporarily excluded from Subpart F Income. The Act extends these exclusions for two years.
Effective Date: This provision is effective for taxable years of foreign corporations beginning before January 1, 2009.
Look-Through Treatment of Payments between related controlled foreign corporations.
Under prior law, the U.S. controlled foreign corporation (CFC) rules generally lacked an equivalent to subparagraph 95(2)(a)(ii) of Canada’s Income Tax Act, which deems to be active business income certain payments between foreign affiliates and related non-resident corporations that would otherwise be income from property. The Act contains a new (and temporary) "look-through" rule that operates to exclude from Subpart F Income a range of payments between related parties that, subject to the application of other existing exceptions, would otherwise be treated as "foreign personal holding company income" (which is one class of Subpart F Income). In particular, under the Act, for taxable years beginning after 2005 and before 2009, dividends, interest, rents and royalties received by one CFC from a related CFC are not treated as foreign personal holding company income to the extent attributable or properly allocable to non-Subpart F income of the payor. For purposes of this provision, CFCs are considered to be "related" if one CFC is controlled by the other CFC or if both CFCs are controlled by the same person or persons. For these purposes, "control" is defined as ownership, directly or indirectly, of more than 50% of the CFC’s stock (by vote or value). The Act also directs the U.S. Treasury Department to issue anti-abuse regulations.
Prior to this legislative change, it was possible, in many cases, for U.S. tax planners to achieve a functionally similar result (e.g., to disregard otherwise passive payments between related CFCs) through appropriate check-the-box elections to treat the related entities as disregarded entities for U.S. federal income tax purposes. This check-the-box strategy may, however, have collateral effects that may in some cases be undesirable (including the blending of earnings & profits of various entities). Consequently, the changes implemented by the Act are a significant cross-border development.
Effective Date: This provision is effective for taxable years of foreign corporations beginning December 31, 2005, but before January 1, 2009. Shareholders of any such corporation should consult their U.S. tax advisors regarding the applicability of these rules to them.
3. Earnings Stripping
Currently, under Section 163(j) of the Code, the ability of a U.S. corporation to deduct interest paid to certain related parties is limited (these rules are referred to as the "earnings stripping" rules). In general, the earnings stripping rules apply if
- the paying corporation’s debt-to-equity ratio exceeds 1.5 to 1, and
- the paying corporation’s net interest expense exceeds 50% of its "adjusted taxable income" (which, in general terms, is cash flow before deducting interest).
For purposes of applying the limitations described above, Proposed Treasury Regulations provide that:
- a corporate partner’s proportionate share of partnership liabilities is treated as a direct liability of the partner, and
- a corporate partner’s distributive share of interest income, and of interest expense, is treated as direct interest income or interest expense of such partner.
The Act codifies the rules contained in the Proposed Treasury Regulations, subject to exceptions that may be provided in Treasury Regulations. The Act also provides the Treasury Department with regulatory authority to reallocate shares of partnership debt (or distributive shares of partnership interest income or expense) as may be appropriate to carry out the purposes of this provision.
Significantly, the Act leaves in place the existing earnings stripping ratios, despite numerous proposals to tighten these rules. Given these proposals, there may well be further developments in this area.
Effective Date: This provision is effective for taxable years beginning on or after May 17, 2006.
4. Amendment to FIRPTA Rules
The Act contains several amendments to the Foreign Investment in Real Property Tax Act (or FIRPTA) rules. In general, the FIRPTA rules operate to treat a nonresident alien individual’s or foreign corporation’s gain or loss from the sale of certain U.S. real property assets as income that is effectively connected with a U.S. trade or business and, therefore, subject to U.S. taxation at the income tax rates generally applicable to U.S. persons.
The Act contains provisions that
- generally modify the FIRPTA tax consequences of distributions by a Regulated Investment Company (or RIC) or a Real Estate Investment Trust (or REIT) to foreign interestholders of such RIC or REIT, and
- impose FIRPTA tax consequences on foreign persons that dispose of (and reacquire) interests in a RIC or REIT in proximity to a distribution by such RIC or REIT that would otherwise be subject to the FIRPTA rules.
An in-depth summary of the Act amendments to the FIRPTA rules is beyond the scope of this update. Any person who may be affected by these rules should contact their U.S. tax advisors.
5. Spin-Offs
Active trade or business requirement.
The ability of a corporation (referred to as a "Distributing" corporation) to make a non-liquidating distribution of appreciated stock of a controlled corporation (referred to as a "Controlled" corporation) to shareholders in a tax-free manner is governed by Section 355 of the Code. Section 355 is an exceptionally complex provision which requires the parties to satisfy a number of detailed requirements in order to achieve tax free treatment. The Act contains a temporary provision that would substantially simplify the manner in which one of the most troublesome of these requirements (the "active trade or business" requirement) may be satisfied. In particular, under the Act, the active trade or business test would be applied on an "affiliated group" basis. In many cases, this may obviate the need to engage in complicated and otherwise undesirable restructurings before a spin-off that are intended to satisfy the prior active trade or business test.
Effective Date: this provision applies to distributions after May 17, 2006 and on or before December 31, 2010 (subject to grandfathering rules).
Cash Rich Split-offs.
One spin-off technique that has attracted a significant amount of attention in the U.S. is the so-called "cash-rich" split-off. A cash-rich split off is the generic name for a tax-free distribution, to a single shareholder (in complete or partial redemption of such shareholder’s interest in the Distributing corporation), of a Controlled corporation whose assets are comprised of a relatively small proportion of "active" business assets and a relatively large proportion of cash or other liquid assets. Under current law, there have been reported transactions in which substantially less than 50% of the fair market value of assets of the Controlled corporation consisted of active business assets. Many commentators have taken the view that tax-free treatment under Section 355 should not be available to cash-rich split-offs which essentially facilitate the indirect "cashing-out" of the redeemed shareholder.
In response, the Act includes a measure that would deny Section 355 treatment to certain split-off distributions if either the Distributing or Controlled corporation were a "disqualified investment company" immediately after the distribution. For this purpose, a disqualified investment company means:
- in the case of distributions during the one year period beginning on May 17, 2006, a corporation that has "investment assets" which equal or exceed 75% of the fair market value of the corporation’s total assets, and
- in the case of distributions after the end of the one year period beginning on May 17, 2006, a corporation that has investment assets which equal or exceed 2/3 of the fair market value of the corporation’s total assets.
"Investment assets" are defined to include: cash, any stock or securities in a corporation, any interest in a partnership, any debt instrument, certain derivative contracts, foreign currency or any similar asset. For purposes of determining the relative proportion of investment assets to total assets, certain look-through rules and other exceptions apply.
Effective date: this provision is generally effective for distributions after May 17, 2006.
Authors Credit: William Corcoran is a partner in the Tax Department of the firm’s New York office. Paul Seraganian is an associate in the Tax Department of the firm's New York office.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
