Review of Foreign Tax Credit Position Critical Due to Education Act
There are many circumstances where it is beneficial for a multinational corporation to choose the fair market value (FMV) election as allowed under Treasury Reg. 861-9T(h) for the purpose of allocation of interest expense. Often, a company’s interest expense represents one of the single highest deductions that must be apportioned to foreign source gross income. Since the Treasury regulations require the interest to be apportioned based on asset values (fair market value or tax book value), asset valuations have become a key issue for corporate tax departments to address in conjunction with determining their foreign tax credit (FTC).
With the passage of the Education Act in August, many companies may be reviewing their FTC position and may be contemplating repatriation transactions and/or restructuring of their international operations. The Education Act contains a number of provisions which impact FTC including measures which target “splitter” structures. These types of structures alter the treatment of certain asset acquisitions where the tax treatment for U.S. purposes differs from local law and which eliminates the opportunity to “hop-scotch” using the investment in U.S. property rules. There is a window of opportunity between now and year-end prior to the effective date for many of these provisions which may prompt companies to consider restructuring or other planning prior to year-end. This, combined with the potentially significant effect of the new provisions, suggests that theFTC will be an important area of focus for multinationals.
FTC is important because it represents a tax credit, offset dollar for dollar against U.S. corporate tax income. However, the tax law is designed to limit this tax credit imposed on “foreign source income.” The United States imposes tax on worldwide income earned by U.S. residents, both individual and corporate. According to FTC theory, a given item of income should not be subject to “double tax,” that is, tax imposed by both the U.S. and another country. However, the FTC law goes on to provide that FTC is limited to U.S. tax imposed on foreign source taxable income. Foreign source taxable income equals foreign source gross income less deductions associated with this income.
The determination of the deductions “associated” (i.e. allocated and apportioned to the relevant classes of foreign source gross income) with this income is made under Section 861 regulations. All expenses, including interest, that are deducted on a U.S. corporate federal tax return must be examined to see if they are associated with foreign source gross income.
Under Section 861, the allocation of interest expense can be based on either the tax basis or fair market value of the underlying assets. Expert valuation guidance is required to evaluate the potential benefits of the fair market value (FMV) method. Preliminary valuation studies can be conducted to analyze the distribution of FMV between domestic and foreign entities. The purpose of the analysis is to choose the method that allocates the least amount of interest expense to foreign source income. An additional advantage to selecting the FMV method is that less interest expense is allocated to any foreign operations that may be underperforming. This is due to the fact that economic penalties are applied to these assets to reflect their underutilization from an economic standpoint.
FAIR MARKET VALUE METHOD
Consideration of the FMV method is a significant step since once a corporation elects this approach it must continue to use the approach unless it receives permission from the IRS to revert back to the tax book method. Careful documentation is key to application of the FMV method. If the FMV method is properly documented it will be difficult for the IRS to challenge. The FMV approach, as set forth in Section 861, refers to end of the year valuation, but it is implied that this end of the year valuation will be averaged with the beginning of the year valuation, i.e. the results of the preceding year valuation.
The key to deriving an FTC benefit when performing a valuation using the FMV approach is to classify the asset or stock interest under the appropriate class of gross income. For example, overseas assets will presumably be associated to foreign source income and U.S. assets to U.S. income. However, factors such as the location of intangible assets related to overseas operations and the passage of title abroad to goods made in the U.S. can significantly change these assumptions.
Once a decision has been made to apply the fair market value method, a final assessment of the availability of information at foreign units should be completed. If inadequate financial statements, poor fixed asset records or asset ownership issues exist, a plan can be developed to resolve any inadequacies. The focus of this step is to ensure that the valuation of all underlying assets is supported by a strong foundation of information. The data is also needed to update and support the interest allocation on an annual basis.
Under Rev. Proc. 2003-37, the FMV method can be applied retroactively to open years. The use of competent professionals is key to evaluating a company’s options under Section 861. A preliminary analysis can provide management with the tools necessary to choose between the tax basis or FMV method. For more information, contact your Valuation Research representative. VR
