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Prior to 2018, widely-used tax plans of U.S.-based multinational
groups were designed to achieve three basic goals in connection
with European operations: (i) the reduction of European taxes as
European profits were generated, (ii) the integration of European
tax plans with U.S. tax concepts to prevent Subpart F from applying
to intercompany transactions in Europe, and (iii) the reduction of
withholding taxes and U.S. tax under Subpart F as profits were
distributed through a chain of European companies and then to the
global parent in the U.S.
Reduction of Taxes in Europe
The first goal – the reduction of European taxation on
operating profits – often entailed the deconstruction of a
business into various affiliated companies, which can be
illustrated as follows:
- Group equity for European operations was placed in a holding
company that served as an entrepôt to Europe. - Tangible operating assets related to manufacturing or sales
were owned by a second company or companies where the facilities or
markets were located. - Financing was provided by a third company where rulings or
legislation were favorable. - Intangible property was owned by a fourth company qualifying as
an innovation box compan
If the roadmap was carefully followed, European taxes on
operations could be driven down in ways that did not result in
immediate U.S. taxation under Subpart F. A simplified version of
the plan that was widely used by U.S.-based multinational groups
involved the following steps:
- Form an Irish controlled foreign corporation
(“TOPCO”) that is managed and controlled in
Bermuda. - Have TOPCO enter into a qualified cost sharing agreement with
its U.S. parent providing for the emigration of intangible property
to TOPCO for exploitation outside the U.S. at an acceptable buy-in
payment that could be paid overtime. - Have TOPCO form a Dutch subsidiary (“DCO”) to serve
as a licensing company, and an Irish subsidiary
(“OPCO”) to carry on active business operations. - Make check-the-box elections for DCO and OPCO so that both are
treated as branches of TOPCO. - Have TOPCO license the rights previously obtained under the
qualified cost sharing agreement to DCO and have DCO enter a
comparable license agreement with OPCO.
The use of check-the-box entities within Europe eliminated
Subpart F income from being recognized in the U.S. A functionally
comparable arrangement could be obtained for intercompany loans
where such loans were required for capital investments. The
qualified cost sharing arrangement eliminated the application of
Code §367, which otherwise would mandate ongoing income
inclusions for the U.S. parent as if it sold the intangible
property pursuant to a deferred payment arrangement with the sales
price being contingent on future revenue. Any intercompany
dividends paid within the group headed by TOPCO were ignored for
Subpart F purposes because of the check-the-box elections made by
all of TOPCO’s subsidiaries. At the same time, deferred taxes
were not reported as current period expenses on financial
statements prepared by the U.S. parent provided the underlying
earnings were permanently invested abroad.
Meanwhile, earnings were funneled up to the European group
equity holder and recycled for further expansion within the
European group. Intragroup payments typically did not attract
withholding tax under the Parent-Subsidiary Directive
(“P.S.D.”) or the Interest and Royalty Directive
(“I.R.D.”) of the European Commission
(“E.C.”).
For other U.S.-based groups – primarily, those companies
that regularly received dividend payments from European operations
– the use of a holding company could reduce foreign
withholding taxes claimed as foreign tax credits by the U.S. parent
in many instances. This was true especially where the U.S. did not
have an income tax treaty in force with a particular country or the
treaty provided for relatively high withholding tax rates on
dividends. Nonetheless, sophisticated planning was often required
to take full advantage of the foreign tax credit because of various
limitations and roadblocks that existed under U.S. tax law.
Foreign Tax Credit Planning in the U.S.
Although the foreign tax credit has often been described as a
“dollar-for-dollar reduction of U.S. tax” when foreign
taxes are paid or deemed to be paid by a U.S. parent company, the
reality has been quite different. Only taxes that were imposed on
items of “foreign-source taxable income” could be
claimed as credits.1 This rule, known as “the
foreign tax credit limitation,” was intended to prevent
foreign income taxes from being claimed as a credit against U.S.
tax on U.S.-taxable income. The U.S., as with most countries that
eliminate double taxation through a credit system, maintains that
it has primary tax jurisdiction over domestic taxable income.
The foreign tax credit limitation was structured to prevent
so-called “cross crediting,” under which high taxes on
operating income could be used to offset U.S. tax on lightly taxed
investment income. For many years, the foreign tax credit
limitation was applied separately with regard to eight different
categories, or baskets, of income designed to prevent the
absorption of excess foreign tax credits by low-tax foreign-source
income. In substance, this eviscerated the benefit of the foreign
tax credit when looked at on an overall basis. The problem was
eased when the number of foreign tax credit baskets was reduced
from eight to two: passive and general.
Additionally, the foreign tax credit was reduced for dividends
received by U.S. citizens and resident individuals from foreign
corporations that, in the hands of the recipient, benefited from
reduced rates of tax in the U.S. A portion of foreign dividends
received by U.S. individuals that qualify for the 0%, 15%, or 20%
tax rate under Code §1(h)(11)(B)(i) was removed from the
numerator and denominator of the foreign tax credit limitation to
reflect the reduced U.S. tax rate imposed on those
items.2 This treatment reduced the foreign tax credit
limitation when a U.S. citizen or resident individual received both
qualifying dividends from a foreign corporation – subject to
low tax in the U.S. – and other items of foreign-source
income within the same basket – subject to much higher
ordinary tax rates. Another reduction in foreign source gains
applied when U.S. source losses reduced foreign source gains. The
goal of the provision was to eliminate a double benefit for the
taxpayer regarding foreign source gains in that fact pattern. The
first benefit was use of a domestic loss to reduce the foreign gain
when computing taxable income. The second benefit was the
elimination of U.S. tax due by reason of the foreign tax
credit.3
As a result of all the foregoing rules, a U.S.-based group was
required to determine (i) the portion of its overall taxable income
that was derived from foreign sources, (ii) the portion derived in
each “foreign tax credit basket,” and (iii) the portion
derived from sources in the U.S. This was not an easy task, and in
some respects, the rules did not achieve an equitable result from
management’s viewpoint.
Allocation and Apportionment Rules for Expenses
U.S. income tax regulations required expenses of the U.S. parent
company to be allocated and apportioned to all income, including
foreign dividend income.4 The allocation and
apportionment procedures set forth in the regulations were
exhaustive and tended to maximize the apportionment of expenses to
foreign-source income. For example, all interest expense of the
U.S. parent corporation and the U.S. members of its affiliated
group were allocated and apportioned under a set of rules that
allocated interest expense on an asset-based basis to all income of
the group.5 Direct tracing of interest expense to income
derived from a particular asset was permitted in only limited
circumstances6 involving qualified nonrecourse
indebtedness,7 certain integrated financial
transactions,8 and certain related controlled foreign
corporation (“C.F.C.”) indebtedness.9
Research and development expenses, stewardship expenses, charitable
deductions, and state franchise taxes needed to be allocated and
apportioned among the various classes of income reported on a tax
return. These rules tended to reduce the amount of foreign-source
taxable income in a particular category, and in some cases,
eliminated all income in that category altogether.
The problem was worsened by carryovers of overall foreign loss
accounts.10 These were “off-book” accounts
that arose when expenses incurred in a particular prior year that
were allocable and apportionable to foreign-source income exceeded
the amount of foreign-source gross income for the year. Where that
occurred, the loss was carried over to future years and reduced the
foreign-source taxable income of the subsequent year when computing
the foreign tax credit limitation.
Self-Help Through Inversion Transactions
The pressure that was placed on the full use of the foreign tax
credit by U.S.-based groups resulted in several public companies
undergoing inversion transactions. In these transactions, shares of
the U.S. parent company held by the public were exchanged for
comparable shares of a newly formed offshore company to which
foreign subsidiaries were eventually transferred. While the share
exchange and the transfer of assets arguably were taxable events,
the identity of the shareholder group (i.e., foreign persons or
pension plans) or the market value of the shares (i.e., shares
trading at relatively low values) often eliminated actual tax
exposure in the U.S. Thereafter, the foreign subsidiaries were
owned directly or indirectly by a foreign parent corporation
organized in a tax-favored jurisdiction and the foreign tax credit
problems disappeared.
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1 Section 904(a) of the Internal Revenue Code of 1986, as
amended from time to time (“Code”).
2 Code §§1(h)(11)(C)(iv) and
904(b)(2)(B).
3 Code §904(b)(2)(A).
4 Treas. Reg. §§1.861-8 through 17.
5 Treas. Reg. §§1.861-9T(f)(1) and
(g).
6 Treas. Reg. §1.861-10T(a).
7 Treas. Reg. §1.861-10T(b).
8 Treas. Reg. §1.861-10T(c).
9 Treas. Reg. §1.861-10T(e).
10 Code §904(f).
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