The IRS told one US company that was unraveling such a structure that its plan would not trigger a US income tax. The IRS made the comments in a private letter ruling that the agency made public in late February. The ruling is PLR 200507009.
The United States taxes American companies on worldwide income. It tries to prevent double taxation of income from foreign sources by allowing a credit, in theory, for any taxes that had to be paid to another country, but the foreign tax credit rules are so full of fine print that few American companies are able to claim such credits in practice.
One problem is the IRS treats a US company’s borrowing costs at home — even for purely domestic purposes — as a cost partly of its foreign operations. A portion of this domestic interest expense is allocated to foreign operations in the same ratio as the company’s assets are deployed at home and abroad. The effect is that a company is not viewed as having earned much money abroad after this allocated interest expense is subtracted. Smaller foreign earnings mean fewer foreign tax credits. The calculations for companies that join together in filing a consolidated income tax return are done as if they were all one company. Most US power companies are in an “overall foreign loss” position, meaning that they have millions of dollars in allocated interest expense to burn off before they are viewed as having earned anything abroad.
Some US companies resort to self-help remedies. One such remedy was stapled stock. A US company might “staple” the shares of a foreign subsidiary to one of its US subsidiaries. This means that the shares of the two companies cannot be sold separately. It has the effect of subjecting the foreign subsidiary to US income taxes as if it were a standalone US company. The key word is standalone. Although the foreign subsidiary must pay US income taxes, it could calculate its own foreign tax credits unhindered by any allocated interest expense from its US affiliates.
The IRS said in Notice 2003-50 in July 2003 that it will require in the future that stapled foreign companies take into account allocated interest expense. This policy applies to foreign companies that were stapled to US companies after July 22, 2003. However, the IRS is also challenging existing stapled stock structures on audit. It warned in the 2003 notice that it will assert on audit that stock was not effectively stapled where there was nothing to prevent the US parent from breaking the staple at will.
The private letter ruling that the IRS released in late February involved a US group with a foreign subsidiary — FC1 — that it had stapled to one of its US subsidiaries. FC1 had, in turn, two other foreign subsidiaries — FC2 and FC3 — and it had recently reorganized them so that they were no longer brother-sister companies, but rather one was put under the other. Moving FC2 and FC3 around in this fashion could have triggered a “toll charge” in the US. The US collects a tax, or toll charge, if it sees assets leaving the US tax net. Since FC1 was treated as an American company for US tax purposes due to the staple, this was a case where one of its assets was moving outside the reach of the US tax authorities. However, the company avoided a toll charge by entering into a “gain recognition agreement,” or a promise to pay the toll charge with interest if FC2 failed to hold the shares in FC3 for at least five years. IRS regulations allow a toll charge to be avoided in certain situations by entering into such a gain recognition agreement.
Later, the group focused on undoing its stapled stock structure. It migrated FC1 to Delaware, thereby turning FC1 into a US corporation, and it dropped the staple.
The US parent asked the IRS whether the migration would blow the gain recognition agreement or, put differently, whether the fact that FC1 had turned into a US company meant it was no longer the same company so that a toll charge would be triggered. The IRS said it considers it still the same company.