by Keith Martin, in Washington

The US government is hoping that US companies will bring back billions of dollars this year from overseas to take advantage of a special 5.25% income tax rate on repatriated earnings.

The Internal Revenue Service explained in mid-January what a company must do to qualify.

The tax break is expected to create a bonanza this year for banks since many US companies will have to borrow outside the United States to enable their foreign subsidiaries to pay dividends. The earnings must be repatriated in cash. The subsidiaries in most cases have undistributed earnings recorded on their books, but the cash has already been redeployed and is not available to pay dividends.

The IRS still needs to address at least one more issue before some US companies will be able to act. The special tax rate only applies to “excess” earnings that a company repatriates this year above what it repatriated on average each year during a five-year period that for most companies runs from 1998 through 2002. The IRS said it is working on a notice that will explain for companies that merged or that acquired or disposed of subsidiaries during this period how to calculate their base-period repatriations.

The details the IRS has released so far about the tax break are in Notice 2005-10.

There is no deadline for reinvestment. However, the agency established a “safe harbor” under which companies will not have to keep filing progress reports with the IRS if they have committed at least 60% of the repatriated funds to investments within three years.

Background

Many US companies with business operations or investments outside the United States own them through offshore holding companies in Holland, the Cayman Islands or similar jurisdictions. Income from the offshore operations accumulates in the holding company and is reinvested offshore. This lets the US company defer US taxes on its offshore earnings until they are brought back to the United States. Estimates of the amount of earnings parked in offshore holding companies run into the hundreds of billions of dollars.

Congress hoped that a lower tax rate would induce US companies to redeploy some of this money in the United States.

A so-called JOBS bill that President Bush signed on October 22 would let US companies deduct 85% of the dividends they receive from some foreign subsidiaries. Thus, only 15% of the dividends would be subject to US income tax. This translates into a 5.25% effective tax rate on the repatriated earnings (or a 3% effective rate for companies on the alternative minimum tax).

It is a limited-time offer. The lower tax rate will only apply to earnings that are repatriated during a one-year period. A company must choose either its tax year that straddles October 22, 2004 or its next tax year (for example, 2005).

A company must bring back more earnings than it did on average each year during a “base period” to benefit from the lower rate. The lower rate would only apply to the “excess” repatriation. The base period is the five tax years ending on or before June 30, 2003, but two years are dropped from the calculation: the years in which it repatriated the highest and lowest amounts. Thus, for example, a company that pays taxes on a calendar-year basis would look at the period 1998 through 2002. It must count as earnings repatriated during the base period not only the cash dividends it received from offshore, but also certain other amounts like distributions of property in kind, distributions of cash that did not have to be reported as dividends because the earnings were taxed in an earlier year, and any “section 956 inclusions.” An example of a “section 956 inclusion” is where a US parent borrowed against cash that was parked in an offshore holding company with the result that it had effective use of the offshore earnings in the US. Such borrowing would have triggered a US tax on the offshore earnings that served as collateral for the loan to the US parent.

Only dividends from certain foreign subsidiaries qualify potentially for the 5.25% tax rate. The subsidiary must be a “controlled foreign corporation,” meaning that it must be owned more than 50% by vote or value by US persons. Shareholding by a US person does not count unless the person owns at least a 10% voting interest in the subsidiary. In addition, the US company repatriating the earnings must itself own at least a 10% voting interest in the subsidiary.

Earnings must be brought back in cash to benefit from the lower rate. The low rate would not apply to other types of offshore earnings on which the US parent company must pay tax during the year. An example is passive income — like dividends or interest — earned by its offshore subsidiaries but taxed directly in the United States. Such passive income is taxed immediately to the US parent under “subpart F” of the US tax code without waiting for the money to be repatriated to the United States.

A company cannot lend its offshore subsidiary money to pay the cash dividends. However, it can borrow from a bank. Any increases in shareholder or other related-party debt of offshore subsidiaries between October 3, 2004 and the end of the tax year in which the lower rate is being claimed are potentially a problem. A technical corrections bill introduced on November 19 in Congress would also bar a US parent from effectively funding the dividends back to itself by making capital contributions or through other means.

The US company must reinvest the repatriated earnings in the United States “pursuant to” a reinvestment plan. The reinvestment plan must be approved by the company president, CEO or someone comparable before the repatriation occurs, and the plan must also eventually be approved by the board or a similar body. The plan must provide for reinvestment of the earnings in the US “including as a source for the funding of worker hiring and training, infrastructure, research and development, capital investments, or the financial stabilization of the corporation for the purpose of job retention or creation.”

A company cannot use net operating losses or most tax credits to shelter the earnings from the 5.25% tax.

Foreign tax credits are an exception. Suppose a foreign subsidiary distributes its earnings as a cash dividend. Income taxes were paid on the earnings to other countries. The income taxes are released with the dividend for use as a foreign tax credit in the United States, but 85% of the taxes will never be creditable against these or any other income in the US. The other 15% can be used as shelter against the 5.25% tax on the repatriated earnings in the US. This is true of both “indirect” foreign tax credits — for income taxes paid by the foreign subsidiary or other companies below it in the ownership chain — as well as “direct” credits for withholding taxes collected by another country when the cash dividends are paid to the parent company in the US.

There is a dollar limit of $500 million on the amount of earnings on which the company can pay tax at the special low rate. However, if the company can produce financial statements proving that it had more than $500 million in offshore earnings “permanently reinvested” outside the United States, then its cap is the higher figure. It must use a particular financial statement for this purpose: the last audited one it had certified or filed with the US Securities and Exchange Commission on or before June 30, 2003.

Reinvestment Plan

Companies flooded the US Treasury Department with questions soon after the earnings repatriation provision was enacted. The IRS released the first set of answers in mid-January.

It said that the reinvestment plan that must be in place before the earnings are repatriated must describe the planned use of the earnings in the United States “in reasonable detail and specificity.” The plan must provide enough detail for the company to be able to prove later on audit that the earnings were in fact used as originally contemplated. The plan will not pass muster if it merely refers to generic categories of spending or provides a laundry list of possible uses.

It should state dollar amounts, but they do not have to be detailed. For example, it can say that $X will be spent to pay down debt on project X and $Y will be spent to develop project Y. Spending can be shifted later among the uses specified in the plan. Thus, money could be shifted from project Y to pay down more debt on project X. The plan can also spell out an alternative use of the funds in case the primary investment is delayed or rejected — for example, due to inability to get permits.

The plan should give a “reasonable” time period over which the investments will be made. The company can have a separate plan for each batch of repatriated earnings or a single master plan.

The plan cannot be amended after the dividend has been paid — with the exception of plans drawn up before January 13 this year when the IRS notice was issued. Companies have until March 14 to amend such plans.

The earnings do not have to be put into a new project; they can be applied to investments that the company already planned (including used to pay down debt on past investments). The reinvestment plan must be approved by the president, CEO or a comparable officer of the ultimate parent company in the US that files the consolidated income tax return. This approval must come before the dividend is paid. It is that company’s board that must also later approve the plan. It does not matter that a US subsidiary received the dividend or will be the one making the investment.

The IRS said that companies do not have to keep repatriated earnings in segregated accounts or otherwise “trace” the money received to the later use of the funds in the United States. It is enough to show that at least $X was invested as suggested in the plan. However, the IRS cautioned that a company would do better on audit if it kept the earnings in a segregated account and had good records showing the uses of the funds in situations where the earnings are invested “over the course of many years.”

There is no “cliff.” If the reinvestment plan calls for $100 in repatriated earnings to be invested in the United States, but only $60 are, then only $60 qualify for the lower tax rate.

Spending on a project counts as reinvestment of a dividend even if that spending occurred before the dividend was paid as long as it is in the same year the US company is claiming the lower tax rate. Thus, spending in January 2005 on a project would count as reinvestment of a dividend not paid until November 2005 for a taxpayer who elected the lower rate for calendar year 2005.

Permitted Investments

The IRS published a list of permitted uses for the repatriated earnings, but said it is not an exclusive list. It also identified a number of uses that do not qualify.

Investments count only when made in cash. Thus, there is no reinvestment of repatriated earnings when a US company uses its shares to acquire a target company. This could affect how some corporate acquisitions are structured in the future. An investment is not made by giving a note until the note principal is paid.

Spending qualifies as a good investment in “infrastructure” even if it is merely to rent or license such things as telephone equipment or computer software. However, the equipment must be used in the United States. The spending must be allocated to the extent the equipment is used only some of the time in the US. The allocation is done according to the percentage of time the equipment is physically used in the US (rather than what portion of the revenue from using the equipment is considered to come from a US or foreign source).

Many US power companies and others in capital-intensive industries may want to use repatriated earnings to pay down existing debt. Debt repayment is permitted if the company can show it contributes to “financial stabilization of the taxpayer for purposes of job retention or creation in the United States.” This is a two-pronged test. However, the IRS suggested both parts should be easy to meet. The agency said debt repayment “ordinarily” helps with financial stabilization since it improves the debt-equity ratio of a company or reduces its obligations for debt service. It suggested that it will take the company’s word that the financial stabilization will help keep existing jobs or create new ones if, at the time the CEO approves the dividend reinvestment plan, the company’s “reasonable business judgment” is that the debt repayment will be a “positive factor” in helping to keep or create jobs in the US. It would be a good idea to explain how it is expected to help in the dividend reinvestment plan.

It is apparently irrelevant whether the assets securing the repaid debt were in the US or abroad.

Some of what passes for earnings repatriation may be little more than a shift of debt offshore. Suppose a foreign subsidiary must borrow from a bank to raise the cash to pay a dividend to the US. The US parent company uses the repatriated earnings to repay its debts. All that has occurred is a domestic debt has been replaced by a foreign one. The IRS suggested it has no problem with this as long as the US parent company or one of its US subsidiaries is not the borrower in substance under the offshore debt. In other words, it wants the debt truly to have shifted offshore. For example, the US parent would effectively remain the borrower if it guaranteed repayment. US companies should consider the other consequences from such debt shifts. For example, the US group would have less foreign source income in future (because of the offshore interest payments), which would reduce its ability to claim foreign tax credits.

The debt repaid cannot be to an affiliate. Money paid by one US company to another US company whose tax results are reported on the same consolidated income tax return do not count as an investment. Such payments are ignored.

A company should be careful when repaying debt not to re-borrow on substantially the same terms within the next six months. In that case, the IRS might argue that there was no reinvestment of the earnings in the United States because the debt was not truly repaid. It was replaced promptly with similar debt. Re-borrowing by another company in the same consolidated group is potentially a problem; all companies that join in filing a consolidated US income tax return are treated as a single company for this purpose.

The IRS said the repatriated earnings can be used to make pension plan contributions. The money cannot be used to pay executive compensation. It does not matter whether the pension plan covers current employees or whether they worked in the United States. However, the dividend reinvestment plan should explain why the US company believes that such contributions will contribute to financial stabilization of the company and how this, in turn, will help keep or create jobs in the United States.

The earnings can be used to acquire an interest in another company — including a company in another country. However, the US company must own at least 10% of the value of the target company after the latest acquisition. Otherwise, it is treated as having made merely a “portfolio” investment, which is not the type of investment Congress wanted to reward. Anyone using earnings to acquire another company must allocate the purchase price among the assets of the target company between those that would be permitted investments if acquired directly and those that would not. If any of the permitted assets is used only part-time in the United States, then there must be a further allocation based on the percentage of domestic use. The bottom line is that only part of the acquisition price will be treated as reinvestment of the repatriated earnings in the US.

The repatriated earnings cannot be used to pay dividends or buy back shares. The tax section of the New York State Bar Association argued that such uses represent a shrinking of the enterprise, or the opposite of an investment. The earnings also cannot be used to acquire debt instruments or to make tax payments.

Tax Planning

Earnings must be repatriated to the US in cash. Wire transfers and checks count as cash. US companies asked the Treasury Department whether they could transfer certificates of deposit, corporate bonds, commodities and other cash equivalents. The IRS said no, but said it would not invoke a “step transaction” theory to claim that no cash dividend was paid in cases where a foreign subsidiary liquidates such a cash equivalent in order to pay a cash dividend, and then its US parent immediately reinvests the money is a similar instrument.

The US company must reinvest the gross amount of the dividend, ignoring any “related expenses” that reduced the cash it actually received. For example, suppose a foreign subsidiary pays a dividend to its US parent of $100, but $5 is taken out at the foreign country border for withholding tax. The US parent must reinvest $100.

Most companies will have to do a fair amount of foreign tax planning to take full advantage of the provision.

The amount of earnings that can be repatriated at the low tax rate is limited to $500 million or, if more, the amount that the financial statements of the US group show is “permanently reinvested” outside the United States. A US company can specify which foreign repatriated earnings during the year it wants to qualify for the low rate.

Companies would do best to choose earnings that were not heavily taxed abroad — and that carry with them little or no foreign tax credits. Most US companies in capital-intensive industries have a hard time using foreign tax credits because of the fine print in the US foreign tax credit rules. Nevertheless, repatriating heavily taxed earnings releases any such credits and the clock begins to run on their use. (Suppose a foreign subsidiary has $100 in undistributed earnings and $35 in foreign income taxes were already paid on the earnings. When the earnings are distributed in cash to the US, they will bring along with them a foreign tax credit. However, because only 15% of the earnings will be taxed in the US, only 15% of the foreign taxes will come with them as a potential foreign tax credit. The remaining foreign taxes are lost as a potential foreign tax credit. The clock will begin to run on use of the 15% of the foreign taxes that are creditable.)

US companies may have to do some reorganizing of their foreign subsidiaries to isolate low-taxed earnings. For example, dividends passing up a chain of foreign subsidiaries will drag whatever foreign tax credits were in the combined earnings pool. In the past, one could leapfrog a subsidiary higher up the chain by having the lower-tier company lend the money directly to the US parent. This caused the earnings to be taxed in the US (since the earnings were effectively repatriated). Since only cash dividends qualify for the tax rate, any repatriation will have to be directly up the ownership chain.

Earnings brought back to the US from abroad but distributed through partnerships or “disregarded entities” (companies that do not exist for US tax purposes) create complications.

The IRS said the earnings are not considered to have reached the US until they are received in cash by the US company that is a partner or is the owner of the disregarded entity. They must also reach the US during the year the US company has chosen to benefit from the lower tax rate. For example, suppose US company A chose 2005 for the lower tax rate. Suppose it owns a foreign subsidiary through US subsidiary B and B is disregarded — it does not exist — for US tax purposes. The foreign subsidiary pays a cash dividend in 2005 to B. B must distribute the cash to A in 2005. The same thing is true of dividends paid through partnerships.

Another complication that will require planning is where some of the undistributed earnings of a foreign subsidiary were already taxed in the United States under “subpart F” rules. (The US looks through foreign subsidiaries and taxes US shareholders on any passive income it sees in the ownership chain.) Suppose a foreign subsidiary has $150 in undistributed earnings. However, $90 of them were already taxed in the US under subpart F. The subsidiary must pay a cash dividend of at least $91 before the first dollar of earnings qualifying for the 5.25% tax rate will be considered to have been distributed. Other earnings are considered distributed first.

by Keith Martin, in Washington