Uncovering the covered asset acquisition rules.

• Author: Kaplan, Joshua S.

On August 10, 2010, President Obama signed legislation to provide education and Medicaid funding to the states. (1) This funding is partially paid for through changes to the foreign tax credit (FTC) rules and other international tax provisions of the Internal Revenue Code that are estimated to raise approximately $10 billion over the next 10 years. (2) One of the most significant of these changes is the addition of new section 901(m) to the Code, which limits a taxpayer's ability to claim FTCs related to a "covered asset acquisition" (CAA). (3) Section 901(m) generally applies to a CAA that occurs after December 31, 2010, but a transition rule exempts certain unrelated party transactions negotiated or announced but not completed by year-end. This article discusses the new CAA rules and highlights some of the open questions that the Treasury Department and Internal Revenue Service will optimally address in future guidance. In addition, this article considers the potential effect of section 901(m) on future tax planning.

Overview

In general, a covered asset acquisition is an acquisition transaction that results in the creation of additional asset basis for U.S. tax purposes without a corresponding increase in asset basis for foreign tax purposes. The basis "step-up" resulting from a CAA may allow a taxpayer to claim additional depreciation or amortization deductions, thereby reducing its taxable income or earnings and profits (E&P) for U.S. tax purposes. (4) Because there is no basis increase for foreign tax purposes, foreign taxable income and, thus, foreign taxes will generally be higher than if the U.S. basis step-up were taken into account in the foreign jurisdiction.

Although there is no official legislative history for the new rules, the purpose of the CAA rules is described in a summary prepared by the staff of the House Committee on Ways and Means in May 2010 when section 901(m) was first proposed as part of the "American Jobs and Closing Tax Loopholes Act of 2010." (5) The summary explains that the general concern addressed by section 901(m) is that the increased cost-recovery deductions available for U.S. tax purposes as a result of a CAA enable a taxpayer to generate additional FTCs with respect to income that will never be recognized for U.S. tax purposes. Situations where income is recognized for foreign tax purposes, but where no income is recognized for U.S. tax purposes, are often referred to as "base differences." To understand Congress's concern and how section 901(m) addresses that concern in the context of the overall U.S. FTC regime, some background is in order.

Under the FTC regime, the United States seeks to relieve double taxation by ceding primary taxing authority to the country of territorial connection (e.g., where income is earned), while retaining residual taxing authority to the extent the foreign country either does not exercise taxing jurisdiction or imposes taxes at a rate lower than the U.S. rate. The FTC regime applies only to taxes that are "creditable foreign taxes" as defined in section 901 and Treas. Reg. [section] 1.901-2. The main requirement for a tax to be a creditable foreign income tax is that the tax has the predominant character of an income tax in the U.S. sense. (6)

Section 901 allows a taxpayer to elect to claim a credit against its U.S. income tax liability for income, war profits, and excess profits taxes paid or accrued, or deemed to have been paid or accrued, during the taxable year to any foreign country or possession of the United States. (7) To prevent high foreign taxes from offsetting U.S.

tax on U.S. source income, section 904 limits the amount of creditable foreign tax for which a taxpayer may claim a credit in a single year to the amount of pre-credit U.S. tax that would be imposed on the taxpayer's foreign source income. (8) Section 904(d) further limits a taxpayer's ability to "cross credit" high foreign taxes against low-taxed foreign source income by requiring the limitation to be computed separately for different categories or "baskets" of foreign source income. The separate basket limitations are designed to separate low-taxed, easily moveable foreign source income from typically higher-taxed foreign source business income. Currently, there are two main separate limitation categories: general and passive. (9) The policy to eliminate double taxation requires only that foreign taxes imposed on an item of foreign source income be creditable against U.S. tax on that item of income. Congress determined that an item-by-item limitation, however, would be nearly impossible to administer. Thus, foreign source income and taxes are grouped to compute FTC limitations. (10) Even in cases where a foreign country taxes income that the United States would never recognize and, thus, where no potential for double taxation exists, the section 904 regulations assign the foreign taxes to the general limitation basket and allow them to potentially offset U.S. tax on other foreign source income. (11)

Foreign taxes treated as creditable under the section 901 regulations (i.e., taxes that have the predominant character of an income tax in the U.S. sense) may nonetheless be disallowed as FTCs under a number of statutory exceptions in section 901. (12) New section 901(m) is the latest statutory exception, disallowing credits for otherwise creditable foreign taxes paid or accrued as a result of a CAA. To illustrate the perceived abuse and the solution that section 901(m) adopts, consider Example 1 on the following page.

Section 901(m) thus effectively requires taxpayers to recompute foreign taxable income under U.S. tax principles to determine the amount of foreign tax that will be allowed as a credit. This is a departure from the general principle that E&P of a foreign corporation are computed under U.S. tax principles, but foreign taxes are computed under foreign law. (15) In other situations in which a foreign country recognizes more income than the United States because of differences between U.S. and foreign law, an FTC is not denied. Instead, the FTC limitation rules under section 904(d) operate to limit the amount of credits that can be claimed in a particular year. (16)

The approach to disallowing FTCs attributable to a CAA under section 901(m) is in effect a per-item FTC limitation overlaid on the section 904(d) separate limitation categories. In Example 1, USP pays $33 of foreign tax and recognizes $100 of foreign source income for U.S. tax purposes. (17) Assume USP also earns $100 of foreign source income from other active foreign business activities subject to $35 of foreign tax. Under current tax rates, USP would be subject to $70 of pre-credit U.S. tax on FT's earnings (35% of $200) and would owe $2 of residual U.S. tax (the difference between the $68 of foreign taxes paid and the $70 FTC limitation). Section 901(m) imposes a separate item limitation on the income attributable to FT, and disallows a credit for the additional $3 of tax even though, under current tax rates, the additional $3 would not constitute excess FTCs. It is not clear why Congress believes that foreign taxes imposed on the class of transactions that constitute CAAs warrant a different approach.

Covered Asset Acquisition Defined

Section 901(m)(2) lists three specific categories of transactions that constitute CAAs: a qualified stock purchase under section 338, an acquisition of an interest in a partnership for which a section 754 election is in effect, and any transaction treated as an asset acquisition under U.S. tax law and a stock acquisition or disregarded transaction under foreign law. In addition, section 901(m)(2) provides regulatory authority to expand the scope of the rules to cover "any similar transaction." This section reviews the categories of CAAs and provides examples of the types of transactions that may fall within each category.

1. Qualified Stock Purchase under Section 338

   The first category of transactions that constitutes a CAA is a "qualified stock purchase" (QSP) to which section 338(a) applies. (18) Generally, the acquisition of stock in a corporation does not result in a basis step-up in the underlying assets of the target corporation. Rather, the purchaser takes a cost (i.e., fair market value) basis in the stock acquired and the assets of the target corporation maintain their historic, typically lower, tax basis for U.S. tax purposes. (19) It the stock purchase is a QSP, however, the purchasing corporation may elect to effectively treat the acquisition as a purchase of assets, resulting in a basis step-up in the target corporation's assets. Very generally, if a section 338 election is made on the purchase of a corporation, the foreign corporation ("Old Target') is treated as selling its assets to a new, unrelated corporation ("New Target") for their fair market value, resulting in a stepped-up basis in the assets in the hands of New Target. (20) The additional basis typically gives rise to additional depreciation and amortization deductions for purposes of computing New Target's E&P. The foreign tax liability, however, will be determined based on foreign depreciation and amortization deductions computed on the lower, historic basis because the foreign country views the transaction as a stock sale with no basis step-up in the underlying assets. Thus, an election under section 338 can result in a permanent difference between the taxable income on which the foreign tax is determined and the U.S. taxable income or E&P on which the U.S. tax is determined.

2. Section 754

   The next type of transaction that constitutes a CAA is the acquisition of a partnership interest for which an election under section 754 is in effect. (21) Similar to a stock acquisition, an acquisition of an interest in a partnership does not generally result in an adjustment to the bases of the underlying assets held by the partnership. (22) It an election under section 754 is in...