Under the Homeland Investment Act portion of the American Jobs Creation Act of 2004, U.S. multinational corporate groups and other significant corporate shareholders of controlled foreign corporations (CFCs) have been given a less-than-two-year window to repatriate earnings of those CFCs at an effective 5.25 percent federal income tax rate. The provision permits such corporate shareholders to repatriate CFC earnings at the reduced rate in the shareholder's last taxable year beginning before, or its first taxable year beginning on or after, October 22, 2004, but only to the extent that such dividends (i) exceed average prior year CFC dividends received by the taxpayer, (ii) are not associated with increased financing of the dividend paying CFCs by related parties, and (iii) are invested in the United States based on a plan approved by the corporation's CEO and Board of Directors. The provision is elective and may not be helpful to every corporate shareholder of CFCs with large earnings. The taxpayer must forgo foreign tax credits and deductions associated with the dividends that are eligible for the favorable treatment.
Under the dividend repatriation provision, U.S. corporate taxpayers that own at least 10 percent of the voting stock in any CFC will, if they elect, be entitled to deduct 85 percent of the cash dividends that they receive from CFCs during the taxable year for which the election is in effect (including distributions of previously taxed amounts attributable to lower-tier CFC dividends paid to the distributing CFC during the year). For this purpose, cash dividends generally do not include amounts that are not actually distributed but are treated as dividends for tax purposes, such as gain on certain sales or exchanges of stock in a CFC that is attributable to the CFC's earnings.
Restrictions on Availability of Temporary CFC Dividend Deduction
The 85 percent dividends received deduction is subject to a number of limitations. First, the total amount of dividends taken into account cannot exceed the greater of (i) $500 million or (ii) the amount shown on the taxpayer's most recent audited financial statement filed with the SEC -- or, if not filed with the SEC, certified -- on or before June 30, 2003, as permanently reinvested outside the United States (or the amount of federal income tax shown on such statement as attributable to earnings permanently reinvested abroad divided by 0.35). Second, the amount of dividends taken into account cannot exceed the cash dividends received from CFCs during the year for which the election is in effect less the average annual dividends, section 956 inclusions and distributions of earnings previously taxed under subpart F received by the taxpayer during three of the five most recent taxable years ending on or before June 30, 2003, disregarding the highest- and lowest-repatriation years during that period. The CFC dividends in excess of the base period average are termed "extraordinary" dividends.
Third, only dividends that are "invested in the United States pursuant to a domestic reinvestment plan" that is approved in advance of payment by the taxpayer's CEO or similar official and ratified by the taxpayer's board, management committee, executive committee or comparable body are eligible for the 85 percent deduction. The dividend reinvestment plan is intended to provide for investment of the dividends (or at least an amount equal to the dividends) in such purposes as worker hiring and training, infrastructure, R&D, capital investments or "the financial stabilization of the [taxpayer] for the purpose of job retention or creation." The law specifically prohibits use of the repatriated earnings to pay executive compensation. However, the law does not identify the universe of permitted or prohibited uses for the dividends, and it appears that the IRS is considering issuing guidance that would specify in more detail whether other purposes, such as debt repayment or stock repurchases, are permissible reinvestment purposes. The IRS is also considering whether it will require tracing of the funds actually distributed to authorized reinvestment purposes. Importantly, there appears to be no requirement that the taxpayer increase its investment in the authorized reinvestment purposes, only that the taxpayer invest at least the amount of the dividends in such purposes.
Fourth, the amount of dividends that are otherwise eligible for the 85 percent deduction is reduced by the amount of debt that all CFCs in which the taxpayer is a direct or indirect 10 percent voting shareholder owe to related parties at the end of the year for which the election is made that is in excess of such CFCs' related party debt as of October 3, 2004. As a consequence, taxpayers that wish to take advantage of the new provision and are part of a multinational group may want to ensure that third party lenders to the group lend directly to CFC operating companies in the group, and not lend to U.S. members for onlending to CFC operating companies. However, because all CFCs in which the taxpayer holds a 10 percent voting stock interest are treated as a single corporation for this purpose, financing of CFC operating companies by a special purpose CFC financing company would not constitute related party debt. One potential issue concerning this restriction is whether related party guarantees of CFC debt count as related party debt for these purposes. It is likely -- but not yet certain -- that such guarantees, if undertaken to obtain more favorable terms from third party lenders, will not count as related party debt.
Considerations in Whether to Take Advantage of Temporary CFC Dividend Deduction
As noted, the 85 percent dividends received deduction will not be beneficial for all taxpayers who own at least 10 percent voting stock interests in CFCs with accumulated earnings. In particular, CFC earnings that are associated with foreign taxes (including withholding taxes on the dividends themselves) at an effective rate that approaches the taxpayer's effective U.S. tax rate might not be good candidates for the deduction because of the loss of foreign tax credits with respect to the deductible portion of dividends taken into account in determining the deduction. However, taxpayers may specify which CFC dividends are "extraordinary" and are thus eligible for the deduction, and which CFC dividends are treated as amounts that are applied to the base period average. The provision imposes no restrictions on the crediting of foreign taxes attributable to the CFC dividends that are specifically applied to the base period average.
In light of the various requirements and restrictions on the availability of the 85 percent dividends received deduction, and the need to ensure that sufficient cash is available to make distributions, a great deal of planning in a short period of time is necessary in order to make the decision as to whether to take advantage of the provision. The limited window provided by Congress means that some corporations have only until October 31, 2005, to determine whether the provision should be used and, if so, to complete the distributions. Buchanan Ingersoll is ready to use its experience in international tax matters to assist taxpayers in making these decisions and to help implement CFC dividend paying strategies.
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