NEW YORK-Seeking to crack down on what it considers abusive overseas transactions by American companies, the Internal Revenue Service recently published a warning of impending regulatory action in its bulletin.
Notice 98-5, as the admonition is formally called, said the agency is looking askance at deals domestic companies engage in abroad that are driven mostly by expected tax advantages here rather than economic advantages overseas.
The IRS has set its sights primarily on financial institutions that develop intricate transactions to gain investors so-called foreign tax credits in excess of the economic benefits generated by the overseas enterprise or project. However, its review and its notice take a swipe at the international canvas with a broad brush so that all kinds of transactions abroad could fall within its promised regulatory restrictions.
There is a separate body of IRS rules that applies specifically to telecommunications companies, said Thomas J. Rasmussen, international tax advisory partner for the telecommunications and media practice of Deloitte & Touche, New York. However, he added, “there are telecommunications companies that, for a variety of reasons, would want to use foreign tax credits.”
“You’d have to look at each company individually, whether a manufacturer or a carrier. There are telcos generating foreign income that can use all the foreign tax credits they can get.”
The underlying regulatory philosophy behind foreign tax credits is to prevent companies from double taxation by two countries, Rasmussen said. Therefore, the IRS generally allows companies that do business abroad to deduct from their U.S. tax liability the amount of foreign taxes they pay.
If foreign taxes are so high that they would cancel out or exceed the U.S. tax, then the American company reports foreign source income for purposes of domestic taxation.
In its notice of pending rule making, the IRS set forth a number of specific examples of transactions it considers driven solely by foreign tax credits rather than economic benefit, said Alan Fischl, a partner in the Washington, D.C., national office of Coopers & Lybrand.
“The difficulty for companies now is trying to figure out where they stand (because) the more you try to extrapolate from the examples, the more uncertain it becomes, (and) there is no objective test (for economic benefit) articulated in the notice.”
One of the most troublesome points in the IRS notice of impending rulemaking has to do with the concept of economic benefit, Fischl said. The notice suggests a possible method for determining economic benefit that equals income received minus all expenses, including foreign taxes but not including domestic taxes, “for a cash flow kind of return.”
“The controversial factor is treating foreign taxes as a deduction from income, with the economic return being calculated before U.S. taxes but after you deduct foreign taxes,” Fischl said.
Some would argue that either both sets of taxes should be able to be deducted from income or neither, he said.
For telecom carriers, another “cryptic and unclear” part of the IRS notice is its promise to deal with “hybrid entities … treated as a corporation in one country and pass-through entity like a partnership or a branch in another country to pass through its items of income or loss to the United States … or it could work in reverse,” Rasmussen said.
“For example, hybrid entities are used for telecom carriers rolling out around the world, especially in emerging markets where you expect losses early on.”
