IRS Provides Guidance on Section 901(m) Disposition Rule

International Tax Alert
07.23.14

The IRS and Treasury issued Notice 2014-44 (the "Notice") this week. The Notice provides guidance regarding the application of section 901(m) to certain dispositions of assets following a covered asset acquisition (CAA). As taxpayers await broader guidance under section 901(m) (including threshold issues such as ambiguities in the definition of "covered asset acquisition" and how to determine the amount of foreign taxes subject to disallowance), the Notice is targeted specifically at a perceived abuse facilitated by the "disposition rule" of section 901(m)(3)(B)(ii).

Notice 2014-44 provides that regulations--which will be effective as of July 21, 2014--will be issued restricting the definition of "disposition" for purpose of section 901(m) and providing rules for partially taxable dispositions.

Background -- Section 901(m)

Section 901(m), which was enacted in 2010, disallows a foreign tax credit (but permits a deduction) for foreign taxes on income attributable to "basis differences" arising from CAAs. In general, a CAA is a transaction, such as a qualified stock purchase with a section 338(g) election, a purchase of a disregarded entity, or a purchase of an interest in a partnership with a section 754 election, that results in a step-up in the basis of an entity's assets for U.S. tax purposes but not for foreign tax purposes. In such cases, the taxpayer's foreign income (and therefore its foreign tax) is relatively greater than the income that is recognized for U.S. tax purposes due to enhanced depreciation deductions attributable to the step-up in the basis of the acquired assets (the "relevant foreign assets" or "RFAs").

Section 901(m) is intended to deny the enhanced foreign tax credits that would otherwise result from this basis disparity. For example, assume a U.S. corporation (USP) wholly owns a foreign subsidiary (FSub), which acquires all of the stock of foreign target (FT) for $100. Further assume that FT's basis in its assets is $60 and the cost-recovery period for the acquired assets is 10 years. FSub makes a section 338(g) election with respect to the acquisition of FT, and therefore FT receives a stepped-up $100 basis in its assets for U.S. tax purposes. The section 338 election, however, does not affect FT's historic $60 basis in its assets for foreign tax purposes. As a result of this "basis difference," FT will recognize more income for foreign tax purposes than for U.S. tax purposes as it recovers the cost of the assets through depreciation deductions. Section 901(m) requires the taxpayer to allocate the $40 basis difference over the remaining 10 year cost-recovery period of the acquired assets. As a result, USP may not claim a foreign tax credit for the foreign tax attributable to $4 of foreign income each year.

Disposition Rule and Targeted Transaction

The statute also sets forth a disposition rule that accelerates the effect of section 901(m) and the potential denial of foreign tax credits in the event that a taxpayer disposes of an asset acquired in a CAA before its cost-recovery period has run. See section 901(m)(3)(B)(ii). Under the disposition rule, if the taxpayer disposes of an asset acquired in a CAA, any unallocated basis difference is allocated entirely to the year of disposition and no basis difference is allocated to any subsequent taxable year. In our example, the "unallocated basis difference" would initially be $40, and would be reduced by $4 each year.

The Notice states that taxpayers were engaging in transactions that qualified as tax-free for both U.S. and foreign tax purposes and were taking the position that, because of the disposition rule, section 901(m) did not apply in later tax years. In our example, FT could elect to be treated as a disregarded entity immediately following the CAA. The election would be treated as a tax-free liquidation of FT into FSub for U.S. tax purposes and would have no effect for foreign tax purposes. If the election were considered a disposition for purposes of section 901(m), then (1) there would be no foreign tax on the transaction, and therefore no foreign tax credits for section 901(m) to disallow in the year of the disposition and (2) pursuant to the disposition rule, the entire basis difference would be allocated to the year of the disposition and section 901(m) would not apply in future years, even though the underlying $40 basis difference in the RFAs would still exist in the FSub assets received from FT in the liquidation.

IRS Response – Notice 2014-44

Notice 2014-44 provides that the IRS and Treasury will end the perceived abuse of the disposition rule by issuing regulations restricting the definition of "disposition." The regulations will provide that, for purposes of section 901(m), a disposition is an event that results in gain or loss being recognized with respect to a relevant foreign asset for purposes of U.S. income tax, foreign income tax, or both. Thus, in the example above, FT's election to be treated as a disregarded entity would not be treated as a disposition and section 901(m) would still apply.

To implement the new rule, the Notice provides a new term: the "disposition amount." This is the portion of a basis difference with respect to an RFA that is taken into account for a taxable year as a result of a disposition, and it is this disposition amount that generally will be taken into account for purposes of section 901(m). For transactions that are fully taxable for both U.S. and foreign tax purposes, the disposition amount is the entire unallocated basis difference of the asset. For transactions that are not fully taxable, however, the disposition amount is the amount by which the disposition reduces the disparity between the U.S. basis and the foreign basis of the RFA. For example, if taxable gain is recognized for foreign tax purposes only, the disposition amount generally will equal the amount of such gain.

The Notice also provides that section 901(m) will continue to apply to an RFA if it is transferred in a tax-free or partially taxable transaction. Specifically, section 901(m) will continue to apply to the RFA until the entire basis difference has been taken into account, even if the asset is transferred. The IRS and Treasury are still assessing whether and to what extent section 901(m) should apply to an asset received in exchange for an RFA in a tax-free or partially taxable transaction. This provision raises practical and administrative considerations because the acquirer of the RFA would need to obtain information from the transferor regarding the basis difference.

Finally, the Notice provides that, for purposes of a CAA resulting from a basis increase under section 743(a) attributable to the acquisition of a partnership interest, the basis difference in an RFA generally is the resulting basis adjustment under section 743(b) that is allocated to the RFA under section 755. The Notice provides guidance regarding the computation of the disposition amount with respect to this kind of transaction. 
 

For additional information, please contact any of the following lawyers:

Layla Asali, lasali@milchev.com, 202-626-5866

Rocco Femia, rfemia@milchev.com, 202-626-5823

Kevin Hall

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