Current US tax issues

By Emad Zabaneh
Illustration: Gary Clement

Before signing any noncompete agreements, purchasers and sellers should carefully consider the tax treatments of such covenants

Canadians may differ in opinion regarding our foreign policy and various global issues. Nevertheless, many Canadians, political analysts, and observers agree that as a result of its activities overseas, the US is experiencing elevated consumption levels that have resulted in an increase in demand for Canadian products and services. This despite a seemingly weakening economy. And as Canadian businesses were harvesting the benefits of the greater demand for their products and services, US policy makers were working on comprehensive changes in US tax legislation. On October 22, 2004 President George W. Bush signed the American Jobs Creation Act, which contains about US$138 billion in tax changes. Many say the act is the most significant revision to the tax code since the 1986 Tax Reform Act.

The new act primarily affects domestic taxpayers. However, it contains provisions that may significantly impact Canadian multinationals and individuals with activities in the US. For example, the act repeals the Extraterritorial Income (ETI) Exclusion Act of 2000, which provided benefits to US taxpayers engaged in qualifying export activities. Instead, the act introduces a provision that provides for deductions relating to income attributable to US production activities, which could benefit Canadian businesses with production activities in the US. Other important changes include significant modifications to tax shelter regimes, deferred compensation arrangements and repatriation of US taxpayers’ foreign earnings rules.

The repeal of the current ETI Exclusion Act and the introduction of the domestic manufacturing deduction provision represent the showpiece of the act. The legislation provides for a 9% (subject to phase-in provisions) deduction against qualified production gross receipts from certain domestic manufacturing activities, which would enhance US job creation. Unlike the ETI regime, the domestic manufacturing deduction provision applies to all taxpayers deriving income from qualified domestic production activities, regardless of whether the taxpayer is engaged in export activities. This was a key requirement under the ETI regime. Another difference is that the domestic manufacturing deduction is not available to taxpayers with a tax loss or to those who have utilized a loss carryover to shelter taxable income.

Qualified production gross receipts generally include sale, exchange or other disposition, or any lease, rental or license of certain qualifying production property, qualified film, electricity, natural gas or potable water that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the US. Qualified production gross receipts also include construction activities or engineering and architectural services performed in the US.

The new legislation is expected to benefit not only manufacturers, as the name suggests, but also handlers of agricultural products, software, film production, construction, electric, and gas and water companies, and engineering and architectural firms. Moreover, the deduction is available to corporations, partnerships and other pass-through entities and individuals.

The qualified manufacturing deduction provision creates significant opportunities for Canadian businesses with US operations. Canadians sell and, in many cases, produce and sell their products and services to the US through various avenues, using commission-based or buy and sell arrangements by way of their US subsidiaries and branches. The decision on the structure by which to conduct US operations is based on a medley of factors, including: transfer pricing, duties, US/Canada treaty exemptions, labour costs, legal and regulatory considerations, etc. Canadians should now consider the qualified manufacturing deduction in their decision-making process, subsequent to a careful examination of the new legislation details, and weighing the tax benefits against other nontax-related matters. For example, many US subsidiaries of Canadian corporations are highly leveraged, but still incur US income tax because of limitations on interest expense deductions such as earnings stripping limitations. Moreover, in the case of a Canadian-related entity debt, interest expense may be taxable as income to the Canadian entity and may also be subject to US withholding tax. The qualified manufacturing deduction can be considered an alternate method of sheltering taxable income of US subsidiaries and branches, as it may eliminate US withholding tax and interest income inclusion to Canadian entities.

In conjunction with the qualified manufacturing deduction, Canadians must consider similar state and local legislation that provide tax deductions and credits for activities that create jobs or new business in that state. Combined federal, state and local tax savings may be significant.

Another significant new legislation introduced by the act is the modifications to the tax-shelter regime. Currently, under the tax shelter regulations, taxpayers are subject to federal income tax reporting and other disclosure requirements relating to reportable transactions, including listed transactions. In general, listed transactions are certain transactions that the IRS has identified as corporate tax shelters, while other reportable transactions are transactions that have certain quantitative tax effects and defined characteristics. Prior to the new legislation under the act, there were no penalties imposed on taxpayers for failure to disclose reportable transactions; rather, it weakened the taxpayer’s defence if and when the transaction resulted in an understatement of income tax.

Distinctly, and as opposed to the existing tax shelter regulations, the act imposes significant penalties on taxpayers who fail to disclose reportable transactions, regardless whether the reportable transaction resulted in an understatement of income tax. For example, the act imposes US$50,000 and US$100,000 penalties on companies for failure to disclose a reportable transaction and listed transaction, respectively. It also provides for a 20% (30% in some cases) accuracy-related penalty to understatements of reportable transactions. Other penalties and restrictions include: extending the statute of limitations on unreported listed transactions; disallowing deductions for interest on underpayments of income tax relating to nondisclosed reportable transactions; imposing stricter guidelines for penalty relief; and requiring mandatory disclosure of penalties and underpayments of income tax in annual reports and other public documents for SEC registrants.

In addition, the act introduces specific reporting requirements to material advisers, who provide any material aid, assistance or advice in organizing, managing, promoting, selling, implementing or carrying out a reportable transaction and receive fees over a certain threshold.

This provision deems compliance with tax shelter regulations imperative, especially since the effects of noncompliance may extend beyond monetary damages to other ramifications such as increased governmental scrutiny and a negative effect on public opinion. It is not uncommon for Canadian taxpayers to overlook US regulatory and tax compliance matters while concentrating on Canadian compliance requirements. To avoid any catastrophic consequences of noncompliance, it is important for Canadian taxpayers to understand various tax shelter regulations and to effectively put in place risk management measures to ensure strict compliance.

Another significant change is to deferred compensation arrangement rules. Previously, there was flexibility surrounding nonqualified deferred compensation plans. New provisions introduced specific compliance requirements, creating an immediate need for companies to review their deferred compensation plans and assess the impact of the new requirements. To the extent the new requirements are not met, participants may have to include the total amount of deferred compensation in gross income and may be subject to a 20% penalty, including interest. Taxpayers with deferred compensation plans (in Canada or the US) who have US participants should review their plans to determine if they are subject to the new requirements and if any action should be taken.

The act also introduces changes to the repatriation of US taxpayers’ foreign earnings rules. Currently, US corporations are taxed on their worldwide income, including income from operations of foreign subsidiaries when such income is distributed as a dividend to the US parent. The act provides for a one-time 85% dividend received deduction on a cash dividend in excess of a base amount, provided the dividend is reinvested in the US under an approved domestic reinvestment plan. This is effective for a one-year election available in either 2004 or 2005, but not both.

Although this legislation seems less relevant to Canadian corporations, it may be utilized to reorganize, in a tax-efficient manner, certain undesirable foreign structures of Canadian corporations with US subsidiaries. A common undesirable structure often seen in the market involves a Canadian parent conducting its US operations through a US subsidiary, and the US subsidiary is a parent to a Canadian subsidiary or other foreign subsidiaries (commonly referred to as sandwich structures). This often results from acquisitions and other transactions, creating adverse income and withholding tax implications, as well as foreign tax credit inefficiencies. Depending on the facts and circumstances, Canadian firms may utilize this new legislation, as well as existing US tax law, to spin out undesirable subsidiaries of US corporations in sandwich structures with reduced adverse tax effects.

Of the many provisions of the act, the above-mentioned are the most relevant to Canadian multinationals. However, many of these provisions are unclear, ambiguous and may leave unanswered questions until the Internal Revenue Service and the US Treasury provide guidance through announcements, notices and proposed regulations. In fact, preliminary guidance relating to deferred compensation provisions, guidance relating to the repatriation of US taxpayers’ foreign earnings rules, and domestic manufacturing deductions have been issued. It is expected that legislation will be introduced to resolve technical problems with some provisions of the act.

In addition to legislative changes, the act requires the US Treasury to submit studies on US transfer pricing rules; US tax treaties focusing on inappropriate reductions in withholding taxes and opportunities for abuse; and US earnings stripping rules by June 30, as well as a study on the anti-inversion provisions of the act by December 31, 2006. These studies represent areas the IRS and US Treasury continue to focus on, and ultimately may result in further tax legislative changes.

A most important US international tax area for Canadian multinationals is the earnings stripping regime, as many US operations of Canadian multinationals are financed by debt. In the past, several proposed bills were introduced on Capitol Hill, including provisions that would have significantly tightened the current earnings stripping rules, but none were included in final bills or in the act. Nevertheless, the battle is not over: the act requires the US Treasury to submit a study on earnings stripping rules, an indicator that new earnings stripping proposals are on the way.

Despite significant changes to international (and domestic) taxation legislation introduced, President Bush has promised further fundamental changes to US tax rules will be considered in the next few years, and taxpayers should expect recommendations on tax reform from a presidential panel during 2005.

Taxpayers examining federal tax implications of the act to their businesses and individual circumstances may overlook state and local tax implications. Generally, states follow federal tax treatment of certain areas of the tax law and impose their own legislation on other areas. Many states have issued guidance on certain provisions of the act. For example, Massachusetts has introduced legislation to decouple its legislation from the qualified manufacturing deduction provided in the act. It’s important for taxpayers to examine state and local tax implications and continually observe new state and local reactions to the act.

Legislation may have changed between the time the article was written and press time