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Thursday, December 5, 2013

How the American Taxpayer Relief Act of 2012 Affects Foreign Companies


During 2012, there was significant talk in Washington about amending the tax laws surrounding how income earned outside of the U.S. would be taxed.

These changes ranged from a “tax holiday” as an incentive to repatriate foreign profits earned by U.S. companies back to the U.S., to changing the whole system of tax from a world-wide system of taxation to a territorial system of taxation which all other industrialized countries currently use.

In the end, the 2012 “Fiscal Cliff” legislation included only a few minor provisions that impacted international taxation. Most of these changes are so limited that they will not affect our readers. However, there is one change that is worth noting: the continuation of a tax deferral on interest, royalties or dividends paid between two foreign companies that share the same ownership.

Continuation of Tax Deferral Interest
As background, the U.S. taxes its resident companies and citizens/greencard holders on their worldwide income. However, if this income is earned by a foreign entity, the tax on this income may be deferred until such time as those earnings are repatriated back to the U.S.

As you can imagine, this system could be easily gamed by taxpayers moving income that would otherwise be taxable in the U.S. immediately into foreign businesses so that the U.S. tax on the income could be deferred. Seeing the potential for abuse, Congress enacted a series of rules that restricted this deferral regime. These rules pay particular attention to the types of income that can easily be moved from place to place; an example includes interest and royalty type income.

One of the ways in which Congress stopped the deferral of foreign income was to tax interest and royalties paid between related parties controlled by a U.S. parent or small group of U.S. shareholders immediately.

However, back in 2005, Congress loosened this restriction on the deferral, so that in certain circumstances the U.S. tax on these types of income was also deferred. The provision was set to expire in 2009, but Congress subsequently extended this deferral through 2011. The 2012 Act has extended this deferral through 2013.

Capital Gains Rate and Qualified Dividend Income
A second change affecting international income extends the application of the capital gains rate to Qualified Dividend Income. It is important to note that Qualified Dividend Income does not just include dividends from U.S. companies, but also includes dividends received from a Qualified Foreign Corporation.

A Qualified Foreign Corporation is a foreign corporation that is incorporated in a U.S. possession or in certain foreign jurisdictions that have a qualifying income tax treaty with the U.S. This provision was set to sunset on December 31, 2012, but the 2012 Act has extended this provision indefinitely.

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