The Repeal of the 80/20 Regime

The Repeal of the 80/20 Regime

On August 10, 2010, the President signed into law the Education, Jobs and Medicaid Assistance Act, P.L. 111-226, which, although not evident in the name of the Act, contained certain key foreign tax credit provisions and other rules that significantly affect U.S. multinational corporations.  The Act contained provisions that, in general:

  • prevent the splitting of foreign tax credits until the related income is taken into account;
  • deny the foreign tax credit in the case of foreign income that is not subject to U.S. taxation by reason covered asset acquisitions;
  • require the separate application of the foreign tax credit limitation with respect to items of income resourced under treaties;
  • limit the amount of foreign taxes deemed paid with respect to Section 956 inclusions; and end the special rules for interest and dividends that are received from persons meeting the 80-percent foreign business requirements under Section 871 (the so-called "80/20 regime").

Attention has been given primarily to the new foreign tax credit provisions, which include the new limitation on the amount of foreign taxes deemed paid with respect to Section 956 inclusions and the addition of Section 909, which adds a "matching rule" that in general prevents the separation of foreign tax credits from the foreign income to which they relate. Treasury officials have indicated that guidance is forthcoming with respect to these provisions by the end of year [See 2010 WTD 179-1, "Early FTC Guidance Coming By Year's End, U.S. Officials Say" (Worldwide Tax Daily, Tax Analysts (Sept. 16, 2010))]. Receiving seemingly less attention, however, is the Act's repeal of the 80/20 regime, the tax-savings provisions of which are utilized by certain domestic corporations with gross income significantly generated from foreign sources.

In general, an interest payment or dividend payment from a domestic corporation to a nonresident alien individual or foreign corporation is treated as U.S. source income and thus subject to the 30-percent gross-basis U.S. withholding tax [under Section 871(a) and Section 1441(a) with respect to nonresident aliens or under Section 881(a) or Section 1442(a) with respect to foreign corporations]. [See LexisNexis Tax Advisor - Federal Code Explanations for the cited IRC sections. See LexisNexis Tax Advisor -- Federal Topical 4B:4.04]. However, under Section 861(a)(1)(A), interest from a resident alien individual or domestic corporation meeting the 80-percent foreign business requirements of Section 861(c) is treated as foreign source income and is, therefore, not subject to the 30-percent withholding tax. [See Lexis Explanation IRC Sec. 861(a) , LexisNexis Tax Advisor -- Federal Topical 4B:3.06]. In addition, under Section 871(i), also exempt from the 30-percent withholding tax is a percentage of any dividend paid by a domestic corporation meeting the 80-percent foreign business requirements of Section 861(c)(1) equal to the percentage of such company's total gross income from sources outside the U.S. during the three-year testing period. [See Lexis Explanation IRC Sec. 871(i), LexisNexis Tax Advisor -- Federal Topical 4B:5.02]. Under Section 861(c), an individual or corporation meets the 80-percent foreign business requirements if it is shown to the satisfaction of the Secretary that at least 80 percent of the gross income from all sources of such individual or corporation for the testing period is active foreign business income. [See Lexis Explanation IRC Sec. 861(c) ]. The term "active foreign business income" is defined in Section 861(c)((1) as gross income that: (1) is derived from sources outside the U.S., or in the case of a corporation, that is attributable to income so derived by a subsidiary of the corporation, and (2) is attributable to the active conduct of a trade or business in a foreign country or possession of the U.S. by the individual or corporation, or by a subsidiary of the corporation. The three-year testing period is defined in Section 861(c)(1) as the three-year period ending with the close of the taxable year of the individual or corporation preceding the payment, or such part of the three-year period as may be applicable.

P.L. 111-226 repealed the interest provision under Section 861(a)(1)(A) and the foreign business requirements provisions under Section 861(c) and amended the dividend provision under Section 871(i)(2). The repeal of the provisions is effective, in general, for taxable years beginning after December 31, 2010. The effect of the repeal of the 80/20 regime is that, in general, interest paid by a resident alien individual or domestic corporation meeting the 80-20 requirements will no longer be treated as foreign source and will thus be subject to the 30-perecent withholding tax, and that all or a portion of a dividend paid by a domestic corporation meeting the 80-20 requirements will no longer be exempt from the 30-percent withholding tax. However, the negative impact of the repeal is tempered by the act's adoption of a grandfather rule found in new subsection (l) of Section 871. Under the grandfather rule, any dividend or interest payment by an "existing 80/20 company" will not be subject to U.S. withholding tax. The term "existing 80/20 company" is defined in Section 871(l)(1)(A) as any corporation if:

(1) the corporation met the 80-percent foreign business requirements of Section 861(c)((1) (as in effect prior to the date of the enactment of new Section 861(l)) for such corporation's last taxable year beginning before January 1, 2011;

(2) such corporation meets the 80-percent foreign business requirements of Section 871(l)(1)(B) with respect to each taxable year after the taxable year referred to in (1) above; and

(3) there has not been an addition of a substantial line of business with respect to such corporation after August 10, 2010 (the date of the enactment of new Section 871(l)). [See Lexis Explanation IRC Sec. 861(a) and 871(l)].

As to the foreign business requirements for purposes of the grandfather rule, Section 871(l)(2) states that except as provided in Section 871(l)(1)(B)(iv), a corporation meets the 80-percent foreign business requirements if it is shown to the satisfaction of the Secretary that at least 80 percent of the gross income from all sources of such corporation for the testing period is active foreign business income. Section 871(l)(1)(B) defines the term "active foreign business income" as gross income which -- (1) is derived from sources outside the United States (as determined under Subchapter N [Sections 861 et seq.]), and (2) is attributable to the active conduct of a trade or business in a foreign country or possession of the United States. Section 871(l)(1)(B) also defines the term "testing period" as the 3-year period ending with the close of the taxable year of the corporation preceding the payment (or such part of such period as may be applicable). Also, per Section 871(l)(1)(B), in the case of a corporation with no gross income for such 3-year period (or part thereof), the testing period is taxable year in which the payment is made. In addition, a transition rule is provided in Section 871(l)(1)(B) in the case of a taxable year for which the three-year testing period includes one or more taxable years beginning before January 1, 2011. See Lexis Explanation IRC Sec. 861(a) and 871(l) for additional details on the transition rule]. Under Section 871(l)(2), except as provided in Section 871(l)(1)(B)(iv) (pertaining to the transition rule), the term "active foreign business percentage", with respect to any existing 80/20 company, is defined as the percentage which: (1) the active foreign business income of such company for the testing period, is of (2) the gross income of such company for the testing period from all sources. In addition, under Section 871(l)(3), subject to certain exceptions, an existing 80/20 company and all its subsidiaries are treated as a single corporation.

As to future guidance, Section 871(l)(4) states that the Secretary may issue such regulations or other guidance as is necessary or appropriate to carry out the purposes of Section 871, including regulations or other guidance which provide for the proper application of the aggregation rules described in Section 871(l)(3). As noted above, Treasury officials have indicated that guidance with respect to some of the key foreign tax credit changes made by P.L. 111-226 will be provided prior to the end of the year. It is unclear whether guidance is also soon forthcoming with respect to the effect of the repeal of the 80/20 regime and the adoption of the grandfather rule under Section 871(l). Considering the number of questions that have been raised with respect to the new foreign tax credit rules and given the similarity between the foreign business requirements provisions in repealed Section 861(c) and the grandfather rule provisions in new Section 871(l) (and, thus, presumable familiarity), it would seem reasonable to conclude that the issuance of guidance with respect to the new foreign tax credit provisions would precede the issuance of guidance pertaining to the repeal of the 80/20 provisions. However, as referenced in Section 871(l)(4), guidance relating to the provisions of new Section 871(l), specifically with respect to the application of the aggregation provisions in Section 871(l)(3), may be reasonably anticipated.

As to the policy reason behind the repeal of the 80/20 regime, when the repeal was initially proposed by the administration in 2009, the Treasury Department expressed that the 80/20 regime was subject to manipulation. [2009 TNT 89-44, "Treasury Releases Explanation of Obama Administration Revenue Proposals," Tax Notes Today, TaxAnalysts (May 12, 2009)], and the repeal of the regime is part of the administration's efforts to close perceived international tax loopholes and curtail abuse of certain provisions. However, such efforts should be balanced against the legitimate business reasons, apart from tax-savings motivations, that exist for organizing and operating U.S. multinational corporations in certain ways, especially in the case of such provisions such as the 80/20 rules, which have been a part of the Code for several years [See LexisNexis Tax Advisor -- Federal Topical 4B:3.06]. The grandfather rule provides significant relief from the impact of the repeal of the 80/20 regime for existing, qualifying 80/20 corporations, but observation is warranted of the impact of the repeal on the operation of U.S. multinational corporations that would have qualified under the 80/20 regime and future investment in U.S. multinational corporations.

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