Legislative update - "Miscellaneous" international proposals in Ways and Means chairman’s tax reform “discussion draft” 

March 3:  The tax reform “discussion draft,” released last week by House Ways and Means Chairman Dave Camp, proposes changes to the the tax rules under subpart F of the Code—including changes relating to dividends from controlled foreign corporations, the tax treatment of income from certain passenger cruise line operations, a limitation of treaty benefits in certain instances, the taxation of certain reinsurance payments, and proposals for tightening the earnings stripping rules.

Other subpart F provisions in the Ways and Means chairman’s discussion draft for tax reform are discussed in separate KPMG reports.

Exclude CFC dividends from personal holding company income

A provision (section 3661 of the draft legislation) would exclude dividends paid by controlled foreign corporations (CFCs) from the definition of personal holding company income under Code section 543(a)(1).

This provision is best understood in the context of the other parts of the proposal.

Specifically, Part IV of the proposal would provide a 95% dividends received deduction (DRD) for dividend distributions from CFCs. As a practical matter under the Code section 959 rules, if a distribution from a CFC is treated as a dividend, then it necessarily is not a distribution of earnings that were previously taxed under the subpart F regime. Thus, the distribution of a dividend would represent a distribution of non-subpart F earnings—which under Part IV, would be eligible for a 95% exemption via the DRD.

Because the “personal holding company” definition is determined on a gross income basis, however, the 95% DRD would not prevent the gross amount of the dividend inclusion from being taken into account for personal holding company income purposes. The amendment thus would prevent such dividends, which otherwise generally would be subject to an exemption system under Part IV, from technically being taken into account as personal holding company income.

The proposed change also would underscore the macro-level policy embodied by Part IV, that non-subpart F earnings of a CFC are generally considered to arise from an active business operation.

The provision would be effective for tax years beginning after December 31, 2014.

Taxation of passenger cruise lines

A proposed provision (section 3702 of the draft legislation) would modify the taxation of income earned from the transportation of passengers aboard cruise ships on “covered voyages” (as defined in Code section 4472).

Ordinarily, U.S.-source income derived by foreign ship operators or lessors for transporting passengers and goods in international traffic (meaning the voyage begins or ends within the United States, but not both) is not subject to tax if the country of the foreign corporation’s organization provides a “reciprocal exemption.” Cruise ship voyages that begin at a U.S. port and end at a foreign port, or vice versa, thus qualify for this standard.

If a reciprocal exemption does not apply, then typically a 4% excise tax on a specified amount of income is imposed, in lieu of the traditional inbound taxation rules for service providers. The excise tax does not apply, however, and instead the relevant income is treated as effectively connected, when the foreign ship operator has a fixed place of business in the United States that is involved with earning the transportation income, and substantially all of the corporation’s transportation income is attributable to regularly scheduled transportation.

The proposal would remove passenger cruise transportation income from the special inbound shipping tax regime and instead treat it as effectively connected income, even if the foreign corporation does not have a U.S. fixed base or sufficient regularly scheduled transportation.

The changes would be effective for tax years beginning after December 31, 2014.

KPMG observation

The Ways and Means staff summary states that one of the reasons for these proposed changes is that cruise operators impose a substantial resource burden on the U.S. Coast Guard and the U.S. maritime infrastructure, while the foreign operators typically pay little to no U.S. tax. The staff summary also asserts that given the pricing and capacity metrics within the cruise line industry, the proposal’s drafters considered it unlikely that the cost of the increased taxes would simply be passed on to the passengers.

Foreign shipping or cruise line companies that are qualified residents of applicable treaty jurisdictions are also entitled to an exemption from most or all of their U.S.-source transportation income under Article 8 (Shipping and Air Transport) of U.S. income tax treaties. Nothing in the legislative text or Ways and Means staff summary suggests that this proposal would be intended to overturn that benefit. Thus, it would presumably only affect non-treaty resident foreign cruise line enterprises.

Limitation of treaty benefits for certain deductible payments

A proposed provision (section 3705 of the draft legislation) would add new Code section 894(d) that would deny applicable treaty benefits to, and thus impose the full 30% gross withholding tax upon, certain deductible payments made by a U.S. person to a foreign related person.

The treaty override provision would apply if the payor and payee are indirectly common controlled by a foreign common parent corporation that is not itself eligible for treaty benefits.

KPMG observation

The Ways and Means discussion draft proposal appears to require only that the foreign common parent be eligible for treaty benefits of some kind, and thus would not require a rate comparison between the withholding tax imposed on the actual payment and the withholding tax that would be imposed upon a hypothetical payment to the foreign common parent.

The change would apply immediately, to payments made after the date of enactment. The Joint Committee on Taxation estimates that it would raise $6.9 billion over the following 10 years.

KPMG observation

Similar proposals have been introduced numerous times over the past few years, without success. In practical terms, however, many companies that might have been affected by the provision have already responded by reorganizing their corporate structure so that their ultimate parent company is resident in a treaty jurisdiction.

Disallow the deduction for non-taxed reinsurance premiums paid to affiliates

The discussion draft proposal would:

  • Deny a U.S. insurance company a deduction for reinsurance premiums paid to a related company that is not subject to U.S. tax on the premiums, unless the taxpayer can demonstrate to the IRS that a foreign jurisdiction taxes the premiums at a rate at least as high as the U.S. corporate rate; and
  • Exclude from the insurance company’s income any reinsurance recovered or ceding commissions received with respect to reinsurance policies for which a premium deduction is denied

A foreign corporation that receives a premium from an affiliate that would otherwise be denied a deduction under this proposal would be permitted to elect to treat the premium and the associated investment income as income effectively connected with the conduct of a trade or business in the United States, and attributable to a permanent establishment for tax treaty purposes. The electing reinsurer would be subject to tax under Code section 842.

For foreign tax credit purposes, however, reinsurance income treated as effectively connected under this rule would be treated as foreign source income and would be placed into a separate category within section 904.

The proposal would be effective for tax years beginning after December 31, 2014.

KPMG observation

The administration and others have made similar proposals in the last few years. Although the disallowance of the U.S. company’s deduction for reinsurance premium paid is often described as a deduction deferral mechanism—not a disallowance mechanism—the foregone deduction for reinsurance may or may not be fully offset by the exclusion of the associated reinsurance recoverable or ceding commission, and the timing of recovery of these items is uncertain.

On the other hand, 100% of reinsurance recoverable and ceding commissions may be excluded from the ceding company’s income regardless of whether such amounts are less than, or exceed, the disallowed deduction for the reinsurance premium paid.

Restrict insurance business exception to PFIC rules

Under the proposed provision, income derived by a foreign corporation in the active conduct of an insurance business would not be treated as passive income for purposes of the passive foreign investment company (PFIC) rules only if:

  • More than 50% the corporation’s gross receipts for the tax year consist of premiums, and
  • Loss and loss adjustment expenses, unearned premiums, and certain reserves constitute more than 35% of the corporation’s total assets

The provision would be effective for tax years beginning after December 31, 2014.

KPMG observation

Under current law, income derived by a foreign corporation in the active conduct of an insurance business qualifies for an exception from passive income if the corporation is “predominantly engaged” in an insurance business. The provision would create a “bright-line test” for that determination, under which some foreign corporations may no longer qualify for the exception.

Tighten limitation on earnings stripping

The proposal would reduce the 50% of adjusted taxable income threshold for the limitation to 40%. In addition, the carryforward of excess limitation would be eliminated.

The proposal would be effective for tax years beginning after December 31, 2014.

KPMG observation

The administration previously proposed tightening the limitation on earnings stripping. The Joint Committee on Taxation (JCT) explanation of the administration’s FY 2013 proposal* discusses in detail the stripping of earnings by entities, particularly those which inverted successfully prior to the effective date of section 7874, including a thorough analysis of a Treasury report prepared to evaluate the impact of earnings stripping.

The JCT explanation points out that the administration’s proposal did not address earnings stripping transactions involving the payment of deductible amounts other than interest (e.g., rents, royalties, reinsurance premiums, and service fees) or the payment of deductible amounts by taxpayers other than corporations. The JCT explanation states that “[t]hese transactions also may erode the U.S. tax base, and thus some argue that a more comprehensive response to earnings stripping is needed.” The JCT explanation does not offer any specific proposals, however, with respect to these other types of payments.

*Joint Committee on Taxation, Description of Revenue Provisions Contained in the President’s Fiscal Year 2013 Budget Proposal (JCS-2-2012), June 2012.

For more information, contact a tax professional with KPMG’s International Corporate Services practice in KPMG’s Washington National Tax:

Seth Green

(202) 533-3022

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