Post by Albert Liguori on Jan 14, 2009 0:21:33 GMT 4
Repatriation and Your Foreign Exchange Exposure
Tax professionals are often held responsible for matters that do not relate to tax. Take foreign exchange exposures, for example. This is an area traditionally governed by in-house treasury professionals. But in today’s environment, don’t be surprised if it’s the tax department that’s held responsible.
These days tax professionals are experiencing a unique convergence of pressures. With the global liquidity crisis, we are pressured to manage global cash more effectively — with an intense focus on repatriating funds to the United States. At the same time, we are dealing with the effects of rapidly changing foreign exchange rates. This convergence creates a unique set of risks and opportunities for a company’s tax and treasury departments. Unfortunately, it’s during such times of urgency and intensity when the lines of communication within an organization typically break down. It’s a good bet that many tax and treasury groups will not communicate adequately during the coming months, yet CFOs will likely hold the tax personnel accountable for the communication between the tax and treasury departments.
The following two repatriation case studies serve as a reminder of the basic issues that ought to be addressed in coordination with your treasury team, with a focus on the unique issues we are encountering in this new financial environment. The point is to avoid being blindsided by issues for which you might not have considered yourself responsible.
Scenario #1 — Repatriating Previously Taxed Income
This first scenario demonstrates how the trend toward a stronger dollar may allow the recognition of foreign exchange loss deductions.
Assume that in a prior year, a controlled foreign corporation (CFC) with the euro as its functional currency realized €50 of Subpart F income. Such income was recognized in the U.S. company’s (U.S.-Co’s) taxable income in the U.S. as converted by the average exchange rate for that prior year. Assume that rate was US$1.50 to the euro. Using that rate, U.S.-Co’s taxable inclusion was US$75 in the prior year.
In the current year, because of the increased pressure to bring funds to the U.S., CFC makes a distribution of the €50. As this income was already taxed in the U.S., it is classified as previously taxed income, and the distribution is not taxed as a dividend. However, when the distribution is made using today’s exchange rates, the actual funds received are different from the amount previously recognized as income. For example, if today’s rate was US$1.20 per euro, U.S.-Co would receive only $60. Compared with the $75 basis that U.S.-Co has in the previously taxed income, U.S.-Co would be entitled to recognize an ordinary $15 foreign exchange loss in its current U.S. tax base. (See Internal Revenue Code Section 986 for related rules.)
For a scenario like this one, here are a few points worth discussing with your treasury and accounting teams:
* Whether this loss will create cash tax savings in the current year;
* Whether the books will recognize a gain or loss;
* Whether the book effect will hit the profit and loss statement (P&L) or the cumulative translation adjustment account;
* How to account for the tax benefit of the deductible loss;
* Whether your treasury or finance team is comfortable with this economic divestment from the euro;
* The cost of using a “tax-free” channel of cash from the CFC;
* The effect of a foreign exchange loss on foreign tax credit utilization; and
* Whether such loss should be disclosed as a reportable IRC Section 165 loss transaction.
Other Settlement and Distribution Scenarios
a. Settlement of intercompany loans across functional currencies
Other repatriation scenarios create many of the same issues discussed above. For instance, the settlement of intercompany loans across functional currencies, while covered by a different code section (see IRC Section 988), results in similar foreign exchange recognition events. Say for example that CFC repays a dollar-denominated loan to U.S.-Co. Whether there would be a gain or loss on the transaction would depend on factors such as the strength of the dollar at the time of the initial loan versus when the loan is repaid. Given the strength of the dollar today versus other currencies, there is a potential IRC Section 988 loss on the transaction. For book purposes, these loans are sometimes hedged. Other times, they are treated as indefinite term investments for accounting purposes, making it more complicated to analyze the book impact — see Statement of Financial Accounting Standards No. 52 (FAS 52).
b. Expanded use of loans from CFCs to the U.S. under Notice 2008-91
Repatriation planning could also include the use of loans from CFCs to the U.S. under Notice 2008-91, a recent expansion of exceptions from IRC Section 956. These loans are typically cross-currency, meaning that either the borrower or the lender has foreign exchange exposure for books and tax. On the book side, it’s not expected that such loans will qualify as “equity investments” under FAS 52 and, therefore, they will be marked to market as exchange rates change. With wild fluctuations in the exchange rates these days, this cross-border lending significantly increases a company’s P&L exposure.
c. Repatriating distribution made through a non-dollar-denominated branch
Consider also the example of a repatriating distribution made through a non-dollar-denominated branch. Branches that are non-dollar-denominated are governed by yet another code section: IRC Section 987. The foreign exchange rules in this area have been in flux for a long time, and uncertainty exists in the tax field as to their application. These calculations can be complex, and the rules leave a lot of discretion to the taxpayer. Also, there are proposed regulations for which the IRS has been granting early method adoptions. The result is that there are often various acceptable treatments of a single branch or transaction in this area that can have varying results — all of which makes this an important scenario for tax professionals to look out for.
Scenario #2 — Repatriation via License Agreements
This second scenario demonstrates how recurring repatriation planning via transfer pricing might have unforeseen book and tax foreign exchange implications.
Assume that U.S.-Co enters into a license agreement with CFC whereby CFC has the right to use a trademark in exchange for a stream of royalty payments. As is generally the case in such an arrangement, assume that the royalty payment obligation is determined based on a percentage of CFC’s revenue, and that the contract requires the payment to be made in euros — CFC's functional currency. Many companies use this transaction or a derivative of this transaction to achieve repatriation through transfer pricing. It often results in tax-efficient repatriation when the CFC is entitled to a deduction in its local country for the royalty payment and when that CFC is subject to a tax rate roughly equivalent to the U.S. rate. In other words, this transaction results in a movement of cash to the U.S. without a significant income tax cost.
Under a typical intercompany license agreement, CFC becomes legally obligated to make a payment shortly after a measurement period ends, usually on a quarterly basis. In our example, assume that CFC became obligated in October to make a royalty payment to U.S.-Co for the license during the immediately preceding quarter that ended September 30. However, here’s a twist. Given the uncertainty of the strength of the dollar going forward, the company decides to defer settlement until the euro strengthens, the idea being to wait until the euro converts to more dollars. Because the obligation to make the royalty payment has become due but has not been settled by the CFC, the likely book and tax treatment is the formation of an intercompany receivable and payable, denominated in euros under the terms of the license agreement.
This is where a communication breakdown between a company’s tax, treasury and accounting teams usually occurs. The formation of such intercompany accounts during the period from the date the royalty becomes due and the actual settlement of the obligation often creates unanticipated book and tax foreign exchange exposures. For books, these intercompany accounts are likely not eligible for FAS 52 indefinite term status. As a result, if not hedged, they will be marked to market, and gains and losses from foreign exchange fluctuation will hit the company’s P&L. And as discussed earlier in this article, for tax purposes, the foreign exchange gain or loss on an intercompany loan is usually recognized when the payable is settled (again, see IRC Section 988). Normally, foreign exchange volatility is managed by a company’s treasury group. But because the original royalty planning was likely implemented by the tax department, CFOs will naturally look to tax department personnel for this kind of foreign exchange exposure on the books. Therefore, the head of tax is frequently held accountable for the P&L volatility.
While a royalty example was given above, this type of risk exists across much of a company’s transfer pricing and intercompany dealings. For example, consider the similar issues that surface in the context of intercompany sales of product, services charges, management fees, guarantee fees, etc. We’ve also seen repatriation planning in the context of prepaying buy-in payments, cost-sharing obligations and management fees. While the tax aspects of these scenarios can be quite beneficial, we stress caution regarding the foreign exchange profile of these kinds of arrangements, and we suggest careful coordination with your treasury team.
Alvarez & Marsal Taxand Says:
Don’t let the intensity and urgency of today’s financial markets lead to either missed opportunities or failed identification of future or current foreign exchange gain or loss exposures. Remember that the tax department is traditionally held accountable for repatriation planning strategies and their consequences, and likely will be on the hook for the foreign exchange traps. Therefore:
* Don’t plan in isolation. Schedule regular internal meetings between your tax, transfer pricing and treasury teams;
* Set a system of reviewing previously taxed income balances, intercompany loans and the status of branch structures;
* Work with your finance team to bring intercompany invoice dates and settlement dates closer in time; and
* Identify foreign exchange implications (book and tax) before implementing any repatriation strategy.
Disclaimer
As provided in Treasury Department Circular 230, this e-newsletter is not intended or written by Alvarez & Marsal Taxand, LLC, to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
Alvarez & Marsal Taxand, LLC distributes a complimentary electronic newsletter to subscribers on a weekly basis. A&M Tax Advisor Weekly provides comprehensive and timely insight on a wide range of taxation issues including international tax, state and local tax, incentives and current issues. Readers are reminded that they should not consider these documents to be a recommendation to undertake any tax position, nor consider the information contained therein to be complete. Before any item or treatment is reported, or excluded from reporting on tax returns, financial statements, or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in these releases may not continue to apply to a reader's situation due to changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
Alvarez & Marsal
Albert Liguori
Managing Director, New York
212-763-1638
Tax professionals are often held responsible for matters that do not relate to tax. Take foreign exchange exposures, for example. This is an area traditionally governed by in-house treasury professionals. But in today’s environment, don’t be surprised if it’s the tax department that’s held responsible.
These days tax professionals are experiencing a unique convergence of pressures. With the global liquidity crisis, we are pressured to manage global cash more effectively — with an intense focus on repatriating funds to the United States. At the same time, we are dealing with the effects of rapidly changing foreign exchange rates. This convergence creates a unique set of risks and opportunities for a company’s tax and treasury departments. Unfortunately, it’s during such times of urgency and intensity when the lines of communication within an organization typically break down. It’s a good bet that many tax and treasury groups will not communicate adequately during the coming months, yet CFOs will likely hold the tax personnel accountable for the communication between the tax and treasury departments.
The following two repatriation case studies serve as a reminder of the basic issues that ought to be addressed in coordination with your treasury team, with a focus on the unique issues we are encountering in this new financial environment. The point is to avoid being blindsided by issues for which you might not have considered yourself responsible.
Scenario #1 — Repatriating Previously Taxed Income
This first scenario demonstrates how the trend toward a stronger dollar may allow the recognition of foreign exchange loss deductions.
Assume that in a prior year, a controlled foreign corporation (CFC) with the euro as its functional currency realized €50 of Subpart F income. Such income was recognized in the U.S. company’s (U.S.-Co’s) taxable income in the U.S. as converted by the average exchange rate for that prior year. Assume that rate was US$1.50 to the euro. Using that rate, U.S.-Co’s taxable inclusion was US$75 in the prior year.
In the current year, because of the increased pressure to bring funds to the U.S., CFC makes a distribution of the €50. As this income was already taxed in the U.S., it is classified as previously taxed income, and the distribution is not taxed as a dividend. However, when the distribution is made using today’s exchange rates, the actual funds received are different from the amount previously recognized as income. For example, if today’s rate was US$1.20 per euro, U.S.-Co would receive only $60. Compared with the $75 basis that U.S.-Co has in the previously taxed income, U.S.-Co would be entitled to recognize an ordinary $15 foreign exchange loss in its current U.S. tax base. (See Internal Revenue Code Section 986 for related rules.)
For a scenario like this one, here are a few points worth discussing with your treasury and accounting teams:
* Whether this loss will create cash tax savings in the current year;
* Whether the books will recognize a gain or loss;
* Whether the book effect will hit the profit and loss statement (P&L) or the cumulative translation adjustment account;
* How to account for the tax benefit of the deductible loss;
* Whether your treasury or finance team is comfortable with this economic divestment from the euro;
* The cost of using a “tax-free” channel of cash from the CFC;
* The effect of a foreign exchange loss on foreign tax credit utilization; and
* Whether such loss should be disclosed as a reportable IRC Section 165 loss transaction.
Other Settlement and Distribution Scenarios
a. Settlement of intercompany loans across functional currencies
Other repatriation scenarios create many of the same issues discussed above. For instance, the settlement of intercompany loans across functional currencies, while covered by a different code section (see IRC Section 988), results in similar foreign exchange recognition events. Say for example that CFC repays a dollar-denominated loan to U.S.-Co. Whether there would be a gain or loss on the transaction would depend on factors such as the strength of the dollar at the time of the initial loan versus when the loan is repaid. Given the strength of the dollar today versus other currencies, there is a potential IRC Section 988 loss on the transaction. For book purposes, these loans are sometimes hedged. Other times, they are treated as indefinite term investments for accounting purposes, making it more complicated to analyze the book impact — see Statement of Financial Accounting Standards No. 52 (FAS 52).
b. Expanded use of loans from CFCs to the U.S. under Notice 2008-91
Repatriation planning could also include the use of loans from CFCs to the U.S. under Notice 2008-91, a recent expansion of exceptions from IRC Section 956. These loans are typically cross-currency, meaning that either the borrower or the lender has foreign exchange exposure for books and tax. On the book side, it’s not expected that such loans will qualify as “equity investments” under FAS 52 and, therefore, they will be marked to market as exchange rates change. With wild fluctuations in the exchange rates these days, this cross-border lending significantly increases a company’s P&L exposure.
c. Repatriating distribution made through a non-dollar-denominated branch
Consider also the example of a repatriating distribution made through a non-dollar-denominated branch. Branches that are non-dollar-denominated are governed by yet another code section: IRC Section 987. The foreign exchange rules in this area have been in flux for a long time, and uncertainty exists in the tax field as to their application. These calculations can be complex, and the rules leave a lot of discretion to the taxpayer. Also, there are proposed regulations for which the IRS has been granting early method adoptions. The result is that there are often various acceptable treatments of a single branch or transaction in this area that can have varying results — all of which makes this an important scenario for tax professionals to look out for.
Scenario #2 — Repatriation via License Agreements
This second scenario demonstrates how recurring repatriation planning via transfer pricing might have unforeseen book and tax foreign exchange implications.
Assume that U.S.-Co enters into a license agreement with CFC whereby CFC has the right to use a trademark in exchange for a stream of royalty payments. As is generally the case in such an arrangement, assume that the royalty payment obligation is determined based on a percentage of CFC’s revenue, and that the contract requires the payment to be made in euros — CFC's functional currency. Many companies use this transaction or a derivative of this transaction to achieve repatriation through transfer pricing. It often results in tax-efficient repatriation when the CFC is entitled to a deduction in its local country for the royalty payment and when that CFC is subject to a tax rate roughly equivalent to the U.S. rate. In other words, this transaction results in a movement of cash to the U.S. without a significant income tax cost.
Under a typical intercompany license agreement, CFC becomes legally obligated to make a payment shortly after a measurement period ends, usually on a quarterly basis. In our example, assume that CFC became obligated in October to make a royalty payment to U.S.-Co for the license during the immediately preceding quarter that ended September 30. However, here’s a twist. Given the uncertainty of the strength of the dollar going forward, the company decides to defer settlement until the euro strengthens, the idea being to wait until the euro converts to more dollars. Because the obligation to make the royalty payment has become due but has not been settled by the CFC, the likely book and tax treatment is the formation of an intercompany receivable and payable, denominated in euros under the terms of the license agreement.
This is where a communication breakdown between a company’s tax, treasury and accounting teams usually occurs. The formation of such intercompany accounts during the period from the date the royalty becomes due and the actual settlement of the obligation often creates unanticipated book and tax foreign exchange exposures. For books, these intercompany accounts are likely not eligible for FAS 52 indefinite term status. As a result, if not hedged, they will be marked to market, and gains and losses from foreign exchange fluctuation will hit the company’s P&L. And as discussed earlier in this article, for tax purposes, the foreign exchange gain or loss on an intercompany loan is usually recognized when the payable is settled (again, see IRC Section 988). Normally, foreign exchange volatility is managed by a company’s treasury group. But because the original royalty planning was likely implemented by the tax department, CFOs will naturally look to tax department personnel for this kind of foreign exchange exposure on the books. Therefore, the head of tax is frequently held accountable for the P&L volatility.
While a royalty example was given above, this type of risk exists across much of a company’s transfer pricing and intercompany dealings. For example, consider the similar issues that surface in the context of intercompany sales of product, services charges, management fees, guarantee fees, etc. We’ve also seen repatriation planning in the context of prepaying buy-in payments, cost-sharing obligations and management fees. While the tax aspects of these scenarios can be quite beneficial, we stress caution regarding the foreign exchange profile of these kinds of arrangements, and we suggest careful coordination with your treasury team.
Alvarez & Marsal Taxand Says:
Don’t let the intensity and urgency of today’s financial markets lead to either missed opportunities or failed identification of future or current foreign exchange gain or loss exposures. Remember that the tax department is traditionally held accountable for repatriation planning strategies and their consequences, and likely will be on the hook for the foreign exchange traps. Therefore:
* Don’t plan in isolation. Schedule regular internal meetings between your tax, transfer pricing and treasury teams;
* Set a system of reviewing previously taxed income balances, intercompany loans and the status of branch structures;
* Work with your finance team to bring intercompany invoice dates and settlement dates closer in time; and
* Identify foreign exchange implications (book and tax) before implementing any repatriation strategy.
Disclaimer
As provided in Treasury Department Circular 230, this e-newsletter is not intended or written by Alvarez & Marsal Taxand, LLC, to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
Alvarez & Marsal Taxand, LLC distributes a complimentary electronic newsletter to subscribers on a weekly basis. A&M Tax Advisor Weekly provides comprehensive and timely insight on a wide range of taxation issues including international tax, state and local tax, incentives and current issues. Readers are reminded that they should not consider these documents to be a recommendation to undertake any tax position, nor consider the information contained therein to be complete. Before any item or treatment is reported, or excluded from reporting on tax returns, financial statements, or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in these releases may not continue to apply to a reader's situation due to changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
Alvarez & Marsal
Albert Liguori
Managing Director, New York
212-763-1638