Repatriated Earnings under Sec. 965: Using the Safe-Harbor Test in 2007 to Ease Compliance Reporting and Protect Tax Benefits

Editor: Anthony S. Bakale, CPA, M.Tax.

U.S. multinational corporations repatriated billions of dollars in earnings from foreign subsidiaries to the U.S. under Sec. 965 during the time such repatriation was allowed. Companies that took advantage of this unique opportunity benefited from the temporary 85% dividends-received deduction (DRD) applied to qualifying dividends. To protect these generous tax benefits, companies must comply with annual reporting requirements and abide by the statute’s somewhat flexible reinvestment guidelines. During 2007, it is especially important for corporations to examine the status of their plans to ensure that at least 60% of those earnings have been reinvested in qualified projects by the end of the year. This item recaps the key features of Sec. 965, describes the related documentation and annual reporting requirements, and examines the advantages afforded companies that satisfy the safe-harbor test by the end of 2007.

U.S. Taxation of Non-U.S. Income and Sec. 965

The U.S. generally taxes the income of U.S. corporations from both domestic and foreign sources. However, income from foreign operations earned by non-U.S. subsidiaries is often subject to tax only when that income is distributed as a dividend to the U.S. parent company. It is estimated that, before the enactment of Sec. 965, multinationals had accumulated over $700 billion offshore in order to avoid U.S. taxes on their overseas earnings; see Gonzalez, “Q&A: Repatriating Foreign Earnings through the American Jobs Creation Act,” July 2005, at http://corp.bankofamerica.com/public/public.portal_
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Sec. 965 was signed into law as part of the American Jobs Creation Act of 2004. Its purpose was to encourage companies to repatriate those accumulated earnings in order to strengthen their domestic operations and stimulate the U.S. economy. For a period of one year, U.S. corporations could elect to receive an 85% DRD for eligible cash dividends repatriated from their non-U.S. subsidiaries. This election was available for the U.S. taxpayer’s last tax year beginning before Oct. 22, 2004, or for the first tax year beginning during the one-year period beginning on Oct. 22, 2004. Thus, for calendar-year taxpayers, the election was made for either the 2004 or 2005 tax year. The lack of initial IRS guidance on certain technical issues, coupled with the time required by companies for extensive tax planning, resulted in many calendar-year corporations making the election for the 2005 tax year.

To qualify for this special DRD, electing corporations agreed to reinvest in the U.S. an amount equal to the dividends received pursuant to a properly approved domestic reinvestment plan (DRP). Repatriated earnings did not need to be reinvested in the same year that the funds were repatriated. Instead, such earnings could be reinvested over time, provided they were made in accordance both with Treasury guidelines and with the corporation’s DRP.

In January 2005, the Service issued Notice 2005-10. This notice clarified a number of ambiguities in the law, particularly with respect to the definition of cash dividends, key elements of DRPs and the nature of permitted investments. This guidance permitted many companies to prepare DRPs, make the election and repatriate non-U.S. earnings. As expected, U.S. corporations responded strongly to this incentive, by repatriating over $300 billion in earnings from foreign subsidiaries; see Graham, “U.S. Firms Brought Money Home in Droves Due to ’05 Tax Break,” Inv. Bus. Daily, Jan. 12, 2006.

Domestic Reinvestment Plans and Allowable Reinvestments

The IRS did not provide a required form or sample template for the DRP, but certain requirements were stated. The DRP needed to describe anticipated permitted investments in “reasonable” detail and specificity and provide a “reasonable” time period within which the company anticipated completing the investments.

Sec. 965(b)(4)(B) provides the general rules as to the categories of expenditures that qualify as permitted U.S. investments. While these categories provided some useful information, the IRS realized that more specificity was needed before U.S. corporations would act. Section 5 of Notice 2005-10 provided additional guidance on:

• Funding of worker hiring, training and other compensation: Expenditures qualify only to the extent attributable to services performed within the U.S. The funding of a qualified pension plan within the meaning of Sec. 401(a) is permitted, but only to the extent the funding is not related to executive compensation.
• Infrastructure and capital investments: This category includes plant, property and equipment; communications and distribution systems; computer hardware and software; and databases and supporting equipment. Such expenditures qualify only to the extent the investments are located and used within the U.S.
• Research and development (R&D): R&D qualifies to the extent the activities are performed within the U.S.
• Financial stabilization for purposes of job retention or creation: This rather broad category permits investments based on all facts and circumstances. The Service will generally consider expenditures that reduce financial constraints to qualify if, at the time the DRP was approved, it was the U.S. corporation’s “reasonable business judgment” that a reduction in corporate financial constraints would be “a positive factor” in its ability to retain and create jobs in the U.S.
• Acquisitions of interests in business entities: The entity in which the interest is being acquired may be foreign or U.S., provided that after the acquisition at least 10% of the entity is held.
• Advertising and marketing: Expenditures related to intangible assets (such as trademarks and trade names) are allowed to the extent provided within the U.S.
• Other intangible property: Expenditures to acquire rights to such property qualify to the extent the rights are used in the U.S.

Notice 2005-10 also provided a list of expenditures that do not qualify as permitted investments. These include executive compensation, intercompany transactions, dividends, stock redemptions, acquisition of debt instruments and tax payments. It is significant that the notice restated language found in the conference committee report, which stated that neither the list of permitted investments nor the list of nonpermitted investments was exclusive. Thus, some uncertainty remains as to allowable investments.

Tracing and Historical Investments

In addition to providing a broad range of permitted investments, Sec. 965 provided favorable treatment of the funds used to make those investments. U.S. corporations were not required to trace or segregate repatriated funds. Of even greater significance, there was no requirement that such expenditures be in excess of the corporation’s historical expenditures in those investments.

Why Is It Important to Review DRPs in 2007?

Though elections under Sec. 965 have already been made and earnings repatriated, it is essential that corporations review their DRPs during 2007 in order to (1) avail themselves of the opportunity to reduce compliance reporting and (2) minimize potential tax exposure.

Notice 2005-10 provides that, unless an exception applies, the U.S. corporation must annually provide a detailed statement of information regarding reinvestments until all amounts repatriated are fully reinvested. The required statement must include the following:

1. A description of permitted investments made during the year;
2. A full reconciliation of expenditures made through the end of the year for which the statement is filed;
3. A calculation of the plan’s percentage of completion; and
4. A statement indicating whether any investments constitute “alternative investments.”

Notice 2005-10 also requires that a company have evidence of the proper investment of repatriated funds. Unless the U.S. corporation avails itself of the safe-harbor provision (see below), the corporation must establish the amount of the dividend that has been invested pursuant to its plan under a facts-and-circumstances test.

Facts and Circumstances

Under the facts-and-circumstances test, the taxpayer must substantiate to the IRS’s satisfaction the amount of permitted investments that have been (or will be) made. Items subject to scrutiny include the degree of specificity of the plan, the extent to which the taxpayer has satisfied the documentation requirements, and the time period in which the taxpayer intends to make all required reinvestments. Notice 2005-10 states that the U.S. corporation must meet a “reasonableness” test with respect to specificity and the time period for reinvestment. A DRP may be subject to greater scrutiny if the plan provides that reinvestment will occur “over many years.” Thus, the facts-and-circumstances test (and the reasonableness standard) leave the U.S. corporation subject to liability for additional taxes if on review it is found that the test was not met.

The Safe-Harbor Alternative

To reduce the risks posed under the facts-and-circumstances test, a U.S. corporation can elect to satisfy its reinvestment requirements using a safe-harbor test. This alternative provides at least two advantages. First, the corporation can cease the annual reporting otherwise required under Sections 8.02(a) and 8.03(c) of Notice 2005-10. Second, if the U.S. corporation meets the requirements of the test, the corporation will have established to the Service’s satisfaction that the amount of repatriated dividends has been invested in the U.S. pursuant to the DRP (as required under Sec. 965(b)(4)).

Action Required in 2007

To satisfy the safe-harbor test, companies must timely satisfy certain substantive and reporting requirements. First, at least 60% of the funds to be reinvested under a DRP must have been expended or be the subject of a binding contract or commitment entered into by the end of the second tax year following the year of the taxpayer’s Sec. 965 election; only permitted investments listed in Notice 2005-10 are taken into account. Second, in addition to complying with the annual reporting requirements, the corporation must make the following representations in an annual report filed for a tax year no later than the second tax year following the tax year to which the corporation elected to apply Sec. 965:

1. The requirements of the safe harbor have been met; and
2. The taxpayer intends to make the remaining investments no later than the fourth tax year following the year of the election.

Thus, in addition to meeting reporting requirements, calendar-year corporations that made the election for 2005 must make such reinvestments (or have a contract or commitment entered into) by Dec. 31, 2007, in order to satisfy the more certain safe-harbor test.

The surest method of establishing that 60% of repatriated earnings have been invested is to actually expend those funds. It is expected that most U.S. corporations will do this. If, however, it is not possible to actually expend these funds, a calendar-year U.S. corporation should take advantage of the ability to have the needed funds be the subject of a binding contract or commitment by Dec. 31, 2007.

Summary

Many U.S. corporations took advantage of the unique opportunity to repatriate earnings at nominal tax cost under Sec. 965. Those corporations now have the opportunity to both reduce the risk of loss of those benefits and reduce their compliance burden by meeting the requirements of the safe-harbor test. To take advantage of this opportunity, calendar-year corporations that made the election in 2005 are encouraged to establish, by the end of 2007, that at least 60% of the amount of repatriated earnings has been expended for qualified investments or is subject to a binding contract or commitment for qualified investments.