Foreign Income & Taxpayers
The extraterritorial income (ETI) regime was enacted in 2000 to provide domestic taxpayers with special tax benefits for certain export-related income. After only a few years on the books, however, the American Jobs Creation Act of 2004, P.L. 108-357 (AJCA), repealed the ETI regime and generally discontinued ETI benefits for transactions entered into after 2006. At the time, many taxpayers assumed that ETI benefits were also discontinued for all income recognized after 2006. Recent IRS guidance confirms, however, that the ETI benefit may still be available for income that taxpayers recognized in post-2006 years from certain transactions occurring before the ETI regime was repealed.
The FSC Repeal and Extraterritorial Income Exclusion Act of 2000, P.L. 106-519, generally replaced the foreign sales corporation (FSC) regime with the ETI regime. Congress created the ETI regime in response to a World Trade Organization (WTO) determination that the FSC regime constituted a prohibited export subsidy. The ETI regime gave domestic taxpayers a new tax benefit by amending the definition of gross income to exclude certain extraterritorial income. The ETI provisions were contained in Secs. 114 and 941–943 and generally were effective for “transactions” entered into after September 30, 2000 (the ETI effective date).
In January 2002, the WTO determined that the ETI regime also constituted a prohibited export subsidy. Accordingly, Congress responded in the AJCA, which repealed the ETI regime for transactions entered into after December 31, 2004 (the ETI repeal date). In addition to the general repeal rule, the AJCA also provided a transition (or phaseout) rule that permits taxpayers to claim 80% of the ETI benefits that would have been available prior to repeal for income recognized from a transaction entered into during 2005 and 60% of ETI benefits for income from a transaction entered into during 2006.
When Does a Transaction Occur?
Assuming that the requirements of Secs. 114 and 941–943 are satisfied, income from a transaction will be eligible for ETI benefits only if the transaction was entered into after the ETI effective date and before the end of the ETI phaseout period. Sec. 943(b)(1)(A) of the ETI regime defines a transaction as:
- Any sale, exchange, or other disposition;
- Any lease or rental; or
- Any furnishing of services.
The term “lease” also includes a license. This discussion will focus on long-term leasing and licensing transactions, as those are the types of transactions more likely to produce income eligible for continued ETI benefits.
Prior to 2007, there was little guidance regarding the treatment of long-term leases and licenses for ETI purposes. For long-term leases or licenses that were executed before the ETI effective date and/or continued after the ETI repeal date, however, the availability of ETI benefits hinges on the determination of when the transaction was entered into. Consequently, in the absence of guidance, taxpayers adopted several different approaches for determining when a long-term transaction occurred for ETI purposes. The two main approaches can be referred to as the single transaction approach and the multiple transaction approach.
The single transaction approach adopts the proposition that a long-term lease or license agreement constitutes a single transaction for ETI purposes that is entered into at the time the lease or license is executed and the underlying property is available for use. Under this interpretation, if a lease or license was executed after the ETI effective date and before the ETI repeal date, any income recognized under the lease or license is eligible for full ETI benefits, regardless of when the income is received. A natural corollary to this position is that any future income recognized from leases or licenses executed during the 2005 or 2006 phaseout years is also eligible for ETI benefits, albeit at the reduced rates. Income is not eligible for ETI benefits, however, if the underlying lease or license was executed before the ETI effective date or after 2006.
The multiple transaction approach, on the other hand, adopts the proposition that a new transaction occurs each time income is received under a lease or license. Thus, under this interpretation, ETI benefits are available for any leasing or licensing income received between October 1, 2000, and December 31, 2006, regardless of when the underlying lease or license was executed. The advantage of this interpretation is that ETI benefits are available for income received from leases or licenses executed before the ETI effective date. The disadvantage is that income received after 2006 does not qualify for ETI benefits, even if the underlying lease or license was executed after the ETI effective date and before the ETI repeal date.
On January 12, 2007, the IRS issued Chief Counsel Attorney Memorandum 2007-001 to address some general questions regarding the application of the ETI and FSC repeal date and transition date rules to long-term leases and sales transactions. The memorandum provides several examples illustrating the application of the rules and takes the position that a long-term lease is a single transaction for ETI purposes that is entered into when the lease is executed, not when the leasing income is received.
An example in the memorandum also confirms that ETI benefits may still be available for income received in post-2006 years from a lease executed prior to the ETI repeal date. The example involves a taxpayer that entered into a 10-year lease on January 1, 2004, and will recognize rental income for 10 years beginning in 2004. In this case, the memorandum adopts the single transaction approach and concludes that because the lease was entered into prior to the ETI repeal date, all the income received under the 10-year lease (including income received in post-2006 years) is eligible for full ETI benefits.
On March 28, 2008, the IRS released a second memorandum (Chief Counsel Advice (CCA) 200813041) that addresses the application of the repeal and transition date rules to a multiyear licensing transaction. The CCA involves a domestic corporation (USCo) that entered into a multiyear software licensing agreement (SLA) with a foreign subsidiary (Sub1) on date 1. The SLA allowed Sub1 to use, copy, distribute, and sublicense USCo’s computer software. The SLA was effective for a minimum duration of one year and would continue until terminated or modified. It was later amended on date 2 and again on date 3.
Although not expressly stated, dates 1 and 2 presumably occurred prior to the ETI effective date. Thus, under the single transaction approach, income attributable to the agreements was not eligible for ETI benefits. The date 3 amendment occurred at some point after the ETI effective date and prior to the ETI repeal date. USCo argued that the SLA (as amended on date 3) represented a new transaction entered into on date 3, because the date 3 amendment constituted a “significant modification” to the agreement. Accordingly, USCo argued that income it recognized in 2005 from the SLA was not subject to the ETI phaseout rules.
The IRS agreed with USCo’s ultimate contention that full ETI benefits were available for income recognized in 2005. Specifically, the IRS concluded that the date 3 amendment resulted in a new license entered into after the ETI effective date and prior to the ETI repeal date. Thus, the income earned in 2005 was eligible for full ETI benefits and was not subject to the 20% reduction provided in the phaseout rules.
Although the IRS agreed with USCo’s ultimate contention, it disagreed with USCo’s assertion that the touchstone of inquiry was whether the date 3 amendment was a significant modification. Instead, the IRS noted that the SLA itself provided that a modification to the SLA resulted in the termination of the existing agreement and the creation of a new one. The IRS stated that the date 3 amendment changed the “terms” of the agreement and thus resulted in a modification that triggered the termination provision of the existing contract. The IRS, however, did not elaborate on what it considered to be a change in terms—indeed, a change in a minor (i.e., insignificant) contractual term may not have risen to the level of a modification for purposes of the termination provision. Thus, the difference between the IRS’s and the taxpayer’s views on the significant modification issue might have been more a matter of semantics than of substance.
Although it is not a definitive statement of the IRS’s position and cannot be used or cited as precedent under Sec. 6110(k)(3), the upshot of CCA 200813041 is that a single transaction can result in ETI benefits for an indefinite period, even though the ETI regime has been repealed. In addition, income from transactions that were entered into prior to ETI but that were modified after the ETI effective date and prior to the ETI repeal date may be eligible for ETI benefits, notwithstanding the fact that the original transaction predated the ETI regime. The IRS memoranda, however, are not entirely taxpayer favorable. In particular, the IRS has expressly rejected the multiple transaction approach and has stated that it interprets the phaseout rule to mean that ETI benefits are available only with respect to income earned in 2005 and 2006 from transactions entered into during those years (thus, in the IRS’s view, no indefinite ETI benefits are available for income attributable to transactions entered into in 2005 and 2006).
Taxpayers that did not claim ETI benefits for eligible income recognized in post-2006 years should carefully review their individual facts and circumstances to determine whether it would be beneficial to amend tax returns for any open year in which they received eligible income. Taxpayers should also examine their facts and circumstances to determine whether ETI benefits are available for income they expect to receive in future years. However, there are a number of important issues that taxpayers should consider before making these decisions.
As discussed above, taxpayers that previously took the multiple transaction approach could not claim ETI benefits for any income received after 2006. Although switching to the single transaction approach may enable these taxpayers to claim ETI benefits for income received in post-2006 years, taxpayers should maintain a consistent position for all open years. Thus, switching to the single transaction approach could cause some taxpayers to lose the ETI benefits they previously claimed in open tax years for income recognized under a lease or license that was executed prior to the ETI effective date. Accordingly, the benefits of changing positions will depend on each taxpayer’s particular circumstances.
Regardless of whether they previously took the multiple or single transaction approach, all taxpayers should carefully review their leasing and licensing agreements to determine whether there has been a subsequent modification that might create a new transaction under the 2008 CCA. Taxpayers should also consult with their advisers regarding the continued availability of benefits for income received from transactions executed during 2005 or 2006. Although the chief counsel guidance indicates that ETI benefits are no longer available for such income, the guidance does not explain the basis for this conclusion, and some taxpayers believe that this position is not a correct interpretation of the statute.
Editor: Mary Van Leuven, J.D., LL.M.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.
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This article represents the views of the author or authors only and does not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.