Foreign Limitations on Tax Loss Carryovers May Affect U.S. Foreign Tax Credits

Editor: Kevin D. Anderson, CPA, J.D.

Foreign Income & Taxpayers

Many foreign countries have recently made statutory changes to their tax loss carryover periods and limitations. The changes may affect the U.S. accounting for income taxes of any U.S. company with foreign subsidiaries operating in jurisdictions where the limitations have been enacted.

France, Hungary, Italy, Japan, and Spain enacted measures in the second half of 2011 that amend tax rules governing the use of net operating losses (NOLs) for local country tax purposes.

France shortened its NOL carryback period from three years to one year and imposed a limitation on its use to €1 million, whereas no limitation existed in the past. Additionally, effective on or after Sept. 21, 2011, where taxable income is over €1 million, French companies may offset only 60% of their current-year taxable income over €1 million with an NOL carryover.

Hungary limits use of an NOL to 50% of the company’s tax base (profit before taxes) effective Jan. 1, 2012. However, additional carryforward rules apply where mergers and acquisitions are involved. For instance, a new owner may use pre-change NOLs where the new company has income for two consecutive years and had significant influence over the old company.

Italy also limits the use of NOL carryforwards to 80% of the company’s taxable income beginning in 2011 for calendar-year companies. In exchange, NOLs generated in or after 2006 can be carried forward indefinitely. Previously, all NOLs were subject to a five-year carryforward period.

Japan followed suit by limiting NOL use to 80% for large noncontrolled companies, beginning on or after April 1, 2012. Control is present where one shareholder and its related persons hold more than a 50% share in the outstanding shares or voting rights of the company. The restriction does not apply to small or medium-size noncontrolled companies. The NOL carryforward period has been extended from seven to nine years.

Lastly, in Spain, the NOL carryforward period has been extended from 15 to 18 years. However, effective for tax periods in 2011, 2012, and 2013, a company whose turnover (revenue), determined in accordance with the provisions of Article 121 of Law 37/1992, is between €20 million and €60 million is subject to a limitation on the use of its NOL carryforward to 75% of taxable income. The percentage drops to 50% of taxable income for NOL use when turnover is greater than €60 million.

U.S. owners of foreign subsidiaries will need to consider these changes in determining the effect on foreign tax credits being claimed on a U.S. tax return. This includes foreign tax credits with respect to the Sec. 902 or Sec. 960 deemed paid credits or in connection with Sec. 901 direct credits with respect to a foreign entity classified as a disregarded entity or partnership for U.S. tax reporting purposes, and any direct operations of a U.S. corporation that are treated as branch operations in a foreign country.

Recent U.S. tax developments will affect the interaction of foreign NOL limitations and U.S. foreign tax credits. The Education Jobs and Medicaid Assistance Act, P.L. 111-226, which was enacted in August 2010, included provisions that limit the use of certain foreign tax credits. The changes include limitations on foreign tax credits in connection with covered asset transactions, which involve acquisitions of foreign assets that result in increases in basis for U.S. tax purposes, but not for foreign tax purposes (Sec. 901(m)), tax splitting transactions (Sec. 909), the determination of foreign tax credits with respect to certain Sec. 956 transactions, and the application of the hopscotch rules of Sec. 960(c), which further limit the amount of foreign taxes deemed paid.

In February, final regulations (T.D. 9576) were issued addressing who is legally liable (the technical taxpayer) to pay foreign income taxes and to help determine whether there was truly a mismatch of foreign income and foreign taxes paid or accrued. At the same time, temporary and proposed regulations (T.D. 9577 and REG-132736-11) were issued to provide guidance on tax splitting arrangements under Sec. 909, supplementing earlier guidance included in Notice 2010-92. The recent foreign NOL changes may also affect the analysis of the foreign effective tax rate for subpart F income inclusions for purposes of making the high-tax election available in Sec. 954(b)(4).

The foreign NOL limitations may increase the actual foreign tax liability in the local country. The ability to actually use the foreign taxes as a credit is affected by the operating rules of the foreign tax credit in the United States, which now include the recently enacted provisions and the regulatory guidance discussed above. Additional regulatory guidance on covered asset transactions and the hopscotch rule is expected in the future. Taxpayers and their advisers must consider the foreign and U.S. tax implications of the recent changes for the use of any foreign income taxes to be claimed as a credit on U.S. tax returns.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.