International Tax Consequences of Year 2000 Fix Costs

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By Joan Paul -- Thelen Reid & Priest LLP

The Year 2000 compliance process will generate a number of vexing tax issues for users. Whether fix costs are deductible or amortizable comprises one set of issues. 1/ Another equally significant and complex set of issues arises for multinational corporations. A detailed discussion of these issues is beyond the scope of this article. Rather, this article is intended to heighten the awareness of multinational user corporations undertaking an organization-wide Year 2000 compliance project to international tax issues created by project costs. Potentially disastrous tax consequences can be avoided if these issues are addressed early in the process through structuring of agreements with Year 2000 service providers and with affiliates which will benefit from, and/or undertake the Year 2000 compliance directly. Some of the more significant problems are discussed below.

1. IRC section 482 and Related Issues - Transfer Pricing in Transactions between Commonly-Controlled Corporations. Generally, when one affiliate in a controlled group of corporations performs technical or other services for the benefit of another affiliate in the group, or transfers property to another affiliate in the group, federal tax law takes the position that the provider of the services or transferor of the property must be compensated at an arm's length price. 2/ If there is no charge or less than an arm's length charge, the IRS has broad authority under IRC section 482 and corresponding Treasury regulations to allocate taxable income to the service provider or transferor even though no payment is actually made. 3/ This means that the service provider or transferor will have phantom income in the amount of the allocation. In the case of services, there will be a corresponding deduction allocated to the recipient of the services. If the service provider is foreign and the recipient is US, then from a US income tax point of view, there will be a net US tax benefit to the recipient, and the IRS is therefore unlikely to use its discretion in these circumstances. In the case of a property transfer by a foreign affiliate, see subsection (b) below. The remainder of the discussion on section 482 issues will focus on Year 2000 fixes undertaken by US affiliates in a multinational corporation.

In the Year 2000 context, if a US affiliate undertakes a compliance project, and as a result, another affiliate's computer system is fixed, the IRS is authorized to allocate income to the affiliate that undertakes the project. The implications of this rule can be far reaching, especially if one of the parties benefiting from the project is subject to foreign tax jurisdiction.

For example, if a US corporation undertakes a Year 2000 compliance project and has structured its agreements to allow for treatment of the costs to be currently deductible, a substantial portion of the deduction could be effectively reversed by an IRS allocation of deemed service or deemed sale income from foreign affiliates benefiting from the project which have not paid for the benefit. The corresponding deduction allocated to the foreign affiliate under US tax principles may be of little or no use to any member of the controlled group in reducing foreign taxes and may even be detrimental from a US tax point of view. 4/

One difficult aspect of the section 482 rules is that affiliates are required to price their intercompany transactions to conform with pricing methods provided in the section 482 regulations. In addition, they are required to prepare contemporaneous documentation establishing that their pricing method conforms to methods in the regulations, or risk a particularly onerous penalty should the IRS successfully challenge the method used. 5/

Pricing methods vary depending on the type of transaction. The methods for pricing services are different than the methods for pricing property transfers, and the methods for pricing tangible property transfers are different than the methods for pricing intangible property transfers. In addition, the provision of services may be determined to involve a property transfer, or vice versa, depending on the nature of the transaction.

(a) Pricing Services Rendered to Affiliates. Very generally, for services which are determined to be an "integral part" of either the service provider's or recipient's business, the regulations require that the charge be the fair market value of the services. That is, a profit factor must be built in to the charge to avoid a section 482 allocation. 6/ Typically, fair market value is determined on a cost-plus basis. 7/ If the services are not integral, the cost of rendering the services will usually be regarded as arm's length. 8/ Therefore, the determination as to whether services are "integral" is an important one.

The regulations identify four circumstances when services will be treated as integral. The first three generally involve situations where (i) the service provider or the recipient is in the business of providing similar services to third parties, (ii) the service provider renders services to related parties as one of its principal activities, or (iii) the service provider is "peculiarly capable" of rendering the services and such services are a principal element in the operations of the recipient. There is an objective test for determining whether the third situation exists. The only circumstance likely to be relevant to users in the Year 2000 context is the fourth circumstance listed in the regulations and arises when the service recipient has received the benefit of a substantial amount of services from one or more related parties during its taxable year. The regulations provide an objective formula for determining when the "substantial amount" threshold is crossed. 9/ Because of the magnitude of Year 2000 costs, the fourth circumstance could cause intercompany Year 2000 services to be integral. To the extent an affiliate is treated as rendering services for Year 2000 compliance and the services are not integral, the arm's length charge will be cost of rendering the services rather than cost-plus.

As part of its Year 2000 tax planning, each company must evaluate how these rules apply to the circumstances involved. One additional element of complexity is that the IRS has announced that the methods for pricing intercompany services are now under review and that the circumstances in which the cost of services will be permitted as the arm's length price may be narrowed.

(b) Pricing Property Transfers and Comparison with Pricing Services. The rules for pricing property transfers under the section 482 regulations is a very complex task, and as mentioned, is beyond the scope of this article. One common theme, however, that consistently applies whether the transfer is a license or sale of intangible property or the lease or sale of tangible property, is that the pricing must be at fair market value (sometimes very difficult to determine). 10/ Therefore, as long as services are not integral as described above, it will often be more beneficial in the context of bringing a multinational corporation's internal computer system into Year 2000 compliance to structure the transaction with affiliates as the provision of services rather than the license, lease or sale of property. 11/ In this regard, it is crucial that intercompany agreements are created which are carefully structured to take account of these rules. 12/

(c) Summary. As the discussion above indicates, the characterization of the transaction as services or a property transfer is an important element in determining the correct tax consequences of an organization-wide Year 2000 compliance project. Under the best of circumstances involving a US service provider and a foreign recipient, the service provider must be paid compensation no less than the cost of the services, or be deemed to have been paid such amount and taxed on the deemed payment. This result could undercut otherwise favorable tax consequences with respect to deductibility of the Year 2000 costs by the US service provider. 13/

(d) Planning Opportunity under Proposed Regulations and Recent Caselaw. Under recently proposed Treasury regulations (which may not be relied upon until and unless adopted in temporary or final form) and caselaw decided on April 30, 1997, 14/ an opportunity to avoid all intercompany charges may have presented itself in the Year 2000 context. The common relevant theme in both the proposed regulations and the cases is that computer software acquired for internal use only with no rights to commercially exploit underlying intellectual property rights is tangible personal property rather than intangible personal property. This seemingly arcane distinction may have significant tax consequences for multinational corporations undertaking an organization-wide Year 2000 compliance project.

Prior to these recent authorities, computer software has often been treated as intangible personal property, regardless of the circumstances, because of the fact that it is entitled to copyright protection. This conclusion has led to a number of unfavorable income tax consequences. Of relevance in the Year 2000 context is the rule similar to the section 482 rules requiring an arm's length royalty be deemed paid to the US parent with respect to intangibles contributed by it to the capital of a foreign subsidiary. 15/

Under the proposed regulations and the cases, if (i) a US parent transfers computer software which is Year 2000 compliant to a foreign subsidiary for use by it to repair its non-compliant system, (ii) neither the copyright nor any other intellectual property inherent in the software is transferred, (iii) the subsidiary has no right to commercially exploit the intellectual property inherent in the software, and (iv) the subsidiary will use the software in the active conduct of a business outside the US, the nasty deemed-royalty rule described above should not apply, and the transaction should be characterized as a tax-free contribution to the capital of the subsidiary. 16/

A number of factors could interfere with the viability of this arrangement. First, until and unless the proposed regulations are adopted, the IRS is not bound by the tangible personal property characterization of copies of computer software and may decide not to acquiesce in the Tax Court's recent holdings. Second, even under the proposed regulations, there is the risk that a transfer of a copy of computer software will be treated as the provision of services rather than a contribution of a copy of the software to the subsidiary. This risk can be minimized if no copyrights are transferred (other than the right to make copies for internal use), and the arrangement and its documentation are carefully structured.

2. Foreign Tax Credits. Domestic US corporations are subject to tax on their worldwide income. In order to prevent double taxation, the Code allows a tax credit for foreign taxes paid or accrued on foreign source income. 17/ In addition, a domestic corporation owning at least 10% of the voting stock in a foreign corporation and receiving dividends from that corporation is allowed an "indirect" foreign tax credit for a proportional share (based on the ratio of dividends paid to the domestic corporation, to total post-1986 undistributed earnings of the foreign corporation) of the foreign taxes paid by the foreign corporation. 18/ The indirect credit is also allowed on income from a controlled foreign corporation which the US parent is required to recognize under the Code regardless of whether dividends are paid. 19/ Foreign tax credits, direct and indirect, play an important role in the tax planning of multinational corporations.

The Internal Revenue Code contains a number of limitations on the availability of foreign tax credits. To understand how Year 2000 costs of a US-based multinational corporation can impact on its foreign tax credits, it is necessary to understand how limitations on the credit operate. The policies underlying the limitations are to ensure that (i) a taxpayer cannot use foreign taxes as a credit against US tax on US source income, and (ii) the US residual tax on separate categories of foreign income subject to rates lower than US tax rates is preserved. 20/

(a) Operation of Foreign Tax Credit Limitations. Very briefly, a separate foreign tax credit limitation must be computed for each of nine categories of income consisting of eight specific categories and a residual category. Once the corporation's foreign source gross income is separated into the nine "baskets," allowable deductions must be appropriately allocated to US source gross income and foreign source gross income, and in the latter case, among the nine baskets. This will result in a preliminary determination of taxable income in each category. Net operating loss carryovers are then allocated under prescribed rules. If any basket generates a loss, it is first allocated to other baskets with income and then to US source income. If there is overall income from the baskets net of all basket losses, and there is US source loss, the US source loss will be allocated among the baskets, and reduce the basket income, pro rata based on the income in the baskets. Various recapture rules apply to ensure that the shifting of losses under this arrangement does not, over the long term, defeat the policy underpinnings of the credit limitations. Finally, the foreign tax credit limitation for each basket is determined by multiplying the US corporation's total US tax by the ratio of (i) the final basket taxable income, to (ii) the US corporation's total taxable income. Any foreign tax credit which is not available for use as a result of this limitation may be carried back two taxable years and then forward for five taxable years. 21/ If the credit is not exhausted during these carryover periods, it expires, and the ability to avoid the corresponding double tax is forever foreclosed.

(b) Effect of Year 2000 Costs on Foreign Tax Credit Availability. The above summary of the maze of foreign tax credit rules provides the framework for understanding the impact of Year 2000 costs. An examination of a few scenarios will help put these rules into perspective.

(i) Foreign Affiliate Directly Incurs Year 2000 Fix Costs. If a foreign affiliate directly incurs Year 2000 compliance costs in a particular year, and the cost is determined to be deductible under US tax principles, then for purposes of computing the foreign tax credit limitation for that year, the deduction must be allocated to a separate basket, with the effect of reducing the foreign source taxable income in that basket and its corresponding foreign tax credit availability that year. In the Year 2000 context, the basket to which this deduction will be allocated will be the basket which includes the active business operations of the foreign affiliate - often a higher tax jurisdiction. Thus, there could be a significant reduction of foreign tax credit available that year under these circumstances. If the foreign jurisdiction allows a deduction for the Year 2000 costs in computing foreign tax, then there could be a corresponding reduction in foreign tax thereby eliminating the problem.

(ii) Section 482 Allocation of Service Income from Foreign Affiliate. If a US corporation incurs Year 2000 fix costs for the benefit of the entire organization, and there is an allocation of deemed service income to the US corporation under section 482, there will be a corresponding deemed deduction under US tax principles created in foreign affiliates which benefited from the services. This deemed deduction must be allocated to a separate basket in the foreign tax credit computation, and will have the same effect as a directly incurred Year 2000 cost described in scenario (i) above. Thus, there could be a significant reduction of foreign tax credit under these circumstances also. If the foreign jurisdiction allows a deduction for the section 482 service allocation, then there could be a corresponding reduction in foreign tax again eliminating the problem.

(iii) US Corporation Pays Year 2000 Fix Costs and Has Net Loss. If (A) a US corporation undertakes the entire Year 2000 compliance project for the entire organization and as a result or otherwise has a net US loss for a particular year, (B) there are separate foreign source baskets with positive taxable income, and (C) foreign affiliates incur foreign taxes during the year, then for purposes of computing the foreign tax credit limitation for that year, the net US loss will be allocated among the US corporation's separate foreign baskets pro rata based on the net taxable income in each basket. This will reduce the foreign source income in each basket and therefore the foreign tax credit availability in each basket that year. However, the result may be less harsh than the results in scenarios (i) and (ii) where the Year 2000 costs incurred offshore are concentrated in one, probably high-taxed, basket.

3. Foreign Tax Consequences. As the foregoing discussion indicates, the effect of section 482 and the foreign tax credit limitations is determined in part by foreign tax law in jurisdictions where affiliates do business. Each jurisdiction in which a multinational corporation operates has its own tax laws. In addition to having their own rules on the deductibility of expenditures generally, many foreign governments are troubled by the idea of allowing deductions in computing foreign taxes for payments which are made to affiliates and even more troubled by allowing deductions for deemed payments arising from section 482 allocations. To maximize effective overall tax planning, it is important to determine the tax consequences of a multinational company's Year 2000 costs in each jurisdiction in which a foreign affiliate with a Year 2000 problem operates in order, among other things, to determine which foreign affiliates can directly undertake Year 2000 compliance with favorable tax consequences considered on a organization-wide basis, and which cannot. While the tax consequences may not in the end determine the outcome of which affiliates actually effect Year 2000 compliance, they are an important factor in planning the process in a manner which minimizes the organization's overall economic downside.

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Joan Paul is a partner at the San Francisco office of the law firm of Thelen Reid & Priest LLP. She specializes in all aspects of federal and California income tax law with emphasis on taxation of intellectual property transactions, partnerships, limited liability companies, S corporations, joint ventures, corporate acquisitions, spin-offs, liquidations, and international transactions. She has been a frequent speaker at conferences, has written extensively and has counseled numerous clients on structuring all types of corporate partnering arrangements and licensing transactions, including transactions focusing on the Year 2000 problem, to achieve favorable business and tax consequences. She is a member of Thelen's "Year 2000 Team" formed by the firm's Technology Law Practice Group.