Bringing it home: summary and analysis of the repatriation provision of the American Jobs Creation Act.

New section 965 of the Internal Revenue Code, added by the American Jobs Creation Act of 2004, offers U.S. multinational corporations a unique one-time opportunity to repatriate low-taxed foreign earnings at an incremental U.S. tax cost as low as 5.25 percent. The new provision, however, is extremely complex, and key definitions are ambiguous and difficult to apply. With the issuance of Notice 2005-10 on January 13, 2005, the Department of the Treasury has taken the first step toward alleviating the uncertainty created by the statute. Notice 2005-10 refines the definition of "cash dividends," and provides guidance concerning the dividend reinvestment plan and the kinds of investments in the United States for which repatriated funds may be used. Future guidance will address the foreign tax credit and expense allocation, rules for adjusting the base period amount to account for mergers, acquisitions and spin-offs, and rules regarding controlled groups. In view of the importance of section 965, Congress is already considering technical corrections to the statute.

As a practical matter, for financial statement purposes, every multinational that has reported a material amount of unrepatriated foreign earnings as indefinitely reinvested outside the United States under APB 23 will be determining whether and to what extent it intends to repatriate these earnings under section 965. Fortunately, a recent FASB Staff Position allows a grace period for making this determination.

This article summarizes new section 965 as supplemented by Notice 2005-10, and attempts to clarify issues that remain ambiguous under the statute. Finally, practical suggestions are offered for navigating through the decision to repatriate and for taking full advantage of the available benefit.

I. Summary of Legislation

A. Purpose

Section 965 is one of several significant international tax reforms included in the American Jobs Creation Act of 2004 (the Jobs Act). The purpose of the Jobs Act is "To amend the Internal Revenue Code of 1986 to remove impediments in such Code and make our manufacturing, service, and high-technology businesses and workers more competitive and productive both at home and abroad." (1) Section 965 was intended to encourage U.S. corporations to repatriate foreign subsidiary earnings for use in strengthening their domestic businesses and creating new jobs in the United States.

B. History of Provision

Section 965 was introduced by House Ways and Means Committee Chair William Thomas, (R-CA), on July 25, 2003, as part of H.R. 2896, the American Jobs Creation Act of 2003. (2) A revised version was reintroduced as part of H.R. 4520, the American Jobs Creation Act of 2004, on June 4, 2004. (3) The House approved the bill on June 17, 2004.

The Senate version of the bill, S. 1637, was introduced by Senate Finance Committee Chair Charles Grassley (R-IA) and Senator Max Baucus (DMT), on September 18, 2003. It was passed by the full Senate on May 11, 2004. The Senate version of the bill contained some notable differences from the House bill. Rather than an 85-percent dividends-received deduction, it would have achieved the reduction in tax by replacing the normal tax on repatriated earnings with a 5.25-percent excise tax. The provision limiting the eligible dividend to the greater of $500 million or the amount shown as permanently reinvested outside the United States on the corporation's applicable financial statement was included in the House bill, but not the Senate version. In addition, although both versions contained the requirement for a dividend reinvestment plan, only the Senate version identified five non-exclusive "permissible uses."

A conference agreement was reached on October 6, 2004, generally following the House bill, with modifications. The Jobs Act, including new section 965, was signed into law by President Bush on October 22, 2004. (4) On November 19, 2004, the House and the Senate each introduced a Technical Corrections bill proposing amendments to the Jobs Act, including clarifications of a number of issues related to section 965. (5)

C. Summary of Section 965

New section 965 permits a U.S. shareholder to elect a one-time 85-percent dividends-received deduction for cash dividends received from controlled foreign corporations (CFCs). (6) The provision offers a one-time reprieve from U.S. taxation on repatriated earnings, but it is bounded by a number of limitations to ensure that the overall goal of the statute is met. Congress intended the provision as an incentive for the repatriation of foreign earnings that would otherwise remain offshore. Thus, eligible dividends must be "extraordinary"--that is, in excess of the average annual amount paid over a three-year base period. There is an overall ceiling on eligible dividends of the greater of $500 million or the amount shown as permanently reinvested outside of the United States on the U.S. shareholder's applicable financial statement. Most important, the deduction is only available for dividends earmarked for reinvestment in the United States in ways that will strengthen the competitiveness and productivity of the U.S. business.

D. Timing Considerations

A taxpayer may choose to make the election for the last tax year beginning before the date of enactment of the section (October 22, 2004), or for the first taxable year beginning after that date. For a calendar year taxpayer, the election is therefore available for either the 2004 or 2005 tax year. The election is made on Form 8895, which must be filed before the due date, including extensions, for filing the return. (7)

E. Common Fact Patterns Where Section 965 May Be Beneficial

Section 965 may be beneficial to a U.S. multinational in a number of situations. The most basic is where the U.S. shareholder's controlled foreign corporations have substantial low-taxed unrepatriated foreign earnings. Absent section 965, the U.S. tax on a payment of these earnings in the form of a dividend to the U.S. shareholder would not be fully offset by the section 902 deemed-paid foreign tax credit, and U.S. tax would be imposed to bring the combined foreign and U.S. tax liability to 35 percent. Section 965 may also be advantageous to U.S. multinationals that are unable to utilize foreign tax credits because of net operating losses or an overall foreign loss. Section 965 may also facilitate the unwinding of structures in which a U.S. company is "sandwiched" between a foreign parent and a foreign subsidiary, by providing a tax efficient way to reduce the value of CFCs owned by the "sandwiched" U.S. corporation. (8)

II. Determining Whether to Repatriate Under Section 965

A. How Much Can Be Repatriated Under Section 965?

1. Greater of $500 million or APB 23 Amount. The maximum amount that may be treated as an eligible dividend under section 965 is the greater of $500 million or the amount shown as earnings permanently reinvested outside the United States on the applicable financial statement. The term "applicable financial statement" means the U.S. shareholder's most recently audited financial statement that is certified on or before June 30, 2003, as being prepared in accordance with generally accepted accounting principles. In the case of a taxpayer required to file a financial statement with the Securities and Exchange Commission, the term means such statement filed on or before June 30, 2003. If the applicable financial statement does not state the amount of earnings permanently reinvested outside the United States but shows the tax liability on such earnings, then the amount of permanently reinvested earnings is computed by dividing the tax liability by 0.35. (9) If no applicable financial statement exists, or if it does not show an amount permanently reinvested outside the United States or the correlative tax liability, the maximum amount of the eligible dividend is $500 million.

For many companies, the amount repatriated under section 965 will be limited by the $500 million ceiling. Certain companies, however, have financial statements showing an amount permanently reinvested outside of the United States greatly in excess of $500 million, with a handful in the $10 to $20 billion range. It has been estimated that the total earnings eligible for repatriation is approximately $750 billion, and that up to $300 billion will actually be repatriated under section 965. (10)

In applying section 965, all U.S. shareholders that are members of an affiliated group filing a consolidated return are to be treated as one U.S. shareholder. (11) All corporations treated as a single employer under section 52(a) are limited to one $500 million ceiling, and the $500 million is to be allocated among those corporations under regulations to be prescribed. (12) If an applicable financial statement applies to more than one U.S. shareholder, the amount shown as permanently reinvested outside the United States (or the tax liability associated with such earnings) is to be divided among all U.S. shareholders under regulations to be prescribed. (13)

2. What Qualifies as a Cash Dividend? The term "cash dividends" includes distributions from non-previously taxed earnings and profits of a first-tier CFC. It also includes distributions that are excluded from taxable income as previously taxed income (PTI) under section 959(a) if they are attributable to a dividend "up the chain" from a lower-tier CFC that caused a subpart F inclusion under section 951(a)(1)(A) in the year of the election.

The definition of "cash dividends" is expansive enough to cover certain amounts received under Code sections that recharacterize amounts as dividends. The focus is on whether the U.S. shareholder actually receives cash and whether the cash comes from one or more CFCs (in contrast to a third party). Thus, cash received in a redemption that is treated as a dividend under section 302 or 304 does qualify. (14) Notice 2005-10 provides the additional clarification that boot received by a target shareholder in a reorganization (and treated as a dividend under section 356(a)(2)) will qualify as a cash dividend. (15) Amounts that do not qualify include amounts treated as dividends under section 78, 367, or 1248. Cash received in a section 332 liquidation to which section 367(b) applies, however, does qualify as an eligible cash dividend. (16) On the other hand, a "deemed liquidation" resulting from a disregarded entity election does not qualify, since no actual distribution of cash is made to the U.S. shareholder.

Also excluded from the definition of cash dividends are inclusions under section 951(a)(1)(B) for section 956 investments in U.S. property. While "cash dividends" includes distributions of previously taxed income that are attributable to an up-the-chain dividend triggering a same-year subpart F inclusion under section 951(a)(1)(A), distributions of previously taxed income attributable to other types of subpart F inclusions are not within the definition of "cash dividends."

* Notice 2005-10 Refines Definition of "Cash Dividends." Notice 2005-10 refines the definition of "cash dividends" in several respects. First, it clarifies that a company with previously taxed E&P must distribute that E&P before it will be deemed to have distributed non-previously taxed E&P. Under the ordering rules of section 959(c), distributions are deemed to come first out of E&P previously taxed under section 951(a)(1)(B) (investments in U.S. property), then out of E&P previously taxed under section 951(a)(1)(A) (subpart F income), and finally out of non-previously taxed E&P. (17) Previously taxed E&P will not be considered a dividend with respect to the amount attributable to the base period amount or the eligible dividend. (18) The exception to this rule is for distributions of previously taxed income attributable to a dividend "up the chain" from a lower-tier CFC that triggered subpart F inclusion in the year of the election. (19) Thus, a CFC with 100u of E&P described in section 959(c)(1) (previously taxed as an investment in U.S. property) and 50u of E&P described in section 959(c)(3) (non-previously taxed E&P) would have to distribute 150u in order to have a 50u cash dividend eligible for deduction under section 965. (20)

Second, Notice 2005-10 provides that the amount of the cash dividend is not reduced by expenses or deductions related to the cash dividend. (21) This includes foreign taxes withheld on the dividend and U.S. federal, state and local taxes imposed on the dividend. Such expenses do not reduce the amount of the cash dividend required to be invested in the United States under a dividend reinvestment plan. Thus, if a CFC distributes $100 of cash to a U.S. shareholder, and foreign tax of $5 is paid on the dividend, the amount of the cash dividend which is required to be invested in U.S. property under the dividend reinvestment plan is still $100. The operation of this rule makes the minimization of withholding tax a priority. The imposition of withholding tax on an eligible dividend, as well as the imposition of U.S. taxes on the non-deductible portion of the dividend, will require the U.S. shareholder to access other sources of cash to fund part of the investments under the dividend reinvestment plan. Such sources may include dividends allocated to the base period amount or earnings from U.S. operations.

Third, Notice 2005-10 addresses the payment of cash dividends by a CFC to a pass-through entity (a partnership or disregarded entity) that is owned by a U.S. shareholder. A cash dividend paid by a CFC to a pass-through entity is treated as received by the U.S. shareholder only if and to the extent that the shareholder receives cash in the amount of the CFC dividend during the tax year for which the election is made. A loan of cash from a disregarded entity is not considered a distribution of cash. In the case of a partnership, a cash dividend is treated as received by a U.S. shareholder that is a partner only if the dividend is (a) allocated to the U.S. shareholder under sections 702 and 704 and the applicable regulations and (b) separately stated to the partner under Treas. Reg. [section] 1.702-1(a)(8)(ii), and (c) the U.S. shareholder receives cash in the amount of the CFC dividend. (22)

* Permissible Sources of Cash. Notice 2005-10 offers guidance on what constitutes "cash." Pursuant to the Notice, "cash" includes both U.S. dollars and foreign currency. The CFC may effect the distribution of cash through a wire transfer or check. (23)

In most cases, a U.S. shareholder's CFCs will not have cash on hand equal to the desired repatriation amount. CFC earnings typically will have been invested in carrying on and expanding foreign operations. To take full advantage of the section 965 dividends-received deduction, a number of methods may be used to generate cash. The most obvious method is through a third-party loan to the CFC, secured by the company's real or personal property. A guarantee by the U.S. shareholder of the third-party loan generally should not prevent a subsequent distribution from the CFC from qualifying as a "cash dividend," so long as the loan is still treated as an obligation of the CFC under a Plantation Patterns analysis. (24)

Some of the methods used by U.S. companies to generate income and cash (for instance, to prevent the expiration of a net operating loss) may be used at the CFC level. For instance, a CFC could factor accounts receivable if it is not already doing so. Another method of generating cash would be a sale-leaseback transaction, where the CFC sells property, plant, or equipment to a third party, generating immediate income and cash, and then leases back the asset, with rental expense coming due over a period of years.

To the disappointment of many taxpayers, Notice 200510 takes the position that the distribution of "cash equivalents," such as marketable securities, will not qualify as a cash dividend under the statute. A CFC wishing to use such cash equivalents to make the dividend must liquidate them and distribute cash. (25) Upon receipt of the cash dividend, however, the shareholder may temporarily invest the cash in cash equivalents, for the period before it is used pursuant to a dividend reinvestment plan. The IRS will not apply the step transaction doctrine to recharacterize the dividend as a distribution of the cash equivalent. (26)

* Impermissible Sources of Cash. Because section 965 is intended to encourage the repatriation of earnings from CFCs into the U.S. economy, transactions that represent a circular flow of cash from the U.S. shareholder to the CFC and then back to the U.S. shareholder will not qualify as cash dividends. Thus, an equity contribution by the U.S. shareholder to a CFC, followed by a cash dividend from the CFC, will not qualify.

Pending technical corrections legislation would add the following sentence to the end of section 965(b)(3): "The Secretary may prescribe such regulations as may be necessary or appropriate to prevent the avoidance of the purposes of this paragraph, including regulations which provide that cash dividends shall not be taken into account under subsection (a) to the extent such dividends are attributable to the direct or indirect transfer (including through the use of intervening entities or capital contributions) of cash or other property from a related person (as so defined) to a controlled foreign corporation."

In addition to the restrictions on sources of cash under section 965, there may be local country restrictions on the payment of cash dividends. For instance, currency controls or local corporate law requirements for distributable reserves may limit the ability to pay a dividend. In many cases, planning may nevertheless be available to allow distributions to be made for purposes of section 965.

* Related Party Debt Limitation. The amount of dividends eligible for the section 965 deduction is reduced for any increase in the CFC's related party indebtedness over the indebtedness that existed as of October 3, 2004. (27) For this purpose, all CFCs of the U.S. shareholder are treated as one CFC. Therefore, an increase in indebtedness between CFCs will not cause a reduction in the eligible dividend. Only an increase in the indebtedness of a CFC to a related U.S. company will reduce the eligible dividend amount. Again, this provision is meant to prevent a circular flow of cash from the U.S. shareholder to a CFC to fund the payment of a dividend by the CFC. This limitation may be particularly troubling in the case of CFCs that have open accounts for the sale of goods with U.S. shareholders.

B. Measuring the Base Period Amount

The section 965 deduction only applies to dividends that are "extraordinary." Thus, the deduction is only available for cash distributions in excess of the annual average, during the base period years, of cash or non-cash dividends from CFCs, section 956 inclusions, and PTI distributions that would be includible in the U.S. shareholder's taxable income but for section 959(a). The base period years are three taxable years out of the five most recent taxable years ending on or before June 30, 2003 (1998-2002 for a calendar year taxpayer), determined by disregarding the years with the highest and lowest base period amount. If the U.S. shareholder has less than five taxable years ending on or before June 30, 2003, then the base period years include all taxable years ending on or before June 30, 2003.

In measuring the base period amount, special adjustments are required to account for acquisitions, dispositions, and section 355 distributions that occur during the five most recent taxable years ending on or before June 30, 2003 (the five-year base period). In the case of acquisitions and dispositions, section 965 cross references section 41, the credit for increasing research activities (the "M&A Rule"). Section 41 provides a credit for certain research expenses in excess of such expenses incurred during a base period. Section 41(f)(3) directs the Treasury to promulgate regulations under which a taxpayer that acquires a trade or business must increase its base period expenses by the portion of the former owner's research expenses that are attributable to the acquired trade or business. (28) The purpose of section 41(f)(3) is to "facilitate an accurate computation of base period expenditures and the credit by attributing research expenditures to the appropriate taxpayer." (29)

When a taxpayer wishing to claim a credit under section 41 acquires an existing trade or business, it is reasonable to assume that the research expenditures previously associated with the conduct of that trade or business will be continued by the new owner. The policy of section 41 therefore requires that the base period research expenses of the transferor should be reduced and that the acquirer's base period research expenses relating to the acquired trade or business should be added to the acquirer's base period. Otherwise, the transferor will not receive credit for some future research expenses that economically reflect an increase in its research investment, and the acquirer will receive credit for expenditures that reflect only a continuation, or even a diminution, of research expenses incurred in connection with the acquired trade or business. In contrast, no section 41(f)(3) adjustment is needed or required when a taxpayer begins a new trade or business from scratch. In that case, any related research expenditure will be incremental (though it will be necessary to determine whether that increase in research expenditures was offset by a decrease in other research).

Correspondingly, the apparent purpose of the M&A Rule is to ensure that the Base Period Limitation is allocated fairly among U.S. shareholders that take part in certain merger and acquisition activity. (30) Nevertheless, there are significant differences between sections 41 and 965. Most fundamentally, the section 41 credit is determined based on research expenses incurred in a trade or business, whereas the section 965 dividends-received deduction is determined by reference to dividends received from CFCs. Because the research credit is provided only for incremental research expenses incurred in the taxpayer's trade or business, section 41(f)(3) appropriately looks to acquisitions and dispositions of a trade or business to allocate the section 41 credit base period among taxpayers. In applying the principles of section 41(f)(3) to the M&A Rule, CFC stock would appear to be the analog to section 41's "trade or business." Accordingly, a good argument can be made that the M&A Rule should apply only to acquisitions or dispositions of CFC stock by a U.S. shareholder. (31)

Section 965(c)(2)(C)(ii) provides a special rule for allocating the base period amount when there is a section 355 distribution of the stock or securities of a U.S. shareholder during the five-year base period. When such a distribution occurs, the controlled corporation (the corporation whose stock is being distributed) is treated as having been in existence for the period that the distributing corporation was in existence. Any base period amounts received or includible by either the distributing corporation or the controlled corporation are to be allocated between the distributing corporation and the controlled corporation based on their respective interests in the controlled foreign corporations that paid dividends in the base period.

C. CFC E&P

The amount of the dividend that can be paid by a CFC will be limited by the amount of its post-1986 E&P pools and its pre-1987 E&P layers. U.S. shareholders may employ several means to increase CFC E&P to help maximize the benefit available under section 965.

Generally, the accounting methods used in preparing a CFC's books and records apply for E&P purposes as well. In certain situations, however, accounting method elections may be made for the purpose of calculating a CFC's E&P, resulting in an increase or decrease in CFC E&P. Accounting method elections must be made within 180 days after the close of the first taxable year in which the computation of the CFC's E&P is "significant" for U.S. tax purposes with respect to its controlling U.S. shareholders. (32)

One common example of an accounting method election that is used to increase CFC E&P is the election to amortize research and experimental expenses ratably over a period of not less than 60 months, rather than expensing them. (33) Another method of generating CFC E&P is a sale of appreciated assets used in the CFC's trade or business to a same country related CFC, followed by a lease of those assets back to the selling CFC. CFC E&P is calculated on a separate entity basis, and the transaction would therefore result in an increase in E&P to the selling CFC, to the extent of the gain. Local country consolidation rules may prevent taxation of the gain. Debt forgiveness may also result in an increase in E&P to the debtor in certain situations. (34)

D. Computing the Cost

1. Minimum Cost of Election. The minimum cost of electing the section 965 deduction is a tax of 5.25 percent (35 percent of 15 percent) on eligible dividends in excess of the base period amount. The U.S. tax may be reduced by foreign tax credits. (35) The payment of the dividend will result in a reduction in the payor's earnings and profits and tax pools for both the deductible and non-deductible portion of the eligible dividend. The dividend may be subject to local country withholding taxes. The benefit of section 965 diminishes, however, in proportion to the effective rate of foreign tax associated with CFC dividends.

2. Effect of Section 901/Section 902 Credits. Section 965(d)(1) provides that no credit is allowed under section 901 for the deductible portion of the eligible dividend. Section 901 allows a credit both for foreign income taxes paid directly by the U.S. taxpayer, and for taxes deemed paid by the U.S. taxpayer under sections 902 and 960. Thus, section 965(d)(1) denies a foreign tax credit both for taxes directly imposed on the U.S. taxpayer (i.e., the local country withholding tax that may apply upon payment of the dividend), and the local country income tax deemed paid by the U.S. taxpayer as the result of receiving a dividend or having a subpart F inclusion. The taxpayer is also prohibited from taking a deduction under section 243 or 245 for the deductible portion of the eligible dividend.

Section 965 does not adequately address the treatment of the section 78 gross-up on the deductible portion of the eligible dividend. Under section 78, for any year in which a taxpayer takes a foreign tax credit, an amount equal to the taxes deemed paid under section 902(a) or section 960(a)(1) for such taxable year is treated as a dividend received by the U.S. taxpayer. Thus, a CFC dividend or Subpart F inclusion is "grossed-up" by the local country income taxes attributable to the dividend or Subpart F inclusion. Section 965(c)(3) provides that the section 78 gross-up amount (which is a deemed, not a cash, amount) is not included in the definition of "dividend" for section 965 purposes. Therefore, the section 78 gross-up amount is not eligible for deduction under section 965, with the consequence being that not only the 15 percent non-deductible portion of the eligible dividend (and the section 78 gross-up thereon), but also the section 78 gross-up on the deductible portion of the eligible dividend, would be subject to U.S. taxation. The statute as enacted would significantly reduce the benefit seemingly intended by section 965. Pending technical corrections legislation addresses this issue by adding paragraph (4) to the end of subsection (d), to provide that section 78 will not apply to any tax that is not allowable as a credit under section 901 by reason of section 965.

The taxpayer is permitted to specify which dividends are allocated to the base period amount. If a taxpayer does not specifically allocate dividends to the base period amount, a pro-rata apportionment will apply. Once the base period amount has been satisfied, the taxpayer is not permitted to specify which portion of a particular eligible dividend is deductible versus non-deductible, but it remains unclear whether a taxpayer may choose which of multiple dividends are eligible for the deduction.

Because no foreign tax credit will be allowed for withholding taxes paid on the deductible portion of the dividend, a key consideration in structuring repatriation under section 965 will be the reduction of withholding taxes. One potential method of avoiding withholding tax is a sale by the U.S. shareholder of the stock of one CFC to another CFC. As previously discussed, cash amounts included in gross income as dividends under section 302 or 304 qualify as "cash dividends" for purposes of section 965. Under section 304(a)(1), if the U.S. shareholder is in control, either directly or constructively, of each of the CFCs ("brother-sister" corporations), and in return for property, one of the CFCs (the "brother") acquires the stock of the other (the "sister") from the U.S. shareholder, the sale will be treated as a redemption to which section 302 applies. Because the U.S. shareholder will directly or constructively own the same proportion of target stock both before and after the deemed redemption, the U.S. shareholder will be treated as receiving a distribution to which section 301 applies, to the extent of the total consideration paid. (37) For purposes of section 301(c)(1), the distribution is deemed to come first from the E&P of the acquiring corporation, and then from the E&P of the issuing corporation (target). (38) Because most foreign tax authorities will respect this transaction as a sale, no withholding tax should apply to the transaction. The use of section 304 may also be beneficial where local country restrictions prevent the payment of dividends.

The tax attributable to the non-deductible portion of the eligible dividend may not reduce the alternative minimum tax otherwise owed by the taxpayer under section 55. (39) The U.S. tax on the non-deductible portion of the eligible dividend, however, may be reduced by the credit for prior year minimum tax liability under section 53. The credit under section 53, along with the foreign tax credit under section 27(a), are the only credits allowed against the tax on the non-deductible portion of the eligible dividend. (40) The income attributable to the non-deductible portion of the eligible dividend also may not be offset by a current year net operating loss, or a loss carryover or carryback from another year. (41)

Section 965 denies a deduction for expenses properly allocated and apportioned to the deductible portion of the eligible dividend. (42) Pending technical corrections legislation would amend the statue to deny a deduction only for expenses "directly allocated" to the deductible portion of the eligible dividend. Senators Gordon Smith (D-OR) and Charles Grassley (R-IA) discussed the scope of expenses disallowed under section 965(d)(2) during Senate debate on the Conference Report. The senators agreed that such expenses did not include general and administrative costs not directly related to generating the repatriated funds, or such indirect costs as research and development costs, interest, state and local income taxes, sales and marketing costs, depreciation, and amortization. Directly related expenses would include, but would not be limited to, stewardship costs and directly related legal and accounting fees. (43)

E. Dividend Reinvestment Plan

1. Statutory Requirements. The heart of section 965 is the requirement that the dividend be invested in the United States pursuant to a dividend reinvestment plan (DRP). Section 965(b)(4)(A) provides that the DRP must be approved by the company's president, chief executive officer, or comparable officer prior to payment of the dividend, and must subsequently be approved by the board of directors or management committee. (44) Under section 965(b)(4)(B), the DRP must provide for the "reinvestment of such dividend in the United States (other than as payment for executive compensation), including as a source for the funding of worker hiring and training, infrastructure, research and development, capital investments, or the financial stabilization of the corporation for the purposes of job retention or creation." The language of the statute suggests that the five uses listed in section 965(b)(4)(B) are only examples of permitted uses, and that other uses may also be permissible. The Committee Report for H.R. 4520 confirms that the five permitted uses listed in section 965(b)(4)(B) are not exclusive.

2. IRS Guidance. Notice 2005-10 provides much-needed practical guidance on the drafting and implementation of a DRP. The Notice allows significant flexibility in drafting the DRP. Pursuant to the Notice, the taxpayer may adopt separate DRPs for each cash dividend received during the year of election or, alternatively, consolidate multiple cash dividends from multiple CFCs on the same DRP. The Notice includes guidance in several areas:

* Specificity. The Notice requires that the DRP describe anticipated investments with reasonable specificity. Reasonable specificity may vary depending on the type of investment to be made, and the time period over which the investment will be made. The DRP must state a reasonable time period in which the investments will be made, taking into account the nature of the investments. (45) The DRP may provide for an alternative investment in the event the principal investment is delayed or rejected. The DRP need not state the conditions under which the alternative investment will be made in place of the principal investment. (46)

* Amending the DRP. The taxpayer is not permitted to amend the DRP after payment of the dividend to which the plan relates. (47) This restriction increases the importance of providing alternative investments in the DRP. There is an exception to this rule for dividends paid before January 13, 2005 (the date Notice 2005-10 was issued). A transitional rule provides that the taxpayer may modify a plan that is not in conformity with Notice 2005-10 to comply with such guidance no later than March 14, 2005. The modified plan must subsequently be approved by the taxpayer's president or CEO, and by the board of directors or management committee. (48)

* Tracing or Segregating Funds. No tracing or segregation of the repatriated funds is necessary. Nor is it necessary to show that the funds used to carry out permitted investments under the DRP were the same funds received as a cash dividend from a CFC. As long as the investments specified in the DRP are actually made, the fact that expenditures are also made for impermissible uses during the period covered by the DRP will not affect the eligibility of the dividend under section 965. A permitted investment may include an expenditure that was anticipated and budgeted prior to the adoption of the DRP. (49)

* Expenditures in Taxable Year of Election. Expenditures made pursuant to a DRP in the taxable year of the election qualify as permitted investments, even if such expenditures are made before the cash dividend is actually paid or before the DRP is adopted. Expenditures made in years prior to the election under section 965, however, will not qualify as permitted investments. (50)

* Partially Completed DRPs. Notice 2005-10 takes a pro-rata approach in the case of a partially completed DRP. Under the Notice, if a taxpayer repatriates funds pursuant to a DRP, but only uses a portion of such repatriated funds for permitted uses under the DRP, the dividends-received deduction will only be allowed for the portion used pursuant to the DRP. (51) This guidance should alleviate the concern of some taxpayers that the IRS might completely deny the deduction if a portion of the dividend did not qualify.

F. Uses of Funds

No area has given rise to as much speculation as the scope of permissible uses for repatriated earnings. The only definite guidance given in the statute is that the DRP must provide for "reinvestment of such dividend in the United States." Although the statute lists some permissible uses, it is clear that these are not exclusive, and commentators have reached disparate interpretations of what the permitted uses include. Notice 2005-10 ends much of the suspense on which uses are and are not permissible under the statute. With a few exceptions, it provides a liberal interpretation of permissible uses, in keeping with the intent of Congress.

1. Permissible Uses. Pursuant to Notice 2005-10, expenditures are permitted investments only if they are made to persons unrelated to the taxpayer, and only if paid in cash. (52) If the taxpayer pays for an expenditure with a note, the permitted investment will be considered made only as the note is paid in cash. Stock may not be used to pay for permitted investments. (53)

Notice 2005-10 provides that the following uses are permitted investments:

* Payment of Wages and Job Training for U.S.-Based Employees. The "funding of worker hiring and training" is one of five specified permitted uses in section 965(b)(4)(B). One of the stated purposes of the 2004 legislation is job creation and retention. Before the issuance of Notice 2005-10, however, it was not clear whether permissible uses under section 965 included all non-executive compensation and benefits, or only those expenses aimed at increasing and retaining the workforce. An amendment proposed by Senators John Breaux (D-LA) and Dianne Feinstein (D-CA) would have approved the use of repatriated funds for non-executive compensation, as one of the four specified qualified expenditures would have been "wages (as defined in section 3121(a)." (54) A more restrictive reading of section 965 could have limited the permissible investment to expenditures specifically targeted at increasing employment, such as under the Work Opportunity Credit (in sections 38(b)(2) and 51 of the Code), which provides a credit for a portion of first and second year wages.

In Notice 2005-10, the IRS adopts the more expansive reading of the statute, providing that a permitted investment includes not only expenditures to hire and train workers, but also expenditures for non-executive compensation and benefits (including the funding of a qualified plan under section 401(a)) for existing and newly hired workers. Such expenditures qualify to the extent they are for services performed within the United States. If payments are for services performed both within and outside of the United States, the payment will be apportioned under the principles of section 1.861-4(b)(1). (55) Where the permitted investment is the funding of a qualified plan, the taxpayer must use a "reasonable method" to apportion the funding between that related to executive versus non-executive compensation, and between funding related to services performed within versus outside the United States.

* Funding of Employee Retirement Plans. The funding of a qualified plan under section 401(a) may qualify as a permitted investment not only as a means of funding worker hiring and training, but also because it contributes to the financial stabilization of the company. In this context, the funding of a qualified plan may qualify as a permitted investment even to the extent it covers former employees and even if the funding is attributable to services performed outside the United States. At the time the DRP is approved by the taxpayer's president or CEO, the taxpayer must find, in its reasonable business judgment, that the funding of the qualified plan will contribute to the financial stabilization of the company for the purpose of job retention or creation. (56)

* Infrastructure and Capital Investments. Investments in infrastructure and capital investments are permitted investments under section 965(b)(4)(B). Notice 2005-10 provides that infrastructure and capital investments include "plant, property and equipment, communications and distribution systems, computer hardware and software, databases, and supporting equipment," as well as improvements. Expenditures for services provided in connection with infrastructure and capital investments also qualify. Expenditures qualify whether they are "to construct, develop, purchase, rent, or license such items." Expenditures for infrastructure and capital investments, and services related thereto, qualify only to the extent the property is located and used within the United States, or the services are provided within the United States.

* Research and Development. Research and development is another permissible use of funds mentioned in section 965(b)(4)(B). Notice 2005-10 takes the more restrictive interpretation that only R&D expenses described in Treas. Reg. [section] 1.174-2 qualify as permitted investments. Taxpayers had hoped that R&D would include all R&D expenses as shown on the U.S. shareholder's financial statements. (57)

Expenditures for R&D qualify only to the extent the R&D is performed in the United States. The taxpayer does not need to perform the R&D itself; payments to a third party to perform R&D on behalf of the taxpayer also qualify. R&D expense will not qualify, however, to the extent it is reimbursed pursuant to a cost sharing agreement under Treas. Reg. [section] 1.482-7. (58)

* Financial Stabilization/Debt Repayment. Section 965(b)(4)(B) permits repatriated funds to be used for "financial stabilization of the corporation for the purpose of job retention or creation." It is clear from the Senate debate over the Breaux-Feinstein amendment that the repayment of debt of the U.S. shareholder is an intended goal of section 965. (59) Notice 2005-10 confirms that repayment of debt to a third party lender, whether U.S. or foreign, qualifies as a permitted use of repatriated earnings. (60)

That many CFCs will access cash through third-party borrowing in order to pay the cash dividend that will be used by the U.S. shareholder to repay its debt presents the prospect of a shift in which entities bear debt. Since many U.S. companies are in a net operating loss or overall foreign loss position because of the interest owed on acquisition and other borrowing, a by-product of the repayment of this debt might be to put them into a taxable position, as well as giving them the ability to use foreign tax credits. Conversely, the assumption of debt at the CFC level should have the effect of reducing the tax burden in the local country. Prior to the issuance of Notice 2005-10, there was some question whether financial stabilization of the company would be achieved where debt is simply shifted from a U.S. company to its foreign subsidiaries. Notice 2005-10 answers this question by providing that the taxpayer need not show a net global reduction in indebtedness. Facts showing that the U.S. shareholder, not the CFC, is actually the obligor on CFC debt may cause the IRS to find that the repayment of debt by the U.S. shareholder does not fulfill the purpose of financial stabilization. Notice 2005-10 provides that the IRS will apply the principles of Plantation Patterns to determine whether a U.S. shareholder that guarantees debt of its CFC is actually the obligor on the debt.

The statute allows the use of repatriated funds for financial stabilization "for the purpose of job retention or creation." One issue that is not addressed in the statute is whether there must be any proof that repayment of debt results in job retention or creation. Companies faced with making large interest and principal payments often look for ways to reduce costs, and a principal way of doing so is by cutting or outsourcing jobs. While this trend can be seen in highly leveraged companies, it may not be as readily apparent in companies with lower levels of debt. Notice 2005-10 addresses this issue by providing that financial stabilization is for the purpose of job retention or creation if, at the time the DRP is approved by the taxpayer's president or CEO, it is the taxpayer's reasonable business judgment that the steps taken for financial stabilization will contribute to job retention or creation. Such a determination could be supported by a business plan that shows that savings attributable to debt reduction will be used for permitted investments, since such investments are likely to promote job retention and creation.

Notice 2005-10 contains an anti-abuse rule that provides that transitory repayments of debt will not qualify as permitted investments. The IRS will apply a facts and circumstances test to determine whether, as of the time debt is repaid, the taxpayer had a plan to incur new debt on substantially the same terms as the repaid debt, and did in fact incur such debt.

In addition to debt repayment, other expenditures that reduce financial constraints on the taxpayer's U.S. operations will qualify as permitted investments. (61) The payment of tort liabilities and other legal costs may fall into this category. (62)

* Acquisition of Interests in Business Entities. Notice 2005-10 takes a look-through approach to determine whether the acquisition of a business entity is a permitted investment. (63) The acquisition of a 10-percent or more interest in a domestic or foreign business entity, including a corporation or a partnership, is a permitted use to the extent that an acquisition of the entity's assets directly would be a permitted use. The constructive stock ownership rules of section 267(c) apply to determine whether the taxpayer owns 10 percent or more of an entity.

Amounts spent to acquire a business entity are to be allocated between permitted and non-permitted investments based on the relative value of the assets that, if acquired directly, would be permitted versus non-permitted investments. In determining asset value, the taxpayer is required to use the same method that it uses for allocating and apportioning interest expense (tax book value, alternative tax book value, or fair market value). The look-through approach also applies to lower tier entities in which the taxpayer indirectly owns a 10-percent or more interest. The allocation of acquisition costs is to be made based on the relative value of the assets held by the lower tier entity that would be permitted or non-permitted investments if acquired directly.

If 95 percent or more of the value of the acquired entity's assets would be permitted or non-permitted investments if acquired directly, a de minimis rule applies to treat the entire acquisition as either a permitted or non-permitted investment, respectively. (64)

* Advertising and Marketing Expenditures. Notice 2005-10 provides that advertising and marketing expenses incurred with respect to trademarks, trade names, brand names, or similar intangible property are permitted investments, to the extent the advertising or marketing activities occur in the United States. (65) The permitted investment includes payments made to third parties for advertising and marketing. If the advertising and marketing costs are not borne by the taxpayer (i.e., if a CFC or other entity shares the costs), however, they will not qualify.

* Intangible Property. Expenditures to acquire intangible property for use in the United States are permitted investments. The expenditure may be to purchase or license the property. (66)

2. Impermissible Uses

* Payment of Executive Compensation. While the statute prohibits the use of repatriated funds for the payment of executive compensation, it does not define "executive." Notice 2005-10 defines "executive" by reference to those employees subject to the insider trading rules of section 16 of the Securities Act of 1934. If the taxpayer is not an issuer of equity securities described in that statute, "executives" are those individuals who would be so described if the taxpayer were subject to the legislation. (67) A former employee who fell under either definition while an employee also is an "executive" for purposes of section 965.

* Dividends and Other Distributions. As expected, Notice 2005-10 will not permit repatriated funds to be used for the payment of dividends or other distributions, regardless of how those payments are treated under section 301.

* Stock Redemptions. To the disappointment of many taxpayers, Notice 2005-10 provides that stock redemptions are not permitted investments. Pursuant to the notice, it is irrelevant whether the redemption is treated as an exchange under section 302(b) or as a distribution of property subject to section 301 under section 302(d). (68) Had such redemptions been allowed, it was estimated that they could boost the per share earnings for the Standard & Poor's 500-stock index by two percentage points, to 7 percent. (69) Stock redemptions, however, were seen to represent a cash outflow from a corporation, with no corresponding benefit to the corporation (as opposed to the shareholders).

* Portfolio Investments in Business Entities. The acquisition of a less-than-10 percent interest in a business entity will not qualify as a permitted investment. (70) A taxpayer, however, may use repatriated earnings for portfolio investments temporarily, until such earnings are used for a permitted investment pursuant to a DRP.

* Debt Instruments. The acquisition of a debt instrument, including the acquisition of such instrument from the debtor, is not a permitted investment. (71) Presumably this would include promissory notes, bonds, and certain types of preferred stock treated as debt.

* Tax Payments. Repatriated earnings may not be used to pay federal, state, local, or foreign taxes, or related interest and penalties. This includes foreign withholding tax and U.S. federal, state, and local taxes imposed on distributions that qualify as cash dividends under section 965(a). (72)

3. No Requirement of Incremental Investment. There is no requirement in section 965 that the repatriated funds be used to incrementally increase spending for permitted uses over the spending for these uses in previous years. This issue was hotly debated in the Senate. The Breaux-Feinstein amendment would have provided that the deduction was only available for repatriated amounts used to fund incremental increases in qualified expenditures over a three-year period (2005-2007) over a base period (2001-2003). As already noted, the amendment was defeated. Notice 2005-10 affirms that there is no incremental investment requirement under the statute. (73)

Thus, there is nothing in the statute that prevents a U.S. shareholder from using funds from sources other than repatriated earnings (such as earnings from U.S. operations) for uses that would not be permitted under section 965, and using repatriated earnings for uses enumerated in section 965 and Notice 2005-10. For instance, the U.S. shareholder could use earnings from U.S. operations to increase executive compensation, make overseas acquisitions, or pay extraordinary dividends, and use repatriated earnings to fund R&D and domestic capital expenditures, or to pay down debt (even if the level of these expenditures was no more than in past years).

The breadth of the permissible uses of the funds and the lack of a requirement for incremental increases in investment point to a prevailing belief in Congress that, regardless of the use to which the funds are put, the repatriation of the funds to the United States, at a 5.25-percent rate, is preferable to those funds not coming back at all. Section 965 will result in a tax on the repatriated funds of 5.25 percent, and an influx of cash into the U.S. economy.

G. Establishing that Repatriated Funds Have Been Invested Pursuant to a DRP

A taxpayer that has elected to take the section 965 dividends-received deduction must meet annual reporting, and documentation and production, requirements. Furthermore, the taxpayer is required to establish that it has used repatriated funds for permitted investments pursuant to a DRP. Such a showing can be made either under a safe harbor test or based on a facts-and-circumstances determination.

1. Annual Reporting. The annual reporting requirements outlined in Notice 2005-10 require the taxpayer to attach a statement to its timely-filed tax return for the year of election and each subsequent year, providing the following information:

* A statement that the document is submitted pursuant to section 965(b)(4)(B) and Notice 2005-10.

* A description of permitted investments made during the taxable year, and a reconciliation of the total specific expenditures made, including a calculation of the percentage of completion of the DRP.

* A statement whether any of the permitted investments that have been made are alternative investments.

* Any additional statements required under either the safe harbor test or the facts-and-circumstances test.

A transitional rule provides that a taxpayer that has filed its tax return for the taxable year for which it elects section 965 to apply prior to January 13, 2005, may meet the annual reporting requirements by filing an amended return by the due date (including extensions) for such taxable year. (74)

2. Documentation and Production. Notice 200510 requires a taxpayer to prepare, maintain, and, upon a request by the Commissioner, make available within 30 days, the following:

* Records showing the amount invested in the United States pursuant to a DRP, including an allocation between permitted and non-permitted investments. If relevant, the documentation should include a demonstration that the methodology is consistent with the principles of Notice 2005-10.

* A copy of the DRP and any supporting documents.

* If a cash dividend is effectuated through a foreign intermediary partnership that is not required to file an information return, substantiation that the dividend is allocated to the U.S. shareholder under the rules of sections 702 and 704, and separately stated to the partner under Treas. Reg. [section] 1.702-1(a)(8)(ii).

3. Safe Harbor. Notice 2005-10 provides a safe harbor rule for establishing that repatriated funds have been invested in the United States pursuant to a DRP. (75) The taxpayer must meet a substantive requirement, an annual reporting requirement, and documentation and production requirements in order to qualify for the safe harbor.

The substantive requirement for falling within the safe harbor rule is that expenditures comprising at least 60 percent of the total investments to be made pursuant to the DRP (i) have been made, or are subject to a binding contract with an unrelated person, by the end of the second year following the year of the election; and (ii) such investments constitute permitted investments listed in Notice 2005-10 (other than investments described as "other expenditures" contributing to financial stabilization in section 5.05(c) of the Notice).

The annual reporting requirements are relaxed for a taxpayer that meets the substantive requirements of the safe harbor rule. The taxpayer is required to meet the annual reporting requirements for the year of election and for each of the two subsequent years (unless all investments pursuant to the DRP are made prior to the first day of either such year). The taxpayer may cease annual reporting if the annual report filed no later than the second taxable year following the election includes a statement that (i) the substantive requirements of the safe harbor rule are met; and (ii) the taxpayer intends to make any remaining investments pursuant to the DRP no later than the end of the fourth taxable year following the year of election. The statement must include additional representations if the repatriated funds are to be used for debt repayment or the funding of a qualified plan. (76) A taxpayer meeting the substantive requirements of the safe harbor rule is required to meet all documentation and production requirements.

4. Facts and Circumstances. If the taxpayer does not meet the safe harbor test, the taxpayer will be required to establish that, taking into account all facts and circumstances, the repatriated funds have been, or will be, invested in the United States pursuant to a DRP. The relevant facts and circumstances include:

* The nature of the investments to be made under the DRP and the time period prescribed in the DRP.

*The degree of specificity with which the investments are described in the DRP.

* The extent to which the investments described in the DRP have been completed, taking into account the nature of the investments and other facts and circumstances.

The relevant facts and circumstances include whether the taxpayer has met the annual reporting requirements, and whether the taxpayer includes a statement, in the annual report filed no later than the second year following the election, that the taxpayer agrees, upon a request by the Commissioner, (1) to extend the statute of limitations on assessment and collection with respect to the DRD claimed in the year of election, and (2) to enter into a multi-year agreement with respect to the taxpayer's completion of the DRP. The filing of such a statement may determine the extent to which annual reporting and documentation requirements must continue.

H. Final FASB Guidance

As previously stated, the maximum amount that may be treated as an eligible dividend under section 965 is the greater of $500 million or the amount shown as earnings permanently reinvested outside the United States on the applicable financial statement. APB 23 provides an exception to the general rule of FASB Statement 109 requiring companies to set up deferred tax liabilities for unrepatriated CFC earnings taxed at a rate lower than the U.S. rate. This exception applies to the company's foreign earnings that the company plans to indefinitely reinvest outside the United States. Until a company completes its assessment of the effect of section 965 on its plans for unrepatriated CFC earnings, the company's plans for those earnings may be uncertain. The uncertainty about whether some or all foreign earnings will be repatriated that exists while the company is completing its evaluation could call into question the assumption underlying the indefinite-reinvestment exception, potentially requiring an immediate adjustment to the company's tax provision, as FAS 109 would require that the effect of the change in the tax law be recognized in the period that includes the enactment date.

FASB Staff Position 109-2, issued December 21, 2004, and effective immediately, allows additional time for companies to decide whether any foreign earnings will be repatriated under section 965, and therefore whether undistributed earnings being considered for repatriation under section 965continue to qualify as indefinitely reinvested outside the United States. Companies that take the additional time are required to provide disclosures about the status of the company's evaluation and the potential effects of its decision. The staff position calls its guidance "a practical exception" made necessary because some of the new law's provisions are unclear and the law was enacted late in the year.

The grant of additional time to decide whether any foreign earnings will be repatriated under section 965 and to re-evaluate the indefinite-reinvestment determination applies only to companies that have not yet completed the evaluation of the effect of section 965 on their plans for reinvestment or repatriation of foreign earnings. A company that has decided to remit foreign earnings must record deferred tax liabilities on the earnings that will be remitted. A company that has not completed the evaluation, but has decided to remit a portion of its undistributed foreign earnings, must record deferred tax liabilities on the portion it has decided to remit. If the company subsequently decides to remit additional amounts of foreign earnings, additional tax liabilities would be recorded at the time the subsequent decision is made.

A company might complete its evaluation of the effect of the new tax law subsequent to the date of its financial statements, but prior to their issuance. This could occur, for example, if clarifying language on key elements of the repatriation provision is released subsequent to the date of the financial statements. In addition, a company may not decide to repatriate earnings until after the date of the financial statements because it needs time to calculate the amount of undistributed foreign earnings that will qualify for the one-time deduction under the new law and the related income tax effects, and then decide whether to repatriate or reinvest those earnings.

According to the staff position, companies should record deferred tax liabilities attributable to foreign earnings to be remitted as a result of the new tax law in the period that the decision is made to remit those earnings. For example, the effect of a decision made in January 2005 by a company with a December 31 year-end to repatriate earnings under the provision is to be recorded in 2005 (the period the decision is made), not as of December 31, 2004, even if the 2004 financial statements have not been issued. That effect would be recorded in the interim period in which the decision is made. It would not be included as part of the estimated annual effective tax rate used for interim financial reporting.

Companies that have not completed their evaluation of section 965 as of the balance sheet date are required to include in the financial statements the following disclosures:

* A summary of how the repatriation provision applies to the company, including the status of the company's evaluation of the repatriation provision's effects and the expected completion date of the evaluation.

* If the company makes the decision in stages, the effect on tax expense or benefit of amounts recognized under the repatriation provision. Annual financial statements should show any effects as a separate component of the disclosures of current and deferred taxes for the period.

* The range of reasonably possible amounts of undistributed earnings being evaluated for repatriation and the potential range of additional income tax effects. If the range of income tax effects cannot be reasonably estimated at the time the financial statements are issued, a statement to that effect should be provided.

* Pro forma financial data showing the potential effect of a decision to reinvest or repatriate foreign earnings subsequent to the date of its financial statements but prior to their issuance. The pro forma financial data must include, at a minimum, the effect on income tax expense or benefit.

Companies reporting on the period during which they complete their evaluation of the effects of the repatriation provision should disclose the effect on income tax expense or benefit for the period. Annual financial statements should show the effects as a separate component of the disclosures of current and deferred taxes for the period.

IV. Conclusion--A Practical Approach

A company with significant unrepatriated foreign earnings needs to develop a practical approach to determine whether, and to what extent, it wishes to take advantage of section 965. As a preliminary step, corporate managers and directors should determine potential permissible uses that may be made of the funds in the United States. Inasmuch as there is no requirement that permitted uses of repatriated funds represent incremental investment, most taxpayers should be able to identify permissible uses of repatriated funds, even if the principal effect is to free otherwise available funds for other uses.

The more interesting issues in evaluating whether to repatriate under section 965 will revolve around computing the tax cost of such repatriation, and determining whether that cost is low enough to justify foregoing further deferral of U.S. tax on the portion of CFC earnings repatriated.

The role of the tax department will include developing a base-line remittance plan, and modeling the U.S. and foreign tax consequences of the plan. The goal of the base-line remittance plan will be to determine the maximum benefit of repatriating earnings under section 965 without proactive planning. After a base-line remittance plan has been developed and analyzed, tax planning and structuring may be considered to help maximize the benefit of the one-time section 965 election.

The corporate tax department will need to gather information related to the section 965limitations. This information will include a determination of:

* The APB 23 exception amount

* The base period limitation

* Any increase in related party indebtedness

* The amount supported by a dividend reinvestment plan

In addition to the limitations imposed by section 965, other limitations that must be considered include:

* Available cash held by CFCs

* The applicable E&P and tax pools for CFCs

* Local country distributable reserves

* Any other local country limitations on distributions, such as currency controls

Section 965 offers U.S. multinationals a unique opportunity to repatriate low-taxed foreign earnings at a substantially reduced U.S. tax cost. Except in exceptional circumstances, we expect that most companies will wait for passage of technical corrections legislation, and further guidance from the IRS, before deciding whether and to what extent to repatriate under section 965. In view of the potential significance of this one-time repatriation opportunity, however, most multinationals would be well advised to begin verifying critical data and modeling the potential benefits of section 965.

(1) Introduction to H.R. 4520, American Jobs Creation Act of 2004.

(2) H.R. 2896, American Jobs Creation Act of 2003, Title I, Subtitle C, [section] 1021, Temporary Deduction by U.S. Shareholders for Dividends Received from Controlled Foreign Corporations. The initial version of H.R. 2896, but not a later version, included the dividends-received deduction.

(3) H.R. 4520, American Jobs Creation Act of 2004, Title II, Subtitle G, [section] 271, Incentives to Reinvest Foreign Earnings in the United States.

(4) Public Law No. 108-357.

(5) H.R. 5395 and S. 3019.

(6) According to economic theory, a temporary deduction would increase near-term repatriations, while a permanent deduction might have no effect on remittances and might in fact encourage the out-flow of cash to foreign operations. See David L. Brumbaugh, CRS Analyzes Foreign Earning Repatriation Proposals, Tax Notes Today, November 29, 2004 (2004 TNT 229-18).

(7) I.R.C. [section] 965(f); Notice 2005-10, [section] 7. Pursuant to the Notice, if a taxpayer files its tax return before to the issuance of Form 8895, the election must be made on a statement attached to its timely-filed tax return.

(8) This structure most commonly results when an existing U.S.-headquartered multinational group is acquired by a foreign company. Acquisition debt pushed down into the U.S. may make it difficult for the acquired U.S. company to utilize foreign tax credits associated with dividends from its CFCs.

(9) Taxpayers that report the U.S. tax liability attributable to deferred foreign earnings, rather than the deferred earnings, may be at a disadvantage under the statute as enacted, because the tax liability may be net of foreign tax credits. Therefore, dividing the reported U.S. tax liability by .35 will result in an amount less than the deferred foreign earnings. It remains unclear whether this issue will be addressed in pending technical corrections legislation.

(10) Dean Foust, Howard Gleckman & Amy Barrett, The Cash Heads Home, Business Week, December 27, 2004, at 42.

(11) I.R.C. [section] 965(c)(5)(A).

(12) I.R.C. [section] 965(c)(5)(B).

(13) I.R.C. [section] 965(c)(5)(C). Although the statute refers to regulations to be prescribed, guidance will probably be issued pursuant to a notice, because of the short-term nature of section 965.

(14) The definition of dividend in section 965(c)(3) does not specifically include amounts recharacterized as dividends under sections 302 and 304. Such dividends, however, are not excluded under section 965(c)(3), and by negative implication, such dividends qualify for the dividends-received deduction. Furthermore, both the conference report to H.R. 4520 and Notice 2005-10, [section] 2 state that such dividends qualify for the section 965 benefit.

(15) Notice 2005-10, [section] 3.01, note 4.

(16) I.R.C. [section] 965(c)(3).

(17) I.R.C. [subsection] 959(c)(1)-(3).

(18) I.R.C. [section] 959(d); Notice 2005-10, [section] 3.04.

(19) Even though such distributions would generally be excluded from gross income under section 959(a), section 965(a)(2) specifically provides that such a distribution is a cash dividend eligible for the dividends-received deduction.

(20) Notice 2005-10, [section] 3.04.

(21) Notice 2005-10, [section] 3.03.

(22) Notice 2005-10, [section] 3.02.

(23) Notice 2005-10, [section] 3.01.

(24) Plantation Patterns, Inc. v. Commissioner, T.C. Memo 1970-182, aff'd, 462 F.2d 712 (5th Cir.), cert. denied, 409 U.S. 1076 (1972) (holding that shareholder, who guaranteed the debt of a thinly capitalized corporation, was actually the debtor).

(25) The sale of cash equivalents may trigger local country capital gains tax and result in the imposition of penalties by financial institutions on the early termination of certain investments. The sale may also generate E&P.

(26) Notice 2005-10, [section] 3.01. Pursuant to the Notice, "cash equivalents" has the meaning provided in Temp. Reg. [section] 1.897-7T(a). Under Temp Reg. [section] 1.897-7T(a), "cash equivalent" means "any asset readily convertible into cash (whether or not denominated in U.S. dollars), including, but not limited to, bank accounts, certificates of deposit, money market accounts, commercial paper, U.S. and foreign treasury obligations and bonds, corporate obligations and bonds, precious metals and commodities, and publicly traded instruments."

(27) I.R.C. [section] 965(b)(3).

(28) Section 41(f)(3)(A) provides:

   If ... a taxpayer acquires the major portion of a trade or
   business of another person (... the "predecessor") or the
   major portion of a separate unit of a trade or business of
   a predecessor, then ... the amount of qualified research
   expenses paid or incurred by the taxpayer during periods
   before such acquisition shall be increased by so much of
   such expenses paid or incurred by the predecessor with
   respect to the acquired trade or business as is attributable
   to the portion of such trade or business or separate unit
   acquired by the taxpayer, and the gross receipts of the
   taxpayer for such periods shall be increased by so much
   of the gross receipts of such predecessor with respect
   to the acquired trade or business as is attributable to
   such portion.

Similar rules are provided for dispositions. I.R.C. [section] 41(f)(3)(B). The regulations under section 41 provide little guidance on these rules, and no case law or IRS release fully explains their application.

(29) H.R. Rep. No. 201, 97th Cong., 1st Sess. 124 (1981).

(30) Section 965 provides no direction with respect to how taxpayers should incorporate section 41(f)(3) principles, and the Conference Report on the 2004 tax bill merely states in a footnote that the rule in section 965(c)(2)(C)(i) concerns "cases involving companies entering and exiting corporate groups." Conference Report at 66 n. 110. The House bill, which the Conference Agreement adopts with modifications, did not contain a similar provision, but the Senate bill provided that "[r]ules similar to the rules of section 41(f)(3) shall apply in the case of acquisitions or dispositions of CFCs." S. 1637, 108th Cong., 2d Sess., [section] 231 (2004) (proposed section 965(c)(5)).

(31) Further discussion of the M&A Rule is beyond the scope of this article. See generally Tax Notes Today, December 27, 2004 (2004 TNT 248-77), suggesting that section 965(c)(2)(C)(i) should apply only when a taxpayer acquires or disposes of a U.S. shareholder, e.g., through merger of the U.S. shareholder into the taxpayer, through the U.S. shareholder becoming part of the taxpayer's consolidated group, or ceasing to be a member of the consolidated group.

(32) Treas. Reg. [section] 1.964-1T(g)(2). For CFC taxable years beginning after Dec. 31, 1988, events that cause a CFC's E&P to have tax significance are those listed in Treas. Reg. [subsection] 1.964-1T(g)(2)(i)-(v). The mere filing of a Form 5471 is not an event that causes the CFC's E&P to have U.S. tax significance. A distribution by the CFC, however, is such an event.

(33) I.R.C. [section] 174(b).

(34) I.R.C. [subsection] 312(1)(1) and 964(a); see 1999 TNT 15-83, discussing FSA 1999-540.

(35) I.R.C. [section] 965(e)(1).

(36) This analysis assumes that pending technical corrections legislation to prevent the application of section 78 to the deductible portion of the dividend is enacted.

(37) I.R.C. [section] 302(d).

(38) I.R.C. [subsection] 304(b)(2)(A) and (B).

(39) I.R.C. [section] 965(e)(1)(B). A taxpayer in AMT in the year of a section 965 dividend may be subject to both regular tax and AMT on that dividend, with the AMT carrying forward as an AMT credit to future years.

(40) I.R.C. [section] 965(e)(1).

(41) I.R.C. [section] 965(e)(2)(B).

(42) I.R.C. [section] 965(d)(2).

(43) 150 Cong. Rec. S10976 (Oct. 9, 2004).

(44) Approval by the company's board of directors or management committee may come after the dividend is paid, and no special meeting is required to grant the approval. Where the U.S. shareholder of the CFC paying the dividend is a member of a consolidated group, the plan must be approved by the president, CEO or comparable officer, and by the board or management committee, of the common parent of the group. Notice 2005-10, [section] 4.02.

(45) Although the Notice requires that the permitted investments be completed within a reasonable time period, it does not place any fixed deadline by which the investment must be completed. See section 4.05 of the Notice, suggesting that segregation and tracing of repatriated funds would be helpful where the DRP is to be completed over a period of "many years."

(46) Notice 2005-10, [section] 4.03.

(47) Id. [section] 4.04.

(48) Id. [section] 9.02.

(49) Id. [section] 4.05.

(50) Notice 2005-10, [section] 4.06.

(51) Notice 2005-10, [section] 4.07.

(52) Whether the person is a related person is determined under section 267(b), other than section 267(b)(8) in the case of an expenditure with respect to a qualified plan.

(53) Notice 2005-10, [section] 5.01(c). Thus, although non-executive compensation is a permissible use, if it is paid in the form of stock grants or stock options it will not be a permissible use. Similarly, while the acquisition of a business entity with U.S. assets is a permitted use, it is only a permitted use to the extent that the taxpayer pays cash for the entity. If instead the taxpayer issues its own stock to acquire the target, the acquisition will not be a permitted investment.

(54) Amendment No. 3117, the Breaux-Feinstein amendment, to S.1637, the Jobs Act, Cong. Rec. S4861-4868, May 5, 2004. The amendment was defeated.

(55) Treas. Reg. [section] 1.861-4(b)(1) provides rules for sourcing compensation for personal services when the services are performed partly within and partly outside of the United States. Apportionment on the basis of time is generally an acceptable method.

(56) Notice 2005-10, [section] 5.05(b).

(57) Technology and pharmaceutical companies, some of which have large amounts of unrepatriated earnings, are expected to be among the biggest beneficiaries of section 965. See Stephen Taub, Repatriation Games: Room for Reinvestment, CFO.com, January 17, 2005.

(58) Notice 2005-10, [section] 5.04.

(59) Supporters of the Breaux-Feinstein amendment were adamantly opposed to the use of repatriated funds for the repayment of debt. Opponents of the amendment strongly supported the repayment of debt as a valid purpose under section 965.

(60) Notice 2005-10, [section] 5.05(a). Repayment of debt to a member of the taxpayer's consolidated group will generally not qualify as a permitted investment; however, if the consolidated group member receiving the repayment uses the funds for a permitted use, such use will qualify.

(61) Notice 2005-10, [section] 5.05(c).

(62) Notice 2005-10 does not specifically address whether the payment of such expenses would qualify under the category of "financial stabilization," though the Treasury Department's Fact Sheet, released at the same time as Notice 2005-10, suggests that such payments may so qualify.

(63) Notice 2005-10, [section] 5.06(a).

(64) Notice 2005-10, [section] 5.06(b).

(65) Notice 2005-10, [section] 5.07. The source rules of Treas. Reg. [section] 1.8614(b)(1) (compensation for labor or personal services) apply where the advertising and marketing services occur partly within and partly outside of the United States.

(66) Notice 2005-10, [section] 5.08.

(67) Notice 2005-10, [section] 6.02. A taxpayer that is not subject to the 1934 Securities Act may treat the 10 employees who received the highest wages in the most recently ended calendar year as "executives" for purposes of section 965, rather than determining which employees would be subject to the insider trading rules.

(68) Notice 2005-10, [section] 6.05.

(69) Dean Foust, Howard Gleckman & Amy Barrett, The Cash Heads Home, Business Week, December 27, 2004, at 42 (comments of Standard & Poor's chief economist David Wyss).

(70) Notice 2005-10, [section] 6.06.

(71) Notice 2005-10, [section] 6.07.

(72) Notice 2005-10, [section] 6.08.

(73) Notice 2005-10, [section] 4.01.

(74) Notice 2005-10, [section] 9.03.

(75) Notice 2005-10, [section] 8.03.

(76) See Notice 2005-10, [subsection] 8.03(c)(ii) and (iii).

PHILIP A. STOFFREGEN is a principal and ELIZABETH SATKOSKI is a senior associate in the International Corporate Tax Practice of KPMG LLP's Detroit, Michigan, office. STEVEN R. LAINOFF, who formerly served as International Tax Counsel for the U.S. Department of the Treasury, as well as with the Internal Revenue Service, is the principal-in-charge of KPMG's Washington National Tax International Corporate Service's group.