Significant changes to definitions of foreign base company income.

Recently published final regulations under Internal Revenue Code sections 954 and 957 define "foreign base company income," "foreign personal holding company income" and "controlled foreign corporation (CFC)" for purposes of the subpart F provisions. The regulations reflect provisions of various tax acts enacted since 1984 and make changes to temporary and proposed regulations published July 21, 1988. Following are some of the more significant changes in the new regulations:

Excess of gains over losses from certain property, transactions

Property held for use in a trade or business. Under the temporary regulations, gain from the sale or exchange of certain property used in a CFC's trade or business generally did not constitute foreign personal holding company income. The final regulations clarify that this exception extends to property hem for use in the CFC's trade or business. They also eliminate the requirement in the temporary regulations that intangible property be disposed of in connection with the sale of an entire trade or business.

Changes in use of property. The temporary regulations generally provided that the use of property should be determined by its use shortly before disposition. The final regulations define "use" based on use for more than one-half of a CFC's holding period.

Notional principal contracts. The final regulations exclude notional principal contracts from the definition of property that does not give rise to income. However, the contracts may give rise to other types of foreign personal holding company income, such as income equivalent to interest or the excess of gains over losses from commodities transactions or foreign currency transactions.

High tax exception

De minimis and full inclusion tests. These generally are applied before the high tax exception is elected. A U.S. shareholder can elect to exclude from subpart F income all items subject to an effective foreign tax rate over 90% of the U.S. rate. In certain cases, the only amounts included in the gross income of a CFC's U.S. shareholders may be the full inclusion income. To mitigate this problem, the final regulations provide that an amount that would otherwise be full inclusion income will be excluded if more than 90% of the CFC's adjusted gross foreign base company and insurance income is excluded under the high tax exception.

Effective rate of foreign income tax. The final regulations determine when an income item is subject to a high effective foreign tax rate after application of the earnings and profits limitation. The amount of subpart F income included in a taxable year is limited to the amount of the CFC's earnings and profits. When comparing the tax incurred for an income item with the income amount, the income amount is reduced by the earnings and profits limitation. This is more than a clarification of the temporary regulations. The final regulations could be beneficial because they generally would result in a higher effective foreign tax rate. However, they could be detrimental if the income would qualify for the high tax exception before the application of the earnings and profits limitation. Income excluded under the high tax exception is deferred permanently until repatriation, while income excluded because of the earnings and profits limitation may be subject to recapture.

Hedging transactions

The final regulations consolidate several definitions for a hedging transaction. New identification requirements have been added for bona fide hedging transactions similar to regulations under section 1221 and require hedging transactions to be identified on the day they are entered.

Payments made by partnerships

The final regulations reflect amendments in the Revenue Reconciliation Act of 1989 for the same country exception. If a partnership with any corporate partners pays interest, rents or royalties, the payment will be treated as paid by the corporate partner if the payment gives rise to a partnership deduction allocable to the corporate partner or if a partnership item reasonably related to the payment would be allocated to that partner.

Foreign currency gains and losses

The excess of foreign currency gains over losses generally is foreign personal holding company income. However, the temporary regulations excluded certain foreign currency exchange gains or losses when they related either to separately identified qualified business transactions or to qualified hedging transactions that were identified with or traced to a qualified business transaction. Under the final regulations, hedging transactions don't have to be traced to a specific transaction or property if all, or all but a de minimis amount of the aggregate risks being hedged, satisfy a business needs test and certain requirements in section 1221.

Income equivalent to interest

The temporary regulations said income equivalent to interest generally did not include income from notional principal contracts, except when the contracts were part of an integrated transaction that gave rise to interest. However, the final regulations say such income based solely on interest rates or interest rate indices is income equivalent to interest, whether or not the contract is integrated with an investment.

When do the new regulations apply?

These regulations apply to CFC taxable years beginning after November 6, 1995; however, special effective dates apply to certain provisions. Taxpayers may elect to apply the final regulations retroactively for any CFC taxable year beginning on or after January 1, 1987, and all subsequent taxable years.

The final regulations generally do not represent broad changes in policy, however, they do clarify a number of issues. It should be noted that the proposed subpart F regulations were released simultaneously with the final regulations, which eliminate the current rule that treats subpart F income that is tax-exempt interest under section 103 as tax-exempt interest in the hands of the U.S. shareholders. Under the proposed rule the interest would have been taxable in the hands of the U.S. shareholders. The proposed regulations also contained complex rules relating to the allocation of deficits and the earnings and profits limitation to categories of subpart F income.

--Kenneth Kral, CPA and international tax partner, Jack Serota, Esq., international tax manager, at Price Waterhouse, New York City.

  Tax Executives Give Incentives Thumbs Up

   A survey of 203 senior tax executives in companies with
annual revenues in excess of $300 million shows a majority
are optimistic tax incentives will help their businesses
expand.  Here is what they had to say.

   Types of incentives companies receive (*)

   51%     Property tax rebate
   48%     Income-franchise tax credit
   35%     Sales tax rebate
   11%     Job training
   11%     Preferred financing
    9%     Employment or payroll tax credit
    8%     Utility rebates
   14%     Other

   Availability
   State and local governments were more likely to offer
   local tax credits now than five years ago
   73%

   Effectiveness
   Tax credits at least somewhat effective at meeting
   company's needs
   69%

   Influencing future plans
   Companies expanding or relocating within the next five
   years
   77%

   Expanding workforce within the next 12 to 24 months
   53%

(*) Base: Respondents receiving any state or local incentives.

Source: KPMG Peat Marwick