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1989 tax act.

1989 TAX ACT

In the early hours of Thanksgiving morning, Congress passed the Revenue Reconciliation Act of 1989, which includes significant international provisions affecting both inbound and outbound investment.

Earnings stripping. The act contains an "earnings stripping" provision that disallows a corporation's interest deductions to the extent they exceed a specified limitation. Interest expense is disallowed only if the interest is paid to a related person and the corresponding interest income is exempt from U.S. withholding tax, for example, under a tax treaty. The limitation equals the amount by which a corporation's net interest expense exceeds 50% of its gross income (with certain adjustments) plus any unused limitation generated in the three most recent years. The disallowed expenses may be carried forward and applied against a subsequent year's limitation.

Reporting and recordkeeping. The act amends IRC section 6038A by imposing additional significant reporting and recordkeeping requirements on foreign-controlled corporations conducting a trade or business in the United States. Both the class of corporations subject to these rules and the class of reportable transactions have been expanded.

The IRS's summons power also has been significantly increased. Monetary penalties for noncompliance are now substantial and without a ceiling. These rules are designed to enhance the IRS's enforcement power under section 482 by providing it with ready access to information it considers necessary in a transfer pricing determination.

Moreover, affected foreign corporations must now designate a U.S. agent for service of process. In the case of failure to comply with this rule or with a summons, the IRS is empowered to determine whether a taxpayer may deduct costs and deductions in connection with reportable transactions.

Conformity of tax years. The act requires the taxable year of a controlled foreign corporation and foreign personal holding company to be conformed to that of its major U.S. shareholder. This rule is designed to end the deferral of subpart F and undistributed foreign personal holding company income that currently arises when the taxable years of a U.S. shareholder and its foreign affiliate differ.

Foreign tax credit deconsolidation technique. The act authorizes the IRS to recharacterize a portion of the foreign source income of an affiliated group as U.S. source income or to modify the consolidated return regulations in order to prevent the circumvention of certain foreign tax credit limitation provisions of the tax code. This provision is generally aimed at the situation in which a consolidated group separates a U.S. subsidiary with foreign source losses from the rest of the group by placing it under a foreign subsidiary. The subsidiary would not be treated as a member of the U.S. group. As a consequence, its foreign source losses would not reduce the group's foreign source income or, hence, the foreign tax credit limitation of the group.

Observation: Congress did not enact the controversial provision regarding the disposition of stock of U.S. corporations by foreign shareholders. Under that provision, U.S. tax would have been imposed if the shareholders owned 10% or more of the shares of the U.S. corporation. Congress also did not enact a provision that would have required taxpayers to capitalize and amortize, rather than deduct, research and experimentation (R&E) expenses attributable to activity conducted outside the United States.

There has been some indication from the Treasury Department that another attempt may be made to enact the stock sale provision. It is unlikely, however, that the R&E provision will be revived.

Herbert Paul, CPA, senior partner of Mahoney, Cohen, Paul & Co., New York City; Robert Willens, CPA, senior vice-president-corporate finance at Shearson Lehman Hutton, New York City; and Marianne Burge, CPA, partner, international tax services, of Price Waterhouse, New York City.
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Author:Willens, Robert
Publication:Journal of Accountancy
Date:Feb 1, 1990
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