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Municipal bond interest - not exempt.

An interesting thing happened to tax-exempt interest in 1986 - it potentially became taxable. With the passage of the Tax Reform Act of 1986 (TRA) and the issuance of Temp. Regs. Sec. 1.954-2T(b)(6) in 1989, interest that would otherwise be tax-exempt may be subject to the alternative minimum tax (AMT). Specifically, municipal bond interest earned by a U.S. corporation's controlled foreign subsidiary (CFC) may result in an AMT liability for the U.S. taxpayer.

Pursuant to the TRA, tax-exempt interest may generate an AMT liability in two ways. If attributable to a private activity bond issued after Aug. 6, 1986, it is a tax preference item includible in computing alternative minimum taxable income (AMTI). Secondly, for tax years beginning after 1989, tax-exempt interest is an adjustment in arriving at adjusted current earnings (ACE). The ACE adjustment effectively includes 75% of the interest in AMTI. For years 1987-1989, the book unreported profit adjustment (BURP) included 50% of the interest in AMTI.

Before Temp. Regs. Sec. 1.954-2T(b)(6) was released, tax-exempt interest was not characterized as foreign personal holding company income (FPHC income). U.S. taxpayers with CFCs that were required by Sec. 951 to include their portion of the CFC's subpart F income in their taxable incomes did not include any municipal bond interest earned by that CFC.

Temp. Regs. Sec. 1.954-2T(b)(6) states that FPHC income includes interest exempt under Sec. 103. However, the net foreign base company income attributable to exempt interest is treated as tax-exempt in the hands of the foreign corporation's U.S. shareholder. Accordingly, income that is included in the subpart F income of a U.S. shareholder attributable to tax-exempt interest remains exempt from regular tax but potentially subject to AMT in the hands of the U.S. shareholder.

For tax years beginning after 1989, the BURP adjustment was replaced by the ACE adjustment. The purpose of this adjustment was to determine the taxpayer's earnings on a more economic basis - an earnings and profits (E&P) approach. Although the components of the ACE adjustment are not identical to the adjustments to taxable income made in arriving at E&P, they are similar. Specifically, tax-exempt interest is an adjustment to taxable income in arriving at ACE.

Clearly, an ACE adjustment is necessary for tax-exempt interest earned by a U.S. taxpayer. However, the answer is not as clear if the income is earned by a CFC and is included in subpart F income.

Regs. Sec. 1.56(g)-1(c)(6)(ii) states that tax-exempt interest is included in determining ACE. There is no distinction between interest earned directly by the taxpayer or deemed earned by the taxpayer via a subpart F inclusion. Accordingly, tax-exempt interest, whether earned by the U.S. shareholder or its CFC, will create an ACE adjustment.

The key question, however, is when does this liability occur: when the interest is earned by the CFC and includible under subpart F, or when actually remitted to the U.S. shareholder in the form of a dividend? There is no direct guidance on this issue, so one must look to the steps taken in arriving at ACE.

Since the starting point for determining ACE is AMTI and the starting point for determining AMTI is taxable income, the year that an item is included in taxable income should be the year it is included in ACE. Therefore, since the subpart F inclusion occurs when the CFC earns the income, the ACE adjustment should arise in that same year.

The regulations, however, do not specifically address this point. Regs. Sec. 1.56(g)-1(c)(1) provides the general rule that ACE includes all items of income permanently excluded from preadjustment AMTI but otherwise taken into account in determining E&P. By way of example, a taxpayer using the completed contract method would not report revenue for preadjustment AMTI until the contract is completed. Even though the percentage of completion method is required in calculating E&P under Sec. 312(n)(6), no ACE adjustment is required since the income will ultimately be included in preadjustment AMTI.

As an exception to this general rule, Regs. Sec. 1.56(g)-1(c)(2) states that items of income that may eventually be included in preadjustment AMTI of another taxpayer on the liquidation, disposal or "similar circumstances" do not fall under the general rule and would be included in ACE as earned.

This would appear to require a current ACE adjustment. First, tax-exempt interest is an item of income permanently excluded from preadjustment AMTI but otherwise included in calculating E&P. In addition, the subpart F inclusion by a U.S. shareholder of a CFC's earnings is not a "timing difference" similar to the difference resulting from the percentage completion/completed contract methods of accounting.

Secondly, the exception to the general rule does not appear to allow deferral of a deemed inclusion until the amount is remitted.

Finally, the conclusion that the ACE adjustment can be deferred until payment is made to the U.S. shareholder contradicts the overall purpose of the subpart F rules and the reference in Temp. Regs. Sec. 1.954-2T(b)(6) to the potential AMT exposure. Effectively, the U.S. shareholder is treated as directly owning the municipal bonds and earning the tax-exempt interest.

The timing issue is moot, however, if the deemed dividend is paid during the year.

Perhaps the only consolation to taxpayers is that Temp. Regs. Sec. 1.954-2T(b)(6) has been controversial since its release. Without this regulation, those taxpayers whose CFCs earn municipal bond interest could have deferred any tax liability until the income was received. As of the date of this article, the Service is still reviewing this regulation, but has not formally commented on any future changes.
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Author:Layne, Scott M.
Publication:The Tax Adviser
Date:Feb 1, 1993
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