In recent years, many U.S. firms have chosen to invest overseas, often because of lower labor costs and favorable tax rates. Foreign direct investment, or FDI, occurs when an investor based in one country acquires an asset in another country with the intent of managing that asset. FDI generally refers to the following:
- The purchase or sale of goods/intellectual property
- Portfolio investments
- Investments in other countries or another country’s investments in the U.S.
FDI can be classified in three ways:
- Ownership of 10% or less – portfolio investment
- 10% – 50% – foreign direct investment
- Over 50% – majority owned foreign affiliate
The majority of U.S. direct investment abroad (USDIA) is in developed economies and most of the foreign direct investment in the U.S. (FDIUS) is also from developed economies. The top five FDI partners with the United States are the United Kingdom, Canada, the Netherlands, Germany and Switzerland.
FDI can have significant tax implications, as well as valuation implications. One of the key tax considerations is whether the acquirer will be entitled to a stepped up tax basis in the assets and thus entitled to future tax deductions through depreciation and amortization.
In the case of a U.S. acquisition of a foreign target, it was oftentimes beneficial to make a Section 338(g) election. This election generally results in the transaction being characterized as a deemed sale of assets by a foreign corporation, with no immediate tax impact assuming the foreign corporation has no U.S. operations. Historically and through the end of this year, the impact of this election, due to the assets being stepped up to fair market value, is that the earnings and profits of the foreign corporation would be lower due to increased depreciation and amortization and may result in high effective tax rate earnings. This could be helpful for foreign tax credit purposes in that repatriation of these high taxed earnings may have been able to shield other low taxed foreign earnings from U.S. tax.
The Education Jobs and Medicaid Assistance Act, which was signed into law by President Obama in August of this year includes a number of provisions which affect the computation of the foreign tax credit. One of the provisions denies foreign tax credits with respect to foreign income not subject to U.S. taxation by reason of certain asset acquisitions. In essence, the foreign tax credit is reduced for the portion related to the basis difference that results where there is a difference in tax basis for the local country and U.S. tax purposes.
Accordingly, the opportunity to make a Section 338(g) election with the result of generating high taxed earnings for foreign tax credit purposes will not be available once the law becomes effective. The new law is effective for covered asset acquisitions after December 31, 2010 with certain transitional rules for written binding contracts in place on January 1, 2011.
Alternatively, foreign companies acquiring U.S. companies may wish to make a 338(h)(10) election. In contrast to the Sec. 338(g) election, a Sec. 338(h)(10) election results generally in a single level of tax. This election is available with respect to acquisitions of subsidiaries within a consolidated group. The target is deemed to have sold all its assets to the new target and to have distributed the proceeds to the old target shareholders. The sale of the shares is in essence ignored. The acquirer receives a stepped-up basis in the assets and thus obtains the benefit of future increased depreciation and amortization deductions. Therefore, the buyer benefits from the step-up without being required to pay a tax on the full amount of the gain up front, at the time of the election. The buyer also receives the benefit of the increased cash flow.
Under Sec. 1060, the purchase price must be allocated to the assets under the residual method per Sec. 338(b)(5). The purchase price is allocated, in order, to each of the following classes (listed below with examples of the types of assets included in the class), based on the value of the assets:
- Class I: Cash and cash equivalents
- Class II: Actively traded personal property (or Sec. 1092(d)), certificates of deposit, and foreign currency
- Class III: Accounts receivables, mortgages, and credit card receivables
- Class IV: Inventory
- Class V: All assets not in classes I – IV, VI and VII (equipment, land, building)
- Class VI: Sec. 197 intangibles, except goodwill and going concern
- Class VII: Goodwill and going concern
Performing the allocation above is also useful for any future restructuring, as well as tax planning, as the allocation may have implications related to movement of assets around the group, transfer pricing and/or the implementation of cost sharing structures. VRG has the resources available internationally (Europe, Asia, Australia, South America, Latin America and Canada) to assist multinational companies with the valuation services required when making foreign investments. We can value the enterprise and all real estate (both owned and leased), fixed assets, and intangible assets. Engagements are managed locally by a single point-of-contact and executed by professionals located in respective countries.