This is a newsletter from
J.D. Choi of
Tax Technologies, Inc. to tax
professionals whose interests are improving the tax management processes.
Table of Contents
- Outsourcing 101
- Over-simplified assumptions
- Lack of effective collaborative tools
I have been approached by a small number of companies for tax compliance outsourcing engagements.
In response to such requests, I have considered various aspects of tax compliance outsourcing and decided to
explore the issue of tax department outsourcing in this newsletter. Also, there have been a few changes to the
foreign tax credit provisions that will be effective for the tax years 2003 and forward, namely, single 902 basket.
I explored the issues regarding the single 902 basket in this newsletter.
I would also like to announce the launch of international tax data collection module with fully integrated task
management module. Lastly, we are going to have an invitation only event for our Global Provision module of Tax
Series in New York City. Please read on for the details.
1. Outsourcing 101
Under the harsh economic environments, many of the companies are considering tax department outsourcing.
Primarily, outsourcing of tax functions have been used as a staff reduction measure which would be difficult to
achieve otherwise. Although it may be necessary for a company to make hard decisions such as tax department
outsourcing, there are important issues that need to be considered before a company makes the final decision.
Without careful consideration of these issues, companies may not achieve the ultimate goal of cost reduction.
In fact, improperly implemented outsourcing will have devastating impact on tax department management.
I have encountered many complaints about their outsourcing vendors and services from companies that
outsourced various tax functions. The following are common points raised by these dissatisfied clients:
- I cannot trace any of the numbers on the returns from the data we provided to them.
- The fee and expenses were over budget.
- The returns were delivered at the last minute and we did not have a chance to review the returns before filing them.
- Our final tax liability was way off from the estimate and we did not know about it until the very last minute.
- They missed filing of some returns.
- They did not reflect the agreement we had with the states correctly to calculate the state allocations.
- They did not update the returns for the audit adjustments.
- We cannot support our audit because we do not have access to the data.
- They had totally inexperienced people working on our return.
- Every year they have different people working on our return.
Since I am also one of the vendors offering similar services, it is not my intent
to point fingers to anyone involved in the outsourcing arrangement. I will propose, however,
the better way to structure the arrangements that may help both the service providers and the clients.
There is a large spectrum of the outsourcing arrangements. Some companies outsource specific functions while others
outsource the entire tax functions. In extreme cases, some outsource the tax functions overseas. Regardless of
the scope of the arrangements, the issues are the same. It all comes down to two basic issues, over-simplified
assumptions and lack of effective collaborative tools.
2. Over-simplified assumptions
»
Return top
Tax processing is a complex set of events that require two types of basic knowledge and a complex
set of skills. First, the participants in the process must have the working knowledge of the underlying
facts regarding the business of the company in order to effectively formulate the expected results.
Second, they should also know about the application of the laws with regard to given set of facts.
Third, the tax processing for large companies require significant degree of working knowledge with
regard to enterprise reporting systems and accompanying tax return software. Often times, the tax
processing for large returns requires in-depth working knowledge of non-tax software such as Microsoft
Excel and Access.
Given these requirements, managers in charge of making decisions must consider relative strengths of the
parties involved. Unless the outsourcing is carved out in a way to employ the relative strength of the employees
and the vendors, the outsourcing cannot be expected to succeed. Arranging a successful outsourcing engagement requires
meticulous allocation of functions between employees and the vendors. In my view, many of the outsourcing
failures are attributable to the over-simplified assumptions of the functional requirements for the complex
tax processing.
Generally, the employees who have been working with the company for many years would have better understanding
of the underlying facts to support the positions on the tax returns. On the other hand, the vendors can be
very efficient in processing the data through the software applications since they are performing the same
task across multiple clients and, accordingly, acquired the expertise with regard to the mechanical processing.
Striking a good balance along this line of relative strength is critical in producing successful outsourcing
arrangements.
A significant part of tax processing involves the creation and maintenance of tax information to support
critical management decision making (such as tax planning and effective tax rate management), provision calculation
and audit supports. I generally refer this as "tax data management" issue. Tax data management issue must also
be taken into account in making the outsourcing arrangement. For example, as part of international tax compliance,
the vendor should also produce historical tax attributes (such as effective tax rates on non-PTI pool) and derived
attributes (such as 1248 E&P versus 367 E&P to assist the management for its decision making). In addition, the
data being created as part of outsourcing projects must be made available to the companies. Otherwise, the cost
associated with re-creating the tax information for every separate need would be unreasonably high or, in many
instances, it may not even be possible. In other words, the outsourcing arrangements must take into account the
larger implication of the tax processing and not just be concerned with simply producing the tax returns.
3. Lack of effective collaborative tools »
Return top
Given the fact that most of the outsourcing engagements require significant geographic and functional collaboration,
the tools being employed must also facilitate such needs. For example, most large-scale international tax compliance
requires collection of detail data from around the world. Likewise, the core compliance functions may also be
geographically spread across multiple locations. Especially in the case of outsourcing arrangements, it is very
important that the vendor and the client collaborate during the tax processes. Currently, most of the outsourcing
engagements are being performed using the software tools that make it very difficult to facilitate the transparency
between the vendor and the clients. Accordingly, as part of the engagement arrangement, the vendor and the client
should agree on the collaborative tools that can be readily accessible by both parties without having to incur large
expenditures.
For example, we use our web-based tax software in most cases of our outsourcing engagements. We use our
web-based data collection module to collect the data across the globe, use our web-based document depository
module (AuditTracker) to have our clients deposit the source data, process the returns through our web-based
tax software using our resources across the United States without having to have them travel around for the
different engagements. Our clients review the returns over the web and produce the returns from their desktop.
By using these set of collaborative tools, we produce the returns that are supported by the clients' original
supporting documentation, therey, providing clear audit trails, provide real-time feedback on the status of
the return, produce audit support documentation depository as part of the tax return process, produce the
derived tax management information database with high degree of transparency to our clients. In short, the
choice of collaborative tool allows us to solve most of the issues relating to the management of outsourcing
engagements.
Proper collaborative tools also provide a strong assistance in managing the engagement and feeling
comfortable from a client perspective. Given a web-based tax processing environment, it is possible for the
home office to login to the system to review outsourcing progress at any point-in-time. This eliminates the concern
of tax returns being delivered at the last minute and facilitates in process reviews of the tax return and underlying
supporting detail.
Got 10/50?
The Taxpayer Relief Act of 1997 Act included significant reforms to the detrimental provisions regarding the
treatment for foreign tax credit purposes of dividends paid by certain foreign corporations with U.S. ownership
(so-called "10/50 corporations"). The 1997 Act provisions, which are effective for tax years beginning after
December 31, 2002, eliminate the separate company foreign tax credit basket limitation for dividends from each
10/50 corporation and instead provides "look-through" treatment for dividends paid by a 10/50 corporation to a
domestic corporation meeting the stock ownership requirements of Section 902(a) (a “qualifying shareholder”) out
of earnings and profits (“E&P”) accumulated in post-2002 tax years.
On December 20, 2002 the Treasury Department and IRS issued Notice 2003-5 providing guidance on the application
of these new look-through rules and the transition from prior law. Notice 2003-5 also discloses that Treasury and
the IRS intend to issue regulations incorporating this guidance and that taxpayers may rely on the notice.
While the new provisions may have long-term future benefits to shareholders of 10/50 corporations, the
transition rules outlined in the notice are rather complex and potentially costly to shareholders in the short-term.
The Notice addresses the transition rules to both foreign corporations and for determining the foreign tax credit
limitation under Section 904 for U.S shareholders who receive dividend income from those foreign corporations.
Transition Rules for Foreign Corporations
In general, 10/50 foreign corporations E&P will be divided between post-2002 taxable years (the look through
years) and pre-2003 taxable years (the “single 10/50 basket” years). This underlines the transition issues addressed
in the notice including the following:
- The 1997 Act provides that dividends paid by foreign corporations in post-2002 tax years will in general
be eligible for look-through treatment if it is sourced from a post-2002 taxable year. When paying a dividend,
it will be sourced on a LIFO basis from post-2002 years first. To the extent the dividend is sourced from earnings
accumulated during pre-2003 taxable years, the earnings will be sourced from the pre-2003 10/50 basket E&P.
- All pre-2003 E&P of 10/50 corporations will be grouped into the new single 10/50 basket. This will occur
the first day of the first post-2002 taxable year. A major exception to this elimination of the company-by-company
baskets is for foreign corporations that are PFICs. For PFICs, the separate corporation-by-corporation 10/50 baskets
will still be maintained for pre-2003 taxable years E&P.
- Section 902 foreign tax credits attributable will follow the E&P sourcing. Hence, Section 902 credits attributable
to a single 10/50 basket year E&P will become single 10/50 basket foreign tax credits.
- Controlled foreign corporations (“CFCs”) will continue to have look-through treatment apply to dividends sourced
from years during which the foreign corporation was a CFC. If the CFC has 10/50 E&Ps from the past, then its 10/50
E&P will retain look-through treatment for post-2002 taxable years. Pre-2003 10/50 E&P will be sourced to the single 10/50 basket.
- The new look-through treatment for 10/50 corporations is only applicable to "dividends" paid by a 10/50 foreign
corporation. It does not apply to any payments of rents, royalty or interest income to a U.S. shareholder as it would
to the payments from CFCs.
- When a qualifying shareholder acquires an interest in a 10/50 corporation, its prior U.S. ownership will impact the
sourcing of future dividends. The acquired corporations E&P will be determined under the look-through rules for post-2002
E&P periods where the foreign corporation was a CFC or if a qualifying shareholder had an ownership interest in the foreign
corporation. Pre-2003 sourced dividends will be sourced from the single 10/50 basket. If the acquired corporation has never
been a CFC or has never been a 10/50 corporation with respect to a qualified shareholder, then all of its E&P will be
sourced from the single 10/50 basket.
- For post-2002 taxable years, 10/50 corporations will be required to allocate and apportion expenses in the same manner
as a CFC. The major exception to this requirement is that 10/50 corporations will not distinguish between related party
interest expense (as defined under section 954(b)(5)) and unrelated party interest expense. 10/50 corporations will apportion
all interest expense as unrelated party interest. This is logical as 10/50 corporations are not subject to subpart F and
look-through treatment does not apply to their interest payments.
- Shareholders in 10/50 corporations will have the ability to make tax elections similar to CFCs for determining E&P. The right
to make these elections will rest with the U.S. shareholder who among all U.S. shareholders owns the majority of stock.
Transition Rules for U.S. Shareholders
Generally, the new rules provide for the creation of a single foreign tax credit limitation for pre-2003 foreign taxes.
- On the first day of the first post-2002 taxable years, U.S. shareholders will combine all their 10/50 corporation
separate limitation losses (“SLL”) and overall foreign losses (“OFL”) account balances carried over from
pre-2003 taxable years into single 10/50 basket SLL and OFL accounts. Mechanically, this will mean any SLL accounts
between separate pre-2003 separate 10/50 baskets will be eliminated. SLLs and OFLs attributable to 10/50 corporations
that were PFICs will not be combined, and taxpayers must continue to maintain those accounts.
- All pre-2003 excess 10/50 basket foreign tax credits carried over to the first post-2002 taxable year will be
combined and can be used to the extent limitation exists in the single 10/50 basket. One potentially significant
detriment outlined in the notice is that these credits carried over cannot offset the post-2002 look-through dividend
income from 10/50 corporations. This “loss of identity” application also applies if excess pre-2003 excess single
basket foreign tax credits are carried back to pre-2003 taxable years. In such situations the carryback of credits
reduces separate 10/50 basket limitations in the carryback taxable year without regard to the originating foreign
corporation. If the credits carried back are less than the total available limitation of all the separate 10/50
corporation baskets, the credits are applied on a pro-rata basis among those limitation baskets.
- For PFICs, the carryover of credits can only be applied to the separate 10/50 basket continued to be maintained
for the PFICs. Similarly, the carryback of excess credits across the consolidation line can only offset limitation for
that separate 10/50 PFIC basket.
- The regulations will provide relief for a taxpayer who have a separate 10/50 basket for an investment in a 10/50
corporation where the taxpayer is no longer a qualifying shareholder as of December 20, 2002. In such case, the SLL
and OFL recapture accounts for that separate 10/50 corporation will not be consolidated and apparently eliminated.
Any foreign tax credit carryovers attributable to such separate 10/50 corporations will also be eliminated. A relief
provision also applies where a taxpayer is no longer a qualifying shareholder on the first day of the taxpayer’s first
post-2002 taxable year, if the 10.50 corporation stock was disposed of in a transaction that is subject to a binding
contract that is in effect as of December 20, 2002.
- The newly created single 10/50 basket also inherits the potential income recapture SLL positions from non 10/50
foreign baskets (such as the general or passive baskets) that existed in the pre- combined separate 10/50 dividend baskets.
Planning Considerations
Even though the key transition date of December 31, 2002 has passed, there are still planning considerations for US
Shareholders of 10/50 foreign corporations.
- In planning the U.S. tax consequences of post-2003 dividends from 10/50 corporations, taxpayers may find it more
advantageous to maximize the sourcing of dividends from the look through periods due to excessive single 10/50
basket SLL and OFLs. U.S. shareholders may want to consider available tax elections for their foreign corporations to
shift E&P between the look through and pre-look through taxable years to achieve the best US tax consequences for dividends
Tax Accounting Elections.
- Fiscal year corporations still have the capability of dividend planning for 10/50 corporations prior to beginning of their
first post-2002 taxable year.
- A significant issue for many taxpayers may be the permanent entrapment of OFL and SLL amounts for 10/50 corporations that
have ceased to have any future economic value, let alone dividend paying ability, yet the qualifying shareholder maintained ownership.
Taxpayers will need to inventory all their 10/50 corporation holdings to determine if they remained qualifying shareholders as of the
transition date.
- Check the box elections under 301.7701 have always been a useful tool to mitigate the effects of the Section 904 rules on 10/50
corporations. Structures should be reviewed again to determine potential benefits of both making new disregarded entity elections and
revoking old elections.
Web-based Foreign Data collection finally arrived
For many years, I believed the most difficult part of the international tax processing is the lack of good data collection mechanism
that is integrated with international tax processing software. I have also believed the data collection should be integrated to the tax
processing in two critical elements - data integration and process integration.
Our data collection module is developed for each clients based on their design. If they so choose from existing schedules already
developed, they can choose to do so. We do not charge separate licensing for the data collection module. Thus, our clients need only to
incur one-time implementation charge for the initial creation of the package. Full implementation of the global data collection may take as
little as two weeks and as long as two months depending on the complexities of the data collection schedules and the types of enhancements
companies wants to implement in the schedules. We have implemented the global data collection for one of our larger clients with over 500
entities in about a two month period. We have also incorporated the task management as part of the data collection to allow dynamic
monitoring of the data collection status.
This data collection approach resolves both issues I mentioned earlier - data integration and process integration. First, because the
data collection packages can dynamically show the data available in the compliance system such as PBT or taxes details to the people
reporting through the data collection, it enables dynamic feedback and correction of information. Second, since the data collection is
fully integrated with the compliance system, much of the data collected can be directly populated to the forms without requiring them to
go through data export and import. For example, much of the intercompany transaction reporting through data collection can be directly
populated to the schedule M of Form 5471 as well as be used to trigger Section 956 calculations. In addition the same data can be used
to analyze the intercompany pricing analysis under Section 482. Thus, by changing the tools, our users can improve overall tax data
processing. In terms of the process integration, we have fully implemented task management as part of all of our software including the
data collection. This allows users to track the status of data collection as well as compliance tasks on real-time basis. Again, this
integration makes significant substantive differences in managing overall tax functions.
Global provision - Invitation only
We are in the process of launching our global provision using our web-based platform. Currently we have completed our first
implementation of current year provision, current year liability calculation, rate reconciliation and deferred asset roll forward
calculations and corresponding reports. This module is fully integrated with our compliance and planning module. This module also has
the ability to create user-defined reports so that provision can be analyzed in many different ways. It allows monthly and quarterly
global provision. We are planning an invitation only event to unveil the global provision module within next few months in New York City.
Please let us know if you would like to be invited.
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Regards,
J.D. Choi
CEO, Tax Technologies, Inc.
201-387-9451
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