International Planning and Recent Reforms of Anti-Deferral Legislation in Mexico, Canada and the U.S. February 15, 200

1. International Planning and Recent Reforms of Anti-Deferral Legislation in Mexico, Canada and the U.S. February 15, 2007 Course 2B MODERATORJohn Forry, Esq. SPEAKERS Walter M. Kolligs, Esq. Lic. Mauricio Bravo Fortoul Jas Hayre

2. Walter M. Kolligs Transaction Advisory Services Ernst & Young LLP – San Francisco

3. Agenda • Revised substantial assistance rules (Notice 2007-13) • Section 954(c)(6) (“TIPRA”) look-through rules • Proposed regulations under Sections 959 and 961 • Proposed 1248 regulations (time permitting)

4. Revised Substantial Assistance Rules (Notice 2007-9)

5. Section 954 – Overview • §957 provides that a foreign corporation is treated as a “controlled foreign corporation” (CFC) if more than 50% of its stock (by vote or value) is owned by “US Shareholders” • US Shareholders are US persons who own 10% or more of the voting stock • §951 provides that a US Shareholder of a CFC must include his pro rata share of subpart F income in his gross income • §952 defines subpart F income to include foreign base company income (FBCI)

6. Section 954 – Overview (cont’d) §954 provides that FBCI includes 4 types of income: • §954(c) foreign personal holding company income (FPHCI) • passive income which includes dividends, interest, royalties, rents, annuities, property sale gains, currency gains, etc. • §954(d) foreign base company sales income • income from transactions involving the purchase & sale of personal property that do not have a specified connection with the CFC’s country of organization and involve a related person • §954(e) foreign base company services income (FBCSI) • income from services performed for, or on behalf of, a related person outside the CFC’s country of organization • §954(g) foreign base company oil related income

7. Section 954 – FBCI Exceptions • De Minimis Rule • Income is not treated as FBCI if sum of FBCI is less than lesser of (i) 5% of gross income or (ii) $1 million • Full Inclusion Rule • If FBCI exceeds 70% of gross income, all income is treated as FBCI (unless high tax exception applies) • High Tax Exception • If taxpayer elects, FBCI does not include any item of income if income is subject to an effective rate of tax > 31.5% • FBCI is reduced by “properly allocable” deductions • Interest paid to a US Shareholder or related person is first allocated to FPHCI which is “passive income”

8. Section 954(e) FBCSI – Overview • Foreign Base Company Services Income (FBCSI) - income from services performed for, or on behalf of, a related person outside the country where the CFC is incorporated • Arises in 4 situations: • CFC is paid by a related person for performing the services • CFC performs services which a related person is or has been obligated to perform • CFC performs services with respect to property sold by a related person and the performance of such services constitutes a condition or material term of such sale • CFC receives substantial assistancefurnished by a related person in the performance of the CFC’s services

9. 1968 Substantial Assistance Rules • If a related party provides “substantial assistance” to a CFC with respect to services that the CFC has been contracted to perform, then the CFC will be deemed to have provided those services to the related person and its income will therefore be treated as FBCSI, unless the services are performed within the CFC’s country of incorporation • Assistance includes direction, supervision, services, know-how, financial assistance (other than contributions to capital), and equipment, material, or supplies • Two tests for determining whether assistance is “substantial”: • Subjective test – assistance is substantial if the assistance provides the CFC with skills which are a principal element in producing the income from the performance of such services by the CFC • Objective test – assistance is substantial if the cost to the CFC of the assistance furnished by persons related to the CFC equals 50% or more of the total cost to the CFC of performing the services • Many have questioned the legal validity of the substantial assistance regulations

10. Notice 2007-13: Revised Substantial Assistance Rules • Notice provides that substantial assistance rules only apply when related U.S. person(s) provides assistance, the cost of which equals or exceeds 80 percent of the total cost to the CFC of performing the services • Eliminates substantial assistance rules for services provided by one foreign corporation to another • Eliminates the subjective test for substantial assistance • Forthcoming regulations will apply to taxable years of foreign corporations beginning on or after January 1, 2007

11. Performs Services in Country Y for CFC 1 USP $85x CFC2 incurs expenses of $10x CFC1 CFC2 $90x Contract for services Contract to design bridge FP Unrelated Person Notice 2007-13: Ex 2 – Substantial Assistance Provided • CFC2 enters into a contract with FP, an unrelated person, to design a bridge in Country Y, a foreign country that is not CFC2’s country of organization • Services associated with contract with FP • USP performs services in Country Y for CFC1 in the form of design and technical services for which CFC1 pays USP $85x • CFC1, in turn contracts with CFC2 to provide those services and others to CFC2 for $90x • CFC2 uses those services together with services it performs itself that cost CFC2 $10x to design the bridge for FP • Cost test • USP provides substantial assistance to CFC2 in the performance of its contract for FP because USP indirectly furnishes services to CFC2 (through CFC1) that exceed 80% of the total cost to CFC2 for performing the contract (85x  100x = 85%)

12. Performs Services in Country Y for CFC 1 USP $60x CFC2 incurs expenses of $30x CFC1 CFC2 $70x Contract for services Contract to design bridge FP Unrelated Person Notice 2007-13: Ex 3 – No Substantial Assistance Provided • CFC2 enters into a contract with FP, an unrelated person, to design a bridge in Country Y, a foreign country that is not CFC2’s country of organization • Contract with FP • USP performs services in Country Y for CFC1 in the form of design and technical services for which CFC1 pays USP $60x • CFC1, in turn contracts with CFC2 to provide those services and others to CFC2 for $70x • CFC2 uses those services together with services it performs itself that cost CFC2 $30x to design the bridge for FP • Cost test • CFC2 is not treated as receiving substantial assistance in the performance of that contract because more than 20% of the cost of that contract is attributable to services furnished directly by CFC2 (30x  (70x + 30x) = 30%)

13. Section 954(c)(6) (“TIPRA”) Look-through Rules

14. Section 954 – FPHCI Exceptions FPHCI does not include: • Rents and royalties derived in the active conduct of a trade or business and received from unrelated parties • Rents and royalties received from a related corporation for the use of, or privilege of using, property in the same country as the CFC’s country of organization • Dividends and interest received from a related corporation which is: • Organized in same foreign country; • Has substantial part of its assets used in trade or business in same foreign country as the CFC’s country of organization • Same country exceptions do not apply to interest, rents or royalties which reduce Subppart F income of payor or create or increase a deficit which may reduce Subpart F income of payor or another CFC • Same country dividend exception does not apply to distributions of E&P accumulated during periods recipient did not directly or indirectly hold stock of payor

15. Section 954(c)(6) – Overview • Enacted by the Tax Increase Prevention and Reconciliation Act of 2005 (“TIPRA”) (May 17, 2006) • Amended by the Tax Relief and Health Care Act of 2006 (December 20, 2006) • Guidance provided under Notice 2007-9 (January 11, 2007) • Applicable to tax years of foreign corporations beginning after December 31, 2005 and before January 1, 2009 • Prognosis uncertain for taxable years beginning on or after January 1, 2009

16. Section 954(c)(6) – Legislative Purpose H.R. Conf Rep. No. 109-455: “Most countries allow their companies to redeploy active foreign earnings with no additional tax burden. The Committee believes that this provision will make U.S. companies and U.S. workers more competitive with respect to such countries. By allowing U.S. companies to reinvest their active foreign earnings where they are most needed without incurring the immediate additional tax that companies based in many other countries never incur, the Committee believes that the provision will enable U.S. companies to make more sales overseas, and thus produce more goods in the United States. Under the provision, for taxable years beginning after 2005 and before 2009, dividends, interest,[ ] rents, and royalties received by one CFC from a related CFC are not treated as foreign personal holding company income to the extent attributable or properly allocable to non-subpart-F income of the payor. For this purpose, a related CFC is a CFC that controls or is controlled by the other CFC, or a CFC that is controlled by the same person or persons that control the other CFC. Ownership of more than 50 percent of the CFC's stock (by vote or value) constitutes control for these purposes.” 

17. Section 954(c)(6)– Overview FPHCI does not include: • Dividends, interest, rents, and royalties • Paid by one CFC to a related CFC • To the extent attributable/allocable to income which is neither subpart F income nor income which is effectively connected with the conduct of a trade or business in the US (ECI) of the payor Not elective – applies to all covered transactions

18. Definition of Dividends • The term “dividend” has the meaning provided in §316(a), and specifically includes dividends pursuant to: • §302 and §304 – deemed dividend • §964(e) – deemed dividend • §356(a)(2) – boot dividend • The term “dividend” does not include: • A deemed dividend when a CFC is an exchanging shareholder under Treas. Reg. §1.367(b)-3(b)(3)(i)

19. Definition of Dividends (cont’d) • Earnings and profits of the distributing CFC need not be accumulated during a period when it was a CFC, or during a period when the CFC receiving the dividend was a related person • The key requirement in this regard is that the relevant CFCs are related persons at the time the dividend is received • Dividends “attributable” to ECI of the payer are not eligible for the §954(c)(6) exception

20. Partnership Payments • In general, the rules currently applicable with respect to same country exception is applicable • With respect to payments of interest, rents and royalties paid by a partnership to a CFC, such payments will be deemed paid by the partners • With respect to payments of dividends, interest, rents and royalties paid to a partnership, such payments will be treated as being received directly by any CFC partners • Same-country partnership questions left unanswered

21. Allocation and Attribution Rules – Interest, Rents & Royalties • Follows the rules of §954 regulations with respect to allocation and apportionment • The look-through rule may be available even if the payments exceed the gross income of the CFC payor • Payments are not eligible for look-through to the extent their deductions create (or increase) a deficit which may reduce the subpart F income of the related CFC payor or another CFC • Interest, rents or royalties “properly allocable” to subpart F or ECI of the payer are not eligible for the §954(c)(6) exception

22. Determination of Payment Attributable/Allocable to Subpart F • Follow the ordering rules of Section 904(d)(3)(C) & (D) [Treas. Reg. §1.904-5(c)] • $50 subpart F income for CFC 3 $125 Interest $100 Interest CFC 1 CFC 2 CFC 3 CFC 1 has no Subpart F income $50 interest income from unrelated bank

23. Foreign Holding Company Before After • Benefits • Dividends no longer Sub F income • Ability to redeploy foreign cash • Useful for per se corps USP USP Foreign Holdco CFC 2 CFC 1 CFC 1 CFC 2

24. Foreign Royalty Planning USP Issues/Opportunities • Foreign Opco active (i.e,. not attributable or allocable to Sub F of payor) • Industry specific application (i.e., film, software) • No extension? • Prepayment of royalties • Migrate to principal structure Description • Newly acquired, migrated or contracted R&D IP • Royalty payment between Foreign Opco (Country Y) and Foreign IPco (Country X) Benefits • Royalty income at IPCo not Supart F • Ability to keep low and high tax earnings separate • Historically relying on same country, high tax, or active trade or business exception which required 3rd party royalties only Low Tax Foreign IPco (Country X) High Tax Foreign Opco (Country Y) Royalty

25. Foreign Financing Company Description • Intercompany note between Foreign Opco (Country Y) and Foreign Finco (Country X) Benefits • Interest income at Finco not Subpart F (no CTB or same country entity necessary) • Ability to keep low and high tax earning separate Issues • Foreign Opco active (i.e,. not attributable or allocable to Sub F of payor) • Depending on how debt inserted may create a taxable transaction • No extension: convert to CTB structure but preserve low tax pool USP Low Tax Finco (Country X) High Tax Foreign Opcos (Country Y) Interest

26. Section 304 Planning USP Description • Foreign ACQco acquires Foreign Target & makes Section 338 election • Foreign Target sells its subs to Foreign Holdco Benefits • Section 304 “Deemed dividend” no longer Subpart F to Foreign Target on sale • E&P of Foreign Holdco and then Foreign Target Subsidiaries move up to Foreign Target then return of basis • Debt Push down (Note) • Interest income no longer Subpart F to Foreign Target • Movement of E&P and cash Low tax E&P Foreign ACQco Foreign Holdco Note Foreign Target Sale FTS 1 FTS 2 Foreign Target Subs • Issues • Foreign Target active income (i.e., not attributable or allocable to Sub F of payor) • FMV of Foreign Target Subs? • Sufficient E&P and basis to avoid cap gain; cap gain = passive FPHCI to which new rules do not apply

27. Notice 2007-9 Anti-Abuse Rules • Amounts that reduce the U.S. income tax base, including factoring income • Avoidance of §956 • Use of options or similar interests (effective for taxable years of foreign corporation beginning after December 31, 2006) • Change of character of income through use of a conduit entity (effective for taxable years of foreign corporation beginning after December 31, 2006)

28. Description USP sells inventory to CFC1 in exchange for receivable USP sells the CFC1 receivable to CFC2 at a discount CFC2 generates income on the collection of the CFC1 receivables Analysis Income earned by CFC2 on collection of CFC1 receivables is related person factoring income and therefore is treated as interest income received on a loan from CFC2 to CFC1 “However, because CFC2 acquired the CFC1 receivables from USP at a discount, resulting in a current loss for USP, such interest income is not eligible for the §954(c)(6) exception.” Example: Reducing U.S. Income Tax Base 1) Sale of Inventory in exchange for receivable 2) Sale of receivable USP CFC1 CFC2 3) Payment on receivable

29. Description Beginning of year 1 CFC2 Applicable earnings = $0 During year 1 CFC2 loans $100 to USP CFC2 generates $100 non-subpart F E&P CFC2 distributes $100 to CFC1 (dividend to CFC1) Example: Avoidance of Section 956 USP CFC1 $100 loan Dividend CFC2 Analysis • USP note held by CFC2 is U.S. property (§956(c)(1)(C)) • USP would have an income inclusion of $100 under §951(a)(1)(B), but for the applicable earnings limitation ((§956(b)(1)) • As a result of the dividend paid to CFC1, CFC2 does not have applicable earnings; thus USP would not have §951(a)(1)(B) inclusion • Dividend income of CFC1 is not eligible for the look-through exception

30. Use of Options or Similar Interests • When use of options or similar interests causes a foreign corporation to become a CFC payor, and a “principal purpose” for such use is to qualify payments for the look-through exception, the payments will not be treated as being received/accrued from a CFC payor and will not be eligible for the look-through exception

31. Description FC leases property from CFC 1 for $100 FC makes $100 rental payment to CFC2 (Excluded from FPHCI) CFC2 makes $100 rental payment to CFC1 Principal purpose for involving CFC2 is to qualify the rental payment for look-through exception Example: Use of Conduit Entity USP CFC1 (Country Y) CFC2 (Country Z) FC Related person (Country Z) 2) $100 Rental payment 1) $100 Rental payment Lease • Analysis • Had rental payment been made directly from FC to CFC1, FPHCI (§956(c)(1)(A)) • Because the principal purpose is to avoid treatment as FPHCI, the payment is treated as being made from FC to CFC1

32. Unresolved Issues • No discussion about payments from CFCs that have subpart F income that meets the high-tax exception • Not very clear guidance on factoring • Long-standing same-country partnership questions left unanswered

33. Proposed Regulations under Sections 959 & 961 – Previously Taxed Income

34. Previously Taxed Income (PTI) – Overview • E&P of a CFC included in a U.S. shareholder’s gross income under §951(a) are referred to as PTI • §959 excludes PTI from the gross income of a U.S. shareholder and an intermediate CFC for distributions of E&P of a CFC to prevent double taxation • §961 provides basis adjustment of the CFC stock equal to the amount of income included in U.S. shareholder’s gross income under §951(a) and the amount equal to PTI excluded under §959 • §304(b)(6) authorizes the Secretary of the Treasury to proscribe regulations that prevent multiple inclusion of any item in income and to provide appropriate basis adjustments, including rules modifying the application of §§ 959 and 961 in case of a §304 transaction in which the acquiring corporation or the issuing corporation is a foreign corporation

35. Proposed Regulations (REG-121509-00) • Released August 28, 2006 • Generally provide detailed rules regarding PTI accounts • Provide the Section 304 and Section 961(c) guidance authorized by Congress in 1998 and 1997 respectively

36. Highlights of the Proposed Regs. • PTI is a shareholder level account (though the CFC must also take into account changes in the shareholder’s PTI account) • PTI is categorized on a share by share (or block by block) basis • Detailed steps for how to adjust a shareholder’s PTI account, including basis • The treatment of US consolidated groups as a single US shareholder • In general, shares of stock can “share PTI” – however, each share takes with it its share of PTI if the share is transferred

37. PTI Sharing ExampleProp. Reg. §1.959-3(f)(3) Example 2 Facts: DP, a US shareholder, owns two blocks of class A stock in CFC, a CFC that uses the U.S. dollar as its functional currency. DP also owns a block of class B stock in CFC. Both DP and CFC use the calendar year as their taxable year. During year 1, FC makes a distribution of earnings and profits on its Class A stock of $50x on each of block 1 and block 2. PTI accounts entering year 1: PTI accounts after $100x distribution: Distribution on Block 1 (A) exceeds PTI account, requiring pro rata allocation to Block 1(A) of PTI earnings remaining in post-distribution Block 2(A) ($15x) and PTI block 3 ($60x). • 5x = ($15x/$75x) x $25x • 20x = ($60x/$75x) x $25x The entire distribution is excluded from DP’s gross income.

38. Highlights of the Proposed Regs. (cont’d) • The successor in interest rules have been expanded to allow for intermediate foreign ownership without clearing out PTI accounts of former US shareholders (these accounts can then be transferred to other US shareholders) • PTI accounts of both issuer and acquirer are available in section 304(a)(1) transactions • Taxes associated with PTI stay with PTI, no other expenses reduce PTI • Deficits do not reduce PTI • Section 961(c) basis rules added – very narrow in scope

39. Adjustments to PTI AccountsProp. Treas. Reg. §1.959-3(e)(2) As of the close of a foreign corporation’s tax year, a covered shareholder’s PTI accounts are increased or decreased pursuant to the following seven steps and in the following order: Step 1: Section 951(a)(1)(A) inclusions Step 2: Distributions on such stock Step 3: Reallocation from other accounts with respect to redemptions Step 4: Section 956 amount Step 5: Reallocation to other accounts with respect to distributions Step 6: Reclassification with respect to section 956 amounts Step 7: Further adjustment for section 956

40. Proposed Section 1248 Regulations

41. Proposed Section 1248 Regulations (REG-135866-02) Overview • Released June 2, 2006 • Attribution of E&P to stock of a foreign corporation received in certain nonrecognition exchanges by • An exchanging Section 1248 shareholder • An exchanging foreign corporate shareholder, or • An acquiring corporation (including an acquiring corporation that is also an exchanging shareholder) • Attribution of E&P to stock of a foreign-acquiring corporation held by a non-exchanging shareholder

42. Proposed Section 1248 RegulationsOverview (cont’d) • Reductions in E&P attributable to stock to prevent multiple inclusions with respect to the same E&P • E&P inherited under Section 381(c)(2)(A) by a foreign-acquiring corporation are not taken into account for purposes of Section 1248 • Sale or exchange of CFC stock by a foreign partnership is treated as if the partners sold or exchanged their proportionate share of stock held by the foreign partnership

43. Transaction: DC2 contributes CFC2 stock to CFC1 in exchange for 80% of the CFC1 stock. The transaction qualifies as a Section 351 exchange E&P Attributable to CFC1 Stock: DC2: 100% of the CFC2 E&P accumulated prior to the contribution, and 80% of the combined CFC1 and CFC2 E&P accumulated after the contribution DC1: 100% of the CFC1 E&P accumulated prior to the contribution and 20% of the combined CFC1 and CFC2 E&P accumulated after the contribution DC1 DC1 DC2 DC2 CFC1 Stock 100% 20% 80% CFC1 CFC2 Stock CFC1 CFC2 100% CFC2 CFC2 Proposed Section 1248 RegulationsNontaxable Contribution of CFC Stock 100%

44. Transaction: DC2 contributes tangible property to CFC1 in exchange for 80% of the outstanding CFC1 stock The transaction qualifies as a Section 351 exchange E&P Attributable to CFC1 Stock: DC2: 80% of the CFC1 E&P accumulated after the contribution DC1: 100% of the CFC1 E&P accumulated prior to the contribution and 20% of the E&P accumulated after the contribution Proposed Section 1248 RegulationsNontaxable Contribution of Tangible Property DC1 DC1 DC2 DC2 CFC1 Stock 100% 20% 80% Tangible Property CFC1 Tangible Property CFC1 Tangible Property Tangible Property

45. USP USP CFC1 CFC2 USS Sale of CFC stock FP FP Sale of CFC stock CFC CFC Proposed Section 1248 Regulations Foreign Partnership Sale of CFC Stock • FP’s sale of CFC stock is treated as a sale by the partners of their proportionate share of CFC stock Prop. Treas. Reg. § 1.1248-1(a)(4)) • A similar result occurs if the CFC stock is held indirectly through a tiered-partnership structure

46. Mexican CFC’s Rules Preferential Tax Regimes Lic. Mauricio Bravo Fortoul Turanzas, Bravo & Ambrosi, S.C.

47. Prior Rules 1. Until 1996 Taxed until actual distribution (income, dividends, capital redemption, liquidation). 2. 1997 – 2004 “Black list” (territorial system). 3. 2005 – Threshold of 75% of Mexican income tax.

48. Income subject to PTR No foreign tax Foreign source income or Foreign tax below 75% of Mexican tax Directly generated. Indirectly generated through direct or indirect participation.

49. Income generation Foreign source income in all cases Foreign bank account Direct income Mexican taxpayer Indirect income through direct participation Financial investments Foreign entity Indirect income through indirect participation Financial investments Foreign entity

50. Income subject to PTR Income of transparent entity or figure in which the taxpayer has an indirect participation through another transparent entity or figure. No taxpayers in country of residence or incorporation Transparency and Tax levied at the member’s level Tax Transparency