Active Financing Exception
However, the tax code embodies an important exception with respect to the FPHCI rules. And it is that section — Section 954(h) — that we believe is the one GE referred to in its 10-K tax footnote. Specifically, the rule says that FPHCI shall not include qualified banking or financing income of an eligible CFC. For this purpose, a CFC is an eligible entity if it is predominantly engaged in the active conduct of a banking, financing, or similar business, and conducts substantial activities with respect to such business.
So what is the criteria a CFC must meet to claim the tax benefit afforded to banks and financial institutions? The statute says that at least one of the following must to apply: More than 70 percent of the gross income of the CFC is derived directly from the “active and regular conduct” of a lending or finance business from transactions with customers that are not related persons3; or the CFC is engaged in the active conduct of a banking business and is an institution licensed to do business as a bank in the United States; or that the CFC is engaged in the active conduct of a securities business and is regulated as a securities broker or dealer under Section 15(a) of the Securities Exchange Act of 1934.
The income that is exempted from classification as FPHCI is denominated qualified banking or financing income. That category is also laden with qualifiers, in that it includes income of an eligible CFC that is (1) derived in the active conduct of a banking, financing, or similar business by such eligible CFC; (2) derived from one or more transactions with customers located in a country other than the U.S., and substantially all the activities in connection with which are conducted directly by the corporation in its home country; and (3) treated as earned by such corporation in its home country (the foreign country in which it was created or organized) for purposes of such country’s tax laws. (See Section 954(h)(3)(A).)
In addition, no income of an eligible CFC is treated as qualified banking or financing income unless more than 30 percent of the corporation’s gross income is derived directly from the “active and regular conduct” of a lending or finance business from transactions with customers who are not related persons, and are located within such corporation’s home country.
The hurdles are many, but GE’s foreign subsidiaries clear them all with respect to conducting banking and financing activity. The problem, however, resides in the tax rule’s “sunset provision” (See Section 954(h)(9).) It says that the subsection only applies to taxable years beginning after December 31, 1998 and before January 1, 2009. In other words, the provision is set to expire at the end of the year.
To be sure, it was scheduled to expire on four previous occasions and, in each case, Congress chose to extend its applicability. But it remains to be seen whether Congress will do it again.
GE and others companies that benefit from this rule have noted that its demise would place U.S. financial institutions at a competitive disadvantage vis a vis foreign financial institutions, which operate under more favorable taxation regimes. Nevertheless, certain members of Congress have sent up a “trial balloon” of sorts, that this provision be repealed with the ensuing revenues being used to help defray the revenue drain associated with the plan to curtail the rampant spread of the alternative minimum tax.
Indeed, even though the arguments for renewal are, in our judgment, quite compelling, it is by no means a certainty that renewal will be forthcoming. If Section 954(h) is not extended, it seems safe to say that GE’s effective tax rate will increase dramatically with a corresponding depressing effect on its net income.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1A U.S. shareholder of a foreign corporation is defined as a “U.S. person” who owns, or is considered as owning, 10 percent or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
2See Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, Para. 15.62.)
3A lending or finance business includes the business of making loans; purchasing or discounting accounts receivable, notes, or installment obligations; engaging in leasing; issuing letters of credit or providing guarantees or providing charge and credit card services.