Institute of International
Bankers
Tuesday, June 24, 3 p.m.
Foreign Tax Credit Issues
Foreign Tax Credit Issues
• We will cover
– The March 2007 Proposed Regulations on “highly engineered”
foreign tax credit transactions [Prop. Regs. §1.901-2(e)(5)(iv)]
and related developments
– The August 2006 Proposed Regulations on the “technical”
taxpayer rules [Prop. Regs. §1.901-2(f)]
– The Section 704(b) Regulations on
• allocations of foreign taxes imposed on partnerships, which
were adopted in October 2006 [Prop. Regs. §1.7041(b)(4)(viii)], and
• other special allocations of partnership items, which were
adopted in May 2008 [T.D. 9398]
– Possible legislation with respect to foreign tax credits and related
issues
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Proposed Section 901 Regulations
on “highly engineered” transactions
• Significant history
– Notice 98-5
– Notice 2004-19, withdrawing Notice 98-5, but threatening
challenges under common law rules
• In June of 2006, Commissioner Everson testified about
“abusive foreign tax credit transactions”,
– identifying U.S. lender and U.S. borrower transactions that
generated credits “used to shelter unrelated foreign source
income” and
– announcing the establishment of an IRS team to deal with these
transactions
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Proposed Section 901 Regulations
on “highly engineered” transactions
• Subsequent challenges on audit and in
national office statements
– E.g., TAM 130972-06 (November 7, 2007), CCA
147868-05 (February 29, 2008)
– In March of 2007, Regulations were proposed under
Section 901 that would disallow a credit for foreign
taxes which (quoting the preamble) are paid
“in…highly engineered transactions” in which the US
taxpayer “intentionally subject[s]… itself to foreign
tax”
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Proposed Regulations on “highly
engineered” transactions
• Under the March 2007 Proposed Regulations, a “structured
passive investment arrangement” must meet six conditions
– An entity
• Substantially all of the gross income of which is passive
income, and
• A payment of foreign tax attributable to the entity’s
income
– A US person which would be entitled to claim a credit for
that payment if the payment was a payment of foreign tax
– An anticipated credit substantially greater than what would
have been taken as a credit if the credit was limited to the
US person’s income from its proportionate share of the
entity’s assets
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Proposed Regulations on “highly
engineered” transactions
• Must meet six conditions – cont’d
– An arrangement which involves a foreign counterparty
that is unrelated to the US person
– An arrangement structured to provide a foreign tax
benefit to the foreign counterparty or a related person
– An inconsistency between the US and the foreign
country’s
characterization
of
the
entity,
characterization of interests in the entity, the
determination of the ownership of interests in the
entity, or the calculation of the entity’s net income
• As proposed, effective for foreign taxes paid or accrued
during years of the taxpayer ending on or after the date
of adoption as final regulations
6
Proposed Regulations on “highly
engineered” transactions
• Audits and litigation?
– E.g., Standard IDR For Tier 1 Foreign Tax
Credit Generators
• “Promotor” audits?
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“Reverse” foreign tax credit
transactions
• Transactions in which foreign counterparties take credit
for U.S. tax – e.g.,
– “Section 33” transactions structured so that a U.S. withholding
tax may be taken by both (i) a U.S. taxpayer as a credit against
its federal income tax liability and (ii) a foreign counterparty as a
foreign tax credit against its home country tax
– Cross-border repo transactions which generate federal income
tax in a US affiliate of a US taxpayer, where U.S. the tax is also
used by the foreign counterparty as a foreign tax credit against
its home country tax
• Are these types of transactions covered by IRS Tier 1
Issue "International Hybrid Instrument Transactions?"
• Will JITSIC serve as a catalyst for the foreign tax
authorities to take action against these types of
transactions?
8
Technical taxpayer issues – Proposed
Regulations
• In August of 2006, the IRS proposed regulations on the definition of
the taxpayer for foreign tax credit purposes
– Would reverse Guardian Industries Corp. v. United States
(March 31, 2005)
• Under the regulations in effect in Guardian Industries, if
foreign consolidated returns are filed, the foreign taxes would
be allocated among the members of the group in proportion
to their shares of the foreign tax base, but only if there was
joint and several liability under foreign law
• In Guardian Industries, the Federal Claims Court found no
joint and several liability for foreign taxes paid by the
Luxembourg parent of other Luxembourg companies – thus,
the Luxembourg parent was the taxpayer for the entire tax
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Technical taxpayer issues – Proposed
Regulations
• Guardian Industries – Cont’d
– Since the Luxembourg parent was a
disregarded entity, this permitted the US
corporation that owned the parent to take
foreign tax credits for taxes imposed on
income of Luxembourg companies that had
not been distributed to, or included in income
by, the US corporation
10
Technical taxpayer issues –
Proposed Regulations
• Under the proposed regulations
– If foreign tax is imposed on the combined income of
multiple persons, the tax considered to be paid by
each is the tax attributable to its portion of the base of
the tax, regardless of which person has the obligation
to remit the tax
• If tax is imposed on the combined income of three
or more persons, a loss of one person is allocated
on the basis used for purposes of the foreign tax
or, if that is not specified, pro rata based on each
person’s share of net income
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Technical taxpayer issues –
Proposed Regulations
• In the case of a foreign tax imposed on the income of a
reverse hybrid (corporation in the U.S.; branch or
partnership under foreign tax law), the tax is allocated
between the hybrid and its owners
• Owner takes into account what it would take into account as
an indirect foreign tax credit, i.e., the tax on the earnings and
profits taxed to it – thus, no credit without a distribution
– Intended to prevent the “inappropriate” separation of the
foreign tax from the amount included in income
– E.g., a case in which a U.S. shareholder takes a credit
for the foreign tax but is not currently (and may be never)
taxable on the income of the reverse hybrid
12
Technical taxpayer issues –
Proposed Regulations
• The definition of legal liability is clarified – i.e., the person
legally liable for the tax is the person who is required to
take the income into account for purposes of the foreign
tax
– Thus, if A “repos” a debt security to B, and the country
of the issuer regards B as the owner, B is legally
liable for any withholding tax even though under U.S.
tax rules A is the owner of the security and the related
interest income
• Was this a mistake?
– And if B buys a debt security with accrued interest,
and then is liable for the full withholding tax when the
interest is paid, B is legally liable for the entire
withholding tax
13
Technical taxpayer issues –
Proposed Regulations
• The treatment of regular hybrids is clarified –
i.e., foreign taxes imposed on
– an entity that is a partnership in the U.S. but is
a separate entity under foreign tax law are
imposed on the partnership and then
allocated to the partners,
– a disregarded entity are imposed on its owner
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Technical taxpayer issues –
Proposed Regulations
• The proposed regulations “reserve” on the treatment of
taxes imposed on hybrid instruments and on disregarded
payments
– Specifically, who is considered to pay any foreign tax
imposed on amounts paid or accrued between related
parties under such an instrument or on payments that
are disregarded
• The proposed regulations
– would be effective for taxable years beginning after
final regulations are adopted
– are not expected to be adopted as final this fiscal year
15
Section 704(b) Regulations: Allocations of
Foreign Taxes Imposed on Partnerships
• In October of 2006 the IRS adopted new regulations on the
allocation of foreign taxes imposed on partnerships
• The prior allocation regulations did not as such address
allocations of foreign tax credits
– Arguably left open whether foreign tax credits should
follow allocations of the income on which foreign tax was
paid or allocations of the associated foreign tax expense
– Taxpayers took position that regulations permitted
allocations based on the associated foreign tax expense,
even when the partners were all members of the same
group (and thus ultimately indifferent to the allocations)
16
New Section 704(b) Regulations
• The new regulations specifically address the allocation of
creditable foreign tax expenditures
 General Rule – An allocation of foreign tax
expenditures “cannot have substantial economic
effect.” Therefore, creditable foreign tax expenditures
– “CFTEs” -- must be allocated “in accordance with
partner’s interest in the partnership” or the “PIP.”
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New Section 704(b) Regulations
 Safe harbor – An allocation will be deemed to satisfy
the PIP
 If the allocation is “in proportion to the partner’s
distributive share of income (including income
allocated pursuant to section 704(c)) to which the
creditable foreign tax relates,” and
 Allocations of other partnership items that have a
material effect on the amount of a creditable
foreign tax expenditure are valid because they
have substantial economic effect
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New Section 704(b) Regulations
 Thus, the safe harbor would be satisfied if
– There was a straight-up allocation of a constant
percentage of all partnership net income to each partner
– only one CFTE category
– The foreign country did not tax passive income and there
was a straight-up allocation of other net income, but a
different allocation of passive income – that income would
be in a different CFTE category
– There were different allocations of net income from
different countries in which the partnership did business
and paid different rates of tax so long as the allocations
were in proportion to the distributive shares of the income
to which the foreign taxes related
19
New Section 704(b) Regulations
 Thus, the safe harbor would be satisfied if
– There was a special allocation of depreciation
from one activity, but that allocation was taken
into account in determining the partner’s
distributive shares of foreign taxes in the
CFTE category in which the depreciation was
incurred
20
New Section 704(b) Regulations
• Effective for taxable years of a partnership
beginning on or after October 19, 2006) but
– An IRS challenge to allocation of credits
based on the allocation of foreign tax expense
is being litigated in Pritired 1 LLC, Principal
Life Insurance Company, Tax Matters Partner
v. United States*
*
Civil No. 4:08-CV-0082 in the Southern District of Iowa (US District
Court)
21
Other special allocations by
partnerships
• Regulations adopted in May 2008 (and proposed in
November 2005) provide
– If a partner in a partnership is a partnership,
controlled foreign corporation, other look-through
entity or member of a consolidated group, then
– Whether partnership allocations have “substantial
economic effect” must take into account the
interaction of the allocations with the tax attributes of
the owner of the partner or member of the same
consolidated group
• Applies through tiers of look-through entities
22
Possible legislation affecting
foreign tax credits
• November 2005 Report of the President’s Advisory
Panel on Federal Tax Reform suggested substantial
changes to foreign tax credit system.
• JCT-22-06: June 21, 2006 Joint Committee Report on
International Tax Reform and Competitiveness of US
Business provides a good overview of worldwide,
territorial and mixed tax systems.
• December 20, 2007 Treasury Report, Approaches to
Improve the Competitiveness of the U.S. Business Tax
System for the 21st Century, "considers the possibility of
moving to a more territorial system…"
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Possible legislation affecting
foreign tax credits
• H.R. 3970: Legislation introduced by Chairman
Rangel to modify the foreign tax credit system.
• H.R. 6049: Legislation introduced by Chairman
Rangel to delay for 10 years the effective date of
worldwide interest allocation under section
864(f).
• H.R. 3920: Legislation to delay for 3 years the
effective date of worldwide interest allocation
under section 864(f).
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