IRS Releases Proposed Regulations on Foreign Tax Credits, the Technical Taxpayer Rule

Yesterday, the IRS issued long-anticipated proposed regulations under section 901(copy attached) clarifying, and in some cases changing in significant ways, the rules for determining which person is the “taxpayer” with respect to foreign income taxes who may claim credits for those taxes under U.S. tax law. The basic rule under current law--often referred to as the “technical taxpayer” rule--is that the person liable for the tax under foreign law is the person who may claim the credit. The proposed regulations preserve the basic principles of the technical taxpayer rule.

The IRS has had concerns about transactions in which the taxpayer claiming the credit is not allocated the underlying income for U.S. tax purposes, and a general theme of the regulations is to seek to reduce cases in which that occurs. Oddly enough, however, the regulations in some instances will clarify the law in a way that has the opposite effect (granting credits to a person who does not earn the related income).

The structures that are most likely to be affected adversely by the regulations are those in which a U.S. parent separates income earned through an active foreign subsidiary from related foreign tax credits. In a typical structure, the subsidiary is a corporation for U.S. tax purposes (a controlled foreign corporation or CFC) that is engaged in an active business (so that income of the CFC is not taxed currently to the U.S. parent under subpart F). The CFC may be part of a consolidated group for local law purposes under a regime in which the parent is the only person liable to pay the group taxes. The parent takes the view that it is the person liable for the taxes under foreign law and hence eligible for the credits even though the income remains in the CFC. Alternatively, the CFC may be a “reverse hybrid” (a CFC that is transparent for foreign tax purposes so that for those purposes its income flows through to the parent). Again the parent would be liable for the taxes under foreign tax law and eligible for the credits under current law. The proposed regulations generally would not affect group relief arrangements such as those in the U.K.

The regulations are proposed to be effective for taxes paid or accrued in taxable years beginning on or after January 1, 2007.

The balance of this alert will provide a summary of the regulations and then add a few comments:

Summary

• Basic technical taxpayer rule. The regulations change the definition of “taxpayer.” The basic rule continues to be that the taxpayer is the person on whom foreign law imposes legal liability for the tax. However, the proposed regulations would add that foreign law is considered to impose legal liability for tax on income on the person who is required to take the income into account for foreign income tax purposes. Thus, the test would not be who is required to pay but who is the income earner. This income test has been applied in the past to withholding taxes, but not across the board (and not clearly based on which party earns the income under foreign law rather than U.S. tax law). The regulations also would change the current regulations by treating a disregarded entity and its owner as one “taxpayer”. This could be relevant in determining if a tax is compulsory (credits are not allowed for voluntary taxes). The new definition might be read to require that a disregarded entity and its owner together take reasonable procedural steps to reduce their combined foreign tax liability.
  
  
• Consolidated groups. The current regulations require income of a consolidated group (group of related companies that compute income on a combined basis, provided the members are jointly and severally liable for the group’s taxes) to be allocated among members having positive amounts of income as determined under foreign law in proportion to those income amounts. The proposed regulations would expand the consolidated group rule by extending it to all cases in which foreign tax is imposed on the combined income of two or more persons (dropping the requirement of joint and several liability and that the parties be related). The proposed regulations make it clear that the mechanics for achieving consolidation do not matter. For example, the proposed regulations would apply to regimes that combine incomes of group members by attributing income of subsidiaries to the parent company (two examples are Australia in which income of consolidated group members is attributed to a head company, and Germany in which profits and losses of a subsidiary may be attributed to a parent through an agreement). The expanded consolidation rules would not apply solely because losses may be surrendered under a group relief scheme, because a shareholder is deemed to realized income and pay taxes of a corporation in an integrated tax system, or because a shareholder is taxed on corporate income under an anti-deferral regime similar to subpart F.
  
  
• Reverse hybrids. In the case of a reverse hybrid, the proposed regulations would treat taxes imposed by a foreign country on an owner’s share of income from the reverse hybrid (together with any tax imposed by the foreign country on other income of the owner) as if the owner’s taxes were imposed on the combined income of the reverse hybrid and the owner. The resulting tax would then be allocated between the owner and the entity in proportion to the amount of the local tax base earned by each (apparently without an adjustment for any tax rate differences). What this means more simply is that if a U.S. parent owns a reverse hybrid subsidiary, the subsidiary earns income that is taxed to the parent under the laws of a foreign country, and the owner has no other income in that country, then the tax payable by the parent would be treated as tax imposed on the subsidiary. Taxes imposed on the subsidiary could be claimed as a credit by the parent only as an indirect credit under and subject to the limitations of section 902 or 960 when the income of the subsidiary is taxable to the parent under U.S. tax principles.
  
  
• Successor owners. The proposed regulations provide for allocations of taxes when there has been a change in the ownership of a tax transparent entity (a partnership or disregarded entity) based on how the income subject to tax is allocated between the owners, without regard to when the taxable year ends for foreign tax law purposes.
  
  
• Hybrid entities. The proposed regulations state that foreign taxes imposed on entities that are treated for U.S. tax purposes as disregarded entities or partnerships are treated as taxes imposed on the owner in the case of a disregarded entity,. or taxes imposed on the partnership in the case of a partnership. Partnership taxes would then be allocated among the partners under section 704 based on how the related income is allocated. This is not a change in law as generally understood, but it is helpful to have the point stated clearly.
  
  
• Hybrid instruments and payments. Hybrid instruments may be used to shift income for purposes of foreign law but not U.S. law or vice versa. That result may also be achieved through arrangements in which payments are made that are deductible for foreign tax purposes but disregarded for U.S. tax purposes. The proposed regulations do not include special rules governing hybrid instruments or disregarded payments. The preamble states that the Government is continuing to study transactions with these features that are designed to generate inappropriate foreign tax credit results, including the use of hybrid instruments that accrue income for foreign tax purposes but not U.S. tax purposes (accelerating credits before income) and the use of disregarded payments that shift foreign tax liabilities away from the person that is considered to earn the associated taxable income for U.S. tax purposes. (An example of a disregarded payment arrangement of this type is given below.) The preamble states that the Government contemplates addressing some or all of these issues in a separate guidance project, and any such regulations may have the same effective date as the proposed regulations (taxable years beginning on or after January 1, 2007). Presumably the two categories of transactions specifically identified in the preamble (hybrid instruments with accelerated foreign income and disregarded payments that shift foreign tax liability away from related income) are the ones most likely to be subject to this effective date rule.

Comments

Consolidated Groups

Under current law, the IRS has attacked arrangements that separated credits from income using foreign consolidation regimes. In the 2005 Guardian Industries case, the taxpayer argued successfully that taxes payable by a Luxembourg parent in respect of income earned by a Luxembourg subsidiary could be claimed as credits by the parent. The taxpayer established that the parent was the sole party liable for the taxes under Luxembourg law. The Government argued unsuccessfully that the taxes should be treated as taxes of the subsidiary because the subsidiary had legal liability for the taxes (a factual point resolved in favor of the taxpayer), and more broadly because the subsidiary was the party directly earning the income that was taxed. The proposed regulations would effectively overturn Guardian for future years.

In the preamble to the proposed regulations, the IRS and Treasury express their view that the general rule of the current regulations allocating tax based on legal liability requires taxes of members of a consolidated group to be allocated among members of the group pro rata based on the income of the members, even if there is no joint and several liability for the taxes so that the specific regulation applicable to consolidated groups does not apply. This position conflicts with Guardian and can best be understood as a reassertion of the Government’s litigation position.

Withholding Taxes

Outside of the context of reverse hybrids, the general rule that treats as a taxpayer the person earning income under foreign law can result in a separation of tax liability from income as measured under U.S. tax principles. This point is illustrated by two examples in the proposed regulations. One example makes it clear that if party A transfers to party B title to a bond issued by a resident of country X under a repo agreement that is recognized to be a sale for country X tax purposes but is a financing for U.S. tax purposes (a loan by B to A, with A being treated as the owner of the bond), then B is treated as the taxpayer with respect to country X taxes withheld on interest on the bond, even though the interest is taxed in the U.S. to A rather than B. This result is not clear under current law. The example will place a premium on managing a repo portfolio so that a U.S. taxpayer seeking credits for withholding taxes is the owner under foreign tax law principles at the time when interest payments are made and tax is withheld. The ability of a financial institution to use withholding tax credits will increase for taxable years beginning after December 31, 2006 with the elimination of the separate foreign tax credit limitation basket for high withholding tax interest. One question is whether B in the example would be denied a credit under section 901(l)(1)(B) on the ground that it is making related payments under the repo with respect to a position in substantially similar or related property. Presumably not, at least if the repo is viewed as a functional currency borrowing, as such a borrowing is not considered a position in property.

The repo example should have no effect on transactions in which stock is subject to a repo and a person in the position of party A claims credits (as the owner of the stock issuer for U.S. tax purposes) for taxes imposed on the net income of the stock issuer. There the taxpayer under local law is clearly the stock issuer, not A or B.

The second example involves a bond sold by A to B with accrued interest. A foreign country imposes a withholding tax on interest payments, and as a result tax is withheld from the next interest payment made to B. The example holds that B is the taxpayer with respect to the full withholding tax even though the tax is imposed in respect of income that was taxed in part to A under U.S. tax principles.

The proposed regulations would also change an example in the current regulations involving withholding taxes imposed on interest on a bond held by a beneficial owner through a nominee. The current regulations treat the beneficial owner (and not the nominee) as the taxpayer without making it clear who is considered the taxpayer under foreign tax law. The proposed regulations would change the example to attribute the taxes to the beneficial owner where the agency relationship is recognized under both U.S. tax law and foreign tax law. The new standard for identifying the taxpayer based on who earns income under foreign tax law principles would seem to require that an agency relationship be recognized under foreign law for credits to pass through. The preamble asks for comments on whether the regulations should apply the same result where the agency relationship is recognized for U.S. purposes but not foreign tax purposes. If a U.S. person receiving interest subject to withholding taxes as a nominee for another person were considered the taxpayer with respect to the taxes, then it is possible that no one would be allowed a credit for the tax. The beneficial owner could not claim the credits because it is not the taxpayer under foreign law. It would seem that the nominee could not claim them because of section 901(l)(1)(B), which denies credits for withholding taxes with respect to a payment if the person has an obligation to make related payments to someone else.

Disregarded Payments

As noted above, the preamble to the proposed regulations indicates that future regulations may address disregarded payments, and indicates that the Government’s concern arises where disregarded payments are used to separate foreign taxes from the related taxable income. While the preamble does not given an example of this type of arrangement, the Government may have something like the following in mind. Suppose a U.S. parent corporation P has three subsidiaries that are tax resident companies in country X, S1, S2 and S3. S1 owns all of the equity of S2, which owns all of S3. S3 is an operating company. For U.S. tax purposes, S1 and S2 are disregarded entities owned by P. S3 is a CFC. S1 makes a loan to S2, which contributes the borrowed funds to the capital of S3. For country X tax purposes, S1 is taxed on interest income on the loan, S2 has a corresponding deduction, and S3 is taxable on its operating income. P claims a credit for the taxes paid by S1. Assuming that S2 has no other tax items, it would have a country X loss equal to the interest paid. Assume that S1, S2 and S3 do not compute income on a combined basis, but country X has a group relief system. Under that system, S2 surrenders its loss to S3, reducing its tax liability. The earnings of S3 are not currently taxable to P because S3 is a CFC engaged in an active business. The effect of this arrangement is similar to a reverse hybrid in that foreign tax attributable to income of S3 has been shifted to S1 (and then to P) without P being currently subject to tax on the related taxable income of S3. By contrast, if the earnings of S3 were currently taxable to P, the same concern should not arise (even if P technically claims a credit for taxes imposed on income of S1 rather than S3).

Regulations in Context

The regulations should be seen as part of an ongoing initiative by the Government to address cases it considers foreign tax credit abuses. Two related tax law changes were (1) the issuance in 2004 of temporary regulations under section 704 requiring taxes imposed on partnerships to be allocated among partners in accordance with the way the underlying income is allocated, and (2) the adoption in 1997 and 2004 of an at-risk, minimum holding period requirement for claiming direct or indirect credits with respect to stock (section 901(k)) and credits for withholding taxes with respect to interest, royalties and other non-dividend income or gain with respect to property (section 901(l)). Notice 98-5 announced that regulations would be issued limiting credits for certain withholding taxes and in certain tax arbitrage transactions unless the transactions met a transaction-specific net income test. In Notice 2004-19, the IRS withdrew Notice 98-5 and announced that it would take other steps to limit foreign tax credit abuses, focusing on the separation of income from credits. Earlier this year, Commissioner Everson outlined steps being taken to limit foreign tax credit abuses in testimony before the Senate Finance Committee. His testimony is described in our e-mail of June 13. The preamble to the proposed regulations focuses on the taxpayer definition and does not provide further insight into other steps the IRS may be contemplating with respect to foreign tax credits.

Please feel free to call any of your regular contacts at the firm or any of our partners and counsel listed under Tax in the Our Practice section of our web site if you have any questions.

CLEARY GOTTLIEB STEEN & HAMILTON LLP