Institute of International Bankers Tuesday, June 24, 3 p.m. Foreign Tax Credit Issues

Institute of International Bankers

Tuesday, June 24, 3 p.m.

Foreign Tax Credit Issues

2

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. §1.704-1(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

3

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

4

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”

5

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

6


• 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

7


• Audits and litigation?– E.g., Standard IDR For Tier 1 Foreign Tax

Credit Generators

• “Promotor” audits?

8

“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?

9

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

10


• 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

11


• 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

12


• 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

13


• 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

14


• 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

15


• 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

16

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)

17

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.”

18


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

19

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

20


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

21


• 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)

22

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

23

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…"

24

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).

Documents

Institute of International Bankers Tuesday, June 24, 3 p.m. Foreign Tax Credit Issues