T.D. 9535, 07/13/2011, T.D. 9536, 07/14/2011, Reg. §1.901-1, Reg. §1.901-2
IRS has issued final, temporary, and proposed regs providing guidance relating to the determination of the amount of taxes paid for purposes of the Code Sec. 901 foreign tax credit (FTC). They affect individual and corporate taxpayers claiming direct and indirect FTCs and are aimed at structured passive investment arrangements that produce inappropriate FTC results.
Background. Under Code Sec. 901, taxpayers can claim a credit against their U.S. tax for income taxes paid or accrued during the tax year to any foreign country or U.S. possession. To qualify for the credit, the payment must be a compulsory payment under the authority of a foreign country, and the predominant character of the foreign tax must be that of an income tax in the U.S. sense. An amount of payment is not compulsory, and thus not a foreign tax paid, to the extent the amount is more than the liability under the foreign tax law. (Reg. §1.901-2(a))
In March of 2007, IRS issued proposed regs that would disallow FTCs for foreign taxes paid in connection with certain artificially engineered, highly structured transactions. In response to written comments, IRS determined that the proposed change to Reg. §1.901-2(e)(5) relating to U.S.-owned foreign groups may lead to inappropriate results in certain cases. Accordingly, in late 2007, IRS issued Notice 2007-95, 2007-49 IRB 1091, which provided that the proposed rule for U.S.-owned foreign groups would be severed from the portion of the 2007 proposed regs addressing the treatment of foreign payments attributable to certain structured passive investment arrangements.
In July of 2008, IRS issued new proposed and temporary regs addressing the treatment of foreign payments attributable to structured passive investment arrangements. (T.D. 9416, 07/15/2008) These complex arrangements are intentionally structured to generate a foreign tax liability when the basic underlying business transaction generally would result in significantly less, or even no, foreign taxes. An arrangement must satisfy six conditions indicative of an abusive arrangement, described below, to be considered a structured passive investment arrangement. The parties use these arrangements to exploit differences between U.S. and foreign law in order to permit a person to claim a FTC for the purported foreign tax payments while also allowing the counterparty to claim a duplicative foreign tax benefit. Under the 2008 temporary regs, foreign payments attributable to such arrangements are treated as noncompulsory payments and, thus, no FTCs are allowed for those amounts. (T.D. 9416, 07/15/2008) Reg. §1.901-2T(e)(5)(iv)(B)
Final regs. The final regs, which are effective for payments that if they were an amount of tax paid, would be considered paid or accrued on or after July 13, 2011, retain the same basic approach and structure of the 2008 temporary regs. Thus, the final regs disallow FTCs for amounts paid to a foreign taxing authority that are attributable to a structured passive investment arrangement, defined as an arrangement that satisfies the six prerequisite conditions. However, some modifications were made to the conditions in light of comments received, as described below.
The six conditions. Under the final regs, the following conditions must be satisfied in order for an arrangement to be considered a structured passive investment arrangement:
(1) Special purpose vehicle (SPV). To satisfy this requirement, (a) the arrangement must use an entity substantially all of the gross income of which, as determined under U.S. tax principles, is attributable to passive investment income, and substantially all of the assets of which are held to produce such passive investment income; and (b) there must be a foreign payment attributable to the income of the entity. The definition of passive investment income in the 2008 regs was modified to exclude personal service contract income as described in Code Sec. 954(c)(1)(H). Additionally, with regard to (b), the exception in the proposed 2007 regs and temporary 2008 regs for a withholding tax on distributions or payments to U.S. parties is eliminated, as is the provision attributing to the income of an entity foreign payments attributable to the entity's share of income of a lower-tier entity that is a branch or pass-through entity under U.S. or foreign law. (Reg. §1.901-2(e)(5)(iv)(B)(1)(ii))
(2) U.S. party. A person would be eligible to claim a credit under Code Sec. 901(a) (including a credit for foreign taxes deemed paid under Code Sec. 902 or Code Sec. 906) for all or a portion of the foreign payment were an amount of tax paid. This condition was adopted without change. (Reg. §1.901-2(e)(5)(iv)(B)(2))
(3) Direct investment. The U.S. party's share of the foreign payment(s) is, or is expected to be, substantially greater than the amount of any credits that the U.S. party reasonably would expect to be eligible to claim under Code Sec. 901(a) for foreign taxes attributable to income generated by the U.S. party's proportionate share of the assets owned by the SPV if the U.S. party directly owned such assets. This condition was adopted without change. (Reg. §1.901-2(e)(5)(iv)(B)(3))
(4) Foreign tax benefit. The arrangement must be reasonably expected to result in a tax benefit to a counterparty (or a related person) under the laws of a foreign country. If the foreign tax benefit available to the counterparty is a credit, then such credit must correspond to 10% or more of the U.S. party's share (for U.S. tax purposes) of the foreign payment. Similarly, other types of foreign tax benefits, such as exemptions, deductions, exclusions or losses, must correspond to 10% or more of the foreign base with respect to which the U.S. party's share (for U.S. tax purposes) of the foreign payment is imposed. This condition was adopted with only minor changes. (Reg. §1.901-2(e)(5)(iv)(B)(4))
(5) Counterparty. The arrangement must include a person that, under the tax laws of a foreign country in which the person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis tax, directly or indirectly owns or acquires equity interests in, or assets of, the SPV. The 2008 regs were modified to provide that certain tax benefits claimed by upper-tier entities don't correspond to the U.S. party's share of the foreign payment, in order to ensure that the condition isn't satisfied in cases where the U.S. and foreign investors claim only those tax benefits that are consistent with their respective investments in the arrangement and their interests are treated as equity and owned by the same persons in both jurisdictions. The regs were also modified to reflect that dual citizens or U.S. residents who are generally subject to U.S. tax on their worldwide income shouldn't be treated as counterparties, because any reduction in foreign tax liability will result in a corresponding increase in U.S. tax. (Reg. §1.901-2(e)(5)(iv)(B)(5))
(6) Inconsistent treatment. The U.S. and an applicable foreign country treat the arrangement inconsistently under their respective tax systems, and that the U.S. treatment results in either materially less income or a materially greater amount of FTCs than would be available if the foreign law controlled the U.S. tax treatment. The final regs were modified to clarify the application of this condition in cases where multiple U.S. parties exist, and examples were provided to illustrate these changes. (Reg. §1.901-2(e)(5)(iv)(B)(6))
Miscellaneous amendments. The final regs also adopt with minor changes amendments made by the 2008 temporary regs to Reg. §1.901-1(a) and Reg. §1.901-1(b) to reflect statutory changes made by the Foreign Investors Tax Act of '66 (P.L. 89-809), the Tax Reform Act of '76 (P.L. 94-455), and the American Jobs Creation Act of 2004 (P.L. 108-357).
Continued scrutiny of “other arrangements.” IRS cautioned that it and the Treasury Department will continue to closely scrutinize “other arrangements” that aren't covered by the regs but nonetheless produce inappropriate FTC results. This may include arrangements that are similar to those described in the final regs, but do not meet all of the conditions. IRS will challenge claimed U.S. tax results in appropriate cases under relevant judicial doctrines, and IRS and the Treasury Department may also issue additional regs in the future to address such other arrangements.
Temporary and proposed regs. The text of the temporary regs serves as the text of the proposed regs. The temporary regs clarify the provisions of Reg. §1.901-2(e)(5)(iv)(B)(1) by providing in a new paragraph, Reg. §1.901-2(e)(5)(iv)(B)(1)(iii), that a foreign payment attributable to income of an entity includes a withholding tax imposed on a dividend or other distribution (including distributions made by a pass-through entity or an entity that is disregarded as an entity separate from its owner for U.S. tax purposes) with respect to the equity of the entity. (T.D. 9536)
IRS is requesting that any comments on the temporary regs or requests for a public hearing be received by 90 days following the publication date (July 18, 2011).
Reg. §1.902-2(h)(3) states that the new guidance in the temporary regs is effective for foreign payments that, if such payments were treated as amount of tax paid, would be considered paid or accrued under Reg. §1.901-2(f) on or after July 14, 2014.
Observation: Presumably, the July 14, 2014 effective date that appears in Reg. §1.901-2T(h)(3) is erroneous. Temporary regs expire in three years, and Reg. §1.902-2(h)(4) makes it clear that these regs expire on July 14, 2014, so this would imply that the correct effective date is July 14, 2011. However, the summary portion of T.D. 9536 states that the regs are effective as of the date of publication—i.e., July 18, 2011.
References: For the foreign tax credit, see FTC 2d/FIN ¶O-4001 et seq.; United States Tax Reporter ¶9014 et seq.; TaxDesk ¶391,000 et seq.; TG ¶30775 et seq.