Final Regulations Attack Artificially Generated Foreign Tax Credits

The IRS issued final regulations on determining the amount of taxes paid for purposes of the foreign tax credit (T.D. 9634). The regulations are designed to curb certain transactions that the IRS says “produce inappropriate foreign tax credit results.” They finalize proposed regulations issued in 2011 with no substantive change (REG-126519-11) and remove the temporary regulations issued at the same time (T.D. 9536). A portion of the regulation specifically added in the final regulations clarifies the treatment of withholding taxes.

The regulations provide that amounts paid to a foreign taxing authority that are attributable to a “structured passive investment arrangement” are not treated as an amount of tax paid for purposes of the foreign tax credit. Structured passive investment arrangements are generally designed to exploit differences between U.S. and foreign tax law by artificially creating a foreign tax liability that allows the U.S. party to claim a U.S. foreign tax credit and a foreign counterparty to claim a duplicative foreign tax benefit. The U.S. and foreign parties share the cost of the purported foreign tax payments through pricing of the arrangement, the IRS said in the preamble to the 2008 temporary regulations (T.D. 9416).

Six conditions must be met for an arrangement to qualify as a structured passive investment arrangement:

1. The SPV condition. The arrangement uses an entity (a special-purpose vehicle, or SPV) that meets two requirements: (a) Substantially all of the entity’s gross income, as determined under U.S. tax principles, is attributable to passive investment income, and substantially all of the entity’s assets are held to produce the passive investment income; and (b) there is a foreign payment attributable to income of the entity. The 2008 temporary regulations contained an exception for withholding tax, but the 2011 regulations removed it, stating that withholding tax imposed on a dividend or other distribution related to equity of the entity made from a foreign entity to a U.S. party is a foreign payment attributable to income of the entity. A portion of the new regulations (Regs. Sec. 1.901-2(e)(5)(iv)(B)(1)(ii)) clarifies that this rule applies to distributions made by a passthrough entity or other entity disregarded as separate from its owner for U.S. tax purposes.

2. The U.S. party condition. A U.S. party is a person eligible to claim a foreign tax credit under Sec. 901(a), including a credit for taxes deemed paid under Sec. 902 or 960, for all or a portion of foreign tax paid.

3. The direct investment condition. The U.S. party’s share of the foreign payment or payments is (or is expected to be) substantially greater than the amount of credits, if any, that the U.S. party reasonably would expect to be eligible to claim under 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 the assets.

4. The foreign tax benefit condition. The arrangement is reasonably expected to result in a tax benefit to a counterparty (or a related person) under the laws of a foreign country.

5. The counterparty condition. The arrangement includes 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.

6. The inconsistent treatment condition. The United States and an applicable foreign country treat the arrangement inconsistently under their respective tax systems, and the U.S. treatment results in either materially less income or a materially greater amount of foreign tax credits than would be available if the foreign law controlled the U.S. tax treatment.

The final regulations are effective for payments that would be considered paid or accrued on or after July 13, 2011, if those payments were an amount of tax paid. The new portion of the regulations (the last sentence of Regs. Sec. 1.901-2(e)(5)(iv)(B)(1)(ii) on withholding taxes) applies to payments paid or accrued on or after Sept. 4 (the date the regulations will be published in the Federal Register).