Final Rules Govern Foreign Tax Credit Splitter Arrangements

The IRS issued regulations that prohibit taxpayers from taking a foreign tax into account for federal foreign tax credit purposes before the tax year in which the taxpayer takes the related income into account (T.D. 9710). The new regulations finalize with a few minor clarifications so-called anti-splitter rules issued under Sec. 909 in 2012. Sec. 909 was enacted in 2010 to prevent foreign income taxes from being separated from the related income.

One example of such a situation is a “hybrid instrument splitter arrangement,” which involves a U.S. hybrid equity instrument that is treated as equity under U.S. law but as debt for foreign purposes, which permits a deduction for foreign purposes for interest expense but not a corresponding taxable interest payment in the United States.

Another splitter arrangement is a “reverse hybrid splitter arrangement,” in which an entity that is a corporation for U.S. purposes is treated as a fiscally transparent entity or a branch under the laws of the foreign country imposing the tax.

One of the clarifications in the regulations involved adding two new examples to Regs. Sec. 1.909-2(b)(1)(v) to illustrate how to determine the amount of the related income for a reverse hybrid splitter arrangement when the reverse hybrid later incurs a loss, causing its earnings and profits to fluctuate over multiple tax years.

Another change is to the definition of “usable shared loss” under Regs. Sec. 1.909-2(b)(2), which is a shared loss of a U.S. combined income group that could be used under foreign law to offset the group’s own income. The final rules modify the definition to clarify that a usable shared loss could be used under foreign tax law to offset income of the U.S. combined income group in a current or previous foreign tax year, rather than only in the current year.

Regs. Sec. 1.909-2(b)(2)(v) is amended from the temporary rules to clarify that, to determine related income from a loss-sharing splitter arrangement, income refers to income under foreign tax law, not U.S. tax law.

And a final change is an added example under Regs. Sec. 1.909-2(b)(3)(i)(E) to illustrate that if an accrual under foreign law for a U.S. equity hybrid instrument gives rise to a foreign-law deduction for the issuer, then regardless of whether a payment is made on the instrument, a splitter arrangement exists whenever an accrual gives rise to the imposition of foreign income taxes on the instrument owner without giving rise to income under U.S. federal income tax law.

In addition, the IRS explained that these rules do not contain mechanical rules for tracking income, but that it will address these issues in future guidance.

These final rules apply to tax years ending after Feb. 9, 2015.