Treasury and IRS finalize regulations under Section 909 foreign tax credit splitting events

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1 13 February 2015 International Tax Alert EY Global Tax Alert Library Access both online and pdf versions of all EY Global Tax Alerts. Copy into your web browser: Services/Tax/International- Tax/Tax-alert-library#date Treasury and IRS finalize regulations under Section 909 foreign tax credit splitting events Executive summary On 9 February 2015, the Department of the Treasury (Treasury) and Internal Revenue Service (IRS) issued final regulations (T.D. 9710) under Sections 909 and 704 (the Final Regulations). The final regulations adopt, with modifications and clarifications, the temporary and proposed regulations issued on 14 February 2012 (REG ; T.D. 9577) (the 2012 Regulations). The Final Regulations, which generally apply to tax years ending after 9 February 2015, retain the approach of an exclusive list of splitter arrangements from the 2012 Regulations and do not identify any additional splitter arrangements. The Final Regulations, however, do: (i) clarify the determination of related income with respect to reverse hybrid splitter arrangements in the event that the reverse hybrid incurs a loss; (ii) modify the definition of usable shared loss, for purposes of losssharing splitter arrangements, to include a shared loss of a US combined income group that could have been used to offset foreign taxable income of the group in a previous tax year; and (iii) clarify that a transaction described under Section 381 does not result in the unsuspension of split taxes if the transaction does not cause the payor of the split taxes to take into account earnings and profits of the covered person equal to the amount of related income specified in the relevant splitter arrangement. Additionally, in T.D. 9710, Treasury and the IRS state that additional mechanical rules for tracking related income and split taxes are under consideration and will be addressed in future guidance.

2 Detailed discussion Background Section 909 is intended, under certain circumstances, to suspend foreign income taxes until those taxes are matched with the income to which they relate (related income). Specifically, Section 909(a) provides that, if there is a foreign tax credit splitting event with respect to a foreign income tax 1 paid or accrued by a taxpayer, then the foreign income tax will not be taken into account before the tax year in which the taxpayer takes the related income 2 into account. 3 Section 909(b) provides that, if there is a foreign tax credit splitting event with respect to a Section 902 corporation, foreign income taxes paid or accrued are not taken into account for purposes of Section 902 or 960, or for purposes of determining earnings and profits (E&P), before the tax year in which the related income is taken into account by the Section 902 corporation or a domestic corporation satisfying the ownership requirements of Section 902(a) or (b) with respect to the Section 902 corporation. 4 A foreign tax credit splitting event is considered to occur with respect to a foreign income tax if the related income is or will be taken into account by a covered person. 5 Covered person means, with respect to any person who pays or accrues a foreign income tax (the payor): (i) any entity in which the payor holds, directly or indirectly, at least a 10% ownership interest (by vote or value); (ii) any person that holds, directly or indirectly, at least a 10% ownership interest (by vote or value) in the payor; (iii) any person bearing a relationship to the payor that is described in Sections 267(b) or 707(b); and (iv) any other person specified by the Treasury Secretary. 6 Congress enacted Section 909 in 2010 as part of the Education, Jobs and Medicaid Assistance Act. The IRS provided initial guidance in Notice that addresses the application of Section 909 to foreign income taxes paid or accrued in tax years beginning on or before 31 December 2010, by Section 902 corporations. On 14 February 2012, Treasury and the IRS issued the 2012 Regulations incorporating and building on the guidance in Notice The 2012 Regulations generally applied to tax years beginning on or after 1 January 2011, and foreign income taxes paid or accrued in those years by any person, not just Section 902 corporations. The 2012 Regulations issued in temporary form expired on 9 February Splitter arrangements Consistent with prior guidance, the Final Regulations set forth an exclusive list of arrangements (splitter arrangements) that may give rise to a foreign tax credit splitting event for purposes of Section 909. The Final Regulations adopt, without expansion, the same four categories of splitter arrangements as the 2012 Regulations: Reverse hybrid splitter arrangements Loss-sharing splitter arrangements Hybrid instrument splitter arrangements Partnership inter-branch payment splitter arrangements 9 Notwithstanding the continued use of an exclusive list of splitter arrangements, according to the preamble to the Final Regulations (the Preamble), Treasury and the IRS continue to consider other arrangements that may inappropriately separate foreign income taxes from the related income, including arrangements between unrelated persons. Related income of reverse hybrid splitter arrangements A reverse hybrid splitter arrangement occurs when a payor pays or accrues a foreign income tax with respect to the income of a reverse hybrid. 10 The foreign tax paid or accrued with respect to income of the reverse hybrid are split taxes. 11 The related income is the E&P (computed for US federal income tax purposes) of the reverse hybrid attributable to the activities that gave rise to the income included in the payor s foreign tax base with respect to which the split taxes were paid or accrued. 12 Under the annual adjustment rules of Treas. Reg. Section (d)(1), which apply to related income of a reverse hybrid splitter arrangements, 13 a covered person s aggregate amount of related income is adjusted each year by the net amount of income and expense attributable to the activities of the covered person that give rise to income included in the foreign tax base, even if the net amount is 2 International Tax Alert

3 negative and regardless of whether any split taxes are paid or accrued in such year. The Final Regulations clarify how such annual adjustments are to be made through two new examples, the pertinent facts and conclusions of which are as follows: 14 Facts. USP, a domestic corporation, wholly owns DE, a Country A corporation treated as a disregarded entity for US tax purposes. DE wholly owns RH, a fiscally transparent entity under Country A law that is treated as a corporation for US tax purposes. Country A imposes income tax at 30% on DE with respect to the income earned by RH. For US tax purposes, USP is treated as legally liable for the country A taxes paid by DE. Prior to Year 1, RH had no income for Country A purposes and had no post-1986 E&P for US tax purposes. In Year 1, RH earns 200u of income on which DE pays 60u of Country A tax. DE has no other income. In Year 2, RH has a 100u loss for both Country A and US tax purposes. For Country A tax purposes, DE takes the 100u loss into account in Year 2 and may not carry back the 100u loss to offset its Country A taxable income for Year 1. At the end of Year 2, RH distributes 100u to DE. Result. Under Treas. Reg. Section (b)(1)(iii), (d)(1) and (a), the total related income of RH is reduced to 100u (200u 100u) in Year 2 because RH incurred a 100u loss in Year 2 attributable to the activities that are included in DE s Country A tax base. Because DE is a disregarded entity, the 100u distribution by RH at the end of Year 2 is treated as a dividend to USP. Under Treas. Reg. Section (d)(7) and (a), 100u of the 100u of related income of RH, or 100%, is taken into account by USP by reason of the 100u dividend. Accordingly, under Treas. Reg. Section (e)(4) and (a), a ratable portion of the split taxes, or 60u of taxes (100% of 60u), is no longer treated as split taxes and is taken into account by USP for US federal income tax purposes. A subsequent loss that reduces related income below zero (a negative amount) would not afford a taxpayer the immediate opportunity to unsuspend suspended taxes, because a positive amount of related income is needed for purposes of matching that income to the split taxes. As the prior example illustrates, however, a subsequent loss that reduces the related income (but does not eliminate that income) could permit a taxpayer to unsuspend all split taxes related to that income through an inclusion that is less than the amount of the original related income. Usable shared loss of loss-sharing splitter arrangements A foreign group relief or other losssharing regime is a loss-sharing splitter arrangement to the extent that a shared loss of a US combined income group could have been used to offset income of that group in the current or in a prior foreign tax year (usable shared loss), but is used instead to offset income of another US combined income group. 15 US combined income group means an individual or a corporation and all entities (including entities that are fiscally transparent for US federal income tax purposes under the principles of Treas. Reg. Section (d)(3)) that, for US federal income tax purposes, combine any of their respective items of income, deduction, gain or loss with the income, deduction, gain or loss of that individual or corporation. 16 The 2012 Regulations did not indicate whether a usable shared loss included a loss that could be carried back or forward to offset income of the US combined income group in a previous or future tax year. As a result, it was generally considered that a loss-sharing splitter arrangement occurred only if the surrendering group could have used the loss in the year of the surrender, regardless of whether the loss could also be carried back or forward. Consistent with this interpretation, a commenter requested that regulations clarify that any shared loss that could not be used within the US combined income group in the current foreign tax year is excluded from the definition of a usable shared loss, notwithstanding that the group could use the loss in a previous or future foreign tax year (i.e., carried back or carried forward). Treasury and the IRS agreed that the usable shared loss definition should not require a US combined income group to carry forward losses. In this regard, the Preamble notes that [i]t would be too unpredictable to adopt a wait and see rule that required a taxpayer to forego the opportunity to use a loss to reduce an affiliate s International Tax Alert 3

4 foreign tax liability in a current (or prior) foreign taxable year based on the speculation that it may be able to use the loss itself in a future foreign taxable year. Treasury and the IRS rejected, however, the suggestion to exclude from the usable shared loss definition a loss that may be carried back to offset the income of the US combined income group in a previous year. Accordingly, the Final Regulations modify the definition [of a usable shared loss] to clarify that a usable shared loss is a shared loss that could be used under foreign tax law to offset income of the US combined income group in the current or in a priorforeign tax year. Because taxpayers have the power of hindsight at the time of the loss, the Preamble notes, they should not be permitted to share such a loss in a way that inappropriately separates foreign income taxes from the related income. Further, Treasury and the IRS believe that the fact that such an approach may convert previously paid or accrued taxes into split taxes is an acceptable outcome in light of the policy concerns that the loss-sharing splitter rules are intended to address. Taking related income into account as a result of a transaction under Section 381 According to the Preamble, one commentator incorrectly interpreted Treas. Reg. Section T(d)(8)(ii), dealing with when related income is considered taken into account by a payor Section 902 corporation, to provide for the unsuspension of 100% of the split taxes with respect to a foreign tax credit splitting event if the payor Section 902 corporation combines with the covered person in a transaction described in Section 381, notwithstanding that the full amount of related income is not reflected in the E&P of the payor (or surviving corporation) as a result of the transaction. In response, the Final Regulations clarify that split taxes are unsuspended only when the appropriate amount of related income is taken into account by the payor Section 902 corporation, either as a result of a distribution or inclusion out of the E&P of the covered person or as a result of the combination of the payor Section 902 corporation and the covered person in a transaction described in Section Mechanical rules for tracking related income and split taxes Treasury and the IRS received comments requesting additional guidance on mechanical rules for tracking related income and split taxes. Treasury and the IRS declined to adopt any of these comments. 18 Acknowledging that that there are a number of issues related to tracking related income and split taxes that are not fully addressed by the Final Regulations, however, Treasury and the IRS indicated that such issues are still under consideration and will be the subject of future guidance. Hybrid instrument splitter arrangements Regarding a US equity hybrid instrument, the Final Regulations make clarifying changes to the definition of US equity hybrid instrument splitter arrangement to address questions that arose with respect to references to payments or accruals and their respective treatment under US and foreign law. The Final Regulations clarify that, regardless of whether an actual payment is made, a splitter arrangement exists whenever an accrual under foreign law with respect to a US equity hybrid instrument gives rise to the imposition of foreign income taxes on the instrument owner without giving rise to income under US federal income tax law, when that accrual under foreign law gives rise to a foreign-law deduction by the issuer. 19 Any actual payment of the accrued amount may be considered a distribution of related income to the extent provided by Treas. Reg. Section and (d). An example was added to the Final Regulations to illustrate the application of the rule. 20 Related income from a loss-sharing splitter arrangement The regulations clarify that references to income in determining related income from a loss-sharing splitter arrangement in Treas. Reg. Section (b)(2)(v) are intended to refer to income for purposes of foreign tax law. Effective dates and election to apply certain provisions of the 2012 regulations The Final Regulations are generally effective for tax years ending after 9 February In lieu of applying Treas. Reg. Section (splitter arrangements), as modified and clarified by the Final Regulations, 4 International Tax Alert

5 however, a taxpayer may choose to apply the provisions of Treas. Reg. Section T to foreign income taxes paid or accrued in its first tax year ending after 9 February 2015 (and to tax years of foreign corporations for which the taxpayer is a domestic shareholder that end with or within that first tax year). 21 Implications The issuance of the Final Regulations on the same date that the temporary 2012 Regulations expired is welcomed, as it provides taxpayers with continued certainty regarding certain aspects of Section 909, including the types of transactions that will be treated as a splitter arrangement. The retention of the exclusive list of splitter arrangements in the Final Regulations, which parallel the 2012 Regulations, should eliminate many uncertainties regarding the statute s scope, given the potential breadth of Section 909. While it is good news that no transactions have been added to the exclusive list at this time, taxpayers should continue to be cautioned that Treasury and the IRS continue to consider other arrangements that inappropriately separate foreign income taxes from the related income, including arrangements between unrelated persons. Although the prospective nature of any future guidance is not expressed in the Preamble, we would expect that any future guidance extending the existing splitter arrangements to include other transactions should apply prospectively only, consistent with the view expressed in the preamble to the 2012 Regulations. The additional guidance and clarifications provided in the Final Regulations on the operation of various rules (e.g., the determination of related income under a reverse hybrid splitter arrangement) is helpful, but the failure to address the myriad mechanical issues for tracking split taxes and related income is disappointing, as such guidance is sorely need. Taxpayers should consider whether to apply the provisions of Treas. Reg. Section T (splitter arrangements), in lieu of Treas. Reg. Section , to foreign income taxes paid or accrued in the first tax year ending after 9 February 2015, in light of the changes to the definitions of certain splitter arrangements, in particular with respect to the modification of the definition of usable shared loss to include carrybacks. International Tax Alert 5

6 Endnotes 1. The term foreign income tax means any income, war profits, or excess profits tax paid or accrued to any foreign country or to any possession of the United States. Section 909(d)(2) and Treas. Reg. Section (a)(5). 2. The term related income means, with respect to any portion of any foreign income tax, the income (or, as appropriate, earnings and profits) to which the portion of foreign income tax relates. Section 909(d)(3). 3. Treas. Reg. Section (a)(2). 4. Id. A Section 902 corporation is any foreign corporation for which one or more domestic corporations meets the ownership requirements of Section 902(a) or (b). Section 909(d)(5) and Treas. Reg. Section (a)(1). 5. Section 909(d)(1) and Treas. Reg. Section (a)(1). 6. Section 909(d)(4) and Treas. Reg. Section (a)(4) C.B REG , 77 FR 8184 (14 February 2012) and T.D. 9577, 77 FR 8127 (14 February 2012). The 2012 Regulations were accompanied by final regulations under Section 901, generally referred to as the technical taxpayer rules. 9. Treas. Reg. Section (b). 10. Treas. Reg. Section (b)(1)(i). A reverse hybrid is an entity that is a corporation for US federal income tax purposes but is a fiscally transparent entity (under the principles of Treas. Reg. Section (d)(3)) or a branch under the laws of a foreign country imposing tax on the income of the entity. Treas. Reg. Section (b)(1)(iv). 11. Treas. Reg. Section (b)(1)(ii). 12. Treas. Reg. Section (b)(1)(iii). 13. See Treas. Reg. Section (a). 14. See Treas. Reg. Section (b)(1)(v). 15. Treas. Reg. Section (b)(2)(i) (emphasis added). 16. Treas. Reg. Section (b)(2)(ii). 17. See Treas. Reg. Section (d)(8). 18. For example, split taxes will not be a carryover attribute in an inbound Section 381 transaction, and split taxes may remain permanently suspended as a result of a disposition or liquidation of the covered person. 19. See Treas. Reg. Section (b)(3)(i)(A)(1). 20. See Treas. Reg. Section (b)(3)(i)(E), Example. 21. Treas. Reg. Section (c). 6 International Tax Alert

7 For additional information with respect to this Alert, please contact the following: Ernst & Young LLP, International Tax Services, Washington, DC John Morris Lisa C. Findlay Ernst & Young LLP, International Tax Services, New York Karen M. Petrosino Ernst & Young LLP, International Tax Services, Chicago Gary Scanlon International Tax Services Global ITS, Alex Postma, London ITS Director, Americas, Jeffrey Michalak, Detroit National Director of ITS Technical Services, Jose Murillo, Washington Member Firm Contacts, Ernst & Young LLP (US) Northeast Johnny Lindroos, McLean, VA Financial Services Phil Green, New York Central Mark Muktar, Detroit Southeast Scott Shell, Charlotte, NC Southwest Amy Ritchie, Austin West Frederick Round, San Jose, CA Canada - Ernst & Young LLP (Canada) Albert Anelli, Montreal Kost Forer Gabbay & Kasierer (Israel) Sharon Shulman, Tel Aviv Mancera, S.C. (Mexico) Koen Van t Hek, Mexico City South America Luiz Sergio Vieira, São Paulo International Tax Alert 7

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