Treasury Issues Temporary Regulations on Certain Foreign Tax Credit Transactions SUMMARY On July 15, 2008, the Treasury Department issued temporary regulations (the Temporary Regulations ) intended to disallow foreign tax credits arising from certain arrangements that the Treasury Department believes are intentionally structured to create a foreign tax liability. These Temporary Regulations are generally similar to proposed regulations (the 2007 Proposed Regulations ) issued on March 29, 2007. However, important differences exist between the Temporary Regulations and the 2007 Proposed Regulations, including the following: for purposes of determining whether a U.S. party receives substantially more credits from an arrangement than it would have received by investing directly in the assets owned by the arrangement, assets that are subject to a gross basis withholding tax are not included in the U.S. party s proportionate share of the assets held by the arrangement; a foreign tax benefit needs to only be reasonably expected, rather than actually realized, to be covered by the Temporary Regulations; arrangements that do not confer a foreign tax benefit corresponding to at least 10 percent of the U.S. party s share of the foreign payment that is imposed (or at least 10 percent of the base on which such foreign payment is calculated) are not covered by the Temporary Regulations; the definition of a Counterparty now includes certain related parties that were excluded from the definition of a Counterparty in the 2007 Proposed Regulations and no longer excludes entities that own less than 10 percent of the special purpose entity in the arrangement or 20 percent of the assets held by the special purpose entity; the Temporary Regulations clarify that they do not apply to a transaction where the credits available from the transaction would not be materially increased, or the taxable income of the U.S. party, SPV or a related person would not be materially decreased, if foreign law were to control certain aspects of the transaction for U.S. tax purposes, even if the treatment of the transaction under foreign law and U.S. law is inconsistent; and the Temporary Regulations generally apply to foreign taxes paid or accrued in a taxable year ending on or after July 16, 2008. The Temporary Regulations clarify that for this purpose the relevant taxpayer is, generally, the person on whom foreign law places legal liability for payment of the tax. However, with respect to foreign payments by a foreign corporation that has a domestic corporate New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney www.sullcrom.com
shareholder, the Temporary Regulations apply to such payments that would be considered paid or accrued in the foreign corporation s U.S. taxable years ending with or within taxable years of its domestic corporate shareholder ending on or after July 16, 2008. With respect to foreign payments made by a partnership, trust or estate for which any partner or beneficiary would otherwise be eligible to claim a foreign tax credit, the Temporary Regulations apply with respect to payments that would be considered paid or accrued in the U.S. taxable years of the partnership, trust or estate ending with or within the taxable years of such partners or beneficiaries that end on or after July 16, 2008. The Preamble to the Temporary Regulations indicates that the IRS will continue to dispute foreign tax credits claimed pursuant to such structured passive investment arrangements and similar arrangements that it calls foreign tax credit generator transactions in taxable years of taxpayers that end prior to the effective date of the Temporary Regulations using all available tools under current law, including the economic substance doctrine, debt-equity principles and other provisions. BACKGROUND A U.S. taxpayer may generally claim a credit against its U.S. tax liability on foreign-source income for the amount of foreign income tax paid on that income. Foreign tax payments are creditable only if they are compulsory under foreign law, but the current foreign tax credit regulations provide that a U.S. taxpayer need not alter its form of doing business, its business conduct or the form of any business transaction in order to reduce its liability under foreign law. 1 On March 29, 2007, the Treasury Department issued the 2007 Proposed Regulations, which were intended to modify this general rule with respect to certain payments made pursuant to structured passive investment arrangements and instead treat such payments as noncompulsory. 2 These proposed regulations were issued in response to concerns that the IRS and the Treasury Department have expressed regarding so-called foreign tax credit generator transactions. In addition to the issuance of the 2007 Proposed Regulations and the Temporary Regulations, the IRS has designated such transactions as a Tier 1 issue, released a technical advice memorandum disallowing the claimed foreign tax credit with respect to one such transaction under existing law on four different grounds, 3 released a chief counsel advice memorandum disallowing the 1 2 3 Treas. Reg. 1.901-2(e)(5)(i). The 2007 Proposed Regulations are further discussed in the Sullivan & Cromwell LLP publication titled : Treasury Issues Proposed Regulations on Certain Foreign Tax Credit Transactions (April 9, 2007), which can be obtained by following the instructions at the end of this publication. See TAM 200807015 (Nov. 7, 2007) (denying foreign tax credit to a U.S. lender structured transaction on the grounds that (i) the payments of U.K. tax were not compulsory, (ii) the securities held by the U.S. party to the transaction were debt, rather than equity, (iii) the partnership anti-abuse rules of Treas. Reg. 1.701-2 require that the transaction be recharacterized as a loan, or (iv) the transaction lacked economic substance). -2-
claimed foreign tax credit on another such transaction 4 and issued a model Information Document Request form intended to be used by IRS agents when one of these transactions is identified. The 2007 Proposed Regulations treated payments as noncompulsory if six conditions (the Conditions ), which the Treasury Department considered common to structured passive investment arrangements, were satisfied: the arrangement involves a special purpose vehicle ( SPV ) that earns substantially all passive income and meets certain other criteria; a U.S. taxpayer (a U.S. Party ) would be eligible to claim a foreign tax credit for the payment attributable to the SPV s income if the payment were treated as a foreign income tax; the foreign payments attributable to the SPV s income are substantially greater than the foreign payments that would be required to be made if the U.S. Party had directly owned the assets owned by the SPV; a counterparty, or person related to a counterparty, receives a tax benefit under foreign tax law; the transaction involves a counterparty (the Counterparty ) other than the SPV that is unrelated to the U.S. Party and meets certain other criteria; and U.S. tax law and either the foreign country to which the payment attributable to the income of the SPV or a foreign country that confers a tax benefit on the Counterparty (or a person related to the Counterparty) treat certain aspects of the arrangement inconsistently, and such inconsistent treatment would materially affect the amount of income declared or credits claimed by the U.S. Party. 5 THE TEMPORARY REGULATIONS The Temporary Regulations 6 retain the six Conditions that were identified in the 2007 Proposed Regulations but make several revisions and add several new examples. The preamble to the Temporary Regulations also provides that the IRS will use all available tools under existing law to challenge transactions similar to those covered by the Temporary Regulations but occurring before the effective date. Under the Temporary Regulations, an arrangement is a structured passive investment arrangement (and accordingly, foreign payments attributable to it will generally be ineligible to be claimed as a foreign tax credit) if it meets the following six Conditions: 4 5 6 See CCA 200826036 (Feb. 29, 2008) (disallowing foreign tax credit on structured transaction under Section 269 of the Code and on the grounds that both the trust device used in the arrangement and the arrangement itself lacked economic substance). See generally Prop. Treas. Reg. 1.902-2(e)(5)(iv), 72 Fed. Reg. 15081 (Mar. 30, 2007). The 2007 Proposed Regulations also contained certain provisions relating to the treatment of net losses transferred among members of a group that is generally at least 80 percent owned by a U.S. person. See Prop. Treas. Reg. 1.902-2(e)(5)(iii). The IRS subsequently released a notice severing these provisions from the provisions applicable to structured passive investment arrangements. See Notice 2007-97, 2007-49 I.R.B. 1091. The Temporary Regulations also make various housekeeping changes to Treas. Reg. 1.901-1 to conform them to current law. -3-
1. SPV As under the 2007 Proposed Regulations, the Temporary Regulations provide that a structured passive investment arrangement must include an SPV. An entity is an SPV if it meets the following requirements: substantially all 7 of the entity s income, if any, is passive investment income, and substantially all of the entity s assets are assets held to produce such passive investment income; and there exists a purported foreign tax payment that is attributable to income of the entity, as determined by the laws of the country to which such payment is made that, were it an amount of tax paid, would be paid or accrued in a U.S. taxable year during which substantially all of the entity s income is passive investment income and substantially all of its assets are assets held to produce such passive investment income. 8 The Treasury Department has clarified that the foreign payment referenced above must relate to a U.S. tax year in which substantially all of the entity s income, if any, is passive and substantially all of its assets are held to produce passive income. Similar to the 2007 Proposed Regulations, the Temporary Regulations generally define passive investment income as dividends, interest, rents, royalties and other income that would be treated as foreign personal holding company income under Section 954(c) of the Internal Revenue Code of 1986 (the Code ), but with several modifications. For example, under both the 2007 Proposed Regulations and the Temporary Regulations, the exception from foreign personal holding company income for certain income earned by an entity engaged in an active banking, financing, insurance or similar business is to be applied at the entity level and income from transactions with a Counterparty (or person related to a Counterparty) is to be disregarded in this computation. The Temporary Regulations have added the following modifications: First, in order for an entity to exclude income that would be considered active banking, financing, insurance or similar business income, the entity must conduct substantial activity with respect to its business through its [own] employees. Second, in a change that makes the Temporary Regulations less restrictive than the 2007 Proposed Regulations, entities may treat income as active banking, financing, insurance or similar business income for this purpose if it is earned in any foreign 7 8 The term substantially all was not defined in the 2007 Proposed Regulations and remains undefined in the Temporary Regulations. This payment can include the entity s share of income that is attributed to the entity from a branch or lower-tier entity under the laws of the foreign country to which the payment is made. Moreover, this payment can include a payment that is attributable to income that the owner of the entity must take into account under the laws of the foreign country if that entity is a branch or pass-through entity under the laws of the foreign country, or a payment attributable to income of a lower-tier entity if that lower-tier entity is a branch or pass-through entity for U.S. tax purposes. Such a foreign payment does not include a withholding tax, however, that is imposed on distributions to a U.S. party. -4-
country, rather than only if it were earned in the SPV s home country under the general rules for active banking, financing, insurance or similar income. Under both the 2007 Proposed Regulations and the Temporary Regulations, income attributable to an equity interest in a subsidiary is treated as passive unless the parent is treated as a holding company. To qualify for holding company status, substantially all of that entity s assets must consist of 10 percent or greater interests (calculated by vote and value, except that certain preferred interests are not considered equity interests under these rules) in one or more subsidiaries, each of which must be engaged in an active trade or business (or itself be a holding company qualifying under these rules) and derive more than 50 percent of its gross income from that active trade or business. In addition, an equity interest in a subsidiary will generate passive investment income if substantially all of the risk of loss and opportunity for gain associated with that equity interest is not shared among the parties to the transaction (or parties related to the parties to the transaction). The Temporary Regulations clarify that a party does not share in the opportunity for gain and risk of loss if it acquires an equity interest through a sale-repurchase transaction or if that interest is treated as debt for U.S. tax purposes. 2. U.S. Party There must be a person that would otherwise be eligible to claim a credit for the foreign payment attributable to the income of the SPV if the foreign payment were treated as a foreign income tax. This requirement is identical to the 2007 Proposed Regulations. 3. Substantially More Credits Than Direct Investment The U.S. Party s proportionate share of the foreign payments attributable to income of the SPV must be (or be expected to be) substantially greater than the amount of credit, if any, that the U.S. Party could reasonably expect to claim if the U.S. Party had directly owned its proportionate share of the assets held by the SPV in a manner that would not subject those assets to net basis taxation. This Condition, as defined in the Temporary Regulations, reflects two significant modifications of the 2007 Proposed Regulations. The Temporary Regulations provide that the baseline credit amount for this determination is the U.S. party s proportionate share of the foreign payments attributable to the SPV (rather than the sum of all foreign payments attributable to the SPV). According to the preamble to the Temporary Regulations, this revision was made in response to concerns that were raised about the 2007 Proposed Regulations being overbroad in the case of an entity that has more than one equity owner. In addition, the Temporary Regulations exclude assets that are subject to a gross basis withholding tax from a U.S. Party s proportionate share of the assets in the SPV, rendering this Condition significantly more difficult to avoid than its predecessor in the 2007 Proposed Regulations. According to the preamble to the Temporary Regulations, this exclusion was added in partial response to a commentator s observation that the 2007 Proposed Regulations may have permitted a holder to avoid satisfying this condition by -5-
entering into a sale-repurchase transaction using an SPV that acquires passive assets subject to foreign withholding tax. 9 4. Foreign Tax Benefit This Condition is generally satisfied if the arrangement is reasonably expected to result in a tax benefit (such as a credit, deduction, loss or exclusion) that is available to the Counterparty (or a person related to the Counterparty) 10 under the tax law of the country where the Counterparty is subject to net basis taxation. Under the Temporary Regulations, unlike the 2007 Proposed Regulations, the required tax benefit available to the Counterparty must correspond to: (i) in any case where the foreign benefit is a credit, at least 10 percent of the U.S. Party s share of the foreign payment or (ii) in any case where the foreign benefit is a loss, deduction, exemption, exclusion or the like, at least 10 percent of the foreign base with respect to which the U.S. Party s share of the foreign payment is imposed. This change was, according to the preamble to the Temporary Regulations, intended to clarify that a joint venture that does not involve any duplication of tax benefits is not covered by the [T]emporary [R]egulations. 11 The Temporary Regulations also diverge from the 2007 Proposed Regulations in that a foreign tax benefit that is reasonably expected will satisfy this Condition under the Temporary Regulations, whereas a foreign tax benefit needed to actually be realized under the 2007 Proposed Regulations. The Temporary Regulations also provide several examples that illustrate how this provision operates. In one such example, 12 a U.S. Party and a subsidiary of that U.S. Party form a foreign partnership that loans all of its capital to a foreign affiliate of the U.S. Party in exchange for coupons and a note. The partnership then strips the coupons and sells them to a second partnership, which is owned by a thirdparty foreign bank and a wholly-owned subsidiary of the same third-party bank. Under local law, the partnership owned by the U.S. Party and its affiliate is considered to have a profit on the transaction equal to the sale price of the coupons. In addition, local law provides that the third-party bank and its subsidiary are entitled to immediately deduct the purchase price of the coupons and do not recognize additional income when they sell their interest to another third party. In such a case, the deduction and exemption correspond to more than 10 percent of the... base with respect to which the 100 percent share of the foreign payments that is attributable to the U.S. Party and its subsidiary was imposed. According to the 9 10 11 12 73 Fed. Reg. 40727, 40730-31. Parties are related under the Temporary Regulations if either (i) one person directly or indirectly owns stock (or an equity interest) possessing more than 50 percent of the value of the total value of the other person or (ii) the same person directly or indirectly owns stock (or an equity interest) possessing more than 50 percent of the value of both persons. 73 Fed. Reg. 40727, 40731. Temporary Regulations, Example 3. -6-
Preamble to the Temporary Regulations, this example clarifies that any duplication of tax benefits need not be direct. 13 In a second such example, 14 a foreign bank contributes cash in exchange for 100 percent of the common stock of a new corporation, and a U.S. Party makes a smaller cash contribution to the new corporation in exchange for securities issued by the new corporation. These securities are treated as equity for U.S. tax purposes but as debt under the tax law of the country where the corporation and foreign bank are subject to net basis taxation. The new corporation then loans this cash to a wholly-owned subsidiary of the foreign bank, which issues two notes to the new corporation: (i) a note paying fixed, noncontingent interest on an annual basis and (ii) a zero coupon note that pays contingent interest. The foreign country treats the contingent note as a note that accrues interest, although U.S. tax law does not require any current accrual on the contingent note. The new corporation distributes all of its income, after paying its foreign-country taxes, to the U.S. Party. Before the two notes mature, and pursuant to a prearranged plan, the foreign bank acquires the U.S. Party s interest in the new corporation for cash. The foreign country s tax law provides that the foreign bank is able to receive the contingent interest, after maturity, as a dividend without paying additional foreign-country tax. Under this example, the full amount of the new corporation s foreign-country income is considered the foreign base with respect to which the U.S. Party s share of the foreign payment is imposed. The Counterparty is also entitled to a tax benefit because it is entitled to receive the contingent interest without paying additional foreign country tax, as it wholly owns both the lender and the borrower entities. Accordingly, the amount of this foreign-country tax benefit is at least 10 percent of the foreign base with respect to which the U.S. Party s share of the foreign payment was imposed. Because the transaction in the example meets the other Conditions of the Temporary Regulations, the foreign payment is deemed to not be a compulsory payment. A third example 15 illustrates how a U.S. Party s share of a payment is calculated and illustrates where a foreign tax exemption is not a foreign tax benefit under the Temporary Regulations. In this example, a foreign corporation and a U.S. corporation contribute equal amounts of cash in exchange for equal shares in a new entity that is treated as a partnership for U.S. tax purposes and a corporation under the tax laws of the country where both the new entity and the foreign corporation are based. The new entity invests in assets that generate passive income, pays tax to the foreign country on its income and distributes equal dividends to the U.S. Party and the foreign corporation. Under the tax law of the country where both the new entity and the foreign corporation are subject to net basis tax, dividends can be paid from the new entity to the foreign corporation without becoming subject to additional tax. Such a distribution does not 13 14 15 73 Fed. Reg. 40727, 40731. Temporary Regulations, Example 5. Temporary Regulations, Example 10. -7-
correspond to any part of the foreign base with respect to which the U.S. Party s portion of the foreign payment was imposed and accordingly is not a foreign tax benefit. 5. Counterparty A Counterparty must also be involved in the transaction. Under the Temporary Regulations, a Counterparty is any person that owns (including indirect ownership) either an equity interest in, or assets of, the SPV, under the tax law applicable to such Counterparty. The SPV itself is not considered a Counterparty. In addition, the following entities are excluded from the definition of a counterparty: an entity in a brother-sister relationship with the U.S. Party where the U.S. parent owner (which must be a U.S. corporation or individual) of both entities owns at least 80 percent of the equity (through direct or indirect ownership) of each entity under U.S. tax law; and an entity that is at least 80 percent owned by the U.S. Party (as measured by equity ownership, and including indirect ownership) but only if the U.S. Party is a U.S. individual or corporation. The Temporary Regulations no longer contain the exclusion available under the 2007 Proposed Regulations for entities that did not own at least 10 percent of the equity of the SPV or 20 percent of the assets of the SPV. In addition, the Temporary Regulations, unlike the Proposed Regulations, do not exclude entities that are related to the U.S. Party. 16 Accordingly, the definition of a Counterparty is significantly broader under the Temporary Regulations than was its counterpart in the 2007 Proposed Regulations. 6. Inconsistent Treatment To satisfy this Condition, during one or more years when a transaction is in effect, the U.S. and the applicable foreign country 17 must treat one or more of the following aspects of the transaction differently under their respective tax systems: the classification of the SPV (or an entity with a direct or indirect ownership interest in the SPV) as a corporation (or other entity subject to entity-level tax), a partnership (or other flow-through entity) or a disregarded entity; the characterization of an instrument issued by the SPV (or an entity with a direct or indirect ownership interest in the SPV) to the U.S. party, the Counterparty or a person related to the U.S. Party or the Counterparty as debt, equity or an instrument that is disregarded; 16 17 The definition of a related party under the 2007 Proposed Regulations is consistent with the definition of a related party under the Temporary Regulations: Entities were related if one person owned more than 50 percent of the other person (as measured by value) or if a brother-sister relationship existed between the parties and the common parent owned more than 50 percent of both entities. Under the Temporary Regulations, an applicable foreign country is a country to which a foreign payment is made that is attributable to the income of the SPV or a country that confers a tax benefit on a Counterparty or a related person. -8-
the proportion of equity of the SPV (or an entity that directly or indirectly owns the SPV) that is owned by each of the U.S. Party and the Counterparty, either directly or indirectly; and the amount of taxable income of the SPV during one or more of the tax years during which the arrangement is in effect. In addition, however, under the Temporary Regulations, this Condition is only satisfied if (i) the amount of income recognized by the SPV, U.S. Party or a person related to the U.S. Party is materially less than the amount of income that would be recognized if the foreign treatment controlled for U.S. tax purposes or (ii) the amount of credits that would be claimed by the U.S. Party is materially greater than the credits that would be recognized if the foreign treatment controlled for U.S. tax purposes. Under the 2007 Proposed Regulations, this Condition merely required that the difference in treatment materially affect the U.S. tax results. EFFECTIVE DATE AND EXPIRATION The Temporary Regulations are generally effective for payments that, if considered an amount paid, would be considered paid or accrued under Treasury Regulations Section 1.901-2(f) by a U.S. or foreign person (the person on whom foreign law places legal liability for payment of the tax) in a taxable year ending on or after July 16, 2008. The Temporary Regulations are also effective with respect to foreign payments made by a partnership, trust or estate for which any partner or beneficiary would otherwise be eligible to claim a foreign tax credit with respect to payments that would be considered paid or accrued in the U.S. taxable years of the partnership, trust or estate ending with or within the taxable years of such partners or beneficiaries that end on or after July 16, 2008. With respect to foreign payments by a foreign corporation that has a domestic corporate shareholder, the Temporary Regulations also apply to such payments that would be considered paid or accrued in the foreign corporation s U.S. taxable years ending with or within taxable years of its domestic corporate shareholder ending on or after July 16, 2008. Accordingly, the Temporary Regulations could apply to some payments that were made before July 16, 2008. For transactions occurring in taxable years of the taxpayer ending before that date, the Preamble to the Temporary Regulations indicates that the IRS will continue to utilize all available tools under current law to challenge the U.S. tax results claimed in connection with these and other similar abusive arrangements, including the substance over form doctrine, the economic substance doctrine, debt-equity principles, tax ownership principles 18 and other provisions. The Temporary Regulations expire on July 15, 2011. 18 73 Fed. Reg. 40727, 40728. -9-
REQUEST FOR COMMENT AND PUBLIC HEARING The Treasury Department has also issued proposed regulations that are identical to the Temporary Regulations, and has scheduled a hearing on these new proposed regulations for December 11, 2008. The IRS and Treasury Department specifically requested comments on the following: how the administrative challenges associated with determining the amount of foreign tax that would be paid but for an arrangement where the foreign payments attributable to an entity that owns an SPV do not substantially exceed the foreign taxes that would have been paid by a controlled foreign corporation that owns the SPV in the absence of the arrangement ; 19 whether the finalized regulations should provide further guidance on the extent to which activities are conducted by a tested entity s own employees or on how employees that are seconded to a tested entity from an affiliate or supervised by employees of an affiliate should be treated; and the clarity and understandability of the Temporary Regulations. * * * Copyright Sullivan & Cromwell LLP 2008 19 Commentators had noted that such payments would effectively substitute for foreign taxes that would have been imposed on such a controlled foreign corporation. Although the IRS suggested that this observation raised important policy questions, the IRS also indicated that it had not been able to develop an administratively feasible way to implement this suggestion that would not ensure that potentially abusive structured arrangements were excluded from such an exception. -10-
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