U.S. Taxpayers with Foreign Operations and Investments Need to Examine Existing Arrangements to Ensure Compliance with the New Rules
On July 13, 2011, the IRS and Treasury Department issued final regulations that limit a U.S. person’s ability to take a foreign tax credit when a "structured passive investment arrangement" is involved. The final regulations modify slightly and make permanent the rules of temporary regulations that were issued in 2008 and that were set to expire on July 15, 2011. The final regulations take immediate effect, applying to foreign taxes paid on or after July 13, 2011, the date the final regulations were filed with the Federal Register. On July 14, 2011, the IRS and Treasury Department followed the final regulations with temporary and proposed regulations that supplement the final regulations regarding withholding taxes.
The final regulations generally retain the basic approach and structure of the 2008 temporary regulations. Under both the 2008 temporary regulations and the final regulations, six conditions are identified: (1) the existence of a special purpose vehicle which earns passive investment income or holds assets that produce passive investment income (the "SPV" condition), (2) a U.S. party eligible to claim a U.S. foreign tax credit (the "U.S. Party" condition), (3) the U.S. party’s proportionate share of foreign taxes under the arrangement is substantially greater than the amount the taxpayer would pay if the U.S. party directly owned the SPV’s assets (the "direct investment" condition), (4) the arrangement is reasonably expected to result in a more than de minimis foreign tax benefit to a counterparty (the "foreign tax benefit" condition), (5) the arrangement includes a counterparty that is subject to foreign income tax and that owns equity interests in or assets of the SPV (the "counterparty" condition), and (6) the United States and the relevant foreign country treat at least one of four identified aspects of the arrangement differently for tax purposes (the "inconsistent treatment" condition). Any arrangement that meets all six conditions is a structured passive investment arrangement, and foreign taxes attributable to the arrangement are not eligible for the U.S. foreign tax credit.
With a few exceptions, the IRS and Treasury Department rejected requests from taxpayers to relax or modify some of the more problematic rules in the temporary regulations. The final regulations make minor changes to:
- The definition of "passive investment income" to exclude certain income from personal services
- The definition of "counterparty" to exclude U.S. citizens and resident aliens
In addition, compared to the 2008 temporary regulations, the final regulations provide more guidance regarding how to apply the six conditions when multiple U.S. parties or counterparties are part of the arrangement.
The final regulations’ most significant change from the 2008 temporary regulations is to the definition of SPV, and the related "holding company" exception. These rules were significantly tightened. Although styled as a clarification, the holding company exception was re-written to require effectively any tiered entity structure to meet the regulation’s "qualified equity interest" requirement at each level; failure to meet this requirement at each level of a tiered structure will now cause one or more upper-tier entities in the tiered structure to become an SPV, even if all of the income earned by entities at the bottom of the tiered structure distributed up the chain is active income. In other words, an arrangement can be a structured passive investment arrangement, and therefore subject to loss of a foreign tax credit in the upper-tier entity, even if none of the income earned by any entity in the chain is considered "passive" for any other purpose of the Internal Revenue Code.
In addition, the final regulations significantly modified the 10% exception to the Foreign Tax Benefit condition by requiring that all of the counterparties be aggregated to determine if the 10% exception is satisfied.
Other changes to the holding company exception include, due to IRS and Treasury Department concern about the possibility of withholding tax being credited by both the U.S. party and the counterparty, elimination of the exclusion of withholding taxes in determining whether an entity is an SPV. That change to the final regulations was immediately followed by the issuance of proposed and temporary regulations that modify the SPV definition so 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. Finally, the final regulations provide new guidance regarding how one determines and measures whether the "opportunity of gain and risk of loss" requirement is met (e.g., generally, "facts and circumstances") and how one applies the tests in a tiered structure (e.g., generally by starting with the lowest-tier entity in the chain that satisfies the holding company exception and proceeding upward).
The final regulations contain two new examples to illustrate the changes: one that shows the application of the holding company exception when there are multiple U.S. parties or counterparties and one that shows the application of the revised foreign tax benefit condition to a tiered holding company structure.
Because the final regulations are effective immediately, any U.S. taxpayer that conducts foreign operations through a tiered structure should review that structure as soon as possible to determine whether the taxpayer’s activities and structure now run afoul of the revised rules. The final regulations, like the 2008 temporary regulations, are mechanistic and ignore the taxpayer’s intent. Accordingly, it is risky to assume that one does not have a structured passive investment arrangement simply because one has not affirmatively entered into transactions designed to boost foreign tax credits. Any U.S. taxpayer that pays foreign taxes, especially if it conducts activities through a tiered structure, has to apply the final regulations carefully to make sure that its activities comply with the final regulations.