On October 31, 2014, the IRS released CCA 201444039, which provides that a US taxpayer has “no support in the Code, the regulations, or sound tax policy” for including an amount of foreign income taxes paid by its foreign subsidiary in such subsidiary’s post-1986 foreign income tax pool when the taxes relate to a year prior to the ownership requirements of Code Section 902(c)(3)(B) being satisfied. In its request for guidance, the taxpayer argued that foreign taxes paid more than two years after the year to which the taxes relate must be taken into account in the year the tax is actually paid, even though none of the earnings to which the taxes relate are included in its post-1986 undistributed earnings pool. The IRS determined that the taxpayer erred in its application of the law and should have applied the law as in effect prior to the effective date of the Tax Reform Act of 1986.
In 2009, US corporation (USP), a parent of a US affiliated group, acquired all the shares of a foreign corporation (FP). At the time of the acquisition, FP owned all of the shares of foreign corporation 3 (FC3), which in turn owned all the shares of foreign corporation 4 (FC4). As a result, FP, FC3, and FC4 became CFCs in 2009.
Between 2008 and 2011, FC4 was assessed additional income taxes and interest by its home jurisdiction in relation to tax years 1994 through 2008. FC4 was actively contesting the tax assessments but was required to pay 50% of the total tax assessments during years 2008 through 2011. In 2010, USP recognized a deemed dividend inclusion from FC4 and claimed a foreign tax credit, which included a portion of the foreign income tax assessments relating to years prior to FC4 becoming a CFC.
Law and Analysis
To claim a deemed paid foreign income tax credit, a domestic corporation must satisfy the section 902(c)(3)(B) ownership requirements with respect to a foreign corporation and properly track such foreign corporation’s earnings and foreign income taxes paid or accrued. Section 902 and the Regulations issued thereunder require that undistributed earnings and foreign income taxes be separated into two categories: post-1986 undistributed earnings and foreign income tax pools and pre-1987 undistributed earnings and foreign income tax pools (including annual layers within the pre-1987 pool). Generally, a foreign corporation’s post-1986 foreign income tax pool includes foreign income taxes relating to tax years beginning after December 31, 1986. However, if the first day on which the foreign corporation satisfies the ownership requirements of section 902(c)(3)(B) is after December 31, 1986, the foreign corporation’s post-1986 foreign income tax pool begins on the first day of the taxable year in which such ownership requirements are met. In the ruling, FC4 was acquired by USP in 2009 and therefore, its post-1986 foreign income taxes were established beginning on January 1, 2009, which is the first year FC4 had a domestic shareholder entitled to compute an amount of foreign taxes deemed paid under section 902.
Section 902(c)(6) provides that distributions out of accumulated profits for taxable years beginning before the first taxable year taken into account in determining the post-1986 undistributed earnings are governed by section 902 as in effect
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5 Tax News and Developments December 2014
before the enactment of the Tax Reform Act of 1986. From an ordering perspective, dividends paid after December 31, 1986 are treated as being made first out of the post-1986 undistributed earnings to the extent thereof and any excess is then treated as being made out of pre-1987 undistributed earnings on a last in, first out ("LIFO") basis.
In 2010, USP recognized an income inclusion and computed its deemed paid foreign tax credit under section 902 (as provided for by Code Section 960). In the ruling request, the taxpayer unsuccessfully argued that Code Section 905(c) and the Regulations thereunder (which address foreign tax redeterminations) should apply with respect to the foreign income taxes paid in 2009. The taxpayer argued that the additional tax assessment with respect to 2002 paid in 2009 should increase FC4’s post-1986 foreign income taxes because the taxes were paid more than two years after the year to which the taxes relate. Thus, the taxpayer argued for an increase in FC4’s post-1986 foreign income tax pool for taxes relating to a year prior to meeting the ownership requirements under section 902(c)(3)(B).
The IRS rejected taxpayer’s argument pointing out that section 905(c), and the Regulations thereunder, were revised in 1997 by the Taxpayer Relief Act and do not apply to section 902 computations relating to pre-1987 foreign income tax pools. The IRS stated that section 902(c) expressly provides that the law in effect prior to the effective date of the Tax Reform Act of 1986 applies. The IRS further emphasized that, even if one were to disregard the position expressly set out in section 902(c) and the Regulations under that section, the taxpayer’s position is expressly contradicted by the section 905(c) temporary regulations in effect for 2008, 2009 and almost all of 2010. Moreover, the IRS expressly provided that the adjustment to pre-1987 undistributed earnings and foreign income taxes is consistent with the purpose of the foreign tax credit regime to alleviate double taxation of foreign source income. To rule otherwise, the IRS believed, “in addition to being squarely contradicted by the statutory and regulatory regime, is flatly inconsistent with the Congressional policy underlying the matching regime established by [S]ection 902.”
Accordingly, the IRS concluded that the foreign income taxes relating to taxable years 1994 through 2008, although paid in a post-1986 year, should be accounted for by adjusting the foreign corporation’s annual layer of pre-1987 foreign income taxes for the appropriate year.