Enactment of several new foreign tax credit rules Anti-splitting rule Basis difference rule Other new foreign tax credit provisions

Enactment of several new foreign tax credit rules

Several new foreign tax credit provisions have recently been added to the Internal Revenue Code. These include:

  • the anti-splitting rule (new Section 909);
  • the basis difference rule (new Section 901(m));
  • the basket rule for treaty re-sourced items (new Section 904(d)(6)); and
  • the deemed paid credit rule with respect to Section 956 amounts (new Section 960(c)).

These new rules, signed into law on August 10 2010, may significantly affect multinationals' ability to utilise foreign tax credits.

Anti-splitting rule

The anti-splitting rule set out in Section 909 may be the most attention-grabbing of the new foreign tax credit provisions, because it provides for a major change in foreign tax credit law while lacking clear indications of how it is to apply in many situations. Section 909 provides that:

"If there is a foreign tax credit splitting event with respect to a foreign income tax paid or accrued by the taxpayer, such tax shall not be taken into account for purposes of this title before the taxable year in which the related income is taken into account under this chapter by the taxpayer."

Similarly, if the foreign tax credit splitting event relates to a Section 902 or Section 960 credit (with respect to a 'deemed paid' tax), the tax is not taken into account until the related income is taken into account for US tax purposes by either the taxpayer or the Section 902 corporation that paid or accrued the taxes. Thus, the rule defers (at least potentially) rather than denies credits, and technically also applies to deductions for foreign taxes.

A foreign tax credit splitting event occurs if a covered person takes related income into account. In other words, it occurs when the foreign income tax and related income are attributed to different but related persons for US tax purposes. A 'covered person' is defined as a person related to the taxpayer by at least 10% direct or indirect ownership, a person described in Sections 267(b) or 707(b), or any other person specified by the Treasury. The Treasury is "anticipated" to exercise this authority to treat unrelated persons as covered persons with respect to abusive sale and repurchase transactions and other abusive situations, according to the technical explanation.(1)

However, the real problem with the new anti-splitting rule is the identification of 'related income', which is defined (rather unhelpfully) in the statute as the income related to a particular tax. The technical explanation gives slightly more guidance than this circular definition, clarifying that related income is determined under US tax principles rather than by following a foreign law's perception of the foreign tax base. Thus, when foreign law perceives a dividend but US law perceives a return of capital, foreign law sees a loss surrender that US law does not recognise or an entity disregarded for US purposes makes distribution to its parent, Section 909 follows the US concept of whether there is income, which entity has the income and to which income the foreign taxes relates.

An example of a hybrid instrument (debt for foreign purposes, equity for US purposes) in the technical explanation illustrates this point. In the example, US tax law perceives the related income as being of a different type, and belonging to a different entity, compared to the foreign law's view of the tax base. Similarly, Treasury officials have strongly implied that Section 909 will apply to UK loss-sharing situations.(2) In those fact patterns, a UK subsidiary typically surrenders a loss to a related entity, then pays UK tax in a later year. US tax law sees no (or less) income in the surrendering subsidiary's hands in the later year (because US tax law does not recognise the loss surrender and treats the surrendering subsidiary as being able to use the loss to reduce income in the later year). The question under Section 909 is which income is related to the later year's UK tax.

Because 'related income' for Section 909 means the US view and not the foreign tax base, and because related income may belong to a different entity, in a different year and be of a different type from that perceived by foreign law, it may not be clear in all situations exactly what the related income is. The IRS view of 'related income' may be hard for taxpayers to predict for particular situations, and that may lead to uncertainty and FIN48 compliance issues. The determination of related income is crucial for the application of Section 909, which applies only if related income is taken into account by a covered person, and defers tax until that related income is taken into account by the taxpayer or the relevant Section 902 corporation for US tax purposes.

Once related income is identified, there are further administrative questions as to how to determine when such income is taken into account by the taxpayer or the Section 902 corporation. For example, if there is a foreign tax credit splitting event and the related income is two levels below the US taxpayer, in a second-tier controlled foreign corporation (CFC), how should the taxpayer determine which distributions or subpart F inclusions from the second-tier CFC include the related income? An IRS official has said that guidance may provide stacking or ordering conventions, or other rules, to help to identify when the related income has reached the US taxpayer (or Section 902 corporation) for Section 909 purposes.(3)

Section 909 applies to foreign taxes paid or accrued in taxable years beginning after December 31 2010. It also applies, for the purposes of applying Sections 902 and 960 to periods after such date, to foreign taxes deemed paid or accrued under Sections 902(a) or 960 in taxable years beginning after such date, even if such taxes were paid or accrued before 2011 (except that it will not apply to such pre-2011 taxes for purposes of determining earnings and profits under Section 964(a)). In other words, for taxable years beginning after 2010, Section 909 applies to the foreign tax pools of Section 902 corporations and controlled foreign corporations, even with respect to foreign taxes paid or accrued in earlier years. Thus, Section 909 can affect a multinational's calculation of its future Section 902 and 960 credits as soon as it takes effect in 2011, even with respect to foreign taxes paid or accrued before 2011.

Persons familiar with the current foreign tax credit rules will note that Section 909 represents a departure from the approach of the current regulations. The legal liability regulations define the 'taxpayer' eligible for foreign tax credits as the person who has legal liability for the foreign taxes under foreign law.(4) Proposed legal liability regulations refine that thought to state that the person with legal liability is the person that takes the income into account for foreign law purposes or (in the case of Section 903 in lieu taxes) the person that owns the foreign tax base.(5) In contrast, Section 909's identification of income and association of income with foreign taxes are determined under US tax law principles rather than foreign law.

When Section 909 takes effect in 2011, both it and the current final legal liability regulations(6) will apply to foreign tax credit splitting events. In the case of such an event, claiming a foreign tax credit will require the taxpayer both to show legal liability under foreign law for the foreign tax and to take the related income into account for US tax purposes. The fate of the proposed legal liability regulations is uncertain, although many of those regulations' provisions are not made redundant by Section 909. For example, the proposed provision that the taxpayer is the person that takes the foreign tax base into account for foreign tax purposes could still be finalised, and could be applied alongside Section 909's rules. It is also not clear what effect, if any, Section 909 will have on potential finalisation of proposed regulations under the compulsory payment rule. Those regulations are currently elective for taxpayers and provide that a US-owned foreign group, connected by at least 80% ownership, is treated as one taxpayer for purposes of the compulsory payment rule.(7) One of the examples in the proposed regulations addresses a loss-sharing case that will also likely be addressed by Section 909.

An IRS official has predicted that the IRS will issue guidance on Section 909 and some of the other recently enacted provisions by December 2010. The same official invited the public to comment on which issues are most in need of early guidance, under the theory that not all issues can be addressed by December.(8)

Basis difference rule

Section 901(m) is entitled "Denial of foreign tax credit with respect to foreign income not subject to United States taxation by reason of covered asset acquisitions". The title highlights its purpose: it is aimed at fact patterns where no double taxation occurs because a foreign country taxes income that the US tax system does not perceive due to a higher basis for US purposes (leading to higher depreciation deductions or lower gain under US tax law compared to foreign tax law).

Section 901(m) provides that in the case of a covered asset acquisition, the disqualified portion of a foreign income tax that is determined with respect to income or gain attributable to the relevant foreign assets is not taken into account under Sections 901(a), 902 or 960. A 'covered asset acquisition' is defined as any of the following:

  • a qualified stock purchase under Section 338(d)(3) (meaning that stock with at least 80% of a corporation's vote and value is purchased within 12 months), to which a Section 338(a) election applies;
  • any transaction treated as an asset acquisition under Chapter 1 of the US Code but as a stock acquisition (or disregarded) under foreign law;
  • acquisition of a partnership interest if a Section 754 election is in effect; or
  • "to the extent provided by the Secretary, any other similar transaction".(9)

For any covered asset acquisition, the disqualified portion of a foreign tax is the percentage derived from the ratio of the aggregate basis differences allocable to the taxable year for all relevant foreign assets divided by the income (attributable to the relevant assets) on which the foreign income tax is determined.(10) If the taxpayer fails to substantiate such income adequately, the IRS may determine the income by dividing the income tax by the highest relevant foreign tax rate. The denominator of this percentage-yielding fraction is the foreign-law-determined foreign tax base.

However, the numerator is determined under US tax law. A basis difference, for this purpose, is the excess of adjusted basis immediately after the covered asset acquisition over adjusted basis immediately before the covered asset acquisition, for any relevant asset.(11) Negative basis differences are also taken into account.(12) Basis differences are allocated among taxable years "using the applicable cost recovery method" under Chapter 1 of the US Code.(13) If a relevant foreign asset is disposed of, its remaining, unused basis difference is taken into account for the year of disposition.(14)

A 'relevant foreign asset' means, for any covered asset acquisition, any asset (including intangibles) with respect to that acquisition if income, deduction, gain, or loss attributable to the asset is taken into account in determining the foreign income tax.(15) Circularly, this is the foreign income tax determined on the income attributable to the relevant foreign assets.(16)

The idea is to determine how much foreign tax is imposed on income that is not included in the US tax base by reason of basis differences. Generally, a higher denominator in the disqualified-portion fraction, coupled with lower foreign taxes in the multiplicand, is more taxpayer favourable. The statute and the technical explanation are not entirely clear as to how the denominator should be calculated. The code language states that the denominator is the income that is attributable to the relevant assets and is subject to foreign tax.(17) That sounds as if one might need to distinguish which part of the foreign tax base is "attributable to the relevant assets". However, the example in the technical explanation includes all of the taxpayer's foreign taxable income in its calculation, without distinguishing between income attributable to the two different assets in the example and without stating that both assets are used in the same business (which presumably could have meant that the same income was attributable to both assets). The fact that negative basis differences can be taken into account implies that some aggregation is possible, but the fact that the disqualified portion is determined "for any covered asset acquisition" and (especially) the reference to income attributable to the relevant foreign assets implies that there may be some limits to such aggregation.

Including all of a taxpayer's foreign income (from the relevant country) could make a difference in the calculation, as illustrated in the following example. Suppose that a taxpayer's CFC conducts both a manufacturing business and a farming business in country X. Country X taxes the CFC's manufacturing income at 35% and its farming income at 15%. Assume that a covered asset acquisition occurs (eg, a Section 338(a) election relating to the purchase of an unrelated foreign corporation). As a result of this acquisition, the CFC obtains two pieces of equipment, which are the relevant assets for purposes of Section 901(m). If both pieces of equipment are used in manufacturing, the disqualified portion of the tax should theoretically be higher than if both are used to generate farming income. That should be the mathematical result if "income attributable to the relevant assets" is limited to income of the same type generated by the assets, or income subject to the same tax rate as income of that type. However, if all of the CFC's income is treated as attributable to the relevant assets, as in the example in the technical explanation, then the disqualified portion of the tax is essentially calculated using a weighted average of the 35% and 15% tax rates, regardless of which income the assets actually produce. This is a taxpayer-favourable result if the assets are used in manufacturing and a taxpayer-disfavourable result if both are used in farming. Presumably, guidance on how to determine 'income attributable to the relevant assets' will be forthcoming.

A further example can be derived from Notice 2004-20. The notice describes a situation in which X sells foreign company Target's stock to Midco. Midco makes a Section 338 election, resulting in a stepped-up basis for Target's assets. Midco then liquidates Target (or checks the box for Target), and receives Target's assets with the stepped-up basis. Soon thereafter, Midco sells Target's assets to Y. The foreign country in which Target is a resident taxes the gain from the asset sale. The foreign-perceived gain is higher than the US-perceived gain because of the difference in the assets' bases for US and foreign purposes after the US basis step-up. In the notice's example, there is no gain on the asset sale for US tax purposes. Midco claims a foreign tax credit for the foreign taxes paid on the gain.(18) The offensive aspects of this situation, from a US tax perspective, are that Midco engages in the purchase and sale solely to obtain US tax benefits and that foreign tax credits are claimed without any actual double taxation, because no US tax is imposed on the gain perceived by the foreign country.

The notice states that the transaction does not produce the claimed US tax benefits, and that "[t]he Service will challenge the purported tax results... by applying principles of existing law". The transaction described in Notice 2004-20 was probably one of the fact patterns at which new Section 901(m) was aimed, and the new rule should indeed apply to this situation. Under Section 901(m), Notice 2004-20's facts present a covered asset acquisition because there is a Section 338(a) election with respect to a qualified stock purchase (and this is also likely to be a transaction treated as an asset acquisition by the United States and as a stock purchase by the foreign country). The disqualified portion of the foreign tax is essentially the foreign tax for the year multiplied by a fraction of which the basis difference allocable to the year is the numerator and the income attributable to the relevant assets for the year is the denominator. The denominator is determined based on the foreign law's perception of income. However, because income attributable to the assets is not defined in the statute or the technical explanation, it is not entirely clear which items of Midco's foreign-perceived income belong in the denominator. The denominator could include only foreign-perceived gain from the sale of Target's assets, or foreign-perceived income and subject to foreign tax at the same rate as the gain, or foreign-perceived gain from all of Midco's asset sales that year or from all of Midco's sales of similar assets (eg, assets used in related industries) or all of Midco's foreign-perceived income and gains that are subject to foreign tax. The answer could make a big difference to the amount of disqualified tax.

Unlike the anti-splitting rule, the basis difference rule denies rather than defers foreign tax credits. However, foreign tax credits denied by reason of new Section 901(m) may be deducted even if the taxpayer elects to claim credits for foreign taxes for the year.(19) This may be a sign that Congress recognised that Section 901(m) could potentially reach some non-abusive situations. Section 901(m) gives the IRS authority to issue necessary or appropriate guidance, including guidance exempting certain covered asset acquisitions and relevant foreign assets with de minimis basis differences. Section 901(m) applies to covered asset acquisitions after December 31 2010, but not to such acquisitions between unrelated persons that are pursuant to a written agreement binding on January 1 2011, described in a ruling request submitted before July 30 2010 or described on or before January 1 2011 in public announcement or a Securities and Exchange Commission filing.

Other new foreign tax credit provisions

The new provisions also address deemed paid foreign taxes associated with Section 956 inclusions. New Section 960(c) of the code provides that the amount of foreign taxes deemed paid by a domestic corporation by reason of a Section 951(a)(1)(B) inclusion (a Section 956 inclusion relating to investments in US property) attributable to earnings and profits of a foreign corporation that is a member of a qualified group (under Section 902(b)) of such domestic corporation shall not exceed the amount of foreign taxes that would have been deemed paid by the domestic corporation if the amount of the inclusion had been distributed in cash from the foreign corporation up the chain of ownership to the domestic corporation. The amount of the hypothetical deemed paid credit is determined without regard to foreign taxes that would have been imposed on a cash distribution.(20) Section 960(c) also grants the Treasury authority to issue guidance, including guidance to "prevent the inappropriate use of the foreign corporation's foreign income taxes not deemed paid by reason of" that provision.(21) The new provision applies to acquisitions of US property (within the meaning of Section 956(c)) after December 31 2010.

Another new provision provides for separate basketing of items re-sourced under treaty provisions. New Section 904(d)(6) resembles Section 904(h)(10), except that its application is not limited to US-owned foreign corporations. Section 904(d)(6) provides that if an item would be treated as US source, except for a treaty provision that provides foreign source treatment, and the taxpayer elects to apply the treaty rule to treat the item as foreign source, then Sections 904(a), (b) and (c) and Sections 902, 907 and 960 apply separately to that item. In other words, there is separate basketing for each item. 'Item' is not defined in the statute, but the Treasury is granted authority to issue guidance on aggregating "related items of income".(22) For purposes of Section 904(h)(10), which provides a similar basketing rule for treaty re-sourced 'amounts' rather than 'items', there is a separate basket "for amounts...with respect to each treaty under which the taxpayer has claimed benefits and, within each treaty, to each separate category of income".(23) The Treasury could take a similar approach for Section 904(d)(6), or might choose a different aggregation rule. Section 904(d)(6) applies to taxable years beginning after August 10 2010 (ie, taxable years beginning after the date of enactment). It does not apply to any income item to which Section 904(h)(10) or Section 865(h) applies.

The newly enacted provisions also include a repeal of the 80/20 rule of Section 861(a)(1)(A), with a grandfather rule for certain corporations meeting the 80% foreign business requirement for the last taxable year beginning before 2011. A modification of the affiliated group rule for purposes of allocating interest expense is also among the new code rules.(24)

For further information on this topic please contact Rebecca Rosenberg at Caplin & Drysdale by telephone (+1 202 862 5000), fax (+1 202 429 3301) or email (rir@capdale.com).



(1) Joint Committee on Taxation, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to HR 1586, scheduled for consideration by the House of Representations on August 10 2010, JCX-46-10 ('technical explanation') .


(2) See comments by Jose Murillo, reported in Sheppard, "News Analysis: Your Advanced Course in Pending Foreign Tax Credit Tighteners", 2010 TNT 140-2, July 22, 2010; remarks of Manal Corwin, international tax counsel, US Treasury Department, American Bar Association Tax Section Joint Meeting, Joint International Developments Panel, September 24 2010.)

(3) See comments of Barbara Felker at DC Bar Tax Section lunch, September 15 2010.

(4) Treas Reg § 1.901-2(f).


(5) Prop Treas Reg § 1.901-2(f).


(6) Treas Reg § 1.901-2(f).


(7) Prop Treas Reg § 1.901-2(e), see also Notice 2007-95 (taxpayers may elect to apply the proposed regulations.

(8) See comments of Barbara Felker at DC Bar Tax Section lunch, September 15 2010; see also Sapirie, "Early FTC Guidance Coming by Year's End, Officials Say," Tax Notes, September 16 2010, 2010 TNT 179-1.

(9) Section 901(m)(2).

(10) Section 901(m)(3)(A).

(11) Section 901(m)(3)(C).

(12) Id.

(13) Section 901(m)(3)(B).

(14) Id.

(15) Section 901(m)(4).

(16) Section 901(m)(4), Section 901(m)(1).)


(17) See Section 901(m)(3)(A)(ii) (the denominator is the "income on which the foreign tax referred to in paragraph (1) is determined") and Section 901(m)(1) ("foreign tax determined with respect to the income or gain attributable to the relevant foreign assets").


(18) Alternatively, rather than liquidating Target or checking the box for it, Midco causes Target to sell Target's assets. Midco then receives a dividend from Target and claims a Section 902 credit for the foreign taxes that Target pays or accrues on the asset sale. See Notice 2004-20.

(19) Section 901(m) is a thus a little more lenient than Notice 2004-20 in that the former allows a possible deduction for the foreign taxes, while the latter implies that the foreign taxes could be disregarded entirely for US tax purposes. Section 901(m) could be interpreted as overriding Notice 2004-20, where both apply.

(20) Section 960(c)(1).

(21) Section 960(c)(2).

(22) Section 904(d)(6)(C).

(23) See Treas Reg Section 1.904-5(m)(7).

(24) See Section 864(e)(5)(A).

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