On March 29, 2007, the Treasury Department published new proposed regulations dealing with foreign tax credits. Following on the heels of earlier proposed regulations (issued in August of last year), the proposed regulations represent an attempt by the government to craft technical rules that will prevent US taxpayers from arbitraging the difference between US and foreign tax laws to claim foreign tax credits that may also provide a benefit to a foreign taxpayer under its own tax regime.
The first notable aspect of the proposed regulations is that they depart from the traditional notion that a tax will be treated as “compulsory” and, hence, creditable, even when it results from a structure that is designed to maximize rather than minimize foreign taxes. While the scope of the present rule has never been entirely clear, it provides that a taxpayer “is not required to 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 for tax.” Treas. Reg. § 1.901-2(e)(5)(i). The proposed regulations provide an exception to this general rule by requiring that certain payments be treated as noncompulsory if they arise from certain structured passive investment arrangements which possess six characteristics described in the regulations. Prop. Reg. 1.901-2(e)(5)(iv).
General Approach of Proposed Regulations
The proposed regulations are remarkably intricate in their approach. There are six conditions that must be satisfied, an additional seven terms that are defined, and special rules that are created for “holding companies” that have substantially all of their assets in the form of lower-tier entities. Without attempting to recapitulate the regulations in all of their complexity, the broad outline of the structures to which they will relate is as follows:
1. The transaction is structured through the use of an entity (which for this purpose includes a legal entity that is otherwise disregarded for U.S. tax purposes);
2. A U.S. person and an unrelated foreign person (the “counterparty”) each have substantial investments in the entity;
3. Substantially all the assets of the entity are passive assets, which term generally does not include operating businesses or substantial voting equity investments (other than certain preferred stock) in subsidiaries that primarily consist of operating businesses;
4. The entity pays foreign taxes in an amount which exceeds any withholding tax that would apply to a direct investment by the U.S. person in the underlying assets;
5. Some element of the transaction (e.g., the classification of an instrument as debt or equity, the classification of an entity as fiscally transparent or non-transparent, or the ownership of an interest in the entity) is treated differently for U.S. tax purposes and foreign tax purposes; and
6. The counterparty or a person related to the counterparty claims some form of benefit on account of the payment of tax by the entity.
Controversial Aspects of Proposed Regulations
Aside from their complexity, several aspects of the proposed regulations are worthy of specific comment. It is, for example, hard to understand why the government has chosen to limit these regulations to transactions involving unrelated foreign “counterparties.” The government would certainly be aware that it is easier to structure internal transactions than transactions with unrelated parties. Thus, it appears that there must have been an assumption that these kinds of transactions simply could not accomplish the desired results if engaged in between related parties. Yet this thought seems demonstrably false. First of all, one need only consider the situation of a foreign-parented U.S. corporation to see how it could be possible to doubledip foreign tax credits without involving an unrelated counterparty. And even in the context of U.S. parented multinationals, one can envision transactions in which internal structures otherwise similar to those described in the proposed regulations would be used to separate taxes from the related income (one of the precise concerns that the regulations issued in August of last year were trying to address).
Additionally, it is curious that the government has chosen to attack this kind of arbitrage (the benefit for the payment of a foreign tax being claimed both in the United States and in a foreign country) via the notion that the tax is not compulsory. The critical element which impacts the U.S. fisc is not so much the structured element of the transaction but rather the fact that a foreign tax credit (a provision of the Internal Revenue Code meant to prevent double taxation) is being granted in a situation where the cost of the foreign tax is (at least arguably) borne by another person. Against this backdrop, one might expect that the government would have addressed the problem via an interpretation or expansion of the existing subsidy rules (currently set forth in Treas. Reg. § 1.901-2(e)(3)) to apply in any situation where the laws of the foreign country whose taxes are in issue will give a tax benefit to another party on account of taxes paid by a particular entity. Under the proposed regulations, however, this is only one of six conditions that must be met to render the tax noncreditable.
Another interesting aspect of the proposed regulations is that they apply regardless of where the foreign counterparty claims a foreign tax benefit. Thus if a U.S. company and a French counterparty form an SPV in Italy that pays Italian taxes, the regulation can still apply if the French company gets a tax benefit in France based on the payment of Italian taxes. In this regard the proposed regulations are broader than what would have resulted if the government had attacked the problem by expanding the subsidy rules of the existing regulations as described above – in which case a tax could be disallowed only to the extent that it provided a tax benefit under rules of the same country to which the tax was initially paid. This discrepancy poses an interesting philosophical question. On the one hand it is true that highly structured deals such as those that the government is targeting with these proposed regulations drain the U.S. fisc and seem to provide little tangible economic benefit to the world at large. On the other hand, it is a drastic change in U.S. tax policy to allow treatment of an amount that would otherwise be creditable as a tax payment to one foreign country (Italy, in the example above) to depend upon the consequences of a transaction in another foreign country (France, in the example above). In general, U.S. tax consequences are entirely a question of domestic law. It is only in very specific circumstances (such as the technical taxpayer rules of Treas. Reg. § 1.901-2(f) that were revised last August) that the U.S. even looks to the tax laws of the foreign country where a transaction takes place or an entity is incorporated in determining the U.S. tax consequences of the transaction.
The closest analogue to these proposed regulations appears to be the “branch rules” of Treas. Reg. § 1.954-3(c) (which effectively compares the tax rate in a company’s home country to the tax rate in a country where it operates as a branch). In that case, however, the relevance of the third country for U.S. tax purposes seems easier to articulate (because a primary purpose of subpart F is to impose U.S. tax on mobile income that is escaping foreign taxation). In addition, the application of subpart F rules generally do not implicate any provisions of a U.S. tax treaty, while most such treaties do include a provisions regarding relief from double taxation under which the U.S. is obligated to give a credit for taxes paid to the treaty partner. A regulation which purports to disallow such credits based on in a third country certainly raises novel questions of treaty compliance.
Given the complexity of these proposed regulations and the controversy that they are sure to stir, it appears likely that substantial revisions may be made before the regulations are adopted as final. Thus, the final chapter on these issues is clearly yet to be written.
This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.