Treasury and the IRS have issued temporary regulations under section 901 that are intended to preclude foreign tax credit generator transactions. The temporary regulations, which are effective as of July 16, 2008, modify proposed regulations that Treasury and the IRS issued in March 2007.
For some years now, Treasury and the IRS have scrutinized certain types of transactional structures that enable U.S. taxpayers to claim foreign tax credits. The proposed regulations addressed foreign tax credit generator transactions, which, in general, are passive investment transactions that make use of differences between U.S. tax law and foreign tax law, and result in a U.S. foreign tax credit. The proposed regulations set forth six criteria to determine whether foreign tax payments incurred in connection with these transactions would not be creditable against U.S. tax. For purposes of applying the criteria, the proposed regulations would have treated all foreign entities in which the same U.S. person had a direct or indirect interest of 80 percent as a single taxpayer. The temporary regulations issued in July 2008 do not include this rule.
The Temporary Regulations: Six Criteria for Structured Passive Investment Arrangements
The temporary regulations retain the structure of the proposed regulations by setting forth six criteria, but modify most of the criteria for determining disallowed transactions that are referred to as “structured passive investment arrangements.” Although all six criteria must be satisfied for a transaction to be a structured passive investment arrangement, it is not necessary for all six criteria to be satisfied in any one taxable year.
To be a structured passive investment arrangement, the arrangement must involve a special purpose vehicle (SPV). To be an SPV, an entity must meet two requirements: (1) Substantially all of its gross income (for U.S. tax purposes) must be attributable to passive investment income, and substantially all of its assets must be held to produce such passive investment income; and (2) a payment to a foreign government must be attributable to the income of the entity, as determined under the law of the foreign country.
The temporary regulations provide that passive investment income is income as defined in section 954(c), but with certain modifications. For example, passive investment income includes income received from related parties (disregarding the related party/same country exception under section 954(c)(3)). Income derived from an active financing business or an active insurance business may be excluded from passive investment income, but only if particular conditions are met. In contrast, income from a holding company’s equity interest in a lower-tier entity that is engaged in the active conduct of a trade or business, and that derives more than 50 percent of its gross income from the conduct of such trade or business, is generally not passive investment income, provided that the owners of the holding company share the opportunity for gain and risk of loss in connection with the holding company’s assets, and that the holding company has a 10 percent or greater interest (by vote and value) in the lower-tier entity. However, the temporary regulations clarify that this exception is not satisfied if one of the owners of the holding company is solely a creditor of the holding company by virtue of holding either a hybrid instrument that is treated as debt for U.S. tax purposes or a put option on the stock.
The temporary regulations adopt the second criterion from the proposed regulations without change. This criterion requires a U.S. party to be eligible to claim a foreign tax credit for all or a portion of a foreign payment attributable to the income of the SPV, provided that the foreign payment would be considered a payment of tax, absent the temporary regulations.
The third criterion provides that the U.S. party’s proportionate share of the foreign payments must be substantially greater than the amount of credits, if any, that the U.S. party to the arrangement would reasonably expect to claim under section 901(a) for foreign taxes generated by the U.S. party’s proportionate share of the SPV’s assets. The proposed regulations looked only to the overall amount of the foreign payments, rather than the U.S. party’s proportionate share of such payments. The amendment is intended to obtain appropriate results where more than one person owns an equity interest in the SPV.
The fourth criterion requires that the arrangement be reasonably expected to result in a credit, deduction, loss or other tax benefit under the laws of the foreign country, and that such benefit be available to a counterparty (as defined in connection with the fifth criterion). In contrast to the proposed regulations, the temporary regulations require the foreign tax benefit only to be reasonably expected, rather than intended or realized. Additionally, the temporary regulations amend the proposed regulations by requiring that a credit is a foreign tax benefit only if it corresponds to 10 percent or more of the U.S. party’s share (for U.S. tax purposes) of the foreign payment that is attributable to the income of the SPV. A deduction, loss or other tax benefit is only a foreign tax benefit for these purposes if it corresponds to 10 percent or more of the foreign base on which the U.S. party’s share of the foreign payment is imposed.
Under the fifth criterion, a structured passive investment arrangement must involve a counterparty. A counterparty is a person that is regarded as directly or indirectly owning an equity interest in or assets of the SPV under the tax laws of the foreign country in which the person is subject to net basis tax. Unlike the proposed regulations, the temporary regulations contain no equity ownership thresholds for this purpose. Additionally, the temporary regulations broaden the definition of counterparty by providing that the same U.S. person cannot directly or indirectly own more than 80 percent of both the counterparty and the U.S. party and that certain types of U.S. parties cannot own more 80 percent of the counterparty. In the proposed regulations, a counterparty could not be related to the U.S. party through a 50 percent or greater ownership share.
The sixth criterion addresses the tax arbitrage aspect of foreign tax credit generators. The temporary regulations require both the United States and a foreign country in which the SPV, the counterparty or a person related to the counterparty is subject to tax, to treat one or more of the following aspects of the arrangement differently: (1) the classification of the SPV; (2) the characterization as debt or equity, or the disregarding of an instrument issued by the SPV to the U.S. party or to the counterparty; or (3) the proportion of the equity of the SPV that is considered to be owned directly or indirectly by the U.S. party or the counterparty. These factors also apply to direct and indirect owners of the SPV. The temporary regulations clarify that the U.S. treatment of the relevant factor must materially increase the amount of the U.S. party’s foreign tax credits, or materially decrease the U.S. party’s income for U.S. tax purposes.
Although the temporary regulations reject a broad anti-abuse rule in favor of detailed criteria, the preamble notes that Treasury and the IRS will continue to scrutinize arrangements that do not fall within the letter of the temporary regulations, but are nevertheless inconsistent with the purpose of the foreign tax credit.