On Wednesday, July 13, the Internal Revenue Service issued final regulations (T.D. 9535) under section 901 addressing the creditability of foreign taxes paid or accrued in connection with a structured passive investment arrangement (SPIA). According to the IRS, a SPIA is intentionally structured to create a foreign tax liability, when the purported underlying business transaction generally would have resulted in significantly less, or even no, foreign taxes. The regulations classify foreign taxes paid in connection with a SPIA as noncompulsory, and therefore non-creditable, taxes. An electronic version of the final regulations can be obtained here.
The initial SPIA regulations were proposed on March 30, 2007 (72 FR 15081). They defined a SPIA as an arrangement meeting six conditions: 1) a special purpose vehicle earning passive income (SPV); 2) a U.S. party entitled to claim a foreign tax credit for taxes paid by or on behalf of the SPV (the U.S. Party); 3) foreign tax “substantially greater than direct foreign investment” (the Direct Investment); 4) a foreign tax benefit (the Foreign Tax Benefit); 5) a counterparty or an affiliate of the counterparty (the Counterparty), which derives the foreign tax benefit; and 6) inconsistent U.S. and foreign tax treatment in selected areas (Inconsistent Treatment). Temporary regulations were later issued on July 16, 2008 (T.D. 9416). The temporary regulations modified some of the definitions in response to public comments and broadened some of the conditions.
The final regulations retain the basic approach of the proposed and temporary regulations. A SPIA is still an arrangement that satisfies the six conditions introduced in the proposed regulations. The final regulations have modified some of these conditions based on public comments and other modifications have been made based on perceived abuses. An electronic comparison of the final regulations with the temporary regulations can be obtained here.
Amendments to the Conditions
SPV - The SPV condition is met if the entity used in the arrangement meets two requirements. First, substantially all of the gross income must be attributable to passive investment income and substantially all of the entity’s assets must be held to produce such passive investment income. Second, there must be a payment to a foreign taxing authority attributable to the income of the SPV.
- Personal service contract income (as defined in section 954(c)(1)(H) is excluded from the passive income calculation for SPV status. This exclusion is based on the theory that services income is not derived from passive assets.
- Income attributable to equity interests in pass-through entities is passive unless the “holding company” exception applies.
The “holding company” exception from SPV status was modified in a number of respects.
- The “opportunity for gain and risk of loss” is explicitly based on “all the facts and circumstances.”
- Some clarification is provided relating to fact patterns involving multiple U.S. Parties. This change is supposed to ensure that only bona fide joint ventures qualify for the holding company exception. However, the final regulations do broaden the holding company exception so that multiple holders from the same U.S. Party do not all have to have to share the same risks in order to qualify.
- When a U.S. Party owns an interest in a purported SPV through a chain of entities, the holding company exception is applied at each level beginning with the lowest-tier entity.
- The withholding tax exception from the definition of a “tax” has been eliminated. The IRS was apparently concerned that taxpayers were using this exception to circumvent the regulations. The Treasury and IRS plan to issue additional guidance relating to withholding taxes.
- The final regulations accepted a comment that foreign taxes paid or accrued by a fiscally transparent entity (for U.S. federal tax purposes) should not be attributed to income of its owner(s). Therefore, in cases where a lower tier entity is liable for foreign taxes under foreign law, the determination of whether those payments are compulsory is made based on whether that entity, and not its owner, satisfies the SPV condition.
U.S. Party - This condition requires the participation of a U.S. person eligible to claim a credit under section 901(a), including a deemed paid credit under section 902 or section 960, for all or a portion of the foreign tax payment attributable to the income of the SPV. The final regulations rejected a recommendation that all members of an affiliated group filing a consolidated U.S. federal income tax return should be treated as a single U.S. Party. The final regulations adopted the temporary regulation’s language without change.
Direct Investment - This condition compares the actual or expected amount of the U.S. Party’s share of the foreign taxes as provided for in the arrangement with what that U.S. Party reasonably would expect to claim as a section 901(a) credit if the U.S. Party had directly owned its proportionate share of the assets which are actually owned by the SPV and had directly paid the foreign taxes on the income generated by such assets. The condition is met if the former amount is substantially greater than the latter. The preamble to the final regulations cites comments which state that this condition seems to always be met. The IRS rejected amendments or clarifications that would have made this condition inapplicable in certain non-abusive circumstances on the grounds of avoiding “administrative complexity and uncertainty.” The final regulations adopted the temporary regulation’s language without change.
Foreign Tax Benefit - This condition is met if the arrangement is reasonably expected to result in a tax benefit to a counterparty under the laws of a foreign country. A tax benefit includes, but is not limited to, a credit, deduction, loss, exemption, and exclusion. A credit is not, however, treated as a tax benefit for these purposes unless it corresponds to 10% or more of the U.S. Party’s share (for U.S. federal income tax purposes) of the foreign payment. Additionally, other non-credit tax benefits are not included as tax benefits for these purposes unless the other tax benefits correspond to 10% or more of the U.S. Party’s share (for U.S. federal income tax purposes) of the foreign base on which the foreign payment is imposed. The final regulations rejected comments on this condition, including comments comparing the temporary regulations with the initial proposed regulations where the condition provided far more clarity. Instead the final regulations compare the aggregate amount of foreign tax benefits available to all counterparties (and related persons) to the aggregate amount of the U.S. Party’s share of the foreign tax or the foreign tax base. Further, a foreign tax benefit does not correspond to the U.S. Party’s share of the foreign taxes in certain situations where a U.S. Party indirectly owns interests in an SPV that are treated as equity for both U.S. and foreign tax purposes.
Counterparty - The arrangement must involve a counterparty. A counterparty is defined as a person that is treated, under the laws of the foreign country in which the person is subjected to taxation as a resident or otherwise under a net basis taxation regime, as owning or acquiring, directly or indirectly, an equity interest in the SPV or the assets of the SPV. The final regulations excluded individuals who are U.S. citizens or resident aliens from the counterparty definition under the rationale that any reduction in foreign tax liability will result in an increase in U.S. federal income tax liability.
Inconsistent Treatment – The arrangement must involve the United States and the “applicable foreign country” treating one or more specific elements differently and the U.S. treatment must either 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. federal income tax purposes. The final regulations clarify the application of this condition to instances involving multiple U.S. Parties in the same transaction.
The final regulations were effective as of July 18, 2011.
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