In General: U.S. Efforts to Thwart Foreign Tax Credit Generator Arrangements

Several years ago a new tax avoidance (or “abusive” as the Service might phrase it) technique was identified by the Large and Mid-Size Business (LMSB) Division of the IRS in a field directive (LMSB-04-0208-003)(3/19/2008) on the subject of foreign tax credit (FTC) generators.

The FTC provisions in the Code  allow a U.S. taxpayer to claim a credit against its U.S. income tax liability for foreign taxes paid or accrued, directly or indirectly, with respect to its foreign source income. FTC generators are complex transactions that are designed to: (i) recover the foreign tax paid claimed as an FTC to avoid any foreign tax cost; or (ii) to eliminate the income that resulted in the FTC; or (iii) transactions which have elements of both (i) and (ii).  LMSB in its 2008 directive  noted that the FTC generator is causing a “significant drain” on the Treasury and also has resulted in the Treasury allocation substantial resources to combating transactions that are abusive. Such transactions are difficult to identify on a tax return including Schedule M-3 or Form 1118 (FTC-Corporations) but may be detected during an actual audit. The market for using FTC generators is strong in the financial services industry since these transactions “appear as a par of their general business operations” and are more difficult to identify. LMSB announced the formation of an issue management team to specifically address such transactions and coordinate their efforts throughout the Service and with the Appeals Division as well. On July 15, 2008, Treasury and the IRS issued final Regulations ( TD 9416 ) that were proposed in 2007  ("new Regulations") to address certain types of foreign tax credit generators. Two weeks earlier, on June 30,  2008, the IRS released CCA 200826036 (dated February 29, 2008), addressing a type of FTC transaction that was not specifically covered by the new Regulations.

The new Regulations to section 901 disallow FTCs (for foreign taxes paid), in connection with certain inappropriate “passive investment arrangements”, which arrangements, if they meet the six specified conditions contained in the regulations, artificially generate FTCs. See Treas. Reg. §1.901-2(e)(5). The final Regulations apply to foreign tax payments paid or accrued for tax years ending on or after the date of finalization (7/15/2008). Treas. Reg. §1.902-2(e)(5) provides that a FTC may only be claimed if it is involuntary within the criteria set in Treas. Reg. §1.901-2(a), which tests whether the payment of foreign taxes was still the produce of a  bona fide effort to minimize the impact of foreign taxes. 

The Regulations categorize three types of passive investment arrangements which involve a U.S. person and a foreign counterparty: (i) U.S. lender transactions; (ii) U.S. borrower transactions; and (iii) asset-holding transactions. In each situation the IRS claims that the U.S. person’s FTC benefit is shared by the parties through the pricing of the arrangement. See also CCA 200826036.

The six features that must be present to disallow the FTCs under the final Regulations are:

  1. The transaction uses a "special purpose vehicle” (SPV) entity, the income and assets of which are substantially all passive (under an expansive definition) and the income of which is subject to taxation in a foreign country, other than a withholding tax on its owners (regardless of whether the income is taxed to the SPV or its owners).
  2. From a U.S. federal income tax perspective, a U.S. person has an equity interest in the SPV and is thus able to claim a credit for the SPV's foreign tax liability.
  3. The tax cost to the SPV is greater than the foreign tax expense that would have been imposed on the U.S. investor if the U.S. investor owned its interest in the SPV's assets directly.
  4. A foreign person participates in the transaction by (under foreign law) owning at least 10% of the SPV's equity or acquiring (directly or indirectly) 20% of the SPV's assets.
  5. The structure results in a foreign tax benefit to the foreign person through a credit, deduction, exemption of income, or disregarded payment.
  6. The foreign tax credit claim of the U.S. person results directly from tax arbitrage between the United States and another country involving (a) hybrid entities, (b) hybrid instruments, (c) inconsistent identity of tax ownership, or (d) inconsistent measurement of an entity's taxable income

Recent Attempts to Thwart Application of Foreign Tax Credit Generators in Canada.

A good example or illustration in this area is a transaction that starts with a loan by a Canadian resident corporation to a resident of the U.S..Had the Canadian taxpayer loaned the amount directly to the nonresident, the interest income would have been subject to Canadian tax without any foreign tax being paid by application of treaty reduction. 

The FTC generator inserts a third party, a special purpose entity or SPV, which is generally a flow thru entity for U.S. tax purposes. A  Canadian nonresident, i.e., U.S domiciled corporation, will also invest in the partnership. The partnership then loans an amount (including the amount invested by the Canadian resident) to another member of the nonresident's corporate group. The loan results in  interest income in the partnership and an offsetting interest deduction for the borrower, so there is no net tax to the U.S. nonresident's corporate group. Instead of receiving interest income with no offsetting credit, the Canadian resident receives an allocation of income from the partnership and claims an FTC for its share of the foreign (U.S.) tax paid by the partnership. The Canadian tax savings are divided between the Canadian lender and the nonresident borrower through a reduced yield being given to the Canadian resident taxpayer on what is in substance a loan with a tax receivable adjustment.

Adverse Impact of FTC Generators on Canadian Treasury; Apparantly Not to the Tax Court of Canada in Canada Liimited

In addition to the concerns expressed by the U.S. Treasury, the Canadian Department of Finance has stated that Canada risks losing billions of dollars in tax revenue from the use of FTC generators.  It therefore has proposed amendments to the ITA (Income Tax Act) to stop the FTC generators for tax years ending after March 4, 2010. Canada also has decided to challenge the FTC generator by taking the issue to the courts. The first judicial review of the subject was recently decided by the Tax Court of Canada in Canada Limited v. The Queen(Case 4145356). 2011 TCC 220, Apr. 21, 2011.

A summary of the facts involve a subsidiary (S) of the Royal Bank of Canada. In 2003, S invested in a Delaware limited partnership, Crown Point Investments LP, for $400 million.  The general partner of Crown Point, Gaskell Management LLC (GM) , and the other limited partner of Crown Point (CP), were subsidiaries of Bank of America.  The U.S. limited partner subsidiary, CP, invested $1.2 billion while the U.S. subsidiary general partner, GM, contributed $15 million to Crown Point Investments LP’s capital. While organized as a limited partnership, Crown Point elected to be taxed as a corporation for U.S. tax purposes.

The Royal Bank’s subsidiary S, and the limited partner (CP), entered into a “repo agreement under which S had the right to require CP to purchase its limited partnership units in Crown Point for $400 million (comprising approximately 25% of the capital in the limited partnership) and GM had the right as well to acquire S’s.  Because of the repo arrangement, S’s investment in Crown Point was treated for U.S. tax purposes as a loan by S (again a Canadian subsidiary to the Royal Bank of Canada) to CP (again a U.S. subsidiary of the Bank of America) . The limited partnership,  Crown Point, made a loan of approximately $1.6 billion to Mecklenberg Park Inc.(MP), another subsidiary of Bank of America.

Under the Crown Point partnership agreement, S was entitled to a cash distribution from Crown Point equal to 4.73%  of the $400 million advanced to Crown Point. In 2003 Crown Point distributed approximately $6.1 millionin  cash to S. Under the limited partnership agreement, the appellant's share of the partnership’s net profit was the lesser of: (i) its pro rata share of net profit of the partnership (that is, total net profit x 25%); and (ii) the total cash distributed to S divided by (1 - the applicable tax rate).

In computing its Canadian tax liability for 2003, S included in its income approximately $9.4 million as its distributive share of partnership income and claimed foreign tax credits of approximately $3.2 which was its share of the foreign tax paid by Crown Point to the U.S. total interest income earned on the MP loan. In 2003 Crown Point earned interest income of $28.7M (U.S.) from theMP loan and paid U.S. tax of approx. $10M (U.S.). The Canadian Revenue Department disallowed the FTC of S and did not reduce the amount of S’s distributive share of the limited partnership’s income.

The first issue was to determine whether the entire limited partnership structure would be respected for Canadian ITA purposes; it was a hybrid entity for Canadian tax purposes since it was a corporation for U.S. income tax purposes. While the partnership rules in Canada resemble the treatment of a flow thru entity for U.S. income tax purposes, even for foreign based partnerships such as Crown Point, While there is no specific rule on partnerships and FTCs under the ITA, in Interpretation Bulletin IT-183 and its replacement, IT-270R3, the Canada Revenue Agency allows a partner to include its distributive share of the foreign taxes paid by a partnership of which it was a member in the computation of its FTC.

Stating that Canadian tax law and not U.S. tax law, would be determinative and that as such, the limited partnership was a partnership for Canadian income tax purposes and that S would have potential liability for Canadian taxes. Therefore, S’s income for 2003 was its distributive share of partnership income or approximately $9.4M. The Canadian Revenue Agency’s argument that its income should be the amount of cash distributed to S or $6.1M, i.e., the fixed return that S was entitled to receive.

Under ITA section 126, a Canadian taxpayer is entitled to claim a foreign tax credit for taxes “paid” to a foreign country on foreign source income. The government argued that because the taxpayer was not personally liable for the U.S. tax, i.e., the U.S. corporation (limited partnership) was, it could not claim FTCs in Canada. The Court rejected the idea that ITA section 126 required actual liability. The Court instead viewed, in accordance with the Supreme Court of Canada’s direction that the courts not interpret the ITA in a restrictive manner but to also consider the context or purpose for which the provision was adopted, that no actual liability requirement is implied on the use of the word “paid”  in section 126.

Since S was subject to U.S. tax as an economic matter on its U.S. source income, and even though CP was taxed as a separate entity for U.S. tax purposes, S should be treated as having the foreign taxes charged against the amount that was distributed to it. The Court viewed this outcome as consistent with a strong policy in avoiding double taxation.

The decision may be fair it does not directly address the FTC generator issue and would have been addressed presumably by a U.S. court were the facts of the case inverted. It is noteworthy that Canada’s GAAR provision was not addressed by the Court.

Stay tuned as to whether the Canadian Revenue Agency appeals Canada Limited to the Federal Court of Appeal.