New Foreign Tax Credit Regs Address Structured Passive Investment Arrangements

The Internal Revenue Service and Treasury on July 15 released temporary regulations addressing the requirement for a payment of foreign taxes to be “compulsory” in order to be creditable, by treating taxes attributable to certain highly structured passive arrangements (SPIAs) as noncompulsory. The regulations generally do not apply to transactions between entities that are at least 80 percent owned (by value) by the same U.S. corporation, U.S. citizen, or resident alien, but may apply to transactions between related entities sharing less ownership or between related entities owned by a foreign person. In contrast, the proposed regulations generally do not apply to arrangements solely between or among related parties.

The regulations (Treasury reg. section 1.901-2T(e)(5)(iv)) address SPIAs, which the government claims result in inappropriate foreign taxes through a highly engineered structure. In the government’s view, a SPIA results in inappropriate taxes because the parties allegedly could have achieved the basic economics of the arrangement with significantly less, or even no, foreign taxes for a U.S. taxpayer, and the SPIA allegedly allows a foreign participant to achieve duplicative foreign tax benefits. For example, a loan to a U.S. bank from a foreign bank resident in a country with a treaty that allows an exemption from U.S. withholding on interest generally does not result in foreign taxes that are creditable against U.S. tax. However, if the U.S. bank had contributed funds to a foreign entity subject to income tax in its country of residence, the foreign entity lent money to the U.S. bank’s foreign subsidiaries as well as third parties, and the U.S. bank made a transfer of equity in the entity to a foreign bank that is treated as a secured loan for U.S. federal tax purposes and as a true sale for foreign tax purposes, then the arrangement may have resulted in foreign taxes creditable against U.S. tax, subject to the SPIA regulations (and various applicable rules under current law, including the sham transaction doctrine).

The regulations identify six conditions that, if satisfied, result in foreign tax payments attributable to the arrangement (foreign payments) being categorized as noncompulsory payments, and thus not treated as an amount of tax paid for purposes of claiming a foreign tax credit. (The regulations do not address whether such taxes are deductible or result in a reduction of earnings and profits.) While the conditions are highly detailed, they can broadly be summarized as follows:

• Special Purpose Vehicle (SPV) – The arrangement being analyzed uses an entity that meets the following two requirements: (1) substantially all of the entity’s gross income (for U.S. federal tax purposes) is attributable to passive income and substantially all of its assets are assets held to produce such passive investment income, and (2) there is a purported foreign tax payment attributable to the entity’s income.
• U.S. Party – A person would be eligible to claim a credit under section 901, including for taxes deemed paid under section 902 or section 960, for all or a portion of the foreign payments attributable to the SPV.
• Direct Investment – The U.S. party’s proportionate share of the foreign payments attributable to the SPV is (or is expected to be) substantially higher than the amount of credits (if any) that the U.S. party reasonably would expect to be eligible to claim under section 901 for foreign taxes attributable to income generated by the U.S. party’s proportionate share of the assets owned by the SPV if the U.S. party “directly” owned such assets. For this purpose, “direct” ownership does not include ownership through a branch or any other arrangement that would result in the income being subject to net basis tax in the foreign country to which the payment is made. Proportionate ownership is determined by reference to the value of debt and equity investments in the SPV (subject to adjustment with respect to assets producing income subject to gross basis withholding tax).
• Foreign Tax Benefit – The arrangement being tested is reasonably expected to result in a foreign tax benefit available to a counterparty (or a person related to a counterparty). However, a foreign tax benefit is described in this requirement only if the benefit is at least 10 percent of the U.S. party’s share of the foreign payment or if the benefit is at least 10 percent of the foreign base with respect to which the U.S. party’s share (for U.S. federal tax purposes) is imposed.
• Counterparty – The arrangement being tested involves a counterparty, which is a person that is subject to net basis taxation in a foreign country based on residence or otherwise and that under the tax laws of such foreign country is treated as owning or acquiring directly or indirectly equity interests in the SPV or assets in the SPV. However, a counterparty does not include (1) the SPV; (2) an entity that, for U.S. federal tax purposes, directly or indirectly is owned at least 80 percent (by value of stock, or equity for a noncorporate SPV) by the same U.S. corporation, U.S. citizen, or resident alien individual that owns the SPV; or (3) an entity that is owned at least 80 percent (by value of stock, or equity for a noncorporate SPV) by the U.S. party if the U.S. party is a domestic corporation, U.S. citizen, or a resident alien.
• Inconsistent Treatment – The United States and an applicable foreign country treat one or more specific aspects of the arrangement differently under their respective tax systems, and for one or more tax years when the arrangement is in effect, either (1) the amount of income recognized by the SPV, the U.S. party, and persons related to the U.S. party for U.S. federal tax purposes is materially less than the amount of income that would be recognized if the foreign tax treatment controlled for U.S. federal tax purposes; or (2) the amount of credits claimed by the U.S. party (if the foreign payments were treated as a foreign tax paid) is materially greater than it would be if the foreign tax treatment controlled for U.S. federal tax purposes. The specific aspects identified in the regulations include hybrid entity classification of the SPV for tax purposes, hybrid instruments issued by the SPV for tax purposes, and hybrid ownership of the SPV for tax purposes.

Effective Date

The regulations generally apply to foreign payments that, if they were an amount of tax paid, would be considered paid or accrued by a U.S. or foreign entity in taxable years ending on or after July 15, 2008.

— Richard Castanon & Seth Goldstein
    Washington International Tax Services
    Deloitte Tax LLP

 

The information contained is for general purposes only. The views expressed in this article are those of the author and do not constitute tax advice from or reflect the view of Deloitte & Touche LLP. Deloitte & Touche LLP assumes no responsibility with respect to assessing and/or advising the reader as to the respective tax consequences arising from circumstances relating to the reader's particular tax situation. It is recommended that the reader consult with their own tax advisor with regard to the application of the tax laws and resulting tax consequences relating to the reader's particular situation.