Internal Revenue Service (IRS), Treasury.
Notice of proposed rulemaking and notice of public hearing.
These proposed regulations provide guidance relating to the determination of the amount of taxes paid for purposes of section 901.
The proposed regulations affect taxpayers that claim direct and indirect foreign tax credits. This document also provides notice of a public hearing.
Written or electronic comments must be received by June 28, 2007. Outlines of topics to be discussed at the public hearing scheduled for July 30, 2007, at 10 a.m. must be received by July 9, 2007.
Send submissions to CC:PA:LPD:PR (REG–156779–06), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–156779–06), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue, NW., Washington, DC, or sent electronically via the Federal eRulemaking Portal at
Concerning submission of comments, the hearing, and/or to be placed on the building access list to attend the hearing, Kelly Banks (202) 622–7180; concerning the regulations, Bethany A. Ingwalson, (202) 622–3850 (not toll-free numbers).
Section 901 of the Internal Revenue Code (Code) permits taxpayers to claim a credit for income, war profits, and excess profits taxes paid or accrued (or deemed paid) during the taxable year to any foreign country or to any possession of the United States.
Section 1.901–2(a) of the regulations defines a tax as a compulsory payment pursuant to the authority of a foreign country to levy taxes, and further provides that a tax is an income, war profits, or excess profits tax if the predominant character of the tax is that of an income tax in the U.S. sense. Section 1.901–2(e) provides rules for determining the amount of tax paid by a taxpayer for purposes of section 901. Section 1.901–2(e)(5) provides that an amount paid is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of liability under foreign law for tax. For purposes of determining whether an amount paid exceeds the amount of liability under foreign law for tax, § 1.901–2(e)(5) provides the following rule:
An amount paid does not exceed the amount of such liability if the amount paid is determined by the taxpayer in a manner that is consistent with a reasonable interpretation and application of the substantive and procedural provisions of foreign law (including applicable tax treaties) in such a way as to reduce, over time, the taxpayer's reasonably expected liability under foreign law for tax, and if the taxpayer exhausts all effective and practical remedies, including invocation of competent authority procedures available under applicable tax treaties, to reduce, over time, the taxpayer's liability for foreign tax (including liability pursuant to a foreign tax audit adjustment).
Section 1.901–2(e)(5) provides further that if foreign tax law includes options or elections whereby a taxpayer's liability may be shifted, in whole or part, to a different year, the taxpayer's use or failure to use such options or elections does not result in a noncompulsory payment, and that a settlement by a taxpayer of two or more issues will be evaluated on an overall basis, not on an issue-by-issue basis, in determining whether an amount is a compulsory amount. In addition, it provides that a taxpayer is not required to alter its form of doing business, its business conduct, or the form of any transaction in order to reduce its liability for tax under foreign law.
Commentators have raised questions regarding the application of § 1.901–2(e)(5) to a U.S. person that owns one or more foreign entities. In particular, commentators have raised questions concerning the application of the regulation when one foreign entity directly or indirectly owned by a U.S. person transfers, pursuant to a group relief type regime, a net loss to another foreign entity, which may or may not also be owned by the U.S. person. Certain commentators have expressed concern that foreign taxes paid by the transferor in a subsequent tax year might not be compulsory payments to the extent the transferor could have reduced its liability for those foreign taxes had it chosen not to transfer the net loss in the prior year. This concern arises because the current final regulations apply on a taxpayer-by-taxpayer basis, obligating each taxpayer to minimize its liability for foreign taxes over time, even though the net effect of the loss surrender may be to minimize the amount of foreign taxes paid in the aggregate by the controlled group over time.
Similar questions and concerns arise when one or more foreign subsidiaries of a U.S. person reach a combined settlement with a foreign taxing authority that results in an increase in the amount of one foreign subsidiary's foreign tax liability and a decrease in the amount of a second foreign subsidiary's foreign tax liability.
The IRS and Treasury Department have become aware that certain U.S. taxpayers are engaging in highly structured transactions with foreign counterparties in order to generate foreign tax credits. These transactions are intentionally structured to create a foreign tax liability when, removed from the elaborately engineered structure, the basic underlying business transaction
The proposed regulations address the application of § 1.901–2(e)(5) in cases where a U.S. person directly or indirectly owns one or more foreign entities and in cases in which a U.S. person is a party to a highly structured passive investment arrangement described in this preamble. The proposed regulations would treat as a single taxpayer for purposes of § 1.901–2(e)(5) all foreign entities with respect to which a U.S. person has a direct or indirect interest of 80 percent or more. The proposed regulations would treat foreign payments attributable to highly structured passive investment arrangements as noncompulsory payments under § 1.901–2(e)(5) and, thus, would disallow credits for such amounts.
Section 1.901–2(e)(5) requires a taxpayer to interpret and apply foreign law reasonably in such a way as to reduce, over time, the taxpayer's reasonably expected liability under foreign law for tax. This requirement ensures that a taxpayer will make reasonable efforts to minimize its foreign tax liability even though the taxpayer may otherwise be indifferent to the imposition of foreign tax due to the availability of the foreign tax credit. The purpose of this requirement is served if all foreign entities owned by such person, in the aggregate, satisfy the requirements of the regulation. Accordingly, for purposes of determining compliance with § 1.901–2(e)(5), the proposed regulations would treat as a single taxpayer all foreign entities in which the same U.S. person has a direct or indirect interest of 80 percent or more. For this purpose, an interest of 80 percent or more means stock possessing 80 percent or more of the vote and value (in the case of a foreign corporation) or an interest representing 80 percent or more of the income (in the case of non-corporate foreign entities).
The proposed regulations provide that if one 80 percent-owned foreign entity transfers or surrenders a net loss for the taxable year to a second such entity pursuant to a foreign law group relief or similar regime, foreign tax paid by the transferor in a different tax year does not fail to be a compulsory payment solely because such tax would not have been due had the transferor retained the net loss and carried it over to such other year. Similarly, it provides that if one or more 80 percent-owned foreign entities enter into a combined settlement under foreign law of two or more issues, such settlement will be evaluated on an overall basis, not on an issue-by-issue or entity-by-entity basis, in determining whether an amount is a compulsory amount. The proposed regulations include examples to illustrate the proposed rule.
The IRS and Treasury Department intend to monitor structures involving U.S.-owned foreign groups, including those that would be covered by the proposed regulations, to determine whether taxpayers are utilizing such structures to separate foreign taxes from the related income. The IRS and Treasury Department may issue additional regulations in the future in order to address arrangements that result in the inappropriate separation of foreign tax and income.
The structured arrangements discovered and identified by the IRS and the Treasury Department can be grouped into three general categories: (1) U.S. borrower transactions, (2) U.S. lender transactions, and (3) asset holding transactions. The transactions, including the claimed U.S. tax results, are described in section B.1 of this preamble. Section B.2 of this preamble discusses the purpose of the foreign tax credit regime and explains why allowing a credit in the transactions is inconsistent with this purpose. Section B.3 of this preamble discusses comments the IRS and the Treasury Department have received on the transactions and describes the proposed regulations. The IRS is continuing to scrutinize the transactions under current law and intends to utilize all tools available to challenge the claimed U.S. tax results in appropriate cases.
(a)
In a typical structured financing arrangement, the loan is made indirectly through an SPV. The foreign lender's interest income (and, in many cases, other income) is effectively isolated in the SPV. The U.S. borrower acquires a direct or indirect interest in the SPV and asserts that it has a direct or indirect equity interest in the SPV for U.S. tax purposes. The U.S. borrower claims a credit for foreign taxes imposed on the income derived by the SPV. The U.S. borrower's purported equity interest may be treated as debt for foreign tax purposes or it may be treated as an equity interest that is owned by the foreign lender for foreign tax purposes. In either case, the foreign lender is treated as owning an equity interest in the SPV for foreign tax purposes, which entitles the foreign lender to receive tax-free distributions from the SPV.
For example, assume that a U.S. person seeks to borrow $1.5 billion from a foreign person. Instead of borrowing the funds directly, the U.S. borrower forms a corporation (SPV) in the same country as the foreign counterparty. The U.S. borrower contributes $1.5 billion to SPV in exchange for 100 percent of the stock of SPV. SPV, in turn, loans the entire $1.5 billion to a corporation wholly owned by the U.S. borrower. The U.S. borrower recovers its $1.5 billion by selling its entire interest in SPV to the foreign counterparty, subject to an obligation to repurchase the interest in five years for $1.5 billion. Each year, SPV earns $120 million of interest income from the U.S. borrower's subsidiary. SPV pays $36 million of foreign tax and distributes the
The U.S. borrower takes the position that, for U.S. tax purposes, the sale-repurchase transaction is a borrowing secured by the SPV stock. Accordingly, the U.S. borrower asserts that it owns the stock of SPV for U.S. tax purposes and has an outstanding debt obligation to the foreign counterparty. It reports the distribution from SPV as dividend income and claims indirect credits under section 902 for the $36 million of foreign taxes paid by SPV. It includes in income the cash dividend of $84 million paid to the foreign counterparty, plus a section 78 gross-up amount of $36 million, for a total of $120 million. The U.S. borrower claims a deduction of $84 million as interest on its debt obligation to the foreign counterparty. In addition, the U.S. borrower's subsidiary claims an interest deduction of $120 million. In the aggregate, the U.S. borrower and its subsidiary claim a foreign tax credit of $36 million and an interest expense deduction (net of income inclusions) of $84 million.
For foreign tax purposes, the foreign counterparty owns the equity of SPV and is not subject to additional foreign tax upon receipt of the dividend. Thus, the net result is that the foreign jurisdiction receives foreign tax payments attributable to what is in substance the lender's interest income, which is consistent with the foreign tax results that would be expected from a direct borrowing.
Both parties benefit from the arrangement. The foreign lender obtains an after-foreign tax interest rate that is higher than the after-foreign tax interest rate it would earn on a direct loan. The U.S. borrower's funding costs are lower on an after-U.S. tax basis (though not on a pre-U.S. tax basis) because it has converted interest expense into creditable foreign tax payments.
The benefit to the parties is solely attributable to the reduction in the U.S. borrower's U.S. tax liability resulting from the foreign tax credits claimed by the U.S. borrower. The foreign jurisdiction benefits from the arrangement because the amount of interest received by SPV exceeds the amount of interest that would have been received by the foreign lender if the transaction had been structured as a direct loan. As a result, the amount paid by SPV to the foreign jurisdiction exceeds the amount of foreign tax the foreign jurisdiction would have imposed on the foreign lender's interest income in connection with a direct loan.
(b)
In a typical structured financing arrangement, the U.S. person advances funds to a foreign borrower indirectly through an SPV. The U.S. person asserts that its interest in the SPV is equity for U.S. tax purposes. Income of the foreign borrower (or another foreign counterparty) is effectively shifted into the SPV. The U.S. person receives cash payments from the SPV and claims a credit for foreign taxes imposed on the income recognized by the SPV for foreign tax purposes. The foreign tax credits eliminate all or substantially all of the U.S. tax the U.S. person would otherwise owe on its return and, in many cases, U.S. tax the U.S. person would otherwise owe on unrelated foreign source income. The economic cost of the foreign taxes is shared through the pricing of the arrangement. See
For example, assume a U.S. person seeks to loan $1 billion to a foreign person. In lieu of a direct loan, the U.S. lender contributes $1 billion to a newly-formed corporation (SPV). The foreign counterparty contributes $2 billion to SPV, which is organized in the same country as the foreign counterparty. SPV contributes the total $3 billion to a second special purpose entity (RH), receiving a 99 percent equity interest in RH in exchange. The foreign counterparty owns the remaining 1 percent of RH. RH loans the funds to the foreign counterparty in exchange for a note that pays interest currently and a second zero-coupon note. RH is a corporation for U.S. tax purposes and a flow-through entity for foreign tax purposes.
Each year, the foreign counterparty pays $92 million of interest to RH, and RH accrues $113 million of interest on the zero-coupon note. RH distributes the $92 million of cash it receives to SPV. Because RH is a partnership for foreign tax purposes, SPV is required to report for foreign tax purposes 99 percent ($203 million) of the income recognized by RH. Because RH is a corporation for U.S. tax purposes, SPV recognizes only the cash distributions of $92 million for U.S. tax purposes. SPV pays foreign tax of $48 million on its net income (30 percent of $159 million, or $203 interest income less $44 million interest deduction) and distributes its remaining cash of $44 million to the U.S. lender.
The U.S. lender takes the position that it has an equity interest in SPV for U.S. tax purposes. It claims an indirect credit for the $48 million of foreign taxes paid by SPV. It includes in income the cash dividend of $44 million, plus a section 78 gross-up amount of $48 million. For foreign tax purposes, the U.S. lender's interest in SPV is debt, and the foreign borrower owns 100 percent of the equity of SPV. The foreign counterparty and SPV, in the aggregate, have a net deduction of $44 million for foreign tax purposes.
Both parties benefit from the transaction. The foreign borrower obtains “cheap financing” because the $44 million of cash distributed to the U.S. lender is less than the amount of interest it would have to pay on a direct loan with respect to which the U.S. lender would owe U.S. tax. The U.S. lender is better off on an after-U.S. tax basis because of the foreign tax credits, which eliminate the U.S. lender's U.S. tax on the “dividend” income.
The benefit to the parties is solely attributable to the reduction in the U.S. lender's U.S. tax liability resulting from the foreign tax credits claimed by the U.S. lender. The foreign jurisdiction benefits because the aggregate foreign tax result is a deduction for the foreign borrower that is less than the amount of the interest deduction the foreign borrower would have had upon a direct loan.
(c)
In a typical structured transaction, a foreign counterparty participates in the arrangement with the SPV. For example, the foreign counterparty may be considered to own a direct or indirect interest in the SPV for foreign tax purposes. The foreign counterparty's participation in the arrangement allows it to obtain a foreign tax benefit that it would not otherwise enjoy. The foreign counterparty compensates the U.S. person for this benefit in some manner. This compensation, which can be viewed as a reimbursement for a portion of the foreign tax liability resulting from the transfer of the assets, puts the U.S. person in a better after-U.S. tax position. See
The benefit to the parties is solely attributable to the reduction in the U.S. taxpayer's U.S. tax liability resulting from the foreign tax credits claimed by the U.S. taxpayer. The foreign jurisdiction benefits because the foreign taxes purportedly paid by the SPV exceed the amount by which the foreign counterparty's taxes are reduced.
The purpose of the foreign tax credit is to mitigate double taxation of foreign source income. Because the foreign tax credit provides a dollar-for-dollar reduction in U.S. tax that a U.S. person would otherwise owe, the U.S. person generally is indifferent, subject to various foreign tax credit limitations, as to whether it pays foreign tax on its foreign source income (if fully offset by the foreign tax credit) or whether it pays U.S. (and no foreign) tax on that income.
The structured arrangements described in section B.1 of this preamble violate this purpose. A common feature of all these arrangements is that the U.S. person and a foreign counterparty share the economic cost of the foreign taxes claimed as credits by the U.S. person. This creates an incentive for the U.S. person to subject itself voluntarily to the foreign tax because there is a U.S. tax motivation to do so. The result is an erosion of the U.S. tax base in a manner that is not consistent with the purpose of the foreign tax credit provisions.
Although the foreign counterparty derives a foreign tax benefit in these arrangements, the foreign jurisdiction generally is made whole because of the payments to the foreign jurisdiction made by the special purpose vehicle. In fact, the aggregate amount of payments to the foreign jurisdictions in connection with these transactions generally exceeds the amount of foreign tax that would have been imposed in the ordinary course. Only the U.S. fisc experiences a reduction in tax payments as a result of the structured arrangements.
The IRS and Treasury Department recognize that often there is a business purpose for the financing or portfolio investment underlying the otherwise elaborately engineered transactions. However, it is inconsistent with the purpose of the foreign tax credit to permit a credit for foreign taxes that result from intentionally structuring a transaction to generate foreign taxes in a manner that allows the parties to obtain duplicate tax benefits and share the cost of the tax payments. The result in these structured arrangements is that both parties as well as the foreign jurisdiction benefit at the expense of the U.S. fisc.
The IRS and Treasury Department have determined that it is not appropriate to allow a credit in connection with these highly engineered transactions where the U.S. taxpayer benefits by intentionally subjecting itself to foreign tax. The proposed regulations would revise § 1.901–2(e)(5) to provide that an amount paid to a foreign country in connection with such an arrangement is not an amount of tax paid. Accordingly, under the proposed regulations, a taxpayer would not be eligible to claim a foreign tax credit for such a payment. For periods prior to the effective date of final regulations, the IRS will continue to utilize all available tools under current law to challenge the U.S. tax results claimed in connection with such arrangements, including the substance over form doctrine, the economic substance doctrine, debt-equity principles, tax ownership principles, existing § 1.901–2(e), section 269, and the partnership anti-abuse rules of § 1.701–2.
Certain commentators recommended that the IRS and Treasury Department adopt a broad anti-abuse rule that would deny a foreign tax credit in any case where allowance of the credit would be inconsistent with the purpose of the foreign tax credit regime. Other commentators recommended a narrower approach that would only deny foreign tax credits attributable to transactions that include particular features. The IRS and Treasury Department are concerned that a broad anti-abuse rule would create uncertainty for both taxpayers and the IRS. The IRS and Treasury Department have concluded that, at this time, a targeted rule denying foreign tax credits in arrangements similar to the arrangements described in section B.1 of this preamble is more appropriate.
For periods after the effective date of final regulations, the IRS and Treasury Department will continue to scrutinize other arrangements that are not covered by the regulations but are inconsistent with the purpose of the foreign tax credit. Such arrangements may include arrangements that are similar to arrangements described in the proposed regulations, but that do not meet all of the conditions included in the proposed regulations. The IRS will utilize all available tools, including those described above, to challenge the claimed U.S. tax results in appropriate cases. In addition, the IRS and Treasury Department may issue additional regulations in the future in order to address such other arrangements.
The proposed regulations would retain the general rule in the existing regulations that a taxpayer need not alter its form of doing business or the form of any transaction in order to reduce its foreign tax liability. However, the proposed regulations would provide that, notwithstanding the general rule, an amount paid to a foreign country (a “foreign payment”) is not a compulsory payment, and thus is not an amount of tax paid, if the foreign payment is attributable to a structured passive investment arrangement. For this purpose, the proposed regulations would define a structured passive investment arrangement as an arrangement that satisfies six conditions. The six conditions consist of features that are common to the three types of arrangements identified in section B.1 of this preamble. The IRS and Treasury Department believe it is appropriate to treat foreign payments attributable to these arrangements as voluntary payments because such arrangements are intentionally structured to generate the foreign payment.
The first condition is that the arrangement utilizes an entity that meets two requirements (an “SPV”). The first requirement is that substantially all of the gross income (for United States tax purposes) of the entity is attributable to passive investment income and substantially all of the assets of the entity are assets held to produce such passive investment income. The second requirement is that there is a purported foreign tax payment attributable to income of the entity. The purported foreign tax may be paid by the entity itself, by the owner(s) of the entity (if the entity is treated as a pass-through entity under foreign law) or by a lower-tier entity (if the lower-tier
For purposes of this first requirement, passive investment income is defined as income described in section 954(c), with two modifications. The first modification is that if the entity is a holding company that owns a direct equity interest (other than a preferred interest) of 10 percent or more in another entity (a lower-tier entity) that is predominantly engaged in the active conduct of a trade or business (or substantially all the assets of which consist of qualifying equity interests in other entities that are predominantly engaged in the active conduct of a trade or business), passive investment income does not include income attributable to the interest in such lower-tier entity. This exception does not apply if there are arrangements under which substantially all of the opportunity for gain and risk of loss with respect to such interest in the lower-tier entity are borne by either the U.S. party or the counterparty (but not both). Accordingly, a direct equity interest in any such lower-tier entity is not held to produce passive investment income provided there are no arrangements under which substantially all of the entity's opportunity for gain and risk of loss with respect to the lower-tier entity are borne by either the U.S. party or the counterparty (but not both). This modification is based on the notion that an entity is not a passive investment vehicle of the type targeted by these regulations if the entity is a holding company for one or more operating companies. This modification ensures that a joint venture arrangement between a U.S. person and a foreign person is not treated as a passive investment arrangement solely because the joint venture is conducted through a holding company structure.
The second modification is that passive investment income is determined by disregarding sections 954(c)(3) and (c)(6) and by treating income attributable to transactions with the counterparties (described in this preamble) as ineligible for the exclusions under sections 954(h) and (i). Sections 954(c)(3) and (c)(6) provide exclusions for certain related party payments of dividends, interest, rents, and royalties. Those exclusions are not appropriate for these transactions because these transactions can be structured utilizing related party payments. The modifications to the application of sections 954(h) and (i) are intended to ensure that income derived from the counterparty cannot qualify for the exclusion from passive investment income, but will not prevent other income from qualifying for those exclusions. The IRS and Treasury Department intend that the structured financing arrangements described in this preamble do not qualify for the active banking, financing or insurance business exceptions to the definition of passive investment income. Comments are requested on whether further modifications or clarifications to the proposed regulations' definition of passive investment income are appropriate to ensure this result.
The requirement that substantially all of the assets of the entity produce passive investment income is intended to ensure that an entity engaged in an active trade or business is not treated as an SPV solely because, in a particular year, it derives only passive investment income.
The second overall condition is that a person (a “U.S. party”) would be eligible to claim a credit under section 901(a) (including a credit for foreign taxes deemed paid under section 902 or 960) for all or a portion of the foreign payment if such payment were an amount of tax paid. Such eligibility to claim the credit could arise because the U.S. party would be treated as having paid or accrued the foreign payment for purposes of section 901 if it were an amount of tax paid. Alternatively, the U.S. party's eligibility to claim the credit could arise because the U.S. party owns an equity interest in the SPV or another entity that would be treated as having paid or accrued the foreign payment for purposes of section 901 if it were an amount of tax paid.
The third overall condition is that the foreign payment or payments are (or are expected to be) substantially greater than the amount of credits, if any, that the U.S. party would reasonably expect to be eligible to claim under section 901(a) if such U.S. party directly owned its proportionate share of the assets owned by the SPV other than through a branch, a permanent establishment or any other arrangement (such as an agency arrangement) that would subject the income generated by its share of the assets to a net basis foreign tax. For example, if the SPV owns a note that generates interest income with respect to which a foreign payment is made, but foreign law (including an applicable treaty) provides for a zero rate of withholding tax on interest paid to non-residents, the U.S. party would not reasonably expect to pay foreign tax for which it could claim foreign tax credits if it directly owned the note and directly earned the interest income.
The fourth condition is that the arrangement is structured in such a manner that it results in a foreign tax benefit (such as a credit, deduction, loss, exemption or a disregarded payment) for a counterparty or for a person that is related to the counterparty, but not related to the U.S. party.
The fifth condition is that the counterparty is a person (other than the SPV) that is unrelated to the U.S. party and that (i) directly or indirectly owns 10 percent or more of the equity of the SPV under the tax laws of a foreign country in which such person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis foreign tax or (ii) acquires 20 percent or more of the assets of the SPV under the tax laws of a foreign country in which such person is subject to tax on the basis of place of management, place of incorporation or similar criterion or otherwise subject to a net basis foreign tax.
The sixth condition is that the U.S. and an applicable foreign country treat the arrangement differently under their respective tax systems. For this purpose, an applicable foreign country is any foreign country in which either the counterparty, a person related to the counterparty (but not related to the U.S. party) or the SPV is subject to net basis tax. To provide clarity and limit the scope of this factor, the proposed regulations provide that the arrangement must be subject to one of four specified types of inconsistent treatment. Specifically, the U.S. and the foreign country (or countries) must treat one or more of the following aspects of the arrangement differently, and the U.S. treatment of the inconsistent aspect must materially affect the amount of foreign tax credits claimed, or the amount of income recognized, by the U.S. party to the arrangement: (i) The classification of an entity as a corporation or other entity subject to an entity-level tax, a partnership or other flow-through entity or an entity that is disregarded for tax purposes; (ii) the characterization as debt, equity or an instrument that is disregarded for tax purposes of an instrument issued in the transaction, (iii) the proportion of the equity of the SPV (or an entity that directly or indirectly owns the SPV) that is considered to be owned directly or indirectly by the U.S. party and the counterparty; or (iv) the amount of taxable income of the SPV for one or more tax years during which the arrangement is in effect.
Under the proposed regulations, a foreign payment would not be a compulsory payment if it is attributable to an arrangement that meets the six conditions. The proposed regulations
The IRS and Treasury Department considered excluding all foreign payments with respect to which the economic cost is not shared from the definition of foreign payments attributable to the arrangement, but determined that such a rule would be difficult to administer. The IRS and Treasury Department request comments on whether it would be appropriate to exclude certain foreign payments from the definition of foreign taxes attributable to the structured passive investment arrangement. Comments should address the rationale and administrable criteria for identifying any such exclusions.
Certain commentators recommended that the proposed regulations include a requirement that the foreign tax credits attributable to the arrangement be disproportionate to the amount of taxable income attributable to the arrangement. This recommendation has not been adopted for three reasons. First, the IRS and Treasury Department were concerned that such a requirement would create too much uncertainty and would be unduly burdensome for taxpayers and the IRS. Second, the extent to which interest and other expenses, as well as returns on borrowed funds and capital, should be considered attributable to a particular arrangement is not entirely clear. A narrow view could present opportunities for manipulation, especially for financial institutions having numerous alternative placements of leverage for use within the group, while an expansive view could undercut the utility of such a test. Third, the fundamental concern in these transactions is that they create an incentive for taxpayers voluntarily to subject themselves to foreign tax. This concern exists irrespective of whether the particular arrangement generates a disproportionate amount of foreign tax credits.
The IRS and Treasury Department considered whether it would be appropriate to permit a taxpayer to treat a foreign payment attributable to an arrangement that meets the definition of a structured passive investment arrangement as an amount of tax paid, if the taxpayer can show that tax considerations were not a principal purpose for the structure of the arrangement. Alternatively, the IRS and Treasury Department considered whether it would be appropriate to treat a foreign payment as an amount of tax paid if a taxpayer shows that there is a substantial business purpose for utilizing a hybrid instrument or entity, which would not include reducing the taxpayer's after-tax costs or enhancing the taxpayer's after-tax return through duplicative foreign tax benefits. The IRS and Treasury Department determined not to include such a rule in these proposed regulations due to administrability concerns. Comments are requested, however, on whether the final regulations should include such a rule as well as how such a rule could be made to be administrable in practice, including what reasonably ascertainable evidence would be sufficient to establish such a substantial non-tax business purpose, or the lack of a tax-related principal purpose. Comments should also address whether it would be appropriate to adopt a broader anti-abuse rule and permit a taxpayer to demonstrate that it should not apply.
The regulations are proposed to be effective for foreign taxes paid or accrued during taxable years of the taxpayer ending on or after the date on which the final regulations are published in the
It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6), does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.
Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the clarity of the proposed regulations and how they can be made easier to understand. All comments will be available for public inspection and copying.
A public hearing has been scheduled for July 30, 2007, at 10 a.m. in the Internal Revenue Building, 1111 Constitution Avenue, NW., Washington, DC. All visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments must submit electronic or written comments and an outline of the topics to be discussed and time to be devoted to each topic (a signed original and eight (8) copies) by July 9, 2007. A period of 10 minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.
The principal author of these regulations is Bethany A. Ingwalson, Office of Associate Chief Counsel (International). However, other personnel from the IRS and the Treasury Department participated in their development.
Income taxes, Reporting and recordkeeping requirements.
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
26 U.S.C. 7805 * * *
(e)(5) * * *
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(B) In year 1, foreign bank pays RH $92 million of interest and accrues $113 million of interest on the zero-coupon note. RH distributes the $92 million of cash it receives to Newco. Newco distributes $44 million to USB. Because RH is a partnership for country X purposes, Newco is required to report for country X purposes 99 percent ($203 million) of the income recognized by RH. Newco is entitled to interest deductions of $44 million for distributions to USB on the securities for country X tax purposes and, thus, has $159 million of net income for country X tax purposes. Newco makes a payment to country X of $48 million with respect to its net income. For U.S. tax purposes, Newco's post-1986 undistributed earnings pool for year 1 is $44 million ($92 million–$48 million). For country X tax purposes, foreign bank is entitled to interest expense deductions of $205 million.
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(B) In addition, RH is an SPV because all of RH's income is passive investment income described in paragraph (e)(5)(iv)(C)(
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(B) For U.S. tax purposes, these steps create a secured loan of $1.5 billion from Fcorp to USP. Therefore, for U.S. tax purposes, USP is the owner of both the class A and class C stock. DE is a disregarded entity for U.S. tax purposes and a corporation for country Z tax purposes. In year 1, DE earns $400 million of interest income on the country Z debt obligations. DE makes a payment to country Z of $100 million with respect to such income and distributes the remaining $300 million to Fcorp. Fcorp contributes the $300 million back to DE. USP and Fcorp are not related within the meaning of paragraph (e)(5)(iv)(C)(
(C) Country Z treats Fcorp as the owner of the class C stock. Pursuant to country Z tax law, Fcorp is required to report the $400 million of income with respect to the $300 million distribution from DE, but is allowed to claim credits for DE's $100 million payment to country Z. For country Z tax purposes, Fcorp's contribution increases its basis in the class C stock. When the class C stock is later “sold” to USP for $1.5 billion, the increase in tax basis will result in a country Z tax loss for Fcorp. Each year, the amount of the basis increase (and, thus, the amount of the loss generated) will be approximately $300 million.
(ii)
(h)