IRS Issues Proposed Foreign Tax Credit Regulations on “Legal Liability” for Foreign Taxes

International Tax Alert

On August 3, 2006, the Treasury and the IRS issued proposed foreign tax credit regulations identifying the person considered to be legally liable for (and, consequently, considered to pay) a foreign tax for purposes of claiming foreign tax credits under sections 901 and 903. The proposed regulations, which are intended to address certain perceived deficiencies in the current regulations and case law, were presaged in various IRS statements, including Commissioner Everson’s June 13, 2006, testimony before the Senate Finance Committee. The proposed regulations would revise Treas. Reg. § 1.901-2(f) for foreign taxes paid or accrued during tax years of the taxpayer beginning on or after January 1, 2007. Treas. Reg. § 1.901-2 (a) through (e) and (g) would remain unchanged.

The current regulations identify the person considered to pay the foreign tax (i.e., the person eligible to credit the foreign taxes) as the person on whom foreign law imposes legal liability for tax, even if another person in fact remits the tax. Furthermore, if foreign tax is imposed on the combined income of multiple persons that are jointly and severally liable for the tax, the current regulations consider each person to have legal liability for taxes attributable to its allocable portion of the tax base. Although the proposed regulations generally leave these principles intact, they explicitly apply to a number of situations not directly addressed in the current regulations. These fact patterns are discussed below. Significantly, some of the new guidance is at odds with case law interpreting the current regulations.

  1. Foreign consolidated group income. The current regulations require allocation of foreign taxes among group members in accordance with their pro rata share of net income. The current regulations illustrate the application of this rule only in the context of a consolidated group in which members are jointly and severally liable for the combined tax. The proposed regulations would expand the scope of the current regulations by requiring allocation whenever foreign tax is imposed on the combined income of multiple persons. Thus, the allocation rule would apply even if members have limited obligations, or even no obligation, to pay the consolidated tax, or if the combined income is attributed to a single person, such as the parent corporation. This would effectively overturn the result in Guardian Industries Corp. & Subs. v. United States, 65 Fed. Cl. 50 (2005), appeal docketed, No. 2006-5058 (Fed. Cir. December 19, 2005).
  2. Reverse hybrid income. In the case of a reverse hybrid, the proposed regulations treat the entity as having legal liability for foreign taxes otherwise imposed on the owner with respect to the owner’s share of the reverse hybrid’s income. This rule is intended to prevent the separation of foreign tax from the related income and to prevent dissimilar treatment of foreign consolidated groups and foreign groups containing reverse hybrids.
  3. Hybrid entity income. The proposed regulations contain two separate rules with respect to hybrid entities. A hybrid entity partnership would be treated as legally liable for foreign taxes imposed on its income. On the other hand, owners of hybrid branches would be considered as legally liable for tax on hybrid branch income.
  4. Collateral consequences. The proposed regulations would apply U.S. principles to determine the treatment of a tax remittance by one person when the tax is the legal liability of another person. For instance, a parent corporation’s payment of tax on its subsidiary’s share of consolidated taxable income would ordinarily be treated as capital contribution to the subsidiary.

Note that issues relating to hybrid instruments and payments (including questions on related party hybrid payments and payments that are disregarded for U.S. tax purposes) are reserved for future guidance, which may also be effective for taxable years beginning on or after January 1, 2007. The IRS and Treasury are requesting comments in three areas: (i) possible rules that would address legal liability in the context of nominee arrangements while preventing opportunities for abuse; (ii) application of the legal liability rule to hybrid instruments and payments; and (iii) other issues that might be incorporated into final regulations. Taxpayers that have foreign tax credit structures targeted by the proposed regulations should consider commenting on the proposals. Furthermore, given the short timeframe between publication and the proposed effective date of these regulations, taxpayers should begin reassessing their foreign tax credit planning on the assumption that the regulations could be finalized as proposed.

For more information, please contact any of the following lawyers:

Rocco Femia,, 202-626-5823

Kevin Kenworthy,, 202-626-5848

Kathryn Morrison Sneade

Kimberly Tan Majure

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