IRS Issues Proposed Foreign Tax Credit Regulations on "Highly Structured Transactions"

International Tax Alert

On March 29, 2007, the Treasury and the IRS issued proposed foreign tax credit regulations addressing certain applications of the compulsory payment rule of Treas. Reg. § 1.901-2(e)(5). In part, the proposed regulations liberalize the application of the compulsory payment rule. However, the proposed regulations also target “highly structured passive investment arrangements,” and deny foreign tax credits arising from such arrangements. The new rules are proposed to be effective when finalized.

Treas. Reg. § 1.901-2(e) provides rules for determining the amount of creditable foreign taxes paid by a taxpayer. Among other things, the rules require the payment to be “compulsory” and disallow credits for amounts paid in excess of the foreign tax liability. The compulsory amount of foreign tax is determined based on a reasonable interpretation and application of the foreign law that results in a reduction, over time, of the taxpayer’s reasonably expected foreign tax liability.

Application to Foreign Groups

The current regulations apply the compulsory payment rule on a taxpayer-by-taxpayer basis. Taxpayers have been concerned that the transfer or surrender of losses from one entity to another under foreign group relief provisions may cause an entity to fail the compulsory payment rule on a stand-alone basis . Taxpayers have had similar concerns in cases where the settlement of a foreign group audit results in individual entities conceding to tax liabilities that are arguably higher than they would have incurred in a standalone audit.

The proposed regulations adopt a limited group approach to the compulsory payment rule, allowing single taxpayer treatment for entities in which the same U.S. person has at least an 80 percent direct or indirect interest. If the reasonably expected group liability is reduced over time by the transfer or surrender of a net loss pursuant to a foreign law group relief regime or similar regime, or by the combined settlement of two or more issues within the group, foreign tax paid will not fail to be a compulsory payment solely on the basis of the surrender or settlement agreement.

Application to Highly Structured Transactions

Perhaps more significantly, the proposed regulations also target cases in which a U.S. person is a party to a “highly structured passive investment arrangement.” These arrangements arise in three different circumstances ?? U.S. borrower transactions, U.S. lender transactions, and asset holding transactions. Asset holding transactions arise when a U.S. person moves income-producing assets into a foreign taxing jurisdiction, the resulting foreign tax cost is shared by a foreign person, and the foreign person obtains a foreign tax benefit by participating in the arrangement. The Preamble notes that these transactions enable a U.S. person and a foreign counterparty to share the economic cost of the foreign taxes and the benefit of the U.S. foreign tax credit. Consequently, the U.S. person has an incentive to incur foreign tax voluntarily, an incentive that the government views as inconsistent with the purpose of the foreign tax credit rules.

The proposed regulations disallow a credit for foreign taxes paid in connection with a “structured passive investment arrangement,” i.e., an arrangement satisfying all six of the following conditions

(1)  Utilization of a special purpose vehicle (“SPV”). An SPV is an entity substantially all of the gross income and assets of which are passive, and whose income is subject to foreign tax. Significantly, a holding company for operating subsidiaries will generally not qualify as an SPV.

(2)  U.S. foreign tax credits. A U.S. party must be eligible to claim foreign tax credits under section 901, 902, or 960.

(3)  Increased foreign tax credits. Foreign taxes paid as a result of the arrangement must be substantially greater than the amount of credits that the U.S. party could have reasonably expected to claim if the SPV’s assets were owned directly by the U.S. party.

(4)  Counterparty benefit. The arrangement results in a foreign tax benefit for a counterparty (including a person that is related to a counterparty) that is unrelated to the U.S. party.

(5)  Counterparty ownership interests. The counterparty is unrelated to the U.S. party and, under its residence country tax laws, either (i) owns (directly or indirectly) at least 10 percent of the equity of the SPV, or (ii) acquires at least 20 percent of the assets of the SPV.

(6)  Inconsistency of tax treatment. The arrangement implicates an inconsistency in U.S. and foreign tax treatment. This condition only applies if two requirements are met. First, 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. In addition, the inconsistency must involve one or more of the following: entity classification, debt-equity characterization, the proportionate share of SPV equity owned by the U.S. party and the counterparty, or the amount of the SPV’s taxable income for one or more tax years.

The government is requesting general comments on the clarity of the proposed regulations, as well as specific comments on (1) the appropriate scope of “passive income”; (2) possible exclusion of certain foreign payments (e.g., tax payments, the economic cost of which is not shared); and (3) the appropriateness of a business purpose exception, not including reduction of the taxpayer’s after-tax costs or enhancement of the taxpayer’s after-tax return through duplicative foreign tax benefits. The deadline for written comments is June 28, 2007.

The government has proposed the structured arrangement provisions in light of foreign tax credit transactions currently under audit, and may attempt to apply the principles of the proposed regulations to prior-year transactions. The Preamble notes that “no inference is intended regarding the U.S. tax consequences of structured passive investment arrangements prior to the effective date of the regulations,” and warns that the IRS will continue to scrutinize such transactions under prior law using “all tools available.” Notably, the government took a similar approach in Guardian Industries Corp. v. United States, No. 2006-5058, 2007 U.S. App. LEXIS 3927 (Fed. Cir. Feb. 23, 2007) ?? an approach that the Appeals Court rejected ?? in arguing that the recently proposed technical taxpayer regulations should apply to past arrangements.

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

Rocco Femia,, 202-626-5823

Marc Gerson,, 202-626-1475

Kathryn Morrison Sneade,, 202-626-1585

Kimberly Majure

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