IRS AGENTS are raising questions on audit about a common foreign tax credit strategy involving stapled stock.

The agency released an internal memo in August that discusses how to attack use of such structures.

Most US power companies are unable to claim credit in the United States for taxes paid to another country on earnings from a foreign project. This is because of interest allocation problems. The US views borrowed money as fungible. Therefore, when a US company borrows money purely for domestic uses, the IRS treats part of the interest paid as a cost of the company’s foreign operations in the same ratio as the company’s assets are deployed at home and abroad. This additional interest expense allocated abroad has the effect of reducing the amount of income that the company is considered to earn overseas. The less income it has from abroad, the smaller the amount of foreign tax credits it is allowed in the United States. The foreign operations of many US power companies are viewed as losing money after this interest expense is taken into account.

US companies try different strategies to get around this problem. One strategy is to “staple” the stock of an offshore company to a US subsidiary. That means that the stock of one company cannot be sold without also selling an equivalent ownership interest in the other company. This turns the offshore holding company into a US taxpayer, but it is not part of the consolidated group headed by the US parent company. As a consequence, it is not weighed down by the allocated interest expense of the rest of the consolidated group. This puts it in a position to use foreign tax credits.

The IRS memo is from the national office to an IRS agent in the field about possible ways to attack use of this strategy in a pending audit. The memo is FSA 200233016.

Keith Martin