Foreign Tax Credit Strategies
Foreign tax credit strategies took a hit in proposed regulations the IRS issued in early August.
Some US companies with business operations outside the United States should revisit their offshore ownership structures.
The United States taxes US companies on their worldwide earnings, but allows them a credit for any income taxes paid to other countries. The credits are ordinarily taken when the foreign earnings are repatriated to the United States.
However, the timing of when foreign tax credits can be claimed can become complicated when a US company has multiple foreign subsidiaries and some of them are treated as a consolidated or combined group for tax purposes in a foreign country. In that case, the US looks to the foreign country law to determine where in the ownership chain the tax is imposed. If the tax is imposed legally on the offshore parent company of the combined group, it is arguably possible to claim foreign tax credits for the taxes imposed on the parent immediately in the United States while shielding the earnings from US tax by trapping them at least one tier down in the other subsidiaries in the group. This would be done, for example, by treating the parent company as a “disregarded entity” for US tax purposes, while treating the subsidiaries as corporations.
The IRS is troubled by such arrangements. It believes taxes should not be credited in the United States until the related earnings also become subject to US taxes.
The proposed regulations address when foreign tax credits can be claimed in situations where offshore consolidated groups, hybrid entities and reverse hybrid entities are involved.
A “hybrid entity” is a company that is treated as transparent for US tax purposes but as a corporation in another country. In other words, the other country treats the entity as subject to tax directly. The United States views any such taxes as imposed on the owners rather than the hybrid entity. The IRS said it would continue to treat the taxes as imposed on the owner. If the hybrid entity is a partnership for US tax purposes, then the taxes will be treated as borne by the partners in the ratio directed by US partnership rules.
A “reverse hybrid entity” is a company that the United States treats like a corporation, but a foreign country treats it as transparent. Since the foreign country does not view the company as subject to tax directly, but rather imposes taxes on the owners, the IRS said it will attribute the taxes paid by the owners to the company. Thus, for example, if a company has three owners, one must figure out what foreign taxes had to be paid by the owners on their shares of company earnings. The company will be treated as if it paid those taxes directly. As a consequence, the taxes cannot be claimed as a foreign tax credit in the United States until earnings trapped in the company become subject to US tax through repatriation. The owners will be treated in the meantime as having made capital contributions to the company for any foreign taxes they paid.
Turning to offshore consolidated groups, the IRS said it will define such groups broadly to include cases not only where a group of companies joins in filing a tax return and each of the group members is “jointly and severally” liable for the full tax shown on the group return, but also where only one of the companies — for example, the group parent — is liable for the full tax and the subsidiaries are not, and where the subsidiaries are ignored in a foreign country because they are treated as mere branches — or offices — of the parent company.
The IRS does not care which type of group is involved. It said it would require the foreign taxes paid by the group to be apportioned among all the companies in the group in the ratio of the net income that each contributes to the group return. The net income for this purpose is computed as defined under foreign law.
This approach has a number of consequences. For example, it means that foreign tax credits considered lodged in a subsidiary cannot be claimed in the United States until the earnings in the subsidiary are repatriated to the United States. It also means that if the group parent actually pays the foreign taxes for the entire group, it will be treated as having made capital contributions in the amount of the taxes to each subsidiary for whom it paid taxes.
The IRS is proposing to have the new rules apply to foreign taxes paid or accrued starting next January 1.
Foreign tax credits are also manipulated through use of hybrid instruments and disregarded payments. An example of a hybrid instrument is an investment that the United States treats as an equity investment while a foreign country classifies it as debt. An example of a disregarded payment is where a parent company lends money to a subsidiary in another country, but the parent chooses to treat the subsidiary as a “disregarded entity” for US tax purposes — in other words, to behave as if the subsidiary does not exist. That means that any payments between the parent and subsidiary do not exist either.
The IRS said it hopes to tackle use of hybrid instruments and disregarded payments later this year.
Ironically, the Clinton administration tried to block use of hybrid entities as a tool for deferring US taxes on offshore earnings, but its efforts were blocked by Congress. Congress has been silent about the Bush administration efforts to block use of the same tools to increase foreign tax credits.