Three Foreign Tax Credit
Three foreign tax credit schemes are shut down by the IRS.
The US tax authorities proposed new regulations at the end of March that would shut down three types of arrangements that US companies are using to generate foreign tax credits.
The United States taxes US companies on worldwide income, but allows credit for income taxes paid to another country so as to prevent double taxation. Credits may only be claimed for compulsory taxes, not taxes that a company pays voluntarily to another country.
One of the transactions the IRS is targeting is used by US companies that borrow money from foreign banks. Rather than borrow directly, a company might borrow in a three-step arrangement that lets it borrow more cheaply after the tax results are taken into account.
The US company forms a special-purpose subsidiary, or “SPV,” in the home country of the bank. It then “sells” the SPV to the bank for the amount it wants to borrow and agrees to return the money to the bank in five years as purchase price to buy back the SPV. Immediately before transferring the SPV to the bank, the US company makes a capital contribution of the amount borrowed from the bank to the SPV and the SPV lends the money to another US subsidiary of the US company. At the end of the day, the US subsidiary pays interest on regular payment dates, and it repays the principal in five years. The SPV has to pay taxes on the interest in the home country of the bank. The bank is credited with having paid the taxes by its home country since it owns the SPV in form while the loan is outstanding. However, the US company takes the position for US tax purposes that it owns the SPV all along because it is bound to repurchase it. The US company claims foreign tax credits.
The IRS says in new proposed regulations that any foreign tax the US company has to pay in such a case is a voluntary tax. The tax cannot be credited.
However, the regulations are so complicated that they will invite more planning to circumvent the new rules.
The IRS said it will treat foreign taxes paid in “certain structured passive investment arrangements” as voluntary taxes.
It then used almost 6,000 words to explain what it considers such an arrangement, with cross references to more than a half dozen other tax code sections that the reader must stop to read along the way. The agency would have done better to state what it will not allow in more general terms rather than try to describe the transaction structures at so granular a level.
The IRS also reassured taxpayers who operate through groups of companies that they will not be viewed as paying foreign taxes voluntarily where a foreign loss is transferred from one group member to another.
For example, company A may have a tax loss that it cannot use immediately. It allows the loss to be used to shelter income of its affiliate, company B. Company A will end up paying more foreign taxes in a future year because it no longer has the loss. The IRS said the higher tax company A will have to pay is not a voluntary tax. However, it did not say it as simply as this, which will require companies to pay careful attention to details. It said companies A and B will be treated as a single entity where a common US parent owns at least 80% of both companies directly or indirectly. The US parent must own at least 80% by both vote and value of any foreign entity that is a corporation for US tax purposes. It must have at least an 80% profits interest — as opposed to voting interest — in any foreign entity that is a partnership for US tax purposes.
The new rules are in section 1.901-2(e)(5) of the IRS regulations.