A Foreign Tax Credit Strategy

A Foreign Tax Credit Strategy

December 01, 2004

A foreign tax strategy that the IRS dislikes is proliferating.

The United States taxes US companies on their foreign earnings, but it allows a credit to be claimed for any income taxes that were already paid abroad on the earnings.

There are two kinds of foreign tax credits. One is credits for taxes that the US company paid directly. The other is “indirect” credits for taxes that an overseas subsidiary paid. For example, when an offshore subsidiary earns income, pays taxes to another country, and then distributes the earnings to its US parent as a dividend, the US parent can claim credit for the income taxes already paid by its subsidiary. This is called an “indirect” credit because the US parent did not pay the taxes itself.

One foreign tax planning strategy involves freeing up foreign tax credits to be claimed in the United States while the earnings remain parked in an offshore holding company.

The IRS is fighting one such structure used by Guardian Industries, a US insurance company, in court. Guardian had a group of Luxembourg subsidiaries. There was a holding company in Luxembourg. The other subsidiaries were under the holding company. Luxembourg allows groups of related Luxembourg companies to file a single, consolidated tax return. Guardian elected to treat the holding company that sits atop the Luxembourg group as a “disregarded entity.” That means the holding company does not exist for US tax purposes. It treated the companies immediately below it as corporations.

Guardian then took the position that all the taxes that had to be paid to Luxembourg on the group return were taxes of the Luxembourg holding company. This meant that credits for taxes paid to Luxembourg were direct credits: the holding company did not exist so any taxes paid by it are considered paid by the US parent directly. The IRS objected. It said the taxes should have been apportioned among the various companies in the Luxembourg group. The case is in the federal Claims Court in Washington.

Meanwhile, Australia moved in 2002 to let affiliated companies in that country file consolidated tax returns. All the companies joining in the return are ordinarily liable for the full amount shown on the group return, but they can alter this through tax sharing agreements that assign to the liability to just one member of the consolidated group. The rules let two Australian sister companies that have the same offshore parent join in a consolidated return, but shift all the tax liability to one of the companies through a tax sharing agreement. This opens the door to the same sort of tax planning in which Guardian Industries engaged. The United States is not happy with the Australian tax law changes.

The IRS has at least one other case like the Guardian situation pending. It involves another country.

The agency has a regulation in the works to prevent the stripping of foreign tax credits without the associated income through use of “check-the-box” elections (to treat offshore companies as transparent).

 

Keith Martin