On the Need for More §901(l) Comment Letters

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By Dirk J.J. Suringa, Esq.
Covington & Burling LLP, Washington, DC

Section 901(l) denies the foreign tax credit for short-holding-period transactions. The basic rule imposes a minimum holding period for property in order to credit withholding taxes imposed on income generated by the property. Like most of §901(l), this provision was borrowed from §901(k),1  which imposes the same restriction on dividend-producing stock. Section 901(k) was adopted to curtail foreign tax credit "splitter" transactions of the type permitted by cases such as CompaqComputer Corp. v. Comr.:2  "tax-motivated transactions designed to transfer foreign tax credits from persons that are unable to benefit from such credits (such as a tax-exempt entity or a taxpayer whose use of foreign tax credits is prevented by the limitation) to persons that can use such credits."3 

Both §901(k) and §901(1) went beyond the basic requirement that taxpayers hold for a specified period of time the property that produces the income subject to the foreign withholding tax. They also deny the credit for withholding taxes imposed on income from property if the taxpayer is "under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property."4  The legislative history of §901(k) indicates that Congress intended by this rule to cover substitute dividend payments.5  In the case of §901(l), however, it is not entirely clear what transactions were meant to be covered.  This lack of clarity makes §901(l) a trap for the unwary, in that by default it denies the credit wherever the recipient of income, subject to a foreign withholding tax, is under an obligation to pass some or all of the income along to another person, related or unrelated.

Fortunately, §901(l)(3) grants authority for the IRS and Treasury to provide exceptions from the denial of credits in §901(l)(1)(B). Unfortunately, few taxpayers appear to have asked the IRS and Treasury for exceptions. One early, notable exception was provided in Notice 2005-90.6  In Notice 2005-90, the IRS and Treasury carved out of §901(l) back-to-back computer program licensing arrangements. In the fact pattern described in the notice, computer manufacturer Y builds computers with operating software designed by X, an unrelated company. The foreign manufacturing subsidiaries of Y assemble the computers and install X's software. To avoid having separate licensing arrangements with each of Y's subsidiaries, X licenses the software to Y, and Y sublicenses the software to its subsidiaries. The subsidiaries pay royalties to Y, which pays them on to X. According to the Notice, §901(l)(1)(B) would deny Y the foreign tax credit for withholding taxes imposed on royalties it receives because Y is under an obligation to make related payments to X with respect to the same software. The Notice exempts these withholding taxes from §901(l)(1)(B), apparently because Y's arrangement was with an unrelated party and was driven by business considerations.

Notice 2005-90 carves very few arrangements out of §901(l). To be covered by the Notice, an arrangement (among other attributes) has to involve a master license between domestic entities covering a copyright in computer software transferred to an affiliate pursuant to the master license, and at least one domestic group member of the licensor must be regularly engaged in the business of selling, leasing, or licensing computer programs. The Notice basically covered a particular set of facts and did not articulate a broad rule or policy rationale. In recognition of its narrow scope, the Notice asked for comments on "other types of licensing arrangements and types of property that should be covered by the licensing exception," as well as "other types of transactions that are not within the purposes of §901(l) and the reasons for excluding such transactions from the application of §901(l)." The IRS and Treasury have received relatively few such comments.7  The lack of comments is somewhat surprising in light of the potential breadth of §901(l). It can apply, for example, to certain just-in-time inventory arrangements, to group licensing of patents and trademarks (as well as copyrights unrelated to computer software), to certain foreign treasury or hedging centers, and to certain domestic IP holding company structures. Another example, and the remaining subject of this commentary, is a partner-to-partnership IP license.

Assume that 10 U.S. partners own equal interests in the profits and capital of a domestic partnership. The partners share equally in the partnership's items of income, loss, deduction, and credit, including creditable foreign tax expenditures (CFTEs).  The partners collectively own IP, which they license to the partnership in exchange for an arm's-length royalty. The partnership contributes the right to sub-license the IP to a domestic LLC wholly-owned by the partnership in exchange for additional interests in the LLC.  The LLC sub-licenses the IP to unrelated foreign licensees for use outside the United States. The LLC is disregarded, and the partnership is considered to receive directly the royalties paid to the LLC.  The LLC distributes to the partnership in cash the royalties it receives from the licensees, and the partnership pays an equal share of the royalties it receives to each of the partners after reduction for its related expenses and a small spread. The payments out to the partners are in proportion to their distributive shares of partnership items, which are equal. The purpose of licensing the software to the partnership is to allow for collective licensing activity and IP management and to reduce the risk that any of the partners individually would have a foreign taxable business presence. Foreign withholding taxes imposed on royalties received by the partnership through the LLC in theory could be denied if §901(l)(1)(B) were to apply at the partnership level. The partnership is making back-to-back payments of the royalties out to the partners, which could be considered "related payments" with respect to the IP.

It would be the wrong answer for §901(l)(1)(B) to apply if the partners receive, either directly or through the partnership, an equal share of both the royalty income and the associated credits.  In that case, the fact pattern would not involve the separation of foreign withholding taxes from the royalty income to which the taxes relate.8  If, however, the partnership splits up the royalty paid to the partners in a different proportion from their distributive share of the foreign withholding taxes, then arguably §901(l)(1)(B) should apply.

For example, assume that the partnership's net foreign-source royalty income is $100, subject to a withholding tax of $30. The partnership pays each partner $7 of income (an equal share of the cash after the $30 withholding tax), and each partner receives a $3 distributive share of foreign tax credits along with a $3 distributive share of income (representing in aggregate the $30 of foreign tax paid). Section 901(l)(1)(B), applied at the partner level, should not deny the credit claimed by any partner because each partner takes into account an amount of income proportionate to the credit received (i.e., $10 ÷ $100 · $30). By contrast, assume the partnership pays five of the 10 partners (Group A) $12 each of royalties and the remaining five partners (Group B) $2 each of royalties. Thus, each Group B partner realizes $2 of income directly from the partnership and $3 as a distributive share of partnership income equal to the partner's distributive share of foreign taxes, for a total of $5. Arguably, each Group B partner should not be entitled to credit his/her full $3 distributive share of foreign taxes. If foreign tax credits are to be allocated in the same proportion as the related income, each Group B partner should be entitled to $1.5 of credits (i.e., $5 ÷ $100 · $30), and the remaining $1.5 of each Group B partner's distributive share of foreign taxes would not be creditable by any partner.

There are many more of these types of issues out there, and the IRS is working on guidance that hopefully will address some of them. In the meantime, it may make sense for taxpayers to examine their receipts subject to foreign withholding taxes to determine if other requests for relief would be in order.

This commentary also will appear in the September 2010 issue of BNA's  Tax Management International Journal .  For more information, in BNA's Tax Management Portfolios, see DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes — General Issues and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.

1 See H.R. Rep. No. 108-548, Pt. 1, at 281 (2004).


2 277 F.3d 778 (5th Cir. 2001).


3 H.R. Rep. No. 105-148, at 545 (1997).


4 §901(k)(1)(B), (l)(1)(B).


5 The legislative history of §901(k) refers to the holding-period requirements of §246(c), which target cases where "a taxpayer is obligated to make a dividend substitute or corresponding payment with respect to a position in substantially similar or related property." Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 143 (1984).


6 2005-2 C.B. 1163.


7 See, e.g., Letter from Jeffrey Tolin and Manish Patel, Los Angeles County Bar Association Taxation Section, June 2, 2008 (requesting an extension of Notice 2005-90 to cover "licensing arrangements entered into in the ordinary course of business within the entertainment, publishing and advertising industries"); Letter from James M. Peaslee to Greg Nickerson and Barbara Angus, Aug. 25, 2003 (requesting relief from §901(l) for withholding taxes on debt instruments that are guaranteed or hedged).


 8 This "straight-up" allocation should meet the regulatory safe harbor for the allocation of creditable foreign tax expenditures. See Regs. §1.704-1(b)(4)(viii)(a).