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By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
* Significant contribution from Seth Goldstein is acknowledged, though Mr. Goldstein is in no way responsible for any errors that may be contained herein.
The enactment of §909 1 with a minimum of legislative history2 leaves a maximum of need for further guidance from the IRS. Among the thorniest of areas needing further guidance is the definition of "related income" in §909(d)(3).
As most readers know, new §909 was enacted to prevent taxpayers from splitting their creditable foreign taxes from the income or earnings on which such taxes were imposed. This so-called "mis-match" is (or was, before the enactment of §909) a fairly natural result of differences between U.S. tax and foreign tax principles with respect to timing, the sharing of tax attributes among related persons, and/or characterization of entities or transactions.
Where, for example, an entity is considered corporate for U.S. tax purposes but fiscally transparent for foreign tax purposes (a reverse hybrid or "RH"), foreign tax would be paid on earnings of the RH by its owners but the United States would see the E&P as remaining in the RH until distributed. This "splits" the foreign tax from the earnings on which it is imposed by placing the tax in one person and the earnings in another.
Utilizing entity or transaction classification rules that created a "mismatch" of U.S.-determined earnings and foreign-determined foreign taxes has been common. While any transaction that may contribute to the mismatch must pass muster under the economic substance and other common law tax principles, until the promulgation of the 2007 SPIA (structured passive investment arrangements) regulations and the more generally applicable §909, there existed no prohibition against choosing business transactions that contribute to the mismatch.
Section 909, generally effective for foreign taxes paid or accrued in taxable years after 2010, is a broad provision intended to prevent both natural and planned enhancements to this mismatch phenomenon. It "suspends" a foreign tax for which a credit would otherwise be available until the "related" earnings or income is taken into account for U.S. tax purposes by the taxpayer of the foreign tax or, in the case of a foreign corporation that is the taxpayer, by the taxpayer's §902 U.S. shareholder.
Section 909(d)(3) attempts to define "related income" for this purpose. Unfortunately, it provides little guidance, defining related income as income that is related.3 It provides as follows:
The term "related income" means, with respect to any portion of any foreign income tax, the income (or, as appropriate, earnings and profits) to which such portion of foreign income tax relates.
The JCT Explanation provides a bit more guidance, but not much, other than making clear that the income or earnings are "calculated under U.S. tax principles," and pointing out several areas where regulations are appropriate (losses, deficits in earnings, and timing differences). As one begins to contemplate various common fact patterns, the superficial simplicity which the term "related income" appears to have soon dissolves into a morass of complexity and confusion. So, unless "related income" is the way pornography was to Justice "I-know-it-when-I-see-it" Stewart, the IRS has a fairly difficult job ahead of it informing taxpayers what related income is under §909(d)(3).
The fact patterns that raise questions as to what constitutes "related income" are myriad. And the ability to describe general principles for defining "related income" is restricted. Here are just a few of the common fact patterns the IRS might wish to address. They provide, however, a sample of the difficult task ahead of the IRS.
Let's say we are dealing with a CFC (CFC1) that owns a reverse hybrid (RH)—a classic splitter which, prior to §909 being effective, leaves non-Subpart F E&P in RH while foreign taxes imposed on that E&P are paid by CFC1 and deemed paid under §902 by CFC1's shareholder when CFC1 pays a dividend of a dollar. Let's also say, however, that RH has a lot of undistributed post-1986 earnings accumulated prior to 2011. Because §909 now compels RH to abandon its splitting practices, in 2011 RH distributes an amount equal to its current E&P to CFC1. Is that E&P "related" E&P (i.e., related to the foreign taxes CFC1 pays in 2011), or must RH also distribute all of its accumulated E&P to have all of its "related" E&P brought up to the person paying the foreign taxes? In other words, what is the ordering rule—LIFO or pro rata or FIFO?
Now let's say, instead of distributing an amount equal to its current E&P to CFC1, RH instead buys shares of a subsidiary of CFC2 (sister to CFC1) from CFC2 in a §304 transaction, such that a deemed distribution is made from RH to CFC2. CFC1 may now be out of luck with respect to ever taking "related income" into account itself since that income appears to have all gone cross-chain to the sister. But what if CFC2 makes a distribution to the common U.S. shareholder of CFC1 and CFC2 (US1)? Shouldn't that then allow CFC1 to take into account the foreign taxes it paid and reduce its E&P? Section 909(b) would apparently permit CFC1 to take into account the tax when US1 takes into account the related income (creating a "reverse splitter").
Real life tends so often to be messier than we expect. Going a further step along the complexity path, what if, after the §304 dividend to CFC2 mentioned above, that deemed dividend is offset by interest paid from CFC2 to a cousin CFC (CFC3, owned by a U.S. subsidiary (US2)) of US1? Now not only may CFC1 be out of luck with respect to ever taking "related income" into account itself since that income appears to have all gone cross-chain to the sister CFC2, as above, but CFC2 may also be unable to pay a dividend to US1 (which one would hope is "related income," as discussed above). Unfortunately, some may think the interest income of CFC3 itself is "related income." IRS officials have been reported as thinking favorably (unfavorably to poor CFC1) about tracing "related income" through character changes — i.e., calling the Subpart F income realized by US2 as a result of CFC3's interest income (in a post-§954(c)(6) world) as the "related income" to CFC1's foreign taxes. And since US2 is not CFC1's §902 U.S. shareholder (see First Chicago), there is a possibility that related foreign taxes suspended until "related income" is earned may forever be hung up if this character change approach is taken. This could also happen when there is interest paid by CFC2 to an unrelated bank. Worse still, since money is fungible, how will a tracing rule be applied if character changes are respected? Will a Regs. §1.881-3 regime be necessary? Or will the overburdened §904(d)(3) look-through rules be employed to chase related income around the group (sort of a mini-basket for each bucket of related income)? Or will any payment that is income to another person constitute the movement of the income that is "related income" to the suspended foreign tax paid by CFC1?
But this sort of messiness is only the beginning of what happens in a complicated foreign group of CFCs. What if there is no Subpart F inclusion in the case above? And what if CFC3 is a subsidiary of CFC4 and pays an actual dividend to CFC4, but CFC4 has an E&P deficit that offsets the dividend. The "related income" may now, if the IRS is serious about tracing through character changes, be traced through the §304 deemed dividend to CFC2, thence through the interest paid to CFC3, thence through the actual dividend to CFC4. Does that E&P deficit offset prevent CFC1 from releasing its suspended foreign tax?
Just to make things a bit more realistic, now let's assume that CFC4's E&P deficit did not completely offset the dividend from CFC3, and CFC4 then distributes the "related income" to US2, which then distributes it to US1. Do CFC1's suspended foreign taxes then get freed up? But what about Regs. §1.1502-13(f), which generally excludes the dividend from gross income?
While these fact patterns may seem contrived to some, it is clear to this commentator that not only are they realistic, they will be repeated in a thousand different variations in any large multinational enterprise's structure. Though the lesson here may be simply to avoid any possible splitting event, that is easier said than done, given the uncertainties surrounding what constitutes a splitting event (a subject, perhaps, for a future commentary). And even if splitting events could be avoided in the future, we must hearken back to the beginning of the chain of fact patterns above and remember that accumulated E&P from old, abandoned splitters will send us down these roads in any event, unless the IRS grants some sort of dispensation for pre-2011 taxes and related income. Imagine attempting to trace the twisted journey of related income initially earned 20 years ago or more.
Further, I fear that, once more thought is given to this subject, it may be revealed that the complexity above is just the tip of the iceberg. The only thing certain, therefore, is that one should be glad not to be responsible for producing the IRS's guidance in this area. But if that guidance is not comprehensive, the rest of us will have a challenging time opining on this subject in the future.
This commentary also will appear in the November 2010, issue of the Tax Management International Journal. For more information, in the 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.
2 Some would say no legislative history because the one explanatory document of the provision as enacted, the Joint Committee on Taxation's "Technical Explanation" (JCX-46-10, Aug. 10, 2010), though available to members of the House and Senate before they voted on the provision, is only a staff document that was never, unlike committee reports, adopted by a tax-writing committee's elected members in reporting out a bill.
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