By Dirk J.J. Suringa, Esq. Covington & Burling LLP, Washington, DC
The IRS recently released a Chief Counsel Advice1 that used the compulsory-payment requirement of Regs. §1.901-2(e)(5) to attack an Italian reverse hybrid structure, which attempted to separate the foreign tax credit from related income. The advice demonstrates the type of transaction the IRS intends to attack on the ground that the compulsory-payment requirement applies taxpayer-by-taxpayer.2 However, finalization of some or all of the proposed technical taxpayer regulations,3 or enactment of the Obama Administration's budget proposal on splitter transactions,4 would probably strike a better balance in dealing with these structures.
The facts considered in the advice can be summarized as follows: U.S. parent corporation (“USP”) owns all the stock of two Italian companies that elect to be disregarded for U.S. tax purposes. The two Italian disregarded entities (DEs), in turn, own all the stock of two Italian corporations, which elect under Italian law to be treated as pass-through entities for Italian tax purposes. For U.S. tax purposes, the lower-tier Italian corporations are CFCs. For Italian tax purposes, the income of the Italian CFCs flows up to the Italian DEs, where the Italian tax liability is imposed. For U.S. tax purposes, however, the Italian DEs are disregarded, and the liability is treated as imposed directly on USP. As a result, the advice notes, USP “claims a significant amount of foreign tax credits for the Italian taxes paid by the Italian DEs without reporting any of the corresponding income from the Italian CFCs.”
If this fact pattern sounds familiar, it is because it resembles that of Guardian Industries v. Comr.5 In Guardian Industries, the same separation of income and credit occurred by virtue of the Luxembourg consolidated return rules. Luxembourg law imposed sole liability for the income taxes of a Luxembourg group on the group parent, which elected to be disregarded for U.S. tax purposes. The U.S. parent was treated as the taxpayer (the person legally liable for the Luxembourg taxes) because it was the owner of the disregarded foreign parent. The related income, however, remained below in the operating CFCs comprising the remainder of the Luxembourg group, effectively separating the foreign taxes and income.
The IRS in that case argued before the Federal Claims Court that the group members were jointly and severally liable for the taxes imposed on the group parent under Regs. §1.901-2(f)(3), which would have required the taxpayer to apportion the taxes among all of the Luxembourg group members based on their respective shares of income subject to Luxembourg tax. The court disagreed. The IRS then switched focus and argued before the Federal Circuit that the group parent did not have legal liability for the foreign tax because legal liability only attaches to the owner of the income included in the foreign base. The Federal Circuit also disagreed, and the IRS responded with the proposed technical taxpayer regulations. The proposed regulations have not yet been finalized. In the meantime, the Obama Administration has proposed to “adopt a matching rule to prevent the separation of creditable foreign taxes from the associated foreign income” -- effective starting in 2011.
The main difference between Guardian Industries and the Italian structure described in the advice is that the separation of income from credit occurs because of the Italian entity classification election, rather than the rote application of local law. The advice targets this distinction and proceeds as follows: Regs. §1.901-2(e)(5) requires taxpayers “to reduce, over time, the taxpayers' reasonably expected liability under foreign law for tax.” The Italian entity classification election requires the consent of the owners of the Italian CFCs, which are the Italian DEs. The election therefore can be considered a joint election by the Italian CFCs and the Italian DEs. The Italian DEs are disregarded for U.S. tax purposes, so the election can be considered a joint election by the Italian CFCs and USP. Because the compulsory-payment requirement applies taxpayer-by-taxpayer, USP is required to reduce its Italian tax liability separately from the Italian CFCs. The effect of each Italian entity classification election was to decrease the Italian CFC's tax liability at the expense of increasing USP's tax liability. Therefore, according to the advice, USP's Italian taxes constitute voluntary payments.
The advice redacts out its discussion of litigating hazards, but here are a few thoughts about what they might be. First, it is unclear whether the Italian entity classification election really was made by USP. In the check-the-box regulations, the fact that the owner or designated officer has to sign the election does not change the fact that the entity itself is electing its classification.6
Second, as the advice recognizes, the compulsory-payment requirement does not require a taxpayer “to alter its form of doing business, its business conduct, or the form of any business transaction in order to reduce its liability under foreign law for tax.”7 The advice responds that USP chose to conduct business in Italy through corporations, and the Italian tax election was not about how to do business. Whether the baseline form chosen by the taxpayer includes a local entity classification election may not be so clear, however. To give a contrasting example, the partnership anti-abuse regulations allow taxpayers, without running afoul of the abuse-of-subchapter-K provisions, to use a foreign partnership rather than a CFC in order to take advantage of look-through treatment and maximize the current availability of the foreign tax credit.8 At least in that context, U.S. tax law views the choice of pass-through treatment as a permissible choice of form, even if the purpose is to maximize the foreign tax credit.
Third, the proposed group-relief regulations9 may apply to the Italian DEs. The proposed group-relief regulations treat as a single taxpayer for purposes of the compulsory-payment requirement all foreign entities in which the same U.S. person directly or indirectly owns an 80%-ownership interest (a “U.S.-owned group”).10 If one member of a U.S.-owned group increases its foreign tax liability to reduce the liability of another group member, the proposed regulations would not treat the foreign tax increase as a voluntary payment.
The advice argues that the proposed regulations do not apply because the Italian DEs are disregarded for U.S. tax purposes. According to the advice, the case therefore involves shifting liability from the Italian CFCs to USP. USP cannot be a member of the U.S.-owned group because it is not a foreign entity. Under the literal language of the proposed regulations, however, the Italian DEs are members of the U.S.-owned group that includes the Italian CFCs. The U.S.-owned group is defined to include all 80%-owned foreign “entities,” and the Italian DEs are foreign entities 100% owned by USP.11 USP could argue that the liability has been shifted between the Italian CFCs and the Italian DEs, both of which are members of the same U.S.-owned group.
If the advice is sustained, the result to USP would be much more severe than under the proposed technical taxpayer regulations or the Obama Administration's budget proposal. Voluntary payments are not creditable taxes at all. The logical result of the advice, therefore, is permanent denial of USP's credit, with the prospect of a potential future taxable inclusion of the earnings to which the taxes relate. By contrast, under the technical taxpayer regulations, the taxes would simply be shifted to the Italian CFCs, from which they later could be distributed and credited under §902. Double taxation can be avoided under the advice only by deferring forever the distribution of earnings from the Italian CFCs.
This commentary also will appear in the August 2009, issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see Streng, 700 T.M., Choice of Entity, and DuPuy and Dolan, 901 T.M., The Creditability of Foreign Taxes -- General Issues, and in Tax Practice Series, see ¶7130, U.S. Persons' Foreign Activities.
1 CCA 200920051 (4/7/09).
2 See generally REG-156779-06, 72 Fed. Reg. 15081 (3/30/07) (“[T]he current final regulations apply on a taxpayer-by-taxpayer basis, obligating each taxpayer to minimize its liability for foreign taxes over time … .”).
3 See REG-124152-06, 71 Fed. Reg. 44240 (8/4/06).
4 Department of the Treasury, General Explanation of the Administration's Fiscal Year 2010 Revenue Proposals, at 31 (2009).
5 477 F.3d 1368 ( Fed. Cir. 2007).
6 See Regs. §301.7701-3(d)(2).
7 Regs. §1.901-2(e)(5)(i).
8 See Regs. §1.701-2(d) (Example 3).
9 REG-156779-06, 72 Fed. Reg. 15081 (3/30/07);see alsoNotice 2007-95, 2007-49 I.R.B. 1091 (“For taxable years ending on or after Mar. 29, 2007, and beginning on or before the date on which the final regulations are published, taxpayers may rely on the portion of the proposed regulations addressing U.S.-owned foreign groups.”).
10 SeeProp. Regs. §1.901-2(e)(5)(iii)(A).
11 See generally Regs. §301.7701-2(a) (“[A] business entity is any entity recognized for federal tax purposes (including an entity with a single owner that may be disregarded as an entity separate from its owner under §301.7701-3) that is not properly classified as a trust under §301.7701-4 or otherwise subject to special treatment under the Internal Revenue Code.”).
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