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By Dirk J.J. Suringa, Esq. Covington & Burling LLP, Washington, DC
Sections 901 and 905(a) provide a credit for foreign taxes accrued even if they have not yet been paid. The ultimate foreign tax liability, however, may differ from the amount of the accrued liability used to compute the taxpayer's credit claim. Section 905(c) therefore requires an adjustment if: (1) the amount of accrued taxes paid differs from the amount claimed as a credit; (2) accrued taxes are not paid within two years of the year to which they relate; or (3) any tax paid is refunded in whole or in part.
Foreign taxes claimed as direct credits under §901 are adjusted retroactively by means of an amended return for the year to which the taxes relate. In the case of indirect credits claimed under §902 or §960, the statute authorizes the IRS to prescribe adjustments to the foreign corporation's post-1986 tax and earnings pools instead of retroactively redetermining the taxpayer's accrued foreign taxes.1 Temporary regulations issued in 2007 and scheduled to sunset next year (“the Temporary Regulations”) follow the statute and generally require, in the case of deemed-paid taxes under §902 or §960, prospective pooling adjustments rather than retroactive adjustments of the U.S. shareholder's liability.2 Those regulations, however, continue to leave various unanswered questions, such as the question of what should be done when tax pools disappear or appear.
Assume for example that in Year 1 a CFC incurs a foreign tax and pays a dividend, and its U.S. parent takes a deemed-paid credit; in Year 2 the CFC converts into a disregarded entity; and in Year 5 the foreign taxing authority audits Year 1 and imposes an additional tax for that year. The Temporary Regulations ordinarily would adjust the CFC's post-1986 tax and earnings pools in Year 5 to reflect the additional tax,3 but in this fact pattern there are no pools to adjust because the CFC has liquidated for U.S. tax purposes in the interim. On similar facts, the IRS has ruled that the Year 1 pools of the CFC should be adjusted retroactively and the shareholder's U.S. tax liability redetermined for the intervening years.4
In the ruling, the IRS cited §905(c)(2), which specifies the treatment of taxes paid more than two years after the year to which they relate. The foreign tax credit generally must be reversed for accrued taxes that are not paid within two years.5 If such taxes are then paid after the two-year deadline, and if they are deemed-paid taxes under §902 or §960, then the statute requires them to be taken into account in the year in which they are paid and specifically prohibits a redetermination in the year to which they relate.6 Other taxes (§901 taxes) paid after the two-year deadline are not subject to this rule and instead are taken into account retroactively in the year to which they relate.7
In its ruling, the IRS essentially concluded that the additional tax imposed by the foreign taxing authority in Year 5 could not be a deemed-paid tax under §902 or 960 because there were no longer any pools in Year 5. Consequently, the ruling required the taxpayer to take the additional tax into account retroactively through a pooling adjustment in the year to which the tax related, Year 1. This result is sensible and, well, pretty generous, given the language of the statute that appears to deny the credit and to prohibit retroactive pooling adjustments. Nevertheless, the Temporary Regulations do not address the facts of the ruling. Other than for three exceptions (none of which covers disappearing pools), the Temporary Regulations require prospective pooling adjustments “to account for the effect of a redetermination of foreign tax paid or accrued by a foreign corporation on the foreign taxes deemed paid by a United States corporation under section 902 or 960.”8 In the ruling there was a redetermination of the CFC's Year 1 deemed-paid taxes without a prospective pooling adjustment.
Other fact patterns remain unaddressed. For example, what if the foreign taxing authority in the example above had acted more quickly and assessed the additional tax in Year 3--within the two-year period? There is no specific statutory language for additional taxes paid within the two-year deadline, and the Temporary Regulations again would appear to require Year 3 adjustments to pools that no longer exist. One statutory argument here for a Year 1 adjustment to the CFC's post-1986 tax and earnings pools in this case and in the case described in the letter ruling would be that the default rule of §905(c)(1) applies because the IRS in this particular case has not “prescribed adjustments to the pools of post-1986 foreign income taxes and the pools of post-1986 undistributed earnings.”9 The alternative presumably would be to allow a direct §901 credit to the U.S. taxpayer in Year 3, but it is unclear how to account for differences between the mechanics of the §902 credit (e.g., the §78 gross-up) and the §901 credit.
The Temporary Regulations do not appear to provide specific guidance in the opposite direction either. Assume that a foreign disregarded entity owned directly by a U.S. taxpayer incurs foreign taxes in Year 1. In Year 2, the U.S. taxpayer forms a new CFC and contributes the disregarded entity to it (or un-checks the disregarded entity). In Year 3, the foreign taxing authority audits the disregarded entity's Year 1 return and assesses additional tax. From a U.S. tax perspective, the CFC has paid the additional tax, but it relates to a year before the CFC existed. The additional tax thus could become a retroactive adjustment to the U.S. taxpayer's Year 1 credit, or the tax could be added to the CFC's post-1986 tax and earnings pools in Year 3.
The existing language of the Temporary Regulations appears to favor a retroactive redetermination in Year 1. As noted above, the Temporary Regulations use prospective pooling adjustments “to account for the effect of a redetermination of foreign tax paid or accrued by a foreign corporation … .”10 In this example, there is no redetermination of foreign tax paid or accrued by a foreign corporation because the CFC was not on the scene in Year 1. A retroactive redetermination, moreover, would be consistent with the treatment the Temporary Regulations do provide for a redetermination of the taxes of a CFC that was a non-pooling foreign corporation in the year to which the taxes relate.11
To complete the circle, assume that the additional tax is assessed in Year 5 rather than Year 3. This appears to be a closer call. After the two-year deadline, there is specific statutory language providing for prospective pooling adjustments in the case of deemed-paid taxes. In this example, moreover, the CFC actually has post-1986 tax and earnings pools to which the additional Year 5 tax could be added. The argument for a retroactive Year 1 adjustment presumably would be based on the same, close reading of the language of the Temporary Regulations and on the theory that the additional tax paid in Year 5 is not a deemed-paid tax because in the year to which it relates it would have been a direct tax. Guidance on such issues in the final regulations would be helpful.
This commentary also will appear in the June 2009, 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, Carr and Moetell, 902 T.M., Indirect Foreign Tax Credits, Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904, and in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign Activities.
2 Regs. §1.905-3T(d)(2).
3 See Regs. §1.905-3T(d)(2)(ii)(B).
4 See PLR 200127011.
5 See §905(c)(2)(A).
6 See §905(c)(2)(B)(i)(I).
7 See §905(c)(2)(B)(i)(II).
8 See Regs. §1.905-3T(d)(2)(i). The exceptions requiring retroactive adjustments are found in Regs. §1.905-3T(d)(3).
9 §905(c)(1) (flush language).
10 See Regs. §1.905-3T(d)(2)(i) (emphasis added).
11 SeeRegs. §1.902-1(a)(13)(i)(B); Regs. §1.905-5T(a), (d)(1).
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