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By Edward Tanenbaum, Esq.
Alston & Bird LLP, New York, NY
Huh? Why would the transfer pricing and foreign tax credit
regimes be relevant in a situation involving disregarded
transactions as, for example, transactions between a U.S.
corporation and its foreign disregarded entity or branch? In our
check-the-box era, a foreign disregarded entity is generally
treated as a foreign branch and the income of a foreign disregarded
entity or branch is included in the income of its owner because
they comprise a single person. Haven't we all been taught that
transactions with disregarded entities are not relevant, and that
they are disregarded, for tax purposes?
Moreover, while the "arm's-length standard" under §482 allows
the IRS to allocate income, deductions, credits, and allowances
among commonly controlled (but separate) taxpayers to prevent tax
evasion and clearly reflect income, the arm's-length standard is
not particularly meaningful for transactions between foreign
disregarded entities or branches and their owners that are
non-events for tax purposes.
Well, the IRS generally agrees except that in CCA 201349015 it
makes clear that inappropriate transfer pricing policies can lead
to an overstatement of foreign tax, leading to "noncompulsory"
payments of foreign tax under Regs. §1.901-2(e)(5). Under Regs.
§1.901-2(e)(5), foreign taxes are not considered paid-and thus are
not creditable under §901-if they exceed the liability under
foreign tax law (the "noncompulsory payment rule"). A taxpayer must
be prepared to substantiate that its or its foreign disregarded
entity's foreign tax return was prepared based on a reasonable
interpretation of the substantive and procedural foreign tax law
(including applicable tax treaties) and must exhaust all effective
and practical remedies to reduce and minimize its foreign tax
The CCA deals with two situations: (1) transactions between a
U.S. corporation and its foreign disregarded entity or
unincorporated branch; and (2) transactions between a U.S.
corporation and an affiliated U.S. corporation's foreign
disregarded entity or unincorporated branch.
With regard to transactions between a U.S. corporation and its
foreign disregarded entity or branch, the IRS points out that such
transactions do not give rise to offsetting amounts of income or
expense for U.S. tax purposes; rather, the transactions are
generally disregarded as occurring within a single person. In fact,
the IRS goes on to say that, in general, transfer pricing rules in
this context are not meaningful for U.S. tax purposes.
Nevertheless, the IRS points out that transfer pricing rules may
be relevant in such a situation in determining whether transfer
prices have resulted in noncompulsory payments for foreign tax
credit purposes, provided the foreign tax law, as modified by tax
treaties, includes similar arm's-length principles. This could
arise, for example, if a transfer price results in a branch
reporting too much income to the foreign country in which it
operates, resulting in an overpayment of foreign income tax.
So, too, a controlled foreign corporation (CFC) resident in one
country and operating through a disregarded entity or branch in
another country may report too much income and overpay foreign tax
in either of the jurisdictions. The issue is relevant for U.S.
foreign tax credit purposes because the foreign taxes in question
may be deemed paid by U.S. shareholders under §902 or §960.
Whether a U.S. person or a CFC is incurring the foreign tax, the
legal basis for disallowing the foreign tax credit is not §482 but
rather the noncompulsory payment rule, i.e., the foreign tax is not
considered "paid" for foreign tax credit purposes to the extent it
exceeds the amount of liability under foreign law for tax (with the
amount of taxable income reported to the foreign jurisdiction
required to be computed in accordance with a reasonable
interpretation of the foreign tax law, as modified by
With respect to transactions between a U.S. corporation's
foreign disregarded entity or branch and another member of the U.S.
consolidated group, §482 technically governs such related-party
transactions as well. However, §482 adjustments do not have current
tax effects because of the intercompany transaction rules of Regs.
§1.1502-13. Under that rule, in combination with §864(e), the
timing, character, and source of intercompany items are treated as
if the transactions occurred between divisions of a single
corporation. As a result, any adjustments under §482 would
not currently be taken into account. Nonetheless, the pricing of
such intercompany transactions could result in overpayments of
foreign tax giving rise to noncompulsory foreign tax payments.
Thus, the pricing is at least relevant to that extent.
So, the CCA is a warning to U.S. corporations with foreign
disregarded entities or branches. Simply because transactions
between a foreign disregarded entity or branch and its owner (or
between a foreign disregarded entity or branch and an affiliate of
its owner) may be ignored (or produce offsetting amounts) for many
U.S. tax purposes, taxpayers should not interpret this general
treatment as a free pass to disregard arm's-length principles.
These transactions can still have significant consequences for the
U.S. foreign tax credit. While the CCA does not discuss in depth
transactions between foreign corporations and their
U.S. disregarded entities or branches, the IRS
counsels that these transactions may similarly be given effect for
limited U.S. tax purposes, e.g., for purposes of the income
sourcing rules or for purposes of determining the profits
attributable to a permanent establishment.
This commentary also will appear in the March 2014 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.
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