IRS's Specious Voluntary Payment Argument to Deny Foreign Tax Credits

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By Lowell D. Yoder, Esq.
McDermott Will & Emery LLP, Chicago, IL

A domestic corporation is entitled to claim a foreign tax credit for the amount of any income tax it pays or accrues during the taxable year to any foreign country.1  The regulations state that the person by whom tax is considered paid is the person on whom foreign law imposes legal liability for the tax.2 

A domestic corporation may also claim a credit for taxes deemed to have been paid under §§902 and 960.3  These include foreign taxes paid or accrued by a foreign subsidiary with respect to earnings distributed as a dividend or earnings of the foreign subsidiary included in the gross income of the domestic corporation under Subpart F.

Under current law, a domestic corporation that is liable for foreign taxes is entitled to claim a credit for the taxes paid or accrued even if the income on which such taxes are levied is earned by a foreign subsidiary. There are legislative and regulatory proposals that would instead treat the foreign subsidiary that derives the income as liable for the foreign taxes, but such change in the law has not been enacted. In the interim, however, the IRS is attempting to permanently deny foreign tax credits to a domestic corporation for foreign taxes paid on business income derived by a foreign subsidiary.

Let's consider a series of examples to help assess the position of the IRS. Under scenario one, a U.S. corporation (USP) owns all of the interests in an Italian company (IC-1), which in turn owns all of the interests in a second Italian company (IC-2).  An election was made to classify both IC-1 and IC-2 as disregarded entities. IC-2 is an operating company that manufactures products in Italy and sells the products to Italian customers. During 2009, IC-2 earns, from its Italian business operations, $1,000 of income, which is subject to $400 of Italian income taxes. Under an Italian tax consolidated group regime, an election is made to treat IC-2 as fiscally transparent, such that IC-1 is liable under Italian law for the $400 of Italian taxes. Accordingly, for U.S. tax purposes, IC-1 is considered as the person liable for the Italian taxes. Because IC-1 is disregarded for U.S. tax purposes, USP is treated as having paid the Italian income taxes, and is entitled to claim a direct foreign tax credit in the amount of $400.

Assume instead that IC-1 is classified as a corporation for U.S. tax purposes, and IC-2 distributes its earnings to IC-1, which in turn distributes the after-tax earnings of $600 to USP. IC-1 is again considered as the person liable for the foreign taxes. The payment of the $600 dividend brings the $400 of Italian taxes to USP under §902 as deemed-paid tax credits that may be claimed by USP.

Consider a third example where both IC-1 and IC-2 are classified as corporations. IC-1 is again treated as the company paying the Italian taxes, because IC-1 is the person liable under Italian law for the income taxes. A distribution of IC-2's profits to IC-1, followed by IC-1's distribution of $600 to USP, would cause the $400 of Italian taxes to be considered as deemed paid by USP under §902.4 

Under a fourth example, IC-1 is classified as a disregarded entity of USP and IC-2 is classified as a corporation for U.S. tax purposes. As in the above three examples, IC-1 is considered as liable for the $400 of Italian taxes, i.e., Italian law applies exactly the same in all four examples. IC-2 distributes to IC-1 $1,000, which is included in the income of USP because IC-1 is a disregarded entity of USP. In addition, USP is treated as paying the $400 of Italian taxes paid by IC-1, a disregarded entity, and USP should be entitled to claim the $400 of Italian taxes as a direct foreign tax credit.

The IRS agrees with the conclusions in the first three examples, i.e., that IC-1 is the party liable for the Italian taxes and that USP is entitled to claim a $400 foreign tax credit.  In the fourth example, the IRS also would agree that the taxes are due and owing under Italian law on the Italian business income and that IC-1 is the person liable for the Italian taxes. Nevertheless, pursuant to its position asserted in CCA 20090051 (discussed below), the IRS apparently would not permit USP to claim a foreign tax credit for the $400 of Italian taxes on the basis that the payment of the taxes by IC-1 is voluntary. This position is fundamentally inconsistent with the IRS's position for over 50 years, is contrary to current law, and leads to the absurd result of permanently denying any credit for the $400 of Italian taxes.

The IRS, in Rev. Rul. 58-518,5  ruled that a person liable for foreign taxes is entitled to claim a credit even though it did not recognize the income on which the tax was imposed. Under the facts of that ruling, foreign tax was imposed on a U.S. parent corporation with respect to the combined income of its subsidiaries (a U.S. subsidiary and a foreign subsidiary). The IRS ruled that the parent corporation could claim a direct foreign tax credit because the tax was "assessed against and borne by" the parent corporation, even though the related income was not earned by the parent corporation. The IRS stated that "[t]here is no authority in the law for prorating to the subsidiaries…, for the purpose of computing the allowance for income taxes paid to a foreign country, the foreign income taxes assessed against and borne by [the parent corporation]."6 

In Rev. Rul. 77-209,7  the IRS reaffirmed the holding in Rev. Rul. 58-518, but distinguished the situation in the prior ruling. Under the facts of that ruling, the subsidiaries of the parent corporation were "jointly and severally liable for the tax due" under foreign law. The regulations provide that if income tax is imposed on the combined income of two or more persons and they are jointly and severally liable for the tax under foreign law, then foreign law is considered to impose legal liability on each such person for the amount of the foreign income tax that is attributable to its portion of the base of the tax.8  Accordingly, the subsidiaries were considered as liable for the foreign taxes imposed on the income they earned.  Such taxes would be available to be claimed by the parent as a deemed-paid credit when the subsidiaries distributed their earnings as a dividend.

Forty years after Rev. Rul. 58-518 was issued, in Notice 98-59  the IRS indicated that it now believes that a taxpayer should be entitled to credits only when the income subject to foreign tax is reported by the taxpayer, and that it is considering various alternatives for achieving this result. The last 10 years have seen the introduction of several legislative proposals that would essentially treat the foreign taxes as paid by the entities earning the income for U.S. tax purposes.10  This new "matching rule" would have a prospective effective date. To date, no legislation has been enacted.

The government litigated its matching position in Guardian Industries Corp. v. U.S.11  Under the facts of that case, a Luxembourg disregarded entity was the parent of a Luxembourg consolidated group. Under Luxembourg law, the parent was liable for the consolidated group's taxes. The government argued that Luxembourg law imposed joint and several liability on the members of the group, and accordingly the taxes should be allocated to the subsidiary that derived the income. The lower court and appellate court rejected this interpretation of Luxembourg tax law, determining that the parent was solely liable for the taxes. On appeal, the government also asserted that the U.S. parent should not be entitled to claim a credit for Luxembourg taxes because the credit must be matched with the income on which the foreign tax is imposed. The Court of Federal Claims rejected this argument, finding that "the person on whom foreign law imposes legal liability for the foreign income tax is the person by whom the tax is considered paid for Section 901 purposes." Accordingly, the courts held that the U.S. parent was entitled to a direct foreign tax credit for the foreign tax paid by the disregarded entity even though a portion of the income was earned by the foreign subsidiaries.

In August 2006, the IRS issued proposed regulations which would provide a matching rule.12  The proposed regulations would retain the general tax principle that the foreign tax is considered paid by the person who is legally liable for the tax under foreign law. However, they would provide that foreign law is considered to impose legal liability for tax on the person who is required to take the income into account for foreign income tax purposes. The proposed regulations would be effective on a prospective basis after being finalized.13  More than three years have passed and the regulations have not been finalized.

Having failed to obtain legislation, issue final regulations, and successfully litigate its position that foreign taxes must be matched with the corresponding income, the IRS developed yet another argument. In CCA 200920051, under facts similar to those in the fourth example above and Guardian Industries, the IRS asserts that a U.S. parent is denied a foreign tax credit because the payment of the Italian taxes is not compulsory.

Under the facts of the CCA, the U.S. parent owned all of the stock of two Italian companies that were disregarded for U.S. tax purposes. The two disregarded entities owned all of the stock of two Italian corporations that elected fiscal transparency for Italian income tax purposes. For Italian purposes, the two disregarded entities were considered as earning the income of the two Italian corporations, and accordingly were considered as liable for the Italian taxes under Italian law. For U.S. tax purposes, the U.S. parent was treated as having paid or accrued the Italian taxes.

The relevant regulations provide that "an amount paid is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of such liability under foreign law for tax."14  The IRS did not assert that the taxes were not due or that the amount paid was greater than the liability.  Rather, the IRS argued that the disregarded entities voluntarily paid the tax under the Italian consolidated group regime, which, absent an election, would have been paid by the Italian subsidiaries.

This novel position, which has never been asserted in prior litigation, nor proposed in legislation or regulations, is fundamentally wrong. The income taxes paid were not voluntarily paid to the Italian government. The taxes were due on income from operations conducted in Italy. As illustrated in the examples above, if instead all Italian entities in the CCA had been disregarded for U.S. purposes or all had been classified as corporations, the IRS would permit a foreign tax credit for the same taxes paid to Italy on the same income.  Permitting a credit under those circumstances, where the Italian tax treatment is identical as under the facts of the CCA, demonstrates the fundamental nature of the Italian taxes paid by the disregarded entities in the CCA as creditable taxes.15 

The fallacy of the IRS's assertion is demonstrated by its consequence. If the Italian tax on business income is considered as noncompulsory, such taxes can never be claimed as a foreign tax credit (nor as a deduction).16  Under this approach, in the fourth example above, USP would pay $750 in combined Italian and U.S. income taxes on the $1,000 of Italian income (a 75% tax rate). This double taxation of the Italian operating earnings is fundamentally inconsistent with the core purpose of the foreign tax credit rules to reduce the burden of double taxation, and may very well be in violation of the U.S./Italian income tax treaty. A permanent denial of foreign tax credits to a U.S. parent for taxes clearly due to the Italian government on income of its Italian subsidiaries is extreme overreaching. To take this legally unsupportable position while waiting for a matching rule to be added to the law—which would allow USP to claim $400 of foreign tax credits in the fourth scenario—is bad form.17 

This commentary also will appear in the June 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.

1 §901(a), (b)(1); Regs. §1.901-1T(a)(2).  See §904(a) (limitation on foreign tax credits), §901(j) (denies foreign tax credit for taxes paid to certain countries).


2 Regs. §1.901-2(f)(1).


3 §901(a).


4 See Notice 2007-95, 2007-2 C.B. 1091, stating that taxpayers may rely on Prop. Regs. §1.901-2(e)(5), which allows consideration of U.S.-owned foreign groups on a consolidated basis.


5 1958-2 C.B. 381.


6 See also Rev. Rul. 72-197, 1972-1 C.B. 215 (similar conclusion).


7 1977-1 C.B. 238.


8 Regs. §1.901-2(f)(3).


9 1998-1 C.B. 334. Notice 2004-19, 2004-11 I.R.B. 606, revoked Notice 98-5, but notes that legislative proposals have been introduced.


 10 See H.R. 4297, 109th Cong. §452 (2006); H.R. Rep. No. 109-455, at 263-64 (2006); H.R. 4520, 108th Cong. §661A (2004); H.R. Rep. No. 108-755, at 783-84 (2005).


11 65 Fed. Cl. 50 (2005), aff'd, 477 F.3d 1368 (Fed. Cir. 2007).


12 Prop. Regs. §1.901-2(f)(1)(i), REG-124152-06, 71 Fed. Reg. 44240 (8/4/06).


13 Notice 2007-95, above.


14 Regs. §1.901-2(e)(5).


15 It is noted that, under the third example above, IC-1, a CFC, is liable for the Italian taxes, but IC-2, a separate CFC, earns the relevant income. Under Notice 2007-95 and Prop. Regs. §1.901-2(e)(5)(iii), IC-1 and IC-2 are treated as a single taxpayer, and therefore the noncompulsory position of the IRS would not apply. The IRS, however, would not apply this single taxpayer construct where IC-1 is a disregarded entity of USP.


16 The rationale for treating the Italian taxes as noncompulsory may also prevent claiming the taxes as a deduction. See Cooperstown Corp. v. Comr., 144 F.2d 693 (3d Cir. 1944). Furthermore, if the taxpayer claims a foreign tax credit for other taxes paid or accrued during the taxable year, it cannot claim a deduction for any foreign income taxes. §275(a)(4); Regs. §1.901-1(c).


17 The Obama Administration has proposed a matching rule in its fiscal year 2011 Budget. See U.S. Treasury Department, General Explanations of the Administration's Fiscal Year 2011 Revenue Proposals (2/1/10).



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