The Long History of the 2011 Green Book Proposal on Dual Capacity Taxpayers

The Tax Management Transfer Pricing Report ™ provides news and analysis on U.S. and international governments’ tax policies regarding intercompany transfer pricing.

By Dirk J.J. Suringa, Esq.
Covington & Burling LLP, Washington, DC

In its FY 2011 Budget, the Obama Administration has proposed to limit the creditability of foreign taxes paid by dual capacity taxpayers. The proposal, described in the FY 2011 "Green Book," would override final regulations adopted in 1983 after almost a decade of legislative and administrative debate, discussion, and compromise. What has changed to merit reexamination of these rules?

Under the 1983 final regulations, which are currently in effect, a foreign tax is not creditable if it represents compensation for a specific economic benefit (an "SEB") provided by the foreign government to the taxpayer.1  Taxpayers that are subject to a foreign levy and also receive an SEB are referred to as dual capacity taxpayers (DCTs).2  If the foreign levy differs in its application to DCTs, either in its terms or in practice, then the foreign levy must be examined separately to determine if any portion of it was paid for the SEB.3  Typically this results in a bifurcation of the levy into a creditable income tax payment and a non-creditable payment for the SEB.

The 1983 final regulations then allow the DCT to prove, based on all the facts and circumstances, the amount of the foreign levy that is not paid for the SEB and thus is a creditable income tax (the "Facts and Circumstances Test").4  Alternatively, the DCT can elect under a regulatory safe harbor one of two methods for determining the portion of the foreign levy that is creditable. Under the "First Safe Harbor," the DCT can treat as a creditable tax the portion of the levy that would be produced, pursuant to a formula, by application of the income tax generally imposed by the foreign country on all taxpayers.5  The "Second Safe Harbor" applies if there is no generally imposed income tax. It allows the DCT to credit the amount of foreign tax that does not exceed the U.S. tax rate applied to the net income included in the foreign tax base.6 

The 1983 final regulations were the culmination of several years of contentious debate, first in Congress and then between taxpayers and the Carter and Reagan Administrations. The underlying policy concern has always been that a foreign sovereign that owns mineral deposits (or some other economic benefit) can play two different roles in its dealings with taxpayers—tax collector and SEB provider. Payments to the foreign sovereign thus could represent a creditable income tax or, for example, a non-creditable royalty paid for extracting the mineral. During 1974 and 1975, Congress debated whether to adopt strict rules for classifying such payments to the foreign sovereign or to limit the credit to the amount of all such payments attributable to foreign oil and gas income, multiplied by the U.S. tax rate. Congress chose the latter course and adopted §907 in 1975.7  Subject to its own complex rules, §907 denies the credit for foreign oil and gas taxes in excess of the U.S. corporate tax (at the maximum rate) on the related income.

Section 907 did not satisfy the Carter Administration. After its enactment, the IRS took up the fight and revoked several revenue rulings that previously had allowed a credit for foreign oil and gas taxes under both production sharing agreements and posted price systems.8  The basic IRS approach in these rulings was to determine whether the foreign levy economically resembled a royalty, according to a list of factors developed by the IRS.9  Taxpayers complained about the resulting uncertainty, and in response the IRS and Treasury issued regulations intended to clarify when a foreign levy would be treated as a non-creditable payment for an SEB. The regulatory provisions regarding DCTs were not well received. The regulations went through four iterations: the 1979 proposed regulations,10  the 1980 temporary regulations,11  the 1983 proposed regulations,12  and the 1983 final regulations.

The 1983 proposed and final regulations took a different approach from the 1979 and 1980 regulations. The early versions of the regulations provided that a foreign levy was either creditable or non-creditable in its entirety. The later versions allowed taxpayers to bifurcate a single levy into creditable and non-creditable components. The early versions did not contain a robust facts-and-circumstances test for taxpayers to prove the portion of the levy that represented a creditable tax. The later versions adopted this test. The early versions of the regulations denied the credit if the foreign sovereign's "take" did not fluctuate with the taxpayer's net income. The later versions relaxed this requirement. Most importantly for present purposes, the early version of the regulations incorporated a "tax burden equivalency" concept, which the later version of the regulations basically rejected.

The 1980 temporary regulations started by assuming that, where the taxpayer receives an SEB from the foreign government, the foreign levy is a non-creditable payment for the SEB. The 1980 regulations then provided relief from the denial of the credit if the taxpayer could show that the amount of the foreign levy was not significantly greater than what would have been paid under an income tax system applicable to those who did not receive the SEB.13  In other words, the taxpayer could escape the denial of the credit if it could show that its tax burden would have been equivalent under the generally applicable tax system.

The 1983 proposed and final regulations essentially rejected this rule, replacing it with the First Safe Harbor. Under that safe harbor, a taxpayer could elect to credit the amount that would be produced, pursuant to a formula, by the application of the income tax generally imposed by the foreign sovereign on all taxpayers.  Unlike the 1980 version of this rule, however, the First Safe Harbor was elective, and it allowed for bifurcation of the levy into creditable and non-creditable portions. Taxpayers also could attempt to prove the creditable portion of the foreign levy under the Facts and Circumstances Test, or they could rely on the Second Safe Harbor if there was no generally applicable foreign income tax—where there would be no equivalent tax burden.

It is not clear exactly why the 1983 proposed regulations rejected the tax burden equivalency concept featured so prominently in the 1980 temporary regulations. It may have been due in part to the prior rejection by Congress of a legislative proposal that incorporated the same concept. In 1976, Congress considered an amendment, proposed by the Carter Administration, that would have authorized Treasury to deny the credit for oil and gas taxes imposed by any foreign country to the extent those taxes exceeded that country's generally applicable tax rate on other income, or to the extent such taxes were deemed to constitute a royalty where the country did not impose a generally applicable tax on the other income.14  The amendment was rejected, and a modification to §907 was adopted instead.15    The Reagan Administration may have given greater weight to Congress' rejection of this approach than had the Carter Administration.

The rejection of the tax burden equivalency concept by Congress and by Treasury has become relevant once again because the FY 2011 Green Book proposal is again based on the same concept. Under the proposal, DCTs would be allowed to credit the amount of the foreign income tax they would pay if they were not DCTs: they would be able to credit the equivalent tax burden for those who do not receive the SEB.

The FY 2011 Green Book proposal would "replace" both safe harbor methods of proving the portion of the foreign levy that is creditable, as well as the Facts and Circumstances Test.  In effect, all the differences in the foreign levy between DCTs and non-DCTs would be conclusively presumed to be tied to the receipt of the SEB—and not, for example, because the foreign government is simply imposing an otherwise creditable excess profits tax on profitable oil companies. The credit still would be allowed for discriminatory foreign tax systems (i.e., systems that tax only foreign persons), but only if the system taxes non-DCTs as well as DCTs.16 

The long history of the various competing proposals regarding DCTs, including the rejection of the tax burden equivalency concept in 1976 and 1983, raises the question what has changed in the interim to merit reconsideration of that concept. Why is it necessary after all these years to deny to oil and gas companies the ability to prove in court that the amount of a foreign levy they are paying is in substance an income or excess profits tax?

One answer may be that they have been too successful in doing exactly that. In the Exxon and Phillips cases,17  the taxpayers were able to persuade the court that special U.K. and Norwegian petroleum taxes were creditable taxes and not non-creditable royalties. The taxpayers were able to show that they already paid an arm's-length royalty for the mineral, that they received no additional mineral rights in exchange for the extra foreign levy, and that the foreign governments were essentially motivated to tax the profits of the taxpayer considered to be excessive. Perhaps the U.S. government is concerned that, in light of these victories, taxpayers are revoking their safe harbor elections in favor of a dubious application of the facts and circumstances test. Under the current regulations, however, the burden of proof is on the taxpayer, which is yet another component of the carefully crafted compromise of 1983.

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, 901 T.M., The Creditability of Foreign Taxes—General Issues, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation, and ¶7160, U.S. Income Tax Treaties.

1 Regs. §1.901-2(a)(2)(i).


2 Regs. §1.901-2(a)(2)(ii)(A).


3 Regs. §1.901-2A(a)(1).


4 Regs. §1.901-2A(c)(2).  The levy, of course, must satisfy all the other requirements for being a creditable income tax (e.g., reach net gain, etc.). See Regs. §1.901-2.


5 Regs. §1.901-2A(c)(3), (e)(1)-(3).  For purposes of this rule, a tax that is imposed only on foreign entities would be considered a generally imposed tax. See Regs. §1.903-1(b)(3) Ex. 4.


6 Regs. §1.901-2A(e)(5).


7 See Tax Reduction Act of 1975, P.L. No. 94-12, §601, 89 Stat. 26, 54-58.


8 See, e.g., Rev. Rul. 76-215, 1976-1 C.B. 194; Rev. Rul. 78-63, 1978-1 C.B. 228.


9 I.R. 1638 (7/14/76).


10 Former Prop. Regs. §1.901-2, 44 Fed. Reg. 36071 (6/20/79).


11 Former Temp. Regs. §4.901-2, 45 Fed. Reg. 75647 (11/17/80).


12 Former Prop. Regs. §1.901-2, 48 Fed. Reg. 14641 (4/5/83).


13 Former Temp. Regs. §4.901-2(b)(2)(ii), 48 Fed. Reg. at 75649.


14 See 122 Cong. Rec. §12133-42 (daily ed. 7/21/76).


15 See S. Rep. No. 94-1236, at 461 (1976).


16 The FY 2011 Green Book proposal resembles a proposal in the FY 2010 Green Book, which itself dates to the Clinton Administration. Under the 2010 proposal, a foreign levy was to be creditable only if the foreign country generally imposed an income tax. That proposal also eliminated the Facts and Circumstances Test and two safe harbor methods, but it made the creditability of the foreign tax for DCTs turn on whether the foreign country had a generally imposed income tax. A discriminatory foreign income tax was not considered to be a generally imposed income tax. This proposal was revised in the FY 2011 Green Book after it was pointed out that for the same discriminatory foreign levy the proposal would have denied a credit to a DCT and allowed it for a non-DCT. See, e.g., JCX-34-09 (2009). This made it somewhat difficult to argue that the levy was payment in consideration for an SEB.


17 Exxon Corp. v. Comr., 113 T.C. 338 (1999); Phillips Petroleum Co. v. Comr., 104 T.C. 256 (1995).



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