The New §904 Limitation Category for Income Re-Sourced by Treaty

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, D.C. 

Along with other changes to the foreign tax credit rules, Congress recently enacted a new limitation category for income re-sourced by a treaty. The purpose of the new provision is to prevent taxpayers from inflating their foreign-source income by applying treaty re-sourcing rules to structures not covered by §904(h).  Like its companion provisions, the new limitation category will require some implementing guidance.

By way of background, some U.S. income tax treaties provide a re-sourcing rule, which allows a U.S. taxpayer electing treaty benefits to treat as arising from foreign sources any income that the treaty authorizes the other Contracting State to tax.1  In the absence of this re-sourcing rule, the foreign tax credit limitation could restrict the taxpayer from claiming a credit for the other Contracting State's tax and thus undermine the allocation of taxing rights provided by the treaty.2  Under U.S. domestic law, however, a special sourcing rule in §904(h)(1) applies to income earned through a majority U.S.-owned foreign corporation (a "United States-owned foreign corporation" or "USOFC")3  that is attributable to U.S.-source income of the USOFC. Section 904(h)(1) treats such income as arising from U.S. sources for purposes of the foreign tax credit limitation. Its purpose is to prevent taxpayers from routing their U.S. source-income through a foreign affiliate to convert it into foreign-source income and thus inflate their foreign tax credit limitation.4 

The enactment of §904(h) in 1984 was intended to override treaty re-sourcing rules where U.S.-source income was earned through a USOFC.5  After its enactment, however, Congress apparently became persuaded that a more targeted approach was possible: §904(h)(10) was added in 1988 to coordinate §904(h)(1) with treaty sourcing rules. Section 904(h)(10) allows a taxpayer to elect to apply a treaty sourcing rule (and thus override §904(h)(1)) for any amount derived by a USOFC that would be treated as U.S.-source income under §904(h)(1) but as foreign-source income under a treaty obligation of the United States in the absence of §904(h)(1).  Section 904(h)(10) enables taxpayers to avoid double taxation where, for example, a USOFC resident in a treaty jurisdiction earns U.S.-source royalty income subject to full, corporate-level foreign taxation.

Despite the enactment of this coordination rule, several U.S. treaties ratified in the latter 1980s and the 1990s made the re-sourcing rule "subject to such source rules in the domestic laws of the Contracting States as apply for purposes of limiting the foreign tax credit" (referred to herein as the "Domestic Source Clause"). This clause has been read as a reference to §904(h), rather than as a general override of the particular treaty re-sourcing rule by domestic-law sourcing rules.6  Nevertheless, confusion on this point persisted. For example, Treasury's Technical Explanation of the U.S.-Luxembourg Income Tax Treaty, which contains the Domestic Source Clause, appears to read the re-sourcing rule right out of the treaty.7  Some treaties of the same vintage dropped the re-sourcing rule altogether.8 

Beginning with the U.S.-U.K. Income Tax Treaty in 2000, re-sourcing rules began to enjoy a resurgence.9  The new re-sourcing rules dropped the Domestic Source Clause. They reverted to the more general proviso that the treaty-based credit would be "subject to the limitations of the laws of the United States." This change helped to clarify the coordination between the re-sourcing rules and §904(h)(10).10  Section 904(h)(10) applies if there would be a conflict between §904(h)(1) and the treaty re-sourcing rule.11  Under the Domestic Source Clause, the treaty re-sourcing rule is subject to U.S. domestic source rules. If one interprets §904(h)(1) as a U.S. domestic source rule, then it simply trumps the treaty re-sourcing rule, and there is no conflict for §904(h)(10) to resolve. Eliminating the Domestic Source Clause thus clarifies that a conflict exists for §904(h)(10) to resolve. In effect, it allows the taxpayer to elect the treaty re-sourcing rule, notwithstanding §904(h)(1), but subject to separate basketing of the re-sourced income.

Section 904(h)(1) applies only to USOFCs—a limitation apparent to both taxpayers and policymakers. The latter became concerned that taxpayers were relying on treaty re-sourcing rules to generate low-tax foreign-source income through structures that fell outside the scope of §904(h).

The response was section 213 of "the Act formerly known as H.R. 1586," which added new §904(d)(6).12  Section 904(d)(6) applies the foreign tax credit limitation separately to "any item of income" that would be treated as U.S.-source income in the absence of a treaty but as foreign-source income under "a treaty obligation of the United States," provided that "the taxpayer chooses the benefits of such treaty obligation."13  The new limitation does not apply to income already subject to a separate limitation under §904(h)(10) or §865(h).14  The statute invites Treasury and the IRS to issue regulations necessary or appropriate to carry out the purposes of the new rule, "including regulations or other guidance which provides that related items of income may be aggregated."15  Section 904(d)(6) is effective for taxable years beginning after the date of enactment, i.e., August 10, 2010.16 

If one believes that the ideal foreign tax credit limitation applies on the basis of each item of income, then new §904(d)(6) is a move in the right direction. It is structured as a separate limitation for each item of income re-sourced pursuant to a treaty.  If one's normative baseline for the elimination of double taxation is a per-category or a per-country limitation, however, §904(d)(6) increases the likelihood of double taxation.

For example, the U.S.-India Income Tax Treaty allows India to tax certain royalties and technical service fees that would be regarded as U.S.-source income under U.S. domestic law.17  Article 25(3) treats such income as arising from sources within India. The treaty provides a special exception from §904(h)(1) for royalties and technical service fees that the treaty permits India to tax. That type of income remains foreign-source notwithstanding U.S. domestic source rules.18  Section 904(d)(6) now apparently would override the treaty re-sourcing rule and require separate basketing of U.S.-source royalties and technical service fees that India is permitted to tax. If the Indian royalties are general category income, and if the taxpayer derives other general category India-source income, excess credits or excess limitation from that other income will not be available in computing the foreign tax credit limitation, which increases the risk of double taxation from the perspective of a per-country or per-category limitation.

Section 904(d)(6) will require administrative guidance on its implementation, e.g., to clarify when a taxpayer's election of treaty benefits implicates §904(d)(6). In most cases, the answer to this question should be when both: (1) the taxpayer elects to credit the foreign tax under the treaty; and (2) the source of the income under the treaty differs from its source under U.S. law.19  Treaty re-sourcing rules typically apply for purposes of computing a foreign tax credit under the treaty.20  If the taxpayer does not elect to compute the credit under the treaty, then the re-sourcing rule should not be implicated, and the taxpayer's income should not be "treated as arising from sources outside the United States" "under a treaty obligation of the United States."21  It would be helpful for Treasury and IRS to clarify in guidance when a taxpayer is considered to elect the source of income under a treaty.

Even if the taxpayer does elect the treaty credit, the separate limitation generally would not apply unless the treaty treats as foreign-source an item of income that would be treated under domestic law as U.S.-source.22  Because §904(d)(6) applies on the basis of each item of income, moreover, the separate limitation should not apply, even where both of the above conditions are satisfied with respect to one or more items of income, to other items of income that have the same source under domestic law and the treaty re-sourcing rule.

It also would be helpful for Treasury and the IRS to consider an exception from §904(d)(6) for treaties that already contain their own separate limitation regime for the treaty credit, such as the treaties with Canada and New Zealand.23  The JCT Report accompanying the legislation appears to envision that type of guidance.24 

This commentary also will appear in the December 2010 issue of BNA's Tax Management International Journal.  For more information, in BNA's Tax Management Portfolios, see Suringa, 904 T.M., The Foreign Tax Credit Limitation Under Section 904,  and in Tax Practice Series, see ¶7150, U.S. Persons—Worldwide Taxation. 

1 See, e.g., U.S.-U.K. Income Tax Treaty, Art. 24(2)(a). 

2  Compare Department of the Treasury, U.S. Model Income Tax Convention, Art. 12(1) (2006) (providing that royalties beneficially owned by a resident of a Contracting State may only be taxed in that Contracting State), with §§861(a)(4) and 862(a)(4) (sourcing royalty income by reference to the place where the licensed property is used). 

3 A foreign corporation is a USOFC if a U.S. person directly or indirectly owns at least 50% of the total combined voting power of all classes of voting stock of the foreign corporation or of the total value of the stock of the foreign corporation.  §904(h)(6). 

4 See H.R. Rep. No. 98-432, at 1346 (1984); S. Rep. No. 98-169, at 386-87 (1984); Staff of the Joint Comm. on Tax'n, 98th Cong., General Explanation of the Deficit Reduction Act of 1984, 346 (1984). Section 904(h) was originally enacted as §904(g). 

5 See P.L. 99-514, §1810(a)(4), 100 Stat. 2085, 2822-23 (1986).

6 See Letter from Mary C. Bennett, Baker & McKenzie, to Patricia A. Brown, Deputy International Tax Counsel, Department of the Treasury (6/2/00), reprinted in 2000 Worldwide Tax Daily 117-52 (6/2/00). 

7 Department of the Treasury, Technical Explanation of the U.S.-Luxembourg Income Tax Convention, Art. 25(4) (1996); see also Report of the Senate Foreign Relations Committee on the U.S.-China Income Tax Convention, S. Exec. Rep. No. 99-7, 1988-1 C.B. 423, 427 ("[T]he Committee … has recommended approval of the treaty based on its understanding that nothing in Article 23 will be interpreted to prevent the United States from determining the source of income (for purposes of the foreign tax credit limitation) in accordance with the provisions of section 904[(h)] of the Internal Revenue Code."). 

8 See, e.g., U.S.-Switzerland Income Tax Treaty, Art. 23. 

9 See, e.g., U.S.-U.K. Income Tax Treaty, Art. 24(2); U.S.-Japan Income Tax Treaty, Art. 23(2); U.S.-Germany Income Tax Treaty, Art. 23(2); U.S.-Mexico Income Tax Treaty, Art. 24(3). 

10 Cf. Department of the Treasury, Technical Explanation of the Model U.S. Income Tax Treaty, Art. 23(2) and (3) (2006) (explaining that the allowance of the credit is subject to the limitations of U.S. law, including §904, and providing a re-sourcing rule subject to separate basketing under §904(h)(10) in the case of USOFCs). 

11 Cf. Letter from Mary C. Bennett to Patricia A. Brown, above, note 6 ("[F]or purposes of determining whether there is a conflict between the section 904[(h)](1) U.S. resourcing rule and a treaty source rule such that the section 904[(h)](10) election becomes available, section 904[(h)](10)(A)(ii) specifically requires that the treaty source rule be applied AS IF SUBSECTION 904[(h)](10) DID NOT EXIST."). 

12 P.L. 111-226, §213(a), 124 Stat. 2389, 2398 (2010). The Act has no formal name. 

13 See §904(d)(6)(A). 

14 See §904(d)(6)(B).  Income subject other special limitation categories apparently is not carved out. See generally §§56(g)(4)(C)(iii)(IV), 245(a)(10), and 901(j)(1)(B). 

15 See §904(d)(6)(C). 

16 See P.L. 111-226, §213(b), 124 Stat. at 2399. 

17 U.S.-India Income Tax Treaty, Art. 12. 

18 See U.S.-India Income Tax Treaty, Art. 25(3) (flush language). 

19 A few older treaties still have a "source of income" article that could cause §904(d)(6) to apply more broadly. See, e.g., U.S.-Philippines Income Tax Treaty, Art. 4. 

20 See, e.g., Department of the Treasury, U.S. Model Income Tax Convention, Art. 23(3) (2006) ("For the purposes of applying paragraph 2 of this Article, an item of gross income, as determined under the laws of the United States, derived by a resident of the United States that, under this Convention, may be taxed in ——- shall be deemed to be income from sources in ——-.") (emphasis added). 

21 §904(d)(6)(A)(ii). 

22 §904(d)(6)(A)(iii). 

23 See U.S.-Canada Income Tax Treaty, Art. 24(1); U.S.-New Zealand Income Tax Treaty, Art. 22(5). 

24 Joint Comm. on Tax'n, Technical Explanation of the Revenue Provisions of the Senate Amendment to the House Amendment to the Senate Amendment to H.R. 1586, at 19 (JCX-46-10) (2010). 

Request Transfer Pricing Report