A New Splitter

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James J. Tobin, Esq.

By James J. Tobin, Esq. Ernst & Young LLP New York, New York

Foreign tax controversy is on the rise, largely inspired by the OECD BEPS Action items and at times with questionable retrospective application. Recent EU state aid decisions evidence an approach even more aggressive than any BEPS theories. So multinationals are facing more audit pressure and uncertainty than ever. Our U.S. worldwide foreign tax credit regime brings the U.S. fisc in as a potential co-contributor to successful foreign assessments and it's quite clear they (the Treasury Department (“Treasury”) and Internal Revenue Service (“the IRS”)) realize that and are none too happy about it.

Treasury and the IRS routinely emphasize the need for any foreign tax to be compulsory under Reg. §1.901-2(e)(5). While certainly taxpayers will need to demonstrate they have pursued all effective remedies to minimize additional foreign tax, unfortunately some additional foreign tax may be unavoidable. I find the additional foreign tax claims under the recent EU state aid cases even more extreme where the recent decisions seem to go well beyond the bounds of traditional transfer pricing and again it seems Treasury is worried about the potential cost to the U.S. fisc. In addition to a letter from Secretary Lew to EC President Juncker, more recently Treasury released a White Paper detailing why recent EU state aid challenges were inconsistent with OECD principles and international norms. Unfortunately, the White Paper appears to have had minimal effect as the decision in the most recent EU state aid case was consistent with those novel principles, and essentially appears to me to be an unprincipled attempt to tax low-tax income of a U.S. multinational group.

So it seemed that U.S. multinationals had an ally in Treasury in defending against this new aggressive EU approach and potentially also against aggressive country tax authorities similarly motivated by a revenue-focused audit approach which goes beyond our existing international arm's-length framework. Unfortunately, it seems that Treasury and the IRS have taken a big step in an attempt to limit the damage to the fisc in the case of foreign audit assessments which in many cases will make it more difficult for U.S. multinationals to obtain full foreign tax credit relief for foreign tax assessments. The step in question is Notice 2016-52 which expands the Foreign Tax Credit Splitter rules with respect to foreign-initiated audit adjustments and is discussed more fully below.

You'll recall that final regulations under the so-called anti-splitter rules of §909 were issued in 2015. The statute defers the ability of a taxpayer to claim a foreign tax credit until the related income associated with the foreign tax is included in income in the United States. The §909 regulations limited the application of the anti-splitter rules to four specific situations: reverse hybrid splitters, loss sharing splitters, hybrid instrument splitters, and partnership inter-branch splitters. The latest notice adds a fifth one — foreign-initiated adjustment splitters (the Notice describes two specific transactions).

With respect to this new splitter, Treasury's concern is rooted in the basic rule of §905(c) which provides that if a §902 corporation pays foreign income taxes more than two years after the year to which the foreign taxes relate (the “relation-back year”), then the additional taxes are taken into account in the year paid and not in the relation-back year. More simply, the additional foreign taxes are included currently in the §902 foreign tax pool of that foreign corporation, a practical rule that avoids the complexity of retroactive adjustment to §902 pools and any amended tax returns required to reflect those adjustments. Inevitably, however, simplicity will result in consequences different than what would follow from a more complex approach requiring retrospective adjustments. In this respect, Treasury's concern is that taxpayers can affirmatively use the §905(c) rule to separate additional foreign taxes paid as a result of a foreign-initiated audit assessment from the related income. So let me first explore the rules described in the Notice and then provide some (predictable) reactions.

The Notice describes two situations that will be subject to §909's anti-splitter rules. Both involve the payment of tax pursuant to a foreign-initiated adjustment with respect to income earned in a prior taxable year and that would be taken into account currently by the taxpayer under §905(c). Both situations relate to fact patterns where the prior period's earnings and profits (E&P) reside in a different §902 corporation at the time the additional foreign tax is paid, thus resulting in a separation of the additional foreign tax from its related income.

The two situations are a structure change such as a §351 transaction (for example, by way of unchecking the box on the foreign corporation in question) or a dividend distribution of prior year E&P to another CFC before the foreign-initiated audit assessment has been made. It's somewhat easy to conceptualize the issue of concern when thinking about a two-tier foreign subsidiary structure. In situation one pictured below, USP owns CFC 1 which owns a foreign subsidiary disregarded entity (DRE; shown as FC2 in the diagram below). The DRE earns 100 per year for say five years before USP unchecks the box with respect to the DRE converting it to a second-tier CFC. Say in year eight it pays foreign tax pursuant to a local tax audit of say 150 relating to years 1–5. The additional 150 tax would be added to CFC 2's foreign tax credit pool in year eight, consistent with §905(c). However, under §909 it would be suspended until USP included in income the 500 E&P earned by CFC 1 in the first five years.

Ex. of Situation 1

The second situation relating to distributions can also be easily understood in a two-tier foreign subsidiary structure as pictured below. USP owns CFC 1 which owns CFC 2 which earns 100 per year for five years. In year six it pays a dividend to CFC 1 of 500 (subject to CFC look-through under §954(c)(6)) and in year eight pays a similar foreign tax assessment relating to years 1–5 of 150 with the same §909 consequences as above.

Ex. of Situation 2

Treasury's obvious concern is that the operation of §905(c) has the potential to create a distortion and that taxpayers will take steps to restructure in anticipation of a foreign tax adjustment to benefit for this distortion and the U.S. fisc will suffer disproportionally from the foreign assessment. And perhaps they think that making it harder to use the foreign tax credit will increase the resolve of U.S. multinationals to fight harder against the assessments — an extra level of compulsory! My reactions below:

  •  It's interesting that this Notice specifically includes reference to EU state aid assessments “to the extent State Aid payments result in creditable foreign taxes.” My reading of the recent state aid cases is that in principle the countries (for example, Ireland and the Netherlands) are directed to make adjustments in computing taxable income of the affected companies so it sure sounds like the countries would be imposing additional income tax. I suspect Treasury sees it that way but is leaving itself options and also waiting to see how the payments are actually assessed from a local standpoint.
  •  Taxes paid pursuant to a state aid claim would likely be eligible for the U.S. foreign tax credit as contested taxes under Reg. §1.901-2(e)(2) (assuming as above that they qualify as income taxes). State aid claims will be appealed to the European Court of Justice. Hopefully, the heavily criticized rationale behind the EU decision will be overturned there and the tax paid will be refunded. If and when refunded, the proposed §905(c) regulations would require a U.S. taxpayer who claimed credit to file an amended return if the tax refund would have the effect of reducing the U.S. shareholder's foreign tax credit by 10% or more. The temporary regulations have expired; however, the IRS has indicated taxpayers can continue to apply their provisions. ( See CCA 201145015.) If Treasury shared my optimism of an eventual favorable ECJ decision, one would think it should be happy if taxpayers rely on a foreign tax credit for this contested tax since a refund will result in a reversal of the credit and increase U.S. tax. A timing issue perhaps but better than no repatriation or perhaps an eventual toll charge on foreign earnings at a reduced rate in connection with future international tax reform.
  •  The purpose of the §905(c) adjustment to the post-1986 pool is to simplify the reporting for U.S. companies and the need to file amended returns for open years and otherwise retroactively adjust E&P/FTC pools in the CFC group every time there is a foreign tax audit result. If an audit adjustment occurs after a distribution has been made to a U.S. shareholder, §905(c) results in a delayed foreign tax credit versus a relate-back adjustment. In the cases described in the Notice it could possibly go the other way. But §905(c) by definition will always result in “distortion” of some sort. And the rule is mandatory. Doesn't seem fair to look at only this one-way distortion under §905(c) as a splitter.
  •  What about §960(c)? The examples illustrated above result in high-tax E&P in a lower tier subsidiary and lower tax E&P in an upper tier. A distribution from the lower tier subsidiary would dilute the effective tax rate on the E&P and, under §960(c), a §956 inclusion to a U.S. shareholder of the lower tier CFC would no longer hopscotch up the higher rate E&P but would also result in a dilution. So we have a statutory rule in §905(c) which can create a distortion in §902 results and a statutory anti-avoidance rule intended to prevent taking advantage of high-tax E&P in the CFC group. Does the IRS really need the complex splitter rules on top of that?
  •  The Notice provides that a taxpayer can rebut the presumption that either a reorganization/§351 transaction or a dividend of related E&P is a splitting event by providing “clear and convincing” evidence that the reorganization or dividend was not structured with a principle purpose of separating covered taxes from the related post-1986 earnings. Reorganizations and dividends are very common within a CFC group so it's nice to have a purpose exception which has been missing from other recent guidance, such as the recent §385 regulations. But I wonder how IRS agents will enforce this standard? It's not commonly used in the Code, certainly not in the international tax rules. What will they consider clear and convincing?
  •  Interesting to note that a splitter will exist only when there has been either a distribution of E&P or an event such as a §351 transaction which separates E&P between two or more entities for U.S. tax purposes. In such a case “related income” for purposes of §909 consists of all relation-back E&P “attributable to all activities that gave rise to income ( computed under foreign law) included in the foreign tax base that was adjusted…” (emphasis added). I'm not sure what the reference to income under foreign law means.
  •   For example, let's say a group has a first-tier Dutch CV, which wholly owns a regarded Dutch BV that earns 100 net income in years 1–5 and pays a 500 dividend to the CV in year 5. In year eight Dutch BV pays additional 50 foreign tax as a result of a foreign-initiated adjustment related to years 1–5 disallowing deductions for a 50 royalty paid to the CV in each year. Assume the royalty was considered arm's-length under U.S. transfer pricing principles. So the Notice seems clearly to apply to the year eight assessment of say 50 (20% rate). I would think the related income is 500 but the reference to income under foreign law might mean that the 250 of disallowed royalties which for U.S. tax purposes was always E&P of the CV might also be related income? That question may often be moot since Reg. §1.909-6(d)(3) provides that dividends from a CFC that has related income are deemed to be distributed pro rata with all E&P. Thus, in the example, all E&P of the CV would be included in the pro rata calculation.
  •  But the above example does illustrate the fact that U.S. E&P will often be quite different than local taxable income, particularly with the current very aggressive transfer pricing audit environment in many countries, overly aggressive interpretation of the BEPS transfer pricing guidance, and the overreaching EU state aid approach. So assume in the above CV/BV example there was no distribution of the year 1–5 E&P. In that case, the Notice would not apply and there would be no splitting event. In such case, the difference between U.S. E&P of 500 and local taxable income of 750 after the royalty disallowance results in an effective §902 rate in excess of the local statutory rate in this example from 20% to 30%. So some foreign tax assessments may create high-tax pools which could be repatriated (if accessible in the foreign ownership chain). But a taxpayer would need in this example to demonstrate that U.S. transfer pricing was appropriate and that the foreign tax assessment was compulsory. In my view this will often be the case.


In case it's not yet clear, I don't like the Notice. Seems to me to be a rushed attempt to discourage U.S. multinationals from claiming a credit for foreign tax assessments without fully analyzing the collateral effects. But I hope the U.S. Treasury continues to challenge foreign governments to refrain from pursuing overly aggressive foreign assessments. There could eventually be a cost to the U.S. fisc and in any event it's the right thing to do.

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