Role of §482 Principles to Determine Noncompulsory Tax Payments Arising from Transactions with Foreign Disregarded Entities

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By Gary D. Sprague,

Baker & McKenzie LLP, Palo Alto,

The IRS recently released CCA
201349015 dealing with the application of the U.S. arm's-length
standard to various transactions involving disregarded entities,
where the amount of income subject to foreign income tax was
potentially subject to a transfer pricing adjustment. The purpose
of the CCA was to provide guidance on how taxpayers should
demonstrate that foreign taxes paid under a foreign income tax law
are compulsory payments under the noncompulsory payment rule of
Regs. §1.901-2(e)(5)(i) and thus qualify as creditable foreign
income taxes. In general, the CCA concludes that "U.S. transfer
pricing principles may be relevant in determining whether
non-arm's-length transfer prices result in noncompulsory payments
of foreign tax, to the extent foreign tax law, as modified by tax
treaties to which the foreign country is a party, includes similar
arm's-length principles…." The question of how income and expense
should be allocated between an owner and an entity disregarded as
separate from its owner is an interesting one, and variants of this
issue arise in contexts beyond the noncompulsory payment
rule.  CCA 201349015 provides a useful context for this
discussion, although it is hard to see why in this context the
primary legal reference should be to U.S., not foreign, transfer
pricing principles.

CCA 201349015 addresses the
noncompulsory payment rule in three factual contexts involving
disregarded entities or traditional branches. The first case is a
transaction between a foreign disregarded entity or branch and its
U.S. tax owner. The second case is a transaction between a foreign
disregarded entity or branch of a member of a U.S. consolidated
group and another member of that consolidated group.  The
third case is a transaction involving foreign disregarded entities
or branches of a controlled foreign corporation (CFC). In the first
two cases, any foreign income taxes incurred by the foreign
disregarded entity or branch would be creditable in the year in
which they are paid or accrued under §901(b), as the foreign entity
is disregarded as a separate entity from its U.S. taxpayer owner.
In the third case, the U.S. shareholder of the CFC would claim the
foreign taxes as deemed paid foreign tax credits upon the
recognition of a dividend distribution or Subpart F inclusion. The
U.S. taxpayer then will be required to establish in the year the
credit is claimed that all taxes for which a credit is claimed were
compulsory taxes. The year the credit must be defended on audit
could be several years after the year in which the foreign tax
liability actually arose. The CCA also describes a fourth case
involving a foreign corporation with a
U.S. disregarded entity or branch, but without
reference to the noncompulsory payment rule.

In discussing the first two cases,
the CCA properly notes that the application of the §482 regulations
to transactions between a U.S. owner and its foreign disregarded
entity, or between a U.S. owner's foreign disregarded entity and
another member of the U.S. owner's consolidated group, does not
affect the amount of worldwide taxable income recognized by the
U.S. owner of the disregarded entity or the consolidated group
including the U.S. owner of the disregarded entity. The CCA then
notes that transactions that are disregarded for U.S. purposes may
nevertheless significantly impact foreign taxes.  In the
context of the noncompulsory payment rule, the CCA expresses the
concern as follows:… the primary concern is often that through the
use of a non-arm's length transfer price the U.S. taxpayer
operating through a foreign branch, or its DE, may report too much
income to the foreign country or countries in which it operates,
resulting in an overpayment of foreign income tax. Similarly, a
controlled foreign corporation in one country that operates through
a branch or DE in a foreign third country may report too much
income and overpay its foreign taxes in either its home country or
the third country.

The §901 regulations are clear that
a taxpayer must ensure that the amount of foreign tax paid does not
exceed the amount of liability under foreign law for tax. The
general rule is as follows:An amount paid does not exceed the
amount of such liability if the amount paid is determined by the
taxpayer in a manner that is consistent with a reasonable
interpretation and application of the substantive and procedural
provisions of foreign law (including applicable tax treaties) in
such a way as to reduce, over time, the taxpayer's reasonably
expected liability under foreign law for tax, and if the taxpayer
exhausts all effective and practical remedies, including invocation
of competent authority procedures available under applicable tax
treaties, to reduce, over time, the taxpayer's liability for
foreign tax (including liability pursuant to a foreign tax audit

Given that the §901 regulations
clearly require that the taxpayer establish that the amount paid
does not exceed the amount of liability under
foreign law, it is puzzling why this CCA should
emphasize the conclusion that U.S. transfer pricing
principles may be relevant. The CCA does condition the conclusion
that U.S. principles "may be relevant" with the caveat that such
principles may apply "… to the extent foreign tax law, as modified
by tax treaties to which the foreign country is a party, includes
similar arm's-length principles, as most do." The examples provided
under the regulations clearly refer only to the application of
foreign law, including the foreign jurisdiction's interpretation of
the arm's-length standard.2 If the
cases being addressed by the CCA are only those where foreign law
includes arm's-length principles "similar" to U.S. law, then the
observation that U.S. principles "may be relevant" seems to provide
little guidance to taxpayers.

What about cases where foreign law
does not follow "similar" arm's-length principles? In that case,
the CCA would seem to have nothing to add to the regulation, and
taxpayers would be required to establish that their foreign tax
liability did not exceed the amount due under the foreign law as it
actually applies.  The CCA asserts that the laws of "most"
foreign countries include "similar" arm's-length principles. It
certainly is true that the domestic law of most countries, and
treaties modeled on the OECD Model Tax Convention, embrace the
arm's-length principle.  But there certainly is no uniformity
of application of the arm's-length principle among countries, much
to the chagrin of multinational taxpayers.

For example, Germany's
transfer-of-functions provisions are meant to legislate a result in
the case of certain business restructurings that the German
legislators regarded as compliant with the arm's-length principle,
but there is no parallel rule under U.S. law and a U.S. law
analysis of the same transaction could support a different result.
Italy recently enacted a proposal that seems to require a return on
sales compensation methodology for certain sales entities, surely a
concept foreign to the U.S. standard requiring the use of the best
method to determine whether a price is arm's length.  Looking
at the question from the perspective of U.S. law, the "commensurate
with income" statutory rule in §482 and the "platform contribution
transaction" concept in the cost sharing regulations have no
foreign equivalents. There would seem to be no basis to test
whether a taxpayer has satisfied its obligation to avoid a
noncompulsory payment by reference to those U.S. principles when
those principles, in fact, are not part of the relevant foreign
law. As with everything these days, there is also a Base Erosion
and Profit Shifting (BEPS) angle: what role would U.S. principles
have to play if the foreign law incorporated a "special measure"
contemplated by the BEPS project, but U.S. law did not adopt a
similar rule?

The CCA applied its conclusion that
U.S. transfer pricing principles "may be relevant" only to the
cases of transactions between a U.S. corporation and its foreign
disregarded entity or branch, and between a U.S. corporation and an
affiliated U.S. corporation's foreign disregarded entity or branch.
Nevertheless, the CCA went on to discuss two other scenarios,
namely transactions involving foreign disregarded entities or
branches of a CFC, and transactions involving the U.S. disregarded
entity or branch of a foreign corporation.  Both discussions
contain interesting elements.

The discussion of the
foreign-to-foreign transactions between two elements of a single
CFC properly notes that the noncompulsory payment rule applies to
this case, even though there is no U.S. taxpayer directly involved
in the transaction. In contrast to the legal analysis applicable to
the first two cases, this section of the CCA does not address the
proper transfer pricing rules to apply, either U.S. or foreign. In
the foreign-to-foreign disregarded transaction, of course, there is
no transaction between controlled parties within the purview of
§482. This would seem to emphasize the point that the applicable
standards which the taxpayer must apply to establish that the tax
paid by the CFC was a compulsory tax could only be the foreign law
that in fact applied to the transaction. There is no difference in
concept between this case and the first two cases on which the CCA
came to its conclusion regarding the relevance of U.S. principles,
as in all cases the taxpayer's obligation is to prove under foreign
law that it did not pay tax in excess of its legal liability.

The discussion of
U.S. disregarded entities or branches of a foreign
corporation is interesting because the CCA noted that certain U.S.
tax treaties have adopted the Authorized OECD Approach (AOA) to
determining the profits attributable to a permanent establishment
(PE).3 The
point of the reference seems to be an assertion that transactions
between a U.S. PE and the other elements of the foreign owner of
the U.S. PE could be relevant for purposes of attributing profits
under those treaties.

For purposes of the noncompulsory
payment question, the reference to the AOA is useful as it reminds
us that "transfer pricing principles," U.S. or otherwise, may not
be the entire applicable legal standard for determining the amount
of income subject to tax in all cases covered by the CCA. In each
of its factual discussions, the CCA grouped both disregarded
entities and actual branches of the owner entity, and applied its
analysis to both of those cases without distinction. While it is
true that the AOA has moved the mechanics of PE profit attribution
closer to the arms-length pricing analysis that applies to
related-party transactions, the two are not the same.  The AOA
calls for taxpayers and tax administrators to undertake a
functional and factual analysis which includes, among other
elements, the identification of significant people functions which
may result in the attribution of the economic ownership of assets
and the attribution of risks to the PE, followed by the attribution
of capital to the PE based on the assets and risks attributed to
the PE.4 Once
the functions, assets, and risks of the PE have thus been
identified, and hypothetical dealings between the PE and the
remainder of the enterprise have been determined, the applicable
transfer pricing guidelines are applied to those hypothetical
dealings "by analogy."5 Despite
the years of labor which were invested in the AOA project, it is
the case at the moment that there is great uncertainty as to how
assets, risks, and capital will be attributed to a PE based on
"significant people functions."  In contrast, the functions,
assets, and risks of a separate legal entity are more clearly
determinable. The distinction from the source country's perspective
between a real branch and a disregarded entity is that profit
attribution to a real branch proceeds under the AOA (assuming that
the jurisdiction follows the AOA for purposes of the relevant
treaty), while the pricing for a transaction with a disregarded
entity proceeds under the arm's-length principle as applied to
related-party transactions. Those two results may be different.

Therefore, the legally correct
amount of income that is subject to tax in a source country may
differ depending on whether the taxable presence is a real branch
or a disregarded entity, whether and how the country applies the
AOA, and how the country implements its version of the arm's-length
principle. There is no doubt that U.S. taxpayers are under an
obligation to prove that the foreign taxes paid do not exceed the
amount required by law, but the analysis and determination of that
required amount should proceed according to the applicable foreign
law, not U.S. principles.

A final note on the burden of proof.
The regulations set out a reasonable common sense approach to how a
taxpayer can carry that burden, as follows:In interpreting foreign
tax law, a taxpayer may generally rely on advice obtained in good
faith from competent foreign tax advisors to whom the taxpayer has
disclosed the relevant facts. A remedy is effective and practical
only if the cost thereof (including the risk of offsetting or
additional tax liability) is reasonable in light of the amount at
issue and the likelihood of success. A settlement by a taxpayer of
two or more issues will be evaluated on an overall basis, not on an
issue-by-issue basis, in determining whether an amount is a
compulsory amount. A taxpayer is not required to alter its form of
doing business, its business conduct, or the form of any business
transaction in order to reduce its liability under foreign law for

An example under this regulation
strikes a similar tone, noting that a taxpayer that has not
obtained relief through a domestic refund claim or a Competent
Authority filing is not required to pursue a domestic judicial
remedy when the cost of pursuing a judicial remedy "would be
unreasonable in light of the amount at issue and the likelihood of
[the taxpayer's] success."7 The
example even concludes that the taxpayer is not required to pursue
the domestic judicial remedy in a factual context where it was the
United States which made the transfer pricing adjustment resulting
in double taxation.8 Apparently
there was in that case a significant risk that the U.S. and foreign
interpretations of the arm's-length standard would not align, given
the pessimistic assessment of the taxpayer's likelihood of success
in the foreign court.

The CCA notes that the taxpayer is
not required to pursue all remedies under any circumstance, but
puts a significantly tougher gloss on the rule, stating: "The
noncompulsory payment rules do not require the taxpayer to waste
time and money in a futile proceeding, but if there is a reasonable
prospect of relief, the credit may be disallowed if the taxpayer
chooses not to pursue it." The "futile" standard seems clearly
beyond what the regulation requires, and the reversal of the
"reasonable" standard from an assessment that pursuing a remedy
would be unreasonable in the circumstances in light of the cost and
uncertainty involved to one which suggests that a remedy must be
pursued if there is a reasonable prospect of relief without
apparent consideration of the cost involved seems to up the ante
for taxpayers making judgments of whether their efforts to obtain
foreign relief have been sufficient.

Ultimately, regardless of whether
the reference to U.S. transfer pricing principles is correct, or
whether the "futile" standard is consistent with the actual
regulatory requirements, the apparent intended message of this CCA
is clear: look closely at your foreign tax liabilities to make sure
they are compulsory.9

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

  1 Regs. §1.901-2(e)(5)(i).

  2 Regs. §1.901-2(e)(5)(ii). 

  3 Report on the Attribution of Profits to Permanent
Establishments, July 17, 2008
(; 2010
Report on the Attribution of Profits to Permanent Establishments,
July 22, 2010
( The
principles of the AOA are now incorporated in the Commentary to
Article 7 of the OECD Model Tax Convention. 

  4 Art. 7 Commentary, para. 21. 

  5 Art. 7 Commentary, para. 22. 

  6 Regs. §1.901-2(e)(5)(i). 

  7 Regs. §1.901-2(e)(5)(ii), Ex. (3). 

  8 Id

  9 For a painful lesson on this point, see
Procter & Gamble Company & Subsidiaries v. United
 2010 BL 370274 (S.D. Ohio 2010). For cases in
which taxpayers have prevailed in their burden of proof, see
Schering Corp. v. Commissioner, 69 T.C. 579 (1978),
acq. in result in part, 1981-2 C.B. 2, and Sundstrand
Corp. v. Commissioner
, 96 T.C. 226 (1991).

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