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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
The Treasury and IRS have issued further guidance on the application of §901(l) to certain ordinary-course of business transactions, but once again the guidance has come by the teaspoonful. While the transactions described in Notice 2010-65, 2010-40 I.R.B. 425, are certainly deserving of being outside the scope of §901(l), there are many other transactions which similarly should not be covered, and uncertainty remains about the proper application of §901(l) in those cases.
Section 901(l) was enacted in 2004 to supplement §901(k) to address "tax-motivated transactions" which separate foreign tax credit entitlements from the underlying income or gain.1 Section 901(k) applies only to dividends, while §901(l) casts a much broader net. The newer rule generally disallows a foreign tax credit for foreign withholding tax imposed on any item of income (other than dividends) or gain with respect to property in two cases. Section 901(l)(1)(A) applies if the recipient of the item has not held the property for more than 15 days (within a 31-day testing period), exclusive of periods during which the taxpayer is protected from risk of loss. Section 901(l)(1)(B) applies if the recipient is under an obligation (whether pursuant to a short sale or otherwise) to make related payments with respect to positions in substantially similar or related property.
This broad scope created concerns for many taxpayers regarding whether transactions undertaken in the ordinary course of business, with no whiff of tax engineering, could fall within this rule. Congress apparently understood that the intended scope of §901(l) needed refinement in light of the narrow Congressional purpose to prevent a foreign tax credit claim in the context of tax-motivated transactions, and expressly provided in §901(l)(3) that the Secretary may by regulation provide that §901(l)(1) does not apply to property where such application "is not necessary to carry out the purposes of [§901(l)]."
The first exercise of that authority came in Notice 2005-90, 2005-2 C.B. 1163. In that Notice, the Treasury and IRS described with great specificity a distribution channel for computer software licensing in which the application of the credit disallowance rules of §901(l) is not necessary to carry out the purposes of §901(l). In general, that business arrangement involved a domestic corporation (referred to as Company X or the "Master Licensor") which licensed rights to a computer program to another domestic corporation (referred to as Company Y or the "Head Licensee") for use in computers and similar and related equipment that the ultimate sublicensee employs in connection with its business or that it manufactures and markets to customers. Under the terms of the license from Company X, Company Y is allowed to sublicense rights to Company X's computer program to Company Y's subsidiaries around the world. Company Y makes payments to Company X whenever Company Y or its subsidiaries reproduce the computer program on equipment that they use in their business or that they manufacture and sell to customers. Gross-basis foreign withholding tax may be imposed on the payments by the Company Y subsidiaries to Company Y. The arrangement was described as being in the ordinary course of the respective trades or businesses of both Company X and Company Y. In that case, Notice 2005-90 stated that regulations would be issued providing that §901(l)(1)(B) will not apply to disallow the credit for foreign withholding taxes imposed on amounts received by Company Y.
Among other transactions, that Notice thus excluded from the coverage of §901(l) various original equipment manufacturer (OEM) distribution arrangements. The effective date of this exception is the enactment date of §901(l). The Treasury and IRS recognized that their work was not done, however, and requested taxpayer comments not just on the transaction described in the Notice, but also on a variety of other issues, including the application of §901(l) to foreign master or head licensors, other types of property or licensing arrangements that should be excepted from §901(l), and restrictions that should apply as part of the ordinary-course-of-business requirement.
The second teaspoonful of guidance has now appeared in Notice 2010-65, 2010-40 I.R.B. 425. In this Notice, the Treasury and IRS have described two additional ordinary-course-of-business transactions where the application of the credit disallowance rules is not necessary to carry out the purposes of §901(l). Perhaps emphasizing the overall incremental approach to providing guidance under this section, the exception described in Notice 2010-65 applies only to amounts paid or accrued after September 23, 2010, in contrast to the retrospective effective date of Notice 2005-90.
It certainly is correct that the two ordinary-course of business arrangements described in Notice 2010-65 should be outside the scope of §901(l). The first case is similar to the transactions described in Notice 2005-90, and is an exception to the "related payments" rule of §901(l)(1)(B). In the arrangement described, the Master Licensor remains a domestic person, but the Head Licensee could be domestic or foreign. The Head Licensee is required to be part of the same affiliated group as either the Master Licensor or the ultimate sublicensees that use the property in their business and that make payments to the Head Licensee subject to foreign withholding tax. The scope of property covered by the exception is expanded to include intellectual property rights in any film, television program, or recording; literary, musical, or artistic composition; computer program; right to publicity (e.g., name and likeness); or other similar property. The exception also covers transactions in covered copyrighted articles, which are defined to mean a copy of any film, television program, or recording; literary, musical, or artistic composition; computer program; or other similar property. Each of the parties in the arrangement is described as participating in the transaction in the ordinary course of their business, with the Head Licensee or an affiliate being required to be regularly engaged in the business of developing, producing, exploiting, distributing, or marketing the intellectual property or copyrighted article.
The second transaction described in Notice 2010-65 deals with a "retail distribution arrangement for covered copyrighted articles" and is an exception to the 15-day holding period rule in §901(l)(1)(A). In this transaction, a domestic corporation used a copyright it owns to produce a covered copyrighted article (which is defined to include the same copyrighted articles as described above in the "related payments" exception), which the domestic corporation then transfers directly or indirectly through one or more U.S. affiliates to foreign retail customers for software copies (and by analogy for other digital products). The activities performed by the two U.S. entities must be in the ordinary course of business, and in the case of the copyright owner, the arrangement must be consistent with the "normal business practices" of that corporation "independent of U.S. federal tax considerations." In an era of digital delivery and drop shipments directly to users, this example describes many normal distribution channels for a variety of copyrighted articles which are not held in inventory by the producer or a distributor for more than 15 days. Despite the fact that the payments by such foreign retail customers would be characterized as income from the sale of property for U.S. tax purposes under Regs. §1.861-18, there remain many instances when foreign withholding tax will be imposed on such payments. These taxes are creditable under Notice 2010-65.
So this is all well and good, but the two teaspoonfuls haven't yet filled the necessary cup of guidance. The Treasury and IRS seem to know this, as the normal request for comments at the end of Notice 2010-65 included a renewed call for additional comments on the longer list of unanswered questions included in the request for comments in Notice 2005-90. It is clear that the two Notices have not addressed many significant "ordinary course" transactions, including those where the Master Licensor is a foreign person. To this observer, it seems that the practice of doling out bits of guidance through specifying particular transaction models likely will leave more uncertainty than would providing more comprehensive guidance to apply to all transactions.
In order to be comprehensive, the focus of the guidance should be less on transaction models, and more on implementing the Congressional intent to acknowledge that transactions that are not tax-motivated should not be covered by §901(l). The general focus of the two Notices of describing distribution channels that are established in the "ordinary course of business" certainly acknowledges that such transactions cannot be regarded as falling within an anti-abuse measure that is intended to capture tax-motivated transactions. The essential issue, however, should be the definition of "ordinary course of business." If the participants in a distribution channel are following their ordinary-course-of-business practices, then it is hard to see why any foreign taxes which may legitimately be imposed under foreign law as a result of that business activity should be disallowed under an anti-abuse rule. The Treasury and IRS seem to be unduly cautious in their approach to this area. It would be preferable from the perspective of implementing Congressional intent and reducing uncertainty for taxpayers if the next Notice (or the regulations themselves) more comprehensively addresses the issue of when a transaction is in the ordinary course of business, and uses that test as the means to distinguish between transactions that are and are not subject to §901(l) instead of attempting to specify certain excluded transactions.
This commentary also will appear in the January 2011 issue of the Tax Management International Journal. For more information, in BNA's 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 See H.R. 105-148, P.L. 105-34 ("some U.S. persons have engaged in tax-motivated transactions designed to transfer foreign tax credits from persons that are unable to benefit from such credits… to persons that can use such credits.… No inference is intended [from §901(k)] as to the treatment under present law of tax-motivated transactions intended to transfer foreign tax benefits.").
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