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By Philip D. Morrison, Esq.
Deloitte Tax LLP, Washington, DC
In a previous commentary,1 I explained some of the very real, very great complexity that will arise from trying to determine what new §909(d)(3)'s "related income" is — income the receipt of which allows foreign taxes that were suspended for foreign tax credit purposes under new §909 to be unsuspended and taken into account.2 The difficulties spelled out in that prior commentary are not hypothetical — they will be common and immensely difficult for both taxpayers and the IRS to administer. Tracing "related income" through a series of transactions likely will be extremely difficult.3 But if such tracing is not done, a foreign tax credit for taxes suspended under §909 might be denied forever — an unfair result. As is often the case, Treasury and the IRS are presented with no good choice and must try to strike a balance between complexity and fairness.
While dismantling (or not entering into) splitter structures may be one solution for certain aspects of certain taxpayers' structures, that approach will not be available for many, many "structures." That is partly because many foreign consolidation/group relief/fiscal unity regimes will be splitters, deferring foreign tax for U.S. foreign tax credit purposes until the "related income" is taken into account for U.S. purposes, whether the taxpayer desires such a split or not. And a decision to consolidate (or remain consolidated) for tax purposes in a foreign jurisdiction (at least where the common parent is not a hybrid entity) is likely driven by foreign tax concerns, not U.S. foreign tax credit planning.
Theoretically, one approach to dealing with the unadministrability-versus-fairness problem of determining what constitutes "related income" would be for Treasury and the IRS to choose the unfair approach and provide guidance that restricts what constitutes related income to a very narrow, relatively easily traceable class. This would be contrary to Congress's expectations, however, and likely to create a chorus of criticism from taxpayers who are in foreign consolidation regimes that cause a natural splitter effect. The alternative approach of providing detailed guidance with respect to tracing related income through myriad transactions, however, is also likely to generate criticism from the same group.
A better approach, and one that should adequately deal with foreign consolidation or fiscal unity regimes where splitting was not the purpose for consolidating, would be to finalize Prop. Regs. §1.901-2(f) (2006 proposed regs) to the extent applicable to foreign tax consolidation or fiscal unity regimes. This would prevent splitting foreign taxes from the income on which such taxes were imposed, eliminating the potentially enormous hardship of trying to identify related future income within the meaning of §909 or the unfairness when suspended foreign taxes stay suspended forever.
Admittedly, the 2006 proposed regs did not work well with respect to reverse hybrid entities.4 Treasury and the IRS have recognized that, however, by stating, in Notice 2010-92, that they do not intend to finalize that portion of the 2006 proposed regs. With respect to foreign consolidated regimes, on the other hand, those 2006 proposed regs provide a fairer and simpler approach than tracing related income for §909 purposes. By applying the 2006 proposed regs (or their finalized version) to foreign consolidation regimes, Treasury and the IRS can simultaneously achieve relative fairness and relative simplicity.
As readers will likely remember, the 2006 proposed regs would allocate foreign taxes paid in a foreign consolidated tax regime among the members of the consolidated group with positive separate taxable income. A member's portion of combined income would not be determined, as under the present regulations, by whether the member has joint and several liability for the foreign tax on its separate income, but rather by determining the member's separate taxable income under foreign law. Actual or deemed dividend payments (or any similar attribution of income) between members of the consolidated group would be ignored.5 A disregarded (for U.S. tax purposes) member would be regarded for purposes of determining a member's portion of combined income, but not for purposes of determining legal liability for paying the tax. Net losses of a member would be allocated among members with positive income either in the manner mandated by foreign law or pro rata.
It seems relatively clear that applying this regime would prevent foreign taxes from being split from the "related income" — the income on which it is imposed. Applying this regime to foreign consolidation and fiscal unity regimes would be far simpler than applying the §909 tracing of related income. Finalizing the 2006 proposed regs and explicitly stating that following such regs will prevent a §909 splitting event would be a big step toward making §909 less of a challenge both for the IRS and taxpayers.
Notice 2010-92 appears to take this approach with respect to pre-2011 splitters that result from a consolidation regime. It states:
A foreign consolidated group is a pre-2011 splitter arrangement to the extent that the taxpayer did not allocate the foreign consolidated tax liability among members of the foreign consolidated group based on each member's share of the consolidated taxable income included in the foreign tax base under the principles of Regs. §1.901-2(f)(3).
Presumably, even if there are grounds for arguing that Regs. §1.901-2(f)(3) does not technically apply (for example, that there is no joint and several liability), dividing up foreign consolidated tax liability among group members as if it did apply will prevent a taxpayer from being subject to §909, at least for foreign taxes paid prior to 2011. This is a welcome rule.
But what about post-2010 foreign taxes? What approach is open for taxpayers with foreign affiliates in foreign consolidated groups to avoid §909? One hopes that the regulations under §909 for post-2010 splitters will provide the same rule as that provided in Notice 2010-92 for pre-2011 splitters. In the meantime, it may be possible to look to that Notice as well as PLR 200225032 and statements from IRS officials to reach a practical result consistent with the Notice 2010-92 rule for pre-2011 splitters.
First, Notice 2010-92 appears to clearly signal that Treasury and the IRS think that allocating foreign taxes among members of a foreign consolidated group "under the principles of [Regs.] §1.901-2(f)(3)" eliminates the splitting of foreign taxes from related income for purposes of §909. While the Notice only technically applies for pre-2011 foreign taxes, there is more than a hint that such an approach may eventually be ratified for post-2010 foreign taxes.
Second, the IRS has long held a very expansive view of the technical applicability of Regs. §1.901-2(f)(3). While they lost the Guardiancase,6 there are foreign consolidation regimes other than the Luxembourg regime at issue in that case that are possibly more problematic (for taxpayers relying on Guardian) with respect to the application of Regs. §1.901-2(f)(3). Moreover, in PLR 200225032 the IRS applied Regs. §1.901-2(f)(3) to a German consolidation regime where, while technically it appeared that there was no joint and several liability, the liability of members was "substantially equivalent in practice to joint and several liability" because members were secondarily liable for the group's tax if the parent, which was primarily liable, failed to pay. It is fairly clear, therefore, that the IRS would be happy to apply Regs. §1.901-2(f)(3) very broadly.7 If Regs. §1.901-2(f)(3) applies, it appears that there is likely no splitting event for §909 purposes. While, prior to the effective date of §909, many taxpayers may have preferred to challenge the IRS's expansive view of the applicability of Regs. §1.901-2(f)(3), after §909's effective date, it may well be to taxpayers' advantage to embrace it to avoid the complexity of tracing "related income" for §909 purposes.
Third, IRS officials have been reported in the tax press8 as saying that they will not challenge taxpayers under §909 if they divide foreign taxes of a consolidated group among members in accordance with the principles of Regs. §1.901-2(f)(3). Combining these comments with the IRS views described in the preceding paragraph might possibly be considered a "widely understood administrative practice" that can be taken into consideration for FIN 48 purposes.
As a practical matter, therefore, it may be possible for taxpayers with foreign consolidated groups to avoid the difficulties of applying §909, not only for pre-2011 foreign taxes but also for those incurred after 2010.
This commentary also will appear in the February 2011 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 Taxation.
2 As most readers know, new §909 was enacted to prevent taxpayers from splitting their creditable foreign taxes from the income on which such taxes were imposed. Section 909, generally effective for foreign taxes paid or accrued in taxable years beginning after 2010, is a broad provision intended to prevent both natural and planned splitting. It "suspends" a foreign tax for which a credit would otherwise be available until the "related" income is taken into account for U.S. tax purposes by the taxpayer of the foreign tax or, in the case of a foreign corporation that is the taxpayer, by the taxpayer's U.S. "section 902 shareholder."
3 The rules regarding determining "related income" for purposes of applying §909 to pre-2011 split taxes and related income, published in Notice 2010-92, 2010-52 I.R.B. 916 (12/27/10), do not relieve my fears that determining related income will be a nightmare. First, such rules do not apply for post-2010 split taxes and related income. Second, because the term "inclusions" is not defined, it is not clear from the notice whether or not payments other than dividends and deemed dividends cause a shift of related income to the payee. If they do, the determination of related income would be still more difficult for a multinational enterprise with numerous CFCs and myriad transactions among them. The complexity could dwarf that of the complex rules for preventing the splitting of interest and principal — the "time value of money" rules that burst upon the scene in 1984.
5 The 2006 proposed regs, however, left to the final regulations the treatment of hybrid payments or accruals between members, with a warning in the Preamble that subsequent guidance on this point might deviate from the general rule that foreign law controls for determining a member's separate income.
7 It is understood among many practitioners that the IRS may continue to challenge pre-§909 effective date split taxes under foreign consolidation regimes on the same theory the IRS put forward in Guardian.
8 See, e.g.,208 BNA Daily Tax Rpt. G-7 (10/29/10), "For consolidated groups, [IRS Branch Chief Barbara] Felker said, she remains unconvinced that the `suspension' approach under new tax code Section 909 is the best approach. If a consolidated group apportioned its taxes to group members rather than `holding' them at the top, there would be no splitter issue, she told practitioners. In general, she said, `If you take the position that it's at the top, you'll have a splitter. I think if you take the position that it's apportioned to the group, you will not get an argument from me.' "
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