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By James J. Tobin, Esq.
Ernst & Young LLP, New York, NY
Final regulations under §909 – on foreign tax credit splitter transactions – were issued earlier this year. There were just a couple of changes from the temporary regulations issued in 2012, so they were not particularly newsworthy. But the issuance of the final regs gave me the chance to revisit the operation of the splitter rules. And I had the opportunity to chair a panel discussion on the splitter rules at an International Tax Institute session in New York together with Andrew Walker from Milbank, Tweed, Hadley & McCloy LLP and Suzanne Walsh from the Internal Revenue Service, which served to remind me of what I don't like about the rules.
As we all know, the splitter rules of §909 were enacted in 2010 together with two other perceived foreign tax credit anti-abuse provisions – §901(m) and §960(c). I've previously shared my concerns with respect to the covered asset acquisition rules of §901(m) (Tobin, Covered asset Acquisitions Uncovered, 40 Tax Mgmt. Int'l J. 426 (July 8, 2011)). Quite frankly, I did not see any of the three so-called anti-abuse provisions as dealing with clear abuses. Indeed, I believe that all three are more in the nature of ways to raise tax revenue, which go too far and create some unreasonable results and unnecessary complexity for taxpayers in many situations. To me, it starts with the fundamental fact that computing U.S. earnings and profits (E&P) for foreign tax credit purposes produces significantly different results than computing foreign taxable income. Therefore, inevitably there will be distortions, both high and low, in comparing the resulting effective tax rates for §901 or §902 purposes with the statutory tax rate a company is subject to outside the United States. And given the way our worldwide overall foreign tax credit and deferral system works, taxpayers naturally will repatriate higher-taxed income and defer repatriation of lower-taxed income to the extent possible. In my view, that's just complying with the rules, not something that should justify anti-abuse measures.
All three of the "anti-abuse" provisions enacted in 2010 deal with the perceived ability of a taxpayer to create and repatriate high-taxed income. The provisions include no discussion of potential relief with respect to artificially low-taxed foreign dividend or Subpart F income – for example, nimble dividends from a CFC with no current but accumulated E&P but a foreign tax pool. Perhaps the thinking (if there was any consideration given) was that taxpayers could always employ self-help to avoid an "artificial" low-tax inclusion but must be prevented from planning into an "artificial" high-tax inclusion. In practice, while that degree of control would be nice, it is rarely that simple.
To refresh, §909 deals with structures where foreign income and associated foreign income taxes are separated between two or more different taxpayers for U.S. tax purposes. The effect of §909 is to suspend the credit for any foreign tax until the foreign income with which it is considered associated is taken into account by the taxpayer. The temporary and final regulations do a good job in providing a list of what transactions/situations are considered to be splitting events covered by §909, which I will elaborate on a bit below.
A particularly interesting aspect of the provision when it was enacted in 2010 was the effective date. The provision applied to foreign taxes paid or accrued after 2010, including foreign tax credits for taxes considered deemed paid under §902 after 2010 without regard to when such taxes were actually paid. Given that the provision was enacted in August 2010, this gave companies the opportunity to repatriate any foreign earnings that included split foreign taxes before the effective date. Any potential split taxes that were not repatriated by the end of 2010 and therefore were not considered deemed paid prior to 2011 were impacted by §909 and were suspended until the related income was taken into account by the CFC or U.S. shareholder. Accordingly, there was a flurry of activity with respect to §909 in late 2010. Frankly, I didn't pay much attention after that date as I expected we would shortly transition to a territorial tax system and all things foreign tax credit would soon be obsolete. But obviously my optimism was unfulfilled and here we are several years later still in our worldwide, foreign tax credit system and quite uncertain about when and what will occur on international tax reform. Therefore, the details of §909 and its two cousins §901(m) and §960(c) still require attention.
Perhaps because of the potential for §909 to be short-lived following its enactment, Treasury and the IRS were quite quick to provide some needed guidance on the operation of the provision. Notice 2010-92 was issued in December of 2010, followed by temporary regulations in February 2012 and final regulations just before the three-year temporary regulations sunset in February 2015. The guidance has been largely consistent and for the most part pretty reasonable. I'll obviously focus on the provisions of the final regulations.
The final regulations provide an exclusive list of what are considered to be splitting events. The Preamble to the regulations makes clear that the list could be expanded, but any expansion would be prospective. The list in the final regulations includes:
Basically, this is the same list included in earlier guidance except for foreign tax consolidation splitters, which are considered to be splitters for prior years but which prospectively are dealt with in Reg. §1.901-2(f)(3) through the allocation of foreign tax within a foreign consolidated group. I won't go through all aspects of each of the splitters on the list but will highlight some interesting (to me) or problematic aspects of each.
Reverse hybrid splitters are likely the most common example of a splitter and perhaps best illustrate what Congress was concerned about. A reverse hybrid is an entity treated as transparent for foreign tax purposes but treated as opaque – a corporation – for U.S. tax purposes. For foreign tax purposes, the income of the entity is taxed to its partners/owners. For U.S. tax purposes, under the technical taxpayer rules that means that a partner/owner would be considered the taxpayer and, in the case of a first-tier reverse hybrid, would be eligible to claim a foreign tax credit. A typical and familiar fact pattern would be a Canadian operating partnership owned by a U.S. group (or by a Canadian corporation disregarded for U.S. tax purposes, such as a Nova Scotia ULC), where the Canadian partnership is checked as a corporation for U.S. tax purposes. Canadian tax is imposed on the partner, i.e., the U.S. group (or the disregarded Canadian owner), and therefore the Canadian tax is a §901 foreign tax even though the underlying income of the Canadian reverse hybrid is deferred until repatriated. The effect of §909 is to suspend those §901 taxes until the related income is included by the U.S. owner.
A couple of observations on interesting aspects of the provision as applied to reverse hybrid splitters. First is to consider what is the related income. It's easy to conceptualize the issue for a single year where U.S. E&P and foreign taxable income are the same. But, of course, the world is not so simple. The regulations make clear that the basis for computing related income is U.S. tax principles – so there could be some degree of mismatch to foreign taxable income. It also seems clear that for multiple years a pooling concept for post-2010 E&P should apply. One example provided shows a foreign reverse hybrid with income in year one of 100 and a loss in year two of 50 and makes clear that the related income is the net income of 50, a distribution of which would unsuspend all of the taxes from year one.
It follows, unfortunately, that if the year two loss were 100 or more there would be no related income to distribute and potentially a permanent loss of foreign tax credits. However, if future income is realized by the reverse hybrid and it again has a positive post-2010 pool, it should then become possible to unsuspend the tax.
A troubling aspect to me relates to situations where a CFC/reverse hybrid has both related and unrelated income. For reverse hybrids there will likely be low- or no-taxed income for pre-2011 periods at a minimum. The regulations do not consider the old E&P to be related income but conclude that any dividend distribution would be sourced pro rata from both related and unrelated E&P. Therefore, the post-effective-date taxes would not be unsuspended in full until all the pre-effective-date income of the reverse hybrid also is repatriated. This seems unreasonable to me, almost a back door way around the grandfathering in the effective date. More reasonable would have been a LIFO-type approach similar to the pre-87/post-86 E&P and tax pool rules. Because a post-2010 approach was adopted in determining related income, I would have thought that Treasury and the IRS would have ample authority to follow that same logic in sourcing distributions.
This will be a significant practical issue for companies. For any "old" reverse hybrid splitter, there will likely be some prior year low-tax pools. Such pools are often first-tier in the CFC chain and due to §960(c) it will not be possible to "hopscotch" higher-taxed E&P around such low-tax pool by way of §956 deemed dividends. Therefore, it will be challenging to even achieve a foreign tax credit at the foreign statutory rate for such reverse hybrids in the future. Likewise, a conversion from a current reverse hybrid structure to a regular foreign corporation structure through a foreign reorganization, for example, will still likely result in an ongoing low-tax pool. The result, therefore, could be that suspended taxes are trapped long-term. Something to watch for in the transition rules when we move to a territorial system – see, I'm still optimistic.
The loss sharing splitter involves foreign group relief regimes. The U.K. system is the one I think of for this provision. It is operative when a so-called U.S. combined group includes both profit companies and loss companies for foreign tax purposes and the combined group shares all or part of the loss with a foreign company not in the same combined group. The structure below illustrates the typical fact pattern.
[Image]UK1 and UK2 are considered a combined income group. Surrendering UK2's loss of 100 to UK3 results in the UK1 combined income group having a higher effective tax rate – assuming a 20% U.K. corporate income tax rate, a 40% §902 effective tax rate would result. Thus, the regulations consider this to be a splitter, with 20 of the 40 of U.K. tax suspended until the related income – 100 of profit in UK3 – is distributed or deemed distributed to USP. Note that for loss sharing splitters the measure used to determine related income is not U.S. E&P but foreign taxable income standards (in this case the amount of foreign loss that is shared with UK3). A change from the temporary regulations to the final regulations is that a splitter will also exist if a loss carryback was available to recover prior years' tax which was foregone by the loss company by instead surrendering its current year loss to a U.K. group member that is not a member of the so-called U.S. combined group.
And don't forget the interaction of a group relief regime with the rules on what is a compulsory tax (see Tobin, Foreign Tax Credit Anti-Abuse Regulations Also Impact Loss Sharing, 36 Tax Mgmt. Int'l J. 326 (July 13, 2007)) in Prop. Reg. §1.901-2(e)(5)(iii). Under those regulations, increased tax paid by a §902 corporation as a result of sharing a loss with a non-U.S.-owned foreign group company would be considered a non-compulsory charge and not eligible for the foreign tax credit. This would mostly arise where the loss is surrendered to an affiliated company not under U.S. ownership, but could well have broader effect. Permanent loss of credits does not seem as bothersome to Treasury and the IRS as it is to me – such permanent loss also could happen under the final splitter regulations in many circumstances beyond the scope of this commentary (and perhaps a good subject for a future commentary). No doubt this is in keeping with the intended deterrent effect of the foreign tax credit splitter regulations. But not all splitters are avoidable unfortunately.
Hybrid instrument splitters are a bit more complex and in my experience did not arise as frequently pre-2011 as the other listed splitters. But hybrid instruments themselves are pretty common so the effect of the splitter rules could be broader than might be anticipated. There are two types of hybrid instrument splitters – U.S. equity hybrids and U.S. debt hybrids. A U.S. equity hybrid has three elements: (1) the instrument is treated as equity for U.S. tax purposes and is treated as debt in the issuer country or payments with respect to the instrument are otherwise deductible; (2) the instrument gives rise to an income inclusion in the holder country on which foreign taxes are paid (including possibly withholding tax paid to the issuer country); and (3) the "event" giving rise to the foreign income inclusion and deduction does not give rise to a U.S. income inclusion. The splitter arrangement can be illustrated by the simple diagram below.
[Image]In this case, the 20 of foreign tax incurred by F1 is a split tax suspended for U.S. tax purposes until the related income in F2 (100) is included for U.S. tax purposes by F1. Absent the application of §909, the §902 foreign tax credit pool of F1 would include the 20 of tax with no associated income. A practical problem, as in the reverse hybrid example discussed above, relates to the unrelated income of F2, i.e., the 900 of foreign E&P which have presumably been taxed by F2's country. A distribution from F2 is deemed to occur pro rata from the related income and unrelated income. Therefore, a dividend of 100 from F2 would only unsuspend 10% of the 20 of split tax but would also bring 10% of the underlying tax of F2 on a deemed paid basis. Absent hybrid treatment, F1 would have had 100 of E&P and 20 of tax. Seems to me the pro rata approach to distributions creates potential distortions and is way more complex than necessary.
The final regulations make clear that Notional Interest Deductions, which are becoming more popular, would potentially be considered U.S. equity hybrids. Consider Brazil, where a Brazilian withholding tax is imposed on the interest on net equity deduction (which is a form of Notional Interest Deduction) – a splitter effect could be quite painful and could impact a U.S. group's decision whether to maximize its potential local tax benefit from the regime.
There is lots of other interesting stuff in, and not in, the final regulations but beyond the scope of this short commentary. One final point I'd like to make relates again to the effective dates of the §909 rules. As indicated above, the splitter rules do have retrospective effect with respect to foreign taxes that are still in §902 pools as of 2011, so a review of splitters in the system is necessary. The rules are retrospective back to 1997 – the starting point of our check-the-box rules, no doubt the suspected culprit for splitter activity. An incredible amount of work would be needed for companies to scrub and track the evolution of their suspended taxes if they have not brought their affected §902 pools onshore before 2011. In my experience, all efforts were made to do so in the case of what I'll refer to as on-purpose, splitter-type structures. However, particularly for group relief, hybrid instrument, and consolidated return splitters (which I did not discuss in this commentary), there may well be splitter structures and potential suspended taxes still in the system which need tracking.
Another interesting effective date aspect relates to pre-87 foreign tax layers. The regulations can apply to pre-87 layers but only for post-2011 years. Sounds like an oxymoron but what it really affects is acquisitions of non-CFCs or §902 corporations. Deal teams need to include in their due diligence lists an inquiry as to whether any suspended taxes might exist in a foreign target. This could well be the case – particularly for hybrid instrument splitters. Of course, this might be yet another reason why a U.S. acquirer of a foreign target would desire a §338 election to wipe out the target's E&P history. But as I have previously written when whining about §901(m), foreign target §338 elections may not be a clearly good thing to do. Which means more time and cost in analyzing foreign deals and post-merger planning steps.
All of this until we go territorial… .
This commentary also will appear in the September 2015 issue of the Tax Management International Journal. For more information, in the Tax Management Portfolios, see DuPuy, 6020 T.M., The Creditability of Foreign Taxes — General Issues, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
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