What's Compulsory?

By James Tobin, Esq.

Ernst & Young LLP

*

The IRS issued a Chief Counsel Advice Memorandum (CCA 201349015)
back in December on the application of the foreign tax credit
compulsory payment rules to the transfer pricing aspects of
transactions which were disregarded for U.S. tax purposes due to
check-the-box structures. My fellow contributors Gary Sprague and
Edward Tanenbaum were quicker off the mark than I in submitting
commentaries on this CCA that nicely lay out the IRS position and
rationale.2 However, I still
find myself troubled by some aspects of the IRS approach; so, while
not repeating Edward's and Gary's good points, I will add a few
more observations in this commentary.

The bottom line of the CCA is that in the case of intercompany
transactions that are disregarded for U.S. tax purposes - assume,
for example, sales from a U.S. parent to its check-the-box foreign
subsidiary -foreign income taxes paid will not be considered
compulsory payments under Regs. §1.901-2(e)(5) to the extent that
the profit taxed by the foreign country is in excess of
arm's-length transfer pricing levels. To refresh on the compulsory
requirement in the regulations, it provides that payment is
compulsory "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." Implicit in this
requirement is not overstating taxable income in the foreign
country through setting transfer prices at inappropriate levels.
Therefore, I am not surprised at the CCA's conclusion that the
arm's-length analysis under local transfer pricing principles would
apply regardless of whether the intercompany transaction was
regarded or disregarded for U.S. tax purposes. I'm not sure a CCA
was really needed to make this technical point but maybe all the
focus and attention on BEPS have softened me up? However, I was
surprised that the CCA referred to U.S. transfer pricing principles
for foreign countries that recognize the arm's-length standard.
(Not all do these days unfortunately.) To me, the appropriate
standard clearly is the foreign country's transfer pricing rules in
all cases.

So what am I worried about? My concern is with the application
of this rule in the field and the level of effort taxpayers may
need to go to in order to satisfy the IRS that they have exhausted
"all practical remedies" to reduce their foreign tax. The CCA does
clearly state that a taxpayer is not required "to waste time and
money in a futile proceeding" but only to pursue a reasonable
prospect of relief. The regulations use similar language. 
Sounds good. However, what I see in practice is a dramatic and
continuing increase in aggressive (sometimes very creatively
aggressive) enforcement action by foreign tax authorities and often
a very long and costly road for taxpayers attempting to challenge
assessments. Coupling those developments with some negative public
reaction by senior IRS officials3 to overreaching
assessments by foreign tax authorities, I'm concerned that the CCA
will be used in the field to deny credits even where further
challenge would be futile or cost prohibitive. The CCA makes clear
that taxpayers have the burden of establishing to the satisfaction
of the IRS that they have exhausted all practical remedies
(including resort to Competent Authority proceedings where
available). How high a bar will that be in this new era of
increasingly hardline foreign tax authorities?

The Competent Authority aspect is interesting.  In the case
of a disregarded transaction, the pricing from a U.S. tax
standpoint would be irrelevant apart from the foreign tax credit
issue. So one would intuitively think that the transaction would
not be Competent Authority eligible. However, it seems clear that
the IRS intends that the Competent Authority process be pursued,
perhaps to help negotiate with the foreign tax authority on the
side of the taxpayer and/or perhaps as a window to allow the IRS to
monitor the taxpayer's degree of effort in defending itself. Some
U.S.-foreign country Competent Authority negotiations are known to
be less fruitful than others, but the "not futile" standard was not
referenced in the "resort to competent authority" portion of the
CCA. Therefore, it seems that the IRS may view resort to Competent
Authority where the other country is a treaty partner as always
being a necessary step to prove compulsoriness? But given obvious
resource constraints in the IRS with respect to Competent Authority
staff and limited resources in most foreign countries, as well,
they can't really intend that, can they?

The issue of compulsoriness came up in the recent Procter
& Gamble
 case,4 also the subject
of a prior commentary.5 In that case,
Procter & Gamble was assessed Korean withholding tax on deemed
royalties and did not pursue local appeal remedies nor Competent
Authority relief based on opinion from local counsel that the
Korean assessment would be sustained. The IRS challenged the
foreign tax credit claim as non-compulsory but the court was
persuaded by the opinion of counsel, pointing out that good faith
reliance on advice of counsel is prescribed as acceptable in the
regulation.  It could be that reliance on a counsel opinion is
clearer for a binary technical issue such as royalty withholding
tax than a valuation or transfer pricing type of issue, which could
be more susceptible to Competent Authority negotiation. But in my
view taxpayers should always be able to rely on a local expert
opinion to document their decisions on how and whether to pursue
available remedies and the regulation in no way limits the reliance
on counsel standard.

A couple of related aspects of the compulsory payment
requirements that I've always found of interest.

First, it's interesting to contrast the requirements for the
crediting of contested taxes to the compulsory requirement. 
Regs. §1.901-2(e) states that credits are allowed for amounts of
income tax paid to a foreign country. This includes tax paid in the
course of a foreign tax dispute. Regs. §1.901-2(e)(2) states that
tax will not be considered to be paid to the extent that it is
"reasonably certain" that the amount will be refunded, credited,
rebated, abated, or forgiven. I've always taken this to mean that
taxes paid in the course of a dispute are generally eligible for
credit because it would be rare that a taxpayer would have a
sufficiently high confidence level of refund to meet the reasonably
certain standard. Presumably, if the IRS were to successfully
assert that the taxpayer later gave up its fight too early or
failed to seek Competent Authority relief and therefore overpaid
its tax, the amount paid during the pendency of the dispute would
potentially cease to be creditable when that determination was made
and would require a §905(c)-type adjustment at that point?

Second, it's clear in the regulations, but not discussed in the
CCA, that a taxpayer is not required to alter its form of doing
business or its business conduct in order to reduce its liability
under the compulsory standard. From a transfer pricing standpoint,
operating as a full-risk distributor as opposed to a limited-risk
distributor or as a full-risk manufacturer rather than a contract
manufacturer would result in more local income and thus more local
tax but without risk of IRS compulsory challenge. (Though I might
worry whether an IRS agent would attempt to categorize the
activities differently?) Also, the choice between a branch or
subsidiary, which could result in differing local tax rates, or the
choice of debt-versus-equity funding are business conduct choices
for a taxpayer that have non-tax commercial effects and that will
consequentially impact the amount of local tax paid but that should
not be subject to a hindsight IRS challenge with respect to whether
the tax paid is compulsory. But I still worry about whether the IRS
will see this as clearly as I do?

It seems to me that two aspects of the existing regulations
erode this choice of business conduct rule. The first is the area
of group relief - a topic on which I have previously commented.6 The regulations render
a portion of tax paid by a foreign subsidiary (or disregarded
entity) as non-compulsory where losses are surrendered to related
entities outside of an 80%-U.S.-controlled subsidiary group to the
extent that the losses surrendered would have later reduced the
foreign tax of the loss company. While I understand the rationale
for this rule, I have previously quibbled with the 80% threshold
and I also think the rule confuses the compulsory requirement as
the loss surrender is clearly reasonable business conduct. The
second aspect is the structured passive investment arrangement
rules of Regs. §1.901-2(e)(5)(iv), which are quite complex and
which render non-compulsory certain foreign taxes that are also
available for credit by an unrelated counter-party in certain
investment or financing transactions. A detailed discussion of
those rules is way beyond the scope of this commentary, but such
transactions could well be considered a reasonable form of doing
business (i.e., a way to procure low-cost financing), as was
apparently considered to be the case by the judge in the
Santander Holdings case7 (which involves a
transaction that pre-dated the structured passive investment
arrangement rules). So again here the regulations reflect an
understandable position for the IRS. However, it is one that in the
context of the compulsory payment standard and the rule on
acceptance of the taxpayer's choice of its business form or model
could confuse the issue or at least confuse an examining agent.

Overall, I do have some empathy for the IRS's plight.
Multinationals are facing an increasingly hostile local tax audit
environment overseas. The current BEPS focus will likely further
exacerbate that situation. As one of the few countries left with a
worldwide tax system, the U.S. fisc will be a co-contributor to
funding the increased foreign taxes incurred by U.S. multinationals
and the IRS not surprisingly would like visibility into the process
or even a seat at the table in negotiating foreign tax disputes
when possible. Indeed, that could be very advantageous to U.S.
companies, as long as all is done in the right spirit of
cooperation and with recognition of the practical realities of the
foreign tax dispute resolution process. The U.S. fisc does not
contribute to funding taxpayer costs in pursuing its foreign
remedies so it could well take a different view of what efforts
would be "futile." One hopes that the CCA is not received by the
IRS in the field as a message to play hardball on allowing foreign
tax credits under the compulsory standard. Perhaps all in all, this
is yet another motivating factor for moving the United States to a
territorial tax system, like most of the rest of the world.

This commentary also will appear in the May 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 Taxation.

 

   The
views expressed herein are those of the author and do not
necessarily reflect those of Ernst & Young LLP.

  2 Sprague, "Role of §482 Principles to Determine
Noncompulsory Tax Payments Arising from Transactions with Foreign
Disregarded Entities," 43 Tax Mgmt. Int'l J. 175
(3/14/14); Tanenbaum, "CCA 201349015: Transfer Pricing and Foreign
Tax Credit Considerations in the Context of Disregarded
Transactions," 43 Tax Mgmt. Int'l J. 178
(3/14/14).

  3 See, for example, "U.S. Competent Authority Has
Harsh Words about India," Tax Notes Today, Feb. 4,
2013.

  4 The Procter & Gamble Company v. United
States
, No. 1:08-cv-00608, 2010 BL 370274 (S.D. Ohio 7/6/10)
(order granting partial summary judgment).

  5 Yoder, "Procter & Gamble Case
Holds Korean Withholding Taxes Were Compulsory," 39 Tax Mgmt.
Int'l J.
 614 (10/8/10).

  6 Tobin, "Foreign Tax Credit Anti-Abuse Regulations
Also Impact Loss Sharing," 36 Tax Mgmt. Int'l. J. 326
(7/13/07).

  7 Santander Holdings USA, Inc. v. United
States
, No. 1:09-cv-11043, 2013 BL 286948 (D. Mass. 2013).