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Foreign Tax Credits September–October 2008 Foreign Tax Credits By James A. Riedy The Evolving Technical Taxpayer and Voluntary Payment Rules here are three basic questions under Code Sec. 901 when addressing the treatment of a Tforeign levy: 1. Is the foreign levy an income tax? 2. Who is legally liable for the foreign income tax under foreign law? 3. Did the taxpayer pay more income tax than re- quired under foreign law? For years, the debate in the foreign tax credit area was usually over whether a foreign tax was an income tax. Putting aside the enactment of the fl at tax in Mexico1 and the cash deposit tax in Mexico,2 recently there have not been many interesting foreign levies to discuss. On the other hand, recent changes relat- ing to the technical taxpayer rule and the voluntary payment rule have exposed taxpayers to new chal- lenges. Set forth below is (1) a summary of the Code Sec. 901 voluntary payment rule, and (2) a recap of three developments relating to that rule that impact the technical taxpayer rule. Voluntary Payment Rule Under the voluntary payment or noncompulsory pay- ment rule, an amount of foreign income tax paid to a foreign government is not treated as an income tax for U.S. foreign tax credit purposes.3 Since such a pay- ment is not viewed as an income tax, no foreign tax James A. Riedy is a Partner in the Tax credit is allowed for the payment, although a deduc- Department of McDermott, Will & tion may be obtained for the payment. A payment of Emery’s Washington, D.C. offi ce. foreign income tax is considered a voluntary payment INTERNATIONAL TAX JOURNAL 5 Foreign Tax Credits if the amount paid exceeds the amount of liability as authority procedure is a practical and effective rem- determined under foreign law. By comparison, Reg. edy. Taxpayers are routinely faced with the choice §1.901-2(e)(5) provides that an amount paid does of either accepting a lower foreign income tax as- not exceed the amount of such liability for tax if the sessment with a voluntary payment exposure in the amount paid is determined by the taxpayer in a man- United States, or accepting a higher assessment and ner that is consistent with a reasonable interpretation taking the case to the competent authority. and application of the laws of the relevant foreign The IRS reserves the right in Rev. Proc. 2006-54 to country. A taxpayer is deemed to reasonably apply the deny credits for foreign taxes paid if either the compe- laws of the foreign country if the taxpayer “exhausts tent authority fails to resolve the case or the taxpayer all effective and practical remedies, including invo- rejects the settlement. Although the U.S. competent cation of competent authority procedures available authority usually allows a taxpayer to claim a credit under applicable tax treaties,” to reduce over time for foreign income taxes paid in an unsettled case the taxpayer’s liability for foreign tax. or to the extent there is a settlement but still some double taxation, this practice has been questioned by Exhaustion of Remedies IRS Deputy Commissioner Barry Shott. He has sug- gested that maybe more pressure should be applied to A long-standing issue is how to determine whether U.S. taxpayers to pursue judicial remedies in foreign a taxpayer has exhausted all effective and practi- countries if a settlement cannot be reached.5 cal remedies following It should also be noted a tax assessment by a that under the Code Sec. foreign revenue authority. A payment of foreign income tax 905 information report- Although most discussion is considered a voluntary payment ing rules, a foreign tax of the voluntary payment redetermination as a result rule is focused on cross- if the amount paid exceeds the of settling a foreign audit border transactions, even amount of liability as determined is transparent to the IRS.6 a completely local issue, under foreign law. The information reporting such as equipment de- rules require the taxpayer preciation in Germany, is to notify the IRS of an in- subject to the voluntary payment analysis. In reaching crease in payment of foreign income tax as a result of a settlement with a foreign revenue authority, it is an audit. Thus, the IRS has an information reporting common practice to obtain advice from local counsel system in place to identify the payment of additional that the settlement is reasonable under local law and foreign income tax and make certain a taxpayer has a better deal is unlikely to be obtained by invoking exhausted all effective and practical remedies. further administrative or judicial remedies. If the foreign audit involves a cross-border payment FTC Generator Regulation and the relevant foreign country has an income tax treaty with the United States, then utilization of the The IRS recently fi nalized the so-called FTC generator competent authority procedure must be taken into ac- regulation, which creates a new category of volun- count. As indicated, Reg. §1.901-2(e)(5) specifi cally tary payment.7 In general, under this new regulation, references the competent authority as a potential foreign income taxes paid in a structured passive remedy. It is commonly understood that the U.S. investment arrangement are considered voluntary competent authority reserves the right to determine payments. Whether the taxpayer is legally liable for whether utilization of that procedure is necessary in the foreign income tax paid in one of these arrange- order to satisfy the exhaustion of remedies rule. Rev. ments is irrelevant under the new rules. In other Proc. 2006-544 provides that acts or omissions by a words, even though the taxpayer may satisfy the taxpayer that preclude effective competent author- traditional technical taxpayer rule, the payment of ity assistance may constitute a failure to exhaust all tax is considered voluntary. effective and practical remedies. On a prospective basis, it is unlikely that a taxpayer Pressure to settle a foreign audit under favorable would inadvertently trigger the application of the terms confl icts with the IRS’s position that only the structured passive investment arrangement rules. IRS can judge whether utilization of the competent There are six specifi c factors that must be satisfi ed 6 ©2008 CCH. All Rights Reserved September–October 2008 under this regulation, and it is easy for a taxpayer to question is whether UK1 has reasonably interpreted make certain it is not within the scope of these rules. and applied the laws of the U.K. to reduce over time However, even without this new regulation, the IRS its foreign income tax liability if it has surrendered has disallowed foreign tax credits in years prior to a loss to another taxpayer. The implied conclusion the effective date of the regulation in transactions in the proposed regulation is that UK1 may not have considered abusive by the IRS.8 Even though it is un- reasonably interpreted and applied the laws of the disputed that the taxpayer is legally liable for the tax in U.K., much to the surprise of many taxpayers. these transactions and, therefore, under the technical Proposed Reg. §1.901-2(e)(5)(iii) resolves the pur- taxpayer rule the taxpayer would traditionally be al- ported problem by treating a “U.S.-owned group” lowed a credit for the foreign income taxes paid, the as a single taxpayer. Generally a U.S.-owned group credits are disallowed. The arguments made by the includes related entities, which is based on an IRS include Code Sec. 269 and economic substance 80-percent or more ownership threshold. Because doctrines, but even a good business purpose is appar- of multiple issues that have been identifi ed by ently not suffi cient to preclude an IRS challenge.9 taxpayers under this new voluntary payment test, fi nalization of this new regulation has been delayed Loss Surrender for further consideration.10 The third development, and one that surprised many Summary taxpayers and practitioners, was Proposed Reg. §1.901-2(e)(5)(iii). This regulation deals with the The technical taxpayer rule and voluntary payment rule surrender of losses between members of a group. A have become interrelated. The technical taxpayer rule basic example would be USP owns 100 percent of is evolving away from the basic question of whether a UK1 and 100 percent of UK2. UK1 has 300 of in- taxpayer is liable for tax as determined under foreign come. UK2 has 100 of loss. Under the UK corporate law. Similarly, the voluntary payment rule has evolved income tax system, UK2 can surrender the 100 loss to the point where it may apply to disallow a foreign tax to UK1 thereby reducing the tax liability of UK1. The credit even though the taxpayer’s liability for payment question addressed by Proposed Reg. §1.901-2(e)(5) of a foreign income tax under foreign law is undisputed (iii) is whether tax paid by UK1 in the future may be and there is a valid business purpose for paying the considered a voluntary payment of tax because UK1 tax. The abandonment of a mechanical rule leads to surrendered the loss to another taxpayer instead of uncertainty both for the IRS and taxpayers. If a foreign retaining the loss to offset its own future tax liability. income tax paid with respect to a structured passive In other words, referring to the description of the investment arrangement supported by a valid business voluntary payment rule set forth above, should UK1 purpose is a voluntary payment, and if surrendering a and UK2 be considered a single taxpayer, or are loss to an affi liate creates a voluntary payment expo- there two taxpayers.
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