Foreign tax credit generators

IRS LMSB Memorandum targets artificially-generated foreign tax credits

LMSB Tier I Issue Foreign Tax Credit Generator Directive – Revision 1 (LMSB-04-0109-002, February 19)

Mike Habib, EA Tax Relief & Tax Problem Resolution

In a Large & Mid Size Business Division (LMSB) Memorandum, IRS has focused on the problem of foreign tax credit generators, complex arrangements that are intentionally structured to artificially create a foreign tax liability and corresponding foreign tax credit.

Observation: Under IRS’s rules of engagement for LMSB examinations, Tier I issues are of high strategic importance to LMSB and have a significant impact on one or more industries. Tier I issues could include areas involving a large number of taxpayers, significant dollar risk, substantial compliance risk or high visibility, where there are established legal positions and/or LMSB direction.

Background. Under Code Sec. 901, taxpayers can claim a credit against their U.S. tax for income taxes paid or accrued during the tax year to any foreign country or U.S. possession. To qualify for the credit, the payment must be a compulsory payment under the authority of a foreign country and the predominant character of the foreign tax must be that of an income tax in the U.S. sense. An amount of payment is not compulsory, and thus not a foreign tax paid, to the extent the amount is more than the liability under foreign law for tax. (Reg. § 1.901-2(a)) Foreign tax credits are intended to prevent the double taxation of foreign income because U.S. taxpayers are subject to U.S. tax on their worldwide income.

IRS’s concern. Foreign tax credit generators are highly structured transactions that exploit the foreign tax credit regime. These complex arrangements are intentionally structured to create a foreign tax liability when, removed from the elaborately engineered structure, the basic underlying business transaction generally would result in significantly less, or even no, foreign taxes. The parties use these arrangements to exploit differences between U.S. and foreign law in order to allow a person to claim a foreign tax credit for the purported foreign tax payments while also allowing the counterparty to claim a duplicative foreign tax benefit. The person claiming foreign tax credits and the counterparty share the cost of the purported foreign tax payment through the pricing of the arrangement, e.g., by adjusting interest rates on loans or paying additional fees. Some of these transactions are designed to recover the foreign tax claimed as a foreign tax credit, so that, in substance, the transaction incurs no foreign tax cost. Some of these transactions are structured to eliminate the income that results in the foreign tax credit. Other types of these transactions do both. In either case, the foreign tax credit is inappropriate because the taxpayer claims a foreign tax credit where no double taxation of income occurs. These transactions are particularly offensive because they are designed strictly to generate credits in any amounts desired by the parties.

In its battle against foreign tax credit generator transactions, IRS issued temporary regs in July of 2008 (2008 regs) that treat amounts attributable to a structured passive investment arrangement as noncompulsory payments and, thus, disallow foreign tax credits for those amounts. (Reg. § 1.901-2T(e)(5)(iv), see Federal Taxes Weekly Alert 07/17/2008) IRS has also denied an inappropriate foreign tax credit claim in a lender/borrower generator transaction in PLR 200807015 by asserting various arguments, including ones based on debt/equity, substance over form, regulatory, and lack of economic substance. In Chief Counsel Advice 200826036, IRS denied a credit in an asset parking foreign tax credit generator transaction on the grounds that the transaction lacked economic substance and ran afoul of Code Sec. 269 (which denies tax benefits where acquisitions are made to evade or avoid income tax).

Observation: Lender/borrower transactions result in the duplication of tax benefits through the use of structured transactions designed to exploit inconsistencies between U.S. and foreign tax laws (financing transactions). Coupon stripping transactions, a subset of borrower transactions, have also been identified. Asset parking transactions involve the movement of assets that generate a passive income stream such as interest or dividends into a structure that subjects them to foreign tax.

IRS targets generator transactions. IRS has designated these transactions as a Tier I issue because a strategic approach to address the issue is appropriate due to the significant compliance risk and the extensive commitment of resources needed to resolve these cases. The LMSB Memorandum advises that not only are these transactions difficult to identify on a tax return, including Schedule M-3 (Net Income (Loss) Reconciliation for Corporations with Total Assets of $10 Million or More) or Forms 1118 (Foreign Tax Credit–Corporations), they are generally only detected during the course of an audit. Examiners may find a Form 8886 (Reportable Transaction Disclosure Statement) attached to the U.S. tax return, describing the transaction and tax impact, which may be filed by the taxpayer on a protective basis. In particular, this form has been included in some of the asset parking transaction tax returns.

The majority of the known transactions involve taxpayers in the financial services industry, and reporting of these transactions often appear as a part of their general business operations and may be indistinguishable from other financing arrangements/transactions. They are thus more difficult to identify through regular audit inquiries or regulatory disclosure requirements.

The Memorandum directs field examiners to review and challenge arguments by taxpayers that claim foreign tax credits generated through these highly structured transactions. It cautions that the analysis is very fact specific and requires a careful examination of the transaction documentation. Examination teams coming across this issue should contact one of the foreign tax credit Generator Technical Advisors as soon as they identify indicators of the issue.

The Memorandum also includes helpful attachments for examiners auditing foreign tax credit generator transactions: (1) an Appeals Coordinated Issue Designation Memorandum that covers the two principal types of lending/borrowing foreign tax credit generator transactions; (2) language developed to identifying this issue that must be inserted into an examiner’s initial Information Document Request (IDR) for all cases with at least $5 million of foreign taxes paid or accrued (or deemed paid) and reported on line 5, Part II, of Schedule B of Form 1118; and (3) additional language to use in a follow up IDR that should be used if the taxpayer’s response to the mandatory IDR indicates that it has participated in any transaction that satisfies the conditions identified in the 2008 regs.

The 2008 regs generally apply to foreign payments that, if they were an amount of tax paid, would be considered paid or accrued by a U.S. or foreign entity in tax years ending on or after July 16, 2008. The Memorandum states that while IRS can’t challenge the foreign tax credits generated in these arrangements on the basis of the 2008 regs before their effective date, the criteria in the regs are useful in identifying abusive arrangements. Such arrangements entered into before the effective date can be challenged on various grounds, including, but not limited to, the substance over form doctrine, the economic substance doctrine, debt-equity principles, Code Sec. 269, the Reg. § 1.701-2 partnership anti-abuse rules, and the Reg. § 1.704-1 substantial economic effect rules.

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