US restricts foreign tax credit splitter arrangements

In the wake of the news of state-aid investigations by the EU and the EU’s order that Apple Inc. repay $14.5 billion in Irish tax breaks, the US tax agency, the Internal Revenue Service (IRS), on Thursday announced that it intends to issue new rules to address the separation of related income from foreign income taxes paid by a “Sec. 902 corporation” under a foreign-initiated tax adjustment (Notice 2016-52). A Sec. 902 corporation (as defined in Internal Revenue Code Sec. 909(d)(5)) is a foreign corporation at least 10% of the voting stock of which is owned by a domestic corporation. The regulations will be issued under Sec. 909, which suspends taxes and credits until the related income is taken into account (prohibiting what is known as foreign tax credit splitting events). The rules will require companies to repatriate earnings to the US before they can claim a credit for foreign taxes paid on the income.

The IRS is issuing these rules because it is aware that, in anticipation of a large foreign-initiated adjustment for a prior tax year, taxpayers that are multinational corporations may take steps to separate the additional payment of foreign income tax from the income to which it relates. These foreign-initiated adjustments may arise under EU state aid law, to the extent EU state aid payments result in creditable foreign taxes.

Before a taxpayer makes a payment of a foreign-initiated adjustment, it may attempt to change its ownership structure or cause the Sec. 902 corporation to make an extraordinary distribution so that the subsequent tax payment creates a high-tax pool of post-1986 undistributed earnings that can be used to generate substantial amounts of foreign taxes deemed paid, without repatriating and including in US taxable income the earnings and profits (E&P) the taxes relate to.

The rules identify two new splitter arrangements.

The notice explains that the regulations will provide that the first new type of splitter arrangement arises when, as a result of a “covered transaction,” a Sec. 902 corporation pays “covered taxes” during a tax year (the “splitter year”).

“Covered taxes” are foreign income taxes that (1) are taken into account by adjusting the payer’s pools of post-1986 undistributed earnings and post-1986 foreign income taxes in the tax year paid under Sec. 905(c) (adjustments to accrued taxes); and (2) result from a “specified foreign-initiated adjustment” to the amount of foreign income tax accrued for one or more prior tax years (“relation-back years”).

A “specified foreign-initiated adjustment” is a foreign-initiated adjustment (or series of related adjustments for more than one tax year) that results in additional foreign income tax liability greater than $10 million, regardless of whether the liability is paid over one or more tax years (e.g., using an installment plan).

A “covered transaction” is defined as any transaction or series of related transactions that meet the following conditions: (1) The transactions result in covered taxes being paid by a Sec. 902 corporation payer that is not the Sec. 902 corporation that would have been the payer of the covered taxes (the predecessor entity) if the covered taxes had been paid or accrued in the relation-back year; and (2) the predecessor entity (or a successor of the predecessor entity) was a covered person (having certain ownership interest) of the payer immediately before the transactions, or, if the payer did not exist immediately before the transaction or related transactions, the predecessor entity (or a successor of the predecessor entity) was a covered person of the payer immediately after the transaction or series of related transactions.

These rules will not apply if either of these two exceptions exists: (1) The transactions result in the transfer of the predecessor entity’s E&P to the payer; or (2) the taxpayer demonstrates by clear and convincing evidence that the transactions were not structured with a principal purpose of separating covered taxes from the predecessor entity’s post-1986 undistributed earnings from the earnings to which the covered taxes relate.

The second splitter arrangement that will be prohibited involves a payer that is a Sec. 902 corporation paying covered taxes (as defined in the notice) during a tax year (the “splitter year”), and the payer (or a predecessor of the payer) has made a “covered distribution.”

A “covered distribution” is any distribution with respect to the payer’s stock to the extent the distribution: (1) occurred in a tax year of the payer to which the covered taxes relate or any subsequent tax year up to and including the tax year immediately before the tax year in which the covered taxes are paid; (2) resulted in a distribution or allocation of the payer’s post-1986 undistributed earnings (but for this purpose not including earnings and profits attributable to income effectively connected with the conduct of a trade or business within the US or otherwise subject to tax under chapter 1 of the Internal Revenue Code in the hands of the payer) to a Sec. 902 covered person; and (3) was made with a principal purpose of reducing the payer’s post-1986 undistributed earnings that included the earnings to which the covered taxes relate in advance of the payment of covered taxes.

The IRS did not indicate when the regulations will be issued, but they will apply to foreign income taxes paid on or after September 15th 2016. The IRS is accepting comments until December 14th 2016.

—Sally P. Schreiber (sschreiber@aicpa.org) is a CGMA Magazine senior editor.