Supercharged FTCs

The foreign tax credit (FTC) reduces double taxation when income is subject to tax in more than one jurisdiction. There are two types of FTC, the direct and indirect credit; see Secs. 901 and 902, respectively. Under Sec. 901, U.S. taxpayers can claim a direct credit for taxes they have paid or that have been paid on their behalf. For a U.S. corporation, the types of income that can generate the direct credit include income (1) from conducting business in a foreign jurisdiction (whether directly, or through a partnership or disregarded entity) and (2) subject to foreign withholding taxes.

Under Sec. 902, an indirect credit can be claimed by a U.S. corporation that receives a dividend from a foreign corporation. For the indirect credit, the U.S. corporation can take a credit for foreign taxes paid by the foreign corporation; a formula determines the amount of foreign subsidiary income tax attributable to the dividend.

The indirect FTC permits several FTC maximization strategies. One involves claiming a direct credit for the foreign subsidiarys income taxes, without receiving any dividends. Under this strategy, the U.S. taxpayer converts what would otherwise be an indirect credit into a direct credit by holding foreign subsidiary corporations through a wholly owned foreign company that the taxpayer elects to treat as disregarded for Federal tax purposes. This is accomplished by making a check the box election, under Regs. Sec. 301.7701-3.

However, this strategy has been attacked by the IRS; see Guardian Industries Corp., Fed. Cl., Dkt. No. 02-1936T. Taxpayers claiming an FTC with little or no repatriation of income to the U.S. should be aware of both this litigation and the IRSs stated position on FTC strategies.

Notice 98-5

Notice 98-5 was the first guidance setting forth the IRSs view on FTC claims it deemed abusive. It announced the IRSs intent to issue regulations applying an economic-profit test to transactions designed to generate FTCs to offset U.S. tax on unrelated foreign-source income. The Service anticipated issuing regulations that would apply this test to disallow FTCs when the economic profit is insubstantial in relation to the FTC generated. Notice 98-5 also addressed certain transactions involving taxpayers claiming FTCs for income generated by property held for a very short time. Legislation addressed the short-holding-period transactions identified in Notice 98-5; see Sec. 901(k) and (l). Notice 2004-19, discussed below, withdrew Notice 98-5.

Notice 2004-19

Notice 2004-19 provides the most current description of the IRSs ap-proach to transactions that, in its view, produce inappropriate FTC results.

Notice 2004-19 states that the IRS will continue to scrutinize FTC-generating transactions it considers abusive. The notice announced that the Service may challenge the claimed tax consequences of such transactions under the (1) substance-over-form doctrine, (2) step-transaction doctrine, (3) debt-equity principles and (4) Sec. 269 provisions on making acquisitions to avoid or evade tax, as well as the subchapter K anti-avoidance and the substantial-economic-effect rules. Guardian Industries gives the Service an opportunity to challenge FTCs, under some of these grounds.

Guardian Industries

In Guardian Industries, the Service is showing its determination to attack tax-motivated transactions involving FTCs that it considers abusive. Guardian Industriesa U.S. corporate groupowned Guardian Industries Europe (GIE), the parent of a consolidated group in Luxembourg that files fiscal unitary group consolidated returns. GIE is a Luxembourg socit responsibilit limite and a disregarded entity for Federal income tax purposes. The taxpayer argues that GIE was solely liable for all the Luxembourg corporate income tax payable for the group. Thus, under Regs. Sec. 1.901-2(f)(1), the taxpayer states that the U.S. group should get a credit for the tax GIE paid, even though it was paid on income earned by foreign subsidiaries (i.e., income of companies in the Luxembourg fiscal unity return). The government contends that the Luxembourg group companies are jointly and severely liable for the tax. How this situation is viewed by the court will be of interest to taxpayers contemplating a similar structure.

The IRSs Next Move?

According to Notice 2004-19, the IRS is working on Sec. 901 guidance on applying the legal liability rule contained in Regs. Sec. 1.901-2(f) for foreign consolidated tax reporting systems. These regulations would be intended to make the allocation of foreign taxes imposed on the combined income of two or more persons more consistent with eachs respective share of the foreign income to which the tax relates.

Notice 2004-19 further states that the Service may modify the reportable transaction regulations under Regs. Sec. 1.6011-4 (i.e., the tax shelter disclosure regulations) to require reporting of transactions that effectively separate foreign taxes from the related foreign income, including those that create a mismatch in the timing of recognition of foreign taxes and the related income for U.S. tax purposes.

Conclusion

U.S. taxpayers with aggressive FTC strategies should monitor both the progress of Guardian Industries and any further guidance the IRS may issue on FTC strategies.

From Bill Zink, CPA, and Stefan Gottschalk, CPA, J.D., LL.M., Washington, DC