Proposed “Technical Taxpayer” Regulations Shut Down Guardian and Reverse Hybrid Structures
- Because U.S. taxpayers are subject to federal income tax on their worldwide income, income earned in a foreign country may be subject to double taxation: once in the foreign country and a second time in the U.S. The foreign tax credit provisions are intended to alleviate this double taxation by permitting U.S. taxpayers to claim a credit for “any income, war profits, and excess profits tax paid or accrued during the taxable year. . . to any foreign country or possession of the United States. . . . ”1 U. S. taxpayers are also able to claim a credit for a tax paid in lieu of an income tax.2
Under the current regulations, a foreign tax is generally considered to be paid by the person or persons on whom foreign law imposes legal liability for such tax (otherwise known as the “technical taxpayer rule”).3 I f foreign income tax is imposed on the combined income of two or more related persons (such as a corporation and one or more of its subsidiaries), and those persons are jointly and severally liable for the income tax under foreign law, foreign law is considered to impose legal liability on each such person for the amount of the foreign income tax that is attributable to its portion of the base of the tax, regardless of which person actually pays the tax.4
On August 3, 2006, the Treasury and IRS issued proposed amendments to the current regulations (the proposed regulations).5 T he proposed regulations are, in large part, designed to shut down transactions in which U.S. taxpayers have sought to “hype” their foreign tax credit by splitting the foreign taxes from the underlying income through the affirmative use of a perceived ambiguity in the legal liability rule and/or the U.S. entity classification regulations (commonly referred to as the “check-the-box” regulations).6 T hese structures have included use of a disregarded foreign parent where the other members of a foreign-consolidated type regime may not have (in the U.S. sense) the full equivalent of joint and several liability (as seen in Guardian Industries Corp. v. United States, 65 Fed. Cl. 50 (2005)); and reverse hybrid structures ( i.e., treated as a pass-through entity under foreign law but as a corporation for U.S. federal income tax purposes).
Guardian Industries Corp. v. United States
In Guardian Industries Corp. v. United States, a Delaware corporation (Guardian) was the parent of a U.S. consolidated group that included a wholly-owned U.S. subsidiary (U.S. HoldCo). U.S. Holdco served as the holding company for a Luxembourg parent company (Foreign HoldCo). Foreign HoldCo was the parent company of a group of Luxembourg companies. A check-the-box election had been made to treat Foreign HoldCo as a disregarded entity (i.e., as a branch of U.S. HoldCo) for U.S. federal tax purposes.7
Under Luxembourg law, the parent of a group is solely liable for the corporate income taxes imposed on the members of the group, i.e., the other members of a Luxembourg group are not joint and severally liable for the Luxembourg corporate income tax paid on the group’s taxable income. Because Foreign HoldCo was treated as a disregarded entity for U.S. federal tax purposes, under the legal liability rule, U.S. HoldCo was treated as the entity that was liable for, and paid, the Luxembourg taxes imposed on the group.
On its U.S. consolidated income tax return, Guardian initially treated the Luxembourg taxes paid as allocable on a pro rata basis to the members of the Luxembourg group. Subsequently, Guardian successfully filed a claim for refund (for approximately $2.86 million) contending that 1) because Foreign HoldCo was solely liable for the group’s Luxembourg taxes and 2) because Foreign HoldCo was a disregarded entity, U.S. HoldCo was entitled to claim a foreign tax credit for all of the Luxembourg taxes paid.8
Reverse Hybrid Structures
Another example of how U.S. taxpayers attempted to hype their foreign tax credit by splitting the foreign taxes from the associated income was through the use of reverse hybrid structures.9 For example, a U.S. person would own a foreign holding company, which would own a foreign operating company. The foreign holding company would be a hybrid entity (i.e., fiscally transparent for U.S. federal tax purposes, but a corporation for foreign tax purposes), and the foreign operating company would be a reverse hybrid entity (i.e., a corporation for U.S. federal tax purposes, but fiscally transparent for foreign tax purposes). Under the relevant foreign tax law, the foreign operating company’s tax would be considered as a liability of its partners (including the foreign holding company). Because the foreign holding company would be fiscally transparent for U.S. federal tax purposes, the foreign tax it paid on its allocable share of the foreign operating company’s income would naturally flow into the return of the U.S. owners. However, because the foreign operating company would be treated as a corporation for U.S. federal tax purposes, the underlying income would not be subject to current U.S. federal income tax.10
Summary of Changes Made by the Proposed Regulations
As more fully discussed below, the proposed regulations would retain the general principle that tax is considered paid by the person who has legal liability under foreign law for the tax, but would, inter alia, clarify the application of the rule with respect to foreign consolidated-type regimes and with respect to reverse hybrids. The proposed regulations provide rules with respect to the apportionment of tax on combined income and certain collateral consequences when taxes are paid or reimbursed by a person other than the person that has the legal liability for such taxes. Additionally, the proposed regulations would clarify the application of the legal liability rule with respect to hybrid partnerships (an entity that is a partnership for U.S. tax purposes, but a corporation for foreign tax purposes) and with respect to disregarded entities. Finally, the proposed regulations provide a rule with respect to foreign tax obligations that are undertaken as part of a transaction.11
• Clarification of the Legal Liability Rule — As noted, the proposed regulations would retain the legal liability rule, but would clarify that the rule applies even if under foreign law another person is obligated to remit the tax, another person (e.g., a withholding agent) actually remits the tax, or foreign law permits the foreign country to proceed against another person to collect the tax in the event the tax is not paid.12 This rule also applies to determine the person who is considered to have legal liability for, and thus, to have paid a tax in lieu of an income tax (within the meaning of Treas. Reg. Sec. 1.903-1(a)).13 As such, the proposed regulations dispel any lingering doubt about whether withholding taxes are creditable by the beneficial owner of the income, notwithstanding the fact that under foreign law the tax authorities can proceed only against the withholding agent (such as in the case of Brazilian withholding taxes imposed on interest payments).14
• Taxes Imposed on Combined Income — The proposed regulations remove any ambiguity with respect to the application of the legal liability if foreign tax is imposed on the combined income of two or more persons. In such cases, foreign law is considered to impose legal liability on each such person for the amount of tax that is attributable to such person’s pro rata share of the base of tax.15 This rule is explicitly made applicable to all foreign consolidated-type regimes, including those that impose joint and several liability among the members, those in which the regime treats subsidiaries as branches of the parent corporation (or otherwise attributes income of subsidiaries to the parent corporation), and those in which some of the group members have limited obligations, or even no obligation, to pay the consolidated tax.16 More specifically, the proposed regulations remove the reference to “joint and several liability under foreign law” and provide that “[i]f foreign tax is imposed on the combined income of two or more persons (for example, a husband and wife or a corporation and one or more of its subsidiaries), foreign law is considered to impose legal liability on each such person for the amount of the tax that is attributable to such person’s pro rata share of the base of the tax.”17
For purposes of this rule, foreign tax is imposed on the combined income of two or more persons if such persons compute their taxable income on a combined basis under foreign law.18 Foreign tax is considered to be imposed on the combined income of two or more persons even if the combined income is computed under foreign law by attributing to one such person (e.g., the foreign parent of a foreign consolidated group) the income of other such persons.19 Foreign tax is not considered to be imposed on the combined income of two or more persons, however, solely because foreign law:
• Permits one person to surrender a net loss to another person pursuant to group relief or similar regime;
• Requires a shareholder of a corporation to include in income amounts attributable to taxes imposed on the corporation with respect to distributed earnings, pursuant to an integrated tax system that allows the shareholder a credit for such taxes; or
• Requires a shareholder to include, pursuant to an antideferral regime (similar to subpart F), income attributable to the shareholder’s interest in the corporation.20
The proposed regulations provide the following example with respect to these provisions:
Example: A, a U.S. person, owns 100 percent of B, an entity organized in foreign country X. B is a corporation for country X tax purposes, and a disregarded entity for U.S. income tax purposes. B owns 100 percent of corporation C and corporation D, both of which are also organized in country X. B, C, and D file on a combined basis for country X income tax purposes. Country X imposes an income tax at the rate of 30 percent on the taxable income of corporations organized in country X. Under the country X combined reporting regime, income (or loss) of C and D is attributed to and treated as income (or loss) of B. B has the sole obligation to pay country X income tax imposed with respect to income of B and income of C and D that is attributed to and treated as income of B. Under the law of country X, country X may proceed against B, but not C or D, if B fails to pay over to country X all or any portion of the country X income tax imposed with respect to such income. In year one, B has taxable income of 100; C has taxable income of 200; and D has a net loss of (60). Under the law of country X, B is considered to have 240 of taxable income with respect to which 72 of country X income tax is imposed. Country X does not provide mandatory rules for allocating D’s loss.
Under the proposed regulations, the 72 of country X tax is considered to be imposed on the combined income of B, C, and D. Because country X law does not provide mandatory rules for allocating D’s loss between B and C, the proposed regulations require that D’s (60) loss be allocated pro rata: 20 to B ((100/300) x 60) and 40 to C ((200/300) x 60). As a result, under the proposed regulations, the 72 of country X tax is allocated pro rata among B, C, and D. Because D has no income for country X tax purposes, no country X tax is allocated to D. Accordingly, 24 (72 x (80/240)) of the country X tax is allocated to B, and 48 (72 x (160/240)) of such tax is allocated to C. A is considered to have legal liability for the 24 of country X tax allocated to B.21 SeeExhibit I titled “Taxes on Combined Income of Two or More Persons.”
• Reverse Hybrid Entities — The proposed regulations revise the current regulations to provide that a reverse hybrid is considered to have legal liability under foreign law for foreign taxes imposed on the owners of the reverse hybrid in respect of each owner’s share of the reverse hybrid’s income.22 In other words, under the proposed rule, the reverse hybrid’s foreign tax liability would be determined based on the portion of the owner’s taxable income (as computed under foreign law) that is attributable to the owner’s share of the reverse hybrid’s income.23 Thus, for example, if an owner of a reverse hybrid has no other income on which tax is imposed by the foreign country, then the entire amount of foreign tax that is imposed on the owner is treated as attributable to the reverse hybrid for U.S. income tax purposes and, accordingly, is a tax for which the reverse hybrid (rather than the owner) has legal liability.24 Under the proposed regulations, this rule would apply regardless of whether the owner and the reverse hybrid are located in the same foreign country. Furthermore, if the owner pays tax to more than one foreign country with respect to income of the reverse hybrid, tax paid to each foreign country would be separately apportioned on the basis of the income included in that country’s tax base.25
The proposed regulations provide the following example with respect to these provisions:
Example: A, a domestic corporation, owns 95 percent of the voting power and value of C, an entity organized in country Z. B, a domestic corporation, owns the remaining five percent of the voting power and value of C. C is a reverse hybrid entity. Accordingly, under country Z law, A and B are required to take into account their respective shares of the taxable income of C
Country Z imposes an income tax at the rate of 30 percent on such taxable income. For 2007, C has 500 of taxable income for country Z tax purposes. A’s and B’s shares of such income are 475 and 25, respectively. In addition, A has 125 of taxable income attributable to a permanent establishment in country Z, which is also subject to the country Z income tax at a rate of 30 percent. Accordingly, country Z imposes 180 of tax on A’s total taxable income of 600 (475 of income from C and 125 of income from the permanent establishment) and 7.5 of tax on B’s 25 of taxable income from C.
Under the proposed regulations, the 180 of tax imposed on the taxable income of A is considered to be imposed on the combined income of A and C. As a result, such tax must be allocated between A and C on a pro rata basis, which means that C is considered to be legally liable for the 142.5 (180 x (475/600)) of country Z tax imposed on A’s 475 share of C’s income, and A is considered to be legally liable for the 37.5 (180 x (125/600)) of the country Z tax imposed on A’s 125 of income from its permanent establishment. Similarly, the 7.5 of tax imposed on the taxable income of B is considered to be imposed on the combined income of B and C. However, because B has no other income on which income tax is imposed by country Z, the entire amount of the tax is allocated to and considered paid by C.26 The proposed regulations indicate that, if A or B paid the tax for which C is considered legally liable, such payment would be treated as a capital contribution by A or B to C.27 See Exhibit II titled “Reverse Hybrid Structure.”
• Collateral Consequences — The proposed regulations also provide that if one person remits a tax that is the legal liability of, and, thus, considered paid by another person, U.S. tax principles will apply to determine the tax consequences of such payment.28 For example, a payment of tax by a shareholder (including an owner of a reverse hybrid) for which the corporation has legal liability ordinarily will result in a deemed capital contribution and a deemed payment of tax by the corporation.29 Similarly, if the corporation reimburses the shareholder for the tax payment, such reimbursement ordinarily would be treated as a distribution for U.S. tax purposes.30
• Taxes on Income of Hybrid Partnerships and Disregarded Entities — If foreign law imposes tax at the entity level on the income of an entity that is treated as a partnership for U.S. tax purposes but a corporation for foreign tax purposes (a hybrid partnership), the hybrid partnership is considered to be legally liable for such tax for U.S. tax purposes.31 If, on the other hand, foreign law imposes tax at the entity level on the income of an entity that is disregarded for U.S. federal income tax purposes, the owner of the disregarded entity (rather than the entity itself) is considered to be legally liability for such tax for U.S. income tax purposes.32 Subject, of course, to the reverse hybrid and combined income rules discussed above.
• Party Undertaking Tax Obligation as Part of a Transaction — Finally, the proposed regulations provide that tax is considered paid by the taxpayer even if another party to a direct or indirect transaction with the taxpayer agrees, as part of the transaction, to assume the taxpayer’s foreign tax liability.33
The proposed regulations are intended to be effective for foreign taxes paid or accrued during taxable years of taxpayers beginning on or after January 1, 2007.34 If finalized in the current form, the proposed regulations will take a big step in shutting down transactions that clearly were never intended to be covered under the current foreign tax credit regime, namely, those transactions that inappropriately separate the foreign taxes from the underlying income.
1 I.R.C. §901(a). All references to “section” refer to sections of the Internal Revenue Code of 1986, as amended, and the Treasury Regulations promulgated thereunder. Certain foreign taxpayers are also permitted to claim a foreign tax credit with respect to income effectively connected to a U.S. trade or business. Section 901(b)(4) and §906.
2 I.R.C. §903(a). In addition, §902 allows U.S. corporations that own 10 percent or more of the voting stock of a foreign corporation from which it receives dividends to claim an “indirect” foreign tax credit for a proportionate share of the foreign taxes paid by the foreign corporation.
3 Treas. Reg. §1.901-2(f)(1) provides: “The person by whom tax is considered paid for purposes of sections 901 and 903 is the person on whom foreign law imposes legal liability for such tax, even if another person (e.g., a withholding agent) remits such tax.” This principle was first articulated by the U.S. Supreme Court in Biddle v. Commissioner, 302 U.S. 573 (1938).
4 Treas. Reg. §1.901-2(f)(3).
6 Notwithstanding the Treasury’s and the IRS’ assertion in the preamble (the Preamble) to the proposed regulations that they believe Treas. Reg. §1.901-2(f)(1) of the current regulations requires a pro rata allocation of the foreign consolidated tax liability among the members of a foreign consolidated group based on each member’s share of the consolidated taxable income, the current regulations do not appear to address the situation where the members of a foreign consolidated group do not have the full equivalent of joint and several liability in the U.S. sense, or where the income of the consolidated group is attributed to the parent corporation in computing the consolidated group’s taxable income. See Treas. Reg. §1.901-2(f)(3) which provides an illustration of the legal liability rule only in situations where the group members are jointly and severally liable for that consolidated tax.
7 Foreign HoldCo was organized in Luxembourg as an S.a.r.l. (Societe a responsabilite limitee) and, therefore, was not a “per se” corporation under Treas. Reg. §301.7701-2(b)(8) and Treas. Reg. §301.7701-3(b).
8 Although Guardian won at trial, the decision is currently under appeal. For a discussion of other potential jurisdictions where the Guardian result may be available, see Lee A. Sheppard, News Analysis – Where Else is the Guardian Industries Result Available?, 111 Tax Notes 286 (Apr. 17, 2006).
9 Rev. Rul. 72-197, 1972-1 C.B. 215, appears to provide support for these structures.
10 A variation of this structure involves the use of a foreign holding company that is treated as a corporation for U.S. and foreign tax purposes, with the foreign operating company still being a reverse hybrid. The result of this structure is both deferral and a “hyped” §902 credit when the foreign holding company makes a distribution to its U.S. parent. For a more complete discussion of these structures, see Lee A. Sheppard, News Analysis: More Check-the Box Fallout; Reverse Hybrids, 87 Tax Notes 1196 (May 29, 2000).
11 Interestingly, the proposed regulations reserve on the application of the legal liability rule with respect to certain related party hybrid payments. See Prop. Treas. Reg. §1.901-2(f)(4).
12 Prop. Treas. Reg. §1.901-2(f)(1)(i).
13 Prop. Treas. Reg. §1.901-2(f)(1)(ii).
14 See Nissho Iwai American Corp. v. Commissioner, 89 T.C. 765, 773-74 (1987); Continental Illinois Corp. v. Commissioner, 998 F.2d 513 (7th Cir. 1993), cert. denied, 510 U.S. 1041 (1994); Norwest Corp v. Commissioner, 69 F.3d 1404 (8th Cir. 1995), cert. denied, 517 U.S. 1203 (1996); Riggs National Corp. & Subs. v. Commissioner, 107 T.C. 301, rev’d and rem’d on another issue, 163 F.3d 1363 (D.C. Cir. 1999). See also Prop. Treas. Reg. §1.901-2(f)(6), examples one and two.
15 Prop. Treas. Reg. §1.901-2(f)(2)(i).
16 Id. See also the Preamble.
18 Prop. Treas. Reg. §1.901-2(f)(2)(ii).
21 Prop. Treas. Reg. §1.901-2(f)(6), example six.
22 Prop. Treas. Reg. §1.901-2(f)(2)(iii). The proposed rules with respect to reverse hybrid entities appear to be based on comments submitted by the Tax Section of the New York State Bar Association. See NYSBA Urges Revision to Reg Allocating Foreign Taxes Among Related Foreign Persons, 2005 TNT 64-26.
26 Prop. Treas. Reg. §1.901-2(f)(6), Example 7.
27 Prop. Treas. Reg. §1.901-2(f)(2)(v). In general, each person’s pro rata share of the combined income is determined by reference to any return, schedule, or other document that must be filed or maintained with respect to a person showing such person’s income for foreign tax purposes. Prop. Treas. Reg. §1.901-2(f)(2)(iv)(A). If no return, schedule, or document is required to be filed or maintained with respect to such person for foreign tax purposes, such person’s income is required to be determined from the books of account regularly maintained by or on behalf of the person for purposes of computing its taxable income under foreign law. Id.
28 Prop. Treas. Reg. §1.901-2(f)(v).
31 Treas. Reg. §1.901-2(f)(3)(i). The foreign tax would then need to be allocated among the owners of the hybrid partnership in accordance with Temp. Treas. Reg. §1.704-1T(b)(4)(xi). If the hybrid partnership’s U.S. taxable year closes for all partners due to termination of the partnership under §708 (other than in a termination under §708(b)(1)(A)) and the foreign taxable year of the partnership does not close, then foreign tax paid or accrued by the partnership with respect to the foreign taxable year that ends with or within the new partnership’s first U.S. taxable year is required to be allocated (under the principles of Treas. Reg. §1.1502-76(b)) between the terminating partnership and the new partnership. Id. Similar rules apply if 1) the hybrid partnership’s U.S. taxable year closes with respect to one or more, but less than all partners; 2) there is a change in any partner’s interest in the partnership during the partnership’s U.S. taxable year; or 3) as a result of a change in ownership during a hybrid partnership’s foreign taxable year, the hybrid partnership becomes a disregarded entity and the entity’s foreign taxable year does not close. Id.
32 Prop. Treas. Reg. §1.901-2(f)(3)(ii). Similar to the rules regarding hybrid partnerships, an allocation of taxes between the old owner and the new owner, or between the old owner and the hybrid partnership is required if 1) there is a change in the ownership of a disregarded entity during the entity’s foreign taxable year and such change does not result in a closing of the disregarded entity’s foreign taxable year; or 2) as a result of a change in ownership, the disregarded entity becomes a hybrid partnership and the entity’s foreign taxable year does not close. Id.
33 Prop. Treas. Reg. §1.901-2(f)(5). See Prop. Treas. Reg. §1.901-2(f)(6), example nine.
34 Prop. Treas. Reg. §1.901-2(h). Notably, the Preamble also indicates that future regulations dealing with related party hybrid payments and disregarded payments (which were not addressed in the proposed regulations) also will be effective for taxable years beginning on or after January 1, 2007.