The §905(c) Temporary Regulations In and Out of Pooling
By Dirk J.J. Suringa, Esq.
Covington & Burling LLP, Washington, DC
Sections 901 and 905(a) provide a credit for foreign taxes accrued
even if they have not yet been paid. The ultimate foreign tax
liability, however, may differ from the amount of the accrued
liability used to compute the taxpayer's credit claim. Section 905(c)
therefore requires an adjustment if: (1) the amount of accrued taxes
paid differs from the amount claimed as a credit; (2) accrued taxes
are not paid within two years of the year to which they relate; or (3)
any tax paid is refunded in whole or in part.
Foreign taxes claimed as direct credits under §901 are
adjusted retroactively by means of an amended return for the year to
which the taxes relate. In the case of indirect credits claimed under
§902 or §960, the statute authorizes the IRS to prescribe
adjustments to the foreign corporation's post-1986 tax and earnings
pools instead of retroactively redetermining the taxpayer's accrued
foreign taxes.1 Temporary
regulations issued in 2007 and scheduled to sunset next year
(“the Temporary Regulations”) follow the statute and
generally require, in the case of deemed-paid taxes under §902 or
§960, prospective pooling adjustments rather than retroactive
adjustments of the U.S. shareholder's
liability.2 Those regulations,
however, continue to leave various unanswered questions, such as the
question of what should be done when tax pools disappear or
appear.
Assume for example that in Year 1 a CFC incurs a foreign tax and
pays a dividend, and its U.S. parent takes a deemed-paid credit; in
Year 2 the CFC converts into a disregarded entity; and in Year 5 the
foreign taxing authority audits Year 1 and imposes an additional tax
for that year. The Temporary Regulations ordinarily would adjust the
CFC's post-1986 tax and earnings pools in Year 5 to reflect the
additional tax,3 but in this fact
pattern there are no pools to adjust because the CFC has liquidated
for U.S. tax purposes in the interim. On similar facts, the IRS has
ruled that the Year 1 pools of the CFC should be adjusted
retroactively and the shareholder's U.S. tax liability redetermined
for the intervening years.4
In the ruling, the IRS cited §905(c)(2), which specifies the
treatment of taxes paid more than two years after the year to which
they relate. The foreign tax credit generally must be reversed for
accrued taxes that are not paid within two
years.5 If such taxes are then
paid after the two-year deadline, and if they are deemed-paid taxes
under §902 or §960, then the statute requires them to be
taken into account in the year in which they are paid and specifically
prohibits a redetermination in the year to which they
relate.6 Other taxes (§901
taxes) paid after the two-year deadline are not subject to this rule
and instead are taken into account retroactively in the year to which
they relate.7
In its ruling, the IRS essentially concluded that the additional
tax imposed by the foreign taxing authority in Year 5 could not be a
deemed-paid tax under §902 or 960 because there were no longer
any pools in Year 5. Consequently, the ruling required the taxpayer to
take the additional tax into account retroactively through a pooling
adjustment in the year to which the tax related, Year 1. This result
is sensible and, well, pretty generous, given the language of the
statute that appears to deny the credit and to prohibit retroactive
pooling adjustments. Nevertheless, the Temporary Regulations do not
address the facts of the ruling. Other than for three exceptions (none
of which covers disappearing pools), the Temporary Regulations require
prospective pooling adjustments “to account for the effect of a
redetermination of foreign tax paid or accrued by a foreign
corporation on the foreign taxes deemed paid by a United States
corporation under section 902 or
960.”8 In the ruling there
was a redetermination of the CFC's Year 1 deemed-paid taxes without a
prospective pooling adjustment.
Other fact patterns remain unaddressed. For example, what if the
foreign taxing authority in the example above had acted more quickly
and assessed the additional tax in Year 3--within the two-year period?
There is no specific statutory language for additional taxes paid
within the two-year deadline, and the Temporary Regulations again
would appear to require Year 3 adjustments to pools that no longer
exist. One statutory argument here for a Year 1 adjustment to the
CFC's post-1986 tax and earnings pools in this case and in the case
described in the letter ruling would be that the default rule of
§905(c)(1) applies because the IRS in this particular case has
not “prescribed adjustments to the pools of post-1986 foreign
income taxes and the pools of post-1986 undistributed
earnings.”9 The alternative
presumably would be to allow a direct §901 credit to the U.S.
taxpayer in Year 3, but it is unclear how to account for differences
between the mechanics of the §902 credit (e.g., the §78
gross-up) and the §901 credit.
The Temporary Regulations do not appear to provide specific
guidance in the opposite direction either. Assume that a foreign
disregarded entity owned directly by a U.S. taxpayer incurs foreign
taxes in Year 1. In Year 2, the U.S. taxpayer forms a new CFC and
contributes the disregarded entity to it (or un-checks the disregarded
entity). In Year 3, the foreign taxing authority audits the
disregarded entity's Year 1 return and assesses additional tax. From a
U.S. tax perspective, the CFC has paid the additional tax, but it
relates to a year before the CFC existed. The additional tax thus
could become a retroactive adjustment to the U.S. taxpayer's Year 1
credit, or the tax could be added to the CFC's post-1986 tax and
earnings pools in Year 3.
The existing language of the Temporary Regulations appears to favor
a retroactive redetermination in Year 1. As noted above, the Temporary
Regulations use prospective pooling adjustments “to account for
the effect of a redetermination of foreign tax paid or accrued by a
foreign corporation …
.”10 In this example, there
is no redetermination of foreign tax paid or accrued by a foreign
corporation because the CFC was not on the scene in Year 1. A
retroactive redetermination, moreover, would be consistent with the
treatment the Temporary Regulations do provide for a redetermination
of the taxes of a CFC that was a non-pooling foreign corporation in
the year to which the taxes
relate.11
To complete the circle, assume that the additional tax is assessed
in Year 5 rather than Year 3. This appears to be a closer call. After
the two-year deadline, there is specific statutory language providing
for prospective pooling adjustments in the case of deemed-paid taxes.
In this example, moreover, the CFC actually has post-1986 tax and
earnings pools to which the additional Year 5 tax could be added. The
argument for a retroactive Year 1 adjustment presumably would be based
on the same, close reading of the language of the Temporary
Regulations and on the theory that the additional tax paid in Year 5
is not a deemed-paid tax because in the year to which it relates it
would have been a direct tax. Guidance on such issues in the final
regulations would be helpful.
This commentary also will appear in the June 2009, issue of
the Tax Management International Journal. For more information,
in the Tax Management Portfolios, see DuPuy and Dolan, 901 T.M.,
The Creditability of Foreign Taxes--General Issues, Carr and
Moetell, 902 T.M., Indirect Foreign Tax Credits, Suringa, 904
T.M., The Foreign Tax Credit Limitation Under Section 904, and
in Tax Practice Series, see ¶7130, U.S. Persons -- Foreign
Activities.
1
§905(c)(1).
2
Regs. §1.905-3T(d)(2).
3
See Regs. §1.905-3T(d)(2)(ii)(B).
4
See PLR 200127011.
5
See §905(c)(2)(A).
6
See §905(c)(2)(B)(i)(I).
7
See §905(c)(2)(B)(i)(II).
8
See Regs. §1.905-3T(d)(2)(i). The exceptions requiring retroactive adjustments are found in Regs. §1.905-3T(d)(3).
9
§905(c)(1) (flush language).
10
See Regs. §1.905-3T(d)(2)(i) (emphasis added).
11
SeeRegs. §1.902-1(a)(13)(i)(B); Regs. §1.905-5T(a), (d)(1).
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