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Proposed Foreign Tax Credit (“FTC”) Regulations Affect
Popular Tax Structures (August 14, 2006) Recently proposed regulations define which US person may claim FTCs by “clarifying” which person or entity is legally liable for the foreign tax subject to credit. 71 Fed. Reg. 44,240 (Aug. 4, 2006). Treasury’s “clarification” when finalized will undermine some popular tax planning structures designed to maximize FTC utilization, while also having a broad impact on the allocation of FTCs among members of foreign consolidated groups for US FTC purposes. The regulations also clarify which parties to certain financial transactions may claim FTCs from a transaction even though the foreign characterization of the transaction differs from the US’s characterization (“Arbitrage Transactions”). General Concept: The proposed regulations amplify a longstanding FTC concept that the person by whom tax is considered paid is the person on whom foreign law imposes legal liability for such tax. Some taxpayers have applied this concept liberally to mismatch income and related foreign taxes through hybridized entities (hybrids, reverse hybrids, and disregarded entities (“DEs”)) and Arbitrage Transactions (such as repos). Taxpayers have also asserted that the parent of their foreign consolidated group can claim the group’s taxes with no allocation to subsidiaries, provided the foreign jurisdiction does not treat the group as jointly and severally liable for taxes. Each concept is briefly explained below. Hybridized Entities: Taxpayers have created hybridized entities through “check the box” structures to maximize any FTC benefits resulting from the US’s treatment of income as flowing to one person, but the foreign treatment of that same income as legally taxable to another. The proposed regulations provide for a flow-through of the taxes when the income flows through (hybrid entity or DE), and deny a flow-through of taxes when the income does not flow-through (reverse hybrid entity). Allocating Consolidated Group Taxes: Currently, if the members of a foreign consolidated group are jointly and severally liable for tax, then each is treated as paying its respective share of the group’s tax. Conversely, taxpayers have claimed that the absence of joint and several liability means that the group’s foreign parent can be treated as paying the tax on all the income of the subsidiaries. The proposed regulations treat each member as liable for the income tax attributable to its share of the group’s income regardless of joint and several liability, thereby reducing the distortions and mismatches that can occur. Arbitrage Transactions: The regulations reserve on hybrid instruments and payments that affect foreign tax liability but are disregarded for US tax purposes. Depending on the circumstances, these deals may be subject to an IRS challenge under existing law despite the reservation. On the other hand, the regulations clarify that the FTC consequences of certain Arbitrage Transactions, such as repos, are respected even though the foreign and US characterization of the transactions differ. RECOMMENDATIONS: Determine if group restructuring, a change in reporting position, or additional FTC planning may be beneficial. Assess potential legal challenges to hybrid instrument/payment structures in light of the regulations’ principles, as well as potential benefits arising from certain Arbitrage Transactions. Disclaimer: We call these "client letters" because we use them to keep our clients informed. We also send them to friends of the firm and other people who have asked to receive them. We have posted these items on our website so people can get an idea of what kind of firm we are. Your reading of these letters does not create an attorney-client relationship with us. Please contact us if you have any questions. |
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