Attribution rules applicable to commercial activities or controlled commercial entities of a foreign government for sec. 163(j) purposes.

Until recently, a foreign person subject to tax in the United States was required to consider the U.S. related party rules only in a fairly narrow set of circumstances, for example, for purposes of the deduction deferral rules of Sec. 267(a)(2), the reporting requirements of Sec. 6038A and the regulations thereunder, and the transfer pricing provisions of Sec. 482. Since 1986, however, several provisions have been added to the Code and regulations that significantly increase the complexity of - and administrative burden of complying with - the U.S. income tax laws by expanding the circumstances under which application of ownership attribution rules is required; notably, under the foreign tax credit rules of Sec. 904(i) and the earnings stripping rules of Sec. 163(j). In the case of foreign governments particularly, these new requirements involve issues that historically have not been considered and on which there is little substantive guidance. This discussion focuses on the attribution requirements imposed by the proposed regulations under Sec. 163(j).

Sec. 163(j) defers a deduction for interest paid to a related person on which no U.S. tax is imposed, subject to certain thresholds and limitations. Pursuant to Sec. 163(j)(6)(C), the computation of these thresholds and limitations must be made as if all members of the same affiliated group (within the meaning of Sec. 1504(a)) were a single taxpayer. Prop. Regs. Sec. 1.163(j)-5(a)(3) goes further, providing that an includible corporation (as defined in Sec. 1504(b)) that owns directly or indirectly at least 80% of another includible corporation is treated as a member of the same affiliated group; for purposes of these rules, the provisions of Sec. 318 are applied to determine indirect ownership. The example illustrating this requirement makes clear that a domestic subsidiary of a foreign corporation is a member of the same affiliated group as its domestic sister corporation that is a subsidiary of the common foreign parent, even though these corporations would not be affiliated within the meaning of Sec. 1504(a) because their common ownership is through a nonincludible corporation.

Assume a foreign government, rather than a foreign corporation, owns two domestic corporations, A and B. Sec. 318(a)(3)(C) provides that if 50% of the value of the stock of a corporation is owned, directly or indirectly, by any "person," the corporation will be treated as owning the stock owned by such person. Thus, if a foreign government is a "person" within the meaning of Sec. 318(a)(3)(C), A and B will be treated as members of the same affiliated group for Sec. 163(j) purposes. If a foreign government is not a "person," it is not subject to the provisions of Sec. 318, and A and B would not be considered members of the same affiliated group. There is precedent that the U.S. government is not a person within the meaning of Sec. 7701. In Letter Ruling 8829089, the IRS held that a bank was not a U.S. person within the meaning of Sec. 7701(a)130) or a government or agency of a government, for purposes of Secs. 2103 and 2104; see also Letter Ruling 8829020. The reference to U.S. person or government in the disjunctive implies that a government is not a U.S. person for purposes of the Code. In addition, in Rev. Rul. 94-16, the Service affirmed a line of prior rulings holding that an Indian tribe is not a taxable entity for Federal income tax purposes. Of course, these precedents may be distinguished from the case of a foreign government, first because a foreign government is not the U.S. government (which was the government at issue in the letter rulings cited) and, second, because a foreign government is subject to U.S. income tax on its commercial activities in the United States pursuant to Sec. 892 (which does not apply to Indian tribes). Nevertheless, it remains relevant to examine whether a foreign government is a "person" within the meaning of Sec. 318(a)(3)(C).

This question appears to be answered by Sec. 892(a)(3), which provides that for purposes of the Code, a foreign government is treated as a "corporate resident of its country." If indeed a foreign government is treated as a corporation for purposes of the Code, it arguably may be viewed as a "person" within the meaning of Sec. 7701(a)(1). Accordingly, it would be a person to which the provisions of Sec. 318(a)(3)(C) apply. The issue may be more precisely distinguished, however; namely, is a "corporate resident" necessarily a "person" for purposes of the Code, or can one be a resident but not a person? Guidance on this issue is scant. Sec. 892(a)(3) was enacted as part of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). Its legislative history is not very illuminating, stating only that the provision codifies the rule that a foreign government is treated as a corporate resident of its country for purposes of a treaty obligation of the United States (so long as reciprocal treatment is granted the United States by the foreign government), and for purposes of the Code generally (without regard to any corresponding treatment by a foreign government); there is no explanation of what the term "corporate resident" means. Moreover, it is not clear why it was determined to be necessary to apply this characterization beyond treaty purposes, other than perhaps to determine the applicable rate of tax corporate versus individual).

It is interesting that the legislative history of the Tax Reform Act of 1986 (TRA), under which Sec. 892 was amended more substantively (by codifying the limitations on the exemption from U.S. tax on income derived by a foreign government from its activities in the United States), discussed the treatment of a foreign government with which the United States has an income tax treaty. The Senate Finance Report stated: "The committee intends that, for treaty purposes, a foreign government be treated as a resident of its country, unless it denies treaty benefits to the United States." (Emphasis added.) No reference to the foreign government as a corporate resident is made, and no explanation of the addition of the word "corporate" in TAMRA's legislative history can be found. Note, though, that the TRA legislative history also stated that it generally was not the intent of Congress to provide a regime that favored nationalized industries over those privately owned. This language reflects the policy that a foreign government that owns several U.S. entities should not be treated differently from a foreign corporation that owns similarly structured U.S. entities for purposes of the Code, and would dictate that the same rules should govern both private and public entities.

The ramifications of these rules are unclear, as there is no additional guidance on the application of these rules. Certain regulatory provisions may be read to support a position that perhaps the scope of the language of Sec. 892(a)(3) may be applied more narrowly in certain circumstances, however.

In Regs. Sec. 1.6038A-1(f), "foreign person" is defined to include a foreign government. A foreign government is therefore a person to which the related party rules of Secs. 267(b) and 707(b) apply for purposes of determining a reporting corporation's reporting requirements; see Regs. Sec. 1.6038A-1(f)(5) and (d). Interestingly, these regulations were promulgated after Sec. 8921a)(3) was enacted. If Sec. 892(a)(3) is read to provide that a foreign government is treated as a corporation resident in its country, the special rules of Regs. Sec. 1.6038A-1(f)(5) should be unnecessary (since a foreign person is defined to include a foreign corporation pursuant to Regs. Sec. 1.6038A-1(f)(3)); see also Temp. Regs. Sec. 1.897-9T(e). Moreover, the practical problems associated with this rule are enormous. Consider any nationalized industry, the scope of which may be extremely broad. As a practical matter, it may not be possible to determine all related party transactions if common control includes all entities controlled by all agencies and branches of a foreign government.

Perhaps an argument may be made based on the implied message of Regs. Sec. 1.6038A-1(f)(5) that the IRS intended to distinguish between a "corporate resident" of a country and a "corporation [that is] resident" in a country; or that these regulations reflect the Service's view that the application of attribution rules to entities controlled by a foreign government requires explicit direction in the operative law or regulations. This argument is difficult to support as a technical matter, and the policy argument articulated in the legislative history (noting a reluctance on the part of Congress to favor commercial activities conducted by a foreign government over those conducted by a private enterprise) further undermines this position. Accordingly, absent more explicit guidance offering direct relief, it appears Sec. 892(a)(3) should be read to characterize a foreign government as a foreign person for purposes of the Code.

A number of considerations remain, however, if it is determined that a foreign government is subject to the attribution rules of Sec. 318 for purposes of Sec. 163(j). As noted, administrative concerns clearly arise, particularly when the activities of the foreign government in the United States are diverse and are conducted through a number of separate government agencies or instrumentalities. In addition, return filing issues also arise; for example, does a foreign government file a single return reporting all of its U.S. trade or business activities, or may a separate return be filed for each of the separate agencies of the government that are so engaged? If there is a failure to report the income or activities of one of its agencies, is the government return an incomplete return for penalty and other purposes (e.g., statute of limitations or denial of deductions)?

Needless to say, the complexities associated with the increased attention of the Code and regulations on an expanded definition of affiliated group activities, for such purposes as the foreign tax credit (Sec. 904(i)), interest expense allocation (Sec. 864(e)) and earnings stripping (Sec. 163(j)), are themselves multiplied when the expansive definition of affiliated group brings under its ambit the activities and entities of a foreign government. As noted, guidance in this area is minimal, and careful consideration must be given when these issues present themselves.