Determining foreign income tax credit.

The Internal Revenue Service has issued proposed regulations implementing the Tax Reform Act of 1986 amendments to Internal Revenue Code section 902.

A controversial provision in the proposed amendments reverses the Tax Court's decision in Vulcan Materials v. Commissioner (96 T.C. 410 [1991]) involving a foreign corporation subject to foreign tax only on the portion of earnings owned by shareholders not residing in the company's home country. The court said that only accumulated earnings subject to foreign tax should be taken into account when determining the ratio of the amount of a dividend on the accumulated earnings of a corporation when calculating the allocable paid foreign tax credits. However, the regulations require that all of the accumulated profits be taken into account.

The regulations also say the relevant time for determining whether the 10% ownership requirement is met to qualify for deemed paid foreign tax credits is the date the dividend is paid, rather than the period the underlying income was earned. However, certain look-through rules for foreign tax credit basket purposes that would generally apply to dividends from a controlled foreign corporation (CFC) will not apply to dividends on earnings accumulated before the corporation became a CFC. In addition, the look-through rules will not apply to dividends on pre-acquisition earnings to a U.S. shareholder that acquires more than 90% voting stock ownership in an existing CFC. Because the look-through rules do not apply, the taxpayer will not be able to average such earnings (and underlying credits) with any other foreign earnings.

Observation: Although the proposed regulations contain few surprises, the preamble raises some concern as to whether deemed-paid credits will be available for dividends received by 10% corporate shareholders indirectly through pass-through entities other than domestic general partnerships. Taxpayers should consider sending the IRS comments on this issue.