FTC denied if competent authority not used in transfer pricing cases.

In Rev. Rul. 92-75, the IRS held that a taxpayer must take steps to reduce the foreign taxes of its controlled foreign corporation (CFC) following a U.S. transfer pricing adjustment between the U.S. parent company and the CFC. These steps include requesting competent authority assistance if the CFC is located in a treaty country. Failure to do so may result in denying the U.S. parent company Sec. 901 deemed-paid foreign tax credit (FTC) on the CFC's foreign taxes.

In the ruling, P, a U.S. parent company, sold goods to S, its wholly owned foreign subsidiary located in country FC during 1986 and 1987. S presumably resold the goods, reported the income and paid tax to FC. Subsequently, the Service initiated an examination of P's 1986 and 1987 returns and determined that P's sales of its products to S were at prices below P's cost. The IRS then allocated income to P under Sec. 482 to reflect an arm's-length selling price for the products to S. P agreed to the adjustment.

In addition, in 1986 and 1987 P received dividends from S and claimed a Sec. 902 deemed-paid FTC for the foreign taxes paid by S. The dividend paid by S to P in 1986 was paid out of earnings and profits (E&P) accumulated in 1986. The dividend paid in 1987 was paid from post-1986 E&P. Following the U.S.-initiated Sec. 482 adjustment, S did not seek a refund from FC of those foreign taxes paid attributable to the income that was reallocated to P, notwithstanding that "a refund might be obtained" if FC accepted the Sec. 482 adjustment. Furthermore, FC and the United States had entered into an income tax treaty, and that treaty contained a mutual agreement article that provided for competent authority to either claim an FC refund or eliminate - in some other fashion - the double taxation that resulted from the Sec. 482 adjustment. S did not request similar assistance from the FC competent authority.

In the ruling, the Service stated that Sec. 902(a) does not authorize a U.S. corporation to take a deemed-paid FTC for all payments made by its foreign subsidiary to a foreign country. Rather, deemed-paid credits may only be taken if the payments quality as an "income tax" under Sec. 901. Thus, citing Regs. Sec. 1.901-2(e)(5), the IRS stated that an amount paid to a foreign country "is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of liability under foreign law for tax."

The Service then indicated that an amount paid as foreign income tax will not be considered as exceeding the liability under foreign law for tax if the taxpayer exhausts all effective and practical remedies, including any available competent authority procedures under applicable tax treaties, to reduce the taxpayer's liability for foreign income tax. If a taxpayer is aware (whether as a result of a proposed IRS adjustment under Sec. 482 or otherwise) of the possibility of securing a refund or reduction of foreign income tax but fails to pursue its remedies to secure such an adjustment, the amounts for which no adjustment was sought may be treated as noncompulsory foreign payments.

The ruling then concluded that P and S failed to exhaust their effective and practical remedies because they failed to invoke competent authority procedures. Consequently, the reduction of S's income as a result of the Sec. 482 increase to P's income will result in a reduction of the amount of FC taxes paid by S for 1986 and 1987 in computing P's FTC.

The Service also indicated that the amounts paid to FC will still reduce S's E&P, regardless of whether an FTC is allowed P for the amounts.

The ruling also discussed how adjustments resulting from a reduction of S's foreign taxes paid are made for both post-1986 pools of foreign taxes and pre-1987 taxes. With respect to a reduction of post-1986 foreign taxes, the ruling referred to Secs. 902, 905(c) and 964, which should generally result in the amounts being removed from the pool of post-1986 foreign income taxes. To the extent the taxes were from a pre-1987 period, the ruling stated that the district director may adjust the Sec. 902 computation with respect to distributions by removing the appropriate amount of nontax payments (i.e., by recomputing the amount of taxes included in the multiplicand of the Sec. 902 formula). If the district director can determine the amount of foreign income taxes that would have been paid if the income, as adjusted by the Sec. 482 allocation, had been correctly reported on S's FC tax return, the multiplicand will be adjusted to this amount; otherwise the district director may use another appropriate allocation method. (Although not stated in the ruling, an appropriate allocation method might be the ratio that the amount of the Sec. 482 adjustment bears to S's gross income.)

As a general observation, it is somewhat unclear why the Service issued Rev. Rul. 92-75. The concept that a foreign tax refund should be sought, and competent authority proceedings used where available, if there has been a reduction of a CFC's foreign income resulting from a U.S.-initiated Sec. 482 adjustment, has been the IRS position for a number of years; see Rev. Rul. 76-508. Although this requirement to seek competent authority treatment in order to insure creditability of a foreign tax was challenged and rejected in Schering Corp., 69 TC 579 (1979), acq. 1981-2 CB 2, the Service continued to state its position in Regs. Sec. 1.901-2(e) (5)(i), issued in 1983. Indeed, the position was restated as recently as 1991. Specifically, Section 9 of Rev. Proc. 91-23 stated:

For purposes of determining the amount of foreign tax creditable under sections 901 and 902 of the Internal Revenue Code, any amounts paid to foreign tax authorities that would not have been due if the treaty country had made a correlative adjustment may not constitute a creditable foreign tax .... A taxpayer's failure to seek competent authority assistance generally will constitute a failure to exhaust all effective and practical remedies for purposes of section 1.901-2(e)(5)(i) of the regulations. Further, the fact that the taxpayer has sought competent authority assistance but obtained no relief, either because the competent authorities failed to reach an agreement or because the taxpayer rejected an agreement reached by the competent authorities, generally will not, in and of itself, demonstrate for purposes of section 1.901-2(e)(5)(i) ... that the taxpayer has exhausted all effective and practical remedies to reduce the taxpayer's liability for foreign tax (including liability pursuant to a foreign tax audit adjustment.)

On the other hand, Rev. Rul. 92-75 could be interpreted to stand for the proposition that when a treaty is available, a competent authority resolution must always be pursued in order to exhaust all effective and practical remedies. If this is its intent, the ruling would conflict with the regulations, which allow one to consider both costs and the likelihood of success. Specifically, Regs. Sec. 1.901-2(e)(5) indicates that a remedy is effective and practical only if "the cost thereof (including the risk of offsetting or additional tax liability) is reasonable in light of the amount at issue and the likelihood of success." Example 3 of the regulation involves a situation in which the costs of filing a claim and pursuing competent authority relief were reasonable in view of the amount at issue and the likelihood of success, while the costs of pursuing a judicial remedy in the foreign country were unreasonable. The example then states that because the taxpayer (unsuccessfully) pursued competent authority, but declined to pursue litigation in the foreign country, its actions were sufficient to exhaust all effective and practical remedies.

It is difficult to apply the "cost/success" factors to Rev. Rul. 92-75; the ruling did not indicate the costs to P or S, or the likelihood of success in claiming a refund, seeking competent authority treatment or pursuing a judicial solution. The facts did indicate that a refund "might he obtained if country FC accepted the section 482 allocation."

The ruling may also stand for the proposition that independently pursuing a claim for refund in a foreign country, without seeking competent authority assistance as part of that pursuit, may not be sufficient if the pursuit results in only a partial refund of foreign taxes. The IRS appears to frown on this self-help approach in any event; see Section 11.02(f) of Rev. Proc. 92-23.

Finally, Rev. Rul. 92-75 contained language that may raise additional issues: * Action must be taken if a "taxpayer is aware of the possibility of securing a refund." Does this rule penalize a U.S. tax director of a U.S. multinational who closely monitors foreign developments as compared to those who do not? * If a taxpayer fails to pursue its remedies, the foreign taxes paid "may" be treated as a noncompulsory payment. It is unclear under what circumstances the tax will remain creditable when a taxpayer fails to pursue its remedies. This could be an inference that costs and likelihood of success in competent authority proceedings should continue to be taken into account.

Although Rev. Rul. 92-75 appears to merely restate the Service's prior position, it may stand for the proposition that the competent authority process, if available, must always be requested in connection with a refund claim in a treaty country as a result of an IRS-initiated Sec. 482 adjustment. In any event, a taxpayer with treaty country subsidiaries should always give early consideration to using the competent authority procedures at the first sign of an IRS-initiated Sec. 482 adjustment. This should be done not only to preserve FTC, but to explore the use of the competent authority mechanism as a means to resolve the double taxation resulting from a Sec. 482 adjustment. From Edwin Reavey, J.D., LL.M., CPA, Washington, D. C.