IRS targets multinationals.

On Jan. 20, 1998, the IRS released Notice 98-5, outlining new rules for the allowance of foreign tax credits (FTCs). Regulations to be issued pursuant to the guidelines in the notice will restrict FTCs in transactions in which the economic benefits are too small in relation to the credits, and will be effective for taxes paid or accrued after Dec. 23, 1997.

Introduction

The Service appears to have attempted to rein in multinational companies that are, in its view, "too aggressive" in managing their FTC positions. However, the IRS has since retreated from its initial assertion that it has the authority to issue regulations outlined in Notice 98-5. Still, companies and advisers should be aware that new and substantial restrictions in the use of FTCs may be in the offing. To the extent that any new restrictions impair the competitiveness of U.S. companies, they should not be ignored.

The Service's concern was that certain U.S. taxpayers may have entered into (or are considering) a variety of "abusive tax-motivated transactions with a purpose of acquiring ... foreign tax credits." While practitioners should advise their clients against transactions in which the tax benefits are suspect, the IRS has attempted to define (and ultimately prohibit FTCs related to) a whole new class of transactions deemed to be "abusive" based on a new standard. That standard involves the relationship between the expected economic benefits and tax benefits in the transaction: Too much tax benefit in relation to the economic benefit will result in the transaction being classified as "abusive."

The contents of the notice are not (and are not purported to be) the new regulations. The notice is an announcement intended to stop certain transactions that are being contemplated, and may cause concern for those companies that have implemented transactions that might be covered.

Discussion

The notice attempts to bootstrap itself into legitimacy by labeling certain transactions as "abusive." These transactions are those structured to yield little or no economic profit relative to the tax benefits they are likely to generate, and fall into two categories. The first involves the acquisition of an asset that generates an income stream subject to foreign withholding tax; the second involves a duplication of tax benefits through the use of "certain structures designed to exploit inconsistencies between U.S. and foreign tax laws."

The obvious problem faced by the IRS in attacking transactions in these categories is that in doing so it is also attacking perfectly legitimate business arrangements that are entered into without regard to the tax consequences. Foreign governments have as much right to assess withholding taxes as the U.S. At the same time, there win always be "inconsistencies" between U.S. and foreign tax laws, some of which may provide tax-saving opportunities.

Clearly, therefore, some of the transactions that fall into these two categories will be permissible (i.e., the FTCs will be allowed) and some will not. However, any new regulations will need to be very explicit, since Notice 98-5 seems to be overly broad and restricts legitimate transactions.

The notice gives five examples of so-called "abusive" transactions (three will be discussed below).

Example 1 involves a U.S. corporation that purchases a copyright for $75 shortly before it expires. The only income expected before the copyright expires is a royalty payment of $100, subject to a 30% withholding tax. On its investment of $100, therefore, the taxpayer will receive $70 plus FTCs worth $30. The example concludes that the U.S. company "...has effectively purchased foreign "tax credits in a transaction that was reasonably expected to result in an economic loss."

On only these facts, the Service's conclusion that the arrangement is abusive is not particularly surprising. The example presents a situation in which the taxpayer had no apparent business purpose for entering the transaction other than obtaining FTCs. In fact, the taxpayer was guaranteed a substantial loss unless the withholding taxes were recovered in full. Because the facts in the example presume there is no reasonable possibility of a profit and that there is no business purpose, most practitioners, without further relevant information, would conclude that the transaction appeared to lack economic substance. However, this conclusion could be reached based on well-established existing principles, without a need for any new concept of "abusive" transactions; see, e.g., Rice's Toyota World, Inc., 752 F2d 89 (4th Cir. 1985).

However, what would the result be if the taxpayer could demonstrate a legitimate business purpose? (Perhaps the about-to-expire copyright supported copyright claims in other countries; perhaps the value (and expected economic return) was remote and speculative, but not frivolous.) Would a taxpayer in that situation be allowed to raise those points, or would an examining agent simply cite Example 1 to disallow any FTC?

In Example 2, the taxpayer actually does make a small profit before taking the FTCs into account. A U.S. corporation buys a foreign bond with accrued interest for $1,096. (The example is silent as to whether this amount is equal to the bond's fair market value, a fact which would be helpful in understanding the principles involved.) The face amount is apparently $1,000. The $100 interest is paid when due on the following day, and is subject to a foreign withholding tax of $4.90; thus, the taxpayer's net cash from the interest is $95.10. Four days after the interest is received, the taxpayer sells the bond for $1,001.05, at which point "the value of the bond is not reasonably expected to appreciate due to market factors." Thus, the taxpayer can only reasonably expect a $0.15 profit (the $1,001.05 proceeds + $95.10 interest - $1,096 purchase price), not considering the $4.90 FTC for the withholding tax.

Unfortunately, the example does not touch on any other tax issues that may reasonably be involved in this situation. For example, a capital loss may result on the sale of the bond, and a capital loss is generally considered to be a detriment to a corporate taxpayer. If the relative size of any tax benefits is compared to the economic return, why are tax detriments not also considered? Why should a potential tax cost not reduce any benefit and therefore increase the relative importance of the nontax economic return? Or would the Service take the position that any tax cost would further diminish the expected economic return and therefore make the result worse?

If the same taxpayer held the bond for five years and received five interest payments of $95.10 (net of withholding), would the result change? In that case, the taxpayer would earn $475.50 pretax on its $1,000 investment, which would amount to about 9.5% annually. In Example 2, the taxpayer is earning approximately 1% annualized for the period of time it held the bond. Is the rule, therefore, that the Service will allow FTCs only when the foreign asset acquired is highly profitable? if so, how profitable? If 1% return is too little, would 9.5% be adequate? If a 9.5% return is adequate, what would the result be at 8%, or 6.5% or 3%? From where does the Service draw its authority to allow FTCs at one level of profitability and not at another? And what are the policy considerations behind encouraging U.S. taxpayers to hold highly profitable foreign assets?

If this is merely an issue relating to the holding period of the bond, the IRS has a model to follow in Sec. 904(k)(4), which disallows deemed-paid credits unless the shares of the foreign corporation are held for more than a minimum period.

Example 3 would cover an everyday, normal, nontax-motivated, unrelated-party hedge arrangement. Corporation F, which does not receive a tax benefit from FTCs and which may be a foreign corporation, wants to acquire a foreign bond with a value of $1,000. The bond that F wants to acquire pays annual interest of $100, subject to 4.9% withholding tax. No business purpose is stated. (Because the example specifically indicates that F does not benefit from FTCs, the omission of a business purpose may be significant.) Instead of purchasing the bond, F invests $1,000 elsewhere and enters into a three-year notional principal contract (NPC) with unrelated Corporation US, a domestic corporation which apparently does benefit from FTCs. Under the interest rate swap portion of the NPC, US pays F $96 annually (fixed), while F pays US a rate which appears to float with the London interbank offered rate (LIBOR). Under the agreement, US has the foreign currency risk on the foreign bond (which is presumed to be denominated in foreign currency, but the example does not make that explicit).

At this point, the transaction bears a remarkable resemblance to a hedge by F. F might have wanted the foreign bond (an asset) to hedge a liability denominated in the same currency as the bond. (This illustrates the possible significance of F's business purpose for wanting the bond.) The basis swap portion of the NPC described would seem to give F the same result: If the original local currency (LC) amount of the bond was LC 2,000, which appreciated in value from $1,000 to $1,100 at the end of the three-year term, US would pay F $100, which F would then add to its $1,000 invested elsewhere and use the total to purchase LC 2,000, which would then be used to repay its presumed LC 2,000 liability.

At the same time, US hedges its own foreign currency exposure by purchasing the foreign bond. In addition, US, either because it is short of cash or simply to hedge its interest rate risk, borrows the face value of the bond at (apparently) a floating LIBOR rate. The interest payments will, of course, be matched by the floating interest being received from F

The offsetting positions described in the example are normal parts of hedging activities that take place continually between unrelated parties. Further, taxpayers hedging assets and liabilities in other than their own functional currency often do so with the expectation of no economic benefit. These corporate taxpayers simply want to preserve their assets against fluctuations in the currency rates. To hedge in a manner that could result in an economic gain also leaves a taxpayer open to economic loss. Therefore, the lack of an economic profit motive in hedging transactions is entirely consistent with the hedging policies in place in most U.S. corporations.

The example observes that at the time US entered into the arrangement, it expected to incur all annual loss of $0.90. In the real world, a hedge shifts risk and the party "buying" the risk protection is usually willing to pay for it. An annual fee of nine basis points for a hedge (which is what the $0.90 "annual loss" would represent) does not seem excessive. Nonetheless, the example concludes that US has "purchased" FTCs; thus, this arrangement is abusive and the Service has the right to disallow the FTCs.

Another problem inherent in Example 3 is that it merely states that several of the steps are related, but does not provide any guidance to determine which items are to be included or excluded from the overall transaction. This may allow the IRS to simply assert its position and require taxpayers to prove that the pieces are unrelated.

Lack of Authority

The Service cites several statutory provisions and two cases in support of its assertion that it has the authority to issue regulations in this area. The statutory authority is inapposite and the cases cannot be read to support unfettered power to disallow FTCs.

Statutory Provisions

The IRS refers to Secs. 901 and 904, which are the sections that allow the FTC (subject to certain limits). Sec. 904(d)(2)(B)(iii) gives the Service the right to publish regulations relating to high withholding tax interest for purposes of the separate-basket calculation for that item of income. Sec. 901(k) is the new rule mandating a minimum holding period for stock before FTCs will be allowed; this prevents a shareholder from obtaining all FTC when the ownership of shares has been transitory. (The IRS suggests in the notice that the regulations could disallow credits for withholding taxes even if the holding period of Sec. 901(k) is satisfied; clearly, the Service lacks the authority under Sec. 901(k) to regulate beyond the bounds of that subsection.) Sec. 864(e)(7) is the statutory authority for the IRS to write regulations to carry out the purposes of Sec. 864, which is the definitional section under the sourcing rules. Sec. 7701(l) is the statutory basis for the conduit financing regulations. Finally, Sec. 7805(a) is the general authority for the Service to publish "... all needful rules and regulations for the enforcement of this title." Individually and collectively, these provisions do not allow the IRS to selectively repeal the FTC on a transaction-by-transaction basis.

In addition to the statutory references, the Service cited American Chicle, 316 US 450 (1942), apparently to establish that the primary intention of the FTC is to avoid double taxation. The argument seems to be that any FTC which, due to some computational quirk, provides more than mere protection from double taxation with respect to an item of income, is inimical to the original purposes of the credit and thus revocable at the IRS's election.

A reading of American Chicle does not support this view. The Court does refer to Congress's intention of preventing double taxation in enacting the FTC, but did not need to rely on that intention to interpret the statute because it found the statutory language unambiguous. This is hardly sufficient authority to support a new and significant limitation to FTCs.

Summary and Conclusions

Notice 98-5 announces the establishment of a wholly new limitation on FTCs, one that is determined by the size of the credit in relation to the economic benefit of the underlying transaction. The Service lacks the authority to issue regulations as broad as outlined in the notice (although it may have the authority to issue regulations in related areas that could address some of the supposed "abuses" that have attracted its attention). The relative economic size standard proposed in the notice is subjective and as yet undefined. This new limitation threatens to jeopardize FTCs in transactions that are part of everyday operations for many multinational corporations. Moreover, the new limitation, if successfully implemented, will put U.S.-based multinationals at a disadvantage in relation to foreign-based competitors.

If tax-advantaged arrangements are genuinely abusive, the IRS can attack them as "sham transactions" lacking economic substance under principles that have long existed. To go beyond that and create an entirely new FTC limitation should require legislative approval.