Proposed section 902 regulations.

On May 16, 1995, Tax Executives Institute filed the following comments with the Internal Revenue Service concerning proposed regulations under section 902 of the Code, relating to the computation of the deemed paid foreign tax credit. TEI's comments were prepared under the aegis of its International Tax Committee, whose chair is Philip J. Bergquist of Apple Computer, Inc. A task force headed by Christine A. Holtzmuller of Mead Corporation was formed to prepare the comments; its members included James A. McFall of Xerox Corporation, Lisa Norton of Ingersoll-Rand Co., Robert G. Sedlacek of Gerber Corporation, and Joseph S. Tann, Jr., of Ameritech Corporation. Thomas J. Brya of G.D. Searle & Co. and the Chicago Chapter's International Tax Committee also contributed materially to the preparation of the comments.

On January 5, 1995, the U.S. Department of the Treasury and the Internal Revenue Service issued proposed regulations under section 902 of the Internal Revenue Code, relating to the computation of foreign taxes deemed paid, to conform the regulations to section 1202(a) of the Tax Reform Act of 1986 (Pub. L. No. 99-514, 100 Stat. 1085) and to section 1012(b) of the Technical and Miscellaneous Revenue Act of 1988 (Pub. L. No. 100-647, 102 Stat. 3242) with respect to taxable years beginning after December 31, 1986. The proposed regulations were published in the Federal Register on January 6, 1995 (60 Fed. Reg. 2049), and in the Internal Revenue Bulletin on March 6, 1995 (1995-10 I.R.B. 18).(1)

Background

Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 5,000 members represent more than 2,500 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations under section 902 of the Internal Revenue Code, relating to the computation of the deemed-paid foreign tax credit.

1. Prop. Reg. [sections] 1.902-1(a)(1): Definition of Domestic Shareholder

U.S. income tax law has long permitted a domestic corporate taxpayer to credit foreign taxes paid on repatriated income against its U.S. income tax on such income. See, e.g., [sections] 240(c) of the Revenue Act of 1918, 40 Stat. 1082 (establishing the foreign tax credit). Section 902 of the Code provides a mechanism by which foreign income taxes paid by a foreign corporation are deemed paid by a domestic corporate shareholder owning at least 10 percent of the voting stock of the foreign corporation. This section 902 credit is often referred to as the "indirect" or "deemed paid" credit. In United States v. Goodyear Tire & Rubber Co., 493 U.S. 132, 139 (1989), the Supreme Court held that "[t]he history of the indirect credit clearly demonstrates that the credit was intended to protect a domestic parent from double taxation of its income."

Prop. Reg. [sections] 1.902-1(a)(1) defines "domestic shareholder" as:

a domestic corporation which

owns at least 10 percent of

the voting stock of the foreign

corporation at the time

it receives a dividend from

such foreign corporation.

The proposed regulations do not define ownership for purposes of section 902. In Rev. Rul. 71-141, 1971-1 C.B. 211; the IRS ruled that two 50-percent domestic corporate partners in a U.S. general partnership could claim the indirect credit with respect to dividends received by the partnership from a 40-percent owned foreign corporation. The preamble to the proposed regulations asks "under what other circumstances a section 902 credit with respect to stock held by a partnership or other pass-through entity should flow through to a domestic corporation."(2) The preamble specifically requests comments on (i) whether the holding of Rev. Rul. 71-141 should be expanded to allow taxes paid by a foreign corporation to be considered deemed paid by domestic corporations that are partners in domestic limited partnerships or foreign partnerships, shareholders in limited liability companies, and beneficiaries of domestic or foreign trusts or estates or interest holders in other pass-through entities, and (ii) if so, how the government would administer the expansion.

The questions in the preamble perplexed and unsettled many tax professionals because the assumption was that Rev. Rul. 71-141 already applied to foreign, as well as domestic, partnerships (and to limited, as well as general, partners). Stated simply, TEI believes the preamble's question should be answered in the affirmative. Where a corporate member of a pass-through entity -- whether a domestic limited partnership, limited liability company, foreign general or limited partnership, or domestic or foreign trust or estate -- owns a sufficient interest in that entity under section 318 to claim at least a 10-percent interest in any foreign corporation's voting stock (which stock is held by the pass-through entity), the (domestic) corporate member should be entitled to a deemed-paid credit. Any other result would destroy the symmetry between sections 902 and 901 (which applies to foreign branch operations), undermine section 702(a)(6) (which accords partners their distributive share of foreign tax credits), and frustrate the legislative purpose of the indirect credit (which is to mitigate double taxation).

A. The legislative history of section 902 evinces congressional intent to treat foreign subsidiaries and branches similarly. In enacting the indirect credit provisions of the Code, Congress sought to equalize the tax treatment between domestic corporations that operate through foreign subsidiaries and those that operate through foreign branches. See Goodyear Tyre & Rubber Co., 493 U.S. at 140. Accord Seidman's Legislative History of Federal Income Tax Laws Vol. 1: 1861-1938), at 936-37 (1938) (the Senate floor debate on the Revenue Act of 1918 reveals that the purpose of the indirect credit is to equalize foreign subsidiary and branch taxation); Debate on Revenue Act of 1921, 61 Cong. Rec. 7184 (1921) (statement of Senator Smoot) ("a foreign subsidiary is much like a foreign branch of an American corporation"). More recently, in enacting the "pooling" provisions of the Tax Reform Act of 1986, Congress affirmed that while "there are difficulties in equating the foreign tax credit results of operation through a subsidiary and a branch, . . . steps to provide more similar results in the two cases are desirable." H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 356 (1985); see Staff of the Joint Comm. on Taxation, General Explanation of the Tax Reform Act of 1986, at 869-70 (1987).

In light of the unwavering congressional intent to remove the differences between branches and subsidiaries, we believe it unreasonable to merely assume that Congress intended different foreign tax credit treatment for pass-through entities. Much more likely, Congress considered the availability of the indirect credit to be unaffected by the utilization of pass-through entities because such entities are indistinguishable from branches. See Donroy Ltd. v. United States, 301 F.2d 300 (9th Cir. 1962) (each partner in a partnership, whether general or limited, has an interest in the assets and profits of the partnership so that the office or permanent establishment of the partnership is the office of each partner); Unger v. Commissioner, 58 T.C.M. (CCH) 1157 (1990), aff'd, 936 F.2d 1316 (D.C. Cir. 1991) (foreign partner deemed to have U.S. permanent establishment as result of U.S. partnership's permanent establishment); Rev. Rul. 91-32, 1991-1 C.B 107 (a foreign partner of a partnership engaged in U.S. trade or business is itself considered so engaged).

B. Domestic and foreign partnerships should be treated similarly for purposes of the U.S. tax laws. TEI strongly disputes the suggestion that the flow-through principle set forth in Rev. Rul. 71-141 should possibly not apply to corporate partners in foreign partnerships. Indeed, we can fathom no sound tax policy for having one set of rules apply to partners in U.S. partnerships and a different set apply to partners in foreign partnerships.

The IRS itself has rejected the dissymmetry between foreign and domestic partnerships in its recent section 701 partnership "anti-abuse" regulations. Treas. Reg. [sections] 1.701-2(d), Ex. 3 describes the use of a foreign partnership to avoid a more restrictive foreign tax credit limitation, as follows:

Subchapter K is intended to

permit taxpayers to conduct

joint business activity

through a flexible economic

arrangement without incurring

an entity level tax... The

decision to organize and conduct

business through PRS 

[the foreign partnership] in

order to take advantage of

the look-through rules for

foreign tax credit purposes,

thereby maximizing X's use

of its proper share of foreign

taxes paid by PRS, is consistent

with this intent.

The regulations conclude that the transaction need not be recast for purposes of the anti-abuse rules; thus, dividends flowing from those subsidiaries to the foreign partnership presumably bring with them section 902 deemed paid credits for the U.S. corporate partner.

A contrary position would operate to the detriment of international businesses. For example, a U.S. parent may hesitate to enter into certain joint ventures with a foreign partner if the joint venture involved the use of partnerships. Even within a controlled group, an effective restriction on the use of foreign partnerships would impede international business operations and further complicate audits of multinational corporations.

Nor has any reason been identified to apply the aggregate theory of partnership for purposes of section 902 to general domestic partnerships -- as was done in Rev. Rul. 71-141 -- but not to other types of partnerships.(3) Section 702(a)(6) of the Code provides that in determining a partner's income tax, each partner shall take into account separately its distributive share of the partnership's "taxes, described in section 901, paid or accrued to foreign countries and to possessions of the United States." Treas. Reg. [sections] 1.7701-1(c) provides:

[A] particular organization

might be classified as a trust

under the law of one State

and a corporation under the

law of another State. However,

for purposes of the Internal

Revenue Code, this organization

would be uniformly

classed as a trust, an association

(and, therefore, taxable

as a corporation), or some

other entity, depending upon

its nature under the classification

standards of the Internal

Revenue Code. Similarly,

the term "partnership"

is not limited to the common-law

meaning of partnership,

but is broader in its scope and

includes groups not commonly

called partnerships. (Emphasis

added.

Hence, under section 7701, the term "partnership" encompasses both foreign and domestic flow-through entities.

That taxpayers have properly construed Rev. Rul. 71-141 to apply to all types of partnerships is supported by the IRS's own use of the ruling in other contexts. Thus, the IRS has extended the reasoning of Rev. Rul. 71-141 to a foreign trust that owned 51 percent of a foreign corporation's voting stock:

Finally, X need not actually

own the voting stock to meet

the ownership test under section

902 of the Code. Rev.

Rul. 71-141 ... holds that a

shareholder was entitled to

its distributive share of the

section 902 credit where the

shareholder owned the stock

through a partnership. The

ruling stated that the ownership

interest was to be determined

by multiplying the

shareholder's percentage interest

in the partnership by

the partnership's percentage

interest in the foreign corporation.

Under this standard,

X satisfies the 10-percent

ownership rule because its

ownership interest is equal

to 24.5 percent (X's interest

in Trust) times 51 percent

(Trust's percentage of full

voting stock), for a total of

12.495 percent. Accordingly,

X may claim its proportionate 

share of the section 902

credit by virtue of its Trust

interest.(4)

Private Letter Ruling 9217026 (January 24, 1992). This position was also advanced by the court (and the government) in Brown Group, Inc. v. Commissioner, 104 T.C. No. 5 (1995) (the aggregate theory of partnerships applies in respect of Subpart F). See also Rev. Rul. 79-82, 1979-1 C.B. 141 (applying the aggregate theory of partnership in respect of former section 333).

C. The voting share requirement should be applied at the partnership level. Section 902(a) permits a deemed-paid credit where the domestic corporation owns 10 percent or more of the voting stock of the foreign corporation. Thus, the question is whether a corporate member of a pass-through entity holding shares of a foreign corporation itself owns voting or non-voting shares for purposes of section 902(a). TEI submits the answer is clear: whatever is held by the pass-through entity -- and whatever its character -- is held by the corporate member. Hence, if the pass-through entity holds voting stock, the domestic corporate partners should be treated as holding voting stock.(5)

The legislative history of the indirect credit is devoid of any discussion of the voting stock requirement.(6) Regardless of whether the domestic corporation is a general or limited partner in the partnership, the focus should be on who has the core incident of ownership -- the right to vote the foreign shares. To the extent a corporate member has the right to vote 10 percent or more of the shares, the ownership rule of section 902(a) of the Code is satisfied. Such an interpretation of the statutory language clearly serves the policy and administrative purposes underlying section 902.

D. The administration of Rev. Rul. 71-141 in the foreign context creates no unique compliance issues. The preamble to the proposed regulations asks how any expansion of Rev. Rul. 71-141 should be handled administratively. 1995-10 I.R.B. at 18. TEI has identified no unique problems with the administration of section 902 in respect of pass-through entities. There are extensive information-reporting requirements currently imposed on U.S. taxpayers concerning their ownership of foreign corporations. These reporting rules apply to any pass-through entities holding such interests. I.R.C. [sections] 6046A(a) (U.S. person acquiring interest in foreign partnership required to file return); Treas. Reg. [sections] 1.6046-1(i) (stock owned directly or indirectly by or for a foreign corporation or foreign partnership considered as being owned proportionately by its shareholders or partners); Form 5471, Schedule M (requiring a CFC to report any partnership interests).

Moreover, just as a U.S. taxpayer with a foreign branch or subsidiary is required to establish the amount of the tax for which a credit is claimed (and to provide all other information necessary for the verification and computation of the credit), a U.S. taxpayer owning the requisite section 902(a) interest in a foreign corporation through a pass-through entity must carry this burden.(7) To require more would undercut the congressional purpose in enacting the indirect credit -- to prevent double taxation.

2. Prop. Reg. [sections] 1.9021(d)(3)(ii): Limitation on Look-Through Rules

Section 904(d)(2)(e)(i) of the Code defines the term "noncontrolled section 902 corporation." The statute states that a controlled foreign corporation (CFC) shall not be treated as a noncontrolled section 902 corporation with respect to any distribution out of its earnings and profits (E&P) for periods during which it is a CFC and, "except as provided in regulations," the taxpayer was a U.S. shareholder in such corporation.

Prop. Reg. [sections] 1.902-1(d)(3)(ii) provides that a dividend shall be treated as a dividend from a noncontrolled section 902 corporation where:

* the dividend is distributed by a CFC and is attributable to E&P of a taxable year in which it was a CFC;

* the distribution is received by an upper-tier CFC or U.S. shareholder that owns directly or indirectly more than 90 percent of the total combined voting power of the CFC; and

* the more-than-90-percent U.S. shareholder was not a U.S. shareholder at the time the distributed E&P was accumulated, by the CFC (the "pre-acquisition period").

The proposed regulations thus adopt the position taken in Prop. Reg. [sections] 1.904-4(g)(3) and eliminate look-through treatment on dividends paid out of a CFC's preacquisition earnings where a U.S. shareholder acquires more than 90 percent of the voting stock ownership in an existing CFC.

TEI submits that the 90-percent threshold set forth in the proposed regulations is inconsistent with Subpart F. Where a CFC is sold to a new U.S. shareholder and the CFC remains a CFC, the buyer is taxed on the CFC's Subpart F income for the entire year. There is no distinction made regarding the character of the acquired CFC's preacquisition income. Under the proposed regulations, however, a dividend paid out of a CFC's preacquisition earnings is treated as a dividend from a noncontrolled section 902 corporation.

Moreover, the 90-percent threshold is entirely arbitrary. The incongruity of the rule can be demonstrated by Example 3 in Prop. Reg. [sections] 1.902-1(d)(3)(v). That example holds that, as long as a foreign corporation has more than 50 percent of its stock controlled by a domestic corporation, any new owner of the shares is entitled to look-through treatment on dividends paid out of pre-acquisition E&R But if a new buyer acquires 91 percent of a foreign corporation (that was not previously a CFC), it is denied look-through treatment. In essence, the proposed regulations favor a U.S. shareholder that buys into a joint venture over a U.S. shareholder that purchases 100 percent of an offshore company. The better rule is to permit look-through treatment for distributions of prior years' earnings so long as the U.S. shareholder's interest does not fall below 10 percent.

Finally, TEI opposes the requirement that taxpayers maintain separate post-1986 E&P and tax pools for "creeping" acquisitions of ownership interests under 90 percent. Under the regulations, if the taxpayer acquires its interest in the foreign corporation in stages, (for example, purchasing 50 percent in year 1, and another 10 percent in each of years 2 and 3), it is required to track multiple separate pools. No legitimate goal is fostered by such a requirement, which would impose significant administrative burdens. (The computational requirements alone would be a nightmare. Indeed, if the ownership interest dipped below 90 percent, would the taxpayer be required to create another pool? TEI submits that the better rule is to permit an aggregate of E&P and tax pools for ownership interests greater than 10 percent.

3. Interaction with Section 985

The final regulations under section 985 of the Code provide rules for the computation and characterization of income and E&P under the dollar approximate separate transactions method (DASTM).(8) Treas. Reg. [sections] 1.985-6(d)(2) provides rules for the carry forward of deficits in accumulated profits from pre-1987 taxable years to post-1986 taxable years. The regulations provide that, for purposes of section 902 and 960, the post-1986 undistributed earnings of a foreign corporation that is subject to DASTM shall be reduced by the dollar amount of the corporation's deficit in accumulated profits, if any, determined under section 902 that was accumulated at the end of the corporation's last taxable year beginning before January 1, 1987. The regulations fail to provide, however, for any section 481 adjustment to earnings and profits (E&P) in respect of the post-1986 pool, and this omission creates a problem in respect of the proposed section 902 regulations.

The proposed section 902 regulations specify that the sum of the post-undistributed 1986 E&P and the preaccumulated 1987 profits must equal the foreign corporation's entire E&P. Prop. Reg. [subsections] 1.902-1(a)(9) & (10). For taxpayers using DASTM that did not compute pre-1987 E&P for Subpart F purposes, however, the pre-1987 pool and the post-1986 pool (computed under DASTM) will never equal the total accumulated E&P unless a section 481 adjustment is made. In other words, the tax balance sheet will not balance.(9)

Section 985(b)(4) clearly states that a change in functional currency is treated as a change in method of accounting under section 481. The Secretary is thus given authority under section 985 to establish the appropriate section 481 adjustment. We recommend that the Secretary exercise this authority and provide for an adjustment spread over time consistent with section 481 principles.(10)

Conclusion

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations under section 902 of the Code, relating to the computation of foreign taxes deemed paid. If you have any questions, please do not hesitate to call Philip J. Bergquist, chair of TEI's International Tax Committee, at [phone] or Mary L. Fahey of the Institute's professional staff at [phone]. (1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions of the proposed regulations are cited as "Prop. Reg. [sections]." References to page numbers are to the proposed regulations (and preamble) as published in the (2) 1995-10 I.R.B. at 18. (3) Rev. Rul. 71-141 accords a deemed-paid credit to partners in a partnership that owns stock in a foreign corporation, even though direct ownership is lacking. The only way to harmonize Rev. Rul. 71-141 with section 902's statutory requirement of direct ownership of voting stock is to interpret it to apply an aggregate (or conduit) theory of partnership, so that each corporate partner is deemed for tax purposes to own a pro rata share of the foreign corporate stock owned by the partnership. (4) See also Bruce N. Davis & Steven R. Lainoff, U.S. Taxation of Foreign Joint Ventures, 46 Tax Law Rev. 165, 273-74 (1991) ("In the context of the foreign tax credit, the Code and the regulations generally adopt an aggregate model for the treatment of partnerships."). (5) The character of the stock held by the pass-through entity is generally determined at the partnership level under local law. United States v. Basye, 410 U.S. 441, 448 (1973) (for purposes of calculating partnership income, "the partnership is regarded as an independently recognizable entity apart from the aggregate of its partners. Once its income is ascertained and reported, its existence may be disregarded since each partner must pay a tax on a portion of the total income as if the partnership were merely an agent or conduit through which the income passed."). (6) The voting stock requirement may owe its existence to the initial placement of the indirect credit within the consolidated return provisions of the Revenue Act of 19 18, where the privilege of filing such a return is conditioned on a unity of interest in the affiliated entity as evidenced by the ownership of voting stock. The considerations involved in filing consolidated returns were not differentiated from those involved in granting the foreign tax credit. See Elizabeth A. Owens & Gerald T. Ball, The Indirect Credit 46 (1975). In other words, there is precious little rationale for imposing the voting stock requirement for purposes of the foreign tax credit. Id. at 47 ("There is little similarity in rationale ... between the indirect credit and the consolidated return."). (7) The legislative history of the deemed-paid credit clearly demonstrates that the 10-percent requirement is intended to mitigate administrative difficulties in calculating and auditing claimed foreign tax credits. These difficulties were discussed in 1970 when Congress expanded the deemed-paid credit to domestic corporations claiming a foreign tax credit for foreign taxes paid through a third-tier subsidiary. Congress found that expanding the credit through the third tier would not create administrative problems for the IRS because of the reporting requirements and the imposition of the burden of proof on taxpayers to substantiate the credits. S. Rep. No. 91-1527, 91st Cong., 2d Sess. 2 (1971). See also S. Rep. No. 82- 781, 82d Cong., lst Sess. 497 (1951) (relating to the lowering of the minimum stock requirement from 50 percent to 10 percent). (8) TEI filed comments on the final and proposed DASTM rules with the IRS and Treasury Department on February 22, 1995. (9) We recognize that, prior to the Tax Reform Act of 1986, section 902 accumulated profits did not equal E&P profits under section 964, but the only difference was timing; upon a complete liquidation, the two would be equal. We suggest that section 985 was enacted, in part, to bring these two provisions into conformity. (10) There is a typographical error in Prop. Reg. [sections] 1.902-1(f), Ex. 3, that should be corrected, as follows:

B. Corporation B (second-tier corporation)

1.. . .

2.. . .

3. Assumed ... (including 150u dividend from Corporation C). There is also a typographical error in Prop. Reg. [sections] 1.902-1(a)(9)(iii), where the ninth line should read "under paragraph (a)(8)(iii)."