Foreign Tax Credit Changes in P.L. 111-226

Foreign Tax Credit Splitting
New section 909 of the Code provides that, in certain circumstances, foreign income taxes paid or accrued are not taken into account for foreign tax credit purposes until the underlying foreign income is taken into account for U.S. federal income tax purposes. This rule applies both to U.S. taxpayers with their own foreign income and creditable foreign taxes (the “direct credit”) and also to U.S. corporate taxpayers with “deemed” creditable foreign taxes arising under the foreign tax credit rules from dividends (or deemed dividends such as under subpart F) from foreign subsidiaries (the “indirect credit”).

More specifically, the rule applies if there has been a “foreign tax credit splitting event,” defined with reference to a foreign income tax as arising when the income (or, when appropriate, the earnings and profits) giving rise to that tax is or will be taken into account by a “covered person.” With respect to the payor of a foreign income tax, a “covered person” is any entity in which the payor holds a ten percent or greater interest (by vote or value), any person holding, directly or indirectly, a ten percent or greater interest in the payor, any person bearing a relationship to the payor described in sections 267(b) or 707(b) of the Code and any other category specified by Treasury.

The basic thrust of this new provision is to prevent taxpayers from circumventing the foreign tax credit limitations (based generally on the amount of foreign and worldwide income in one of two categories or “baskets”) through so-called “splitting” transactions with loosely related parties. It is not intended that there would be a splitting transaction simply because of differences in U.S. and foreign tax accounting rules where the same person pays a foreign tax but takes the related income into account for U.S. tax purposes in a different taxable period. In the case of partnerships, this new provision is to be applied at the partner level, and unless otherwise provided by Treasury, a similar approach applies to S corporations. Moreover, Treasury is given authority to apply the provision at the shareholder level in the case of regulated investment companies that elect under section 853 of the Code to treat foreign taxes paid by them as creditable by their shareholders. Treasury is also granted broad regulatory authority regarding, among other things, exceptions to application of the new provision and its application in the case of hybrid instruments (e.g., instruments treated as equity for U.S. tax purposes but as debt for foreign tax purposes).

These foreign tax credit splitting rules are effective for foreign taxes paid or accrued after December 31, 2010. They also apply to foreign taxes paid or accrued prior to that date by foreign subsidiaries, but only for purposes of applying the indirect credit rules after December 31, 2010 (e.g., in the case of a dividend paid or deemed paid by a foreign subsidiary after December 31, 2010 out of pre-January 1, 2011 earnings and profits). Act, § 211, enacting I.R.C. § 909.

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