by Amanda Varma & Brigid Kelly
The US Treasury Department and IRS issued Notice 2016-52 on September 15, targeting tax planning undertaken by US multinationals that anticipate large foreign-initiated tax adjustments.
The notice specifically mentions, but is not limited to, adjustments that may arise under EU state aid law. The notice follows the European Commission’s high-profile ruling last month ordering Apple to pay $14.5 billion (€13 billion) in back taxes and Treasury’s August 24 release of a white paper describing its concerns with the Commission’s approach.
This article summarizes the notice and considers its potential implications for taxpayers.
Background and Overview
The notice states that Treasury and the IRS “are aware that, in anticipation of a large foreign-initiated adjustments . . . a taxpayer may take steps to separate the additional payment of foreign income tax from the income to which it relates.”
Specifically, before a payment is made pursuant to a foreign-initiated adjustment, a taxpayer may attempt to change its ownership structure or have a subsidiary make a distribution, separating the tax pool created by the tax payment from the associated earnings. The taxpayer may then be able to repatriate the foreign taxes, which can be credited against US tax on other foreign source income, without repatriating and including in US taxable income the earnings to which the taxes relate.
When a taxpayer’s foreign income tax liability for a prior year changes, section 905(c) imposes certain requirements, such as notifying the IRS to permit the redetermination of US tax or, in the case of certain foreign subsidiaries, adjusting the taxpayer’s “pools” of taxes and earnings in the year the taxes are paid.
Neither section 905(c) nor the regulations thereunder, however, specifically address how to account for additional tax payments where, as the result of a liquidation, reorganization, or other corporate transaction of a foreign subsidiary, the subsidiary that makes an additional payment of tax pursuant to a foreign-initiated adjustment is different from the subsidiary that would have paid the tax had it been paid in the year to which the additional tax relates.
The notice attacks the transactions of concern, not under the section 905(c) redetermination rules, but instead under section 909. That provision was added to US tax law in 2010 and is aimed at preventing the separation of foreign taxes from the related income. In the case of a “foreign tax credit splitting event,” section 909 defers the right to claim credits until the related income is included in US taxable income.
The statute provides that a foreign tax credit splitting event occurs with respect to a foreign tax if the related income is or will be taken into account by certain related persons. Regulations narrow the statutory definition so that section 909 applies only in connection with certain identified “splitter arrangements.”
Notice 2016-52 announces Treasury and the IRS’s intent to issue new regulations under section 909 that will identify two new splitter arrangements, the first involving certain successor entities and the second involving distributions. The new rules will apply to foreign income taxes paid on or after September 15.
Are state aid repayments creditable?
Treasury and the IRS have not conceded that payments made pursuant to state aid orders are creditable foreign taxes. The notice itself states that no inference is intended as to whether “payments made pursuant to any particular foreign-initiated adjustment, including those arising under EU State aid law, qualify as payments of creditable foreign income taxes.”
The recent Treasury white paper noted the “possibility” that state aid repayments will be considered creditable foreign income taxes, but did not analyze the issue in further detail.
Splitter arrangement one: successor entities
According to the notice, Treasury and the IRS intend to issue regulations that will provide that a splitter arrangement arises when, as a result of a “covered transaction,” a foreign corporation at least 10% owned, directly or indirectly, by a US corporation pays “covered taxes” during a taxable year.
“Covered taxes” are foreign income taxes that (i) are taken into account by adjusting the payor’s pools earnings and taxes in the taxable year paid pursuant to section 905(c); and (ii) result from a foreign-initiated adjustment (or series of adjustments to more than one taxable year) that results in additional foreign income tax liability that is greater than $10 million.
A “covered transaction” is generally a transaction that meets two conditions. First, the transaction (or series of related transactions) results in covered taxes being paid by a person that would not have been the payor of the covered taxes if the covered taxes had been paid or accrued in one or more prior taxable years. Second, the person who would have been the payor is related to the actual payor. (Specifically, the person who would have been the payor must be a “covered person” as defined in section 909(d)(4).)
A covered transaction does not include, however, (i) a transaction that results in the transfer of the earnings and profits of the predecessor entity to the payor, such as certain liquidations and reorganizations, and (ii) any transaction where the taxpayer demonstrates by clear and convincing evidence that the transaction was not structured with a principal purpose of separating covered taxes from the undistributed earnings of the predecessor entity that include the earnings to which the covered taxes relate. The notice gives as an example of a covered transaction a section 351 contribution of a disregarded entity by one foreign subsidiary to another foreign subsidiary.
Splitter arrangement two: covered distributions
The second splitter arrangement described by the notice would generally arise when a foreign subsidiary pays covered taxes (as defined above) following a distribution of its earnings to another foreign subsidiary and the distribution is made with a principal purpose of reducing the payor’s undistributed earnings in advance of the payment.
Specifically, a splitter arrangement arises where the payor (or a predecessor of the payor) has made a “covered distribution,” which is any distribution with respect the payor’s stock to the extent such distribution (i) occurred in a taxable year of the payor to which the covered taxes relate or any subsequent taxable year up to and including the taxable year immediately before the taxable year in which the covered taxes are paid; (ii) resulted in a distribution or allocation of the payor’s undistributed earnings to covered person; and (iii) was made with a principal purpose of reducing the payor’s undistributed earnings that included the earnings to which the covered taxes relate in advance of the payment of covered taxes.
A distribution is presumed to have been made with such a principal purpose if the sum of all distributions that would be covered distributions without regard to the principal purpose requirement is greater than 50 percent of the sum of (i) the payor’s undistributed earnings as of the beginning of the payor’s taxable year in which the covered tax is paid and (ii) the sum of all distributions that would be covered distributions without regard to the principal purpose requirement.
A taxpayer may rebut this presumption, however, with clear and convincing evidence that the distributions were not in fact made with a principal purpose of reducing the payor’s undistributed earnings that included the earnings to which the covered taxes relate. The notice suggests that the presumption might be rebutted where the distributions were consistent with the payor’s pattern of distributions before the taxpayer reasonably anticipated the specified foreign-initiated adjustment.
Concluding thoughts
Although the timing of the notice and certain statements in it suggest that the notice was issued in response to specific planning related to state aid repayments, the notice applies to any foreign-initiated adjustments exceeding the $10 million threshold where the other specified conditions are met. For large businesses, this threshold is relatively low, especially given that adjustments to more than one taxable year may be considered.
As a result, and given the broad scope of the transactions potentially covered by the notice, companies should consider the application of the notice when facing a potential foreign adjustment or considering potential future restructuring transactions and distributions.
Treasury, as stated in its recent white paper, and the chairmen of the Congressional tax-writing committees, continue to have serious concerns about how the Commission has conducted its EU state aid investigations and the impact of those investigations on the US. fisc. The release of Notice 2016-52 demonstrates that Treasury and the IRS are also on the lookout for US taxpayers seeking to use significant state aid payments as a US tax planning strategy.
Amanda Varma
Amanda Varma advises clients on US federal income tax matters, with particular focus on international tax planning and controversies.
Her practice includes counseling domestic and foreign businesses with respect to cross-border acquisitions, business restructurings, and financings, tax treaty matters, deferral and foreign tax credit issues, transfer pricing, and withholding and reporting issues.
She also regularly advises clients on special issues arising in international tax controversies, including competent authority and information exchange. Ms. Varma also represents clients in connection with regulatory and legislative tax policy matters.
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Brigid Kelly
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