Rev. Rul. 80-231

ISSUE

How does the reduction in the amount of foreign income tax paid by a foreign subsidiary following an allocation of income under section 482 of the Internal Revenue Code affect the computation of its domestic parent corporation's deemed paid foreign tax credit under section 902 of the Code in the circumstances described below?

FACTS

P, a domestic corporation, owns all of the voting stock of S, a foreign corporation organized under the laws of foreign country Z. Country Z does not have an income tax convention in force with the United States. P and S use the accrual method of accounting.

In 1977, P sold its products to S at a price below P's normal charge to unrelated customers, so that P did not realize its normal profit. The Internal Revenue Service proposed an allocation of income under section 482 of the Code for 1977 to reflect an arm's length selling price. For 1977, S paid an 80x country Z income tax on reported income of 200x. Pursuant to the allocation of income under section 482, the Internal Revenue Service reduced S's country Z income by 20x and increased P's income by the same amount.

P received a dividend of 15x from S during 1977 out of S's 1977 accumulated profits and claimed a deemed paid foreign tax credit under section 902 of the Code based on the amount of country Z taxes paid by S in 1977 before the income allocation. The 15x dividend was not excluded from P's income under Rev. Proc. 65-17, 1965-1 C.B. 833, and P has not elected to compute S's earnings and profits under section 964 of the Code.

LAW AND ANALYSIS

The applicable sections of the Code are 901 and 902. Subject to certain limitations, section 901 permits domestic corporations to claim a credit for income taxes paid or accrued to foreign countries. Under section 902, a domestic corporation owning at least 10 percent of the voting stock of a foreign corporation from which it receives dividends shall be deemed to have paid a specified portion of any creditable income tax paid or deemed paid to any foreign country on or with respect to the accumulated profits of such foreign corporation. The specified portion is in the ratio that the dividends bear to accumulated profits in excess of foreign income taxes.

Section 1.902-1(e)(1) of the Income Tax Regulations provides, in part, that the accumulated profits for any taxable year of a first-tier foreign corporation shall be the sum of the earnings and profits of such corporation for such year, and the foreign income taxes imposed on or with respect to the gains, profits, and income to which such earnings and profits are attributable.

United States principles for computing earnings and profits, not foreign principles, are used to determine the computation of accumulated profits for purposes of section 902. See H.H. Robertson Co. v. Commissioner, 59 T.C. 53, 78-79 (1972), aff'd without opinion, 500 F.2d 1399 (3d Cir. 1974); Untermyer v. Commissioner, 24 B.T.A. 906 (1931), aff'd per curiam, 59 F.2d 1004 (2d Cir. 1932), XII-1 C.B. 157 (1933), cert. denied, 287 U.S. 647 (1932). Accumulated profits under section 902 are determined on an annual basis. H.H. Robertson Co. v. Commissioner, at 78-79.

Foreign income taxes are generally attributed to a particular year in which such taxes are paid or accrued on or with respect to the foreign corporation's accumulated profits, pursuant to section 1.902-1(f) of the regulations.

Rev. Rul. 76-508, 1976-2 C.B. 225, concerns the allocation of income from a foreign subsidiary corporation to its domestic parent under section 482 of the Code. Rev. Rul. 76-508 holds that in such a case the Service can reduce the amount of foreign income taxes paid by the foreign subsidiary that qualify for use by the parent in computing the deemed paid foreign tax credit under section 902.

Under the facts of Rev. Rul. 76-508, the amount of foreign income taxes paid for purposes of section 902 of the Code is reduced because it is presumed that an amount has been paid to the foreign country that exceeds the amount required to be paid pursuant to such country's law and that the amount of the non-required or voluntary overpayment will be refunded. (The word "contribution" as used with respect to overpayments of foreign taxes in Rev. Rul. 76-508 means a voluntary overpayment to the foreign country.)

Generally, for domestic corporations, the earnings and profits of an accrual method taxpayer for a given year are reduced by the amount of tax accrued. A subsequent tax refund increases earnings and profits for that given year, regardless of the year in which such refund is received. See Sweets Company of America v. Commissioner, 8 T.C. 1104, 1106 (1947), which indicates that adjustments to earnings and profits on account of mistaken or erroneous overpayments or underpayments of tax for prior years are made as of the years for which the tax was due (accrued).

Thus, a reduction in the amount of foreign income taxes accrued by the amount of a voluntary overpayment, in conjunction with the presumption that the overpayment will be refunded, has an effect on the foreign subsidiary's earnings and profits in the earlier year of accrual of the foreign tax liability. Voluntary overpayments that the foreign corporation has treated as a tax expense item must be treated as a reduction of tax expense in such earlier year. This will increase earnings and profits in excess of foreign income taxes in such earlier year by the amount of the overpayment that it is presumed will be refunded.

When the foreign country actually refunds the voluntary overpayment there is no effect on the earnings and profits or accumulated profits in excess of foreign income taxes (except for exchange rate differentials in certain situations) because the adjustment (increase) to earnings and profits and accumulated profits in excess of foreign income taxes has already taken place.

If it is established to the satisfaction of the Internal Revenue Service that under the provisions of the law of country Z, S did not pay an amount in excess of that required by such law, or P and S exhaust all effective and practical remedies and the foreign country does not refund the voluntary overpayment, the refund presumption will be rebutted and the amount of the voluntary overpayment will be treated as a tax expense item in the original year of S's accrual of the foreign tax liability. S's earnings and profits will then be reduced in the original year of S's accrual of the foreign tax liability by the amount of the tax expense that is not refunded. If an income tax convention were in force between the United States and country Z, all effective and practical remedies would include requesting consideration of the matter by the United States competent authority.

If P and S fail to pursue all effective and practical remedies and do not establish that S has made payments as required by the law of country Z, and it is established that S cannot receive a refund of the voluntary overpayment (for example, because the statute of limitations has expired), the amount of foreign income taxes paid, as reduced because of the refund presumption, will not be increased by the amount of the voluntary overpayment.

Moreover, even if P and S exhaust all effective and practical remedies and country Z refuses to refund the voluntary overpayment, the amount of the foreign income taxes paid, as reduced by the refund presumption, will not be increased by the amount of the voluntary overpayment in certain egregious cases, such as where it is clear that P and S knew or should have known that, under the law of country Z, S would not have had to make the voluntary overpayment because P grossly underpriced its products by selling them to S at substantially below cost and the law of country Z provides for arm's length pricing in computing tax liability. Thus, in such a case the amount of foreign income taxes paid will not be increased by the amount of the voluntary overpayment even after the foreign taxing authority and courts refuse for procedural reasons to grant any income tax refund based on increasing the price paid from S to P pursuant to an appropriate section 482 arm's length allocation by the Service.

In cases where there is a failure to exhaust remedies and in the aforementioned egregious cases, where the foreign income taxes paid (as reduced by the refund presumption) will not be increased by the voluntary overpayment, earnings and profits will be reduced by the amount of the overpayment, but only for the subsequent year when the right to the refund becomes worthless--for example, for the year in which the foreign statute of limitations for such a refund expires. See Schweppe v. Commissioner, 8 T.C. 1224 (1947), aff'd, 168 F.2d 284 (9th Cir. 1948), regarding the adjustment to earnings and profits in the year an otherwise valid debt becomes worthless because of the expiration of the statute of limitations; and Sweets Company of America, which distinguishes for earnings and profits adjustment purposes a mistake situation (such as the deemed rebutted refund presumption) from a subsequent event situation (such as the expiration of the statute of limitations).

HOLDING

The reduction, pursuant to Rev. Rul. 76-508, in the amount of foreign income tax paid by a foreign subsidiary following an allocation of income under section 482 of the Code affects the computation of its domestic parent's section 902 deemed paid foreign tax credit in the following manner:

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Rev. Rul. 76-508 is amplified.