Rev. Rul. 78-258

Advice has been requested, under the circumstances described below, as to the amount of a foreign tax credit a domestic corporation is entitled to under sections 901 through 907 of the Internal Revenue Code of 1954 when a pecuniary benefit (subsidy) granted by a foreign government is directly related to the otherwise creditable income tax of that foreign country.

X is a domestic commercial bank that has loans outstanding in Brazil. X is subject to the 25 percent withholding tax imposed by Article 344, I, and 355, Sole Paragraph, of Brazilian Decree No. 76,186 (the Decree), the most recent consolidation of the Brazilian income tax laws, on interest paid to X by Brazilian borrowers.

With respect to the incidence of such withholding tax, the outstanding loan agreements between X and its Brazilian borrowers provide that the Brazilian borrowers shall deduct the 25 percent withholding tax imposed on X by the Government of Brazil on any interest payments due to X.

Articles 16 and 343 of the Decree provide, in part, that income from sources located in Brazil, received or accrued by natural persons or legal entities residing or domiciled abroad is subject to tax in accordance with the provisions of Articles 344 to 349.

Article 344, I, of the Decree requires the withholding of the above tax at the source at the rate of 25 percent on all remittances of interest income to individuals or legal entities referred to in Article 343.

Apart from the subsidy aspect in the subject case, the 25 percent withholding tax on interest is a creditable tax under section 901 of the Code. See Rev. Rul. 78-61, page 221, and Rev. Rul. 70-49, 1970-1 C.B. 158.

In order to encourage the use of foreign funds by Brazilian borrowers, on July 31, 1975, the Government issued Brazilian Decree No. 1,411 that, in part, granted to the National Monetary Council the authority to grant monetary benefits in favor of recipients of foreign financing (borrowers). The National Monetary Council is a governmental agency responsible for such economic programs and acts through the Central Bank of Brazil.

Pursuant to Decree No. 1,411, the Central Bank of Brazil issued Resolution No. 335 of August 5, 1975, which grants to Brazilian borrowers a "pecuniary benefit" (subsidy) equal to 85 percent of the income tax withheld. To obtain the 85 percent subsidy, the Brazilian borrower (as provided in Items I and II of Circular No. 266 issued by the Central Bank of Brazil) must withhold 25 percent of the interest due to a foreign lender and pay this amount over to the Brazilian Ministry of Finance. Usually, the borrower accomplishes this by paying over the amount withheld to a commercial (collecting) bank authorized by the Ministry to handle such transactions. The collecting bank, upon receipt of such withheld amount, is directed under Item IV of Circular No. 266 to credit immediately the borrower's account with an amount equal to 85 percent of the income tax withheld by the borrower and paid over to such bank. Item VII of Circular No. 266 states that such payment (the crediting of the borrower's account) shall be debited to the miscellaneous account of the current assets of the collecting bank under the subtitle of "pecuniary benefits--D. L. 1,411." Item VII further states that on the same date the collecting bank is to decrease the debited miscellaneous pecuniary benefits account by offsetting that account with a credit equal to such debit (85 percent of the 25 percent withheld amount). Item VIII of Circular No. 266 requires the collecting bank to advise (by the form designated therein) the Central Bank of Brazil concerning the collecting bank's use of the above-described offset procedure. The result is that the Brazilian borrowers of X receive the above-described subsidies.

The specific question presented is whether any part of the amount withheld under Article 344, I, of the Decree is a tax that if paid or accrued would be creditable by X under sections 901 through 907 of the Code in view of the fact that the borrowers of X receive a subsidy from the Brazilian Government that is directly related to the income tax liability of X to the Brazilian Government.

Under section 901 of the Code, a credit against United States income tax is allowable for foreign income, war profits, and excess profits taxes paid or accrued during the taxable year by a United States taxpayer.

In order to show its entitlement to a credit for the amount withheld, the lender must show that it has paid or accrued an amount that is the substantial equivalent of an income tax in the United States sense. For example, see Commissioner v. American Metal, 221 F.2d 134 (2d Cir. 1955), cert. denied, 350 U.S. 829, and F.W. Woolworth Co. v. Commissioner, 54 T.C. 1233 (1970), nonacq. on another issue, 1971-2 C.B. 4. The fact that Brazil treats the amount withheld by the borrower as a tax and the subsidy as separate from the tax does not establish that such an amount is the substantial equivalent of an income tax paid or accrued. The focus is on the real nature of the transaction under United States law. See, Biddle v. Commissioner, 302 U.S. 573 (1938), 1938-1 C.B. 309; Rev. Rul. 76-215, 1976-1 C.B. 194; and cf. Rev. Rul. 58-141, 1958-1 C.B. 101, which states ". . . (t)he question of whether a particular contribution, charge, or burden is to be regarded as a tax depends on its real nature and . . . if it is not in the nature of a tax, it is not material that it may have been so called . . . ."

In denying a credit under section 901 of the Code for any part of the Indonesian Government's share of oil production, Rev. Rul. 76-215 concludes that such share is not in the nature of a tax but in reality is a royalty.

In Rev. Rul. 69-433, 1969-2 C.B. 153, a Virgin Islands subsidiary of a United States corporation received a nontaxable subsidy from the Virgin Islands equal to 75 percent of the taxes for which it was liable and paid over to the Virgin Islands. Rev. Rul. 69-433 holds that the United States corporation could only claim an indirect foreign tax credit for the amount of income tax paid over by the subsidiary to the Virgin Islands that exceeded the amount of the subsidy the subsidiary received back from the Virgin Islands. This holding is based on the fact that Congress, in adopting section 934(a) of the Code, had concluded that a subsidy received from the Virgin Islands by a taxpayer that was measured by the amount of tax owed and paid over by such taxpayer had substantially the same effect as a rebate or reduction of the taxpayer's income tax liability to the Virgin Islands.

In the instant situation, Brazil grants a subsidy to a Brazilian borrower measured by the amount of the United States lender's purported Brazilian income tax that is withheld by the borrower. By having the borrower withhold an amount allegedly representing the income tax liability of the lender and then simultaneously granting the borrower a subsidy of 85 percent of the amount withheld, the Brazilian Government, in effect, reduces (1) the amount of interest the Brazilian borrower has to pay a foreign lender, and (2) the amount of Brazilian income tax a foreign lender has to pay on such interest. The arrangement is similar to the one described in Rev. Rul. 69-433 wherein the Virgin Islands, in effect, reduces the amount of income tax a Virgin Islands corporation has to pay by means of a tax subsidy. Thus, to the extent of the 85 percent subsidy, the amount withheld that allegedly represents Brazilian income tax owed by the lender in the instant situation is in reality an abatement of interest due from the borrower to the lender pursuant to a Brazlian Government policy reducing the real amount of interest that a Brazilian borrower has to pay a foreign lender. The interest abatement is accomplished by internal government mandated bookkeeping that does not rise to the level of a tax. Further, since liability to pay the 85 percent is never imposed on X, that amount cannot be considered paid or accrued by X for purposes of section 901 of the Code.

Accordingly, it is concluded that (1) X receives interest income from each of its Brazilian borrowers equal to the excess of the amount of interest payable under the loan agreement with each such borrower over the subsidy received by such borrower; (2) X pays a tax to Brazil with respect to that interest income equal to the excess of the amount withheld over the subsidy received by such borrower; and (3) X may claim a credit under section 901 of the Code for only that portion of the amount withheld that exceeds the subsidy received by such borrower.

A statement in Rev. Rul. 57-106, 1957-1 C.B. 242, is inconsistent with the position taken in this Revenue Ruling. Rev. Rul. 57-106 involves a foreign corporation that purchased all of the assets of two domestic affiliates of a domestic corporation. In addition to the purchase price, the foreign corporation agreed to pay all income taxes imposed on the seller by the foreign government relating to the sale. That Revenue Ruling holds that the income taxes assumed by the foreign corporation are part of the sales price of the assets, and that a foreign tax credit is allowed to the domestic corporation for the income taxes accrued by such corporation.

Rev. Rul. 57-106 expressly states as a fact that the foreign corporation was granted a subsidy by the foreign country equivalent to 100 percent of the income taxes it agreed to pay as a result of the acquisition of the two domestic affiliates. The existence of this fact in Rev. Rul. 57-106 leads to an erroneous interpretation of that Revenue Ruling. In the absence of this fact, Rev. Rul. 57-106 is correct. Therefore, Rev. Rul. 57-106 is modified to provide that the foreign corporation was not granted a subsidy by the foreign country, but rather the foreign corporation simply paid the foreign income taxes accrued by the domestic corporation as a result of and pursuant to the sale agreement.

The Service will not follow the Mexican railroad car rental court decisions in Missouri Pacific R.R. Co. v. United States, 301 F. Supp. 839 (E. D. Mo. 1967), aff'd in part and rev'd in part on other grounds, 411 F.2d 327 (8th Cir. 1969), cert denied, 396 U.S. 1037; Missouri-Illinois R.R. Co. v. United States, 381 F.2d 1001 (Ct. Cl. 1967); Chicago, Burlington & Quincy R.R. Co. v. United States, 455 F.2d 933 (Ct. Cl. 1972), rev'd on other grounds, 412 U.S. 401 (1973), 1973-2 C.B. 428; and Missouri Pacific R.R. Co. v. United States, 497 F.2d 1386 (Ct. Cl. 1974), to the extent such decisions are inconsistent with the position taken in this Revenue Ruling.

Pursuant to the authority of section 7805(b) of the Code, the conclusions in this Revenue Ruling will not be applied to disallow a foreign tax credit for amounts claimed as income taxes imposed by Brazil on interest accrued or received (but not prepaid) prior to January 1, 1980, with respect to loans made prior to March 16, 1978.

For the purposes of the preceding paragraph, the phrase "loans made" means (1) any loan to the extent of funds disbursed prior to March 16, 1978, or (2) any loan to the extent of funds disbursed subsequent to March 15, 1978, pursuant to a written contract binding on March 15, 1978, and at all times thereafter until the loan is made provided that (a) the contract is unconditional, or (b) the contract is subject only to written conditions and does not permit the rate of interest set forth therein to be renegotiated, or (3) any loan with respect to which, prior to March 16, 1978, a lender had taken every action to signify approval under procedures ordinarily employed by such lender in similar transactions and had sent or deposited for delivery to the person to whom the loan is to be made written evidence of such approval in the form of a document setting forth, or referring to a document sent by the person to whom the loan is to be made that sets forth, the principal terms of such loan.

Rev. Rul. 57-106 is modified.

¹ Also released as News Release IR-2006, dated June 8, 1978.