IRS Addresses Termination of Possessions Tax Credits

BACKGROUND

Subject to certain limitations, special tax credits are available under section 936 (possession tax credit) or section 30A (Puerto Rico Economic Activity Credit) for taxable income of a domestic corporation derived from the active conduct of a trade or business in a possession of the United States, provided that an election is made under sections 936(a) and (e). The tax credits provided by sections 936 and 30A will not be allowed for taxable years beginning after December 31, 2005. See sections 936(j) and 30A(h). The Treasury Department and the Internal Revenue Service (Service) anticipate that certain issues are likely to arise in connection with the termination of sections 936 and 30A (including election revocations in advance of such termination) and accordingly provide guidance with respect to these issues in this notice. The Treasury Department and the Service intend that these issues be resolved by applying existing provisions of the Internal Revenue Code and the Treasury regulations. This notice provides explanations and cross-references as appropriate to certain applicable statutory and regulatory provisions. Other issues not discussed in this notice may also arise, depending on a specific taxpayer's facts and circumstances.

Whether certain issues are likely to arise will depend on the manner in which a section 936 corporation's business continues to be conducted following the termination of sections 936 and 30A. Three possible situations and the issues that are likely to arise in each are discussed in Sections I through III below.

Regardless of how a section 936 corporation's business is conducted following the termination of sections 936 and 30A, in the case of a section 936 corporation that does not affirmatively revoke its election to be treated as a section 936 corporation and has not otherwise allowed the election to terminate (for example, by not claiming the possession tax credit on Form 5735 ("Possessions Corporation Tax Credit (Under Sections 936 and 30A)")), the election will terminate by operation of law for the taxable years of such corporation beginning after December 31, 2005. No new filing requirements (for example, a requirement to file a special form) will apply to such a corporation.

SECTION I. THE SECTION 936 CORPORATION CONTINUES ITS ACTIVITIES AS A DOMESTIC CORPORATION.

One possible situation upon the termination of sections 936 and 30A (or earlier election revocation) is for the former section 936 corporation to continue its activities as a domestic corporation.

When the former section 936 corporation becomes an includible corporation, the parent corporation is the agent for the group for many elections and other matters related to the tax liability of the former section 936 corporation and the other consolidated return group members. See § 1.1502-77 of the Income Tax Regulations.

If the former section 936 corporation becomes includible in a consolidated return group, the carryover of specific tax attributes of the corporation will be governed by applicable consolidated return provisions. The special rules governing prior losses and earnings are discussed below.

If a former section 936 corporation (whether or not includible in a consolidated return group) continues its activities as a domestic corporation, section 382 will not apply to limit the carryover of NOLs or built-in losses in the absence of an "ownership change" (as defined in section 382(g)). The termination of sections 936 and 30A or the revocation of a section 936 election alone will not constitute an ownership change for that purpose.

If the section 936 corporation is an unaffiliated dual resident corporation or an unaffiliated domestic owner that has filed an agreement described in § 1.1503-2(g)(2) with respect to dual consolidated losses, becoming a member of a consolidated group may cause the dual consolidated losses to be recaptured pursuant to § 1.1503-2(g)(2)(iii)(A).

SECTION II. THE SECTION 936 CORPORATION LIQUIDATES INTO ITS DOMESTIC PARENT CORPORATION.

Another possible situation upon the termination of sections 936 and 30A (or earlier election revocation) is for the section 936 corporation to be completely liquidated into its domestic parent corporation.

Section 901(g)(1) provides a special rule for taxes paid or accrued to foreign countries or possessions of the United States with respect to distributions that are attributable to periods during which the distributing corporation was a "possessions corporation." For this purpose, the term "possessions corporation" includes section 936 corporations. See section 901(g)(2). Under this special rule, to the extent the distribution is received in connection with a liquidation with respect to which gain or loss is not recognized, such taxes shall not be treated as taxes paid to a foreign country or U.S. possession. As a result, no foreign tax credit or deduction shall be allowed with respect to any amount so paid or accrued.

If the section 936 corporation is an unaffiliated dual resident corporation or an unaffiliated domestic owner that has filed an agreement described in § 1.1503-2(g)(2) with respect to dual consolidated losses, the liquidation of such corporation may cause the dual consolidated losses to be recaptured pursuant to § 1.1503-2(g)(2)(iii)(A).

Section 381(c)(1) provides rules regulating the carryover of an NOL of a liquidating corporation to its parent corporation's first taxable year ending after the date of the liquidation. In particular, section 381(c)(1)(B) limits the deductibility of the NOL carryover for that taxable year of the parent to the proportion of the parent's taxable income that the number of days in the taxable year after the liquidation bears to the total number of days in the year. Also, section 381(b)(3) provides that the parent corporation may not carry back an NOL or a net capital loss for a taxable year ending after the date of the liquidation to a taxable year of the liquidated corporation.

If the parent corporation is a member of a consolidated return group, NOLs, built-in losses, and other tax attributes to which the parent corporation of a liquidated section 936 corporation succeeds are subject to the SRLY rules. The SRLY limitation applies to a carryover of NOLs from the subsidiary under § 1.1502-21, to built-in losses on assets distributed by the subsidiary under § 1.1502-15, and to certain other carryovers. All of the items of income, gain, deduction, and loss of the parent (that is, not solely the items attributable to the assets distributed by the subsidiary) are included for purposes of determining the SRLY limitation for the parent's taxable years after a section 332 liquidation. See § 1.1502-15(d), Example 1, part (iv) (applying a similar rule when assets are contributed to a corporation in a section 351 transaction).

The ACE adjustment under section 56(g)(4)(C) does not apply to a liquidation of a section 936 corporation into its parent corporation because, under section 331(b), a distribution in liquidation is not treated as a dividend.

SECTION III. THE SECTION 936 CORPORATION REINCORPORATES AS A FOREIGN CORPORATION.

A third possible situation upon the termination of sections 936 and 30A (or earlier election revocation) is for the section 936 corporation (or former section 936 corporation) to reincorporate as a foreign corporation. For these purposes, a foreign corporation includes a corporation formed under the laws of a possession of the United States. See section 7701(a)(5).

Section 367 generally will apply to transfers of property by a section 936 corporation to a foreign corporation without regard to whether the section 936 election is in effect at the time of the transfer. However, if the transfer is made while the section 936 election is in effect, the taxpayer may receive a possession tax credit with respect to income recognized on the transfer, to the extent such income is from sources outside the United States. See sections 936(a)(1)(A)(ii) and 30A(a)(1)(B).

Section 367(d) does not apply to the transfer of foreign goodwill or going concern value. Section 1.367(d)-1T(b). For this purpose, § 1.367(a)-1T(d)(5)(iii) defines "foreign goodwill or going concern value" as "the residual value of a business operation conducted outside the United States after all other tangible and intangible assets have been identified and valued." The transfer of a section 936 corporation's business to a foreign corporation typically will not involve the transfer of significant goodwill of the section 936 corporation to the foreign corporation, but it may in certain cases. Goodwill associated with a section 936 corporation's business operations in a possession, to the extent it exists, may or may not be considered "foreign goodwill" under § 1.367(a)-1T(d)(5)(iii), depending on the facts and circumstances.

Section 936 contains special rules regarding intangibles that may affect the application of section 367(d) to transfers of intangibles by a section 936 corporation or former section 936 corporation.

Section 936(h) provides that the intangible property income of a section 936 corporation -- that is, the gross income of a section 936 corporation attributable to any intangible property (other than intangible property that has been licensed to the section 936 corporation since prior to 1948) -- shall be included on a pro rata basis in the gross income of the shareholders of the section 936 corporation as income from sources within the United States. Under section 936(h)(5), however, the shareholders of a section 936 corporation are not required to recognize such intangible property income if an eligible section 936 corporation elects one of two alternative methods of computation of taxable income: (1) the cost sharing method of section 936(h)(5)(C)(i) ("section 936 CSM"); or (2) the profit split method of section 936(h)(5)(C)(ii) ("section 936 profit split method"). Under the section 936 CSM, the electing section 936 corporation pays a "cost sharing payment" (as defined in section 936(h)(5)(C)(i)(I)) and is treated as an owner (solely for purposes of earning a return thereon) of certain intangible property related to the section 936 corporation's economic activities in the possession. Under the section 936 profit split method, the electing section 936 corporation's taxable income is equal to 50 percent of the section 936(h)(5)(C)(ii)(II) "combined taxable income" of the affiliated group from covered sales of products produced or services rendered, in whole or in part, by the section 936 corporation in a possession.

Following the termination of sections 936 and 30A, the section 936 CSM and the section 936 profit split method will no longer apply and the income of a former section 936 corporation (or a successor entity), including income from intangibles, will be required to be determined under generally applicable federal income tax principles. Thus, for example, the arm's length amount charged in a controlled transfer of an intangible to a former section 936 corporation must be determined under one of the four methods listed in § 1.482-4(a), applied in accordance with all of the provisions of § 1.482-1, and must be commensurate with the income attributable to the intangible. In this regard, it is important to note that Congress intended for cost sharing under section 936(h)(5)(C)(i) to remain separate and distinct from cost sharing arrangements under section 482. See section 936(h)(5)(C)(i)(I) (providing that amounts paid under cost sharing agreements with related persons are not considered in the determination of section 936 CSM payments). A section 936 corporation does not obtain an interest in intangibles in exchange for payments it makes pursuant to an election of the section 936 CSM, but rather, it obtains a temporary limited entitlement to manufacturing intangible income. See section 936(h)(5)(C)(i)(II). That is, the statutorily determined section 936 CSM payment entitles the section 936 corporation to manufacturing intangible income only in the taxable year for which the payment is made. A section 14 936 corporation or a former section 936 corporation will accordingly not possess any interest in any intangible property as a result of payments made pursuant to an election of the section 936 CSM.

To the extent that a section 936 corporation (or a former section 936 corporation) does own intangible property ("possession- owned intangibles"), and transfers such property to a foreign corporation, certain of the section 367 consequences may depend on whether the section 936 election is in effect at the time of the property transfer. Under section 936(h)(6), when a section 936 corporation transfers possession-owned intangibles to a related foreign corporation, the shareholders of the section 936 corporation are generally required by section 936(h)(1) to include in gross income, on a pro rata basis, the annual payments provided for by section 367(d) as U.S. source ordinary income. In contrast, if a section 936 election is not in effect at the time of the transfer (for example, following the termination of sections 936 and 30A), the transferor of possession-owned intangibles (that is, a former section 936 corporation or a successor corporation) to a foreign corporation will itself be treated as having sold such possession-owned intangibles in exchange for the annual payments provided for by section 367(d), with the source of such payments generally determined by the applicable source rule in section 861(a)(4) or 862(a)(4), pursuant to section 865(d).

Section 1.243-3(b) provides that a foreign corporation shall, for purposes of section 243(e), maintain separate accounts for E&P to which it succeeds that were accumulated by a domestic corporation and for other accumulated E&P of the foreign corporation. Under § 1.316-2, every distribution made by a corporation is considered to be made first out of any current year E&P and then out of E&P accumulated in prior taxable years. With respect to the accumulated E&P of the foreign corporation, § 1.243-3(c) provides that dividends paid by the foreign corporation shall be treated as having been paid out of the most recently accumulated E&P of such foreign corporation (regardless of whether such E&P was accumulated by a predecessor domestic corporation or by the foreign corporation itself). To the extent that a dividend is paid out of E&P accumulated by the foreign corporation and by a predecessor domestic corporation for taxable years ending on the same day (so that neither is more recently accumulated), then the portion of such dividend considered paid out of each account shall be the same proportion of the total dividend as the amount of E&P in that account bears to the sum of the E&P in all such accounts. Thus, for example, if a section 936 corporation is reincorporated as a newly formed foreign corporation, and the foreign corporation subsequently makes distributions to its U.S. parent, the distributions will be treated as first coming from current E&P, then from accumulated E&P with the latest E&P accumulated being treated as distributed first. Subject to section 245, dividends from earnings accumulated by the foreign corporation itself generally will not be entitled to the DRD. However, dividends from E&P accumulated while the predecessor corporation was a section 936 corporation will be entitled to the DRD.

Section 901(g)(1) provides in relevant part that no credit or deduction is allowed for any tax that is paid or accrued to any foreign country or possession of the United States with respect to any distribution from a corporation to the extent such distribution is attributable to periods during which such corporation is a section 936 corporation and a DRD is allowable with respect to such distribution. As a result, no foreign tax credit or deduction is allowed with respect to any foreign or possession tax imposed on dividend distributions by a foreign corporation from earnings accumulated by a predecessor section 936 corporation.

For purposes of determining the alternative minimum foreign tax credit, section 56(g)(4)(C)(iii)(I) provides, subject to the limitation in section 56(g)(4)(C)(iii)(II), that 75 percent of any withholding or income taxes paid to a possession of the United States shall be treated as a tax paid to a foreign country by the corporation receiving the dividend. Taxes paid to a U.S. possession by a section 936 corporation shall be treated as a withholding tax paid with respect to any dividend distributed by such corporation to the extent such taxes would be treated as paid by the corporation receiving the dividend under rules similar to the rules of section 902. Section 56(g)(4)(C)(iii)(III). Section 56(g)(4)(C)(iii)(IV) provides that, in determining the alternative minimum foreign tax credit, section 904(d) shall be applied as if dividends from a section 936 corporation were a separate category of income referred to in a subparagraph of section 904(d)(1). To the extent a dividend distributed by a foreign corporation comprises E&P accumulated in taxable years for which an election under section 936 (or section 30A) was in effect (and to which the foreign corporation has succeeded), the recipient of the dividend will determine the alternative minimum foreign tax credit with respect to such part of the dividend pursuant to the rules provided in section 56(g)(4)(C)(iii).

Certain taxpayers may choose to continue to conduct business in a possession through a branch of a CFC organized or created elsewhere. Such a branch may constitute a manufacturing branch for purposes of the regulations under section 954(d)(2). Under certain facts and circumstances, income derived by a CFC with a manufacturing branch located outside the country under the laws of which the CFC is organized may constitute foreign base company sales income, a form of subpart F income that the United States shareholder must include in income. See § 1.954-3(b)(4), Example (2).

DRAFTING INFORMATION

The principal author of this notice is Edward R. Barret of the Office of Associate Chief Counsel (International). However, other personnel from the Service and the Treasury Department participated in its development. For further information regarding this notice contact Thomas A. Vidano or Edward R. Barret at (202) 435-5265 (not a tollfree call).