Attorney Comments on Foreign Tax Credit Proposal in H.R. 2896

[1] Section 3022 of H.R. 2896, the American Jobs Creation Act of 2003, would add a new section 901(1) to the Code extending the principles of section 901(k) to debt instruments and other property. Section 901(k) denies credits for withholding taxes on dividends on stock where the taxpayer holds the stock 15 days or less during the 30-day period beginning 15 days before the ex-dividend date. The change was recommended as part of the Administration's 2004 Revenue Proposals.¹

[2] For the reasons given below, section 901(1) is likely to have a much broader reach than likely was intended. Specifically, it would potentially deny credits for withholding taxes relating to interest on debt instruments that are guaranteed, or that are hedged against interest rate, currency or credit risk through derivatives, even if the taxpayer actually holds the instrument over its entire life. It would also potentially deny credits for taxes on loans with a very short term.

[3] New section 901(1)(3) would grant to the Treasury authority to cut back on the holding period requirement through regulations. There is, however, no guidance in existing descriptions of the bill (from the Treasury and Joint Committee on Taxation (August 13)) as to how the authority should be exercised. Also, the statute would have an immediate effective date (amounts paid or accrued more than 30 days after the date of enactment) and regulations likely would appear only after an extended delay. Rather than relying on administrative grace, it would be far preferable either (1) to conclude that a holding period requirement is not appropriate for debt and thus drop the extension of section 901(k) principles to debt, or (2) to address the attendant problems before the extension becomes effective.

[4] Section 901(k) denies credits for withholding taxes on dividends paid on stock where the stock is not held for a minimum period around the ex-dividend date. The section effectively extends to credits for withholding taxes the holding period requirement of section 246(c) applicable to the dividends received deduction (although with a required holding period of 16 days rather than 46). Section 901(k) is aimed at Compaq type "dividend capture" transactions in which a taxpayer buys stock shortly before a dividend is paid, claims a credit for withholding taxes imposed on income it did not earn economically and then sells the stock at a loss. Because it is difficult to measure the period over which dividend income is earned, the section does rough justice by requiring a minimum holding period.

[5] In applying the holding period test in section 246, paragraph (4) of section 246(c) disregards any period in which a taxpayer has a contract to sell or option on stock or, under regulations, has diminished its risk of loss by holding one or more other positions with respect to substantially similar or related property ("SSRP"). Treasury Regulation § 1.246-5 implements the SSRP rule. Section 901(k)(5) applies the hedge tolling rule of section 246(c)(4) for purposes of subsection (k).

[6] This letter comments on two aspects of the extension of section 901(k): the policy justification for extending section 901(k) to debt and the effect of hedges on the measurement of the holding period.

[7] The problems addressed in this letter are also relevant in applying the 45 day holding period test that is now part of the definition of reportable transactions.²

Reasons for Extension to Debt

[8] A threshold question is why the section 901(k) limitation should ever apply to a debt instrument. The ability to use credits to offset taxes on unrelated income is greatly restricted by the separate foreign tax credit basket for high withholding tax interest. Also, for debt instruments (unlike stocks), inclusions of interest income closely track economic income, so there would not seem to be any justification for limiting credits with respect to taxes imposed on interest that is included in a taxpayer's income.

[9] If a debt instrument pays interest periodically (say semi- annually), and a withholding tax is imposed on actual interest payments (the usual case), then a taxpayer who purchases the debt instrument shortly before an interest payment date could potentially claim credits on income the taxpayer did not earn. For example, if a debt instrument paid $60 of interest semi-annually subject to a tax of 10%, a taxpayer who purchased the instrument 15 days (half a month) before an interest payment date could claim a credit for a tax of $6 on $60 even though the taxpayer's income for the 15 day period would be only $5. However, for most taxpayers, any benefit would be substantially restricted by the foreign tax credit limitation. There is a separate limitation basket in section 904(d)(1)(B) for high withholding tax interest (interest subject to a withholding tax of at least 5 percent). This basket applies even to financial services entities. Thus if a taxpayer had $5 of interest income from a debt instrument and a credit of $6, it could generally claim the credit only to the extent of U.S. tax on its net income from the transaction (the gross interest of $5 less allocated funding and other expenses) unless it had excess limitation in the high withholding tax interest basket. By contrast, withholding taxes imposed at a high effective rate on portfolio dividends fall into the general limitation or financial services baskets.³

[10] Even if a holding period test were adopted, it should not limit taxes imposed on interest that accrues during the period the taxpayer owns the debt. Presumably, the purpose of the rule would be to curb the use of tax benefits on income that is "bunched" (allocated to a taxpayer but not earned by the taxpayer). Unlike dividends, the interest income reported by a taxpayer generally corresponds to the interest the taxpayer earns economically. This is true even if the taxpayer reports income under a cash method.⁴

[11] To illustrate a simple case where an exception for taxes on interest included in income would be clearly appropriate, suppose a taxpayer makes a 10 day loan to a borrower and interest on the loan is subject to withholding tax. The credit relates to interest the taxpayer earned and accordingly should not be denied under section 901(k) principles (as it would be under proposed section 901(1) absent regulations).

[12] The fact that income bunching is possible with stock but not with debt explains why there is a minimum holding period rule for stocks in cases where a taxpayer earns tax advantaged dividend income but no similar requirement for interest on municipal bonds. Municipal bond interest is properly allocated among successive holders so that taxpayers cannot implement an "interest capture" strategy resulting in artificial tax exempt interest income and a corresponding taxable loss.

Hedging of Debt Instruments

[13] The section 246(c)(4) hedge tolling period rule would also apply for purposes of section 901(1) (see section 901(1)(4), which invokes section 901(k)(5)). The section 246(c)(4) hedge rules were, of course, drafted with stocks in mind and do not work very well when applied to debt instruments.

[14] It would appear that no debt instrument can ever have a holding period under section 246(c)(4) applied in a most literal way. Revenue Ruling 94-28, 1994-1 C.B. 86, states that stock that takes the form of debt for non-tax purposes cannot have a holding period because the right to enforce payment of principal at maturity -- a feature of all debt instruments -- is an option to sell or a contractual right to sell for purposes of section 246(c)(4). It is obvious that the drafters of section 901(1) could not have intended the reasoning of this ruling to apply to debt instruments under section 901(1). The holding of the ruling does illustrate nicely that significant adjustments would be needed in extending stock hedging principles to debt instruments.

[15] The regulations under section 246(c)(4)(C) tolling the holding period for risk-reducing positions in SSRP raise a number of questions when applied to debt instruments. Specifically, they appear to deny a holding period for debt that is guaranteed, and also potentially for debt that is hedged against interest rate, currency or credit risk using derivatives unless curiously enough the hedge is a perfect hedge that is integrated with the debt.

[16] Treasury Regulation § 1.246-5(c)(4) provides that a taxpayer cannot have a holding period in stock that is guaranteed (assuming the guarantee provides for payments that will substantially offset decreases in the fair market value of the stock). Applying this rule (woodenly) to debt instruments, it would appear that any debt instrument that benefits from a guarantee would not have a holding period. Thus, if taxes are withheld on interest paid on a debt instrument that is issued by a corporation and guaranteed by its shareholder, arguably, no credits would be allowed. The same would be true for debt instruments benefiting from financial guarantee insurance or a letter of credit.

[17] Treasury Regulation § 1.246-5(b)(1) states that if the value of stock and other property primarily reflect the performance of the same economic factor or factors, including interest rates or currency, and changes in the fair market value of one approximates directly or inversely changes in the fair market value of the other, then the property is SSRP. In the case of stock, it is very rare for the value of stock to be sufficiently determined by interest rates or exchange rates so that a currency or interest rate hedge is SSRP. By contrast, the value of a debt instrument of a high-quality borrower is almost exclusively determined by these factors. Accordingly, if a taxpayer purchases such a debt instrument and enters into an interest rate swap and/or currency hedge, depending on the facts, the taxpayer could be denied a holding period under the SSRP rule.

[18] It is very common these days for banks and other lenders to own debt instruments and transfer some or all of their credit exposure to third parties using credit default swaps or other credit derivatives. Hedges against credit risk might also be considered positions in SSRP tolling the holding period. It would represent a significant change in the law to deny credits for withholding taxes in these circumstances.

[19] One curious consequence of applying the SSRP regulations to debt instruments is that "perfect hedges" may be treated better than imperfect ones. The reason is that a taxpayer can generally integrate a perfect hedge and a debt instrument under Treasury Regulation § 1.1275-6 or § 1.988-5. In that event, the hedge would no longer be a separate position and the holding period would not be tolled. It makes no sense from a policy perspective to prefer perfect hedges over imperfect ones in applying a risk-based tolling rule. The fact that the hedging rules when applied to debt have this result illustrates again that there are basic differences between debt instruments and stock (there are no integration rules for stocks).

[20] Anyone reading the parade of horribles set out above may be inclined to dismiss it on the ground that the results simply could not have been intended by the drafters. Well, if that is true, what do they intend? If the effort to extend section 901(k) to debt is not abandoned, it will be quite important to articulate the guiding principles in the legislative history so that taxpayers and the Treasury will know how to treat the very common cases discussed above.

Some Concluding Thoughts

[21] I understand that some of the conceptual problems discussed above have already been identified, and it was thought that they could be remedied by regulations. This approach suffers from two fairly significant drawbacks. First, the descriptions of the legislation that have surfaced to date give no hint of what the regulations might say, or even what the underlying policy issues are. Drafting regulations in a vacuum would be a difficult task. Second, there would likely be a very long period between the effective date of section 901(1) and the date when regulations are issued. It is quite unfair to expose taxpayers to the risk of losing credits during the gap period under a set of overly broad statutory rules, particularly when many of the taxpayers who will be affected are engaging in straightforward commercial activity that is not tax motivated.

[22] Congress should consider carefully whether an extension of section 901(k) to debt really is warranted in light of the differences between stock and debt discussed above. If it is so extended, the holding period test should apply only to withholding taxes imposed on interest that is not included in income by the taxpayer. To the extent there is a hedge tolling rule, it should not apply until taxpayers have notice of what the rules will be when applied in a debt setting.

[23] I would be pleased to discuss any of these points with you or your colleagues.

²The holding period test is found in Treasury Regulation § 1.6011-4(b)(7). I commented on that regulation in a letter to Jeffrey Paravano dated May 9, 2003. The reportable transaction rule is actually worse in one way than the proposed extension of section 901(k) in that it applies to net income taxes. Thus, it would affect conventional corporate income taxes imposed on interest on debt instruments held for 45 days or less.

³There is a high-taxed income kick out rule in section 904(d)(2)(A)(iii)(III) that converts otherwise passive income subject to tax at a high rate into general limitation income.

⁴When a cash-method taxpayer buys a debt instrument with accrued interest, the portion of the purchase price paid for the accrued interest is offset against the next interest payment. Treasury Regulation § 1.61-7(c).