Ernst & Young Comments on Foreign Tax Credit Splitter Rules

Dear Ginny and John:

We appreciate the opportunity to discuss with you and your colleagues our June 27th letter regarding the potential overlap between Section 901(m), which denies the foreign tax credit for certain foreign taxes related to "covered asset acquisitions," and new Section 909, which suspends the foreign tax credit for certain foreign taxes where there has been a "foreign tax credit splitting event." That submission focused in particular on the complexities and inequities that would arise if Section 909 were to be applied retrospectively to related party covered asset acquisitions that occurred prior to the 2011 effective date of Section 901(m) and urged Treasury and the IRS not to take such an approach in any guidance that is issued. Our submission also encouraged the government to take a narrow approach to any potential application of Section 909 to related party covered asset acquisition type transactions on a going forward basis so as to avoid unduly harsh results.

With this letter, we would like to address the suggestion that it might be appropriate to apply Section 909 to pre-2011 covered asset acquisition type transactions if the transaction occurred after the date of enactment of Section 901(m) or, alternatively, after the date that the covered asset acquisition concept first was included in proposed legislation. For the reasons discussed below, we believe that any application of Section 909 to a covered asset acquisition type transaction that occurred before the Section 901(m) effective date would be unwarranted and would be inconsistent with legitimate taxpayer expectations.

In addition, we would like to elaborate further on our prior comments on the broader implications of any potential application of Section 909 to covered asset acquisition type transactions involving related parties on a going forward basis. For the reasons discussed below, we believe that rather than a somewhat strained application of Section 909 to these types of transactions, the best approach would be the application of Section 901(m) to all covered asset acquisition type transactions with an exception for related party transactions that do not result in any potential for foreign taxes to be taken into account for foreign tax credit purposes any earlier than when the associated income is taken into account for U.S. tax purposes.

Section 901(m) is a targeted provision aimed at a particular type of transaction and enacted with a purely prospective transaction-based effective date. At the time the legislation that included both new Section 901(m) and new Section 909 was enacted, there was no indication that a transaction that fell within the definition of a covered asset acquisition could also be subjected to Section 909. Taxpayers could not reasonably have anticipated that the foreign tax credit consequences arising from a covered asset acquisition type transaction consummated before the 2011 effective date of Section 901(m) could be affected by Section 909. Moreover, with the significant changes to the foreign tax credit regime brought by the legislation, many taxpayers reassessed their corporate structures and undertook some restructuring in order to better align their structures with the new rules coming into force in 2011. Indeed, the effective dates of both provisions were structured in a way that provided time for taxpayers to make such adjustments and that encouraged the repatriation of earnings back to the United States which could necessitate restructuring. It would be inappropriate to penalize taxpayers that followed the effective date of Section 901(m) by subjecting transactions undertaken before 2011 to treatment under Section 909 that could be harsher than the treatment that would be accorded by Section 901(m) after its effective date.

Looking at the reach of Section 901(m) on a going forward basis, we share the concern expressed by Treasury and the IRS that denial of foreign tax credits is inappropriate in the case of covered asset acquisition type transactions involving related parties where the income on the transaction is subject to tax in the United States. However, application of Section 909 to related party covered asset acquisitions would result in harm rather than relief in those situations where the income and foreign taxes cannot be matched up such that the result would be no foreign tax credit and a denial of the deduction for foreign taxes that would be available under Section 901(m). Rather than attempting to apply Section 909 across the board to all related party covered asset acquisition type transactions, the better approach would be to apply Section 901(m) to such transactions subject to an exception for situations in which income related to the transaction would be included in a U.S. tax return no later than when the foreign taxes that otherwise would be disqualified are taken into account for U.S. foreign tax credit purposes.

Section 909 and Section 901(m) both were enacted on August 10, 2010 and both have generally prospective effective dates. Both provisions apply to foreign income taxes paid or accrued in a post-2010 taxable year. However, in certain situations, Section 909 may apply to foreign income taxes paid or accrued before the 2011 taxable year. In the case of foreign income taxes that are paid or accrued by a Section 902 corporation in tax years beginning before 2011 and that are not considered to be deemed paid for U.S. tax purposes before 2011, Section 909 applies to such taxes for purposes of the application of Sections 902 and 960 with respect to periods after 2010. In this regard, Notice 2010-92 limits the reach of Section 909's application to foreign taxes paid or accrued in pre-2011 taxable years, including limiting the types of transactions that are considered to be within the scope of Section 909 for purposes of its application to pre-2011 taxes to four enumerated transactions. In contrast to the Section 909 effective date which is based solely on the date foreign taxes are paid or accrued, the Section 901(m) effective date is solely transaction-based. Thus, Section 901(m) is purely prospective and does not apply in any way to a pre-2011 covered asset acquisition, without regard to whether foreign taxes that could be considered to have some connection to that transaction are paid or accrued in 2011 or beyond.

In addressing the potential overlap between Sections 901(m) and 909 that was identified in Notice 2010-92, Treasury and IRS officials have indicated publicly that consideration is being given to suspending Section 901(m) as it applies to certain related party covered asset acquisitions and instead applying Section 909 to such transactions. Under such an approach, it appears that a covered asset acquisition could be treated as a foreign tax credit splitting event by treating the initial transferor's gain that is recognized for U.S. tax purposes but not for foreign tax purposes as "related" to future foreign taxes of the transferee that are associated with the assets acquired in the covered asset acquisition, with those foreign taxes potentially subject to suspension under Section 909. If the transferor and transferee in the covered asset acquisition are related parties such that the transferor is a covered person with respect to the transferee and if Section 909 were to be applied to such a covered asset acquisition, the future foreign taxes related to the covered asset acquisition would be allowed for foreign tax credit purposes if and when the transferor's related income is "matched" with the suspended foreign taxes.

The rationale for potentially overriding Section 901(m) for related party covered asset acquisitions and instead applying Section 909 to such transactions seems to be that where the income that is considered related to the future foreign taxes following the covered asset acquisition ultimately is taken into account for U.S. tax purposes it is appropriate to allow the taxpayer the credit for such foreign taxes. Thus, the concept of applying Section 909 instead of Section 901(m) to such transactions has at its core an assumption that the taxpayer will be able to credit the foreign taxes related to the income generated by the covered asset acquisition. However, as discussed in more detail below, this frequently will not be the result. Because Section 909 suspends both credits and deductions for foreign taxes associated with a foreign tax credit splitting event, the taxpayer would end up with a harsher result than is provided for in Section 901(m) with respect to covered asset acquisitions in those situations where the future foreign taxes cannot be matched up with the earlier gain. In such cases, subjecting those covered asset acquisitions to Section 909 instead of Section 901(m) would result in the additional cost of the loss of the foreign tax deduction that is available under Section 901(m).

For the reasons discussed in our earlier letter and elaborated below, we believe that application of Section 909 across the board to Section 901(m) type transactions involving related persons would lead to unintended results that would be overly harsh. If it were nevertheless to be decided to apply Section 909 and not Section 901(m) to certain related party covered asset acquisitions, it is our view that there would be no basis for applying such treatment to covered asset acquisition type transactions that occurred before the 2011 effective date of Section 901(m).

As noted in our prior submission, Section 901(m) is a targeted provision, specifically tailored to address one particular set of transactions: transactions that result in a step-up in basis for U.S. tax purposes but not for foreign tax purposes and that therefore may on a going forward basis give rise to cost recovery deductions for U.S. tax purposes that exceed the amounts allowable for foreign tax purposes. The Section 901(m) prospective effective date is consistent with the targeted transactional nature of Section 901(m). Transaction-based provisions typically apply on a prospective basis only and typically do not apply to modify the results stemming from transactions that were concluded before the overall effective date of the provision.

By contrast, Section 909 is a more general provision that potentially could apply across a wide range of arrangements. Section 909 can apply to suspend a taxpayer's ability to credit foreign taxes in post-2010 taxable years regardless of when the arrangement or transaction that gave rise to the "split" between taxes and income occurred. Moreover, subject to the limitations reflected in Notice 2010-92, Section 909 can apply to suspend the ability to credit foreign taxes in post-2010 taxable years even though the taxes were paid or accrued in a pre-2011 year. This non-transactional based structure of the Section 909 effective date does not mesh naturally with the circumstances of a Section 901(m) type transaction. While the difference in the structure of the effective dates of the two provisions creates a potential trap in which Section 909 could be applied to a covered asset acquisition type transaction that occurred before the effective date of Section 901(m), the imposition of Section 909 in such circumstances would be an unfair trap for the unwary.

There is no indication in the legislative history to Section 901(m) and Section 909 that a transaction that constituted a covered asset acquisition subject to Section 901(m) could also be treated as a foreign tax credit splitting event subject to Section 909. On the contrary, it was not unreasonable to infer that the more general provision of Section 909 was not intended to apply to a transaction that fell within the more targeted provision of Section 901(m). Section 901(m) applies both to unrelated party transactions, where Section 909 has no possible relevance, and to related party transactions, where Notice 2010-92 identified the possibility of an overlap. With respect to unrelated party transactions, the legislation included a special grandfather provision for covered asset acquisitions involving unrelated persons that were already in process and that otherwise would be subject to Section 901(m).³ This grandfather provision potentially further extended the already explicitly prospective effective date of Section 901(m) for unrelated party transactions. While this grandfather rule does not apply to Section 901(m) transactions involving related parties, the legislation did not in any way indicate that such transactions could be affected by another provision with an earlier effective date than the overall Section 901(m) effective date. It strains credibility that taxpayers would have reasonably anticipated that a covered asset acquisition consummated prior to the Section 901(m) effective date nevertheless could be subject to adverse foreign tax credit treatment under a separate provision of the same legislation.

The legislation that enacted Sections 901(m), 909 and 960(c) significantly altered the landscape of the U.S. foreign tax credit system. The U.S. international tax regime shifted from more of a pure pooling of foreign taxes for foreign tax credit purposes to more of a matching approach. The effective dates reflected in the legislation, which was enacted in August 2010, are consistent with Congressional awareness that taxpayers would need a limited period to align their corporate groups more rationally with the new framework. The Section 901(m) effective date allowed taxpayers to go forward with transactions until 2011 without regard to covered asset acquisition treatment. Indeed, in many instances, transactions that were done during the post-enactment, pre-effective date period were undertaken for the purpose of better aligning the taxpayer's structure for the whole set of new foreign tax credit rules coming into force.

Similarly, the Section 909 effective date allowed taxpayers to take prophylactic measures in advance of the application of the new provision. Section 909 only applies to foreign taxes that are not considered to be deemed paid for U.S. tax purposes before 2011. Under this effective date, taxpayers are entitled to foreign tax credits for pre-2011 taxes without regard to the provisions of Section 909, so long as such taxes are brought back to the United States prior to the 2011 taxable year.⁴ The provision thus was structured in a way that encouraged taxpayers to repatriate dividends prior to their 2011 taxable year. In order to mobilize cash in a tax-effective manner overseas to pay such a dividend and in order to make a distribution in a country that has limitations on the ability to pay dividends under the applicable corporate law or due to distributable reserves rules, in many instances it was necessary for taxpayers to undertake restructuring transactions before their 2011 taxable year that could well have included covered asset acquisition type transactions done before the Section 901(m) effective date. Such transactions allowed taxpayers to repatriate earnings as required under the Section 909 effective date and to do so without incurring foreign withholding taxes. A decision at this point to apply Section 909 to a Section 901(m) type transaction that occurred before the January 2011 effective date of Section 901(m) would be inconsistent with the overall approach reflected in these effective dates of allowing taxpayers time to realign and restructure before imposition of the new provisions.

This overall effective date approach of the legislation was reflected in Notice 2010-92's further mitigation of the potential effects of Section 909 with respect to events that occurred before the effective date of the new legislation. The Notice limited the types of transactions that are considered to be within the scope of Section 909 for purposes of its application to pre-2011 foreign taxes to four specified transactions for which, arguably, taxpayers had long been on notice regarding potential restrictions on foreign tax credits. In this regard, it is notable that the dividing line in the Notice keyed off the effective date of the new legislation -- post-2010 taxable years -- and not the enactment date of the legislation. Thus, foreign taxes paid or accrued in pre-2011 taxable years attributable to a transaction that could be a foreign tax splitting event but that is not enumerated in the Notice are not subject to Section 909 even where such taxes are paid or accrued after the enactment date of the new legislation.

The approach adopted in the Notice for defining "post-2010 taxable years for section 902 corporations" also bears noting. The Notice provided that section 909 does not apply in computing foreign taxes deemed paid under Sections 902 or 960 before the first day of the section 902 corporation's first post-2010 taxable year (i.e., taxable years beginning after December 31, 2010). The Notice is clear that the effective date is determined based on the taxable year of the section 902 corporation and not on the taxable year of the U.S. shareholder. This effective date, as elaborated in the Notice, provides taxpayers with section 902 corporations that use a taxable year other than the calendar year with additional time to restructure arrangements in place that could potentially give rise to a foreign tax credit splitting event on a going forward basis.

As discussed above, following the enactment of the August 2010 legislation and its several significant foreign tax credit changes, many taxpayers reassessed their existing corporate structures and engaged in some restructuring to rationalize their operations with the new foreign tax credit regime going forward. The legislation included effective dates that allowed a limited period before the provisions took effect and that effectively encouraged restructuring activity. Thus, taxpayers reasonably expected the foreign tax credit provisions then applicable to apply to the restructuring transactions undertaken to realign their structure in anticipation of the application of the new provisions in future years. It would be inappropriate subsequently to penalize such taxpayers by overriding the specific effective date adopted by Congress for covered asset acquisition type transactions.

Based on the public comments of Treasury and IRS officials, the concept of applying Section 909 instead of Section 901(m) to related party covered asset acquisitions would be meant to provide relief from the permanent denial of foreign tax credits under Section 901(m) in situations where the income associated with the transaction is recognized by the taxpayer in the United States and matched with the future foreign taxes. Taxpayers, depending on their tax posture, however, may be unable to match future foreign taxes to the income attributable to the covered asset acquisition, in which case the application of Section 909 would yield a harsher result than Section 901(m). In such a case, the taxpayer would be denied the ability to deduct the foreign taxes in addition to being denied the foreign tax credit. On a going forward basis, if a decision were to be made to apply Section 909 to certain related party covered asset acquisitions, taxpayers would be able to consider the implications of this before entering into a transaction. However, applying Section 909 to Section 901(m) type transactions that occurred before the 2011 effective date of Section 901(m) would be patently unfair. Taxpayers that followed the clear effective date of Section 901(m) could end up being penalized by being subjected to a result that would be worse than if Section 901(m) were applied to the transaction without regard to its prospective effective date.

Covered asset acquisitions should be subject to section 901(m) with an exception for related party transactions where there is no potential for taking foreign taxes into account for foreign tax credit purposes any earlier than when the associated income is taken into account for U.S. tax purposes.

As discussed in our prior submission, Treasury and the IRS should give careful consideration to the implications of applying Section 909 across the board to related party transactions that otherwise would be subject to Section 901(m). The application of Section 909 to such transactions could yield significantly harsher consequences than application of Section 901(m). As discussed above, taxpayers that cannot match the income on a covered asset acquisition type transaction with the future foreign taxes would lose the deduction for the foreign taxes that is available under Section 901(m). Further, for post-2010 taxable years, section 902 corporations that paid or accrued foreign taxes would be precluded from reducing their E&P under Section 964(a) for such payment or accrual until the related income is taken into account. Disallowance of the E&P deduction in connection with a covered asset acquisition type transaction would dilute the post-1986 earnings pool of the section 902 corporation such that the taxpayer would not be able to fully credit foreign taxes wholly unrelated to the transaction.

There are a variety of different circumstances in which the income on a covered asset acquisition type transaction may never be "married up" with the future foreign taxes with respect to the acquired assets. In our prior submission, we noted the example of a situation involving a Section 338 election. Moreover, because the covered person standard of Section 909 contemplates an ownership interest as low as 10%, this difficulty could arise in common joint venture situations. A U.S. corporation that participates in a foreign joint venture may transfer assets to the joint venture in a transaction that qualifies as a covered asset acquisition. The U.S. owner may have only a minority interest in the joint venture and thus may not be able to ensure the matching of the income to the future foreign taxes. The majority owner may dispose of the relevant assets or may enter into other transactions that could curtail or eliminate any likelihood of ever matching the income and the future foreign taxes. While these issues can arise in any joint venture situation to which Section 909 may be applicable, the risk of never being able to match income and taxes would be particularly high in the context of a covered asset acquisition type transaction where the income is recognized in advance of the imposition of the taxes.

Moreover, even though applying Section 909 to a covered asset acquisition type transaction could provide some relief for those taxpayers that are able to match up the income and taxes, the potential for such relief may not be worth the complexity and uncertainty. In many situations the taxpayer may well prefer the certainty of the current deduction for the disallowed foreign taxes that is allowed under Section 901(m) over the theoretical benefit of perhaps being able at some point in the future to credit such taxes under an application of Section 909.

We acknowledge that guidance clearly is needed regarding which provision would apply in the case of a Section 901(m) covered asset acquisition type transaction that could fall within the broad reach of Section 909. If both provisions were considered to be applicable, the treatment that would result would be both complicated and burdensome. The concurrent application of the two provisions could have the effect of suspending taxes under Section 909 without allowance of a current deduction for such taxes. If the taxpayer were to manage ultimately to match the income with the foreign taxes, such taxes would be "unsuspended" but Section 901(m) could kick in then to trigger a denial of foreign tax credits. However, it is not clear how the Section 901(m) computations would work at that point.

We agree with the concern of Treasury and the IRS that it would be unfair to deny foreign tax credits related to a covered asset acquisition type transaction where the income with respect to such transaction is recognized by a U.S. person. However, a forced application of Section 909 to any covered asset acquisition type transaction involving a related person that meets the covered person definition may well cause more harm than provide relief. There is no rationale for penalizing taxpayers by denying the deduction for foreign taxes allowed under Section 901(m) because their transaction is forced into Section 909 notwithstanding that they may be unlikely to benefit from the hypothetical ability to claim future foreign tax credits.

Rather than trying to force covered asset acquisition type transactions into Section 909, we believe that the best approach would be to continue to apply Section 901(m) to these transactions. The legitimate concern expressed by Treasury and the IRS that applying Section 901(m) to covered asset acquisition type transactions where the related income subsequently is recognized in the United States would be overly harsh could best be addressed by providing an exception to Section 901(m) for related party transactions that meet specified conditions. Such an exception would be applicable to any transaction where the disallowance of credits provided under Section 901(m) is unnecessary because the income with respect to the transaction is taken into account on a U.S. tax return not later than when the foreign taxes with respect to the acquired assets would be taken into account for foreign tax credit purposes.

Under this approach, the exception to Section 901(m) would apply, for example, in the situation of a covered asset acquisition type transaction undertaken by a U.S. parent or by a CFC that repatriates all its income back to the United States on a current basis. In such cases, the future foreign taxes would relate to income that the United States already has subjected to tax. Another example of when the exception would apply is the situation of a taxpayer that repatriates the foreign income back to the United States before or at the same time as the foreign taxes are to be taken into account as a credit for U.S. tax purposes. In this case as well, the income would be recognized for U.S. tax purposes by the time the treatment of the foreign taxes for U.S. foreign tax credit purposes is at issue. In sum, the rationale for this proposed approach of applying Section 901(m) subject to an exception is that as long as the income related to a covered asset acquisition type transaction would be included in a U.S. tax return no later than when the foreign taxes that otherwise would be disqualified are relevant for U.S. foreign tax credit purposes, the equitable result would be to allow taxpayer the full benefit of the foreign tax credit and there would be no need to apply Section 901(m) to such a transaction.

In addition, we continue to believe that Treasury and the IRS should take a cautious approach in any application of Section 909 to Section 901(m) transactions on a going forward basis. Rather than overriding Section 901(m) with Section 909, those situations where the foreign tax credit denial of Section 901(m) seems improper because the income is recognized in the United States would best be addressed by providing targeted relief in the form of an exception to Section 901(m) for circumstances that do not result in any potential for taking foreign taxes into account for foreign tax credit purposes any earlier than when the associated income is taken into account for U.S. tax purposes.

If you have questions or would like further information, please contact one of us. We have appreciated the opportunity to discuss these important issues with you and we would welcome the chance to discuss the points in this letter in more detail.

² A covered asset acquisition is a transaction that generally results in a step-up in the basis for U.S. tax purposes of the assets of the acquired entity computed by reference to the fair market value that was paid in the acquisition without a similar step-up in basis for foreign tax purposes. As a result, the cost recovery deductions (e.g., amortization, depreciation or depletion) for U.S. tax purposes following such a transaction generally exceed the amount of such allowances for foreign tax purposes.

³ Specifically, Section 901(m) does not apply to any covered asset acquisition that involves unrelated parties if such acquisition is: (1) made pursuant to a written agreement which was binding on January 1, 2011 and at all times thereafter; (2) described in a ruling request submitted to the Internal Revenue Service on or before July 29, 2010; or (3) described in a public announcement or in a filing with the Securities and Exchange Commission on or before January 1, 2011.

⁴ Notably, Section 909 was not structured so as to apply to all taxes that were deemed paid after the August enactment date. Instead, the effective date of Section 909 allowed taxpayers the opportunity to take protective measures with respect to foreign taxes paid or accrued before the 2011 taxable year.