n-04-19.pdf

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Part I – Rulings and Decisions Under the Internal Revenue Code of 1986

Foreign Tax Credit Abuse

Notice 2004-19

PURPOSE

The purpose of this Notice is to describe the approach that the Treasury
Department and the Internal Revenue Service (IRS) are using to address transactions
involving inappropriate foreign tax credit results and to withdraw Notice 98-5, 1998-1
C.B. 334, because Treasury and the IRS do not intend to issue regulations in the form
described in that notice.

BACKGROUND

Notice 98-5 announced that Treasury and IRS intended to issue regulations that
would apply an economic profit test to address abusive tax-motivated transactions that
generate foreign tax credits that can be used to reduce residual U.S. tax on other
foreign source income. Part II of Notice 98-5 describes two classes of transactions that
create the potential for foreign tax credit abuse. The first class includes transactions
that effectively transfer a foreign tax liability through the acquisition of an asset that
generates an income stream subject to foreign gross basis taxes such as withholding
taxes. The second class includes cross-border tax arbitrage transactions that
effectively permit the duplication of tax benefits. Notice 98-5 contemplated that
regulations would apply an economic profit test to disallow credits for foreign taxes
generated in an arrangement such as those described above if the reasonably expected
economic profit were determined to be insubstantial compared to the value of the
foreign tax credits expected to be obtained as a result of the arrangement. Notice 2003-
76, 2003-49 I.R.B. 1181, and its predecessors identified transactions that are the same
as or substantially similar to transactions described in Part II of Notice 98-5 as listed
transactions for purposes of the tax shelter disclosure, registration, and list maintenance
requirements of §1.6011-4 of the Income Tax Regulations and §§301.6111-2 and
301.6112-1 of the Procedure and Administration Regulations.

DISCUSSION

Treasury and the IRS do not intend to issue regulations in the form described in
Notice 98-5. Accordingly, Notice 98-5 is withdrawn. Consistent with this withdrawal,
Notice 2003-76 is modified by eliminating the reference to Notice 98-5 in the
identification of listed transactions. Accordingly, transactions will not be considered
listed transactions for purposes of §§1.6011-4(b)(2), 301.6111-2(b)(2), and 301.6112-
1(b)(2) solely because they are the same as or substantially similar to the transactions

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or arrangements described in Part II of Notice 98-5. No inference is intended, however,
as to whether such transactions are otherwise subject to the disclosure requirements of
section 6011, the registration requirements of section 6111, or the list maintenance
requirements of section 6112 .

Treasury and the IRS remain concerned about transactions that involve
inappropriate foreign tax credit results. The tax benefits claimed in these transactions
are inconsistent with the purposes of the foreign tax credit provisions, including the
foreign tax credit limitation of section 904, which are intended to reduce or eliminate
double taxation of income.

The IRS will continue to scrutinize abusive transactions that are designed to
generate foreign tax credits. In appropriate circumstances, the IRS will challenge the
claimed tax consequences of such transactions under the following principles of existing
law: the substance over form doctrine, the step transaction doctrine, debt-equity
principles, section 269, the partnership anti-abuse rules of §1.701-2, and the substantial
economic effect rules of §1.704-1.

Treasury also has proposed legislative changes to address transactions involving
inappropriate foreign tax credit results. Section 901(k), which was enacted in 1997,
disallows a credit for certain foreign taxes paid with respect to a dividend if the recipient
of the dividend does not meet certain holding period requirements or is under an
obligation to make related payments with respect to substantially similar or related
property. The Administration’s FY 2005 Budget includes a proposal to expand section
901(k) to apply to foreign taxes with respect to income or gain other than dividends
(such as interest, rents, and royalties), disallowing a credit for foreign withholding taxes
if the recipient of the income or gain does not meet certain holding period requirements
with respect to the asset generating the income or is under an obligation to make
related payments with respect to substantially similar or related property. See
Department of the Treasury, General Explanation of the Administration’s Fiscal Year
2005 Revenue Proposals at 113 (Feb. 2004). This proposed expansion of section
901(k) addresses the first class of transactions described in Notice 98-5. This proposal
was also included in the Administration’s FY 2004 Budget and has been incorporated in
pending proposed legislation. See Department of the Treasury, General Explanation of
the Administration’s Fiscal Year 2004 Revenue Proposals, at 103 (Feb. 2003);
American Jobs Creation Act, H.R. 2896, 108
th
Cong. §3022 (2003); Jumpstart Our
Business Strength Act, S. 1637, 108
th
Cong. §456 (2003).

The Administration’s FY 2005 Budget also includes a proposal for broad
regulatory authority to address transactions that involve inappropriate separation of
foreign taxes from the related foreign income in cases where foreign taxes are imposed
on any person with respect to income of an entity. The regulations that would be issued
under this proposed authority may provide for the disallowance of a credit for all or a
portion of the foreign taxes or for the allocation of the foreign taxes among the
participants in the transaction in a manner that is more consistent with the underlying
economics of the transaction. The Administration’s FY 2005 Budget proposal to expand

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existing regulatory authority is intended to provide additional mechanisms for Treasury
and the IRS to address the second class of transactions described in Notice 98-5 as
well as other abusive transactions involving foreign tax credits.

Treasury and the IRS will use existing authority under section 901 and other
provisions of the Code to address transactions or structures that produce inappropriate
foreign tax credit results. The 2004 business plan for published guidance includes
regulations addressing the allocation of foreign taxes by a partnership under section
704. In particular, the regulations will address situations involving special allocations of
foreign taxes among the partners that are inconsistent with the allocation of the related
foreign income. Treasury and the IRS expect to issue these regulations shortly.
Treasury and the IRS also are working on guidance under section 901 concerning the
application of the legal liability rule of §1.901-2(f) in certain circumstances, including, for
example, in the case of consolidated tax reporting systems in foreign countries. These
regulations are intended to provide rules that make the allocation of foreign taxes
imposed on the combined income of two or more persons more consistent with each
person’s respective share of the foreign income to which the tax relates.

Notice 2004-20, issued concurrently with this Notice, identifies as a listed
transaction for purposes of the tax shelter disclosure, registration, and list maintenance
regulations a purported stock acquisition that is intended to generate credits for foreign
taxes paid on gain that is not subject to tax in the United States. That notice provides
that the IRS will challenge the purported foreign tax credit results where a domestic
corporation purportedly acquires the stock of a foreign target corporation, makes a 338
election, and then, pursuant to a prearranged plan, sells all or substantially all of the
target corporation’s assets in a transaction that generates a taxable gain for foreign tax
purposes (but not for U.S. tax purposes). Treasury and the IRS also are considering
amending §1.338-9(d) (concerning the allocation of foreign taxes of a target that accrue
after the stock acquisition and section 338 election) to address cases in which the target
is liquidated (either in a liquidation under local law or by making an election under
§301.7701-3 to treat the target as a disregarded entity) before the end of its foreign
taxable year and to address the allocation of foreign taxes imposed on post-acquisition
sales in order to prevent inappropriate foreign tax credit results. Treasury and the IRS
anticipate that such amendments only would apply prospectively.

In addition, Treasury and the IRS are working on modifications to the tax shelter
disclosure regulations of §1.6011-4(b) (identifying transactions subject to the disclosure
requirements) to ensure that the regulations require appropriate reporting of potentially
abusive transactions involving foreign tax credits. In particular, Treasury and the IRS
are considering revisions to the tax shelter disclosure regulations to require reporting of
transactions that effectively separate foreign taxes from the related foreign income,
including transactions that create a mismatch in the timing of recognition for U.S. tax
purposes of foreign taxes and the related foreign income.

EFFECT ON OTHER DOCUMENTS

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Notice 98-5 is withdrawn. Notice 2003-76 is modified by eliminating the
reference to Notice 98-5 in the identification of listed transactions. Effective for taxable
years for which the due date of the return (including extensions, whether or not actually
requested) is after February 17, 2004, transactions will not be considered listed
transactions for purposes of §§1.6011-4(b)(2) and 301.6112-1(b)(2) solely because they
are the same as or substantially similar to the transactions or arrangements described
in Part II of Notice 98-5. Effective for offers made after February 17, 2004, transactions
will not be considered listed transactions for purposes of §301.6111-2(b)(2) solely
because they are the same as or substantially similar to the transactions or
arrangements described in Part II of Notice 98-5. No inference is intended, however, as
to whether such transactions are otherwise subject to the disclosure requirements of
section 6011, the registration requirements of section 6111, or the list maintenance
requirements of section 6112.

DRAFTING INFORMATION

The principal author of this notice is Ginny Chung of the Office of Associate Chief
Counsel (International). For further information regarding this notice contact Ms. Chung
on (202) 622-3850 (not a toll-free call).