U.S. FIRM LOSES CREDIT FOR FOREIGN TAXES DEEMED PAID AFTER FAILING TO PURSUE COMPETENT AUTHORITY REMEDY.

Rev. Rul. 92-75

ISSUE

If income is allocated from a foreign subsidiary corporation to its domestic parent corporation under section 482 of the Internal Revenue Code of 1986, under what circumstances, and in what amount, may the Internal Revenue Service reduce the amount of foreign income taxes paid or accrued by that foreign subsidiary to be used in computing foreign taxes deemed paid by the parent under section 902?

FACTS

P, a domestic corporation, owns all of the outstanding capital stock of S, a foreign corporation organized under the laws of foreign country FC. Both corporations use the calendar year as their taxable year.

In 1986 and 1987, P made sales of its products to S at prices below P's cost. The Service allocated income to P under section 482 of the Code for 1986 and 1987 to reflect arm's length selling prices.

In 1986 and 1987, P received dividends from S and claimed deemed paid foreign tax credits under section 902 of the Code based on the amount of country FC taxes paid by S in 1986 and 1987 before the section 482 allocations. The dividend paid by S to P in 1986 was paid out of earnings and profits accumulated in 1986. The dividend paid by S to P in 1987 was paid from earnings and profits accumulated subsequent to December 31, 1986. S did not seek refunds of its country FC taxes attributable to the income allocated from S to P in 1986 and 1987 under section 482, notwithstanding that a refund might be obtained if country FC accepted the section 482 allocation.

The United States has a tax treaty in force with country FC that provides for consideration between the Competent Authority of the United States and the Competent Authority of country FC. Rev. Proc. 91-23, 1991-1 C.B. 534, sets forth procedures for United States persons to obtain competent authority consideration if the United States or a foreign treaty country proposes or has made an allocation of income and/or deductions among related parties. P did not request the assistance of the Competent Authority of the United States to coordinate the amount of income tax due to country FC and the United States as a result of the adjustments made under section 482 of the Code, nor did S request similar assistance from the Competent Authority of country FC.

LAW AND ANALYSIS

Section 482 of the Code provides, in part, that in any case of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, the Secretary of the Treasury or the Secretary's delegate may distribute, apportion, or allocate gross income, deductions, credits or allowances between or among such organizations, trades, or businesses, if the Secretary or the Secretary's delegate determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

Section 901(a) of the Code allows a credit against United States income tax of domestic corporations for foreign income, war profits, and excess profits taxes paid or accrued or deemed to have been paid under section 902 during the taxable year.

Section 902(c)(6) of the Code, which is applicable to distributions out of earnings and profits that are not post-1986 undistributed earnings, provides, in general, that a domestic corporation that owns at least 10 percent of the voting stock of a foreign corporation from which it receives dividends in any taxable year is deemed to have paid a certain proportion of any creditable income tax paid or deemed to have been paid by that foreign corporation to any foreign country or to any possession of the United States on or with respect to the accumulated profits of such foreign corporation.

The effect of an allocation under section 482 of the Code on the computation of the deemed paid credit attributable to distributions out of earnings and profits that are not post-1986 undistributed earnings is explained in Rev. Rul. 74-158, 1974-1 C.B. 182; Rev. Rul. 76-508, 1976-2 C.B. 225; and Rev. Rul. 80-231, 1980-2 C.B. 219. Under the facts of Rev. Rul. 74-158, there was no tax treaty in force with country Y; thus, the ruling did not consider the consequences for the deemed paid credit of the failure to request competent authority assistance.

In Rev. Rul. 76-508, income is allocated from a foreign subsidiary, in a country with which the United States has an income tax convention, to its domestic parent under section 482 of the Code. The ruling concludes that the section 482 allocation reduces the amount of the foreign tax paid by the subsidiary to be used in computing the parent's deemed paid foreign tax credit under section 902, since neither the foreign subsidiary nor the domestic parent pursues its effective and practicable remedies, including a request for competent authority assistance, in seeking a reduction in the subsidiary's foreign tax liability.

In Rev. Rul. 80-231, there was no income tax treaty in force between the United States and the relevant foreign country. The ruling states that, except in certain egregious cases, if it is established that a foreign subsidiary did not pay tax in excess of its legal liability, that S exhausted all effective and practical remedies, and that country Z did not refund the voluntary overpayment, the voluntary overpayment will be treated as a tax expense item in the original year of S's accrual of the foreign tax liability.

Section 1202(a) of the Tax Reform Act of 1986, 1986-3 C.B. (Vol. 1) 445, amended section 902 of the Code to require a pooling of a foreign corporation's post-1986 undistributed earnings and post-1986 foreign income taxes as these terms are defined in section 902(c). Dividend distributions are considered to be made first from the foreign corporation's post-1986 undistributed earnings pool. A pro rata share of the post-1986 foreign income taxes paid by the foreign corporation are deemed to be paid by the dividend recipient with respect to distributions from the post-1986 undistributed earnings pool. Thus, the formula for determining the amount of the deemed paid credit under section 902(a) of the Code on distributions made out of post-1986 undistributed earnings is as follows:

   (Dividends (without regard to section 78) / Post-1986 earnings)

Section 902(a) does not authorize a domestic corporation to claim a credit for all payments made by its foreign subsidiary to a foreign country. Instead, it merely provides the proper method for computing the portion of the payment that may be credited if the payment otherwise qualifies as an "income tax" under section 901. In order for a payment to a foreign country to qualify as an income tax, it must be shown that the tax imposed by the foreign country is a tax on income within the United States concept thereof. Biddle v. Commissioner, 302 U.S. 573 (1938), 1938-1 C.B. 309; and section 1.901-2(a)(1).

An amount paid is not a compulsory payment, and thus is not an amount of tax paid, to the extent that the amount paid exceeds the amount of liability under foreign law for tax. See section 1.901- 2(e)(5)(i). Section 1.901-2(e)(5) of the Income Tax Regulations provides in part that an amount paid to a foreign government will not be considered to exceed the liability under foreign law for tax if the taxpayer exhausts all effective and practical remedies, including any available competent authority procedures under applicable tax treaties, to reduce the taxpayer's liability for foreign tax. If a taxpayer is aware (whether as a result of a proposed adjustment by the Service under section 482 of the Code or otherwise) of the possibility of securing a refund or reduction of foreign income tax liability but fails to pursue its remedies to secure such an adjustment, the amounts for which no adjustment was sought may be treated as noncompulsory payments to the foreign government. See section 1.901-2(e)(5)(ii), Examples (2) and (3), of the Regulations.

HOLDINGS

Accordingly, since P and S failed to exhaust their effective and practical remedies because they failed to invoke available competent authority procedures in seeking adjustment of S's country FC income tax liability, the reduction in S's income pursuant to allocations of income under section 482 of the Code will result in reductions of the amount of country FC taxes paid by S for 1986 and 1987 for purposes of computing foreign taxes deemed paid by P under section 902(a). The amounts paid to FC by S are not a liability of, or actually paid by, P. Therefore, these amounts are not deductible by P under section 164(a). Generally, the amounts paid to country FC reduce S's earnings and profits regardless of whether a foreign tax credit is allowed P for the amounts.

In computing the foreign taxes deemed paid, the District Director may adjust the section 902 computation with respect to distributions attributable to earnings and profits that are not post- 1986 undistributed earnings by removing the appropriate amount of non-tax payments (i.e., by recomputing the amount of taxes included in the multiplicand of the section 902 formula). If the District Director can determine the amount of foreign income taxes that would have been paid if the income, as adjusted by the section 482 allocation, had been correctly reported on S's country FC return, then the multiplicand will be adjusted to this amount. For this purpose, the United States Competent Authority may, at its option, consult with the Competent Authority of country FC pursuant to the applicable mutual agreement treaty provision. Inability of the District Director to determine this amount will require the use of another appropriate allocation method. With respect to distributions out of post-1986 undistributed earnings, the effect on undistributed earnings and on the foreign tax credit pools will be determined under sections 902, 905(c), and 964 and the regulations thereunder.

EFFECT ON OTHER RULINGS

Rev. Rul. 76-508, 1976-2 C.B. 225, is superseded and Rev. Rul. 80-231, 1980-2 C.B. 219, is modified.

DRAFTING INFORMATION

The principal author of this revenue ruling is Ed Williams, Office of the Associate Chief Counsel (International). For further information on the ruling, call Mr. Williams on (202) 874-1490 (not a toll-free call).