Rev. Rul. 84-143

ISSUES

(1) Whether the use of the Mexican `official` exchange rate to convert to dollars the interest and Mexican withholding tax payments, made in pesos by Mexican borrowers with respect to dollar loans made by a United States bank (the taxpayer), constitutes a Mexican government tax subsidy within the meaning of the foreign tax credit regulations.

(2) What is the appropriate rate of exchange at which to translate (from pesos to dollars) the Mexican withholding tax on interest payments made by Mexican borrowers to the taxpayer for purposes of computing the foreign tax credit under sections 901 and 903 of the Code?

FACTS

The taxpayer is a domestic commercial bank that has dollar denominated loans outstanding in Mexico. The taxpayer structures its loan transactions in two different ways: (1) the borrower remits the net amount of interest to the taxpayer (interest due less withholding tax), pays the tax withheld to the Mexican government, and provides the taxpayer with a receipt of payment (gross loans); and (2) the borrower remits to the taxpayer the gross amount of interest due, pays the withholding tax, to the Mexican government, and is reimbursed by the taxpayer for payment of the withholding tax upon presentation of a receipt of payment (reimbursement loans).

In December 1982, Mexico enacted the Mexican Exchange Control Decree (CCD), effective as of December 20, 1982, which established a dual exchange rate system, comprised of a controlled official exchange rate and a free exchange rate. Under the CCD, the Mexican government controls the major portion of foreign currency available in Mexico and makes it available for payment of priority obligations at the official exchange rate. Among the transactions governed by the official exchange rate are: (1) exports of merchandise by any natural or legal person (except those exempted by reason of impracticality or inappropriateness); (2) imports of merchandise and related verifiable expenses payable abroad, as well as credit extended by the suppliers of such merchandise; (3) payment of principal and interest on foreign currency loans payable abroad to foreign financial entities and Mexican credit institutions that are contracted for after the effective date of the CCD; and (4) payment of expenses of the Mexican Foreign Service and payments for Mexico's participation in international organizations. Transactions not governed by the official exchange rate take place at the free exchange rate.

Under the transition rules of the CCD, the official exchange rate expressly applies to principal and interest payments to be made to foreign lenders on registered loans entered into before December 20, 1982.

Article 144 of the Mexican Income Tax Law (the Income Tax Law) provides, in part, that foreign residents who obtain income in cash derived from sources of wealth located in Mexico are obligated to pay income tax in conformity with its Title.

Article 154 of the Income Tax Law provides that, with regard to interest income, the source of wealth shall be deemed to be located within Mexico when the principal is located or invested within Mexico. Article 154 of the Income Tax Law further provides, in part, that the tax shall be a withholding tax equal to 15 percent, in the case of foreign financial entities registered with the Ministry of Finance and Public Credit, of the amount of interest paid to the taxpayer.

Apart from the subsidy and exchange rate aspects of the subject case, the 15-percent withholding tax on gross interest imposed by Mexico is a creditable tax in lieu of an income tax under section 1.903-1(a) of the Income Tax Regulations.

SITUATION 1. On June 1, 1982, the taxpayer entered into a 10-year nonamortizing gross loan agreement with a Mexican borrower. The principal amount of the loan was $1,000, wth interest payable at 10 percent annually. For purposes of this situation, it is assumed that on June 1 and July 15, 1983, the official exchange rate was 100 pesos to 1 dollar and the free exchange rate was 150 pesos to 1 dollar. On June 1, 1983, the Mexican borrower deposited 8,500 pesos with a Mexican commercial bank owned by the Mexican government and the Mexican bank remitted $85 to the taxpayer. On July 15, 1983, the Mexican borrower paid 1,500 pesos to the Mexican tax authorities and obtained a receipt for 1,500 pesos acknowledging that the Mexican withholding tax liability had been satisfied.

SITUATION 2. The facts are the same as described above; however, the loan transaction is structured as a reimbursement loan. Thus, the Mexican borrower remitted the gross interest payment ($100) to the taxpayer in dollars obtained by paying the Mexican commercial bank 10,000 pesos, which were then converted at the official rate), and then paid the 1500-peso Mexican withholding tax. The taxpayer reimbursed the borrower for making the Mexican tax payment by purchasing 1500 pesos for $10 at the free exchange rate and remitting such amount to the borrower.

LAW AND ANALYSIS

Section 901 of the Code provides that a credit is allowed against United States income tax for the amount of any income, war profits, and excess profits taxes paid or accrued to any foreign country.

Section 903 of the Code provides that the term `income, war profits, and excess profits taxes` shall include a tax paid in lieu of a tax on income, war profits, or excess profits otherwise generally imposed by any foreign country or by any possession of the United States.

Section 1.901-2(e)(3)(i)(A) of the Income Tax Regulations provides, in part, that an amount is not an amount of income tax paid by a taxpayer to a foreign country to the extent that the amount is used directly or indirectly by the country to provide a subsidy to the taxpayer.

Section 1.901-2(e)(3)(ii)(B) provides that a foreign country is considered to provide a subsidy to a taxpayer if the country provides a subsidy to another person that engages in a transaction with the taxpayer, but only if the subsidy received by such other person is determined, directly or indirectly, by reference to the amount of income tax, or the base used to compute the income tax, imposed by the country on the taxpayer with respect to each transaction.

Section 1.901-2(e)(3)(iii) provides the following example to illustrate the provisions of paragraph (e)(3):

EXAMPLE. Country X imposes a 30-percent tax on interest received by nonresident lenders from borrowers who are residents of Country X, and it is established that this tax is a tax in lieu of an income tax within the meaning of section 1.903-1(a). Country X remits to resident borrowers an incentive payment for engaging in foreign loans, which payment is an amount equal to 20 percent of the interest paid to nonresident lenders. Because the incentive payment is based on such interest, it is determined by reference to the base used to compute the tax in lieu of an income tax that is imposed on the nonresident lender. Under paragraph (e)(3)(ii)(B) of this section, the incentive payment is considered a subsidy provided indirectly to the nonresident lender since it is provided to a person (the borrower) that engaged in a business transaction with the lender and is based on the amount of tax in lieu of an income tax that is imposed on the lender with respect to this transaction. Therefore, two-thirds (20 percent/30 percent) of the amount withheld by a resident borrower from interest payments to a nonresident lender is not tax in lieu of an income tax that is paid by the lender under paragraph (e)(3)(i) of this section and section 1.903-1(a).

In order to determine the amount, in pesos, of Mexican withholding tax on gross dollar interest payments, the Mexican tax authorities translate the interest payments to pesos using the official exchange rate applicable to those interest payments. The withholding tax in pesos is then computed by multiplying the gross interest amount in pesos by 15 percent. Thus, the borrower does not purchase dollars in the amount of the Mexican withholding tax due, but pays an amount of pesos to satisfy such tax liability determined at the official exchange rate.

The use of the official exchange rate to determine the amount of Mexican withholding tax liability in pesos on dollar-denominated loans is not a tax subsidy within the meaning of section 1.901-22(e)(3) of the regulations. Unlike the above example, or the Brazilian withholding tax rebate situation considered in Rev. Rul. 78-258, 1978-1 C.B. 239, the economic benefit to the Mexican borrower represented by the use of Mexico's official exchange rate to convert pesos into dollars or dollars into pesos is not targeted to or tied to transactions that give rise to a claim for a foreign tax credit. The benefit of the Mexican official exchange rate applies to a broad range of international transactions, in all cases based on the total payment to be made, whether it is a return of principal, gross income, or net income, and whether it is subject to tax or not. For many of the transactions governed by the official exchange rate, such as imports and the payment of principal on foreign loans, there is no related Mexican tax and thus no foreign tax credit. For those transactions governed by the official exchange rate when there is a Mexican withholding tax and thus a potential related foreign tax credit, such as the payment of interest on foreign loans, the reduction in the overall cost of the transaction to the Mexican borrower is merely coincidental to the broad structure and operation of the official exchange rate.

Accordingly, under sections 901 and 903 of the Code, the taxpayer is entitled to a section 901 foreign tax credit of $15 under the gross loan agreement described in situation 1. The $15 credit is computed by converting the 1500 pesos paid on the taxpayer's behalf by the borrower into dollars at the official exchange rate. In the reimbursement loan agreement described in situation 2, the txpayer is entitled to a credit for the $10 it actually paid to acquire 1500 pesos at the free exchange rate.

HOLDINGS

(1) The use of the official exchange rate to convert the Mexican interest and withholding tax payments from pesos to dollars does not result in a tax subsidy within the meaning of section 1.901-2(e)(3) of the regulations.

(2) The appropriate rate of exchange at which to translate the Mexican withholding tax from pesos to dollars is the official exchange rate for purposes of the foreign tax credit in sections 901 and 903 of the Code, unless the taxpayer has the option to use or actually uses the free exchange rate to purchase the pesos used to satisfy (or reimburse) such tax obligation, in which case the free exchange rate would be the appropriate rate to use for such translation purpose.