DEFICIT IN FOREIGN CORPORATION'S EARNINGS AND PROFITS IS CARRIED BACK TO PRECEDING TAXABLE YEARS, REGARDLESS OF APPLICABLE FOREIGN LAW

Rev. Rul. 87-72

ISSUE

For distributions occurring prior to the effective date of section 902 of the Internal Revenue Code of 1986, whether a deficit in earnings and profits of a foreign corporation is carried back to taxable years preceding the deficit year for purposes of determining accumulated profits under section 902 (or carried forward to taxable years following the deficit year) without regard to whether the applicable foreign law provides for the carryback or carryforward of deficits in earnings and profits.

FACTS

FS is a foreign corporation that is wholly owned by X, a domestic corporation. FS is organized under FC law, which imposes an income tax on FC corporations of 30 percent of the current taxable profits of FC corporations for each taxable year. FC law does not permit the carryforward or carryback of losses to offset taxable profits in other taxable years. The FC income tax is a creditable income tax under section 902 of the Internal Revenue Code of 1954 and the regulations thereunder. The taxable years in the following situations each begin before January 1, 1987. The distributions are made more than 60 days after the beginning of the relevant taxable year.

SITUATION 1

FS had taxable profits under FC law for taxable years 1, 2 and 3 and paid FC income taxes each year. As computed under U.S. tax rules, however, FS has a deficit in earnings and profits in year 3. FS made a 50u distribution to X in year 3. The earnings and profits of FS (computed under U.S. tax rules) and the foreign taxes paid for taxable years 1, 2, and 3, each computed in FS's functional currency, are stated below:

                Earnings and Profits

FS had taxable profits under FC law for taxable years 1, 2, 3 and 4 and paid FC income taxes each year. As computed under U.S. tax rules, however, FS had a deficit in earnings and profits in year 1. FS made a 100u distribution to X in year 3. The earnings and profits of FS (computed under U.S. tax rules) and the foreign taxes paid for taxable years 1, 2, 3 and 4, each computed in FS's functional currency, are stated below:

                Earnings and Profits

The facts are the same as in Situation 2 except that FS made a 100u distribution in year 4, rather than in year 3.

LAW AND ANALYSIS

For distributions from accumulated profits derived during taxable years beginning before January 1, 1987, section 902(a) of the 1954 Code provides, in part, that a domestic corporation which owns at least 10 percent of the voting stock of a foreign corporation from which it receives dividends shall be deemed to have paid the same proportion of foreign income taxes paid or deemed to be paid by the foreign corporation on or with respect to the accumulated profits of the foreign corporation from which the dividends were paid, which the amount of the dividends (determined without regard to section 78) bears to the amount of accumulated profits in excess of foreign income taxes. The dividend and credit are calculated on a year-by- year basis, based on the accumulated profits for each year.

Expressed in algebraic terms, the credit for taxes deemed paid by a domestic corporate shareholder of a foreign corporation pursuant to section 902 of the 1954 Code is determined as follows:

                                              Dividend received by the

The aggregate amount of dividends considered distributed for all taxable years for purposes of section 902 of the 1954 Code cannot exceed the aggregate dividends as determined under section 316. Under section 316, a dividend is a distribution out of the corporation's current earnings and profits or its accumulated earnings and profits. In Situation 1, for example, the maximum dividend that X can receive from FS in year 3 is 50u. In order to determine which taxable year's foreign income taxes are to be considered in calculating the deemed paid credit under section 902, it is necessary to determine from which taxable years' earnings and profits the 50u dividend is paid.

Under Rev. Rul. 74-550, 1974-2 C.B. 209, a deficit in earnings and profits incurred in any year is carried back and reduces the accumulated profits of the most recent preceding year(s) for purposes of determining the earnings and profits from which a dividend is paid. Thus, in Situation 1, the deficit of (150u) in year 3 is carried back first to offset year 2's earnings and profits of 100u and then to offset 50u of year 1's earnings and profits. As a result, the 50u dividend paid in year 3 is considered to have been paid from year 1's earnings and profits, and, in determining the indirect foreign tax credit from the 50u dividend, the multiplicand of the section 902 formula will consist of year 1's foreign taxes paid or deemed paid by FS. Rev. Rul. 74-550, however, did not address whether the denominator of the section 902 fraction which consists of accumulated profits for year 1, is affected by deficits from other years.

In Champion International Corp., 81 T.C. 424 (1984), acq., 1984- 2 C.B. 1, the court held that a deficit is accumulated profits resulting from a net operating loss incurred by a foreign subsidiary of a domestic corporation reduces the prior years' accumulated profits for purposes of section 902 of the 1954 Code when a loss or deficit results under both U.S. and foreign law. However, the Champion case did not involve a U.S. computed deficit where: (1) the foreign law does not provide for a carryback or carryforward of losses; or (2) even though carryovers are permitted generally under foreign law, a deficit approximately the deficit computed under U.S. tax principles does not result under foreign law.

Earnings and profits are determined under U.S. principles for purposes of computing the amount of accumulated profits under section 902 of the Code. The foreign rules for computing deficits and for the carryforward or carryback of deficits are not applicable in calculating the amount of the section 902 deemed paid credit.

In Situation 1, the earnings and profits for years 2 and 1 are reduced by year 3's deficit for purposes of determining the aggregate amount of dividends that can be paid and determining from which years' earnings and profits the dividends are paid. The accumulated profits for year 1 includible in the denominator of the section 902 fraction also are reduced. Otherwise, a portion of year 1's taxes could never be deemed paid by X under section 902 of the 1954 Code even though all distributable earnings and profits from year 1 have been distributed -- a result which the court in Champion found inappropriate when foreign law permits carryovers of losses.

Accordingly, in Situation 1, X's indirect foreign tax credit under section 902 of the 1954 Code resulting from the 50u dividend received from FS in year 3 is determined by applying the year 3 deficit of (150u) first against the earnings and profits accumulated in year 2 of 100u and the balance (50u) against the 100u of earnings and profits accumulated in year 1. This procedure applies for purposes of determining both the year's earnings and profits from which the dividend is paid and the amount of accumulated profits in the denominator of the section 902 fraction. Therefore, the 50u dividend paid in year 3 is treated as being paid out of the remaining 50u of accumulated profits in year 1. The tax deemed paid with respect to this dividend pursuant to section 902 of the 1954 Code is 30u:

 Foreign taxes           Year 1 foreign       Dividend received by X

In Situation 2, FS made a 100u distribution to X in year 3. The deficit in year 1 has no effect on FS's current earnings and profits for purposes of determining the amount of the 100u distribution made in year 3 that will be treated as a dividend. Section 1.316-1(a)(1) of the regulations. Because FS has earnings and profits of 100u in year 3, the 100u distributed to X in year 3 will be treated as a dividend in its entirety. The tax deemed paid with respect to this dividend pursuant to section 902 of the 1954 Code is 10u:

 Foreign taxes           Year 3 foreign       Dividend received by X

In Situation 3, the facts are the same as in Situation 2 except that FS distributed 100u to X in year 4. FS has no year 4 earnings and profits; therefore, under section 316 of the 1954 Code, the amount of the 100u distribution in year 4 that will be considered a dividend is limited to FS's accumulated profits for years 1 through 4, or 50u. The dividend of 50u will be considered to have been made out of FS's year 3 earnings and profits. In determining FS's accumulated profits for year 3, the year 1 deficit of (100u) may be carried forward. The deficit will eliminate all of the earnings in year 2 (50u) and the remaining year 1 deficit (50u) will reduce the year 3 earnings from 100u to 50u. The deficit carries over for purposes of determining both the year's earnings and profits from which a dividend can be paid and the amount of accumulated profits in the denominator of the section 902 fraction. The year 3 tax deemed paid by X with respect to the distribution will be 10u (the same amount deemed paid by X with respect to the 100u distribution in year 3 in Situation 2):

 Foreign taxes           Year 3 foreign       Dividend received by X

The results in Situations 1, 2, and 3 would occur even if the foreign law contained rules for the carryforward or carryback of losses which are inconsistent with U.S. principles. In Situations 1, 2, and 3 the deficit computed for U.S. purposes did not result in a taxable loss as computed under foreign tax rules. This may occur in a variety of circumstances due to differences between U.S. and foreign law with respect to the timing of income recognition, the timing and deductibility of expenses, reorganization provisions, etc. Differences between U.S. and foreign tax law may result in a deficit as computed under U.S. rules and positive taxable profits under foreign tax rules (or vice versa) even if U.S. and foreign laws are consistent with respect to carryovers of losses or deficits. Foreign law carryovers of losses are merely one of many aspects of foreign law which affect the effective rate of foreign tax on U.S. computed earnings and profits. Pursuant to section 1.902-1(e) of the regulations, earnings and profits and "accumulated profits" must be computed for purposes of section 902 of the 1954 Code without regard to foreign tax rules governing carryovers of foreign computed losses. Therefore, the Internal Revenue Service's acquiescence in the Champion decision is limited to the result reached in the decision: a deficit is carried back to reduce the prior years' earnings and profits for purposes of computing the denominator of the section 902 fraction. The Internal Revenue Service does not acquiesce to the Champion decision to the extent that it states that a carryback of a deficit in earnings and profits may depend on foreign law, because the carryback or carryforward of a deficit in earnings and profits for section 902 purposes is determined solely under U.S. law and is not governed to any extent by foreign law.

HOLDING

For purposes of section 902 of the 1954 Code, a deficit in earnings and profits of a foreign corporation is first carried back to reduce prior years' accumulated profits to the extent of such prior years' accumulated profits and is then carried forward to reduce accumulated profits in years following the deficit without regard to whether foreign law provides for the carryback or carryforward of losses. This ruling applies only to distributions which are subject to the rules of section 902 of the 1954 Code as in effect prior to the effective date of section 902 of the Internal Revenue Code of 1986.