Final Regs on Denial of Foreign Tax Credits for Government-Provided Subsidies

 [4830-01]

 ACTION: Final regulations.

 SUMMARY: This document contains final Income Tax Regulations relating to denial of foreign tax credits for subsidies provided by foreign governments through the use of taxing systems. These regulations implement the Tax Reform Act of 1986. These final regulations provide guidance needed to comply with these changes and affect taxpayers that pay or accrue foreign income taxes.

 EFFECTIVE DATE: These rules are effective for amounts paid or accrued in taxable years beginning after December 31, 1986.

 FOR FURTHER INFORMATION CONTACT: Carol E. Murphy of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington, DC 20224 (Attention: CC:CORP:T:R (INTL-942-86)) (202) 566-6795, not a toll free call).

SUPPLEMENTARY INFORMATION:

BACKGROUND

 On November 15, 1988, the Internal Revenue Service published in the Federal Register (53 FR 45942) proposed amendments to the Income Tax Regulations (26 CFR part 1) under section 901(i) of the Internal Revenue Code. Those amendments were proposed to conform the regulations to section 1204 of the Tax Reform Act of 1986 (Pub. L. 99-514, 100 Stat. 2085, 2532). Written comments responding to the notice of proposed rulemaking were received. No public hearing was requested or held. After consideration of all comments regarding the proposed regulations, these regulations are adopted by this Treasury Decision with revisions in response to those comments. The comments and revisions are discussed below.

EXPLANATION OF PROVISIONS

 Section 901(i) was added to the Code to deny foreign tax credits where the amount paid or accrued (and designated as a "tax" by the foreign government) is used to provide a subsidy. The final regulations clarify the circumstances under which the foreign tax credit is denied for such amounts.

 Under the final regulations, the amount of the tax is treated as a subsidy and not as an amount of tax paid or accrued if the amount is used, directly or indirectly, by the foreign country imposing the tax to provide a subsidy to the taxpayer, to a related person (within the meaning of section 482), to any party to the transaction, or to any party to a related transaction. The subsidy may be provided by any means but must be determined, directly or indirectly, by reference to the amount of the tax or to the base used to compute the amount of the tax.

 The final regulations state that the method of providing a subsidy may include, but is not limited to, a rebate, a refund, a credit, a deduction, a payment, a discharge of an obligation, or any other method. The term "subsidy" is defined to include any benefit conferred, directly or indirectly, by a foreign country. Examples are provided that describe specific circumstances which give rise to a subsidy as contemplated by the regulations.

 A comment was received which stated that there should be consistent treatment of entities that are treated as part of the government for purposes of section 901(a) of the Code (specifically the granting of a specific economic benefit under section 1.901-2(a)(2)(ii)(B)) and the treatment of that entity under section 901(i). Existing treatment under the two sections is not inconsistent because each is concerned with separate considerations. Whether a specific economic benefit has been provided depends upon whether the government has used its power to provide economic benefits within its control which are not made generally available to its taxpayers. Under section 1.901-2(a)(2)(ii), an entity may be treated as a part of the government where the entity acting as the government provides a specific economic benefit to the taxpayer. Under section 1.901-2(e)(3), however, an entity may be treated as separate from the government where the entity derives a subsidy directly from the government. Thus, account must be taken of the relationship between the entity and the taxpayer, and the circumstances under which the benefit is being conferred. To conclude otherwise would directly contravene the purpose of section 901(i).

 Special treatment for government (or government-owned) entities also was rejected because it would create the potential for a credit to be claimed for a tax nominally paid by or on behalf of a U.S. person when the substance of the transaction with a government entity was to grant a tax holiday to the U.S. taxpayer. This is especially true in the case of a transaction with a government entity that pays taxes: where a tax holiday for the U.S. taxpayer is intended, the government entity could simply assume a tax liability that was nominally borne by the U.S. person and receive a tax credit against its own liability in the amount of the tax nominally paid on the U.S. person's behalf. Where a foreign company has de minimis private ownership, or where a foreign country undertakes a privatization program, the problems presented by the government entity cases would be exacerbated.

 This regulation, therefore, denies a foreign tax credit for the amount of an indirect subsidy provided to a taxpayer through the provision of a direct subsidy by the government to any person (governmental or not) with which it deals or which is a party to a related transaction. Examples 4 and 5 have been added, therefore, to clarify the treatment, under these regulations, of dual capacity taxpayers under section 1.901-2(a)(2)(ii) that deal with governmental agencies and when they will be treated as receiving indirect subsidies from such agencies. This clarification provides appropriate consistency with Example 3 of section 1.901-2(f)(2) which provides that even though a government assumes a taxpayer's liability for tax otherwise due under a generally applicable income tax, that taxpayer may nevertheless be entitled to claim a foreign tax credit for those amounts if all other tests are satisfied. If such consistency was not provided in section 1.901-2(e)(3), it would be possible for a government-owned enterprise to pay a tax on a taxpayer's behalf but not to receive a subsidy on a taxpayer's behalf. This would create the unwarranted result of granting a foreign tax credit even where a foreign government has effectively granted a tax holiday to specific taxpayers as described above.

 A comment was received which stated that a taxpayer should be allowed the opportunity to avoid subsidy treatment by establishing that it did not, on the basis of all the facts and circumstances, receive a benefit from the subsidy. This comment is inconsistent with the express language of section 901(i), and the Service, consequently, has rejected it.

 Under the final regulations, the use of an official exchange rate under certain circumstances would not be a subsidy determined, directly or indirectly, by reference to the amount of the tax, or to the base used to compute the amount of tax. Rev. Rul. 84-143, 1984-2 C.B. 127, held that the use of the official exchange rate of the Mexican Exchange Control Decree, effective December 20, 1982, is not a subsidy under prior law. The official exchange rate rule in the final regulations adopts the holding of Rev. Rul. 84-143. The fact pattern of Rev. Rul. 84-143 is addressed in Example 3.

SPECIAL ANALYSES

 It has been determined that these rules are not major rules as defined in Executive Order 12291. Therefore, a Regulatory Impact Analysis is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to these regulations, and therefore, a final Regulatory Flexibility Analysis is not required.

DRAFTING INFORMATION

 The principal author of these regulations is Carol E. Murphy of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, Internal Revenue Service. Other personnel from the Internal Revenue Service and Treasury Department participated in developing the regulations.

LIST OF SUBJECTS IN 26 CFR SECTIONS 1.901-1 THROUGH 1.907(f)-1A

 Income taxes, Reporting and recordkeeping requirements, United States investments abroad.

Treasury Decision 8372

ADOPTION OF AMENDMENTS TO THE REGULATIONS

Accordingly, 26 CFR part 1 is amended as follows:

PART 1 -- INCOME TAX; TAXABLE YEARS BEGINNING AFTER DECEMBER 31, 1953

Paragraph 1. The authority for part 1 continues to read in part:

Authority: Sec. 7805, 68A Stat. 917; 26 U.S.C. 7805 * * *

Par. 2. Section 1.901-2(e)(3) is revised to read as follows:

SECTION 1.901-2 INCOME, WAR PROFITS, OR EXCESS PROFITS TAX PAID OR ACCRUED.

* * * * *

(e) * * *

(3) SUBSIDIES -- (i) GENERAL RULE. An amount of foreign income tax is not an amount of income tax paid or accrued by a taxpayer to a foreign country to the extent that --

(A) The amount is used, directly or indirectly, by the foreign country imposing the tax to provide a subsidy by any means (including, but not limited to, a rebate, a refund, a credit, a deduction, a payment, a discharge of an obligation, or any other method) to the taxpayer, to a related person (within the meaning of section 482), to any party to the transaction, or to any party to a related transaction; and

(B) The subsidy is determined, directly or indirectly, by reference to the amount of the tax or by reference to the base used to compute the amount of the tax.

(ii) SUBSIDY. The term "subsidy" includes any benefit conferred, directly or indirectly, by a foreign country to one of the parties enumerated in paragraph (e)(3)(i)(A) of this section. Substance and not form shall govern in determining whether a subsidy exists. The fact that the U.S. taxpayer may derive no demonstrable benefit from the subsidy is irrelevant in determining whether a subsidy exists.

(iii) OFFICIAL EXCHANGE RATE. A subsidy described in paragraph (e)(3)(i)(B) of this section does not include the actual use of an official foreign government exchange rate converting foreign currency into dollars where a free exchange rate also exists if --

(A) The economic benefit represented by the use of the official exchange rate is not targeted to or tied to transactions that give rise to a claim for a foreign tax credit;

(B) The economic benefit of the official exchange rate applies to a broad range of international transactions, in all cases based on the total payment to be made without regard to whether the payment is a return of principal, gross income, or net income, and without regard to whether it is subject to tax; and

(C) Any reduction in the overall cost of the transaction is merely coincidental to the broad structure and operation of the official exchange rate.

In regard to foreign taxes paid or accrued in taxable years beginning before January 1, 1987, to which the Mexican Exchange Control Decree, effective as of December 20, 1982, applies, see Rev. Rul. 84-143, 1984-2 C.B. 127.

(iv) EXAMPLES. The provisions of this paragraph (e)(3) may be illustrated by the following examples:

EXAMPLE 1. (i) Country X imposes a 30 percent tax on nonresident lenders with respect to interest which the nonresident lenders receive 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 provides the nonresident lenders with receipts upon their payment of the 30 percent tax. 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.

(ii) Because the incentive payment is based on the interest paid, it is determined by reference to the base used to compute the tax that is imposed on the nonresident lender. The incentive payment is considered a subsidy under this paragraph (e)(3) since it is provided to a party (the borrower) to the transaction and is based on the amount of tax that is imposed on the lender with respect to the transaction. Therefore, two- thirds (20 percent/30 percent) of the amount withheld by the resident borrower from interest payments to the nonresident lender is not an amount of income tax paid or accrued for purposes of section 901(b).

Example 2. (i) A U.S. bank lends money to a development bank in Country X. The development bank relends the money to companies resident in Country X. A withholding tax is imposed by Country X on the U.S. bank with respect to the interest that the development bank pays to the U.S. bank, and appropriate receipts are provided. On the date that the tax is withheld, fifty percent of the tax is credited by Country X to an account of the development bank. Country X requires the development bank to transfer the amount credited to the borrowing companies.

(ii) The amount successively credited to the account of the development bank and then to the account of the borrowing companies is determined by reference to the amount of the tax and the tax base. Since the amount credited to the borrowing companies is a subsidy provided to a party (the borrowing companies) to a related transaction and is based on the amount of tax and the tax base, it is not an amount paid or accrued as an income tax for purposes of section 901(b).

Example 3. (i) A U.S. bank lends dollars to a Country X borrower. Country X imposes a withholding tax on the lender with respect to the interest. The tax is to be paid in Country X currency, although the interest is payable in dollars. Country X has a dual exchange rate system, comprised of a controlled official exchange rate and a free exchange rate. Priority transactions such as exports of merchandise, imports of merchandise, and payments of principal and interest on foreign currency loans payable abroad to foreign lenders are governed by the official exchange rate which yields more dollars per unit of Country X currency than the free exchange rate. The Country X borrower remits the net amount of dollar interest due to the U.S. bank (interest due less withholding tax), pays the tax withheld in Country X currency to the Country X government, and provides to the U.S. bank a receipt for payment of the Country X taxes.

(ii) The use of the official exchange rate by the U.S. bank to determine foreign taxes with respect to interest is not a subsidy described in paragraph (e)(3)(i)(B) of this section. The official exchange rate is not targeted to or tied to transactions that give rise to a claim for a foreign tax credit. The use of the official exchange rate applies to the interest paid and to the principal paid. Any benefit derived by the U.S. bank through the use of the official exchange rate is merely coincidental to the broad structure and operation of the official exchange rate.

EXAMPLE 4. (i) B, a U.S. corporation, is engaged in the production of oil and gas in Country X pursuant to a production sharing agreement between B, Country X, and the state petroleum authority of Country X. The agreement is approved and enacted into law by the Legislature of Country X. Both B and the petroleum authority are subject to the Country X income tax. Each entity files an annual income tax return and pays, to the tax authority of Country X, the amount of income tax due on its annual income. B is a dual capacity taxpayer as defined in section 1.901-2(a)(2)(ii)(A). Country X has agreed to return to the petroleum authority one-half of the income taxes paid by B by allowing it a credit in calculating its own tax liability to Country X.

(ii) The petroleum authority is a party to a transaction with B and the amount returned by Country X to the petroleum authority is determined by reference to the amount of the tax imposed on B. Therefore, the amount returned is a subsidy as described in this paragraph (e)(3) and one-half the tax imposed on B is not an amount of income tax paid or accrued.

EXAMPLE 5. Assume the same facts as in EXAMPLE 4, except that the state petroleum authority of Country X does not receive amounts from Country X related to tax paid by B. Instead, the authority of Country X receives a general appropriation from Country X which is not calculated with reference to the amount of tax paid by B. The general appropriation is therefore not a subsidy described in this paragraph (e)(3).

(v) EFFECTIVE DATE. This paragraph (e)(3) shall apply to foreign taxes paid or accrued in taxable years beginning after December 31, 1986.