By Seth Goldstein, Gretchen Sierra, Mark Genrizi and Timothy Messenger

The U.S. Treasury and Internal Revenue Service (IRS) on 9 February 2012 filed (i) temporary regulations (T.D. 9577) under §909 of the Internal Revenue Code (the "Code") addressing foreign tax credit splitter transactions ("Foreign Tax Credit Splitter Regulations") and (ii) final regulations (T.D. 9576) providing guidance on determining who is considered the taxpayer of foreign taxes for purposes of the foreign tax credit ("Final Technical Taxpayer Regulations").¹

Section 909, added to the Code on 10 August 2010 by P.L. 111-226, suspends foreign taxes ("split taxes") that accrue as a result of a "foreign tax credit splitting event" (FTCSE). On 6 December 2010, Treasury and the IRS issued Notice 2010-92, which provided initial guidance under §909 for foreign taxes paid or accrued by a §902 corporation in taxable years beginning on or before 31 December 2010. Notice 2010-92 provided an exclusive list of four categories of FTCSEs for taxes accrued by foreign corporations in pre-2011 years. The Foreign Tax Credit Splitter Regulations (i) incorporate the guidance provided in Notice 2010-92 for pre-2011 tax years, (ii) add an additional category of FTCSEs for post-2010 tax years ("Partnership Inter-Branch Payment Splitter Arrangements"), and (iii) significantly expand the Notice's loss-sharing FTCSE category for post-2011 tax years.

On 4 August 2006, Treasury and the IRS issued proposed regulations providing guidance regarding who is considered the taxpayer of foreign taxes with respect to reverse hybrids, foreign consolidations, transfers of partnership interests and transfers of disregarded entities. The Final Technical Taxpayer Regulations adopt the approach of the proposed regulations, except with respect to reverse hybrids.

This Alert briefly describes some of the key aspects of these regulations.

Final Technical Taxpayer Regulations

Consistent with the 2006 proposed regulations, the final regulations provide that, if foreign tax is imposed on the combined income of two or more persons (such as in a foreign tax consolidation), the foreign tax is considered paid proportionally by those persons, based on each person's proportionate share of combined income as determined under foreign law.²

Also consistent with the proposed regulations, if a partnership terminates pursuant to an ownership transfer and its foreign taxable year does not close, income taxes imposed with respect to such year are allocated between the terminating partnership and its successors or assigns based on the respective portions of taxable income (under foreign law) earned prior to and after the termination under the principles of Treas. Reg. §1.1502-76(b).³ Similarly, if a disregarded entity is transferred, and its foreign taxable year does not close, taxes imposed upon the entity during such year are allocated based on the portions of the entity's taxable income (as determined under foreign law) attributable to the ownership period of each transferor and transferee under the principles of Treas. Reg. §1.1502-76(b).⁴

The rules with respect to foreign taxes of transferred partnerships and disregarded entities as well as foreign taxes on combined income are generally effective for taxes paid or accrued in taxable years beginning after 14 February 2012.⁵ Taxpayers may choose to apply the new rules regarding foreign taxes on combined income for taxes accrued in post-2010 tax years.

The 2006 proposed rules regarding reverse hybrids (generally treating the reverse hybrid as the taxpayer) have been withdrawn. Reverse hybrids are subject to the Foreign Tax Credit Splitter Regulations described below.

Exclusive list of splitter arrangements

Under §909, in the case of a FTCSE, the foreign tax may not be taken into account until the taxable year in which the "related income"⁶ is taken into account by the payor or the payor's U.S. shareholder. Similar to Notice 2010-92, the temporary regulations provide an exclusive list of "splitter arrangements" that give rise to FTCSEs.

The five "splitter arrangements" covered by the temporary regulations are as follows:

1. Reverse Hybrid Splitter Arrangements. A Reverse Hybrid Splitter Arrangement exists when a payor pays or accrues foreign income taxes with respect to income of a reverse hybrid.⁷ The split taxes from a Reverse Hybrid Splitter Arrangement are the foreign income taxes paid or accrued with respect to the income of the reverse hybrid. The related income (with respect to the split taxes) from a Reverse Hybrid Splitter Arrangement is the E&P (for U.S. income tax purposes) of the reverse hybrid attributable to activities of the reverse hybrid that gave rise to income included in the payor's foreign tax base.
   
   Effective date. Foreign income taxes paid or accrued with respect to Reverse Hybrid Splitter Arrangements are covered by Notice 2010-92 and are thus subject to the Notice's effective date and subject to the temporary regulations for years beginning on or after 1 January 2011.⁸
   
   
2. Loss-Sharing Splitter Arrangements. A Loss-Sharing Splitter Arrangement exists when, under a foreign group relief or other loss-sharing regime, a shared loss⁹ of a "U.S. combined income group"¹⁰ could have been used to offset income of that group ("usable shared loss") but is used instead to offset income of another U.S. combined income group. The split taxes from a Loss-Sharing Splitter Arrangement are the foreign income taxes paid or accrued by a member of a U.S. combined income group that relate to the income that would have been offset by the usable shared loss, had the loss not been used to offset income of another U.S. combined income group. The related income (with respect to the split taxes) from a Loss-Sharing Splitter Arrangement is the income of the other U.S. combined income group that is offset by the usable shared loss. The scope of the Loss-Sharing Splitter Arrangement is much broader than the scope of the pre-2011 "group relief or other loss-sharing regime splitter arrangement" under Notice 2010-92. The Notice applied only to shared loss arising from a disregarded debt instrument.
   
   Effective date. Foreign income taxes paid or accrued with respect to Loss-Sharing Splitter Arrangements in taxable years beginning on or after 1 January 2012 are subject to the temporary regulations. Foreign income taxes paid or accrued with respect to the narrower loss-sharing arrangements described in Notice 2010-92 are subject to the Notice's effective date and are subject to the temporary regulations for years beginning on or after 1 January 2011 and before 1 January 2012.¹¹
   
   
3. Hybrid Instruments Splitter Arrangements. Hybrid Instrument Splitter Arrangements consist of both U.S. Equity Hybrid Instrument Splitter Arrangements and U.S. Debt Hybrid Instrument Splitter Arrangements.
   
   
   1. U.S. Equity Hybrid Instrument Splitter Arrangements. A U.S. Equity Hybrid Instrument Splitter Arrangement exists when, with respect to the U.S. equity instrument, payments or accruals (1) give rise to foreign income taxes paid or accrued by the owner of the instrument, (2) are deductible for foreign tax purposes by the issuer, and (3) do not give rise to income for U.S. Federal income tax purposes. The split taxes from a U.S. Equity Hybrid Instrument Splitter Arrangement are determined by subtracting the foreign income taxes that would have been paid or accrued had the owner of the instrument not been subject to foreign income tax on income related to the instrument from the total amount of foreign income taxes paid or accrued by the owner of the instrument. The related income (with respect to the split taxes) from a U.S. Equity Hybrid Instrument Splitter Arrangement is income of the issuer of the instrument in an amount equal to the payments or accruals which are deductible by the issuer for foreign tax purposes. Notice 2010-92 contains a very similar pre-2011 splitter arrangement, but which applies only if the instrument gives rise to "interest" deductions under foreign law. The temporary regulations include instruments that give rise to deductions other than interest (such as imputed deductions on equity).¹²
      
      
   2. U.S. Debt Hybrid Instrument Splitter Arrangements. A U.S. Debt Hybrid Instrument Splitter Arrangement exists when foreign income taxes are paid or accrued by the issuer of the instrument (treated as equity under foreign law) with respect to income in an amount equal to the interest (including original issue discount) paid or accrued on the instrument that is deductible for U.S. Federal income tax purposes but that does not give rise to a deduction for foreign tax purposes. The split taxes from a U.S. Debt Hybrid Instrument Splitter Arrangement are the foreign income taxes paid or accrued by the issuer on the income that would have otherwise been offset by the interest paid or accrued on the instrument had such interest been deductible for foreign tax purposes. The related income (with respect to the split taxes) from a U.S. Debt Hybrid Instrument Splitter Arrangement is the gross amount of interest income recognized for U.S. Federal income tax purpose by the owner of the instrument.
      
      
   Effective date. Foreign income taxes paid or accrued with respect to a U.S. Equity Hybrid Instrument Splitter Arrangement in taxable years beginning on or after 1 January 2012 are subject to the temporary regulations. Foreign income taxes paid or accrued with respect to the narrower U.S. equity hybrid instrument splitter arrangement described in Notice 2010-92 are subject to the Notice's effective date and are subject to the temporary regulations for years beginning on or after 1 January 2011 and before 1 January 2012.¹³
   
   Foreign income taxes paid or accrued with respect to a U.S. Debt Hybrid Instrument Splitter Arrangement are covered by Notice 2010-92 and are thus subject to the Notice's effective date and subject to the temporary regulations for years beginning on or after 1 January 2011.¹⁴
   
   
4. Partnership Inter-Branch Payment Splitter Arrangements. Under the temporary regulations, the allocation of creditable foreign tax expenditures (CFTEs) that are paid or accrued by a partnership with respect to an inter-branch payment described under Treas. Reg. §1.704-1(b)(4)(viii)(d)(3) (as revised as of 1 April 2011) will be treated as a splitter arrangement to the extent that the CFTEs attributable to the inter-branch payment ("inter-branch payment CFTEs") are not allocated to the partners in the same proportion as the distributive share of partnership income to which the CFTEs relate.¹⁵ The split CFTEs from a Partnership Inter-Branch Payment Splitter Arrangement are equal to the excess amount of inter-branch payment CFTEs that are actually allocated to a partner under a partnership agreement over the amount of inter-branch payment CFTEs that would have been allocated to the partner if the CFTEs would have been allocated to the partners in the same proportion as the distributive share of partnership income to which the inter-branch payment CFTEs relate.¹⁶ The related income (with respect to the split CFTEs) from a Partnership Inter-Branch Payment Splitter Arrangement is equal to the amount of income allocated to a partner that exceeds the amount of income that would have been allocated to the partner if the income attributable to amount of the inter-branch payment would have been allocated to the partners in the same proportion as the inter-branch payment CFTEs were actually allocated under the partnership agreement.¹⁷
   
   Effective date. Treas. Reg. §1.909-2T(b)(4) generally applies to CFTEs that are paid or accrued in taxable years beginning on or after 1 January 2011.
   
   
5. Foreign Consolidated Group Splitter Arrangements. A change from the exclusive list of splitter arrangements in Notice 2010-92 is the removal of Foreign Consolidated Group Splitter Arrangements; however, certain foreign consolidated groups remain a pre-2012 splitter arrangement. A Foreign Consolidated Group Splitter Arrangement exists to the extent that the taxpayer did not allocate the foreign consolidated tax liability among the members of the foreign consolidated group based on each members' share of the consolidated taxable income included in the foreign tax base under the principles of Treas. Reg. §1.901-2(f)(3). The pre-2012 split taxes from a Foreign Consolidated Group Splitter Arrangement are pre-2012 foreign income taxes paid or accrued with respect to the income of a foreign consolidated group to the extent that foreign income taxes paid or accrued by one member of the foreign consolidated group are imposed on a covered person's share of consolidated taxable income included in the foreign tax base. The related income is the E&P (for U.S. income tax purposes) of the other members that gave rise to the income included in the foreign tax base with respect to which the pre-2012 split taxes were paid or accrued.
   
   Effective date. Pre-2011 foreign income taxes paid or accrued with respect to Foreign Consolidated Group Splitter Arrangements described in Notice 2010-92 are subject to the Notice's effective date. In addition, the temporary regulations apply to foreign income taxes arising from a Foreign Consolidated Group Splitter Arrangement which are paid or accrued in taxable years beginning on or after 1 January 2011 and on or before 14 February 2012. This extension ensures that §909 will apply to suspend foreign income tax on income of foreign consolidated groups paid or accrued in post-2010 taxable years to the extent the tax is not apportioned among the members of the group in accordance with the principles of Treas. Reg. §1.901-2(f)(3) discussed above.

Rules for applying §909 to split taxes and related income

Section 909 provides that split taxes are taken into account for U.S. Federal income tax purposes when the related income is taken into account by the taxpayer. The temporary regulations generally adopt the approach in Notice 2010-92 for determining the amount of related income and split taxes paid or accrued with respect to splitter arrangements for related income and split taxes in taxable years beginning on or after 1 January 2011.¹⁸ Generally, distributions, deemed distributions and inclusions out of a covered person's E&P are deemed to come pro rata from related and non-related income. However, the related income first out approach permissible under Notice 2010-92 is still applicable to pre-2011 split taxes.

Interaction between §909 and other Code provisions

Treasury and IRS expect to issue regulations that provide additional guidance on the interaction of §909 and other code provisions such as §§904(c), 905(a) and 905(c). Until that guidance is issued, the regulations provide that the principles of Treas. Reg. §1.909-6T(g), adopting the rules of section 6 of Notice 2010-92, will apply to taxable years beginning on or after 1 January 2011.

¹ The regulations are scheduled to appear in the 14 February 2012 issue of the Federal Register.
² See Treas. Reg. §1.901-2(f)(3).
³ See Treas. Reg. §1.901-2(f)(4)(i).
⁴ See Treas. Reg. §1.901-2(f)(4)(ii).
⁵ Treas. Reg. §1.901-2(h)(4).
⁶ "Related income" is the income to which the FTCSE taxes relate.
⁷ A reverse hybrid is an entity that is a corporation for U.S. Federal income tax purposes but a fiscally transparent entity (under the principles of Treas. Reg. §1.894-1(d)(3)) or a branch under the laws of the foreign country imposing the foreign income tax on the income of the entity. Treas. Reg. §1.909-2T(b)(1)(iv). Note that, in contrast to Notice 2010-92, a Reverse Hybrid Splitter Arrangement is expanded to cover taxes paid or accrued by persons other than section 902 corporations (foreign corporations meeting the ownership threshold to be eligible for deemed paid taxes).
⁸ Treas. Reg. §§1.909-2T(c), -5T(a) and -6T(a) and (b)(1). Technically, the rules of Notice 2010-92 are incorporated into Treas. Reg. §1.909-6T, so all years covered by the Notice are covered by the temporary regulations. For simplicity, this Alert identifies foreign taxes as covered by the Notice if they are subject to the Notice's effective date and foreign taxes covered by the temporary regulations if they are not subject to the Notice and only subject to the temporary regulations.
⁹ A "shared loss" means a loss, for foreign tax purposes, of one entity (including a branch) that is taken into account by one or more other entities.
¹⁰ A U.S. combined income group can be either a single individual or corporation and any other entity (including disregarded entities, partnerships and branches) that combine their income for U.S. federal income tax purposes. Treas. Reg. §1.909-2T(b)(2)(ii).
¹¹ Treas. Reg. §§1.909-2T(c), -5T(a) and -6T(a) and (b)(3).
¹² Note that, in contrast to Notice 2010-92, a U.S. Equity Hybrid Instrument Splitter Arrangement, as well as a U.S. Debt Hybrid Instrument Splitter Arrangement, is expanded to cover taxes paid or accrued by persons other than section 902 corporations.
¹³ Treas. Reg. §§1.909-2T(c), -5T(a) and -6T(a) and (b)(4)(ii).
¹⁴ Treas. Reg. §§1.909-2T(c), -5T(a) and -6T(a) and (b)(4)(iii).
¹⁵ Treas. Reg. §1.909-2T(b)(4)(i).
¹⁶ Treas. Reg. §1.909-2T(b)(4)(ii).
¹⁷ Treas. Reg. §1.909-2T(b)(4)(iii).
¹⁸ The temporary regulations do not include the alternative "related income first" method (which adopts section 4.06(b)(4) of Notice 2010-92) for identifying distributions of related income, which applies only to identity the amount of pre-2011 split taxes of a section 902 corporation that are suspended as of the first day of the section 902 corporation's first post-2010 taxable year. Treas. Reg. §1.909-6T(d)(4).