TAM 200030002: Statutory rate controls a foreign tax credit safe harbor

Plain-English summary

A U.S. corporation's subsidiary paid taxes in a foreign country under an agreement that also gave it a right to conduct business there. Because the subsidiary received that economic benefit, it used a regulatory safe harbor to determine how much of its payments counted as creditable foreign tax. The question was whether the formula should use the country's generally applicable statutory rate or a lower rate under a U.S. tax treaty. The IRS advised using the statutory rate: the treaty's lower rates did not apply to the subsidiary under its agreement, and the safe harbor looks to the rate imposed in practice on comparable taxpayers without the special benefit. The memorandum acknowledged ambiguity in the regulations but called the statutory rate the better reading.

Ruling snapshot

• Question: Which rate belongs in the safe harbor formula's D factor, the statutory rate or the lower treaty rate?
• Outcome: Advice given: use the statutory rate.
• Key authorities: IRC §§ 901 and 903; Treas. Reg. §§ 1.901-2 and 1.901-2A.

Full text (IRS public release)

                         INTERNAL REVENUE SERVICE
               NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM
                                 April 6, 2000


Number:             200030002
Release Date:       7/28/2000
Index (UIL) No.:    901.01-05
CASE MIS No.:       TAM-118929-99/CC:INTL:B3

District Director


       Taxpayer’s Name:
       Taxpayer’s Address:

       Taxpayer’s Identification No:
       Years Involved:
       Date of Conference:

LEGEND:

Taxpayer                   =
business a                 =


USSub                     =
business b                =
Country X                 =
Agreement C               =
Certain Country X laws and
government decrees        =




Generally applicable tax
laws of Country X          =
Country X taxes            =
Treaty                     =
statutory rate             =
date d                     =
treaty rate e              =
treaty rate f              =
Article G                  =
Article H                  =

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Article I                   =

ISSUE:

When applying the safe harbor method of Treas. Reg. §1.901-2A(e), should the
statutory tax rate or the lower treaty rate be used in the “D” factor?

CONCLUSION:

The statutory rate should be used in the “D” factor under the regulatory safe harbor
method.

FACTS:

Taxpayer is a domestic corporation engaged (with its affiliates) in business a. Taxpayer
owns indirectly 100% of the stock of USSub, a domestic corporation engaged in
business b through a permanent establishment in Country X.

USSub’s operations are conducted under Agreement C with a controlled entity of the
government of Country X. Agreement C obligates USSub to be subject to and pay
Country X taxes imposed by certain Country X laws and government decrees as in
effect when Agreement C was entered into. USSub’s obligation under Agreement C to
pay Country X taxes as provided for in these laws and government decrees is not
affected by changes that may be made to Country X law. For the years under audit, the
total tax imposed by these Country X laws and government decrees on USSub
consisted of a tax on business profits and an additional tax on after-tax profits. During
the same years, the generally applicable tax laws of Country X also imposed corporate
income tax and an additional tax on the after-tax profits of non-Country X corporations
that are owned by foreign shareholders and operate in Country X through a permanent
establishment. The rate of additional tax under the generally applicable laws of Country
X is hereinafter referred to as the statutory rate. The rate of additional tax applicable to
USSub under Agreement C was the same as the statutory rate.

An income tax treaty was in effect between the U.S. and Country X during the period
under audit (“Treaty”). The Treaty allows Country X to impose a tax on the business
profits of U.S. corporations that operate in Country X through a permanent
establishment. See Article G of the Treaty. In addition, under Article H of the Treaty,
Country X is allowed to impose a tax at the treaty rate on the after-tax profits of U.S.
corporations that operate in Country X through a permanent establishment. Prior to
date d, the treaty rate of additional tax was treaty rate e. A protocol to the Treaty, which
reduced the treaty rate from treaty rate e to treaty rate f, entered into force on date d.
On and after date d, the treaty rate was treaty rate f. Treaty rates e and f were both
lower than the statutory rate. Article I of the Treaty specifically provides, however, that
the reduced treaty rates do not apply to corporations, like USSub, operating under

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agreements such as Agreement C. Agreement C was entered into before, and
continued to apply after, the Treaty went into effect. As a result, USSub remained
subject to and paid tax to Country X on its business profits and after-tax profits at rates
contractually fixed when Agreement C was entered into by USSub.

During the audit period, USSub was a dual capacity taxpayer as defined in Treas. Reg.
§1.901-2(a)(2)(ii). USSub elected the safe harbor method of Treas. Reg. §1.901-2A
(e)(1) to determine the portion of Country X levies that is considered to be a tax for
purposes of sections 901 and 903 of the Internal Revenue Code. Under the safe
harbor method, USSub’s Country X tax base must be multiplied by the Country X
general tax rate, the “D” factor in the formula, to determine the amount of creditable tax.
USSub used the generally applicable Country X corporate tax rate on its business
income and the generally applicable statutory rate on its after-tax profits in the “D”
factor. USSub did not use the lower treaty rates.

LAW AND ANALYSIS:

Section 901 of the Internal Revenue Code allows a credit for the amount of income
taxes paid or accrued by or on behalf of a taxpayer to a foreign country or possession
of the United States. A foreign levy is creditable only if it is a tax whose predominant
character is that of an income tax in the U.S. sense. A levy is a tax if it requires a
compulsory payment pursuant to the foreign country’s authority to levy taxes. Under
Treas. Reg. §1.901-2(a)(2)(i), a payment in exchange for a specific economic benefit is
not a tax. A taxpayer who is subject to a foreign levy and who also, directly or indirectly,
receives a specific economic benefit from a foreign government is a dual capacity
taxpayer. Treas. Reg. § 1.901-2(a)(2)(ii)(A). Under Treas. Reg. § 1.901-2 (a)(2)(i), a
dual capacity taxpayer must establish the portion, if any, of the foreign levy that is a tax.


During the audit period, USSub was a dual capacity taxpayer because under
Agreement C it received the right to engage in business b in Country X. Because the
laws governing amounts levied pursuant to Agreement C were different than those
applicable to non-dual capacity taxpayers, USSub must establish the distinct element of
the levy that is a tax. Treas. Reg. §1.901-2A(b)(1) provides that a dual capacity
taxpayer may use either the facts and circumstances method or the safe harbor method
to establish the tax amount. Under the facts and circumstances method, not relevant
here, the taxpayer must establish by all of the facts and circumstances the portion, if
any, of the levy “that is not paid in exchange for a specific economic benefit.” See
Treas. Reg. §1.901-2A(c)(2)(i). The portion so established is the creditable tax. USSub
elected to apply the safe harbor method, which employs a “splitting” approach to
determine the portion, if any, of the payments made under the foreign levy that is a
creditable tax.

Under the safe harbor method described in Treas. Reg. §1.901-2A(e), the dual capacity

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taxpayer applies a formula to determine the amount of the levy that is the “qualifying
amount” or the creditable tax. Treas. Reg. §1.901-2A(e)(1) provides that the formula is
intended to provide a foreign tax credit for an amount “approximately equal to the
amount of generally imposed income tax . . . that would have been required to be paid
in the taxable year by the dual capacity taxpayer if it had not been a dual capacity
taxpayer” and if the amount considered to be paid for the specific economic benefit had
been deductible in determining the income tax liability.

The safe harbor formula is (A-B-C) x D/(1-D), where:

              A = the amount of gross receipts determined under foreign law;
              B = the amount of costs and expenses;
              C = the total amount paid pursuant to the levy; and
              D = the tax rate.

Treas. Reg. §1.901-2A(e)(3) provides that “the tax rate [the “D” factor] for purposes of
the safe harbor formula is the tax rate . . . that is applicable in computing tax liability
under the general tax.” If the rate of the general tax varies with the amount of the base,
the rate to be used is “the rate that applies under the general tax to a person whose
base is” the same as that of the dual capacity taxpayer minus the specific economic
benefit amount paid, provided that such rate applies in practice to non-dual capacity
taxpayers. Id. Treas. Reg. §1.901-2A(e)(4)(i) further provides:

       If the general tax is a series of income taxes (e.g., on different types of income),
       or if the application of the general tax differs by its terms for different classes of
       persons subject to the general tax (e.g., for persons in different industries), then,
       except as otherwise provided in this paragraph (e), the qualifying amount shall
       be computed by reference to the income tax contained in such series of income
       taxes, or in the case of such different applications the application of the general
       tax, that by its terms and in practice imposes the highest tax burden on persons
       other than dual capacity taxpayers. Notwithstanding the preceding sentence, the
       general tax amount shall be computed by reference to the application of the
       general tax to entities of the same type (as determined under the general tax) as
       the dual capacity taxpayer and to persons of the same resident or nonresident
       status (as determined under the general tax) as the dual capacity taxpayer; and,
       if the general tax treats business income differently from non-business (e.g.,
       investment) income (as determined under the general tax), the dual capacity
       taxpayer’s business and non-business income shall be treated as the general tax
       treats such income. If, for example, the dual capacity taxpayer would, under the
       general tax, be treated as a resident . . . and as a corporation (i.e., because the
       rules of the general tax treat an entity like the dual capacity taxpayer as a
       corporation), . . . the dual capacity taxpayer . . . shall be so treated in computing
       the qualifying amount.

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It is not disputed that USSub was actually required under Agreement C to use a rate
equal to the statutory rate on its after-tax profits to compute its tax liability to Country X
in the years under audit. The reduced treaty rates did not apply because USSub was a
dual capacity taxpayer that entered into Agreement C. See Article I of the Treaty. The
disputed point is whether to use the statutory rate or the U.S. treaty rate as the “general
tax” rate in the safe harbor formula in determining the portion of USSub’s tax payments
that qualify as creditable taxes. In other words, the question is whether the dual
capacity taxpayer’s status as a U.S. taxpayer that would be eligible for reduced tax
rates under the Treaty if it were not a dual capacity taxpayer is a factor that should be
taken into account in determining the applicable rate.

Treas. Reg. §1.901-2A(e)(1) suggests that the reduced treaty rates should be used,
because use of those rates would approximate the amount of tax USSub itself, as a
U.S. resident eligible to be taxed at the reduced treaty rates, would have paid to
Country X on its profits if it had been a non-dual capacity taxpayer. However, Treas.
Reg. §1.901-2A(e)(1) provides only a general statement of what the safe harbor
formula is designed to do. The specific rules for determining what tax rate is used in
the D factor are contained in Treas. Reg. §1.901-2A(e)(3) and (4)(i). Treas. Reg.
§1.901-2A(e)(3) indicates that the appropriate rate is the highest tax rate imposed in
practice on “a person” that is a non-dual capacity taxpayer with income comparable to
that of the dual capacity taxpayer. This suggests that the specific dual capacity
taxpayer’s eligibility for treaty benefits is not taken into account in determining the
generally applicable tax rate.

Similarly, Treas. Reg. §1.901-2A(e)(4)(i) provides that if the general tax applies
differently to different classes of persons, the qualifying amount is computed by
reference to the application that “by its terms and in practice imposes the highest tax
burden on persons other than dual capacity taxpayers.” This language indicates that
the higher statutory rate, rather than lower treaty rates for which some but not all
classes of taxpayers are eligible, should be used. The context of the reference in
Treas. Reg. §1.901-2A(e)(4)(i) to “entities of the same type” suggests that this factor
refers to entity classification, such as corporation, partnership or trust, and not to all of
the specific attributes of the dual capacity taxpayer. There is no dispute in this case
over the application of the other rules referenced in Treas. Reg. §1.901-2A(e)(4)(i).

While the regulations are ambiguous, the better view is that the generally applicable
statutory rate of additional tax, and not the lower U.S. treaty rate, should be used in
computing the D factor. This reading of the regulations best furthers the underlying
purpose of the safe harbor formula. As discussed above, the purpose of the safe
harbor formula is to approximate the portion of the payment made by the dual capacity
taxpayer that is a tax. The regulations identify the highest tax burden imposed by the
foreign country on non-dual capacity taxpayers as the amount treated as a tax, so that
only amounts paid in excess of this amount by the dual capacity taxpayer are
considered to be paid in exchange for the specific economic benefit that it received, i.e.,

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the deemed royalty element of the payment. If the highest rate that applies in practice
to other, non-dual capacity taxpayers is not used in the safe harbor formula, an amount
of tax paid by a non-dual capacity taxpayer would be treated as a royalty when paid by
a dual capacity taxpayer. Accordingly, use of the statutory rate in the “D” formula
reaches the correct result in this case.

A copy of this technical advice memorandum is to be given to the taxpayer. Section
6110(j)(3) of the Code provides that it may not be used or cited as precedent.

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