In a recently issued and published (FOIA) IRS Legal Memorandum, ILM 201441015, the IRS concluded that a domestic parent corporation will not be deemed to have paid foreign income taxes under sections 902 and 960, which taxes in fact were paid by its foreign subsidiary as a result of a foreign tax redetermination. The facts also involved a complex corporate restructuring of various foreign subsidiaries several of which converted into defective entities in accordance with the check-the-box regulations.

Sections 902, 960 and 78

Under section 902, a domestic corporation is treated as having paid foreign income taxes paid by a foreign corporation as it receives or is deemed to have received dividend income provided the domestic corporation owns at least 10% of the foreign corporation’s voting stock. The amount of the deemed foreign tax paid is determined by allocating the foreign corporation’s foreign income taxes among its earnings and profits and then charging such portion of the tax to the earnings and profits wrapped in the dividend. For example, if a foreign corporation distributes 40% of its earnings and profits in the form of a dividend to a domestic corporation owning 40% of its stock, the U.S. corporation receiving the dividend is treated as having paid 40% of the amount of the earnings and profits included in the dividend which represents the foreign corporation’s foreign income taxes with respect to such dividend. The deemed dividend under section 902 is creditable under section 901 subject to the overall foreign tax credit limitation in section 904(a) as well as other applicable FTC limitations. Section 78 also enters into the mix requiring the domestic corporation receiving the dividend from the foreign owned subsidiary to include the deemed taxes (foreign) paid in the amount of the dividend includible in gorss income. The indirect foreign taxes paid regime also applies to U.S. shareholders of controlled foreign corporations (CFCs) under the subpart F provisions. Section 960 requires that a subpart F inclusion is treated as a dividend for FTC purposes and implicates sections 902 and 78.

The indirect or deemed FTC under section 902 is sourced or connected with the foreign corporation’s post-1986 foreign income taxes which is the sum of foreign income taxes paid with respect to the tax year of the dividend plus all foreign taxes for prior years starting after 1986. The foreign corporation’s pool of post-1986 foreign income taxes is reduced when dividends are made to which foreign taxes are attributed. See sections 902(c)(2)(B), 960(a)(2). The earnings and profits pool is reduced when dividends are paid to a shareholder that does not qualify for or does not claim the indirect foreign tax credit. See Treas. Reg. §1.902-1(f). There may be some tax advisors who may take issue with this last sentence.

As to pre -1987 earnings and profits, such e&p is allocated to specific years and distributions sourced to such pre-1987 earnings and profits are “layed” to the proper tax year per section 902(c)(6). TRA 1986 changed this rule for post-1986 tax years, treating such earnings and profits as a single multi-year pool . As of August 5, 1997, the Taxpayer Relief Act of 1997 clarified that in determining the deemed paid credit for a tax year, a foreign corporation’s post-1986 foreign income taxes includes foreign income taxes with respect to prior post-1986 tax years to the extent those taxes are not attributable to (rather than deemed paid with respect to) dividends distributed by the foreign corporation in prior tax years. Pub. L. No. 105-34, § 1163. Once all post-1986 pools of earnings and profits are eliminated, dividends are considered paid out of pre -1987 earnings and profits. Section 902(d)(6). Such dividends reduce earnings and profits available to be distributed as a dividend, but do not reduce the components of the deemed-paid credit formula.

Now onto ILM 201441015.

ILM 201441015
The facts beging with a U.S. corporation (P) owning 100% of CFC1, which foreign corporation was incorporated in country X. P also owned 100% of CFC4 that owned 100% of CFC5. Both CFC4 and CFC5 were incorporated in country Y. Since 2002 the U.S. parent and CFC5, together, owned 100% of US Corp2 which was a member of P’s consolidated group.

In 2001, prior to being acquired by P, USCorp2 acquired more than 10% but less than 50% of the voting stock of CFC2, a country X corporation. Accordingly, CFC2 and its wholly-owned country X subsidiaries became noncontrolled section 902 corporations. See section 904(d)(2)(E) in 2001. CFC2 was renamed CFC3 and it became a member of a qualified group through a chain of ownership as defined in section 902(b)(2) because 100% of its voting stock was owned by CFC1 and CFC5.
Now let’s fast forward to 2010 in which a number of CFCs wholly owned by CFC (and incorporate in country X) became disregarded entities under Treas. Reg. §301.7701-3(c) and were deemed liquidated under section 332. Under section 381, and in accordance with Treas. Regs. §§ 1.367(b)-7(d) and -7(e), CFC3 succeeded to the post-1986 undistributed earnings and post-1986 foreign taxes paid by the wholly owned subsidiaries, now defective entities, as well as their pre-1987 accumulated profits and pre-1987 foreign income taxes paid.

Also in 2010, CFC1 elected deemed liquidation treatment in becoming a defective entity resulting in a deemed dividend to the U.S. parent to the extent of CFC1′s earnings and profits under Treas. Reg. §1.367(b)-3(b)(3)(i). CFC3 elected to be treated as a partnership in a deemed liquidation under section 331 and gain on the sale of CFC3 was recharacterized as a dividend under section 1248 to US Corp2, CFC1, and CFC5, a portion of which was attributable to post-2001 earnings and profits but not pre-1987 accumulated profits.

So, what is the issue(s)? The ILM was issued in response to whether P, in computing its 2010 deemed FTC under sections 902 and 960, properly included in its country X CFC’s post-1986 foreign income tax pools, amounts paid by CFC3 in 2007 as a result of a foreign tax redetermination regarding its pre-1987 accumulated profits for its 1994-1999 tax years.

The answer provided in ILM 201441015 was that P country X CFC pools of post-1986 undistributed earnings and post-1986 foreign income taxes include amounts from CFC3 for tax years after 2000, when US Corp2 first satisfied the minimum ownership requirements in section 902(c)(3)(B). Further, the foreign income taxes paid by CFC3 in 2007 related to pre-1987 accumulated profits and could be used to adjust the parent’s country X CFC pools of pre-1987 accumulated profits and pre-1987 foreign income taxes paid but are excluded from post-1986 foreign income taxes under Treas. Regs. §§1.902-1(a)(10), -1(a)(13), and Temp. Reg. § 1.905-5-5T.
However, because the CFCs’ pre-1987 accumulated profits were eliminated by the CFCs’ check-the box elections in 2010, no portion of the earnings had been or ever will be included in the taxable income of the parent’s consolidated group. As a result, P’s country X pools of pre-1987 foreign income taxes were found to be ineligible for a deemed FTC. Since the foreign taxes paid by CFC3 relate to tax years when it and its lower-tier entities were not CFCs, taxes paid below the third tier in the qualified group are nevertheless ineligible for a deemed FTC as provided in section 902(b)(2) for post-1997 tax years in which the corporation was a CFC.