IRS targets multinationals.

• Author: DiMuzio, David A.

On Jan. 20, 1998, the IRS released Notice 98-5, outlining new rules for the allowance of foreign tax credits (FTCs). Regulations to be issued pursuant to the guidelines in the notice will restrict FTCs in transactions in which the economic benefits are too small in relation to the credits, and will be effective for taxes paid or accrued after Dec. 23, 1997.

Introduction

The Service appears to have attempted to rein in multinational companies that are, in its view, "too aggressive" in managing their FTC positions. However, the IRS has since retreated from its initial assertion that it has the authority to issue regulations outlined in Notice 98-5. Still, companies and advisers should be aware that new and substantial restrictions in the use of FTCs may be in the offing. To the extent that any new restrictions impair the competitiveness of U.S. companies, they should not be ignored.

The Service's concern was that certain U.S. taxpayers may have entered into (or are considering) a variety of "abusive tax-motivated transactions with a purpose of acquiring ... foreign tax credits." While practitioners should advise their clients against transactions in which the tax benefits are suspect, the IRS has attempted to define (and ultimately prohibit FTCs related to) a whole new class of transactions deemed to be "abusive" based on a new standard. That standard involves the relationship between the expected economic benefits and tax benefits in the transaction: Too much tax benefit in relation to the economic benefit will result in the transaction being classified as "abusive."

The contents of the notice are not (and are not purported to be) the new regulations. The notice is an announcement intended to stop certain transactions that are being contemplated, and may cause concern for those companies that have implemented transactions that might be covered.

Discussion

The notice attempts to bootstrap itself into legitimacy by labeling certain transactions as "abusive." These transactions are those structured to yield little or no economic profit relative to the tax benefits they are likely to generate, and fall into two categories. The first involves the acquisition of an asset that generates an income stream subject to foreign withholding tax; the second involves a duplication of tax benefits through the use of "certain structures designed to exploit inconsistencies between U.S. and foreign tax laws."

The obvious problem faced by the IRS in attacking transactions in these categories is that in doing so it is also attacking perfectly legitimate business arrangements that are entered into without regard to the tax consequences. Foreign governments have as much right to assess withholding taxes as the U.S. At the same time, there win always be "inconsistencies" between U.S. and foreign tax laws, some of which may provide tax-saving opportunities.

Clearly, therefore, some of the transactions that fall into these two categories will be permissible (i.e., the FTCs will be allowed) and some will not. However, any new regulations will need to be very explicit, since Notice 98-5 seems to be overly broad...