Back-to-back computer licensing arrangements narrowly carved out of the ambit of sec. 901(l) (1).

• Author: Calianno, Joseph M.

In Notice 2005-90, the IRS and Treasury provided an exception to Sec. 901(1)(1)'s general rule that denies a foreign tax credit (FTC) for withholding taxes imposed on an item of income (other than dividends) or gain, when the underlying property generating the income or gain is held for a relatively short period. This narrow exception applies to foreign withholding taxes imposed on payments in certain back-to-back computer licensing arrangements. This item provides (1) a brief overview of the FTC; (2) a brief discussion of Sec. 901(k) and (1), and the types of transactions that have led to their enactment; and (3) a discussion of Notice 2005-90.

FTCs

The FTC can be extremely valuable in minimizing a taxpayer's global tax liability, and in managing a U.S. multinational group's effective tax rate. Generally, it provides a dollar-for-dollar offset against a U.S. taxpayer's gross Federal tax liability. It may be available for foreign income taxes imposed directly on a taxpayer (e.g., on the net income of the taxpayer's foreign branch or foreign disregarded entity) or, in the case of a domestic corporation, indirectly on a taxpayer. If certain conditions are satisfied (including owning 10% or more of the foreign corporation's voting stock), a domestic corporation receiving a dividend from a foreign corporation may claim an indirect FTC under Sec. 902; see also Sec. 960. Further, foreign withholding taxes may be imposed on certain income items, such as dividends, interest, rents and royalties, and they may be eligible for an FTC. However, the FTC has limits and restrictions, which can reduce its availability and potentially expose a U.S. taxpayer to double taxation.

IRS Challenges

Given the FTC's significance and its ability to drive down a U.S. multinational's effective tax rate, U.S. taxpayers have entered into certain arrangements designed to generate FTCs. The IRS and Congress have closely scrutinized such arrangements because of their perceived lack of economic substance outside of generating FTCs, especially when a taxpayer claims an FTC on withholding taxes on dividend income, but holds the underlying stock on which the dividend is paid for a relatively short period. For example, the IRS hotly contested two cases on the ground that the taxpayer's underlying transaction had no economic substance or business purpose other than reducing taxes; see Compaq Computer Corp., 113 TC 214 (1999), rev'd, 277 F3d 778 (5th Cir. 2001), and IES Industries Inc., 253 F3d 350 (8th Cir. 2001).

In Compaq and/IES, U.S. taxpayers claimed FTCs for foreign withholding taxes on dividends from a foreign corporation. In both cases, they had a brief...