Sec. 901(m): potential trap for partnership transactions.

• Author: Dokko, Sean

In 2010, President Barack Obama signed P.L. 111-226, enacting new Sec. 901(m), which limits the creditability of foreign taxes in certain acquisition transactions where a taxpayer receives a basis step-up for U.S. tax purposes but no corresponding basis step-up for foreign tax purposes. Soon, the IRS is expected to issue regulations under Sec. 901(m) that will, among other things, clarify what types of covered asset acquisitions are considered "any other similar transaction" for purposes of Sec. 901(m).

Basic Application of Sec. 901(m)

Sec. 901(m) limits the creditability of foreign taxes in: "covered asset acquisitions" (CAAs). A CAA is defined in Sec. 901(m) (2) as:

1. A qualified stock purchase to which Sec. 338(a) applies;

2. Any transaction that is treated as an acquisition of assets for U.S. income tax purposes and is treated as an acquisition of stock of a corporation (or is disregarded) for foreign income tax purposes (i.e., the acquisition of interests in a hybrid entity that is recognized as a disregarded entity for U.S. tax purposes but is recognized as a corporation for foreign tax purposes);

3. Any acquisition of an interest in a partnership that has a Sec. 754 election in effect; and

4. Any other similar transaction, to the extent provided by the IRS.

   The disqualified portion of a foreign income tax is defined in Sec. 901(m)(3) (A) as the ratio (expressed as a percentage) of:

1. The aggregate basis difference (but not below zero) allocable to the tax year for all relevant foreign assets, divided by

2. The income on which the foreign tax is assessed.

   Sec. 901(m)(6) provides that any foreign taxes disqualified under Sec. 901(m) may still be deducted by the taxpayer.

   Essentially, the purpose of Sec. 901(m) is to limit the ability of taxpayers to claim foreign tax credits with respect to transactions that create permanent differences between a taxpayer's foreign tax base and U.S. tax base by disallowing foreign tax credits for foreign taxes paid on income that is not also subject to U.S. income tax.

   Sec. 704(c) Allocations

   As noted above, Sec. 901(m)(2) includes within the scope of a CAA "any other similar transaction" that creates a permanent difference between the foreign tax base and the U.S. tax base. Without clarification from. the IRS, transactions that create a Sec. 704(c) or reverse Sec. 704(c) allocation could fall within the catch-all provision because such allocations could create a permanent difference between the U.S. and...