Proposed "technical taxpayer" regulations shut down guardian and reverse hybrid structures.

• Author: Rubinger, Jeffrey L.

Because U.S. taxpayers are subject to federal income tax on their worldwide income, income earned in a foreign country may be subject to double taxation: once in the foreign country and a second time in the U.S. The foreign tax credit provisions are intended to alleviate this double taxation by permitting U.S. taxpayers to claim a credit for "any income, war profits, and excess profits tax paid or accrued during the taxable year ... to any foreign country or possession of the United States...." (1) U.S. taxpayers are also able to claim a credit for a tax paid in lieu of an income tax. (2)

Under the current regulations, a foreign tax is generally considered to be paid by the person or persons on whom foreign law imposes legal liability for such tax (otherwise known as the "technical taxpayer rule"). (3) If foreign income tax is imposed on the combined income of two or more related persons (such as a corporation and one or more of its subsidiaries), and those persons are jointly and severally liable for the income tax under foreign law, foreign law is considered to impose legal liability on each such person for the amount of the foreign income tax that is attributable to its portion of the base of the tax, regardless of which person actually pays the tax. (4)

On August 3, 2006, the Treasury and IRS issued proposed amendments to the current regulations (the proposed regulations). (5) The proposed regulations are, in large part, designed to shut down transactions in which U.S. taxpayers have sought to "hype" their foreign tax credit by splitting the foreign taxes from the underlying income through the affirmative use of a perceived ambiguity in the legal liability rule and/or the U.S. entity classification regulations (commonly referred to as the "check-the-box" regulations). (6) These structures have included use of a disregarded foreign parent where the other members of a foreign-consolidated type regime may not have (in the U.S. sense) the full equivalent of joint and several liability (as seen in Guardian Industries Corp. v. United States, 65 Fed. Cl. 50 (2005)); and reverse hybrid structures (i.e., treated as a pass-through entity under foreign law but as a corporation for U.S. federal income tax purposes).

Guardian Industries Corp. v. United States

In Guardian Industries Corp. v. United States, a Delaware corporation (Guardian) was the parent of a U.S. consolidated group that included a wholly-owned U.S. subsidiary (U.S. HoldCo). U.S. Holdco served as the holding company for a Luxembourg parent company (Foreign HoldCo). Foreign HoldCo was the parent company of a group of Luxembourg companies. A check-the-box election had been made to treat Foreign HoldCo as a disregarded entity (i.e., as a branch of U.S. HoldCo) for U.S. federal tax purposes. (7)

Under Luxembourg law, the parent of a group is solely liable for the corporate income taxes imposed on the members of the group, i.e., the other members of a Luxembourg group are not joint and severally liable for the Luxembourg corporate income tax paid on the group's taxable income. Because Foreign HoldCo was treated as a disregarded entity for U.S. federal tax purposes, under the legal liability rule, U.S. HoldCo was treated as the entity that was liable for, and paid, the Luxembourg taxes imposed on the group.

On its U.S. consolidated income tax return, Guardian initially treated the Luxembourg taxes paid as allocable on a pro rata basis to the members of the Luxembourg group. Subsequently, Guardian successfully filed a claim for refund (for approximately $2.86 million) contending that 1) because Foreign HoldCo was solely liable for the group's Luxembourg taxes and 2) because Foreign HoldCo was a disregarded entity, U.S. HoldCo was entitled to claim a foreign tax credit for all of the Luxembourg taxes paid. (8)

Reverse Hybrid Structures

Another example of how U.S. taxpayers attempted to hype their foreign tax credit by splitting the foreign taxes from the associated income was through the use of reverse hybrid structures. (9) For example, a U.S. person would own a foreign holding company, which would own a foreign operating company. The foreign holding company would be a hybrid entity (i.e., fiscally transparent for U.S. federal tax purposes, but a corporation for foreign tax purposes), and the foreign operating company would be a reverse hybrid entity (i.e., a corporation for U.S. federal tax purposes, but fiscally transparent for foreign tax purposes).

Under the relevant foreign tax law, the foreign operating company's tax would be considered as a liability of its partners (including the foreign holding company). Because the foreign holding company would be fiscally transparent for U.S. federal tax purposes, the foreign tax it paid on its allocable share of the foreign operating company's income would naturally flow into the return of the U.S. owners. However, because the foreign operating company would be treated as a corporation for U.S. federal tax purposes, the underlying income would not be subject to current U.S. federal income tax. (10)

Summary of Changes Made by the Proposed Regulations

As more fully discussed below, the proposed regulations would retain the general principle that tax is considered paid by the person who has legal liability under foreign law for the tax, but would, inter alia, clarify the application of the rule with respect to foreign consolidated-type regimes and with respect to reverse hybrids. The proposed regulations provide rules with respect to the apportionment of tax on combined income and certain collateral consequences when taxes are paid or reimbursed by a...