Economic Substance and the Foreign Tax Credit Generator Regs

In July 2008, Treasury issued Temp. Reg. Section 1.901-2T(e)(5)(iii) designed to shut down what has become known as the "foreign tax credit generator" transaction. In March 2010, Congress finally granted Treasury its wish and codified the "economic substance" doctrine.

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... [A] foreign tax credit generator['s]... purpose is to create for a U.S. taxpayer a foreign tax credit where none (or a smaller one) might otherwise be available. Under the plan, the FTC [foreign tax credit] is increased without much change in the underlying structure.

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The solution that Treasury chose was to expand the "voluntary" tax payment concept..., even though it might have tried to challenge on the economic substance doctrine. ...[A] payment to a foreign government that is voluntary is not an income tax.

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Treasury labeled... as a "structured passive investment arrangement" ...any transaction that... would strip the foreign tax of its foreign income tax character. The foreign tax would still be deductible; it just would not be creditable. A transaction that meets... six conditions will be treated as a “structured passive investment arrangement” under Temp. Treas. Reg. § 1.901-2T(e)(5)(iii) (Jul 15, 2008).

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While reading the temporary regulations, one might wonder if Treasury is not guilty of...  over-engineering. Why would it not be easier for both Treasury and taxpayers to have a regulation that simply adopts the "but for" test - that is, we look at a transaction and ask whether a reasonable businessman would have entered into the transaction but for the foreign tax credit benefit.

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Historically, courts have struggled with what the "economic substance" doctrine is and when (or even if) it applies to a given fact pattern. Congress has now given all of us, courts included, some form of answer in IRC Section 7701(o), which was adopted as a part of the Reconciliation Act of 2010 (HR 4872).

As Congress struggled to craft that section, it also struggled with the concept. As written, the section only applies to transactions to which the doctrine is relevant. As the Joint Committee on Taxation stated..., the provision does not change present law standards in determining when to utilize the doctrine.

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A taxpayer who engages in a "noneconomic substance" transaction is looking at a penalty of 40 (!) percent on the underpayment attributable to the transaction unless the taxpayer discloses the relevant facts on its tax return. [See IRC § 6662(i).] The reasonable cause exception contained in IRC § 6664(c) is not to apply to a nondisclosed noneconomic substance penalty. [See IRC § 6664(c)(2).]

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The section has the likelihood of creating havoc with a large number of transactions, ...because the taxpayer and its advisors will not know whether the section applies to any particular transaction... [I]n reality, none of us knows what those basic transactions are.

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As with so many sections of the Code (think corporate inversions), Congress has created another rigmarole for taxpayers, with little, if any, corresponding benefit to Treasury...

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The foreign tax credit generator transaction seems to fall squarely within the scope of IRC Section 7701(o)...

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New IRC Section 7701(o) may well have rendered the temporary regulations academic, in which case Treasury, in light of the limited scope of the regulations, should give some thought to withdrawing them.

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LEXIS users can access the complete commentary here. Additional fees may be incurred. (Approx. 5 pages)

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