IRS provides roadmap for examining foreign tax credit ‘voluntary tax’ issues

Tax Insights
from International Tax Services
IRS provides roadmap for examining
foreign tax credit ‘voluntary tax’
issues
December 17, 2015
In brief
The Large Business and International Division (LB&I) of the IRS issued three International Practice
Units (IPUs) on December 15, 2014 that provide field examiners with audit guidelines on ’voluntary tax’
issues for foreign tax credit (FTC) purposes under Section 901. The three IPUs, each in the form of a
slide deck, are titled respectively ‘Exhaustion of Remedies’ (23 slides), ‘Exhaustion of Remedies and
Transfer Pricing’ (19 slides), and ‘Exhaustion of Remedies in Non-Transfer Pricing Situations’ (21 slides).
These three IPUs address the requirement in Treas. Reg. sec. 1.901-2(e)(5)(i) that foreign income tax
payments must be ‘compulsory’ in order to be creditable for US federal income tax purposes.
Specifically, they deal (among other things) with the FTC creditability rule calling for a US taxpayer to
exhaust all remedies before paying an amount of foreign income tax.
LB&I has released 86 International Practice Units (IPUs) since December 15, 2014. These IPUs provide
roadmaps for IRS examiners in addressing certain issues involving US federal income taxation of crossborder activities. Each IPU presents the topics, issues, technical foundations, and conceptual approaches
that IRS examiners are expected to follow on the relevant topic. These IPUs differ from the voluminous
Internal Revenue Manual (IRM) in being focused on specific issues (international only) in greater depth,
providing more detailed guidance to IRS examiners. Taxpayers that may be subject to IRS examination
in areas covered by IPUs should be aware of these expected approaches. Taxpayer awareness can both
facilitate preparation for examination and provide a basis for questioning examinations that do not
follow the relevant IPUs.
In detail
LB&I classification
LB&I issues all IPUs under a
classification scheme based on
an international tax topical
matrix. All three of the
Exhaustion of Remedies IPUs
are classified under the Shelf
‘Business Outbound,’ the
Volume ‘FTC Management,’ the
Part ‘Creditability,’ and the
Chapter ‘Compulsory
Payments/Exhaustion of
Remedies.’ The Sub-Chapter in
each case is the title of the IPU.
General voluntary tax
concerns
LB&I issued these three IPUs to
ensure that field examiners
understand how to audit
situations in which US
taxpayers claim FTCs for foreign
income tax amounts that may be
higher than those taxpayers
were absolutely compelled to
pay under foreign law. As the
IPU titled ‘Exhaustion of
Remedies’ states,
A system under which the U.S.
Treasury allows foreign tax
credits (FTCs) without requiring
that U.S. taxpayers effectively
and practically reduce their
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foreign tax payments as legally
imposed would potentially create a
hazard. Taxpayers would otherwise
have no incentive to challenge any
foreign tax whether or not properly
imposed, thereby transferring the
foreign tax cost to the United States.
Taxpayers are required to exhaust all
“effective and practical” remedies
(including competent authority
procedures provided under applicable
tax treaties) to reduce, over time, its
liability for (foreign) tax.
That IPU specifies that is it aimed at
process issues regarding potential
voluntary tax situations, while the
other two deal more with addressing
the substance of FTC claims in certain
factual situations. The IPUs describe
the circumstances where voluntary tax
issues are most likely to arise as
involving either (i) transfer pricing
adjustments (US or foreign) or (ii)
where inconsistent tax treatment of a
transaction or instrument by the US
and foreign authorities could be
conformed to reduce or eliminate
foreign tax through either (a) foreign
administrative or judicial appeals or
(b) invoking Competent Authority.
The IPUs acknowledge that not every
difference in treatment between
foreign and US tax law will create a
situation causing foreign income tax
not to be creditable. In particular,
creditability may not be an issue in
timing differences between US and
foreign tax treatment, including
situations involving amortization,
depreciation, inventory valuation,
capitalization, and R&D expenses. The
IPUs also remind examiners that an
exhaustion of remedies challenge may
not result in a current US federal
income tax adjustment if the taxpayer
has an excess credit or NOL position.
Process criteria and resources
The IPU on voluntary tax process
issues lists the following criteria for
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examiners to recognize during an
audit:
1. There may be different treatment
of a transaction under US and
foreign tax law.
2. The examiner should:
a) Review Form 5471 Schedule H
book-to-tax adjustments and
request an explanation of
material adjustments.
b) Examine foreign books and
records, foreign tax returns,
and other sections of Form
5471 (schedules C, E, G and I),
along with Form 1118 to
identify high foreign effective
tax rates that may have been
improperly computed or
could have been abated.
c) Ask the taxpayer about the
existence of foreign audits
and transfer pricing
adjustments.
d) Review US initiated transfer
pricing adjustments.
The IPU directs the examiner to use
the following resources for this
process:
 Form 1118
 The taxpayer’s FTC workpapers
 Form 5471 and its instructions
 Any Section 905(c) adjustments
based on foreign tax audits
 Any transfer pricing study
documentation
 Any applicable tax treaty
 Pattern Letter 1853, advising
taxpayers to extend foreign
statutes of limitation in light of
potential IRS tax adjustments
 Any Mutual Agreement Procedure
(MAP) letter or report
 Any Rev. Proc. 99-32 statements
filed with the taxpayers US federal
income return with respect to
Section 482 adjustments
Transfer pricing fact patterns
The IPU on voluntary tax issues
involving transfer pricing situations
describes two generic factual
scenarios in which the US parent
corporation (USP) either (a) acquires
goods from a controlled foreign
corporation (CFC) in exchange for
payment or (b) exchanges (for
payment from a CFC) property,
services, the use of intellectual
property or financing services.
Scenario 1 addresses situations in
which the IRS reallocates income
from CFC to USP, thus decreasing the
CFC’s E&P pool. Reallocating that
income creates the possibility of
double taxation in the foreign country.
As the IRS notes, if a taxpayer did not
pursue Competent Authority or other
relief to reduce the amount of taxable
income in the foreign country, the
CFC’s E&P pool would be decreased
but its tax pool would remain
unadjusted. Scenario 1 also includes
the situation in which the IRS may
apply transfer pricing principles to
analyze branch (organic or hybrid)
allocations for foreign tax purposes.
Scenario 2 addresses situations in
which the foreign government
reallocates income from USP to CFC.
The foreign country would then assess
additional foreign tax, thus increasing
CFC’s tax pool. As a result, the
taxpayer would be eligible to claim a
higher deemed-paid FTC than if the
foreign transfer pricing adjustment
had not occurred.
Non-transfer pricing fact patterns
The IPU on voluntary tax issues
involving non-transfer pricing
situations describes three generic
factual scenarios in which the US
parent corporation (USP) either (a)
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receives a dividend from a CFC or (b)
encounters inconsistent
characterizations between the US and
a foreign country of certain
transaction flows.
Scenario 1 addresses situations in
which different treaty countries can
impose different withholding rates
based on their tax treatment of a
payee entity. The fact pattern is as
follows:
 USP is a US corporation that owns
100% of CFC1, a Country A
corporation.
 CFC1 owns 100% of CFC2, a
Country B corporation.
 The tax treaty between Country A
and Country B permits Country B
to impose X% tax on dividend
payments from CFC2 to CFC1.
 The tax treaty between the United
States and Country B permits
Country B to impose X+1% tax on
dividend payments from CFC2 to a
US corporation.
 CFC2 pays a dividend to CFC1 and
withholds at the X% Country ACountry B treaty-rate.
 On audit, Country B disregards
CFC1 (thereby treating USP as the
direct owner of CFC2), treats CFC2
as having paid the dividend to
USP1, and assesses additional tax
based on the X+1% US-Country B
treaty rate.
Scenario 2 addresses situations in
which there is inconsistent
characterization of debt and equity
between different jurisdictions. The
fact pattern is as follows:
 USP is a US corporation that owns
100% of CFC, a Country A
corporation.
 The tax treaty between the United
States and Country A permits
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Country A to impose X% tax on
interest payments from CFC to
USP and X+1% tax on dividend
payments from CFC to USP.
 USP advances money to CFC,
which they treat as debt.
 CFC pays interest to USP, deducts
those payments in computing its
Country A taxable income, and
withholds at the X% US-Country A
treaty rate.
 On audit, Country A characterizes
USP’s advance to CFC as an equity
contribution and the payments
from CFC to USP as dividends,
disallowing CFC’s interest expense
deductions.
 Country A assesses additional tax
based on the X+1% US-Country A
treaty rate on dividends and the
interest deduction disallowance.
Scenario 3 addresses situations in
which there is inconsistent
characterization of US-provided
information technology (IT) services
versus royalties. The fact pattern is as
follows:
 USC is a US corporation resident in
the United States, and FC is an
unrelated Country A corporation.
 The US-Country A tax treaty
permits Country A to (1) tax USC’s
business profits attributable to a
permanent establishment (PE) that
USC has in Country A, and (2)
impose X% withholding tax on any
royalties payments from FC to
USC.
 USC and FC enter into an
agreement under which FC pays
USC a fee to provide IT services.
 USC provides IT services to FC
from the United States and does
not have a PE in Country A.
 FC pays for the IT services as
agreed, and USC does not pay tax
in Country A because the fees are
not business profits attributable to
a Country A PE.
 On audit, Country A determines
that USC provided FC the right to
use USC’s intellectual property (IP)
in addition to IT services. Thus,
Country A recharacterizes a
portion of FC’s fee payments as
royalties for the use of IP in
Country A, and assesses tax based
on the X% US-Country A treaty
royalties rate.
Issues raised
In all three IPUs, LB&I raises the
same three issues in auditing possible
FTC voluntary payment situations:
1.
How does a taxpayer prove
exhaustion of local law remedies?
2. How is the exhaustion of remedies
analysis affected where a tax
treaty applies?
3. Can there be an exhaustion of
remedies in a treaty country if
taxpayer does not invoke US
Competent Authority?
LB&I lays out its approach to these
questions in steps, each one composed
of ‘Considerations’ and ‘Resources’.
Proving exhaustion of local law
remedies
General process issues
The IPU on voluntary tax process
issues begins with basic
considerations:
 A taxpayer should pursue
administrative appeals and court
challenges if a foreign tax
authority’s position is
unreasonable under local law, but a
remedy is effective and practical
only if its cost is reasonable in light
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of the amount at issue and its
likelihood of success.
 A taxpayer is not required to
pursue ineffective remedies.
 A settlement of two or more issues
is evaluated on an overall basis, not
an issue-by-issue basis.
 If a taxpayer knew (or should have
known) it could have pursued
effective and practical remedies to
reduce its taxes under foreign law,
then the IRS will view any failure
to preserve its remedies within the
foreign statute of limitations as
creating a voluntary payment.
 If a taxpayer did not have actual or
constructive notice that it overpaid
foreign taxes before the statute
expired, and no treaty applies, then
it may have exhausted its remedies.
For these considerations, the
resources listed are the voluntary tax
regulation, the relevant foreign
substantive and procedural law, and
any relevant foreign-law legal
opinions.
The IPU then notes that foreign audits
of US-based taxpayers have become
more frequent and, at times, more
aggressive. In LB&I’s view, a US
taxpayer should not simply pay
additional tax due as a result of a
foreign audit and then attempt to
recoup the tax as part of the Section
905(c) foreign tax redetermination
process. Accordingly, examiners are
instructed to:
 Ask the taxpayer about any foreign
tax audit adjustments and what
steps the taxpayer has taken to
ameliorate any additional foreign
taxes resulting from the foreign tax
audit.
 Review the taxpayer’s amnesty
documentation (if a foreign
country offers a general or partial
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tax amnesty) to verify whether the
taxpayer made a good faith effort
to reduce its foreign tax. The IPU
notes that accepting a foreign tax
amnesty may be the taxpayer’s best
option, but it may also deprive US
Competent Authority of the chance
to negotiate a better settlement.
For these considerations, the
resources listed are any Section 905(c)
workpapers, translated documents
related to the foreign tax adjustment,
and foreign tax amnesty
documentation.
The IPU then addresses what an
examiner should do under the
following circumstances:
 A CFC pays but disputes a foreign
tax. The IPU directs that the
taxpayer may claim FTCs while the
contest is ongoing,
‘notwithstanding that the tax
cannot accrue until the contest is
resolved.’ Although a Section
905(c) redetermination may occur
if foreign tax is refunded, the IPU
suggests that examiners secure a
statute extension from the taxpayer
in case the taxpayer stops
contesting the foreign tax once the
FTC is allowed. For this
consideration, the resources listed
include Rev. Rul. 84-125; IBM v.
US, 38 Fed. Cl. 661 (1997), and
documentation from any foreign
tax audit or court proceedings.
 The taxpayer has an opinion letter
from foreign counsel or a CPA firm
supporting the position that
available remedies are not effective
and practical under the
circumstances. The IPU notes that
an opinion letter may not be
sufficient unless it includes (i) a
detailed discussion of the relevant
legal authorities and (ii) a
conclusion that the foreign tax was
properly assessed -- or a reasoned
explanation why a challenge to the
assessment was unlikely to
succeed. Lacking an opinion letter,
the taxpayer must demonstrate
that it (a) has requisite foreign tax
expertise and (b) made a
reasonable decision not to pursue
the contest. In this situation, the
IPU instructs examiners to consult
with IRS counsel in reviewing an
opinion letter.
Observation: It is interesting and
important that LB&I believes in-house
expertise on this issue may be
sufficient.
The IPU emphasizes that voluntary
tax analyses depend on facts and
circumstances. It recommends
examiners rely as resources on
Procter & Gamble Co. v. US, 2010
WL2925099 (SD Ohio, 2010) and
Field Service Advisory (FSA) 1993WL
1468222 (July 15, 1993). It describes
Procter & Gamble as a case in which
the taxpayer established that a Korean
tax was compulsory but failed to show
that it exhausted available remedies
under Japanese law and the US-Japan
treaty to recover tax previously paid to
Japan.
Transfer pricing and non-transfer
pricing situations
Both IPUs on substantive voluntary
tax situations set forth considerations
and resources similar to those
discussed above with respect to the
general voluntary payment process.
These two IPUs note that a taxpayer
should undergo largely the same
process to exhaust its remedies
whether or not the issue is in a
transfer pricing context.
In the transfer pricing context, the
second IPU adds a further
consideration inquiring whether (i)
the relevant foreign country has a
history of raising unsupportable
transfer pricing adjustments and (ii)
that country’s courts have been
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available to contest such adjustments.
The IPU instructs examiners to
consult with the IRS’ Advance Pricing
and Mutual Agreement (APMA)
section on that country’s particular
characteristics in this context.
Potential treaty impact
The three IPUs emphasize that
taxpayers operating in treaty
countries must generally utilize
favorable treaty provisions or properly
pursue US Competent Authority relief.
They also note that exhausting
remedies in a treaty country involves
largely the same process whether the
issue is in a transfer pricing or nontransfer pricing context. An
appropriate remedy may involve (i)
claiming a reduced treaty rate on the
taxpayer's foreign return; (ii) a refund
claim; (iii) an objection to a foreign
assessment; or (iv) a Competent
Authority request. The IPUs reference
Rev. Proc. 2006-54 and Rev. Rul. 9275 as audit resources.
If a taxpayer has settled a foreign tax
dispute, the IPUs warn that such a
settlement may preclude the US
Competent Authority from negotiating
relief under the treaty, which could
make any foreign taxes paid
voluntary. The examiner is instructed
to obtain a copy of the settlement
agreement and consult Competent
Authority as to whether the settlement
was reasonable (and thus exhausted
remedies).
The process IPU also instructs an
examiner what to do if a taxpayer
claims it has already gone through the
Competent Authority process: request
the Competent Authority disposition
letter if the process was supposedly
successful and the Competent
Authority disposition memorandum if
the taxpayer proved ineligible for
Competent Authority proceedings.
The IPU also instructs the examiner to
consult with Competent Authority to
verify the taxpayer’s position and
supporting documentation. The IPU
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further addresses what is required
when US and foreign authorities do
not agree on a case and a taxpayer
refuses to accept the deal negotiated
by the Competent Authorities.
Basically, the taxpayer must still
exhaust ‘all effective and practical
remedies’ in the treaty country or
support any claim that such effort
would be futile, which may include
reliance on an opinion letter.
The IPUs all make clear that a
taxpayer not invoking Competent
Authority in a treaty country tax
dispute would likely not be considered
to have exhausted its remedies. The
process IPU notes that there are a few
exceptions to this rule, but the burden
to prove an exhaustion of remedies
without Competent Authority relief is
on the taxpayer. The exceptions
include cases where (i) Competent
Authority assistance may not be
necessary (such as de minimis cases),
(ii) other administrative remedies or
litigation are successful, (iii) the
taxpayer has received an opinion of
local counsel or (iv) the taxpayer has
otherwise complied with foreign laws
to minimize its taxes. The IPU also
mentions that Rev. Proc. 2006-54 lists
other possible exceptions. Examiners
are instructed to determine (i) why
the taxpayer did not request
Competent Authority relief and (ii)
whether the taxpayer obtained relief
in some other manner. In nontransfer pricing cases, the examiner
should consult with the Competent
Authority’s Treaty Assistance &
Interpretation Team (TAIT) section.
Observation: The exceptions to
invoking Competent Authority are
broader than some observers might
have expected.
Finally, the process IPU notes that
taxpayers with non-creditable foreign
taxes can still deduct them if they
qualify as ordinary and business
expenses. It also lists some additional
resources examiners should consult in
voluntary tax cases.
Observation: More aggressive tax
audits in various countries are likely
to result in more cross-border tax
disputes, especially as new laws are
enacted in response to the OECD base
erosion and profit shifting (BEPS)
project. Accordingly, the voluntary
tax issue may be of increasing interest
to US multinationals. The possibility
of overburdened Competent Authority
resources and potentially restricted
Competent MAP access in some
countries could result in difficulties
for taxpayers seeking to exhaust all
remedies in order to claim FTCs on
certain contested foreign income.
Even though the OECD BEPS process
seeks to improve cross-border dispute
resolution mechanisms, it is unlikely
that mandatory arbitration will apply
in most cases. This could leave
taxpayers without effective remedies
in some situations. The three IPUs on
Exhaustion of Remedies helpfully
show the approach examiners are
expected to take. However taxpayers
may find it challenging to satisfy some
of the criteria that the IPUs present.
The takeaway
The three IPUs on Exhaustion of
Remedies helpfully set forth the IRS
roadmap for examining voluntary tax
FTC issues. The IPUs show the
examiners’ expected approach, but
taxpayers may find it challenging to
satisfy some of the criteria for
avoiding a voluntary payment issue.
In particular, as tax authorities in
many countries become more
aggressive and cross-border dispute
resolution mechanisms become
overburdened, US multinationals may
have difficulties establishing that they
have exhausted all remedies in a
manner sufficient to satisfy IRS
examiners.
See also PwC Tax Insight dated July
22, 2015.
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Let’s talk
For more information, please contact:
International Tax Services
Alan Fischl
202-414-1030
[email protected]
Carl Dubert
202-414-1873
[email protected]
Marty Collins
202-414-1571
[email protected]
Elizabeth Nelson
202-312-7562
[email protected]
Tax Controversy and Regulatory Services
Mike Danilack
202-414-4504
[email protected]
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