Global Tax Alert (News from Transfer Pricing) | 12 December 2013

US IRS issues guidance on treatment under Sections 482 and 901 of transactions with foreign branches or disregarded entities

  • Share

Executive summary

On 6 December 2013, the Service issued Chief Counsel Advice Memorandum 201349015 (CCA), addressing the extent to which US transfer pricing principles may be applied to determine whether a transaction between a foreign branch or disregarded entity (DE) and its US tax owner or another member of a consolidated group or a related controlled foreign corporation (CFC) results in a noncompulsory payment of foreign tax for which a foreign tax credit may be denied.

Although the application of transfer pricing principles to transactions between the foreign branch or DE and its US tax owner will not affect the amount of the tax owner’s income or earnings and profits for US tax purposes, the use of a non-arm’s length transfer price may result in the branch or DE reporting too much income to the foreign country or countries in which it operates, resulting in an overpayment of foreign income tax. Thus, the IRS advised that US transfer pricing principles may be relevant in determining whether non-arm’s length transfer prices in transactions between a foreign branch or DE and its US owner result in noncompulsory payments of foreign tax that are not eligible for a US foreign tax credit, to the extent foreign tax law, including any applicable tax treaty, includes similar arm’s length principles. Furthermore, the IRS advised that taxpayers have the burden of establishing they have properly minimized their creditable foreign tax liability by exhausting all effective and practical remedies (including resort to competent authority proceedings when available) to reduce, over time, their liability for foreign tax. When applicable, taxpayers also have the burden of establishing that claims based on deemed paid credits include only foreign taxes that were properly accrued and paid within the meaning of the applicable regulations.

While the CCA specifically addresses the application of this principle in the context of transactions between a foreign branch or DE of a member of a US consolidated group and another member and transactions involving foreign branches or DEs of CFCs, it also discusses a foreign corporation’s computation of income that is effectively connected, or treated as effectively connected, with its conduct of a trade or business within the United States. It notes that, under certain treaties, profits of a US permanent establishment (PE) may be determined based on all of the PE’s dealings, including transactions between a US PE and the foreign corporation of which it is a part (or another branch of the foreign corporation) despite the fact that such inter-branch dealings would not give rise to income, gain, profits, or loss of that foreign corporation under US tax law.

Detailed discussion

Under the noncompulsory payment rule of Treas. Reg. Section 1.901-2(e)(5), a US foreign tax credit is denied for any amount of foreign tax paid that exceeds the amount of the taxpayer’s foreign tax liability. For these purposes, a taxpayer’s foreign tax liability must be determined in accordance with a reasonable interpretation of foreign tax law, as modified by applicable tax treaties, in such manner as to reduce, over time, the taxpayer’s reasonably expected liability under foreign law for tax. In addition, the regulations require a taxpayer to exhaust all effective and practical remedies, including invocation of competent authority procedures to reduce, over time, the taxpayer’s liability for foreign tax.

When a US tax owner’s foreign branch or DE fails to use an arm’s length transfer price to compute the income reported on a foreign tax return, the IRS raises the concern that the foreign branch or DE may have overstated the profits subject to foreign tax and, therefore, made a noncompulsory payment of foreign tax based on that overstatement. Accordingly, the CCA advises that, to the extent the foreign jurisdiction treats transactions between the foreign branch, or DE, and its US tax owner as related-party transactions and applies the arm’s-length standard to such transactions, US transfer pricing principles may be relevant to determine whether a noncompulsory payment of foreign tax was made that is ineligible for a US foreign tax credit.

The CCA specifically addresses the application of this principle in the context of the following factual patterns:

1. Transactions between a foreign branch or DE and its US tax owner

For US tax purposes, a foreign DE is treated as a foreign branch, and all of the income of a foreign branch or DE is included in the taxable income of its owner. Under this single-entity approach, items of income and expense attributable to a foreign branch or DE are not netted against those of its US owner; rather, transactions between them are generally disregarded for tax purposes. Because the transactions are disregarded in the single-entity scenario, the application of Section 482 and its regulations would not affect the amount of taxable income the US owner would recognize for US tax purposes. However, transfer pricing principles may still be relevant in determining whether non-arm’s length prices between the US owner and its foreign branch or DE result in too much foreign income being attributed to the foreign branch or DE, thereby resulting in noncompulsory payments of foreign tax that are ineligible for foreign tax credits. The CCA acknowledges the application of the arm’s-length principle of Section 482 in this context will often be limited to the applicable tax treaty’s incorporation of the same, but remarks that many tax treaties already contain an articulation of the arm’s-length principle.

2. Transactions between a foreign branch or DE of a member of a US consolidated tax group and another member

In contrast to the first scenario, transactions between a foreign branch or DE of a US member of a consolidated group and another member of the same group are transactions that have effect for US tax purposes. Here, US transfer pricing principles apply to these intercompany transactions, as articulated in Treas. Reg. Section 1.1502-13, which notes the amount and location of intercompany items are determined on a separate-entity basis, while the timing, character, source and other tax attributes of intercompany items and corresponding items are adjusted to produce the effect of transactions between divisions of a single corporation. In other words, for transactions between members of a consolidated group, Section 482 applies to determine and allocate arm’s-length amounts between the members, while the consolidated return rules will apply to determine all of the tax attributes on a single-entity basis. Accordingly, adjustments to transfer prices of transactions in this scenario would give rise to offsetting amounts of gross income and expense, but these adjustments would not change the amount of US worldwide income recognized by the US consolidated group for the year in which the adjustment is made. Similarly, any transfer pricing adjustments also would not affect the amounts of the consolidated group’s US and foreign-source income, or the amounts of deductible expenses or losses allocated and apportioned to US and foreign-source gross income.

3. Transactions involving foreign branches or disregarded entities of CFCs

Similar issues involving noncompulsory payments may arise when a CFC that is the US tax owner (CFC tax owner) of a foreign branch or DE, when the foreign branch or DE engages in transactions with its (1) CFC tax owner; (2) a related but separately regarded CFC; or (3) a US shareholder of either the CFC tax owner or a related but separately regarded CFC. In these cases, applying transfer pricing principles to transactions between the foreign branch or DE and its CFC tax owner would not affect the amount of the CFC’s income or earnings and profits for US purposes. However, transactions between a foreign branch or DE and any of the other parties described above may result in adjustments to income and earnings and profits of the CFC(s) and US shareholder(s) for US tax purposes.

When transactions involve the foreign branch or DE of a CFC, deemed paid foreign taxes under Section 902 are generally implicated. Regardless of whether the foreign tax is direct (Section 901) or deemed paid (Section 902), Treas. Reg. Section 1.901-2(e)(5)’s obligation to exhaust remedies to reduce foreign tax liabilities over time still applies. Further, US shareholders of CFCs have the burden of establishing, to the Service’s satisfaction, that foreign tax credit claims for deemed paid credits include only foreign income taxes that were properly accrued under applicable regulations.

The CCA goes on to note that transactions between a foreign corporation and its US branch or DE are typically disregarded for US tax purposes, and thus, do not give rise to effectively connected income (ECI) or to deductions that are properly allocated and apportioned to ECI. The CCA notes, however, that there are limited circumstances under which disregarded transactions between the foreign home office of a foreign corporation and its US branch or DE that do not give rise to ECI or related deductions are nonetheless given effect for limited US tax purposes; e.g., for source determinations.1

Finally, the CCA notes that certain US tax treaties adopt the authorized Organisation for Economic ­Co-operation and Development (OECD) approach to attributing profits to PEs, which takes into account assets used, functions performed, and risks assumed when determining business profits of a foreign corporation that is subject to US tax. Under these treaties, the profits of a US PE are determined based upon all of its dealings, including those between the US PE and the foreign corporation of which it is a part (or another branch of that foreign corporation), even if these transactions would not ordinarily give rise to income, gain, profit, or loss for the foreign corporation under US tax law.

Implications

For purposes of determining whether a noncompulsory payment of foreign tax was made, this CCA establishes that it is appropriate for US taxpayers to apply Section 482 principles to determine the arm’s-length amount of income attributable to a foreign branch or DE, to the extent these principles are consistent with foreign tax law and any applicable treaty. Considering the arm’s length principle is almost universally adopted, and has been incorporated into an extensive treaty network, it is unlikely that an application of US principles would run afoul of most foreign legal articulations of transfer pricing concepts. Further, in applying Section 482 principles to determine the amount of foreign income attributable to foreign branches or DEs, taxpayers are more likely to derive an accurate determination of income, and therefore compulsory foreign tax amounts, to be used for purposes of calculating US foreign tax credit amounts. We have seen our clients face these issues more often. While some taxpayers may take the position that transfer pricing is not a relevant risk on transactions with foreign branches or DEs, this guidance from the IRS shows that applying the arm’s length standard is just as important in these types of transactions as in any other, and can help taxpayers avoid the risk of having foreign tax credits denied.

Endnote

1. See Treas. Reg. Section 1.863-3(b)(3).

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services - Transfer Pricing, Washington, DC
  • Karen Kirwan
    +1 202 327 8731
    karen.kirwan@ey.com
  • Loren Ponds
    +1 202 327 8758
    loren.ponds@ey.com
Ernst & Young LLP, International Tax Services, New York
  • Karen Petrosino
    +1 212 773 0375
    karen.petrosino@ey.com

EYG no. CM4035