[Federal Register Volume 72, Number 61 (Friday, March 30, 2007)]
[Proposed Rules]
[Pages 15081-15091]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-5862]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-156779-06]
RIN 1545-BG27


Determining the Amount of Taxes Paid for Purposes of Section 901

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: These proposed regulations provide guidance relating to the 
determination of the amount of taxes paid for purposes of section 901.
    The proposed regulations affect taxpayers that claim direct and 
indirect foreign tax credits. This document also provides notice of a 
public hearing.

DATES: Written or electronic comments must be received by June 28, 
2007. Outlines of topics to be discussed at the public hearing 
scheduled for July 30, 2007, at 10 a.m. must be received by July 9, 
2007.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-156779-06), Room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
156779-06), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-156779-06). 
The public hearing will be held in the Auditorium of the Internal 
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning submission of comments, the 
hearing, and/or to be placed on the building access list to attend the 
hearing, Kelly Banks (202) 622-7180; concerning the regulations, 
Bethany A. Ingwalson, (202) 622-3850 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    Section 901 of the Internal Revenue Code (Code) permits taxpayers 
to claim a credit for income, war profits, and excess profits taxes 
paid or accrued (or deemed paid) during the taxable year to any foreign 
country or to any possession of the United States.
    Section 1.901-2(a) of the regulations defines a tax as a compulsory 
payment pursuant to the authority of a foreign country to levy taxes, 
and further provides that a tax is an income, war profits, or excess 
profits tax if the predominant character of the tax is that of an 
income tax in the U.S. sense. Section 1.901-2(e) provides rules for 
determining the amount of tax paid by a taxpayer for purposes of 
section 901. Section 1.901-2(e)(5) provides that an amount paid is not 
a compulsory payment, and thus is not an amount of tax paid, to the 
extent that the amount paid exceeds the amount of liability under 
foreign law for tax. For purposes of determining whether an amount paid 
exceeds the amount of liability under foreign law for tax, Sec.  1.901-
2(e)(5) provides the following rule:

    An amount paid does not exceed the amount of such liability if 
the amount paid is determined by the taxpayer in a manner that is 
consistent with a reasonable interpretation and application of the 
substantive and procedural provisions of foreign law (including 
applicable tax treaties) in such a way as to reduce, over time, the 
taxpayer's reasonably expected liability under foreign law for tax, 
and if the taxpayer exhausts all effective and practical remedies, 
including invocation of competent authority procedures available 
under applicable tax treaties, to reduce, over time, the taxpayer's 
liability for foreign tax (including liability pursuant to a foreign 
tax audit adjustment).

    Section 1.901-2(e)(5) provides further that if foreign tax law 
includes options or elections whereby a taxpayer's liability may be 
shifted, in whole or part, to a different year, the taxpayer's use or 
failure to use such options or elections does not result in a 
noncompulsory payment, and that a settlement by a taxpayer of two or 
more issues will be evaluated on an overall basis, not on an issue-by-
issue basis, in determining whether an amount is a compulsory amount. 
In addition, it provides that a taxpayer is not required to alter its 
form of doing business, its business conduct, or the form of any 
transaction in order to reduce its liability for tax under foreign law.

A. U.S.-Owned Foreign Entities

    Commentators have raised questions regarding the application of 
Sec.  1.901-2(e)(5) to a U.S. person that owns one or more foreign 
entities. In particular, commentators have raised questions concerning 
the application of the regulation when one foreign entity directly or 
indirectly owned by a U.S. person transfers, pursuant to a group relief 
type regime, a net loss to another foreign entity, which may or may not 
also be owned by the U.S. person. Certain commentators have expressed 
concern that foreign taxes paid by the transferor in a subsequent tax 
year might not be compulsory payments to the extent the transferor 
could have reduced its liability for those foreign taxes had it chosen 
not to transfer the net loss in the prior year. This concern arises 
because the current final regulations apply on a taxpayer-by-taxpayer 
basis, obligating each taxpayer to minimize its liability for foreign 
taxes over time, even though the net effect of the loss surrender may 
be to minimize the amount of foreign taxes paid in the aggregate by the 
controlled group over time.
    Similar questions and concerns arise when one or more foreign 
subsidiaries of a U.S. person reach a combined settlement with a 
foreign taxing authority that results in an increase in the amount of 
one foreign subsidiary's foreign tax liability and a decrease in the 
amount of a second foreign subsidiary's foreign tax liability.

B. Certain Structured Passive Investment Arrangements

    The IRS and Treasury Department have become aware that certain U.S. 
taxpayers are engaging in highly structured transactions with foreign 
counterparties in order to generate foreign tax credits. These 
transactions are intentionally structured to create a foreign tax 
liability when, removed from the elaborately engineered structure, the 
basic underlying business transaction

[[Page 15082]]

generally would result in significantly less, or even no, foreign 
taxes. In particular, the transactions purport to convert what would 
otherwise be an ordinary course financing arrangement between a U.S. 
person and a foreign counterparty, or a portfolio investment of a U.S. 
person, into some form of equity ownership in a foreign special purpose 
vehicle (SPV). The transaction is deliberately structured to create 
income in the SPV for foreign tax purposes, which income is purportedly 
subject to foreign tax. The parties exploit differences between U.S. 
and foreign law in order to permit the U.S. taxpayer to claim a credit 
for the purported foreign tax payments while also allowing the foreign 
counterparty to claim a foreign tax benefit. The U.S. taxpayer and the 
foreign counterparty share the cost of the purported foreign tax 
payments through the pricing of the arrangement.

Explanation of Provisions

    The proposed regulations address the application of Sec.  1.901-
2(e)(5) in cases where a U.S. person directly or indirectly owns one or 
more foreign entities and in cases in which a U.S. person is a party to 
a highly structured passive investment arrangement described in this 
preamble. The proposed regulations would treat as a single taxpayer for 
purposes of Sec.  1.901-2(e)(5) all foreign entities with respect to 
which a U.S. person has a direct or indirect interest of 80 percent or 
more. The proposed regulations would treat foreign payments 
attributable to highly structured passive investment arrangements as 
noncompulsory payments under Sec.  1.901-2(e)(5) and, thus, would 
disallow credits for such amounts.

A. U.S.-Owned Foreign Entities

    Section 1.901-2(e)(5) requires a taxpayer to interpret and apply 
foreign law reasonably in such a way as to reduce, over time, the 
taxpayer's reasonably expected liability under foreign law for tax. 
This requirement ensures that a taxpayer will make reasonable efforts 
to minimize its foreign tax liability even though the taxpayer may 
otherwise be indifferent to the imposition of foreign tax due to the 
availability of the foreign tax credit. The purpose of this requirement 
is served if all foreign entities owned by such person, in the 
aggregate, satisfy the requirements of the regulation. Accordingly, for 
purposes of determining compliance with Sec.  1.901-2(e)(5), the 
proposed regulations would treat as a single taxpayer all foreign 
entities in which the same U.S. person has a direct or indirect 
interest of 80 percent or more. For this purpose, an interest of 80 
percent or more means stock possessing 80 percent or more of the vote 
and value (in the case of a foreign corporation) or an interest 
representing 80 percent or more of the income (in the case of non-
corporate foreign entities).
    The proposed regulations provide that if one 80 percent-owned 
foreign entity transfers or surrenders a net loss for the taxable year 
to a second such entity pursuant to a foreign law group relief or 
similar regime, foreign tax paid by the transferor in a different tax 
year does not fail to be a compulsory payment solely because such tax 
would not have been due had the transferor retained the net loss and 
carried it over to such other year. Similarly, it provides that if one 
or more 80 percent-owned foreign entities enter into a combined 
settlement under foreign law of two or more issues, such settlement 
will be evaluated on an overall basis, not on an issue-by-issue or 
entity-by-entity basis, in determining whether an amount is a 
compulsory amount. The proposed regulations include examples to 
illustrate the proposed rule.
    The IRS and Treasury Department intend to monitor structures 
involving U.S.-owned foreign groups, including those that would be 
covered by the proposed regulations, to determine whether taxpayers are 
utilizing such structures to separate foreign taxes from the related 
income. The IRS and Treasury Department may issue additional 
regulations in the future in order to address arrangements that result 
in the inappropriate separation of foreign tax and income.

B. Certain Structured Passive Investment Arrangements

    The structured arrangements discovered and identified by the IRS 
and the Treasury Department can be grouped into three general 
categories: (1) U.S. borrower transactions, (2) U.S. lender 
transactions, and (3) asset holding transactions. The transactions, 
including the claimed U.S. tax results, are described in section B.1 of 
this preamble. Section B.2 of this preamble discusses the purpose of 
the foreign tax credit regime and explains why allowing a credit in the 
transactions is inconsistent with this purpose. Section B.3 of this 
preamble discusses comments the IRS and the Treasury Department have 
received on the transactions and describes the proposed regulations. 
The IRS is continuing to scrutinize the transactions under current law 
and intends to utilize all tools available to challenge the claimed 
U.S. tax results in appropriate cases.
1. Categories of Structured Passive Investment Arrangements
    (a) U.S. borrower transactions. The first category consists of 
transactions in which a U.S. person indirectly borrows funds from an 
unrelated foreign counterparty. If a U.S. person were to borrow funds 
directly from a foreign person, the U.S. person generally would make 
nondeductible principal payments and deductible interest payments. The 
U.S. person would not incur foreign tax. The foreign lender generally 
would owe foreign tax on its interest income. In a structured financing 
arrangement, the U.S. borrower attempts to convert all or a portion of 
its deductible interest payments and, in certain cases, its 
nondeductible principal payments into creditable foreign tax payments. 
The U.S. borrower's foreign tax credit benefit is shared by the parties 
through the pricing of the arrangement. See Example 1 of proposed Sec.  
1.901-2(e)(5)(iv)(D).
    In a typical structured financing arrangement, the loan is made 
indirectly through an SPV. The foreign lender's interest income (and, 
in many cases, other income) is effectively isolated in the SPV. The 
U.S. borrower acquires a direct or indirect interest in the SPV and 
asserts that it has a direct or indirect equity interest in the SPV for 
U.S. tax purposes. The U.S. borrower claims a credit for foreign taxes 
imposed on the income derived by the SPV. The U.S. borrower's purported 
equity interest may be treated as debt for foreign tax purposes or it 
may be treated as an equity interest that is owned by the foreign 
lender for foreign tax purposes. In either case, the foreign lender is 
treated as owning an equity interest in the SPV for foreign tax 
purposes, which entitles the foreign lender to receive tax-free 
distributions from the SPV.
    For example, assume that a U.S. person seeks to borrow $1.5 billion 
from a foreign person. Instead of borrowing the funds directly, the 
U.S. borrower forms a corporation (SPV) in the same country as the 
foreign counterparty. The U.S. borrower contributes $1.5 billion to SPV 
in exchange for 100 percent of the stock of SPV. SPV, in turn, loans 
the entire $1.5 billion to a corporation wholly owned by the U.S. 
borrower. The U.S. borrower recovers its $1.5 billion by selling its 
entire interest in SPV to the foreign counterparty, subject to an 
obligation to repurchase the interest in five years for $1.5 billion. 
Each year, SPV earns $120 million of interest income from the U.S. 
borrower's subsidiary. SPV pays $36 million of foreign tax and 
distributes the

[[Page 15083]]

remaining $84 million to the foreign counterparty.
    The U.S. borrower takes the position that, for U.S. tax purposes, 
the sale-repurchase transaction is a borrowing secured by the SPV 
stock. Accordingly, the U.S. borrower asserts that it owns the stock of 
SPV for U.S. tax purposes and has an outstanding debt obligation to the 
foreign counterparty. It reports the distribution from SPV as dividend 
income and claims indirect credits under section 902 for the $36 
million of foreign taxes paid by SPV. It includes in income the cash 
dividend of $84 million paid to the foreign counterparty, plus a 
section 78 gross-up amount of $36 million, for a total of $120 million. 
The U.S. borrower claims a deduction of $84 million as interest on its 
debt obligation to the foreign counterparty. In addition, the U.S. 
borrower's subsidiary claims an interest deduction of $120 million. In 
the aggregate, the U.S. borrower and its subsidiary claim a foreign tax 
credit of $36 million and an interest expense deduction (net of income 
inclusions) of $84 million.
    For foreign tax purposes, the foreign counterparty owns the equity 
of SPV and is not subject to additional foreign tax upon receipt of the 
dividend. Thus, the net result is that the foreign jurisdiction 
receives foreign tax payments attributable to what is in substance the 
lender's interest income, which is consistent with the foreign tax 
results that would be expected from a direct borrowing.
    Both parties benefit from the arrangement. The foreign lender 
obtains an after-foreign tax interest rate that is higher than the 
after-foreign tax interest rate it would earn on a direct loan. The 
U.S. borrower's funding costs are lower on an after-U.S. tax basis 
(though not on a pre-U.S. tax basis) because it has converted interest 
expense into creditable foreign tax payments.
    The benefit to the parties is solely attributable to the reduction 
in the U.S. borrower's U.S. tax liability resulting from the foreign 
tax credits claimed by the U.S. borrower. The foreign jurisdiction 
benefits from the arrangement because the amount of interest received 
by SPV exceeds the amount of interest that would have been received by 
the foreign lender if the transaction had been structured as a direct 
loan. As a result, the amount paid by SPV to the foreign jurisdiction 
exceeds the amount of foreign tax the foreign jurisdiction would have 
imposed on the foreign lender's interest income in connection with a 
direct loan.
    (b) U.S. lender transactions. The second category consists of 
transactions in which a U.S person indirectly loans funds to an 
unrelated foreign counterparty. If a U.S. person were to loan the funds 
directly to the foreign person, the U.S. person generally would be 
subject to U.S. tax on its interest income and the borrower would 
receive a corresponding deduction for the interest expense. The U.S. 
person generally would not be subject to foreign tax other than, in 
certain circumstances, a gross basis withholding tax.
    In a typical structured financing arrangement, the U.S. person 
advances funds to a foreign borrower indirectly through an SPV. The 
U.S. person asserts that its interest in the SPV is equity for U.S. tax 
purposes. Income of the foreign borrower (or another foreign 
counterparty) is effectively shifted into the SPV. The U.S. person 
receives cash payments from the SPV and claims a credit for foreign 
taxes imposed on the income recognized by the SPV for foreign tax 
purposes. The foreign tax credits eliminate all or substantially all of 
the U.S. tax the U.S. person would otherwise owe on its return and, in 
many cases, U.S. tax the U.S. person would otherwise owe on unrelated 
foreign source income. The economic cost of the foreign taxes is shared 
through the pricing of the arrangement. See Example 4 of proposed Sec.  
1.901-2(e)(5)(iv)(D).
    For example, assume a U.S. person seeks to loan $1 billion to a 
foreign person. In lieu of a direct loan, the U.S. lender contributes 
$1 billion to a newly-formed corporation (SPV). The foreign 
counterparty contributes $2 billion to SPV, which is organized in the 
same country as the foreign counterparty. SPV contributes the total $3 
billion to a second special purpose entity (RH), receiving a 99 percent 
equity interest in RH in exchange. The foreign counterparty owns the 
remaining 1 percent of RH. RH loans the funds to the foreign 
counterparty in exchange for a note that pays interest currently and a 
second zero-coupon note. RH is a corporation for U.S. tax purposes and 
a flow-through entity for foreign tax purposes.
    Each year, the foreign counterparty pays $92 million of interest to 
RH, and RH accrues $113 million of interest on the zero-coupon note. RH 
distributes the $92 million of cash it receives to SPV. Because RH is a 
partnership for foreign tax purposes, SPV is required to report for 
foreign tax purposes 99 percent ($203 million) of the income recognized 
by RH. Because RH is a corporation for U.S. tax purposes, SPV 
recognizes only the cash distributions of $92 million for U.S. tax 
purposes. SPV pays foreign tax of $48 million on its net income (30 
percent of $159 million, or $203 interest income less $44 million 
interest deduction) and distributes its remaining cash of $44 million 
to the U.S. lender.
    The U.S. lender takes the position that it has an equity interest 
in SPV for U.S. tax purposes. It claims an indirect credit for the $48 
million of foreign taxes paid by SPV. It includes in income the cash 
dividend of $44 million, plus a section 78 gross-up amount of $48 
million. For foreign tax purposes, the U.S. lender's interest in SPV is 
debt, and the foreign borrower owns 100 percent of the equity of SPV. 
The foreign counterparty and SPV, in the aggregate, have a net 
deduction of $44 million for foreign tax purposes.
    Both parties benefit from the transaction. The foreign borrower 
obtains ``cheap financing'' because the $44 million of cash distributed 
to the U.S. lender is less than the amount of interest it would have to 
pay on a direct loan with respect to which the U.S. lender would owe 
U.S. tax. The U.S. lender is better off on an after-U.S. tax basis 
because of the foreign tax credits, which eliminate the U.S. lender's 
U.S. tax on the ``dividend'' income.
    The benefit to the parties is solely attributable to the reduction 
in the U.S. lender's U.S. tax liability resulting from the foreign tax 
credits claimed by the U.S. lender. The foreign jurisdiction benefits 
because the aggregate foreign tax result is a deduction for the foreign 
borrower that is less than the amount of the interest deduction the 
foreign borrower would have had upon a direct loan.
    (c) Asset holding transactions. The third category of transactions 
(``asset holding transactions'') consists of transactions in which a 
U.S. person that owns an income-producing asset moves the asset into a 
foreign taxing jurisdiction. For example, assume a U.S. person owns 
passive-type assets (such as debt obligations) generating an income 
stream that is subject to U.S. tax. In an asset holding transaction, 
the U.S. person transfers the assets to an SPV that is subject to tax 
in a foreign jurisdiction on the income stream. Ordinarily, such a 
transfer would not affect the U.S. person's after-tax position since 
the U.S. person could claim a credit for the foreign tax paid and, 
thereby, obtain a corresponding reduction in the amount of U.S. tax it 
would otherwise owe. In the structured transactions, however, the cost 
of the foreign tax is shared by a foreign person who obtains a foreign 
tax benefit by participating in the arrangement. Thus, the U.S. person 
is better off paying the foreign tax instead of U.S. tax because

[[Page 15084]]

it does not bear the full economic burden of the foreign tax.
    In a typical structured transaction, a foreign counterparty 
participates in the arrangement with the SPV. For example, the foreign 
counterparty may be considered to own a direct or indirect interest in 
the SPV for foreign tax purposes. The foreign counterparty's 
participation in the arrangement allows it to obtain a foreign tax 
benefit that it would not otherwise enjoy. The foreign counterparty 
compensates the U.S. person for this benefit in some manner. This 
compensation, which can be viewed as a reimbursement for a portion of 
the foreign tax liability resulting from the transfer of the assets, 
puts the U.S. person in a better after-U.S. tax position. See Example 7 
of proposed Sec.  1.901-2(e)(5)(iv)(D).
    The benefit to the parties is solely attributable to the reduction 
in the U.S. taxpayer's U.S. tax liability resulting from the foreign 
tax credits claimed by the U.S. taxpayer. The foreign jurisdiction 
benefits because the foreign taxes purportedly paid by the SPV exceed 
the amount by which the foreign counterparty's taxes are reduced.
2. Purpose of the Foreign Tax Credit
    The purpose of the foreign tax credit is to mitigate double 
taxation of foreign source income. Because the foreign tax credit 
provides a dollar-for-dollar reduction in U.S. tax that a U.S. person 
would otherwise owe, the U.S. person generally is indifferent, subject 
to various foreign tax credit limitations, as to whether it pays 
foreign tax on its foreign source income (if fully offset by the 
foreign tax credit) or whether it pays U.S. (and no foreign) tax on 
that income.
    The structured arrangements described in section B.1 of this 
preamble violate this purpose. A common feature of all these 
arrangements is that the U.S. person and a foreign counterparty share 
the economic cost of the foreign taxes claimed as credits by the U.S. 
person. This creates an incentive for the U.S. person to subject itself 
voluntarily to the foreign tax because there is a U.S. tax motivation 
to do so. The result is an erosion of the U.S. tax base in a manner 
that is not consistent with the purpose of the foreign tax credit 
provisions.
    Although the foreign counterparty derives a foreign tax benefit in 
these arrangements, the foreign jurisdiction generally is made whole 
because of the payments to the foreign jurisdiction made by the special 
purpose vehicle. In fact, the aggregate amount of payments to the 
foreign jurisdictions in connection with these transactions generally 
exceeds the amount of foreign tax that would have been imposed in the 
ordinary course. Only the U.S. fisc experiences a reduction in tax 
payments as a result of the structured arrangements.
    The IRS and Treasury Department recognize that often there is a 
business purpose for the financing or portfolio investment underlying 
the otherwise elaborately engineered transactions. However, it is 
inconsistent with the purpose of the foreign tax credit to permit a 
credit for foreign taxes that result from intentionally structuring a 
transaction to generate foreign taxes in a manner that allows the 
parties to obtain duplicate tax benefits and share the cost of the tax 
payments. The result in these structured arrangements is that both 
parties as well as the foreign jurisdiction benefit at the expense of 
the U.S. fisc.
3. Comments and Proposed Regulations
    The IRS and Treasury Department have determined that it is not 
appropriate to allow a credit in connection with these highly 
engineered transactions where the U.S. taxpayer benefits by 
intentionally subjecting itself to foreign tax. The proposed 
regulations would revise Sec.  1.901-2(e)(5) to provide that an amount 
paid to a foreign country in connection with such an arrangement is not 
an amount of tax paid. Accordingly, under the proposed regulations, a 
taxpayer would not be eligible to claim a foreign tax credit for such a 
payment. For periods prior to the effective date of final regulations, 
the IRS will continue to utilize all available tools under current law 
to challenge the U.S. tax results claimed in connection with such 
arrangements, including the substance over form doctrine, the economic 
substance doctrine, debt-equity principles, tax ownership principles, 
existing Sec.  1.901-2(e), section 269, and the partnership anti-abuse 
rules of Sec.  1.701-2.
    Certain commentators recommended that the IRS and Treasury 
Department adopt a broad anti-abuse rule that would deny a foreign tax 
credit in any case where allowance of the credit would be inconsistent 
with the purpose of the foreign tax credit regime. Other commentators 
recommended a narrower approach that would only deny foreign tax 
credits attributable to transactions that include particular features. 
The IRS and Treasury Department are concerned that a broad anti-abuse 
rule would create uncertainty for both taxpayers and the IRS. The IRS 
and Treasury Department have concluded that, at this time, a targeted 
rule denying foreign tax credits in arrangements similar to the 
arrangements described in section B.1 of this preamble is more 
appropriate.
    For periods after the effective date of final regulations, the IRS 
and Treasury Department will continue to scrutinize other arrangements 
that are not covered by the regulations but are inconsistent with the 
purpose of the foreign tax credit. Such arrangements may include 
arrangements that are similar to arrangements described in the proposed 
regulations, but that do not meet all of the conditions included in the 
proposed regulations. The IRS will utilize all available tools, 
including those described above, to challenge the claimed U.S. tax 
results in appropriate cases. In addition, the IRS and Treasury 
Department may issue additional regulations in the future in order to 
address such other arrangements.
    The proposed regulations would retain the general rule in the 
existing regulations that a taxpayer need not alter its form of doing 
business or the form of any transaction in order to reduce its foreign 
tax liability. However, the proposed regulations would provide that, 
notwithstanding the general rule, an amount paid to a foreign country 
(a ``foreign payment'') is not a compulsory payment, and thus is not an 
amount of tax paid, if the foreign payment is attributable to a 
structured passive investment arrangement. For this purpose, the 
proposed regulations would define a structured passive investment 
arrangement as an arrangement that satisfies six conditions. The six 
conditions consist of features that are common to the three types of 
arrangements identified in section B.1 of this preamble. The IRS and 
Treasury Department believe it is appropriate to treat foreign payments 
attributable to these arrangements as voluntary payments because such 
arrangements are intentionally structured to generate the foreign 
payment.
    The first condition is that the arrangement utilizes an entity that 
meets two requirements (an ``SPV''). The first requirement is that 
substantially all of the gross income (for United States tax purposes) 
of the entity is attributable to passive investment income and 
substantially all of the assets of the entity are assets held to 
produce such passive investment income. The second requirement is that 
there is a purported foreign tax payment attributable to income of the 
entity. The purported foreign tax may be paid by the entity itself, by 
the owner(s) of the entity (if the entity is treated as a pass-through 
entity under foreign law) or by a lower-tier entity (if the lower-tier

[[Page 15085]]

entity is treated as a pass-through entity under U.S. law).
    For purposes of this first requirement, passive investment income 
is defined as income described in section 954(c), with two 
modifications. The first modification is that if the entity is a 
holding company that owns a direct equity interest (other than a 
preferred interest) of 10 percent or more in another entity (a lower-
tier entity) that is predominantly engaged in the active conduct of a 
trade or business (or substantially all the assets of which consist of 
qualifying equity interests in other entities that are predominantly 
engaged in the active conduct of a trade or business), passive 
investment income does not include income attributable to the interest 
in such lower-tier entity. This exception does not apply if there are 
arrangements under which substantially all of the opportunity for gain 
and risk of loss with respect to such interest in the lower-tier entity 
are borne by either the U.S. party or the counterparty (but not both). 
Accordingly, a direct equity interest in any such lower-tier entity is 
not held to produce passive investment income provided there are no 
arrangements under which substantially all of the entity's opportunity 
for gain and risk of loss with respect to the lower-tier entity are 
borne by either the U.S. party or the counterparty (but not both). This 
modification is based on the notion that an entity is not a passive 
investment vehicle of the type targeted by these regulations if the 
entity is a holding company for one or more operating companies. This 
modification ensures that a joint venture arrangement between a U.S. 
person and a foreign person is not treated as a passive investment 
arrangement solely because the joint venture is conducted through a 
holding company structure.
    The second modification is that passive investment income is 
determined by disregarding sections 954(c)(3) and (c)(6) and by 
treating income attributable to transactions with the counterparties 
(described in this preamble) as ineligible for the exclusions under 
sections 954(h) and (i). Sections 954(c)(3) and (c)(6) provide 
exclusions for certain related party payments of dividends, interest, 
rents, and royalties. Those exclusions are not appropriate for these 
transactions because these transactions can be structured utilizing 
related party payments. The modifications to the application of 
sections 954(h) and (i) are intended to ensure that income derived from 
the counterparty cannot qualify for the exclusion from passive 
investment income, but will not prevent other income from qualifying 
for those exclusions. The IRS and Treasury Department intend that the 
structured financing arrangements described in this preamble do not 
qualify for the active banking, financing or insurance business 
exceptions to the definition of passive investment income. Comments are 
requested on whether further modifications or clarifications to the 
proposed regulations' definition of passive investment income are 
appropriate to ensure this result.
    The requirement that substantially all of the assets of the entity 
produce passive investment income is intended to ensure that an entity 
engaged in an active trade or business is not treated as an SPV solely 
because, in a particular year, it derives only passive investment 
income.
    The second overall condition is that a person (a ``U.S. party'') 
would be eligible to claim a credit under section 901(a) (including a 
credit for foreign taxes deemed paid under section 902 or 960) for all 
or a portion of the foreign payment if such payment were an amount of 
tax paid. Such eligibility to claim the credit could arise because the 
U.S. party would be treated as having paid or accrued the foreign 
payment for purposes of section 901 if it were an amount of tax paid. 
Alternatively, the U.S. party's eligibility to claim the credit could 
arise because the U.S. party owns an equity interest in the SPV or 
another entity that would be treated as having paid or accrued the 
foreign payment for purposes of section 901 if it were an amount of tax 
paid.
    The third overall condition is that the foreign payment or payments 
are (or are expected to be) substantially greater than the amount of 
credits, if any, that the U.S. party would reasonably expect to be 
eligible to claim under section 901(a) if such U.S. party directly 
owned its proportionate share of the assets owned by the SPV other than 
through a branch, a permanent establishment or any other arrangement 
(such as an agency arrangement) that would subject the income generated 
by its share of the assets to a net basis foreign tax. For example, if 
the SPV owns a note that generates interest income with respect to 
which a foreign payment is made, but foreign law (including an 
applicable treaty) provides for a zero rate of withholding tax on 
interest paid to non-residents, the U.S. party would not reasonably 
expect to pay foreign tax for which it could claim foreign tax credits 
if it directly owned the note and directly earned the interest income.
    The fourth condition is that the arrangement is structured in such 
a manner that it results in a foreign tax benefit (such as a credit, 
deduction, loss, exemption or a disregarded payment) for a counterparty 
or for a person that is related to the counterparty, but not related to 
the U.S. party.
    The fifth condition is that the counterparty is a person (other 
than the SPV) that is unrelated to the U.S. party and that (i) directly 
or indirectly owns 10 percent or more of the equity of the SPV under 
the tax laws of a foreign country in which such person is subject to 
tax on the basis of place of management, place of incorporation or 
similar criterion or otherwise subject to a net basis foreign tax or 
(ii) acquires 20 percent or more of the assets of the SPV under the tax 
laws of a foreign country in which such person is subject to tax on the 
basis of place of management, place of incorporation or similar 
criterion or otherwise subject to a net basis foreign tax.
    The sixth condition is that the U.S. and an applicable foreign 
country treat the arrangement differently under their respective tax 
systems. For this purpose, an applicable foreign country is any foreign 
country in which either the counterparty, a person related to the 
counterparty (but not related to the U.S. party) or the SPV is subject 
to net basis tax. To provide clarity and limit the scope of this 
factor, the proposed regulations provide that the arrangement must be 
subject to one of four specified types of inconsistent treatment. 
Specifically, the U.S. and the foreign country (or countries) must 
treat one or more of the following aspects of the arrangement 
differently, and the U.S. treatment of the inconsistent aspect must 
materially affect the amount of foreign tax credits claimed, or the 
amount of income recognized, by the U.S. party to the arrangement: (i) 
The classification of an entity as a corporation or other entity 
subject to an entity-level tax, a partnership or other flow-through 
entity or an entity that is disregarded for tax purposes; (ii) the 
characterization as debt, equity or an instrument that is disregarded 
for tax purposes of an instrument issued in the transaction, (iii) the 
proportion of the equity of the SPV (or an entity that directly or 
indirectly owns the SPV) that is considered to be owned directly or 
indirectly by the U.S. party and the counterparty; or (iv) the amount 
of taxable income of the SPV for one or more tax years during which the 
arrangement is in effect.
    Under the proposed regulations, a foreign payment would not be a 
compulsory payment if it is attributable to an arrangement that meets 
the six conditions. The proposed regulations

[[Page 15086]]

would treat a foreign payment as attributable to such an arrangement if 
the foreign payment is attributable to income of the SPV. Such foreign 
payments include a payment by the SPV, a payment by the owner of the 
SPV (if the SPV is a pass-through entity under foreign law) and a 
payment by a lower-tier entity that is treated as a pass-through entity 
under U.S. law. For this purpose, a foreign payment is not treated as 
attributable to the income of the SPV if the foreign payment is a gross 
basis withholding tax imposed on a distribution or payment from the SPV 
to the U.S. party. Such taxes could be considered to be noncompulsory 
payments because the U.S. party intentionally subjects itself to the 
taxes as part of the arrangement. However, the IRS and Treasury 
Department have determined that such taxes should not be treated as 
attributable to the arrangement because, among other reasons, the 
foreign counterparty generally does not derive a duplicative foreign 
tax benefit and, therefore, generally does not share the economic cost 
of such taxes.
    The IRS and Treasury Department considered excluding all foreign 
payments with respect to which the economic cost is not shared from the 
definition of foreign payments attributable to the arrangement, but 
determined that such a rule would be difficult to administer. The IRS 
and Treasury Department request comments on whether it would be 
appropriate to exclude certain foreign payments from the definition of 
foreign taxes attributable to the structured passive investment 
arrangement. Comments should address the rationale and administrable 
criteria for identifying any such exclusions.
    Certain commentators recommended that the proposed regulations 
include a requirement that the foreign tax credits attributable to the 
arrangement be disproportionate to the amount of taxable income 
attributable to the arrangement. This recommendation has not been 
adopted for three reasons. First, the IRS and Treasury Department were 
concerned that such a requirement would create too much uncertainty and 
would be unduly burdensome for taxpayers and the IRS. Second, the 
extent to which interest and other expenses, as well as returns on 
borrowed funds and capital, should be considered attributable to a 
particular arrangement is not entirely clear. A narrow view could 
present opportunities for manipulation, especially for financial 
institutions having numerous alternative placements of leverage for use 
within the group, while an expansive view could undercut the utility of 
such a test. Third, the fundamental concern in these transactions is 
that they create an incentive for taxpayers voluntarily to subject 
themselves to foreign tax. This concern exists irrespective of whether 
the particular arrangement generates a disproportionate amount of 
foreign tax credits.
    The IRS and Treasury Department considered whether it would be 
appropriate to permit a taxpayer to treat a foreign payment 
attributable to an arrangement that meets the definition of a 
structured passive investment arrangement as an amount of tax paid, if 
the taxpayer can show that tax considerations were not a principal 
purpose for the structure of the arrangement. Alternatively, the IRS 
and Treasury Department considered whether it would be appropriate to 
treat a foreign payment as an amount of tax paid if a taxpayer shows 
that there is a substantial business purpose for utilizing a hybrid 
instrument or entity, which would not include reducing the taxpayer's 
after-tax costs or enhancing the taxpayer's after-tax return through 
duplicative foreign tax benefits. The IRS and Treasury Department 
determined not to include such a rule in these proposed regulations due 
to administrability concerns. Comments are requested, however, on 
whether the final regulations should include such a rule as well as how 
such a rule could be made to be administrable in practice, including 
what reasonably ascertainable evidence would be sufficient to establish 
such a substantial non-tax business purpose, or the lack of a tax-
related principal purpose. Comments should also address whether it 
would be appropriate to adopt a broader anti-abuse rule and permit a 
taxpayer to demonstrate that it should not apply.

C. Effective Date

    The regulations are proposed to be effective for foreign taxes paid 
or accrued during taxable years of the taxpayer ending on or after the 
date on which the final regulations are published in the Federal 
Register. No inference is intended regarding the U.S. tax consequences 
of structured passive investment arrangements prior to the effective 
date of the regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It also has 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and because 
the regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6), does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
regulation has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
businesses.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed regulations and how they can be made easier to understand. 
All comments will be available for public inspection and copying.
    A public hearing has been scheduled for July 30, 2007, at 10 a.m. 
in the Internal Revenue Building, 1111 Constitution Avenue, NW., 
Washington, DC. All visitors must present photo identification to enter 
the building. Because of access restrictions, visitors will not be 
admitted beyond the immediate entrance area more than 30 minutes before 
the hearing starts. For information about having your name placed on 
the building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments must submit electronic or written 
comments and an outline of the topics to be discussed and time to be 
devoted to each topic (a signed original and eight (8) copies) by July 
9, 2007. A period of 10 minutes will be allotted to each person for 
making comments. An agenda showing the scheduling of the speakers will 
be prepared after the deadline for receiving outlines has passed. 
Copies of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is Bethany A. Ingwalson, 
Office of Associate Chief Counsel (International). However, other 
personnel from the IRS and the Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

[[Page 15087]]

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.901-2 is amended by adding paragraphs (e)(5)(iii) 
and (iv), and revising paragraph (h) to read as follows:


Sec.  1.901-2  Income, war profits, or excess profits tax paid or 
accrued.

* * * * *
    (e)(5) * * *
    (iii) U.S.-owned foreign entities--(A) In general. If a U.S. person 
described in section 901(b) directly or indirectly owns stock 
possessing 80 percent or more of the total voting power and total value 
of one or more foreign corporations (or, in the case of a non-corporate 
foreign entity, directly or indirectly owns an interest in 80 percent 
or more of the income of one or more such foreign entities), the group 
comprising such foreign corporations and entities (the ``U.S.-owned 
group'') shall be treated as a single taxpayer for purposes of 
paragraph (e)(5) of this section. Therefore, if one member of such a 
U.S.-owned group transfers or surrenders a net loss for the taxable 
year to a second member of the U.S.-owned group and the loss reduces 
the foreign tax due from the second member pursuant to a foreign law 
group relief or similar regime, foreign tax paid by the first member in 
a different year does not fail to be a compulsory payment solely 
because such tax would not have been due had the member that 
transferred or surrendered the net loss instead carried over the loss 
to reduce its own income and foreign tax liability in that year. 
Similarly, if one or more members of the U.S.-owned group enter into a 
combined settlement under foreign law of two or more issues involving 
different members of the group, such settlement will be evaluated on an 
overall basis, not on an issue-by-issue or entity-by-entity basis, in 
determining whether an amount is a compulsory amount. The provisions of 
this paragraph (e)(5)(iii) apply solely for purposes of determining 
whether amounts paid are compulsory payments of foreign tax and do not, 
for example, modify the provisions of section 902 requiring separate 
pools of post-1986 undistributed earnings and post-1986 foreign income 
taxes for each member of a qualified group.
    (B) Special rules. All domestic corporations that are members of a 
consolidated group (as that term is defined in Sec.  1.1502-1(h)) shall 
be treated as one domestic corporation for purposes of this paragraph 
(e)(5)(iii). For purposes of this paragraph (e)(5)(iii), indirect 
ownership of stock or another equity interest (such as an interest in a 
partnership) shall be determined in accordance with the principles of 
section 958(a)(2), whether the interest is owned by a U.S. or foreign 
person.
    (C) Examples. The following examples illustrate the rules of this 
paragraph (e)(5)(iii):

    Example 1. (i) Facts. A, a domestic corporation, wholly owns B, 
a country X corporation. B, in turn, wholly owns several country X 
corporations, including C and D. B, C, and D participate in group 
relief in country X. Under the country X group relief rules, a 
member with a net loss may choose to surrender the loss to another 
member of the group. In year 1, C has a net loss of (1,000x) and D 
has net income of 5,000x for country X tax purposes. Pursuant to the 
group relief rules in country X, C agrees to surrender its year 1 
net loss to D and D agrees to claim the net loss. D uses the net 
loss to reduce its year 1 net income to 4,000x for country X tax 
purposes, which reduces the amount of country X tax D owes in year 1 
by 300x. In year 2, C earns 3,000x with respect to which it pays 
900x of country X tax. Country X permits a taxpayer to carry forward 
net losses for up to ten years.
    (ii) Result. Paragraph (e)(5)(i) of this section provides, in 
part, that an amount paid to a foreign country does not exceed the 
amount of liability under foreign law for tax if the taxpayer 
determines such amount in a manner that is consistent with a 
reasonable interpretation and application of the substantive and 
procedural provisions of foreign law (including applicable tax 
treaties) in such a way as to reduce, over time, the taxpayer's 
reasonably expected liability under foreign law for tax. Under 
paragraph (e)(5)(iii)(A) of this section, B, C, and D are treated as 
a single taxpayer for purposes of testing whether the reasonably 
expected foreign tax liability has been minimized over time, because 
A directly and indirectly owns 100 percent of each of B, C, and D. 
Accordingly, none of the 900x paid by C in year 2 fails to be a 
compulsory payment solely because C could have reduced its year 2 
country X tax liability by 300x by choosing to carry forward its 
year 1 net loss to year 2 instead of surrendering it to D to reduce 
D's country X liability in year 1.
    Example 2. (i) Facts. L, M, and N are country Y corporations. L 
owns 100 percent of the common stock of M, which owns 100 percent of 
the stock of N. O, a domestic corporation, owns a security issued by 
M that is treated as debt for country Y tax purposes and as stock 
for U.S. tax purposes. As a result, L owns 100 percent of the stock 
of M for country Y purposes while O owns 99 percent of the stock of 
M for U.S. tax purposes. L, M, and N participate in group relief in 
country Y. Pursuant to the group relief rules in country Y, M may 
surrender its loss to any member of the group. In year 1, M has a 
net loss of $10 million, N has net income of $25 million, and L has 
net income of $15 million. M chooses to surrender its year 1 net 
loss to L. Country Y imposes tax of 30 percent on the net income of 
country Y corporations. Accordingly, in year 1, the loss surrender 
has the effect of reducing L's country Y tax by $3 million. In year 
1, N makes a payment of $7.5 million to country Y with respect to 
its net income of $25 million. If M had surrendered its net loss to 
N instead of L, N would have had net income of $15 million, with 
respect to which it would have owed only $4.5 million of country Y 
tax.
    (ii) Result. M and N, but not L, are treated as a single 
taxpayer for purposes of paragraph (e)(5) of this section because O 
directly and indirectly owns 99 percent of each of M and N, but owns 
no direct or indirect interest in L. Accordingly, in testing whether 
M and N's reasonably expected foreign tax liability has been 
minimized over time, L is not considered the same taxpayer as M and 
N, collectively, and the $3 million reduction in L's year 1 country 
Y tax liability through the surrender to L of M's $10 million 
country Y net loss in year 1 is not considered to reduce M and N's 
collective country Y tax liability.

    (iv) Certain structured passive investment arrangements--(A) In 
general. Notwithstanding paragraph (e)(5)(i) of this section, an amount 
paid to a foreign country (a ``foreign payment'') is not a compulsory 
payment, and thus is not an amount of tax paid, if the foreign payment 
is attributable to an arrangement described in paragraph (e)(5)(iv)(B) 
of this section. For purposes of this paragraph (e)(5)(iv), a foreign 
payment is attributable to an arrangement described in paragraph 
(e)(5)(iv)(B) of this section if the foreign payment is described in 
paragraph (e)(5)(iv)(B)(1)(ii) of this section.
    (B) Conditions. An arrangement is described in this paragraph 
(e)(5)(iv)(B) if all of the following conditions are satisfied:
    (1) Special purpose vehicle (SPV). An entity that is part of the 
arrangement meets the following requirements:
    (i) Substantially all of the gross income (for United States tax 
purposes) of the entity is passive investment income as defined in 
paragraph (e)(5)(iv)(C)(4) of this section, and substantially all of 
the assets of the entity are assets held to produce such passive 
investment income. As provided in paragraph (e)(5)(iv)(C)(4)(ii) of 
this section, passive investment income generally does not include 
income of a holding company from qualified equity interests in lower-
tier entities that are predominantly engaged in the active conduct of a 
trade or business. Thus, except as provided in paragraph 
(e)(5)(iv)(C)(4)(ii) of this section,

[[Page 15088]]

qualified equity interests of a holding company in such lower-tier 
entities are not held to produce passive investment income and the 
ownership of such interests will not cause the holding company to 
satisfy this paragraph (e)(5)(iv)(B)(1)(i).
    (ii) There is a foreign payment attributable to income of the 
entity (as determined under the laws of the foreign country to which 
such foreign payment is made), including the entity's share of income 
of a lower-tier entity that is a branch or pass-through entity under 
the laws of such foreign country. A foreign payment attributable to 
income of an entity includes a foreign payment attributable to income 
that is required to be taken into account by an owner of the entity, if 
the entity is a branch or pass-through entity under the laws of such 
foreign country. A foreign payment attributable to income of an entity 
also includes a foreign payment attributable to income of a lower-tier 
entity that is a branch or pass-through entity for U.S. tax purposes. A 
foreign payment attributable to income of the entity does not include a 
withholding tax (within the meaning of section 901(k)(1)(B)) imposed on 
a distribution or payment from the entity to a U.S. party (as defined 
in paragraph (e)(5)(iv)(B)(2) of this section).
    (2) U.S. party. A person (a ``U.S. party'') would be eligible to 
claim a credit under section 901(a) (including a credit for foreign 
taxes deemed paid under section 902 or 960) for all or a portion of the 
foreign payment described in paragraph (e)(5)(iv)(B)(1)(ii) of this 
section if the foreign payment were an amount of tax paid.
    (3) Direct investment. The foreign payment or payments described in 
paragraph (e)(5)(iv)(B)(1)(ii) of this section are (or are expected to 
be) substantially greater than the amount of credits, if any, the U.S. 
party would reasonably expect to be eligible to claim under section 
901(a) for foreign taxes attributable to income generated by the U.S. 
party's proportionate share of the assets owned by the SPV if the U.S. 
party directly owned such assets. For this purpose, direct ownership 
shall not include ownership through a branch, a permanent establishment 
or any other arrangement (such as an agency arrangement) that would 
result in the income generated by the U.S. party's proportionate share 
of the assets being subject to tax on a net basis in the foreign 
country to which the payment is made. A U.S. party's proportionate 
share of the assets of the SPV shall be determined by reference to such 
U.S. party's proportionate share of the total value of all of the 
outstanding interests in the SPV that are held by its equity owners and 
creditors.
    (4) Foreign tax benefit. The arrangement is structured in such a 
manner that it results in a foreign tax benefit (such as a credit, 
deduction, loss, exemption or a disregarded payment) for a counterparty 
described in paragraph (e)(5)(iv)(B)(5) of this section or for a person 
that is related to the counterparty (determined under the principles of 
paragraph (e)(5)(iv)(C)(6) of this section by applying the tax laws of 
a foreign country in which the counterparty is subject to tax on a net 
basis) but is not related to the U.S. party (within the meaning of 
paragraph (e)(5)(iv)(C)(6) of this section).
    (5) Unrelated counterparty. The arrangement involves a 
counterparty. A counterparty is a person (other than the SPV) that is 
not related to the U.S. party (within the meaning of paragraph 
(e)(5)(iv)(C)(6) of this section) and that meets one of the following 
conditions:
    (i) The person is considered to own directly or indirectly 10 
percent or more of the equity of the SPV under the tax laws of a 
foreign country in which the person is subject to tax on the basis of 
place of management, place of incorporation or similar criterion or 
otherwise subject to a net basis tax.
    (ii) In a single transaction or series of transactions, the person 
directly or indirectly acquires 20 percent or more of the value of the 
assets of the SPV under the tax laws of a foreign country in which the 
person is subject to tax on the basis of place of management, place of 
incorporation or similar criterion or otherwise subject to a net basis 
tax. For purposes of determining the percentage of assets of the SPV 
acquired by the person, an asset of the SPV shall be disregarded if a 
principal purpose for transferring such asset to the SPV was to avoid 
this paragraph (e)(5)(iv)(B)(5)(ii).
    (6) Inconsistent treatment. The U.S. and an applicable foreign 
country (as defined in paragraph (e)(5)(iv)(C)(1) of this section) 
treat one or more of the following aspects of the arrangement 
differently under their respective tax systems, and the U.S. treatment 
of the inconsistent aspect would materially affect the amount of income 
recognized by the U.S. party or the amount of credits claimed by the 
U.S. party if the foreign payment described in paragraph 
(e)(5)(iv)(B)(1)(ii) of this section were an amount of tax paid:
    (i) The classification of the SPV (or an entity that has a direct 
or indirect ownership interest in the SPV) as a corporation or other 
entity subject to an entity-level tax, a partnership or other flow-
through entity or an entity that is disregarded for tax purposes.
    (ii) The characterization as debt, equity or an instrument that is 
disregarded for tax purposes of an instrument issued by the SPV (or an 
entity that has a direct or indirect ownership interest in the SPV) to 
the U.S. party, the counterparty or a person related to the U.S. party 
or the counterparty.
    (iii) The proportion of the equity of the SPV (or an entity that 
directly or indirectly owns the SPV) that is considered to be owned 
directly or indirectly by the U.S. party and the counterparty.
    (iv) The amount of taxable income of the SPV for one or more tax 
years during which the arrangement is in effect.
    (C) Definitions--(1) Applicable foreign country. An applicable 
foreign country means each foreign country to which a foreign payment 
described in paragraph (e)(5)(iv)(B)(1)(ii) of this section is made or 
which confers a foreign tax benefit described in paragraph 
(e)(5)(iv)(B)(4) of this section.
    (2) Entity. For purposes of paragraph (e)(5)(iv)(B)(1) and 
(e)(5)(iv)(C)(4) of this section, the term entity includes a 
corporation, trust, partnership or disregarded entity described in 
Sec.  301.7701-2(c)(2)(i) of this chapter.
    (3) Indirect ownership. For purposes of paragraph (e)(5)(iv) of 
this section, indirect ownership of stock or another equity interest 
(such as an interest in a partnership) shall be determined in 
accordance with the principles of section 958(a)(2), whether the 
interest is owned by a U.S. or foreign entity.
    (4) Passive investment income--(i) In general. For purposes of 
paragraph (e)(5)(iv) of this section, the term passive investment 
income means income described in section 954(c), as modified by this 
paragraph (e)(5)(iv)(C)(4)(i) and paragraph (e)(5)(iv)(C)(4)(ii) of 
this section. In determining whether income is described in section 
954(c), sections 954(c)(3) and 954(c)(6) shall be disregarded, and 
sections 954(h) and (i) shall be taken into account by applying those 
provisions at the entity level as if the entity were a controlled 
foreign corporation (as defined in section 957(a)). In addition, for 
purposes of the preceding sentence, any income of an entity 
attributable to transactions with a person that would be a counterparty 
(as defined in paragraph (e)(5)(iv)(B)(5) of this section) if the 
entity were an SPV, or with other persons that are described in 
paragraph (e)(5)(iv)(B)(4) of this section and that are eligible for a 
foreign tax benefit described in such paragraph (e)(5)(iv)(B)(4), shall 
not be treated as

[[Page 15089]]

qualified banking or financing income or as qualified insurance income, 
and shall not be taken into account in applying sections 954(h) and (i) 
for purposes of determining whether other income of the entity is 
excluded from section 954(c)(1) under section 954(h) or (i).
    (ii) Income attributable to lower-tier entities. Except as provided 
in this paragraph (e)(5)(iv)(C)(4)(ii), income of an entity that is 
attributable to an equity interest in a lower-tier entity is passive 
investment income. If the entity is a holding company and directly owns 
a qualified equity interest in another entity (a ``lower-tier entity'') 
that is engaged in the active conduct of a trade or business and that 
derives more than 50 percent of its gross income from such trade or 
business, then none of the entity's income attributable to such 
interest is passive investment income, provided that there are no 
arrangements whereby substantially all of the entity's opportunity for 
gain and risk of loss with respect to such interest is borne by the 
U.S. party (or a related person) or the counterparty (or a related 
person), but not both parties. For purposes of the preceding sentence, 
an entity is a holding company, and is considered to be engaged in the 
active conduct of a trade or business and to derive more than 50 
percent of its gross income from such trade or business, if 
substantially all of its assets consist of qualified equity interests 
in one or more entities, each of which is engaged in the active conduct 
of a trade or business and derives more than 50 percent of its gross 
income from such trade or business and with respect to which there are 
no arrangements whereby substantially all of the entity's opportunity 
for gain and risk of loss with respect to such interest is borne by the 
U.S. party (or a related person) or the counterparty (or a related 
person), but not both parties. For purposes of this paragraph 
(e)(5)(iv)(C)(4)(ii), a lower-tier entity that is engaged in a banking, 
financing, or similar business shall not be considered to be engaged in 
the active conduct of a trade or business unless the income derived by 
such entity would be excluded from section 954(c)(1) under section 
954(h) or (i), determined by applying those provisions at the lower-
tier entity level as if the entity were a controlled foreign 
corporation (as defined in section 957(a)). In addition, for purposes 
of the preceding sentence, any income of an entity attributable to 
transactions with a person that would be a counterparty (as defined in 
paragraph (e)(5)(iv)(B)(5) of this section) if the entity were an SPV, 
or with other persons that are described in paragraph (e)(5)(iv)(B)(4) 
of this section and that are eligible for a foreign tax benefit 
described in such paragraph (e)(5)(iv)(B)(4), shall not be treated as 
qualified banking or financing income or as qualified insurance income, 
and shall not be taken into account in applying sections 954(h) and (i) 
for purposes of determining whether other income of the entity is 
excluded from section 954(c)(1) under section 954(h) or (i).
    (5) Qualified equity interest. With respect to an interest in a 
corporation, the term qualified equity interest means stock 
representing 10 percent or more of the total combined voting power of 
all classes of stock entitled to vote and 10 percent or more of the 
total value of the stock of the corporation or disregarded entity, but 
does not include any preferred stock (as defined in section 351(g)(3)). 
Similar rules shall apply to determine whether an interest in an entity 
other than a corporation is a qualified equity interest.
    (6) Related person. Two persons are related for purposes of 
paragraph (e)(5)(iv) of this section if--
    (i) One person directly or indirectly owns stock (or an equity 
interest) possessing more than 50 percent of the total value of the 
other person; or
    (ii) The same person directly or indirectly owns stock (or an 
equity interest) possessing more than 50 percent of the total value of 
both persons.
    (7) Special purpose vehicle (SPV). For purposes of this paragraph 
(e)(5)(iv), the term SPV means the entity described in paragraph 
(e)(5)(iv)(B)(1) of this section.
    (D) Examples. The following examples illustrate the rules of 
paragraph (e)(5)(iv) of this section. No inference is intended as to 
whether a taxpayer would be eligible to claim a credit under section 
901(a) if a foreign payment were an amount of tax paid.

    Example 1. U.S. borrower transaction. (i) Facts. A domestic 
corporation (USP) forms a country M corporation (Newco), 
contributing $1.5 billion in exchange for 100 percent of the stock 
of Newco. Newco, in turn, loans the $1.5 billion to a second country 
M corporation (FSub) wholly owned by USP. FSub is engaged in the 
active conduct of manufacturing and selling widgets and derives more 
than 50 percent of its gross income from such business. USP then 
sells its entire interest in Newco to a country M corporation (FP) 
for the original purchase price of $1.5 billion, subject to an 
obligation to repurchase the interest in five years for $1.5 
billion. The sale has the effect of transferring ownership of the 
Newco stock to FP for country M tax purposes. The sale-repurchase 
transaction is structured in a way that qualifies as a 
collateralized loan for U.S. tax purposes. Therefore, USP remains 
the owner of the Newco stock for U.S. tax purposes. In year 1, FSub 
pays Newco $120 million of interest. Newco pays $36 million to 
country M with respect to such interest income and distributes the 
remaining $84 million to FP. Under country M law, the $84 million 
distribution is excluded from FP's income. FP is not related to USP 
within the meaning of paragraph (e)(5)(iv)(C)(6) of this section. 
Under an income tax treaty between country M and the U.S., country M 
does not impose country M tax on interest received by U.S. residents 
from sources in country M.
    (ii) Result. The payment by Newco to country M is not a 
compulsory payment, and thus is not an amount of tax paid. First, 
Newco is an SPV because all of Newco's income is passive investment 
income described in paragraph (e)(5)(iv)(C)(4) of this section, 
Newco's only asset, a note, is held to produce such income, and the 
payment to country M is attributable to such income. Second, if the 
foreign payment were treated as an amount of tax paid, USP would be 
deemed to pay the foreign payment under section 902(a) and, 
therefore, would be eligible to claim a credit for such payment 
under section 901(a). Third, USP would not pay any country M tax if 
it directly owned Newco's loan receivable. Fourth, distributions 
from Newco to FP are exempt from tax under country M law. Fifth, FP 
is a counterparty because FP and USP are unrelated and FP owns more 
than 10 percent of the stock of Newco under country M law. Sixth, FP 
is the owner of 100 percent of Newco's stock for country M tax 
purposes, while USP is the owner of 100 percent of Newco's stock for 
U.S. tax purposes, and USP's ownership of the stock would materially 
affect the amount of credits claimed by USP if the payment to 
country M were an amount of tax paid. If the foreign payment were 
treated as an amount of tax paid, USP's ownership of the stock for 
U.S. tax purposes would make USP eligible to claim a credit for such 
amount under sections 901(a) and 902(a). Because the payment to 
country M is not an amount of tax paid, USP has dividend income of 
$84 million and is not deemed to pay any country M tax under section 
902(a). USP also has interest expense of $84 million. FSub's post-
1986 undistributed earnings are reduced by $120 million of interest 
expense.
    Example 2. U.S. borrower transaction. (i) Facts. The facts are 
the same as in Example 1, except that FSub is a wholly-owned 
subsidiary of Newco. In addition, FSub agrees not to pay, and Newco 
and FP agree not to cause FSub to pay, dividends during the five-
year period in which FP holds the Newco stock subject to the 
obligation of USP to repurchase the stock.
    (ii) Result. The results are the same as in Example 1. Although 
Newco wholly owns FSub, which is engaged in the active conduct of 
manufacturing and selling widgets and derives more than 50 percent 
of its income from such business, income attributable to Newco's 
stock in FSub is passive investment income because there are 
arrangements whereby substantially all of Newco's opportunity for 
gain and risk of loss with respect to its stock in FSub is borne by 
USP.

[[Page 15090]]

See paragraph (e)(iv)(C)(4)(ii) of this section. Accordingly, 
Newco's stock in FSub is held to produce passive investment income. 
Thus, Newco is an SPV because all of Newco's income is passive 
investment income described in paragraph (e)(5)(iv)(C)(4) of this 
section, Newco's assets are held to produce such income, and the 
payment to country M is attributable to such income.
    Example 3. Active business; no SPV. (i) Facts. A, a domestic 
corporation, wholly owns B, a country X corporation engaged in the 
manufacture and sale of widgets. On January 1, 2008, C, also a 
country X corporation, loans $400 million to B in exchange for an 
instrument that is debt for U.S. tax purposes and equity for country 
X tax purposes. As a result, C is considered to own 20 percent of 
the stock of B for country X tax purposes. B loans $55 million to D, 
a country Y corporation wholly owned by A. For its 2008 tax year, B 
has $166 million of net income attributable to its sales of widgets 
and $3.3 million of interest income attributable to the loan to D. 
Country Y does not impose tax on interest paid to nonresidents. B 
makes a payment of $50.8 million to country X with respect to B's 
net income. Country X does not impose tax on dividend payments 
between country X corporations. A and C are not related within the 
meaning of paragraph (e)(5)(iv)(C)(6) of this section.
    (ii) Result. B is not an SPV within the meaning of paragraph 
(e)(5)(iv)(B)(1) of this section because the amount of interest 
income received from D does not constitute substantially all of B's 
income and the $55 million loan to D does not constitute 
substantially all of B's assets. Accordingly, the $50.8 million 
payment to country X is not attributable to an arrangement described 
in paragraph (e)(5)(iv) of this section.
    Example 4. U.S. lender transaction. (i) Facts. (A) A country X 
corporation (foreign bank) contributes $2 billion to a newly-formed 
country X corporation (Newco) in exchange for 100 percent of Newco's 
common stock. A U.S. bank (USB) contributes $1 billion to Newco in 
exchange for securities that are treated as stock of Newco for U.S. 
tax purposes and debt of Newco for country X tax purposes. The 
securities represent 10 percent of the total voting power of Newco. 
Newco contributes the entire $3 billion to a newly-formed country X 
entity (RH) in exchange for 99 percent of RH's equity. Foreign bank 
owns the remaining 1 percent of RH. RH is treated as a corporation 
for U.S. tax purposes and a partnership for country X tax purposes. 
RH loans the entire $3 billion it receives from Newco to foreign 
bank in exchange for a note that pays interest currently and a zero-
coupon note. Under an income tax treaty between country X and the 
U.S., country X does not impose country X tax on interest received 
by U.S. residents from sources in country X. Country X does not 
impose tax on dividend payments between country X corporations. USB 
and the foreign bank are not related within the meaning of paragraph 
(e)(5)(iv)(C)(6) of this section.
    (B) In year 1, foreign bank pays RH $92 million of interest and 
accrues $113 million of interest on the zero-coupon note. RH 
distributes the $92 million of cash it receives to Newco. Newco 
distributes $44 million to USB. Because RH is a partnership for 
country X purposes, Newco is required to report for country X 
purposes 99 percent ($203 million) of the income recognized by RH. 
Newco is entitled to interest deductions of $44 million for 
distributions to USB on the securities for country X tax purposes 
and, thus, has $159 million of net income for country X tax 
purposes. Newco makes a payment to country X of $48 million with 
respect to its net income. For U.S. tax purposes, Newco's post-1986 
undistributed earnings pool for year 1 is $44 million ($92 million-
$48 million). For country X tax purposes, foreign bank is entitled 
to interest expense deductions of $205 million.
    (ii) Result. (A) The payment to country X is not a compulsory 
payment, and thus is not an amount of tax paid. First, Newco is an 
SPV because all of Newco's income is passive investment income 
described in paragraph (e)(5)(iv)(C)(4) of this section, Newco's 
sole asset, stock of RH, is held to produce such income, and the 
payment to country X is attributable to such income. Second, if the 
foreign payment were treated as an amount of tax paid, USB would be 
deemed to pay the $48 million under section 902(a) and, therefore, 
would be eligible to claim a credit under section 901(a). Third, USB 
would not pay any country X tax if it directly owned its 
proportionate share of Newco's asset, the 99 percent interest in RH, 
because under the U.S.-country X tax treaty country X would not 
impose tax on USB's distributive share of RH's interest income. 
Fourth, foreign bank is entitled to interest deductions under 
country X law for interest it pays and accrues to RH, and will 
receive tax-free dividends from Newco upon payment of the accrued 
interest. Fifth, foreign bank and USB are unrelated and foreign bank 
is considered to own more than 10 percent of Newco under country X 
law. Sixth, the U.S. and country X view several aspects of the 
transaction differently, and the U.S. treatment would materially 
affect the amount of credits claimed by USB if the country X payment 
were an amount of tax paid. If the country X payment were treated as 
an amount of tax paid, the equity treatment of the securities for 
U.S. tax purposes would make USB eligible to claim a credit for the 
payment under sections 901(a) and 902(a). Moreover, the fact that 
Newco recognizes a smaller amount of income for U.S. tax purposes 
than it does for country X tax purposes would increase the amount of 
credits USB would be eligible to claim upon receipt of the $44 
million distribution. Because the $48 million payment to country X 
is not an amount of tax paid, USB has dividend income of $44 
million. It is not deemed to pay tax under section 902(a).
    (B) In addition, RH is an SPV because all of RH's income is 
passive investment income described in paragraph (e)(5)(iv)(C)(4) of 
this section, RH's sole assets, notes of foreign bank, are held to 
produce such income, and Newco's payment to country X is 
attributable to such income. Second, if the foreign payment were 
treated as an amount of tax paid, USB would be deemed to pay the $48 
million under section 902(a) and, therefore, would be eligible to 
claim a credit under section 901(a). Third, USB would not pay any 
country X tax if it directly owned its proportionate share of RH's 
assets, notes of foreign bank, because under the U.S.-country X tax 
treaty country X would not impose tax on interest paid by foreign 
bank to USB. Fourth, foreign bank is entitled to interest deductions 
under country X law for interest it pays and accrues to RH, and will 
receive tax-free dividends from Newco upon payment of the accrued 
interest. Fifth, foreign bank and USB are unrelated and foreign bank 
is considered to own directly or indirectly more than 10 percent of 
RH under country X law. Sixth, the U.S. and country X view several 
aspects of the transaction differently, and the U.S. treatment would 
materially affect the amount of credits claimed by USB if the 
country X payment were an amount of tax paid. If the country X 
payment were treated as an amount of tax paid, the equity treatment 
of the Newco securities for U.S. tax purposes would make USB 
eligible to claim a credit for the payment under sections 901(a) and 
902(a). Moreover, the entity classification of RH for U.S. tax 
purposes results in Newco recognizing a smaller amount of income for 
U.S. tax purposes than it does for country X tax purposes, which 
would increase the amount of credits USB would be eligible to claim 
upon receipt of the $44 million distribution. Because the $48 
million payment to country X is not an amount of tax paid, USB has 
dividend income of $44 million. It is not deemed to pay tax under 
section 902(a).
    Example 5. Active business; no SPV. (i) Facts. A, a country X 
corporation, and B, a domestic corporation, each contribute $1 
billion to a newly-formed country X entity (C) in exchange for stock 
of C. C is treated as a corporation for country X purposes and a 
partnership for U.S. tax purposes. C contributes $1.95 billion to a 
newly-formed country X corporation (D) in exchange for 100 percent 
of D's stock. It loans its remaining $50 million to D. Accordingly, 
C's sole assets are stock and debt of D. D uses the entire $2 
billion to engage in the business of manufacturing and selling 
widgets. For the 2015 tax year, D derives $300 million of income 
from its widget business and derives $2 million of interest income. 
For the 2015 tax year, C has dividend income of $200 million and 
interest income of $3.2 million with respect to its investment in D. 
Country X does not impose tax on dividends received by one country X 
corporation from a second country X corporation. C makes a payment 
of $960,000 to country X with respect to C's net income.
    (ii) Result. C's dividend income is not passive investment 
income, and C's stock in D is not held to produce such income, 
because C owns at least 10 percent of D and D derives more than 50 
percent of its income from the active conduct of its widget 
business. See paragraph (e)(5)(iv)(C)(4)(ii) of this section. As a 
result, less than substantially all of C's income is passive 
investment income and less than substantially all of C's assets are 
held to produce passive investment income. Accordingly, C is not an 
SPV within the meaning of paragraph (e)(5)(iv)(B)(1) of this

[[Page 15091]]

section, and the $960,000 payment to country X is not attributable 
to an arrangement described in paragraph (e)(5)(iv) of this section.
    Example 6. Active business; no SPV. (i) Facts. The facts are the 
same as in Example 5, except that instead of loaning $50 million to 
D, C contributes the $50 million to E in exchange for 10 percent of 
the stock of E. E is a country Y entity that in not engaged in the 
active conduct of a trade or business. Also, for the 2015 tax year, 
D pays no dividends to C, E pays $3.2 million in dividends to C, and 
C makes a payment of $960,000 to country X with respect to C's net 
income.
    (ii) Result. C's dividend income attributable to its stock in E 
is passive investment income, and C's stock in E is held to produce 
such income. C's stock in D is not held to produce passive 
investment income because C owns at least 10 percent of D and D 
derives more than 50 percent of its income from the active conduct 
of its widget business. See paragraph (e)(5)(iv)(C)(4)(ii) of this 
section. As a result, less than substantially all of C's assets are 
held to produce passive investment income. Accordingly, C does not 
meet the requirements of paragraph (e)(5)(iv)(B)(1) of this section, 
and the $960,000 payment to country X is not attributable to an 
arrangement described in paragraph (e)(5)(iv) of this section.
    Example 7. Asset holding transaction. (i) Facts. (A) A domestic 
corporation (USP) contributes $6 billion of country Z debt 
obligations to a country Z entity (DE) in exchange for all of the 
class A and class B stock of DE. A corporation unrelated to USP and 
organized in country Z (Fcorp) contributes $1.5 billion to DE in 
exchange for all of the class C stock of DE. DE uses the $1.5 
billion contributed by Fcorp to redeem USP's class B stock. The 
class C stock is entitled to ``all'' income from DE. However, Fcorp 
is obligated immediately to contribute back to DE all distributions 
on the class C stock. USP and Fcorp enter into--
    (1) A forward contract under which USP agrees to buy after five 
years the class C stock for $1.5 billion; and
    (2) An agreement under which USP agrees to pay Fcorp interest at 
a below-market rate on $1.5 billion.
    (B) For U.S. tax purposes, these steps create a secured loan of 
$1.5 billion from Fcorp to USP. Therefore, for U.S. tax purposes, 
USP is the owner of both the class A and class C stock. DE is a 
disregarded entity for U.S. tax purposes and a corporation for 
country Z tax purposes. In year 1, DE earns $400 million of interest 
income on the country Z debt obligations. DE makes a payment to 
country Z of $100 million with respect to such income and 
distributes the remaining $300 million to Fcorp. Fcorp contributes 
the $300 million back to DE. USP and Fcorp are not related within 
the meaning of paragraph (e)(5)(iv)(C)(6) of this section. Country Z 
does not impose tax on interest income derived by U.S. residents.
    (C) Country Z treats Fcorp as the owner of the class C stock. 
Pursuant to country Z tax law, Fcorp is required to report the $400 
million of income with respect to the $300 million distribution from 
DE, but is allowed to claim credits for DE's $100 million payment to 
country Z. For country Z tax purposes, Fcorp's contribution 
increases its basis in the class C stock. When the class C stock is 
later ``sold'' to USP for $1.5 billion, the increase in tax basis 
will result in a country Z tax loss for Fcorp. Each year, the amount 
of the basis increase (and, thus, the amount of the loss generated) 
will be approximately $300 million.
    (ii) Result. The payment to country Z is not a compulsory 
payment, and thus is not an amount of tax paid. First, DE is an SPV 
because all of DE's income is passive investment income described in 
paragraph (e)(5)(iv)(C)(4) of this section, all of DE's assets are 
held to produce such income, and the payment to country Z is 
attributable to such income. Second, if the payment were treated as 
an amount of tax paid, USP would be eligible to claim a credit for 
such amount under section 901(a). Third, USP would not pay any 
country Z tax if it directly owned DE's assets. Fourth, Fcorp is 
entitled to claim a credit under country Z tax law for the payment 
and will recognize a loss under country Z law upon the ``sale'' of 
the class C stock. Fifth, Fcorp and USP are not related within the 
meaning of paragraph (e)(5)(iv)(C)(6) of this section and Fcorp is 
considered to own more than 10 percent of DE under country Z law. 
Sixth, the United States and country X view certain aspects of the 
transaction differently and the U.S. treatment would materially 
affect the amount of credits claimed by USP if the country Z payment 
were an amount of tax paid. USP's ownership of the class C stock for 
U.S. tax purposes would make USP eligible to claim a credit for the 
country Z payment if the payment were treated as an amount of tax 
paid.
* * * * *
    (h) Effective date. Paragraphs (a) through (e)(5)(ii) and paragraph 
(g) of this section, Sec.  1.901-2A, and Sec.  1.903-1 apply to taxable 
years beginning after November 14, 1983. Paragraphs (e)(5)(iii) and 
(iv) of this section are effective for foreign taxes paid or accrued 
during taxable years of the taxpayer ending on or after the date on 
which these regulations are published as final regulations in the 
Federal Register.

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E7-5862 Filed 3-29-07; 8:45 am]
BILLING CODE 4830-01-P