Definition of Taxpayer for Purposes of Section 901 and Related Matters, 44240-44247 [E6-12358]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 150 (Friday, August 4, 2006)]
[Proposed Rules]
[Pages 44240-44247]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E6-12358]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-124152-06]
RIN 1545-BF73


Definition of Taxpayer for Purposes of Section 901 and Related 
Matters

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 who is considered to pay a foreign tax for purposes of 
sections 901 and 903. The proposed regulations affect taxpayers that 
claim direct and indirect foreign tax credits.

DATES: Written or electronic comments must be received by October 3, 
2006. Outlines of topics to be discussed at the public hearing 
scheduled for October 13, 2006, must be received by October 3, 2006.

ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-124152-06), Room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be sent electronically via the 
IRS Internet site at https://www.irs.gov/regs or via the Federal 
eRulemaking Portal at https://www.regulations.gov (IRS and REG-124152-
06). The public hearing will be held in the Auditorium, Internal 
Revenue Service, New Carrollton Building, 5000 Ellin Road, Lanham, MD 
20706.

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 (Kelly.D.Banks@irscounsel.treas.gov); concerning 
the regulations, Bethany A. Ingwalson, (202) 622-3850 (not a toll-free 
number).

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 during the taxable year to any foreign country or to 
any possession of the United States. Section 903 of the Code permits 
taxpayers to claim a credit for a tax paid in lieu of an income tax.
    Section 1.901-2(f)(1) of the current final regulations provides 
that the person by whom tax is considered paid for purposes of sections 
901 and 903 is the person on whom foreign law imposes legal liability 
for such tax. This legal liability rule applies even if another person, 
such as a withholding agent, remits the tax. Section 1.901-2(f)(3) 
provides that if foreign income tax is imposed on the combined income 
of two or more related persons (for example, a husband and wife or a 
corporation and one or more of its subsidiaries) and they are jointly 
and severally liable for the tax under foreign law, foreign law is 
considered to impose legal liability on each such person for the amount 
of the foreign income tax that is attributable to its portion of the 
base of the tax, regardless of which person actually pays the tax.
    The existing final regulations were published in 1983. Since that 
time, numerous questions have arisen regarding the application of the 
legal liability rule to fact patterns not specifically addressed in the 
regulations or the case law. These include situations in which the 
members of a foreign consolidated group may not have in the U.S. sense 
the full equivalent of joint and several liability for the group's 
consolidated tax liability, and cases in which the person whose income 
is included in the foreign tax base is not the person who is obligated 
to remit the tax. Courts have reached inconsistent conclusions on these 
matters. Compare Nissho Iwai American Corp. v. Commissioner, 89 T.C. 
765, 773-74 (1987), Continental Illinois Corp. v. Commissioner, 998 
F.2d 513 (7th Cir. 1993), cert. denied, 510 U.S 1041 (1994), Norwest 
Corp v. Commissioner, 69 F.3d 1404 (8th Cir. 1995), cert. denied, 517 
U.S. 1203 (1996), Riggs National Corp. & Subs. v. Commissioner, 107 
T.C. 301, rev'd and rem'd on another issue, 163 F.3d 1363 (D.C. Cir. 
1999) (all holding that U.S. lenders had legal liability for tax 
imposed on their interest income from Brazilian borrowers, 
notwithstanding that under Brazilian law the tax could only be 
collected from the borrowers) with Guardian Industries Corp. & Subs. v. 
United States, 65 Fed. Cl. 50 (2005), appeal docketed, No. 2006-5058 
(Fed. Cir. December 19, 2005) (concluding that the subsidiary 
corporations in a Luxembourg consolidated group had no legal liability 
for tax imposed on their income, because under Luxembourg law the

[[Page 44241]]

parent corporation was solely liable to pay the tax).
    Questions have also arisen regarding the application of the legal 
liability rule to entities that have different classifications for U.S. 
and foreign tax law purposes (e.g., hybrid entities and reverse 
hybrids). This is particularly the case following the promulgation of 
Sec. Sec.  301.7701-1 through -3 (the check the box regulations) in 
1997. A hybrid entity is an entity that is treated as a taxable entity 
(e.g., a corporation) under foreign law and as a partnership or 
disregarded entity for U.S. tax purposes. For purposes of these 
regulations, a reverse hybrid is an entity that is a corporation for 
U.S. tax purposes but is treated as a pass-through entity for foreign 
tax purposes (i.e., income of the entity is taxed under foreign law at 
the owner level). Current Sec.  1.901-2(f) does not explicitly address 
how to determine the person that is considered to pay foreign tax 
imposed on the income of hybrid entities or reverse hybrids.
    The IRS and the Treasury Department have determined that the 
regulations should be updated to clarify the application of the legal 
liability rule in these situations, and request comments on additional 
matters that should be addressed in published guidance.

Explanation of Provisions

A. Overview

    The IRS and Treasury Department have received substantial comments 
as to matters that may be addressed under the legal liability rule of 
Sec.  1.901-2(f). These matters include rules relating to the treatment 
of foreign consolidated groups, reverse hybrids, hybrid entities, 
hybrid instruments and payments, and other issues. The proposed 
regulations would provide guidance on foreign consolidated groups, 
reverse hybrids, and hybrid entities. However, the proposed regulations 
reserve on issues relating to hybrid instruments and payments, 
specifically on the question of who is considered to pay tax imposed on 
income attributable to amounts paid or accrued between related parties 
under a hybrid instrument or payments that are disregarded for U.S. tax 
purposes. These and other issues will be addressed in a subsequent 
guidance project.
    The proposed regulations would retain the general principle that 
tax is considered paid by the person who has legal liability under 
foreign law for the tax. However, the proposed regulations would 
further clarify application of the legal liability rule in situations 
where foreign law imposes tax on the income of one person but requires 
another person to remit the tax. The proposed regulations make clear 
that foreign law is considered to impose legal liability for income tax 
on the person who is required to take such income into account for 
foreign tax purposes even if another person has the sole obligation to 
remit the tax (subject to the above-referenced reservation for hybrid 
instruments and payments).
    The proposed regulations would provide detailed guidance regarding 
how to treat taxes paid on the combined income of two or more persons. 
First, the proposed regulations would clarify the application of Sec.  
1.901-2(f) to foreign consolidated-type regimes where the members are 
not jointly and severally liable in the U.S. sense for the group's tax. 
The proposed regulations would make clear that the foreign tax must be 
apportioned among all the members pro rata based on the relative 
amounts of net income of each member as computed under foreign law. The 
proposed regulations would provide guidance in determining the relative 
amounts of net income.
    Second, the proposed regulations would revise Sec.  1.901-2(f) to 
provide that a reverse hybrid is considered to have legal liability 
under foreign law for foreign taxes imposed on an owner of the reverse 
hybrid in respect of the owner's share of income of the reverse hybrid. 
The reverse hybrid's foreign tax liability would be determined based on 
the portion of the owner's taxable income (as computed under foreign 
law) that is attributable to the owner's share of the income of the 
reverse hybrid.
    Third, the proposed regulations would clarify that a hybrid entity 
that is treated as a partnership for U.S. income tax purposes is 
legally liable under foreign law for foreign income tax imposed on the 
income of the entity, and that the owner of an entity that is 
disregarded for U.S. income tax purposes is considered to have legal 
liability for such tax.
    These provisions are discussed in more detail below.

B. Legal Liability Under Foreign Law

    Section 1.901-2(f)(1)(i) of the proposed regulations clarifies 
that, except for income attributable to related party hybrid payments 
described in Sec.  1.901-2(f)(4), foreign law is considered to impose 
legal liability for income tax on the person who is required to take 
such income into account for foreign tax purposes. This paragraph of 
the proposed regulations further clarifies that such person has legal 
liability for the tax even if another person is obligated to remit the 
tax, another person actually remits the tax, or the foreign country 
(defined in Sec.  1.901-2(g) to include political subdivisions and U.S. 
possessions) can proceed against another person to collect the tax in 
the event the tax is not paid.
    Similarly, Sec.  1.902-1(f)(1)(ii) of the proposed regulations 
clarifies that, in the case of a tax imposed with respect to a base 
other than income, foreign law is considered to impose legal liability 
for the tax on the person who is the owner of the tax base for foreign 
tax purposes. Thus, in the case of a gross basis withholding tax that 
qualifies as a tax in lieu of an income tax under Sec.  1.903-1(a), the 
proposed regulations provide that the person that is considered under 
foreign law to earn the income on which the foreign tax is imposed has 
legal liability for the tax, even if the foreign tax cannot be 
collected from such person.
    The IRS and Treasury Department request comments on whether the 
regulations should provide a special rule on where legal liability 
resides in the case of withholding taxes imposed on an amount received 
by one person on behalf of the beneficial owner of such amount. In 
certain cases, a foreign country may consider the recipient to earn 
income (or be the owner of the tax base) while the United States 
considers the recipient to be a nominee receiving the payment on behalf 
of the beneficial owner. Comments should focus on how a special rule 
for such nominee arrangements could be narrowly drawn to prevent 
opportunities for abuse while maintaining the administrative advantages 
of the legal liability rule, which generally operates to classify as 
the taxpayer the person who is in the best position to prove the tax 
was required to be, and actually was, paid.

C. Taxes Imposed on Combined Income

1. Foreign Consolidated Groups
    The IRS and Treasury Department believe that Sec.  1.901-2(f)(1) of 
the current final regulations requires allocation of foreign 
consolidated tax liability among the members of a foreign consolidated 
group pro rata based on each member's share of the consolidated taxable 
income included in the foreign tax base. In addition, the IRS and 
Treasury Department believe that Sec.  1.901-2(f)(3) confirms this rule 
in situations in which foreign consolidated regimes impose joint and 
several liability for the group's tax on each member. With respect to a 
foreign consolidated-type regime where the members do not have the full 
equivalent of joint and several liability in the U.S. sense, or where 
the income of the consolidated group members is attributed to the 
parent corporation in

[[Page 44242]]

computing the consolidated taxable income, the current regulations do 
not include a specific illustration of how the consolidated tax should 
be allocated among the members of the group for foreign tax credit 
purposes.
    Thus, the IRS and Treasury Department believe that Sec.  1.901-
2(f)(1) of the current final regulations requires as a general rule pro 
rata allocation of foreign tax among the members of a foreign 
consolidated group, and that Sec.  1.901-2(f)(3) illustrates the 
application of the general rule in cases where the group members are 
jointly and severally liable for that consolidated tax. Failure to 
allocate appropriately the consolidated tax among the members of the 
group may result in a separation of foreign tax from the income on 
which the tax is imposed. This type of splitting of foreign tax and 
income is contrary to the general purpose of the foreign tax credit to 
relieve double taxation of foreign-source income. Accordingly, Sec.  
1.901-2(f)(2) of the proposed regulations would explicitly cover all 
foreign consolidated-type regimes, including those in which the regime 
imposes joint and several liability in the U.S. sense, those in which 
the regime treats subsidiaries as branches of the parent corporation 
(or otherwise attributes income of subsidiaries to the parent 
corporation), and those in which some of the group members have limited 
obligations, or even no obligation, to pay the consolidated tax. 
Several significant commentators recommended that the regulations be 
clarified in this manner.
    The proposed regulations would define combined income to include 
cases where the foreign country initially recognizes the subsidiaries 
as separate taxable entities, but pursuant to the applicable 
consolidated tax regime treats subsidiaries as branches of the parent, 
requires or treats all income as distributed to the parent, or 
otherwise attributes all income to the parent. This approach will 
minimize the need for extensive analysis of the intricacies of the 
relevant foreign consolidated tax regime, by treating a foreign 
subsidiary as legally liable for its share of the consolidated tax 
without regard to the precise mechanics of the foreign consolidated 
regime. This approach will not only reduce inappropriate foreign tax 
credit splitting but will also reduce administrative burdens on 
taxpayers and the IRS.
    Section 1.902-1(f)(2) of the proposed regulations retains the 
general principle that the foreign tax must be apportioned among the 
persons whose income is included in the combined base pro rata based on 
the relative amounts of net income of each person as computed under 
foreign law. As under current law, this rule would apply regardless of 
which person is obligated to remit the tax, which person actually 
remits the tax, and which person the foreign country could proceed 
against to collect the tax in the event all or a portion of the tax is 
not paid. Under Sec.  1.902-1(f)(2)(i), person for this purpose 
includes a disregarded entity.
2. Reverse Hybrid Entities
    The proposed regulations would revise Sec.  1.901-2(f) to provide 
that a reverse hybrid is considered to have legal liability under 
foreign law for foreign taxes imposed on the owners of the reverse 
hybrid in respect of each owner's share of the reverse hybrid's income. 
Proposed regulation Sec.  1.902-1(f)(2)(iii). This rule is necessary to 
prevent the inappropriate separation of foreign tax from the related 
income and to prevent dissimilar treatment of foreign consolidated 
groups and foreign groups containing reverse hybrids, which are treated 
identically for U.S. tax purposes. Under the proposed rule, the reverse 
hybrid's foreign tax liability would be determined based on the portion 
of the owner's taxable income (as computed under foreign law) that is 
attributable to the owner's share of the reverse hybrid's income. Thus, 
for example, if an owner of a reverse hybrid has no other income on 
which tax is imposed by the foreign country, then the entire amount of 
foreign tax that is imposed on the owner is treated as attributable to 
the reverse hybrid for U.S. income tax purposes and, accordingly, is 
tax for which the reverse hybrid has legal liability. This rule would 
apply irrespective of whether the owner and the reverse hybrid are 
located in the same foreign country. If the owner pays tax to more than 
one foreign country with respect to income of the reverse hybrid, tax 
paid to each foreign country would be separately apportioned on the 
basis of the income included in that country's tax base. The treatment 
of reverse hybrids in the proposed regulations is consistent with the 
treatment recommended by a significant commentator.
3. Apportionment of Tax on Combined Income
    Section 1.901-2(f)(2)(iv) of the proposed regulations includes 
rules for determining each person's share of the combined income tax 
base, generally relying on foreign tax reporting of separate taxable 
income or books maintained for that purpose. The regulations provide 
that payments between group members that result in a deduction under 
both U.S. and foreign tax law will be given effect in determining each 
person's share of the combined income, but, as noted above, explicitly 
reserve with respect to the effect of hybrid instruments and 
disregarded payments between related parties (to be dealt with in a 
separate guidance project). Special rules address the effect of 
dividends (and deemed dividends) and net losses of group members on the 
determination of separate taxable income.
    Once an amount of foreign tax is determined to be paid by a 
consolidated group member or reverse hybrid under the combined income 
rule, applicable provisions of the Code would determine the specific 
U.S. tax consequences of that treatment. For example, a parent 
corporation's payment of tax on its subsidiary's share of consolidated 
taxable income, or the payment of tax by the owner of a reverse hybrid 
with respect to its share of the income of the reverse hybrid, 
ordinarily would result in a capital contribution to the subsidiary or 
reverse hybrid. Further, under sections 902 and 960, domestic corporate 
owners that own 10 percent or more of a foreign corporation's voting 
stock are eligible to claim indirect credits. Thus, domestic 
corporations that are considered to own 10 percent or more of a reverse 
hybrid's voting stock would be able to claim indirect credits for the 
taxes attributable to the earnings of the reverse hybrid that are 
distributed as dividends or otherwise included in the owner's income 
for U.S. tax purposes.

D. Hybrid Entities

    Section 1.901-2(f)(3) of the proposed regulations would also 
clarify the treatment of hybrid entities. In the case of an entity that 
is a partnership for U.S. income tax purposes but taxable under foreign 
law as an entity, foreign law is considered to impose legal liability 
for the tax on the entity. This is the case even if the owners of the 
entity also have a secondary obligation to pay the tax. Sections 702, 
704, and 901(b)(5) and the Treasury regulations thereunder apply for 
purposes of allocating the foreign tax among the owners of a hybrid 
entity that is a partnership for U.S. tax purposes. In the case of tax 
imposed on an entity that is disregarded as separate from its owner for 
U.S. income tax purposes, foreign law is considered to impose legal 
liability for the tax on the owner.

E. Effective Date

    The regulations are proposed to be effective for foreign taxes paid 
or accrued during taxable years beginning

[[Page 44243]]

on or after January 1, 2007. Comments are requested as to how to 
determine which person paid a foreign tax in cases where a foreign 
taxable year ends, and foreign tax accrues, within a post-effective 
date U.S. taxable year of a reverse hybrid and a pre-effective date 
U.S. taxable year of its owner.

F. Request for Additional Comments

    As indicated above, in developing these proposed regulations, the 
IRS and Treasury Department considered comments on the proper scope and 
content of the regulations. Commentators generally agreed that 
amendments to clarify that foreign tax is properly apportioned among 
the members of a foreign consolidated group were appropriate. 
Commentators also agreed that the regulations should clarify that tax 
imposed on a disregarded entity is considered paid by its owner, and 
that tax imposed on a hybrid partnership should be allocated under the 
rules of sections 702, 704, and 901(b)(5). Some comments strongly 
stated that the IRS and Treasury Department have authority to extend 
the scope of the regulations to require the attribution of foreign tax 
to reverse hybrids. One comment, however, suggested that the IRS and 
Treasury Department may lack such authority. The IRS and Treasury 
Department considered these comments and concluded that the proposed 
regulations are well within applicable regulatory authority and fully 
consistent with the case law, including Biddle v. Commissioner, 302 
U.S. 573 (1938).
    Comments also suggested that the IRS and Treasury Department should 
extend the scope of the regulations to ensure that hybrid instruments 
and hybrid entities could not be used effectively to separate foreign 
tax from the related foreign income. As indicated above, however, the 
IRS and Treasury Department have decided not to exercise this authority 
in these regulations. The proposed regulations reserve on the effect 
given to hybrid payments and disregarded payments in determining the 
person whose income is subject to foreign tax. The IRS and Treasury 
Department are continuing to study certain transactions employing 
hybrid instruments and other transactions designed to generate 
inappropriate foreign tax credit results. These include the use of 
hybrid instruments that accrue income for foreign tax purposes, but not 
U.S. tax purposes, to accelerate the payment of creditable foreign 
taxes before the related income is subject to U.S. tax. These also 
include the use of disregarded payments to shift foreign tax 
liabilities away from the person that is considered to earn the 
associated taxable income for U.S. tax purposes. It is contemplated 
that some or all of these issues will be addressed in a separate 
guidance project, and that any such regulations may also be effective 
for taxable years beginning on or after January 1, 2007.
    The IRS and Treasury Department request additional comments 
regarding the appropriate application of the legal liability rule to 
hybrid instruments and payments that are disregarded for U.S. tax 
purposes. They also request comments on other issues that might be 
incorporated into final 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, these 
proposed regulations will be submitted to the Chief Counsel for 
Advocacy of the Small Business Administration for comment on their 
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 October 13, 2006, beginning 
at 10 a.m., in the Auditorium, Internal Revenue Service, New Carrollton 
Building, 5000 Ellin Road, Lanham, MD 20706. In addition, 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 
October 3, 2006. 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.

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. In Sec.  1.706-1, paragraph (c)(6) is added to read as 
follows:


Sec.  1.706-1  Taxable years of partner and partnership.

* * * * *
    (c) * * *
    (6) Foreign taxes. For rules relating to the treatment of foreign 
taxes paid or accrued by a partnership, see Sec.  1.901-2(f)(3)(i) and 
(ii).
* * * * *
    Par. 3. In Sec.  1.901-2, paragraphs (f) and (h) are revised to 
read as follows:


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

* * * * *
    (f) Taxpayer--(1) In general--(i) Income taxes. Income tax (within 
the meaning of paragraphs (a) through (c) of this section) is 
considered paid for U.S. income tax purposes by the person on whom 
foreign law imposes legal liability for such tax. In general, foreign 
law is considered to impose legal liability for tax on income on the 
person who is required to take the income into account for foreign 
income tax purposes

[[Page 44244]]

(paragraph (f)(4) of this section reserves with respect to certain 
related party hybrid payments). This rule applies even if under foreign 
law another person is obligated to remit the tax, another person (e.g., 
a withholding agent) actually remits the tax, or foreign law permits 
the foreign country to proceed against another person to collect the 
tax in the event the tax is not paid. However, see section 905(b) and 
the regulations thereunder for rules relating to proof of payment. 
Except as provided in paragraph (f)(2)(i) of this section, for purposes 
of this section the term person has the meaning set forth in section 
7701(a)(1), and so includes an entity treated as a corporation, trust, 
estate or partnership for U.S. tax purposes, but not a disregarded 
entity described in Sec.  301.7701-2(c)(2)(i) of this chapter. The 
person on whom foreign law imposes legal liability is referred to as 
the ``taxpayer'' for purposes of this section, Sec.  1.901-2A, and 
Sec.  1.903-1.
    (ii) Taxes in lieu of income taxes. The principles of paragraph 
(f)(1)(i) and paragraphs (f)(2) through (f)(5) of this section shall 
apply to determine the person who is considered to have legal liability 
for, and thus to have paid, a tax in lieu of an income tax (within the 
meaning of Sec.  1.903-1(a)). Accordingly, foreign law is considered to 
impose legal liability for any such tax on the person who is the owner 
of the base on which the tax is imposed for foreign tax purposes.
    (2) Taxes on combined income of two or more persons--(i) In 
general. If foreign tax is imposed on the combined income of two or 
more persons (for example, a husband and wife or a corporation and one 
or more of its subsidiaries), foreign law is considered to impose legal 
liability on each such person for the amount of the tax that is 
attributable to such person's portion of the base of the tax. 
Therefore, if foreign tax is imposed on the combined income of two or 
more persons, such tax shall be allocated among, and considered paid 
by, such persons on a pro rata basis. For this purpose, the term pro 
rata means in proportion to each person's portion of the combined 
income, as determined under paragraph (f)(2)(iv) of this section and, 
generally, under foreign law. The rules of this paragraph (f)(2) apply 
regardless of which person is obligated to remit the tax, which person 
actually remits the tax, or which person the foreign country could 
proceed against to collect the tax in the event all or a portion of the 
tax is not paid. For purposes of this paragraph (f)(2), the term person 
shall include a disregarded entity described in Sec.  301.7701-
2(c)(2)(i) of this chapter. In determining the amount of tax paid by an 
owner of a hybrid partnership or disregarded entity (as defined in 
paragraph (f)(3) of this section), this paragraph (f)(2) shall first 
apply to determine the amount of tax paid by the hybrid partnership or 
disregarded entity, and then paragraph (f)(3) of this section shall 
apply to allocate the amount of such tax to the owner.
    (ii) Combined income. For purposes of this paragraph (f)(2), 
foreign tax is imposed on the combined income of two or more persons if 
such persons compute their taxable income on a combined basis under 
foreign law. Foreign tax is considered to be imposed on the combined 
income of two or more persons even if the combined income is computed 
under foreign law by attributing to one such person (e.g., the foreign 
parent of a foreign consolidated group) the income of other such 
persons. However, foreign tax is not considered to be imposed on the 
combined income of two or more persons solely because foreign law:
    (A) Permits one person to surrender a net loss to another person 
pursuant to a group relief or similar regime;
    (B) Requires a shareholder of a corporation to include in income 
amounts attributable to taxes imposed on the corporation with respect 
to distributed earnings, pursuant to an integrated tax system that 
allows the shareholder a credit for such taxes; or
    (C) Requires a shareholder to include, pursuant to an anti-deferral 
regime (similar to subpart F of the Internal Revenue Code (sections 951 
through 965)), income attributable to the shareholder's interest in the 
corporation.
    (iii) Reverse hybrid entities. For purposes of this paragraph 
(f)(2), if an entity is a corporation for U.S. income tax purposes and 
a person is required to take all or a part of the income of one or more 
such entities into account under foreign law because the entity is 
treated as a branch or a pass-through entity under foreign law (a 
reverse hybrid), tax imposed on the person's share of income from each 
reverse hybrid and tax imposed by the foreign country on other income 
of the person, if any, is considered to be imposed on the combined 
income of the person and each reverse hybrid. Therefore, under 
paragraph (f)(2)(i) of this section, foreign tax imposed on the 
combined income of the person and each reverse hybrid shall be 
allocated between the person and the reverse hybrid on a pro rata 
basis. For this purpose, the term pro rata means in proportion to the 
portion of the combined income included in the foreign tax base that is 
attributable to the person's share of income from each reverse hybrid 
and the portion of the combined income that is attributable to the 
other income of the person (including income received from a reverse 
hybrid other than in the owner's capacity as an owner). If the person 
has a share of income from the reverse hybrid but no other income on 
which tax is imposed by the foreign country, the entire amount of 
foreign tax is allocated to and considered paid by the reverse hybrid.
    (iv) Portion of combined income--(A) In general. Except with 
respect to income attributable to related party hybrid payments or 
accrued amounts described in paragraph (f)(4) of this section, each 
person's portion of the combined income shall be determined by 
reference to any return, schedule or other document that must be filed 
or maintained with respect to a person showing such person's income for 
foreign tax purposes, as properly amended or adjusted for foreign tax 
purposes. If no such return, schedule or document must be filed or 
maintained with respect to a person for foreign tax purposes, then, for 
purposes of this paragraph (f)(2), such person's income shall be 
determined from the books of account regularly maintained by or on 
behalf of the person for purposes of computing its taxable income under 
foreign law.
    (B) Effect of certain payments. Each person's portion of the 
combined income shall be determined by giving effect to payments and 
accrued amounts of interest, rents, royalties, and other amounts to the 
extent such payments or accrued amounts are taken into account in 
computing the separate taxable income of such person both under foreign 
law and under U.S. tax principles. With respect to certain related 
party hybrid payments, see the reservation in paragraph (f)(4) of this 
section. Thus, for example, interest paid by a reverse hybrid to one of 
its owners with respect to an instrument that is treated as debt for 
both U.S. and foreign tax purposes would be considered income of the 
owner and would reduce the taxable income of the reverse hybrid. 
However, each person's portion of the combined income shall be 
determined without taking into account any payments from other persons 
whose income is included in the combined base that are treated as 
dividends under foreign law, and without taking into account deemed 
dividends or any similar attribution of income made for purposes of 
computing the combined income under foreign law. This rule applies 
regardless of whether any such dividend, deemed dividend or

[[Page 44245]]

attribution of income results in a deduction or inclusion under foreign 
law.
    (C) Net losses. If tax is considered to be imposed on the combined 
income of three or more persons and one or more of such persons has a 
net loss for the taxable year for foreign tax purposes, the following 
rules apply. If foreign law provides mandatory rules for allocating the 
net loss among the other persons, then the rules that apply for foreign 
tax purposes shall apply for purposes of paragraph (f)(2)(iv) of this 
section. If foreign law does not provide mandatory rules for allocating 
the net loss, the net loss shall be allocated among all other such 
persons pro rata based on the amount of each person's income, as 
determined under paragraphs (f)(2)(iv)(A) and (B) of this section. For 
purposes of this paragraph (f)(2)(iv)(C), foreign law shall not be 
considered to provide mandatory rules for allocating a loss solely 
because such loss is attributed from one person to a second person for 
purposes of computing combined income, as described in paragraph 
(f)(2)(ii) of this section.
    (v) Collateral consequences. U.S. tax principles shall apply to 
determine the tax consequences if one person remits a tax that is the 
legal liability of, and thus is considered paid by, another person. For 
example, a payment of tax for which a corporation has legal liability 
by a shareholder of that corporation (including an owner of a reverse 
hybrid) will ordinarily result in a deemed capital contribution and 
deemed payment of tax by the corporation. If the corporation reimburses 
the shareholder for the tax payment, such reimbursement would 
ordinarily be treated as a distribution for U.S. tax purposes.
    (3) Taxes on income of hybrid partnerships and disregarded 
entities--(i) Hybrid partnerships. If foreign law imposes tax at the 
entity level on the income of an entity that is treated as a 
partnership for U.S. income tax purposes (a hybrid partnership), the 
hybrid partnership is considered to be legally liable for such tax 
under foreign law. Therefore, the hybrid partnership is considered to 
pay the tax for U.S. income tax purposes. See Sec.  1.704-1(b)(4)(viii) 
for rules relating to the allocation of such tax among the partners of 
the partnership. If the hybrid partnership's U.S. taxable year closes 
for all partners due to a termination of the partnership under section 
708 and the regulations thereunder (other than in the case of a 
termination under section 708(b)(1)(A)) and the foreign taxable year of 
the partnership does not close, then foreign tax paid or accrued by the 
partnership with respect to the foreign taxable year that ends with or 
within the new partnership's first U.S. taxable year shall be allocated 
between the terminating partnership and the new partnership. The 
allocation shall be made under the principles of Sec.  1.1502-76(b) 
based on the respective portions of the taxable income of the 
partnership (as determined under foreign law) for the foreign taxable 
year that are attributable to the period ending on and the period 
ending after the last day of the terminating partnership's U.S. taxable 
year. The principles of the preceding sentence shall also apply if the 
hybrid partnership's U.S. taxable year closes with respect to one or 
more, but less than all, partners or, except as otherwise provided in 
section 706(d)(2) or (d)(3) (relating to certain cash basis items of 
the partnership), there is a change in any partner's interest in the 
partnership during the partnership's U.S. taxable year. If, as a result 
of a change in ownership during a hybrid partnership's foreign taxable 
year, the hybrid partnership becomes a disregarded entity and the 
entity's foreign taxable year does not close, foreign tax paid or 
accrued by the disregarded entity with respect to the foreign taxable 
year shall be allocated between the hybrid partnership and the owner of 
the disregarded entity under the principles of this paragraph 
(f)(3)(i).
    (ii) Disregarded entities. If foreign tax is imposed at the entity 
level on the income of an entity described in Sec.  301.7701-2(c)(2)(i) 
of this chapter (a disregarded entity), foreign law is considered to 
impose legal liability for the tax on the person who is treated as 
owning the assets of the disregarded entity for U.S. income tax 
purposes. Such person shall be considered to pay the tax for U.S. 
income tax purposes. If there is a change in the ownership of such 
disregarded entity during the entity's foreign taxable year and such 
change does not result in a closing of the disregarded entity's foreign 
taxable year, foreign tax paid or accrued with respect to such foreign 
taxable year shall be allocated between the old owner and the new 
owner. The allocation shall be made under the principles of Sec.  
1.1502-76(b) based on the respective portions of the taxable income of 
the disregarded entity (as determined under foreign law) for the 
foreign taxable year that are attributable to the period ending on the 
date of the ownership change and the period ending after such date. If, 
as a result of a change in ownership, the disregarded entity becomes a 
hybrid partnership and the entity's foreign taxable year does not 
close, foreign tax paid or accrued by the hybrid partnership with 
respect to the foreign taxable year shall be allocated between the old 
owner and the hybrid partnership under the principles of this paragraph 
(f)(3)(ii). If the person who owns a disregarded entity is a 
partnership for U.S. income tax purposes, see Sec.  1.704-1(b)(4)(viii) 
for rules relating to the allocation of such tax among the partners of 
the partnership.
    (4) Tax on income attributable to related party payments or accrued 
amounts that are deductible for foreign (or U.S.) tax law purposes and 
that are nondeductible for U.S. (or foreign) tax law purposes or that 
are disregarded for U.S. tax law purposes. [Reserved].
    (5) Party undertaking tax obligation as part of transaction. Tax is 
considered paid by the taxpayer even if another party to a direct or 
indirect transaction with the taxpayer agrees, as a part of the 
transaction, to assume the taxpayer's foreign tax liability. The rules 
of the foregoing sentence apply notwithstanding anything to the 
contrary in paragraph (e)(3) of this section. See Sec.  1.901-2A for 
additional rules regarding dual capacity taxpayers.
    (6) Examples. The following examples illustrate the rules of 
paragraphs (f)(1) through (f)(5) of this section.

    Example 1. (i) Facts. Under a loan agreement between A, a 
resident of country X, and B, a United States person, A agrees to 
pay B a certain amount of interest net of any tax that country X may 
impose on B with respect to its interest income. Country X imposes a 
10 percent tax on the gross amount of interest income received by 
nonresidents of country X from sources in country X, and it is 
established that this tax is a tax in lieu of an income tax within 
the meaning of Sec.  1.903-1(a). Under the law of country X this tax 
is imposed on the interest income of the nonresident recipient, and 
any resident of country X that pays such interest to a nonresident 
is required to withhold and pay over to country X 10 percent of the 
amount of such interest. Under the law of country X, the country X 
taxing authority may proceed against A, but not B, if A fails to 
withhold and pay over the tax to country X.
    (ii) Result. Under paragraph (f)(1)(ii) of this section, B is 
considered legally liable for the country X tax because such tax is 
imposed on B's interest income. Therefore, for U.S. income tax 
purposes, B is considered to pay the country X tax, and B's interest 
income includes the amount of country X tax that is imposed with 
respect to such interest income and paid on B's behalf by A. No 
portion of such tax is considered paid by A.
    Example 2. (i) Facts. The facts are the same as in Example 1, 
except that in collecting and receiving the interest B is acting as 
a nominee for, or agent of, C, who is a United States person. 
Accordingly, C, not B, is the beneficial owner of the interest for 
U.S. income tax purposes. Country X law also

[[Page 44246]]

recognizes the nominee or agency arrangement and, thus, considers C 
to be the beneficial owner of the interest income.
    (ii) Result. Under paragraph (f)(1)(ii) of this section, legal 
liability for the tax is considered to be imposed on C, not B (C's 
nominee or agent). Thus, C is the taxpayer with respect to the 
country X tax imposed on C's interest income from C's loan to A. 
Accordingly, C's interest income for U.S. income tax purposes 
includes the amount of country X tax that is imposed on C with 
respect to such interest income and that is paid on C's behalf by A 
pursuant to the loan agreement. Under paragraph (f)(1)(ii) of this 
section, such tax is considered for U.S. income tax purposes to be 
paid by C. No such tax is considered paid by B.
    Example 3. (i) Facts. A, a U.S. person, owns a bond issued by C, 
a resident of country X. On January 1, 2008, A and B enter into a 
transaction in which A, in form, sells the bond to B, also a U.S. 
person. As part of the transaction, A and B agree that A will 
repurchase the bond from B on December 31, 2013 for the same amount. 
In addition, B agrees to make payments to A equal to the amount of 
interest B receives from C. As a result of the arrangement, legal 
title to the bond is transferred to B. The transfer of legal title 
has the effect of transferring ownership of the bond to B for 
country X tax purposes. A remains the owner of the bond for U.S. 
income tax purposes. Country X imposes a 10 percent tax on the gross 
amount of interest income received by nonresidents of country X from 
sources in country X, and it is established that this tax is a tax 
in lieu of an income tax within the meaning of Sec.  1.903-1(a). 
Under the law of country X this tax is imposed on the interest 
income of the nonresident recipient, and any resident of country X 
that pays such interest to a nonresident is required to withhold and 
pay over to country X 10 percent of the amount of such interest. On 
December 31, 2008, C pays B interest on the bond and withholds 10 
percent of country X tax.
    (ii) Result. Under paragraph (f)(1)(ii) of this section, B is 
considered legally liable for the country X tax because B is the 
owner of the interest income for country X tax purposes, even though 
A and not B recognizes the interest income for U.S. tax purposes. 
The result would be the same if the transaction had the effect of 
transferring ownership of the bond to B for U.S. income tax 
purposes.
    Example 4. (i) Facts. On January 1, 2007, A, a United States 
person, purchases a bond issued by X, a foreign person resident in 
county Y. A accrues interest income on the bond for U.S. tax 
purposes from January 1, 2007, until A sells the bond to B, another 
United States person, on July 1, 2007. On December 31, 2007, X pays 
interest on the bond that accrued for the entire year to B. Country 
Y imposes a 10 percent tax on the gross amount of interest income 
received by nonresidents of country Y from sources in country Y, and 
it is established that this tax is a tax in lieu of an income tax 
within the meaning of Sec.  1.903-1(a). Under the law of country Y 
this tax is imposed on the interest income of the nonresident 
recipient, and any resident of country Y that pays such interest to 
a nonresident is required to withhold and pay over to country X 10 
percent of the amount of such interest. Pursuant to the law of 
country Y, X withholds tax from the interest paid to B.
    (ii) Result. Under paragraph (f)(1)(ii) of this section, legal 
liability for the tax is considered to be imposed on B. Thus, B is 
the taxpayer with respect to the entire amount of the country Y tax 
even though, for U.S. income tax purposes, B only recognizes 
interest that accrues on the bond on and after July 1, 2007. No 
portion of the country Y tax is considered to be paid by A even 
though, for U.S. income tax purposes, A recognizes interest on the 
bond that accrues prior to July 1, 2007.
    Example 5. (i) Facts. A, a United States person and resident of 
country X, is an employee of B, a corporation organized in country 
X. Under the laws of country X, B is required to withhold from A's 
wages and pay over to country X foreign social security tax of a 
type described in paragraph (a)(2)(ii)(C) of this section, and it is 
established that this tax is an income tax described in paragraph 
(a)(1) of this section.
    (ii) Result. Under paragraph (f)(1)(i) of this section, A is 
considered legally liable for the country X tax because such tax is 
imposed on A's wages. Therefore, for U.S. income tax purposes, A is 
considered to pay the country X tax.
    Example 6. (i) Facts. A, a United States person, owns 100 
percent of B, an entity organized in country X. B is a corporation 
for country X tax purposes, and a disregarded entity for U.S. income 
tax purposes. B owns 100 percent of corporation C and corporation D, 
both of which are also organized in country X. B, C and D use the 
``u'' as their functional currency and file on a combined basis for 
country X income tax purposes. Country X imposes an income tax 
described in paragraph (a)(1) of this section at the rate of 30 
percent on the taxable income of corporations organized in country 
X. Under the country X combined reporting regime, income (or loss) 
of C and D is attributed to, and treated as income (or loss) of, B. 
B has the sole obligation to pay country X income tax imposed with 
respect to income of B and income of C and D that is attributed to, 
and treated as income of, B. Under the law of country X, country X 
may proceed against B, but not C or D, if B fails to pay over to 
country X all or any portion of the country X income tax imposed 
with respect to such income. In year 1, B has taxable income of 
100u, C has taxable income of 200u, and D has a net loss of (60u). 
Under the law of country X, B is considered to have 240u of taxable 
income with respect to which 72u of country X income tax is imposed. 
Country X does not provide mandatory rules for allocating D's loss.
    (ii) Result. Under paragraph (f)(2)(ii) of this section, the 72u 
of country X tax is considered to be imposed on the combined income 
of B, C, and D. Because country X law does not provide mandatory 
rules for allocating D's loss between B and C, under paragraph 
(f)(2)(iv)(C) of this section D's (60u) loss is allocated pro rata: 
20u to B ((100u/300u) x 60u) and 40u to C ((200u/300u) x 60u). Under 
paragraph (f)(2)(i) of this section, the 72u of country X tax must 
be allocated pro rata among B, C, and D. Because D has no income for 
country X tax purposes, no country X tax is allocated to D. 
Accordingly, 24u (72u x (80u/240u)) of the country X tax is 
allocated to B, and 48u (72u x (160u/240u)) of such tax is allocated 
to C. Under paragraph (f)(3)(ii) of this section, A is considered to 
have legal liability for the 24u of country X tax allocated to B 
under paragraph (f)(2) of this section.
    Example 7. (i) Facts. A, a domestic corporation, owns 95 percent 
of the voting power and value of C, an entity organized in country Z 
that uses the ``u'' as its functional currency. B, a domestic 
corporation, owns the remaining 5 percent of the voting power and 
value of C. Pursuant to an election made under Sec.  301.7701-3(a), 
C is treated as a corporation for U.S. income tax purposes, but as a 
partnership for country Z income tax purposes. Accordingly, under 
country Z law, A and B are required to take into account their 
respective shares of the taxable income of C. Country Z imposes an 
income tax described in paragraph (a)(1) of this section at the rate 
of 30 percent on such taxable income. For 2007, C has 500u of 
taxable income for country Z tax purposes. A's and B's shares of 
such income are 475u and 25u, respectively. In addition, A has 125u 
of taxable income attributable to a permanent establishment in 
country Z. Income of nonresidents that is attributable to a 
permanent establishment in country Z is also subject to the country 
Z income tax at a rate of 30 percent. Accordingly, country Z imposes 
180u of tax on A's total taxable income of 600u (475u of income from 
C and 125u of income from the permanent establishment). Country Z 
imposes 7.5u of tax on B's 25u of taxable income from C.
    (ii) Result. Under paragraph (f)(2)(iii) of this section, the 
180u of tax imposed on the taxable income of A is considered to be 
imposed on the combined income of A and C. Under paragraph (f)(2)(i) 
of this section, such tax must be allocated between A and C on a pro 
rata basis. Accordingly, C is considered to be legally liable for 
the 142.5u (180u x (475u/600u)) of country Z tax imposed on A's 475u 
share of C's income, and A is considered to be legally liable for 
the 37.5u (180u x (125u/600u)) of the country Z tax imposed on A's 
125u of income from its permanent establishment. Under paragraph 
(f)(2)(iii) of this section, the 7.5u of tax imposed on the taxable 
income of B is considered to be imposed on the combined income of B 
and C. Since B has no other income on which income tax is imposed by 
country Z, under paragraph (f)(2)(iii) of this section the entire 
amount of such tax is allocated to and considered paid by C. C's 
post-1986 foreign income taxes include the U.S. dollar equivalent of 
150u of country Z income tax C is considered to pay for U.S. income 
tax purposes. A, but not B, is eligible to compute deemed-paid taxes 
under section 902(a) in connection with dividends received from C. 
Under paragraph (f)(2)(v) of this section, the payment by A or B of 
tax for which C is considered legally liable is treated as a capital 
contribution by A or B to C.
    Example 8. (i) Facts. A, B, and C are U.S. persons that each use 
the calendar year as their taxable year. A and B each own 50

[[Page 44247]]

percent of the capital and profits of D, an entity organized in 
country M. D is a partnership for U.S. income tax purposes, but is a 
corporation for country M tax purposes. D uses the ``u'' as its 
functional currency and the calendar year as its taxable year for 
both U.S. tax purposes and country M tax purposes. Country M imposes 
an income tax described in paragraph (a)(1) of this section at a 
rate of 30 percent at the entity level on the taxable income of D. 
On September 30, 2008, A sells its 50 percent interest in D to C. 
A's sale of its partnership interest results in a termination of the 
partnership under section 708(b) for U.S. tax purposes. As a result 
of the termination, ``old'' D's taxable year closes on September 30, 
2008 for U.S. tax purposes. New D also has a short U.S. taxable 
year, beginning on October 1, 2008, and ending on December 31, 2008. 
The sale of A's interest does not close D's taxable year for country 
M tax purposes. D has 400u of taxable income for its 2008 foreign 
taxable year with respect to which country M imposes 120u equal to 
$120 of income tax.
    (ii) Result. Under paragraph (f)(3)(i) of this section, hybrid 
partnership D is legally liable for the $120 of country M income tax 
imposed on its net income. Because D's taxable year closes on 
September 30, 2008, for U.S. tax purposes, but does not close for 
country M tax purposes, under paragraph (f)(3)(i) of this section 
the $120 of country M tax must be allocated under the principles of 
Sec.  1.1502-76(b) between the short U.S. taxable years of 
terminating D and new D. See Sec.  1.704-1(b)(4)(viii) for rules 
relating to the allocation of terminating D's country M taxes 
between A and B and the allocation of new D's country M taxes 
between B and C.
    Example 9. (i) Facts. A, a United States person engaged in 
construction activities in country X, is subject to the country X 
income tax. Country X has contracted with A for A to construct a 
naval base. A is a dual capacity taxpayer (as defined in paragraph 
(a)(2)(ii)(A) of this section) and, in accordance with paragraphs 
(a)(1) and (c)(1) of Sec.  1.901-2A, A has established that the 
country X income tax as applied to dual capacity persons and the 
country X income tax as applied to persons other than dual capacity 
persons together constitute a single levy. A has also established 
that that levy is an income tax within the meaning of paragraph 
(a)(1) of this section. Pursuant to the terms of the contract, 
country X has agreed to assume any country X income tax liability 
that A may incur with respect to A's income from the contract.
    (ii) Result. For U.S. income tax purposes, A's income from the 
contract includes the amount of tax that is imposed by country X on 
A with respect to its income from the contract and that is assumed 
by country X; and the amount of the tax liability assumed by country 
X is considered to be paid by A. By reason of paragraph (f)(5) of 
this section, country X is not considered to provide a subsidy, 
within the meaning of section 901(i) and paragraph (e)(3) of this 
section, to A.
* * * * *
    (h) Effective Date. Paragraphs (a) through (e) and paragraph (g) of 
this section, Sec.  1.901-2A and Sec.  1.903-1 apply to taxable years 
beginning after November 14, 1983. Paragraph (f) of this section is 
effective for foreign taxes paid or accrued during taxable years of the 
taxpayer beginning on or after January 1, 2007.

Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E6-12358 Filed 8-3-06; 8:45 am]
BILLING CODE 4830-01-P