Determining the Amount of Taxes Paid for Purposes of Section 901, 40727-40738 [E8-16329]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 73, Number 137 (Wednesday, July 16, 2008)]
[Rules and Regulations]
[Pages 40727-40738]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E8-16329]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9416]
RIN 1545-BH74


Determining the Amount of Taxes Paid for Purposes of Section 901

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final and temporary regulations under 
section 901 of the Internal Revenue Code providing guidance relating to 
the determination of the amount of taxes paid for purposes of the 
foreign tax credit.
    The regulations affect taxpayers that claim direct and indirect 
foreign tax credits. The text of these temporary regulations also 
serves as the text of the proposed regulations (REG-156779-06) 
published in the Proposed Rules section in this issue of the Federal 
Register .

DATES: Effective Date: These regulations are effective on July 16, 
2008.
    Applicability Dates: For dates of applicability, see Sec.  1.901-
1T(j) and Sec.  1.901-2T(h)(2).

FOR FURTHER INFORMATION CONTACT: Michael Gilman, (202) 622-3850 (not a 
toll-free number).

[[Page 40728]]


SUPPLEMENTARY INFORMATION:

Background

    On March 30, 2007, the Federal Register published proposed 
amendments (72 FR 15081) to the Income Tax Regulations (26 CFR part I) 
under section 901 of the Internal Revenue Code (Code) relating to the 
amount of taxes paid for purposes of the foreign tax credit (the ``2007 
proposed regulations''). The 2007 proposed regulations would revise 
Sec.  1.901-2(e)(5) in two ways. First, for purposes of Sec.  1.901-
2(e)(5), the 2007 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 (a ``U.S.-owned foreign 
group''). Second, the 2007 proposed regulations would treat amounts 
paid to a foreign taxing authority as noncompulsory payments if those 
amounts are attributable to certain structured passive investment 
arrangements. The 2007 proposed regulations provide that the 
regulations will be effective for foreign taxes paid or accrued during 
taxable years of the taxpayer ending on or after the date on which the 
regulations are finalized.
    The IRS and Treasury Department received written comments on the 
2007 proposed regulations, which are discussed in this preamble. A 
public hearing was held on July 30, 2007. In response to written 
comments, the IRS and Treasury Department determined that the proposed 
change to Sec.  1.901-2(e)(5) relating to U.S.-owned foreign groups may 
lead to inappropriate results in certain cases. Accordingly, on 
November 19, 2007, the IRS and Treasury Department issued Notice 2007-
95, 2007-49 IRB 1 (see Sec.  601.601(d)(2)(ii)(b)). Notice 2007-95 
provided that the proposed rule for U.S.-owned foreign groups would be 
severed from the portion of the 2007 proposed regulations addressing 
the treatment of foreign payments attributable to certain structured 
passive investment arrangements. Notice 2007-95 further provided that 
the proposed rules for U.S.-owned groups would be effective for taxable 
years beginning after final regulations are published in the Federal 
Register .
    In light of comments, the IRS and the Treasury Department believe 
that it is appropriate to issue new proposed and temporary regulations 
addressing the treatment of foreign payments attributable to structured 
passive investment arrangements. These new regulations make several 
changes to the 2007 proposed regulations to take into account comments 
received, while adopting without amendment substantial portions of the 
2007 proposed regulations. The new temporary and proposed regulations 
will permit the IRS to enforce the rules relating to structured passive 
investment arrangements, while also allowing taxpayers a further 
opportunity for comment. The significant comments and revisions are 
described in this preamble.

Explanation of Provisions

    The temporary regulations address the application of Sec.  1.901-
2(e)(5) in cases in which a person claiming foreign tax credits is a 
party to a structured passive investment arrangement. These complex 
arrangements are intentionally structured to create a foreign tax 
liability when, removed from the elaborately engineered structure, the 
basic underlying business transaction generally would result in 
significantly less, or even no, foreign taxes. The parties use these 
arrangements to exploit differences between U.S. and foreign law in 
order to permit a person to claim a foreign tax credit for the 
purported foreign tax payments while also allowing the foreign 
counterparty to claim a duplicative foreign tax benefit. The person 
claiming foreign tax credits and the foreign counterparty share the 
cost of the purported foreign tax payments through the pricing of the 
arrangement.
    The temporary regulations treat foreign payments attributable to 
such arrangements as noncompulsory payments under Sec.  1.901-2(e)(5) 
and, thus, disallow foreign tax credits for such amounts. For periods 
prior to the effective date of the temporary regulations, the IRS will 
continue to utilize all available tools under current law to challenge 
the U.S. tax results claimed in connection with these and other similar 
abusive arrangements, including the substance over form doctrine, the 
economic substance doctrine, debt-equity principles, tax ownership 
principles, other provisions of Sec.  1.901-2, section 269, and the 
partnership anti-abuse rules of Sec.  1.701-2.
    The temporary regulations 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, Sec.  1.901-2T(e)(5)(iv)(A) provides 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, Sec.  
1.901-2T(e)(5)(iv)(B) defines a structured passive investment 
arrangement as an arrangement that satisfies six conditions. The six 
conditions consist of features that are common to arrangements that are 
intentionally structured to generate the foreign payment.

A. Section 1.901-2T(e)(5)(iv)(B)(1): Special Purpose Vehicle

    The first condition provided in the 2007 proposed regulations 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, if any, 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 entity is treated as a pass-
through entity under U.S. law).
    For purposes of the first requirement, Sec.  1.901-
2(e)(5)(iv)(C)(4) of the 2007 proposed regulations defines passive 
investment income as income described in section 954(c), with two 
modifications. The first modification excludes income of a holding 
company attributable to qualifying equity interests in lower-tier 
entities that are predominantly engaged in the active conduct of a 
trade or business (or that are themselves holding companies). The 
second modification is that passive investment income is determined by 
disregarding sections 954(c)(3) and 954(c)(6) and by treating income 
attributable to transactions with a counterparty as ineligible for the 
exclusions under sections 954(h) and 954(i).
    One commentator recommended, in lieu of the holding company rules 
in the 2007 proposed regulations, applying look-through rules to income 
and assets of lower-tier entities similar to the rules of section 
1297(c), under which a foreign corporation, if it owns at least 25 
percent of the stock of another corporation, is treated as owning its 
proportionate share of the assets of the other corporation and 
receiving its proportionate share of the income of the other 
corporation. Alternatively, the commentator recommended that the 
holding company rules in the 2007 proposed regulations be modified to 
eliminate the requirement that

[[Page 40729]]

substantially all of the assets of the tested entity must consist of 
qualified equity interests; to permit income other than dividends (for 
example, interest and royalties) received from a lower-tier entity that 
is predominantly engaged in an active business to qualify as active 
income; and to treat a lower-tier entity as an operating company if 
more than 50 percent of either its assets or its income meet the active 
business test. In addition, commentators suggested eliminating the 
requirement that the U.S. party and the counterparty must share the 
opportunity of gain or loss with respect to the lower-tier entity, or 
replacing it with a rule disqualifying the equity interest if 
contractual restrictions limit the counterparty's recourse against the 
lower-tier entity's income or assets. Finally, commentators suggested 
that preferred stock should be treated as a qualifying equity interest.
    These comments were not adopted. The holding company exception is 
intended only to clarify that a joint venture arrangement is not 
treated as a structured passive investment arrangement solely because 
it is conducted through a holding company structure, not to liberalize 
the definition of structured passive investment arrangements. The 
requirement that the parties share the opportunity for gain and risk of 
loss with respect to the holding company's assets is intended to ensure 
that the arrangement between the parties is a bona fide joint venture. 
In this regard, a commentator recommended that the regulations be 
clarified to provide that the holding company exception is not 
satisfied if either the U.S. party or the counterparty is solely a 
creditor with respect to the entity because it either owns a hybrid 
instrument that is debt for U.S. tax purposes or purchases stock 
subject to an obligation to sell the stock back. This modification is 
reflected in Sec.  1.901-2T(e)(5)(iv)(C)(5)(ii) of the temporary 
regulations. In addition, Example 2 of Sec.  1.901-2T(e)(5)(iv)(D) is 
modified to clarify that the holding company exception is not met if 
the counterparty's interest is acquired in a sale-repurchase 
transaction.
    The IRS and Treasury Department recognize that under the 
regulations an entity conducting business through an active foreign 
subsidiary may fail to meet the holding company exception, even though 
the entity would not be treated as an SPV under the ``substantially 
all'' test if it operated the subsidiary's business directly through a 
branch operation. The IRS and Treasury Department believe this result 
is appropriate because the segregation of active business income and 
assets in a lower-tier entity may facilitate the use of an upper-tier 
entity to conduct a structured passive investment arrangement.
    The IRS and Treasury Department remain concerned that taxpayers may 
continue to enter into structured passive investment arrangements 
designed to generate foreign tax credits through entities that meet the 
technical requirements of the holding company exception. The IRS and 
Treasury Department intend to monitor the use of holding companies to 
facilitate abusive foreign tax credit arrangements, 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, other provisions of Sec.  1.901-
2, section 269, and the partnership anti-abuse rules of Sec.  1.701-2) 
in appropriate cases, and to issue additional regulations modifying or 
eliminating the holding company exception if necessary to prevent 
abuse.
    The second modification in the 2007 proposed regulations is that 
passive investment income is determined by disregarding sections 
954(c)(3) and 954(c)(6) and by treating income attributable to 
transactions with a counterparty as ineligible for the exclusions under 
sections 954(h) and 954(i). The IRS and Treasury Department received a 
number of comments suggesting that the definition of passive investment 
income should be narrowed by excluding income that would be treated as 
non-subpart F income under section 954(c)(3) or 954(c)(6), excluding 
income from unrelated persons other than the counterparty, or 
eliminating the requirement in section 954(h) that the tested entity's 
activity be conducted in the entity's ``home country.'' Other 
commentators suggested substituting other tests for the active 
financing exception in section 954(h), such as exempting financial 
services income as defined in section 904(d), with or without 
modification. For example, commentators suggested various 
modifications, such as excluding income derived from unrelated persons 
or from direct activities of employees of the tested entity; exempting 
any income derived from or related to transactions with customers; 
exempting income that would be considered attributable to an active 
foreign trade or business under the principles of section 864 and Sec.  
1.367(a)-2T(b); or exempting income other than income from ``tainted'' 
assets such as cash or cash equivalents, stock or notes of persons 
related to the U.S. party or counterparty, or assets giving rise to 
U.S. source income. One commentator suggested that payments described 
in section 954(c)(3) should not be treated as passive investment income 
to the extent the payment was deductible under foreign law and the 
corresponding income inclusion by the tested entity did not result in a 
net increase in foreign taxes paid. This commentator suggested that the 
result in the U.S. borrower transaction described in Example 2 of the 
2007 proposed regulations was inappropriate since the foreign tax paid 
by the SPV was offset by a reduction in tax paid by the CFC borrower.
    The IRS and Treasury Department carefully considered these 
suggestions but ultimately determined that none of the suggested 
approaches has significant advantages over relying on section 954(h) to 
determine whether income from financing activities is sufficiently 
active that it should be excluded from passive investment income for 
purposes of these regulations. Section 954(h) includes detailed 
requirements that ensure that the entity is predominantly engaged in 
the active conduct of a banking, financing or similar business and 
conducts substantial activity with respect to such business. In 
addition, the IRS and Treasury Department continue to believe it is not 
appropriate to exclude income described in sections 954(c)(3) and 
954(c)(6) from passive investment income, because financing 
arrangements between related parties that are engaged in the active 
conduct of a trade or business are commonly used in the structured 
transactions that are the target of these regulations. The IRS and 
Treasury Department also do not believe that U.S. borrower transactions 
should not be considered to result in a net increase in foreign tax, 
since in the absence of the structured passive investment arrangement 
the CFC borrower would still reduce its foreign tax by reason of the 
interest expense deduction but the U.S. party would not claim foreign 
tax credits for foreign payments attributable to income in the SPV that 
is in substance the foreign lender's interest income. Accordingly, 
Sec.  1.901-2T(e)(5)(iv)(C)(5)(i) generally retains the definition of 
passive investment income in the 2007 proposed regulations.
    However, the temporary regulations include two modifications in 
response to comments. First, the IRS and Treasury Department agree it 
is appropriate to require the entity's activities to be conducted 
directly by its own employees rather than by employees of affiliates, 
because the purpose of the SPV condition is to

[[Page 40730]]

distinguish between active entities and those with largely passive 
income, and it is reasonable to require an entity engaged in an active 
business to conduct that business through its own employees. 
Accordingly, Sec.  1.901-2T(e)(5)(iv)(C)(5)(i) provides that section 
954(h)(3)(E) shall not apply, and that the entity must conduct 
substantial activity through its own employees.
    Second, the IRS and Treasury Department agree that the requirement 
that activities be conducted in the entity's ``home country'' reflects 
a subpart F policy that is more restrictive than necessary for purposes 
of these regulations. Accordingly, Sec.  1.901-2T(e)(5)(iv)(C)(5)(i) 
provides that for purposes of these regulations the term home country 
means any foreign country.
    Concerning the requirement in Sec.  1.901-2(e)(5)(iv)(B)(1)(i) of 
the 2007 proposed regulations that substantially all of the gross 
income of the entity be passive investment income and substantially all 
of the entity's assets are assets held to produce such passive 
investment income, one commentator recommended that the regulations 
provide examples illustrating situations in which such requirement is 
met. The IRS and Treasury Department did not adopt this comment because 
the ``substantially all'' test requires evaluation of all the facts and 
circumstances and cannot be satisfied by reference to a specific 
percentage benchmark.
    Several commentators requested that the regulations clarify the 
time at which the six conditions must be met to result in a structured 
passive investment arrangement. Section 1.901-2T(e)(5)(iv)(B)(1)(ii) of 
the temporary regulations is revised to clarify that the foreign 
payment must be made with respect to a U.S. tax year in which 
substantially all of the gross income (for U.S. tax purposes) of the 
entity, if any, is attributable to passive investment income and 
substantially all of the assets of the entity are assets held to 
produce such passive investment income. This clarification is intended 
to ensure that foreign tax credits are disallowed for foreign payments 
that relate primarily to passive investment income, but not for taxes 
that relate to active business income earned in an earlier or later 
year when the entity is not treated as an SPV. The regulations do not, 
however, require all six conditions to be met in the same tax year. For 
example, the regulations disallow credits for foreign payments with 
respect to income of an SPV even if the U.S. party acquires its 
interest, or a hybrid instrument is issued to the counterparty, after 
the foreign payments are made.
    Other commentators recommended that the regulations eliminate the 
SPV condition and treat as noncompulsory payments only those foreign 
payments that directly relate to passive investment income, or with 
respect to which duplicative tax benefits are claimed. The IRS and 
Treasury Department did not adopt such an approach in the temporary 
regulations because of the administrative difficulty of tracing 
specific foreign payments to specific income or to the duplicative tax 
benefits. Accordingly, the temporary regulations retain the SPV 
condition and the approach of treating all foreign payments 
attributable to a structured passive investment arrangement as 
noncompulsory. However, the IRS and Treasury Department recognize that 
an element of the arrangements intended to be covered by the 
regulations is that they are designed to generate duplicative tax 
benefits, and that some connection between the counterparty's foreign 
tax benefit and the U.S. party's share of the foreign payments should 
be a pre-condition to the finding of a structured passive investment 
arrangement. Accordingly, as described in section D of this preamble, 
the foreign tax benefit condition is revised to provide that the 
counterparty's foreign tax benefit must correspond to 10 percent or 
more of the U.S. party's share of the foreign payments or the U.S. 
party's share (under U.S. tax principles) of the foreign tax base used 
to compute such payments.

B. Section 1.901-2T(e)(5)(iv)(B)(2): U.S. Party

    Section 1.901-2T(e)(5)(iv)(B)(2) of the temporary regulations 
adopts without change the second overall condition of the 2007 proposed 
regulations 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.
    One commentator requested that the regulations be amended to 
clarify that the ``U.S. party'' condition must be met at the same time 
as the other five conditions. The temporary regulations do not include 
this condition because the IRS and Treasury Department believe it is 
inappropriate to exempt arrangements that are structured so that the 
U.S. party claims a credit in a taxable year or period that is not the 
same taxable year or period in which the counterparty is entitled to a 
foreign tax benefit. In addition, the IRS and Treasury Department are 
concerned that this modification would allow a person to acquire an 
interest in an SPV and claim credits with respect to purported foreign 
taxes paid in an earlier period by the SPV in connection with an 
arrangement that met the other five conditions of the regulations.

C. Section 1.901-2T(e)(5)(iv)(B)(3): Direct Investment

    The third overall condition provided in the 2007 proposed 
regulations 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. Commentators 
recommended several changes to the direct investment condition, several 
of which are adopted in the temporary regulations. First, in order to 
reach appropriate results in cases where more than one person owns an 
equity interest in the SPV for U.S. tax purposes, the temporary 
regulations amend the direct investment test to compare the U.S. 
party's proportionate share of the foreign payment made by the SPV to 
the amount of foreign tax the U.S. party would be eligible to credit if 
the U.S. party directly owned its proportionate share of the assets. 
Second, the temporary regulations clarify that a dual resident 
corporation that is an SPV meets the direct investment condition since 
its ownership of the passive assets is treated the same as ownership 
through a branch operation. Third, a commentator suggested that the 
direct investment test of the 2007 proposed regulations could be 
avoided by entering into a sale-repurchase transaction using an SPV 
that acquires passive assets subject to foreign withholding tax. This 
commentator recommended that the direct investment condition be revised 
to reduce the value of the U.S. party's interest by any amount advanced 
by the foreign counterparty that is treated as debt for U.S. tax 
purposes but as equity for foreign tax purposes. The IRS and Treasury 
Department agree that situations where the SPV's income is subject to 
gross basis foreign taxes raise the same foreign tax credit policy 
concerns as situations where the SPV's income is subject to net basis 
foreign taxes. The IRS and Treasury

[[Page 40731]]

Department, however, believe the commentator's recommended solution is 
incomplete, since the other conditions of the regulations can be met by 
structures employing techniques other than sale-repurchase agreements. 
Accordingly, the temporary regulations provide that the U.S. party's 
proportionate share of the SPV's assets does not include any assets 
that produce income subject to gross basis withholding tax.
    Several commentators recommended that the regulations include an 
exception for certain transactions in which the amount of the foreign 
payments attributable to income of an SPV does not substantially exceed 
the amount of foreign taxes that would have been paid by a controlled 
foreign corporation that owns the SPV in the absence of the 
arrangement. The commentators suggested that such foreign payments 
should not be treated as noncompulsory payments because they 
effectively substitute for taxes that would have been imposed on the 
controlled foreign corporation in the absence of the arrangement.
    These comments raise the fundamental question as to the appropriate 
baseline to which such transactions should be compared to determine if 
there has been a significant increase in the total amount of foreign 
taxes paid. Although the IRS and Treasury Department carefully 
considered an exception from the definition of structured passive 
investment arrangements for such transactions, the IRS and Treasury 
Department have been unable to develop an exception that can be 
administered by the IRS and that does not exclude abusive cases. 
Accordingly, the temporary regulations do not include this exception.

D. Section 1.901-2T(e)(5)(iv)(B)(4): Foreign Tax Benefit

    The fourth condition provided in the 2007 proposed regulations 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 similar tax benefit) for a counterparty or for a person that is 
related to the counterparty, but not related to the U.S. party. In 
response to comments, to relieve administrative burdens these 
regulations clarify that while the benefit must be reasonably expected, 
there is no requirement to show that the benefit be intended or 
actually realized. The temporary regulations also provide that the 
ability to surrender the use of a tax loss to another person is a 
foreign tax benefit because a foreign tax benefit need only be made 
available to a counterparty. See Example 9 of Sec.  1.901-
2T(e)(5)(iv)(D).
    Several commentators recommended that the regulations be revised to 
require a causal relationship between one or more of the six 
conditions. For example, one commentator recommended adding a 
requirement that the foreign tax benefit either relate to the foreign 
tax paid by the SPV or result from the counterparty being treated for 
foreign but not U.S. tax purposes as owning an equity interest in the 
SPV or a portion of the SPV's assets. Another commentator suggested 
requiring that the inconsistent aspect of the arrangement be created or 
used to achieve the foreign tax benefit. Another commentator 
recommended requiring that the foreign tax benefit would not have been 
allowed or allowable ``but for'' the existence of one or more of the 
other conditions.
    In response to the comments, the temporary regulations revise the 
``foreign tax benefit'' condition to provide that the credit, 
deduction, loss, exemption, exclusion or other tax benefit must 
correspond to 10 percent or more of the U.S. party's share (for U.S. 
tax purposes) of the foreign payment or 10 percent or more of the 
foreign tax base with respect to which the U.S. party's share of the 
foreign payment is imposed. The revisions are intended to clarify that 
a joint venture that does not involve any duplication of tax benefits 
is not covered by the temporary regulations. At the same time, the 
temporary regulations provide that the duplication need not be direct. 
For example, while the U.S. party generally seeks to claim foreign tax 
credits in the United States for foreign payments attributable to 
income of the SPV, the counterparty's foreign tax benefit may consist 
of tax-exempt income paid out of the SPV's income with respect to which 
foreign payments claimed as credits by the U.S. party were made and 
deductions or losses attributable to payments of corresponding amounts 
to the SPV or U.S. party. See Example 3 of Sec.  1.901-2T(e)(5)(iv)(D).

E. Section 1.901-2T(e)(5)(iv)(B)(5): Counterparty

    The 2007 proposed regulations define a counterparty as 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.
    Commentators proposed that the counterparty factor be amended to 
include certain related parties. Commentators noted that structured 
transactions engaged in by related persons under common foreign 
ownership present the same tax policy concerns as transactions between 
unrelated persons. However, these same commentators noted that 
structured transactions engaged in by related parties that are under 
common U.S. ownership do not pose the same tax policy concerns because 
the reduction in foreign tax liability obtained by the U.S.-controlled 
foreign counterparty will result in a corresponding increase in U.S. 
taxes when the foreign counterparty repatriates its earnings to the 
United States. The IRS and Treasury Department agree with these 
comments. Consequently, the temporary regulations amend the definition 
of a counterparty to include related persons, but excluding cases where 
the U.S. party is a U.S. corporation or individual that owns (directly 
or indirectly) at least 80 percent of the value of the potential 
counterparty and cases where at least 80 percent of the value of the 
U.S. party and the potential counterparty are owned (directly or 
indirectly) by the same U.S. corporation or individual.
    Several commentators also suggested that the requirement that the 
counterparty own at least 10 percent (directly or indirectly) of the 
equity of the SPV or acquire at least 20 percent of the assets of the 
SPV should be revised. Some commentators proposed these thresholds be 
increased to 50 percent. Other commentators proposed that the ownership 
of all foreign parties deriving a foreign tax benefit should be 
aggregated to determine whether the thresholds are met. The IRS and 
Treasury Department agree that the regulatory conditions should be 
revised to better reflect that the counterparty is entitled to more 
than a nominal foreign tax benefit. Accordingly, the temporary 
regulations eliminate the percentage ownership thresholds from the 
counterparty definition, and modify the definition of a foreign tax 
benefit in Sec.  1.901-2T(e)(5)(iv)(B)(4), as described in section D of 
this preamble.

F. Section 1.901-2T(e)(5)(iv)(B)(6): Inconsistent Treatment

    The sixth condition in the 2007 proposed regulations is that the 
U.S. and an applicable foreign country treat

[[Page 40732]]

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 or 
the SPV is subject to net basis tax. To provide clarity and limit the 
scope of this factor, the 2007 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.
    Commentators recommended that this condition be clarified so that 
the U.S. treatment of the inconsistent aspect must materially increase 
the amount of the U.S. party's foreign tax credits or materially 
decrease the U.S. party's income for U.S. tax purposes. The temporary 
regulations reflect this clarification. In addition, commentators 
requested that this factor be limited to instances when the 
inconsistent treatment is reasonably expected to result in a permanent 
difference in the U.S. party's income or foreign tax credits. The IRS 
and Treasury Department believe that the revisions to the foreign tax 
benefit condition described in Section D of this preamble are 
sufficient to establish the appropriate linkage between the 
inconsistent U.S. and foreign law treatment and the duplicative tax 
benefits. Accordingly, the temporary regulations retain the 
inconsistent treatment factor without further changes.
    One commentator also recommended that the inconsistent treatment 
condition be narrowed to instances where the inconsistent treatment 
under U.S. and foreign law related to definitions of ownership and the 
amount of the SPV's taxable income. The IRS and Treasury Department 
have not adopted this recommendation because it would cause certain 
types of abusive arrangements to fall outside the scope of the 
regulations and because differences in entity classification are 
features common to structured passive investment arrangements.

G. Other Comments

    Commentators also made suggestions that did not relate to any 
single factor. For example, commentators also requested clarification 
that the foreign payments treated as noncompulsory amounts under the 
regulation may be deductible payments under sections 162 and 212 and 
reduce a foreign corporation's earnings and profits for purposes of 
subpart F. The IRS and Treasury Department believe that providing 
guidance regarding sections 162, 212, and 964 is beyond the scope of 
this regulation project. The usual rules for determining the 
deductibility of a payment and determining the earnings and profits of 
a foreign corporation for subpart F purposes apply.
    In addition, commentators requested that foreign payments 
attributable to a structured passive investment arrangement be excluded 
from the scope of the regulations if the arrangement has a valid 
business purpose. Other commentators suggested that the regulations 
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. The IRS and Treasury 
Department are concerned that these approaches 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 described in the temporary regulations is more 
appropriate.

H. Other Examples

    In response to comments, the temporary regulations include more 
examples illustrating additional variations of the structured passive 
investment arrangements that are covered by the regulations. For 
example, new Example 3 illustrates a U.S. borrower transaction in which 
a foreign lender acquires assets instead of an equity interest in the 
SPV and new Example 10 illustrates a joint venture in which the 
counterparty's foreign tax benefits do not correspond to the U.S. 
party's share of the base with respect to which the foreign payment is 
imposed. Modifications to examples in the 2007 proposed regulations 
were also necessary to reflect comments received and other changes to 
the regulations.

I. Effective/Applicability Dates

    The 2007 proposed regulations were 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 . A commentator observed that the 
final regulations would potentially be retroactively effective because 
the regulations would apply, for example, to calendar year taxpayers as 
of January 1 of the year in which the final regulations are published 
in the Federal Register and to taxpayers that participated in 
structured passive investment arrangements involving entities with 
taxable years that differ from the U.S. taxpayers' taxable years. 
Commentators also requested clarification of whether the relevant 
taxable year for purposes of the effective date is the taxable year of 
the SPV in which it pays or accrues the purported foreign taxes, or the 
taxable year of the U.S. taxpayer in which it claims a credit. For 
example, commentators observed that if the taxable year of the U.S. 
taxpayer in which it claims a credit is the relevant taxable year, the 
final regulations would apply to U.S. shareholders of controlled 
foreign corporations where the shareholder claims a deemed paid credit 
under section 902 with respect to foreign taxes paid by the foreign 
corporation in years prior to the effective date of the regulations. 
These commentators recommended that the regulations provide that the 
relevant taxable year is the SPV's taxable year. Commentators also 
recommended that the final regulations apply only to foreign taxes paid 
or accrued in taxable years beginning after the date the final 
regulations are published, or only to foreign taxes paid or accrued 
with respect to income accrued after the date the final regulations are 
published.
    The IRS and Treasury Department have not adopted the recommendation 
to delay the effective date of these regulations to apply only in tax 
years beginning after the regulations are published. The IRS and 
Treasury Department generally believe the regulations should apply to 
disallow credits for foreign payments that would otherwise be eligible 
to be claimed as credits in taxable years ending after the regulations 
are published. The IRS and Treasury Department agree, however, that the 
regulations should not apply to foreign taxes paid or accrued by a 
foreign corporation in a U.S. taxable

[[Page 40733]]

year of the foreign corporation ending prior to the effective date of 
the regulations, provided that such year ends prior to the first 
taxable year of the domestic corporate shareholder for which these 
regulations are first applicable.
    Accordingly, the effective date for these regulations is July 16, 
2008. The regulations generally apply to foreign payments that, if they 
were an amount of tax paid, would be considered paid or accrued by a 
U.S. or foreign entity in taxable years ending on or after July 16, 
2008. In the case of foreign payments by a foreign corporation that has 
a domestic corporate shareholder, the regulations also apply to such 
payments that would be considered paid or accrued in the foreign 
corporation's U.S. taxable years ending with or within taxable years of 
its domestic corporate shareholder ending on or after July 16, 2008. 
Finally, in the case of foreign payments by a partnership, trust or 
estate for which any partner or beneficiary would otherwise be eligible 
to claim a foreign tax credit, the regulations also apply to payments 
that would be considered paid or accrued in taxable years ending with 
or within taxable years of such partners or beneficiaries ending on or 
after July 16, 2008.
    No inference is intended regarding the U.S. tax consequences of 
structured passive investment arrangements prior to the effective date 
of the regulations.
    For periods after the effective date of the temporary 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 temporary regulations, but that do not meet all of the 
conditions included in the temporary regulations. The IRS will continue 
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.

J. Miscellaneous Amendments

    The temporary regulations also amend Sec.  1.901-1(a) and (b) to 
reflect statutory changes made by the Foreign Investors Tax Act of 1966 
(Pub. L. 89-809 (80 Stat. 1539), section 106(b)), the Tax Reform Act of 
1976 (Pub. L. 94-455 (90 Stat. 1520), section 1901(a)(114)), and the 
American Jobs Creation Act of 2004 (Pub. L. 108-357 (118 Stat. 1418-
20), section 405(b)).

 Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. For applicability 
of the Regulatory Flexibility Act, please refer to the cross-referenced 
notice of proposed rulemaking published elsewhere in this issue of the 
Federal Register. 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.

Drafting Information

    The principal author of these regulations is Michael I. Gilman, 
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.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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


0
Par. 2. Section 1.901-1 is amended by revising paragraphs (a) and (b) 
to read as follows:


Sec.  1.901-1  Allowance of credit for taxes.

    (a) and (b). [Reserved]. For further guidance, see Sec.  1.901-
1T(a) and (b).
* * * * *
0
Par. 3. Section 1.901-1T is added to read as follows:


Sec.  1.901-1T  Allowance of credit for taxes (temporary).

    (a) In general. Citizens of the United States, domestic 
corporations, and certain aliens resident in the United States or 
Puerto Rico may choose to claim a credit, as provided in section 901, 
against the tax imposed by chapter 1 of the Code for taxes paid or 
accrued to foreign countries and possessions of the United States, 
subject to the conditions prescribed in paragraphs (a)(1) through 
(a)(3) and paragraph (b) of this section.
    (1) Citizen of the United States. A citizen of the United States, 
whether resident or nonresident, may claim a credit for--
    (i) The amount of any 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; and
    (ii) His share of any such taxes of a partnership of which he is a 
member, or of an estate or trust of which he is a beneficiary.
    (2) Domestic corporation. A domestic corporation may claim a credit 
for--
    (i) The amount of any 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;
    (ii) Its share of any such taxes of a partnership of which it is a 
member, or of an estate or trust of which it is a beneficiary; and
    (iii) The taxes deemed to have been paid under section 902 or 960.
    (3) Alien resident of the United States or Puerto Rico. Except as 
provided in a Presidential proclamation described in section 901(c), an 
alien resident of the United States, or an alien individual who is a 
bona fide resident of Puerto Rico during the entire taxable year, may 
claim a credit for--
    (i) The amount of any 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; and
    (ii) His share of any such taxes of a partnership of which he is a 
member, or of an estate or trust of which he is a beneficiary.
    (b) Limitations. Certain Code sections, including sections 814, 
901(e) through (l), 906, 907, 908, 911, 999, and 6038, limit the credit 
against the tax imposed by chapter 1 of the Code for certain foreign 
taxes.
    (c) through (i) [Reserved]. For further guidance, see Sec.  1.901-
1(c) through (i).
    (j) Effective/applicability date. This section applies to taxable 
years beginning after July 16, 2008.
    (k) Expiration date. The applicability of this section expires July 
15, 2011.

0
Par. 4. Section 1.901-2 is amended by adding paragraphs (e)(5)(iii) and 
(e)(5)(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) and (iv) [Reserved]. For further guidance, see Sec.  1.901-
2T(e)(5)(iii) and (iv).
* * * * *
    (h) Effective/applicability date--(1) In general. This section and 
Sec. Sec.  1.901-2A

[[Page 40734]]

and 1.903-1 apply to taxable years beginning after November 14, 1983.
    (2) [Reserved]. For further guidance, see Sec.  1.901-2T(h)(2).

0
Par. 5. Section 1.901-2T is added to read as follows:


Sec.  1.901-2T  Income, war profits, or excess profits tax paid or 
accrued (temporary).

    (a) through (e)(5)(ii) [Reserved]. For further guidance, see Sec.  
1.901-2(a) through (e)(5)(ii).
    (e)(5)(iii) [Reserved].
    (iv) Structured passive investment arrangements--(A) In general. 
Notwithstanding Sec.  1.901-2(e)(5)(i), 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 
(within the meaning of paragraph (e)(5)(iv)(B)(1)(ii) of this section) 
to a structured passive investment arrangement (as described in 
paragraph (e)(5)(iv)(B) of this section).
    (B) Conditions. An arrangement is a structured passive investment 
arrangement 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 U.S. tax purposes) 
of the entity, if any, is passive investment income, 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)(5)(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)(5)(ii) of this section, 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 meet the requirements of 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, that, if the foreign payment were an 
amount of tax paid, would be paid or accrued in a U.S. taxable year in 
which the entity meets the requirements of paragraph 
(e)(5)(iv)(B)(1)(i) of this section. 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.
    (2) U.S. party. A person 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 U.S. party's proportionate share of the 
foreign payment or payments described in paragraph (e)(5)(iv)(B)(1)(ii) 
of this section is (or is expected to be) substantially greater than 
the amount of credits, if any, that the U.S. party reasonably would 
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 or dual resident status) 
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. A U.S. party's proportionate share of the 
assets of the SPV, however, shall not include any assets that produce 
income subject to gross basis withholding tax.
    (4) Foreign tax benefit. The arrangement is reasonably expected to 
result in a credit, deduction, loss, exemption, exclusion or other tax 
benefit under the laws of a foreign country that is available to a 
counterparty or to a person that is related to the counterparty 
(determined under the principles of paragraph (e)(5)(iv)(C)(7) of this 
section by applying the tax laws of a foreign country in which the 
counterparty is subject to tax on a net basis). However, a foreign tax 
benefit is described in this paragraph (e)(5)(iv)(B)(4) only if any 
such credit corresponds to 10 percent or more of the U.S. party's share 
(for U.S. tax purposes) of the foreign payment referred to in paragraph 
(e)(5)(iv)(B)(1)(ii) of this section or if any such deduction, loss, 
exemption, exclusion or other tax benefit corresponds to 10 percent or 
more of the foreign base with respect to which the U.S. party's share 
(for U.S. tax purposes) of the foreign payment is imposed.
    (5) Counterparty. The arrangement involves a counterparty. A 
counterparty is a person that, 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, directly or indirectly owns or acquires 
equity interests in, or assets of, the SPV. However, a counterparty 
does not include the SPV or a person with respect to which for U.S. tax 
purposes the same domestic corporation, U.S. citizen or resident alien 
individual directly or indirectly owns more than 80 percent of the 
total value of the stock (or equity interests) of each of the U.S. 
party and such person. In addition, a counterparty does not include a 
person with respect to which for U.S. tax purposes the U.S. party 
directly or indirectly owns more than 80 percent of the total value of 
the stock (or equity interests), but only if the U.S. party is a 
domestic corporation, a U.S. citizen or a resident alien individual.
    (6) Inconsistent treatment. The United States and an applicable 
foreign country treat one or more of the following aspects of the 
arrangement differently under their respective tax systems, and for one 
or more tax years when the arrangement is in effect either the amount 
of income recognized by the SPV, the U.S. party, and persons related to 
the U.S. party for U.S. tax purposes is materially less than the amount 
of income that would be recognized if the foreign tax treatment 
controlled for U.S. tax purposes, 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) is 
materially greater than it would be if the foreign tax treatment 
controlled for U.S. tax purposes:
    (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

[[Page 40735]]

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. The following definitions apply for purposes of 
paragraph (e)(5)(iv) of this section.
    (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) Counterparty. The term counterparty means a person described in 
paragraph (e)(5)(iv)(B)(5) of this section.
    (3) Entity. The term entity includes a corporation, trust, 
partnership or disregarded entity described in Sec.  301.7701-
2(c)(2)(i) of this chapter.
    (4) Indirect ownership. 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), 
regardless of whether the interest is owned by a U.S. or foreign 
entity.
    (5) 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)(5)(i) and paragraph (e)(5)(iv)(C)(5)(ii) of 
this section. In determining whether income is described in section 
954(c), paragraphs (c)(3) and (c)(6) of that section shall be 
disregarded, and sections 954(h) and 954(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)). For 
purposes of the preceding sentence, any income of an entity 
attributable to transactions that, assuming the entity is an SPV, are 
with a person that is a counterparty, or with persons that are related 
to a counterparty within the meaning of paragraph (e)(5)(iv)(B)(4) of 
this section, 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 954(i) for purposes of 
determining whether other income of the entity is excluded from section 
954(c)(1) under section 954(h) or 954(i), but only if any such person 
(or a person that is related to such person within the meaning of 
paragraph (e)(5)(iv)(B)(4) of this section) is eligible for a foreign 
tax benefit described in paragraph (e)(5)(iv)(B)(4) of this section. In 
addition, in applying section 954(h) for purposes of this paragraph 
(e)(5)(iv)(C)(5)(i), section 954(h)(3)(E) shall not apply, section 
954(h)(2)(A)(ii) shall be satisfied only if the entity conducts 
substantial activity with respect to its business through its own 
employees, and the term ``any foreign country'' shall be substituted 
for ``home country'' wherever it appears in section 954(h).
    (ii) Holding company exception. Except as provided in this 
paragraph (e)(5)(iv)(C)(5)(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 substantially all 
of the entity's opportunity for gain and risk of loss with respect to 
such interest in the lower-tier entity is shared by the U.S. party or 
parties (or persons that are related to a U.S. party) and, assuming the 
entity is an SPV, a counterparty or counterparties (or persons that are 
related to a counterparty). 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 
substantially all of the entity's opportunity for gain and risk of loss 
with respect to each such interest in a lower-tier entity is shared 
(directly or indirectly) by the U.S. party or parties (or persons that 
are related to a U.S. party) and, assuming the entity is an SPV, a 
counterparty or counterparties (or persons that are related to a 
counterparty). A person is not considered to share in the entity's 
opportunity for gain and risk of loss if its equity interest in the 
entity was acquired in a sale-repurchase transaction, if its interest 
is treated as debt for U.S. tax purposes, or if substantially all of 
the entity's opportunity for gain and risk of loss with respect to its 
interest in any lower-tier entity is borne (directly or indirectly) by 
the U.S. party or parties (or persons that are related to a U.S. party) 
or, assuming the entity is an SPV, a counterparty or counterparties (or 
persons that are related to a counterparty), but not both parties. For 
purposes of this paragraph (e)(5)(iv)(C)(5)(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 954(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 that, assuming the 
entity is an SPV, are with a person that is a counterparty, or with 
other persons that are related to a counterparty within the meaning of 
paragraph (e)(5)(iv)(B)(4) of this section, 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 
954(i) for purposes of determining whether other income of the entity 
is excluded from section 954(c)(1) under section 954(h) or 954(i), but 
only if any such person (or a person that is related to such person 
within the meaning of paragraph (e)(5)(iv)(B)(4) of this section) is 
eligible for a foreign tax benefit described in paragraph 
(e)(5)(iv)(B)(4) of this section. In applying section 954(h) for 
purposes of this paragraph (e)(5)(iv)(C)(5)(ii), section 954(h)(3)(E) 
shall not apply, section 954(h)(2)(A)(ii) shall be satisfied only if 
the entity conducts substantial activity with respect to its business 
through its own employees, and the term ``any foreign country'' shall 
be substituted for ``home country'' wherever it appears in section 
954(h).
    (6) Qualified equity interest. With respect to an interest in a 
corporation, the term qualified equity interest means

[[Page 40736]]

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.
    (7) Related person. Two persons are related 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.
    (8) Special purpose vehicle (SPV). The term SPV means the entity 
described in paragraph (e)(5)(iv)(B)(1) of this section.
    (9) U.S. party. The term U.S. party means a person described in 
paragraph (e)(5)(iv)(B)(2) 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. 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. None of FP's stock is owned, directly or indirectly, by 
USP or any shareholders of USP that are domestic corporations, U.S. 
citizens, or resident alien individuals. Under an income tax treaty 
between country M and the United States, country M does not impose 
country M tax on interest received by U.S. residents from sources in 
country M.
    (ii) Result. The $36 million payment by Newco to country M is 
not a compulsory payment, and thus is not an amount of tax paid 
because the foreign payment is attributable to a structured passive 
investment arrangement. First, Newco is an SPV because all of 
Newco's income is passive investment income described in paragraph 
(e)(5)(iv)(C)(5) of this section; Newco's only asset, a note, is 
held to produce such income; the payment to country M is