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Notice sets out method for RIC’s refund of foreign tax that was treated as paid by shareholders

Notice 2016-10, 2016-6 IRB

In a Notice, IRS has provided guidance with regard to regs it intends to issue on alternative methods that regulated investment companies (RICs) and their shareholders may use to satisfy their obligations under Code Sec. 853 and Code Sec. 905(c) where a RIC receives a refund of a foreign tax that was paid by the RIC and was treated as paid by the RIC’s shareholders under Code Sec. 853(b)(2) because an election was made under Code Sec. 853(a). The Notice also provides guidance on obtaining administrative relief through closing agreements.

Background. Under Code Sec. 853, a RIC that meets certain requirements is allowed to make an annual election under which the RIC’s shareholders are treated as if they paid a proportionate share of any foreign tax that was paid by the RIC during the RIC’s tax year to which the election relates. The election is available to a RIC if: (1) more than 50% of the value of its assets, at the close of the tax year, consists of stock or securities in foreign corporations, and (2) the RIC has complied with the requirements in Code Sec. 852(a) and Reg. § 1.852-1(a). If the RIC makes this election for a tax year, it forgoes a deduction or credit for foreign taxes. Instead, under Code Sec. 853(b)(2)(A), the RIC’s shareholders are required to include in their gross income and treat as paid by them their proportionate shares of the foreign taxes and, accordingly, are eligible to claim either a deduction or credit for those foreign taxes in accordance with Code Sec. 164 and Code Sec. 901. In addition, each shareholder of an electing RIC, under Code Sec. 853(b)(2)(B), must treat as gross income from sources without the U.S. the sum of the shareholder’s proportionate share of the foreign taxes and the portion of any dividend paid by the RIC that represents income derived from sources without the U.S.

Under Code Sec. 905(c), if a taxpayer claims a credit for taxes paid or accrued under Code Sec. 901 (or deemed paid under Code Sec. 902 or Code Sec. 960) and that foreign tax is refunded, the taxpayer generally must notify IRS, which will redetermine the amount of the taxpayer’s U.S. tax liability for the year or years affected. Any U.S. tax due by reason of the foreign tax refund must be paid upon notice and demand. Interest accrues under Code Sec. 6601 on the amount of tax due, but under Code Sec. 905(c)(5), the amount of interest is capped for the period before the receipt of the refund at the amount of interest paid by the foreign country or possession of the U.S. on the refund.

RICs do not generally have changes to their foreign tax liabilities, as described in Code Sec. 905(c), both because foreign withholding taxes, which RICs generally pay, are usually determinable at the time the income from which the tax is withheld is paid or accrued, and because Code Sec. 986(a)(1)(E) provides that a RIC reporting income using an accrual method translates foreign income taxes into dollars using the exchange rate as of the date the income accrues. Recently, however, the Court of Justice of the European Union held that member states of the European Union could not impose withholding taxes on certain foreign investors if substantially similar domestic investors were not subject to tax. Numerous RICs are now seeking, and some have received, refunds of foreign taxes paid to these countries. In light of these refund claims and payments, taxpayers have requested that IRS provide guidance concerning the appropriate treatment of these refunds by RICs that made elections under Code Sec. 853(a) for the years in which the taxes were originally paid. Although such refunds are subject to Code Sec. 905(c), the Code does not explicitly address how Code Sec. 905(c) applies to amounts that were treated as paid by a RIC’s shareholders under Code Sec. 853 or the manner in which a RIC and its shareholders may satisfy their obligations under Code Sec. 905(c).

New guidance. As an alternative to the general rules under Code Sec. 905(c), Notice 2016-10 provides that a RIC which receives in a tax year (the “refund year”) a refund of foreign tax that had been paid in a tax year in which the RIC made an election under Code Sec. 853(a), and its shareholders, may discharge their obligations under Code Sec. 853 and Code Sec. 905(c) with respect to foreign tax refunds by using either the method described in Notice 2016-10, Sec. 4, or Notice 2016-10, Sec. 5

Netting method. Under the method described in Notice 2016-10, Sec. 4 (the netting method), a RIC must reduce the amount of foreign taxes reported by the RIC to its shareholders for the refund year by the foreign tax adjustment—i.e., all foreign tax refunds received by the RIC in the refund year and all interest adjustments described in Notice 2016-10, Sec. 4.03(b). As a result, under this method:

…The RIC will not include the amount of the foreign tax adjustments income from sources without the U. S.;
…The RIC shareholders will not include in their gross income under Code Sec. 853(b)(2)(A) and Reg. § 1.853-2(b) the amount of the current year foreign taxes that are offset by the foreign tax refund component of the foreign tax adjustment, and that amount shall be excluded from the amount of income reported to the shareholders under Reg. § 1.853-3. The RIC shareholders will include in their gross income the amount of the current year foreign taxes that are offset by the interest adjustment component of the foreign tax adjustment, and that amount will be included in the amount of income reported to shareholders under Reg. § 1.853-3; and
…To determine the dividends paid deduction, the amount of the foreign taxes paid in the refund year for which an addition to the dividends paid deduction otherwise would be allowed under Code Sec. 853(b)(1)(B), will be reduced by the amount of the foreign tax adjustment for that tax year.

The amount of the interest adjustment under Notice 2016-10, Sec. 4.03(b), calculated for each interest adjustment period, is an amount equal to the lesser of: (1) the amount of interest that would be calculated for that period under Code Sec. 6601 with respect to an underpayment of tax equal to the amount of the associated foreign tax refund; or (2) the amount of interest paid by a foreign country or possession of the U.S. to the RIC with respect to the associated foreign tax refund for that period. An interest adjustment period begins on the date on which the RIC made a payment of foreign tax related to the refund and ends on the date on which the RIC receives the refund. Each payment of foreign tax that relates to a refund produces one or more separate interest adjustment periods. (Foreign tax amounts paid in the same tax year may have been refunded on different dates during the refund year at issue, and foreign taxes refunded on a single date may have been paid on different dates and in different tax years.)

The regs are expected to provide that, if a RIC applies the netting method, the RIC must notify IRS of each refund on a statement attached to a Form 1118, (Foreign Tax Credit—Corporations) or its successor, for the refund year. Notice 2016-10, Sec. 4.05, specifies the information to be included on the statement.

A RIC can apply the netting method if:

1. The economic benefit of the refund and any related interest payment received by the RIC primarily inures to the RIC’s refund-year shareholders (as opposed to, if different, shareholders in the year or years in which the RIC paid the refunded foreign taxes);
2. The RIC was not held predominantly by entities described in Code Sec. 817(h)(4)(A) or Code Sec. 817(h)(4)(B) (i.e., entities to which a look-through rule applies because all the assets are held by insurance companies (or affiliated companies) in segregated or general asset accounts or by fund managers) in the year in which the RIC paid the refunded foreign taxes;
3. The RIC makes a valid election under Code Sec. 853(a) for the refund year; and
4. The RIC paid an amount of foreign taxes in the refund year that is equal to or greater than the amount of the foreign tax adjustment.

Closing agreement. Under the method described in Notice 2016-10, Sec. 5 (closing agreement), a RIC may request a closing agreement addressing the treatment of the refund. A request for a closing agreement will be granted when such an agreement is determined by IRS to be in the interest of sound tax administration. A closing agreement generally will be considered to be in the interest of sound tax administration when: (a) the RIC has demonstrated that either it is precluded from applying, or it is not reasonably practical for it to apply, the general rules under Code Sec. 905(c) or the method described in Notice 2016-10, Sec. 4; and (b) the RIC can provide information that is sufficient to establish, to IRS’s satisfaction, a reasonable estimate of the aggregate adjustments that would be due under Code Sec. 905(c) with respect to the foreign tax credits claimed by its shareholders (including former shareholders) who were treated under Code Sec. 853 as paying the foreign tax.

Effective date. Except as otherwise provided, the regs described Notice 2016-10, Sec. 4, are expected to apply to any refund year ending on or after Feb. 8, 2016. The guidance described in Notice 2016-10, Sec. 5, applies to requests for closing agreements filed on or after Feb. 8, 2016. For refund years ending before the issuance of any proposed or temporary regs described in Notice 2016-10, taxpayers may rely on the rules described in Notice 2016-10, Sec. 4.

Special rules for taxpayers applying the netting rules to refund years ending before Feb. 8, 2016. The regs on the netting method are expected to provide that a RIC may apply the regs to refund years ending before Feb. 8, 2016. If a RIC does so, then for such refund years, the RIC may, as an alternative to applying the rules described in Notice 2016-10, Sec. 4.04(b): (i) apply the rules described in Notice 2016-10, Sec. 4.04(b) by excluding from the amount included in the shareholder’s gross income under Code Sec. 853(b)(2)(A) and Reg. § 1.853-2(b) the full amount of the current year foreign taxes that are offset by the foreign tax adjustment, rather than just the amount of the current year foreign taxes that are offset by the foreign tax refund component of the foreign tax adjustment; or (b) apply an approach that is expected to produce substantially the same U.S. Federal income tax liability that the RIC’s shareholders would have had, in the aggregate, under either Notice 2016-10, Sec. 4.04(b) or under (i) above.

References: For adjustment to taxes for purposes of the foreign tax credit, see FTC 2d/FIN ¶  O-5400  ; United States Tax Reporter ¶  9054.03  ; TaxDesk ¶  391,016  ; TG ¶  30792  .