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Tax Insights, January 20, 2016
Tracking Tax News You Need to Know

January 20, 2016
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IRS Releases Guidance for RICs Relating to Refunds of Foreign Tax for Which an Election Was Made Under Section 853
The Treasury Department and the IRS released Notice 2016-10 on Jan. 16 to address the application of Sections 853 and 905(c) (section references are to the Internal Revenue Code of 1986, as amended) to the receipt by a regulated investment company of a refund of a tax that was eligible for a foreign tax credit under Sections 901 or 903 (“foreign tax”) if that foreign tax, when paid by the RIC, was treated as paid by the RIC’s shareholders under Section 853(b)(2) because an election was made under Section 853(a). The notice describes regulations under Sections 853 and 905(c) that the Treasury Department and the IRS intend to issue and states that RICs may rely on the rules set forth in the notice prior to the issuance of such regulations.

The guidance is necessary because the Court of Justice of the European Union recently held that EU member states could not impose withholding taxes on certain foreign investors, such as RICs, if substantially similar domestic investors were not subject to tax. Numerous RICs have been seeking, and some RICs have received, refunds of foreign taxes paid to these countries. The normal rules that apply when a taxpayer receives a refund of foreign taxes paid (the rules under Section 905(c), described below) do not explicitly address how they should apply to RIC shareholders who, because of an election made by the RIC (also described below), were treated as having paid the foreign taxes imposed on the RIC.

Under certain circumstances, Section 853 allows a RIC 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 taxable year to which the election relates. If the RIC makes this election for a taxable year, it forgoes a deduction or credit for such foreign taxes at the RIC level. Instead, under Section 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 those shareholders are eligible to claim either a deduction or a credit for those foreign taxes in accordance with Sections 164 and 901. Under Section 905(c), if a taxpayer claims a credit for taxes paid or accrued under Section 901 (or deemed paid under Sections 902 or 960) and that foreign tax is refunded, the taxpayer generally must notify the IRS, which then redetermines 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, plus interest, must be paid upon notice and demand.

Guidance was requested from the Treasury Department and the IRS concerning the appropriate treatment of these refunds by RICs that made elections under Section 853(a) for the years in which the taxes were originally paid (even though such refunds are subject to Section 905(c)). As an alternative to applying the general rules under Section 905(c), a RIC and its shareholders may discharge their obligations under Sections 853 and 905(c) with respect to foreign tax refunds described below by either (1) utilizing the netting method or (2) requesting a closing agreement addressing the treatment of the refund (the notice describes this as applying one of two alternative methods).

A RIC can use the netting method if it receives in a taxable year (the “refund year”) a refund of foreign tax that had been paid in a taxable year in which the RIC made an election under Section 853(a), and if the following requirements are met:
(a) 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);

(b) RIC shares were not held predominantly by entities described in Section 817(h)(4)(A) or (B), i.e., insurance companies in their general account or in segregated asset accounts or fund managers in connection with the creation or management of the RIC, in the year in which the RIC paid the refunded foreign taxes;

(c) The RIC makes a valid election under Section 853(a) for the refund year (i.e., as described above, an 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 taxable year); and

(d) 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” for that year. The “foreign tax adjustment” for a refund year is equal to the sum of all foreign tax refunds received by the RIC in the refund year and all “interest adjustments” (as described in the notice). (As currently drafted, the notice does not allow for netting of a refund if the foreign tax adjustment exceeds the foreign taxes paid in the refund year or the carryover of excess refunds to a subsequent year or years to be netted against foreign taxes paid in those years.)

If a RIC applies the netting method, then for purposes of Section 853, the RIC must reduce the amount of foreign taxes reported by the RIC to its shareholders for the refund year by the amount of the “foreign tax adjustment.” The RIC’s shareholders do not, under the netting method, include in their gross income the amount of current year foreign taxes that are offset by the foreign tax refund component of the foreign tax adjustment (this amount is excluded from the amount of income reported to shareholders). For purposes of determining the RIC’s dividends paid deduction, the amount of foreign taxes paid in the refund year is reduced by the amount of the foreign tax adjustment. If a RIC applies the netting method, the RIC must notify the IRS of each refund on a statement attached to an IRS Form 1118 (“Foreign Tax Credit—Corporations”) for the refund year, which must include certain information, including the amount of each refund and the date(s) on which the RIC paid the foreign taxes to which each refund relates.

When calculating the foreign tax adjustment, a RIC must translate the refunded foreign tax into dollars using the same exchange rate that it used to translate the foreign taxes into dollars when such taxes were originally reported as paid. Upon disposition of the foreign currency refunded, the RIC must recognize any foreign currency gain or loss. Such gain or loss does not result in an adjustment to the foreign tax credit.

Alternatively, a RIC that receives a refund of foreign tax that had been paid in a prior taxable year in which an election was made under Section 853(a) 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 the IRS to be “in the interest of sound tax administration.” A request for a closing agreement generally will be considered to be in the interest of sound tax administration if (1) the RIC demonstrates that it is precluded from applying, or that it is not reasonably practical for it to apply, the general rules under Section 905(c) or the netting method (for example, the netting method would not apply if the foreign tax adjustment exceeds the foreign taxes paid in the refund year) and (2) the RIC can provide information that is sufficient to establish, to the satisfaction of the IRS, a reasonable estimate of the aggregate adjustments that would be due under Section 905(c) with respect to the foreign tax credits claimed by its shareholders (including former shareholders) who were treated under Section 853 as paying the foreign tax. If a RIC has submitted a request for a closing agreement, but the IRS has not yet determined whether a closing agreement is in the interest of sound tax administration, then the RIC must attach to its Form 1118 for the refund year a statement containing the information noted above, along with a statement that a closing agreement has been requested, that the request has not been withdrawn or denied, and the date on which the request was submitted. 

The regulations are generally expected to apply to any refund years ending (or closing requests filed) on or after Feb. 8, 2016 (the anticipated date of publication of the notice in the Federal Register). However, the notice provides special rules for RICs applying the netting method with respect to refund years ending before Feb. 8, 2016.

The Treasury Department and the IRS are soliciting comments on the foregoing rules. One area of interest for comments is on whether, and to what extent, netting of a refund should be permitted if the foreign tax adjustment exceeds the foreign taxes paid in the refund year, and whether excess refunds should be allowed to carry over to a subsequent year or years and netted against foreign taxes paid in those years. Other areas of interest for comments include the principles to be applied to interest adjustments, the possible standardization of closing agreements relating to foreign tax credit refund issues for RICs and whether guidance is needed relating to the application of Section 905(c) with respect to both a RIC that makes a Section 853(a) election and its shareholders.

Determination Letter Procedures for Certain Foundations Revised
In Rev. Proc. 2016-10; 2016-2 IRB 270, the IRS updates its procedures for issuing determination letters on the private foundation status under Section 509(a), the operating foundation status under Section 4942(j)(3) and the exempt operating foundation status under Section 4940(d)(2) of organizations exempt from federal income tax under Section 501(c)(3). The revenue procedure also applies to the issuance of determination letters on the foundation status under Section 509(a)(3) of nonexempt charitable trusts described in Section 4947(a)(1). Specifically, Section 6 of Rev. Proc. 2015-10, 2015-2 I.R.B. 262 has been modified to eliminate the sentence indicating that an organization could request a letter ruling from the Associate Chief Counsel (Tax Exempt and Government Entities) that a given change in facts and circumstances will not adversely affect exempt status because Rev. Proc. 2016-3 has been amended to provide that the Associate Chief Counsel (TEGE) will not issue such letter rulings.

Fourth Circuit Affirms Transfer of Tax Credits Was Disguised Sale
In Route 231, LLC, John D. Carr, Tax Matters Partner, v. Commissioner Of Internal Revenue, the taxpayer, a Virginia limited liability company, reported on its 2005 federal tax return a capital contribution of $3.8 million that it received from one of its members. The IRS disputed the treatment and argued that the taxpayer should have reported the $3.8 million received as gross income and not a capital contribution. The Tax Court agreed with the IRS and determined that the transaction was a “sale” and reportable as gross income in 2005. The Fourth Circuit affirmed the decision of the Tax Court finding (1) the Virginia tax credits were “property” for purposes of Section 707 and (2) since the exchange of tax credits for money occurred within a two-year period, the transaction is presumed to be a disguised sale unless the facts and circumstances clearly establish otherwise, which the court, in this case, said they did not.

Income of PTP From Oil and Gas Production Is Qualifying Income
In Private Letter Ruling 201602004, the taxpayer was formed to provide a full suite of fluid, solid, and oilfield waste handling, treatment, and disposal services to oil and natural gas producers engaged in the exploration, development, and production of oil and gas. The IRS concluded that gross income derived by the taxpayer from the delivery of fluids, the provision of interwell water transfer services, and the processing, treatment, and disposal of waste solids and waste fluids, including washout services, constitutes qualifying income for purposes of Section 7704(d)(1)(E). Further, gross income derived by the taxpayer from the recovery, recycling, and marketing of brine, chemicals, and drilling mud to oil and gas producers and of hydrocarbons, other than to end users at the retail level, also constitutes qualifying income within the meaning of Section 7704(d)(1)(E).

IRS Updates FAQ on OVDP Streamlined Domestic Offshore Procedures
The IRS has updated a list of FAQs regarding its offshore voluntary disclosure program’s streamlined compliance procedures for U.S. taxpayers residing in the United States.

Cayman Islands-U.S. and Jamaican-U.S. FATCA IGA Competent Authority Plans Available
The Cayman Islands and U.S. and the Jamaican and U.S. competent authorities have signed an arrangement under each jurisdiction’s intergovernmental agreement to implement the information reporting and withholding tax provisions of FATCA.

JCT Lists Expiring Federal Tax Provisions From 2016 Through 2025
The Joint Committee on Taxation has provided a listing of federal tax provisions (other than those providing time-limited transition relief after the repeal of an underlying rule) that are currently scheduled to expire sometime between 2016 and 2025 (with references to the applicable section of the Internal Revenue Code of 1986 or other applicable law).

IRS Releases Publication on Partnerships
The IRS has released Publication 541 (Rev. January 2016), “Partnerships,” which provides guidance on forming and terminating a partnership, partnership distributions, and transactions between a partner and the partnership.

IRS Releases Form 990 Instructions for 2015
The IRS has released the 2015 instructions for Form 990, “Return of Organization Exempt From Income Tax.”

Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.

Copyright © 2016 Stradley Ronon Stevens & Young, LLP. All rights reserved.

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