Rev. Rul. 76-508

Advice has been requested whether, in a situation where income is allocated from a foreign subsidiary corporation to its domestic parent corporation under section 482 of the Internal Revenue Code of 1954, the Internal Revenue Service can reduce the amount of the foreign tax paid by that foreign subsidiary to be used in computing the parent's deemed paid foreign tax credit under section 902.

P, a domestic corporation, owns all of the outstanding capital stock of S, a foreign corporation organized under the laws of foreign country Z. S is not a less developed country corporation within the meaning of section 955(c)(3) of the Code. Both corporations use the calendar year as their taxable year.

In 1973, P made sales of its products to S at a price below P's cost. In 1975, the Service proposed an allocation of income under section 482 of the Code for 1973 to reflect an arm's length selling price. For 1973, S had paid a country Z income tax on reported income for 30x dollars. Pursuant to the allocation of income under section 482, S's country Z income was reduced by 10x dollars and P's income was increased by the same amount.

P received a dividend from S during 1973 out of its 1973 earnings and profits and claimed a deemed paid foreign tax credit under section 902 of the Code based on the amount of country Z taxes paid by S in 1973 before the allocation. S did not seek a refund of its country Z tax attributable to its income allocated to P under section 482.

The United States has a tax treaty in force in country Z that provides for consideration between the Competent Authority of the United States and the Competent Authority of country Z. Rev. Proc. 70-18, 1970-2 C.B. 493, sets forth procedures for United States persons to obtain competent authority consideration where the United States or a foreign treaty country proposes or has made an allocation of income and deductions among related parties. P did not request competent authority assistance to coordinate the amount of income tax due to country Z and the United States as a result of the adjustment made under section 482 of the Code.

Section 482 of the Code provides, in part, that in any case of two or more organizations, trades, or businesses owned or controlled directly or indirectly by the same interests, the Secretary of the Treasury or the Secretary's delegate may distribute, apportion, or allocate gross income, deductions, credits, or allowances between or among such organizations, trades, or businesses, if the Secretary or the Secretary's delegate determines that such distribution, apportionment, or allocation is necessary in order to prevent evasion of taxes or clearly to reflect the income of any of such organizations, trades, or businesses.

Section 901 of the Code allows a credit against United States income tax of certain taxpayers for foreign income, war profits, and excess profits taxes paid or accrued or deemed to have been paid or accrued within the taxable year.

Section 902(a)(1) of the Code provides, in general, that a domestic corporation that owns at least 10 percent of the voting stock of a foreign corporation from which it receives dividends in any taxable year that were paid out of accumulated profits shall be deemed to have paid a certain portion of any creditable income tax paid or deemed to have been paid by such foreign corporation to any foreign country or to any possession of the United States on or with respect to such accumulated profits.

The effect of an allocation under section 482 of the Code on the computation of the deemed paid credit is explained in Rev. Rul. 74-158, 1974-1 C.B. 182. Rev. Rul. 74-158 states as a fact that the income taxes of the subsidiary were not changed by the allocation under section 482; thus, the question raised in the instant case did not arise in Rev. Rul. 74-158.

Rev. Rul. 74-158 holds that the foreign income taxes deemed paid under section 902(a)(1) of the Code shall be determined in accordance with the following formula:

Dividends (without regard to section 78) ---------------------- X Foreign = Foreign income Accumulated profits income taxes deemed paid (as defined in section taxes 902(c)(1)(A) in excess of income taxes paid)

The statutory language of section 901 of the Code permits a domestic corporation a credit for the foreign income taxes it pays, including foreign income taxes it is deemed to have paid under section 902. Section 902(a)(1) does not authorize a domestic corporation to claim a credit for all payments made by its foreign subsidiary to a foreign country. Instead, it merely provides the proper method for computing what portion of the payment may be credited if the payment otherwise qualifies as an "income tax" under section 901. In order for a tax paid to a foreign country to qualify as an income tax, however, it must be shown that the tax imposed by the foreign country is a tax on income within the United States concept thereof. Biddle v. Commissioner, 302 U.S. 573 (1938), 1938-1 C.B. 309.

If a taxpayer is put on notice, whether by a proposed adjustment by the Service under section 482 of the Code or otherwise, of the possibility of securing a refund or reduction of foreign income tax liability but fails to pursue its remedies to secure such an adjustment the amounts as to which an adjustment was not sought may be contributions to the foreign government. See Kenyon Instrument Co., 16 T.C. 732 (1951), which held that state franchise taxes were not deductible to the extent that at the time of payment the taxpayer knew that it was not liable to pay them. See also section 1.901-2(a) of the Income Tax Regulations.

When as in the instant case income is allocated to a domestic corporation from its foreign subsidiary under section 482 of the Code, a presumption arises that the subsidiary has made a contribution to the foreign government. This presumption will be rebutted if the subsidiary exhausts all effective and practicable administrative remedies in seeking a refund of its foreign income tax liability and if the domestic parent exhausts its rights under the competent authority procedure pursuant to station 5 of Rev. Proc. 70-18.

Accordingly, since both P and S failed to exhaust their respective administrative remedies in seeking readjustment of S's country Z income tax liability, the reduction is S's income pursuant to an allocation of income under section 482 of the Code will result in the reduction of the amount of country Z taxes paid by S for 1973 that qualify for use by P in computing the deemed paid foreign tax credit under section 902(a)(1).

In computing the deemed paid foreign tax credit, P is to use the foreign income tax as recomputed as the multiplicand in the section 902 fraction set forth above. The multiplicand to be use may be determined as follows:

(1) The foreign tax liability recomputed by country Z under its law as a result of the allocation under section 482 may be used as the multiplicand.

(2) Absent a recomputation of the foreign tax liability by country Z, if P can establish to the satisfaction of the District Director of Internal Revenue with whom P files its return what the proper amount of foreign tax liability should be under the laws of country Z after the allocation under section 482, such amount will then be utilized for purposes of the multiplicand in the section 902 fraction.

(3) Absent a recomputation of the foreign tax liability by country Z, if P cannot establish to the satisfaction of the District Director what the proper amount of foreign tax liability should be under the laws of country Z after the above allocation, then the District Director may adjust the section 902 formula by an appropriate amount of non-tax payments, such as by recomputing the amount of taxes used in the multiplicand of the section 902 fraction by applying the ratio that the amount of the section 482 adjustment bears to S's total gross income.

Further, for the purposes of determining the foreign tax liability to country Z, the United States Competent Authority may, at its option, consult with the Competent Authority of country Z pursuant to the applicable treaty provision.

Rev. Rul. 74-158 is clarified. The conclusion contained therein that the income taxes of the subsidiary were not changed by the allocation under section 482 is meant to reflect no change in the foreign taxes paid by the foreign subsidiary upon recomputation by country Y under alternative (1) above. Under the facts of Rev. Rul. 74-158 there was no tax treaty in force with country Y; thus, the competent authority procedure could not be invoked.

¹ Also released as News Release IR-1703, dated December 2, 1976.