DENIAL OF FOREIGN TAX CREDIT FOR TAXES PAID TO SOUTH AFRICA.

Rev. Rul. 89-44

ISSUE

What is the effective date of section 901(j)(2)(C) of the Internal Revenue Code of 1986, relating to income earned in and taxes paid to South Africa?

FACTS

P, a calendar year domestic corporation receives dividends attributable to South African sources from FX, its wholly owned subsidiary, on April 1, 1988, and on April 1, 1989, subject to South African withholding taxes. FX has a June 30 taxable year. In its taxable years ending June 30, 1988, 1989, and 1990, FX pays taxes to South Africa on its income from South African sources. In its taxable years ending June 30, 1988, and June 30, 1989, FX has no income that would be characterized as subpart F income under section 952 of the Code but for the application of section 952(a)(5). On June 1, 1990, P sells all of the stock of FX.

LAW AND ANALYSIS

IN GENERAL

Section 901(a) of the Code allows a credit against U.S. taxes for foreign taxes paid or accrued by a taxpayer and for taxes deemed to be paid by a corporation under sections 902 and 960. Section 901(j) disallows a credit under section 901(a) for taxes paid or accrued to certain countries. Section 952(a)(5) further requires that income derived from those countries be treated as Subpart F income and taxed currently.

Section 10231 of the Omnibus Budget Reconciliation Act of 1987 (the Act), Pub. L. No. 100-203, 101 Stat. 1330 (1987), applies section 901(j) of the Code to South Africa by adding section 901(j)(2)(C). Section 10231(c) of the Act provides that section 901(j)(2)(C) applies to taxable years beginning after December 31, 1987. Section 10231 of the Act further requires that, under section 952(a)(5), income derived in South Africa in taxable years beginning after December 31, 1987, is to be treated as subpart F income and taxed currently.

The legislative history of section 10231 of the Act states that the provision will apply to "income attributable to the period from January 1, 1988," until the date on which the Secretary of the Treasury certifies that certain actions have been taken to undermine apartheid in South Africa. H.R. Conf. Rep. No. 495, 100th Cong., 1st Sess., 976-977 (1987). Section 901(j)(1)(A) of the Code provides that a credit will be disallowed for taxes paid or accrued "with respect to income attributable to a period to which [section 901(j)] applies to such country."

As the foregoing language indicates, both the statutory provisions and the legislative history focus on when the income subject to tax by South Africa is derived, not on when the foreign tax credit may be claimed. Accordingly, for purposes of section 901 of the Code, section 901(j)(2)(C) shall apply to taxes paid or accrued with respect to income derived in the taxable years of the person deriving the income beginning after December 31, 1987. Thus, if P directly derives income from South Africa after January 1, 1988, the beginning of its 1988 taxable year, no foreign taxes paid to South Africa (including withholding taxes) attributable to such income will be creditable under section 901.

WITHHOLDING TAXES

South African withholding taxes imposed on the actual dividends received by P on April 1, 1988, and April 1, 1989, will not be creditable. Such taxes are imposed upon the income of the recipient derived from South Africa in taxable years beginning after December 31, 1987, and, therefore, are taxes with respect to income attributable to the period to which section 901(j)(2)(C) of the Code applies.

APPLICATION TO SECTIONS 902 AND 960

Under sections 902 and 960 of the Code, foreign taxes paid or accrued by a foreign corporation are deemed to be paid by a corporate shareholder only when the shareholder receives a dividend distribution (or an inclusion in gross income under section 951(a)) from the earnings and profits of the foreign corporation. Under pre- 1987 law, the foreign taxes were creditable only when a distribution was made from the earnings and profits of the year in which the foreign taxes were paid or accrued. Under post-1986 law, the foreign taxes deemed to be paid bear the same proportion to the post-1986 foreign taxes paid as the dividend distribution bears to all post- 1986 undistributed earnings, defined in section 902(c)(1) as the earnings and profits of the foreign corporation. Accordingly, in post-1986 years, foreign taxes will be pooled, and become creditable on a proportionate basis when earnings are distributed.

The taxes deemed to be paid by P under section 902 of the Code attributable to the April 1, 1988, dividend payment to P were paid by FX to South Africa with respect to income earned in a taxable year of FX that did not begin after December 31, 1986. Accordingly, such taxes are not subject to section 901(j) and may be claimed as a credit under section 901. Such taxes and the earnings and profits with respect to which they are paid are subject to the post-1986 poolings requirements.

In the case of the subpart F inclusion of P with respect to the income of FX earned in its taxable year ending June 30, 1989, the taxes paid by FX were paid with respect to income earned after December 31, 1987, and in a taxable year of FX beginning after that date. Accordingly, such taxes are subject to section 901(j) of the Code, and are not allowed as a credit under section 901.

APPLICATION OF SECTION 952(a)(5) TO THE INCOME OF FX

The first taxable year of FX subject to section 901(j) of the Code and, therefore, subject to section 952(a)(5), is its taxable year ending June 30, 1989, its first taxable year beginning after December 31, 1987. Accordingly, FX has no subpart F income in its taxable year ending June 30, 1988. All of the income of FX derived from South African sources in its taxable year ending June 30, 1989, however, is subpart F income.

APPLICATION TO SECTION 1248

Section 1248 of the Code requires that, under certain circumstances, the gain derived by a U.S. person from the sale of stock of controlled foreign corporation be included in the gross income of that U.S. person as a dividend to the extent of earnings and profits as calculated under section 1248(c) and (d). If a dividend is deemed to be paid under section 1248, a foreign tax credit is ordinarily available to the U.S. person under sections 901 and 902 at the time of the deemed dividend distribution.

The limitation of section 901(j)(2)(C) of the Code applies to foreign tax credits allowed with respect to amounts included in gross income as dividends under section 1248 as though an actual dividend had been paid. Thus, to the extent that South African taxes were paid with respect to amounts treated as a dividend under section 1248 and attributable to earnings and profits derived from South Africa in taxable years beginning after December 31, 1987, no foreign tax credit will be allowed with respect to such taxes. A foreign tax credit, however, will be allowed to the extent that South African taxes were paid with respect to amounts treated as a dividend under section 1248 and attributable to earnings and profits derived from South Africa in taxable years beginning before January 1, 1988.

DEDUCTION UNDER SECTION 164

Section 901(j) of the Code has no effect upon the allowance of deductions under section 164 for taxes paid or accrued to South Africa. The legislative history of section 901(j) states that "foreign taxes that are not creditable under this provision are deductible." H.R. Conf. Rep. No. 1012, 99th Cong., 2d Sess., 374 (1986). Accordingly, the withholding taxes paid with respect to the dividends received by P on April 1, 1988, and on April 1, 1989, may be deducted to the extent allowed under section 164.

HOLDING

For purposes of sections 901, 902, 960, and 1248 of the Code, the limitation of section 901(j)(2)(C) applies to taxes paid or accrued to South Africa with respect to income attributable to taxable years beginning after December 31, 1987.

DRAFTING INFORMATION

The principal author of this revenue ruling is Carol P. Tello, Office of the Associate Chief Counsel (International). For further information, please telephone Ms. Tello on 202-634-5404 or address written comments to her at 1111 Constitution Avenue, N.W., Room 3051, CC:INTL:6, Washington, D.C. 20024.