Sullivan & Cromwell Discusses U.S. Tax Consequences of EU State Aid Recoupment

On September 15, the IRS and Treasury Department proposed, in Notice 2016-52 (the “Notice”), new rules that limit the ability of U.S. multinational groups to claim credits against U.S. taxes for significant foreign tax adjustments (i.e., adjustments of more than $10 million).  Foreign assessments within the scope of the Notice include (but are not limited to) those that may arise in connection with the state aid investigations that have been initiated by the European Commission over the last several years.

The Notice describes two categories of transactions that might otherwise allow a U.S. multinational to expedite its ability to claim foreign tax credits in respect of amounts paid to resolve a significant foreign assessment, and treats such structures as “splitter arrangements”.  Accordingly, the creditability of foreign taxes paid in connection with such transactions will generally be suspended until the “related income” is taken into account for U.S. tax purposes.  Because a U.S. multinational might consider paying a foreign assessment to be less burdensome if the additional foreign tax can be credited in the United States on an efficient basis, the new rules are intended to encourage U.S. multinationals to contest major foreign tax adjustments.

In addition, although the Notice was issued in the context of (and, in places, specifically refers to) the European Commission’s state aid investigations, the Notice states that “no inference” is intended as to whether amounts paid to resolve any particular tax proceeding are creditable foreign taxes.  Therefore, the IRS could still determine that some (or all) payments made in connection with the European Commission’s state aid investigations are not creditable foreign taxes for U.S. foreign tax credit purposes.

The Notice refers to the new categories of “splitter arrangements” as “covered transactions” and “covered distributions”.  Although the Notice’s definitions of “covered transactions” and “covered distributions” exclude transactions that are effected for a non-tax “principal purpose” (as demonstrated by clear and convincing evidence), these categories are otherwise very broad.  In particular, subject to this “principal purpose” exception (and a limited exception for transactions in which the “earnings and profits” of the target entity are also transferred), any transaction that causes a significant foreign tax assessment to be paid by a corporation other than the corporation that was treated as originally earning the taxed income (including, for example, an intra-group sale of a “disregarded entity”, a liquidation, or a reorganization) will generally be a “covered transaction”.  Similarly, any dividend that is paid to a foreign subsidiary of a U.S. multinational during or after the year when income to which a significant foreign assessment relates is earned (but before the year when a significant assessment is paid) may be a “covered distribution” (unless, again, the U.S. multinational group can demonstrate a non-tax “principal purpose” for the distribution by clear and convincing evidence).

The rules described in the Notice are proposed to be effective for foreign taxes paid on or after September 15, 2016.  However, the Notice does not appear to include a “grandfather” or similar rule for restructurings or distributions that have already been completed.  Accordingly, U.S. multinationals that have already entered into transactions described in the Notice may wish to consider their options in respect of such transactions.


A.     Foreign Tax Credit “Splitter Arrangements”

Although the United States generally (subject to certain limitations) allows a domestic parent corporation to credit foreign taxes paid by its non-U.S. subsidiaries against the domestic parent’s U.S. tax liability, such foreign taxes are only “deemed paid” by a domestic parent to the extent the foreign subsidiary’s earnings are repatriated (or deemed repatriated) to the United States.  Therefore, for example, if the parent of a U.S. multinational group owned a foreign subsidiary with earnings of $100 (which had been subject to $10 in foreign tax), a $50 dividend from this foreign subsidiary would generally give rise to a foreign tax credit of no more than $5.  Because (at a 35% corporate federal tax rate) $17.50 in U.S. tax would be due on this dividend, the domestic parent would generally owe $12.50 in residual U.S. tax.  On the other hand, if the foreign subsidiary in the above example had been subject to $35 in foreign tax, a dividend of $50 could give rise to a foreign tax credit up to $17.50, potentially offsetting the domestic parent’s entire U.S. tax liability in respect of the dividend.

U.S. law has historically treated an entity as having paid a foreign tax if—under applicable foreign law—that entity is legally liable for the foreign tax.[1]  At times, this general principle can create a mismatch between the entity that recognizes an item of income (for U.S. tax purposes) and the entity that is treated as having paid an associated amount of creditable foreign tax (for U.S. tax purposes).  Strategic use of such “splitting” can concentrate a U.S. multinational group’s foreign taxes within a subset of the group’s foreign entities, each of which may be treated as having paid creditable foreign taxes at a high effective rate.  By selectively repatriating income from such entities (while not repatriating income of foreign entities that are considered subject to creditable foreign taxes at a low effective rate), a U.S. multinational group may then be able to expedite the rate at which foreign tax credits become available and reduce collateral increases in U.S. tax.

In August 2010 (and in response to perceived deficiencies in the rules governing the allocation of creditable foreign taxes), Congress enacted Section 909, which suspends foreign tax credits that arise in connection with a “foreign tax credit splitting event” until the “related income” is taken into account for U.S. tax purposes.  Although Section 909 grants the Treasury Department broad authority to identify “splitter arrangements”, regulations issued under Section 909 deliberately limit the applicability of this rule to four exclusive categories of “splitter arrangements”: (i) “reverse hybrids” (i.e., entities that are treated as corporations for U.S. tax purposes but are fiscally transparent for applicable foreign tax purposes); (ii) group-relief and loss-sharing regimes; (iii) hybrid instruments (i.e., in general, instruments that are treated as equity under U.S. tax law but characterized as debt under applicable foreign tax law, or vice versa); and (iv) certain partnership inter-branch payments.[2]

B.     EU State Aid Investigations

Since 2014, the European Commission has commenced a number of state aid investigations into tax rulings (including unilateral advance pricing agreements) granted to multinational groups operating within EU member states.  Under EU law, if the European Commission determines that state aid has been unlawfully granted, the European Commission can order the relevant member state to recover the aid from its beneficiary (plus compound interest)‎ going back up to ten years.

Although the European Commission has investigated rulings granted to at least two EU-headquartered multinationals (Fiat Chrysler and Engie), four of the six cases that have been officially opened to date (and four of the five cases opened before this week)[3] examined rulings granted to U.S. multinational groups (Amazon, Apple, McDonald’s and Starbucks).  The European Commission’s state aid investigations and proposed large assessments against U.S. taxpayers have become the subject of high-level disputes between the European Commission and the U.S. government.   For example, in February 2016, U.S. Treasury Secretary Jacob Lew sent a letter to Commission President Jean-Claude Juncker asserting, among other things, that the European Commission’s state aid investigations “appear to target . . . income that Member States have no right to tax under well-established international tax standards” and “appear to be targeting U.S. companies disproportionately”.[4]  Additionally, in January 2016, members of the Senate Finance Committee sent a letter to the U.S. Treasury Department expressing both similar apprehensions and a concern that the investigations “could give rise to U.S. companies paying EU Member States billions of dollars in tax assessments that may be creditable foreign taxes, resulting in U.S. taxpayers ‘footing the bill’”.[5]  In August 2016, the U.S. Treasury Department also published a white paper on the European Commission’s state aid investigations, in which the U.S. Treasury Department reiterated this background, outlined several legal and policy arguments against the approach used by the European Commission, and warned that “[t]he U.S. Treasury Department continues to consider potential responses should the [European] Commission continue its present course”.[6]

On August 30, the European Commission announced that two tax rulings granted by Ireland to Apple gave rise to undue tax benefits representing impermissible state aid.[7]  This determination—while subject to appeal—could require Ireland to recover up to €13 billion (plus interest) from Apple.  Statements from both U.S. government officials and trade associations since the Apple decision have sharply criticized the European Commission’s approach.  For example, on August 31, U.S. Treasury Secretary Jacob Lew remarked that, “[a]s the head of the U.S. tax agency, I’ve been concerned that [the European Commission’s approach] reflects an attempt to reach into the U.S. tax base to tax income that ought to be taxed in the U.S.” and that “we think that [the European Commission’s approach] undermines the environment in Europe for international business because it creates uncertainty and ultimately will not be good for the European economy”.[8]  On September 16, the Business Roundtable also released an open letter to leaders of the 28 EU member states, urging them to overturn the Apple decision.[9]  Although European Commission Competition Commissioner Margrethe Vestager recently met with U.S. officials and has denied that the European Commission’s state aid investigations are targeted at U.S. companies, reports indicate that both the appropriateness of and legal basis for these cases remain a significant point of contention between the European Commission and the U.S. Treasury Department.[10]


Although paying any tax assessment necessarily involves a cost, a U.S. multinational group may find that paying a prior-year foreign adjustment is less burdensome if foreign tax credits arising from that assessment can be claimed on an expedited basis and / or without collateral increases in U.S. tax.  A U.S. multinational group may (in the absence of a rule to the contrary) be able to accomplish such a result by restructuring its foreign entities so any taxes paid in a significant foreign dispute arise in a foreign corporation with a significant “pool” of foreign taxes, relative to that foreign corporation’s earnings.  Such a reorganization could—for example—involve transferring a “disregarded entity” that anticipates resolving a major foreign tax liability to a newly organized foreign corporation, thereby causing any creditable taxes resulting from the assessment (but not the earnings on which those taxes were paid) to be paid or accrued by the new corporation.  A similar outcome could be achieved if a foreign corporate subsidiary within a U.S. multinational group were to pay an extraordinary dividend to another foreign corporation (thereby reducing the payor’s foreign earnings) before settling a foreign tax dispute.

Under the Notice, such restructuring transactions and distributions will—if they are undertaken in connection with a prior-year foreign tax assessment—generally be treated as “splitter arrangements”.  In particular, the Notice states that the IRS and Treasury Department intend to issue regulations that treat a payment of “covered taxes” as a “splitter arrangement” if that payment is made as a result of a “covered transaction” or a “covered distribution”.  “Covered taxes”, for this purpose, are generally defined as foreign income taxes that: (i) are reflected in the payor’s “pools” of foreign taxes in the taxable year when they are paid; and (ii) result from a “specified foreign-initiated adjustment” (in general, a prior-year foreign tax assessment of more than $10 million).  The preamble to the Notice specifically observes that assessments made to recoup EU state aid can fall within this definition “to the extent [such] payments result in creditable foreign taxes”, and the Notice therefore leaves open the possibility that the IRS will conclude that payments (or some payments) representing a recovery of state aid are not creditable taxes.  Of course, any other assessments of prior-year foreign income taxes (including taxes paid in connection with ordinary-course local tax audits) can also be treated as “covered taxes” if they exceed the $10 million threshold.

A “covered transaction” is generally defined by the Notice as any transaction (or series of related transactions) that results in “covered taxes” being paid by a foreign corporation other than the “predecessor entity” (i.e., the corporation that would have been liable for the “covered taxes” had such taxes been paid in the year to which such taxes relate), subject to limited exceptions for transactions between unrelated entities, tax-free reorganizations or liquidations that transfer the “earnings and profits” of the “predecessor entity” to the payor, and transactions that were not structured with a principal purpose of separating “covered taxes” from the undistributed earnings of the “predecessor entity” (as demonstrated by clear and convincing evidence).[11]

A “covered distribution” is, likewise, generally defined as any dividend or similar distribution to the extent such distribution: (i) is made during or after the taxable year of the payor to which the covered taxes relate but before the taxable year in which the covered taxes are paid; (ii) results in a distribution or allocation of the payor’s “post-1986 undistributed earnings” (other than a distribution or allocation of income that was subject to U.S. tax when such income was earned by the payor)[12] to a “section 902 covered person”;[13] and (iii) is made with a principal purpose of reducing the payor’s “post-1986 undistributed earnings” in advance of the payment of “covered taxes”.  In determining whether a distribution is made with such a “principal purpose”, the Notice states that a distribution will be rebuttably presumed to have been made with the required “principal purpose” if the sum of all distributions exceeds the payor’s “post-1986 undistributed earnings” as of the beginning of the taxable year in which the “covered tax” is paid.  A taxpayer may, however, rebut this presumption with clear and convincing evidence that the distribution was not made with the required “principal purpose”.[14]

According to the Notice, the IRS and Treasury Department expect that these new rules will apply to foreign income taxes paid on or after September 15, 2016.  It appears that this “grandfathering” provision applies to tax payments only, meaning that restructurings that took place and distributions that were made before September 15 may be characterized as “covered transactions” or “covered distributions”.  Given this possibility, it may be worthwhile for U.S.-based multinational groups that entered into “covered transactions” or made “covered distributions” before the Notice was released to evaluate their options in respect of such arrangements.


[1]     See Treas. Reg. § 1.901-2(f)(1).

[2]     See generally Treas. Reg. § 1.909-2.  Although the Section 909 regulations generally do not treat tax consolidation regimes as “splitter arrangements”, amendments that were made to the “technical taxpayer” rule after Section 909 was enacted reach a similar result.  See Treas. Reg. § 1.901-2(f)(3).  In addition, special (and generally slightly more permissive) rules within these regulations define “pre-2011 foreign tax credit splitting events” (i.e., circumstances in which foreign taxes paid or accrued in a taxable year beginning before January 1, 2011 are suspended under Section 909).  See generally Treas. Reg. § 1.909-6.

[3]     The European Commission’s investigation into Engie was officially opened on September 19, 2016.

[4]     See Letter from Jacob J. Lew, U.S. Secretary of the Treasury, to Jean-Claude Juncker, President of the European Commission (Feb. 11, 2016).

[5]     See Letter from U.S. Senate Committee on Finance to Jacob J. Lew, U.S. Secretary of the Treasury (Jan. 15, 2016).

[6]     See U.S. Dep’t of the Treasury, “The European Commission’s Recent State Aid Investigations of Transfer Pricing Rulings” (Aug. 24, 2016).

[7]     See European Commission, “State Aid: Ireland Gave Illegal Tax Benefits to Apple Worth up to €13 Billion” (press release, Aug. 30, 2016).

[8]     See Alex Lewis, “Apple’s Income Should Be Taxed in U.S., Not Ireland, Lew Says”, Tax Notes Today (Sept. 1, 2016).

[9]     See Business Roundtable, “Letter to EU Heads of State or Government Regarding State Aid Investigations” (Sept. 16, 2016).

[10]    See Alex Parker, “EU-U.S. Tensions Simmer Over Apple, State-Aid Tax Cases”, BNA Daily Tax Report (Sept. 20, 2016).

[11]    Although the Notice proposes that a subjective “principal purpose” test be used to determine whether a “covered transaction” has been entered into or a “covered distribution” has occurred, the Notice requests comments on whether an objective test would be more appropriate for these purposes.  The Notice also solicits feedback on whether, in lieu of creating new “splitter arrangements”, it would be more germane to prescribe guidance under Section 905(c) providing that additional payments of tax be accounted for through adjustments to the pools of foreign income taxes and undistributed earnings of non-U.S. corporations that are not the same entity as the payor of the tax.

[12]    Prior-year subpart F inclusions generally reduce “post-1986 undistributed earnings”, so a distribution of previously taxed income would generally not be considered a distribution of “post-1986 undistributed earnings”.  See T.D. 8708.

[13]    A “section 902 covered person” is a “Section 902 corporation” (i.e., in general, a non-U.S. corporation the foreign taxes of which could be creditable to a domestic corporation under the “deemed paid” rules of Section 902) that is at least 10% owned by (or bears certain other relationships to) the payor.

[14]    As one example, the Notice indicates that a taxpayer could rebut this presumption by demonstrating that the distributions were consistent with a pre-existing pattern of distributions. However, the Notice also states that in the case of a distribution from a pool of “post-1986 undistributed earnings” that included earnings to which the covered taxes relate and also earnings to which the covered taxes did not relate, a taxpayer may not rebut this presumption by claiming that the distribution reduced only the unrelated earnings.

This post comes to us from Sullivan & Cromwell LLP. It is based on the firm’s client alert, “U.S. Tax Consequences of EU State Aid Recoupment: IRS Issues Notice Treating Certain Payments of Prior-Year Foreign Taxes as ‘Splitter Arrangements’,” dated September 22, 2016, and available here.