A Double Taxation Warning

U.S. companies with overseas subsidiaries may want to heed the warning of an older tax case that discusses what constitutes ownership for purposes ...
Robert WillensJuly 26, 2010

As the global economy begins to show signs of recovery, it may be a good time to review an Internal Revenue Service ruling, upheld by two courts, related to income generated by foreign subsidiaries of U.S. corporate taxpayers. Indeed, it may not always be possible for a parent company to aggregate subsidiary ownership as a way to steer clear of double taxation.

To set the stage, consider that relief from international double taxation is generally accomplished by means of the foreign tax credit rules. Typically, the rules allow a U.S. taxpayer to offset the foreign taxes it has paid — or deemed to have paid — against the U.S. taxes otherwise due on foreign earnings.

In the case of a U.S. corporation that conducts its foreign business activities through foreign subsidiaries, Section 902 of the Internal Revenue Code provides important guidance. The section says that a domestic corporation that owns at least 10% of the voting stock of a foreign corporation from which it receives dividends is deemed to have paid the fraction of foreign taxes on the profits of the foreign corporation that is equal to the following ratio: the dividends received to the total profits of the foreign corporation. The question put to the IRS focused on ownership, specifically direct versus indirect ownership.

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Indirect Ownership?

In the case the revenue ruling is based on, five wholly owned subsidiaries of First Chicago NBD Corp. together owned more than 10% of the voting stock of a Dutch bank from which, during the taxable year, dividends were received. None of the affiliates, however, owned 10% of the bank’s stock by themselves. The question was whether a group of affiliated domestic corporations that files a consolidated income-tax return can aggregate its holdings in a foreign corporation to reach the 10% threshold set forth in Section 902.

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The IRS concluded that such aggregation was impermissible (see Revenue Ruling 85-3, 1985-1 C.B. 222). The U.S. Tax Court upheld the IRS’s determination, and so did the Seventh Circuit Court of Appeals.1 The Tax Court noted that the statute, read literally, does not countenance aggregation. Further, the court noted that the rule refers to “a corporation,” not to a group of affiliated corporations.

However, First Chicago argued that “owns” as written in Section 902 could well mean “owns directly or indirectly.” In fact, the parent bank insisted that the IRS allows for indirect ownership but only by means of a partnership, a grantor trust, or a corporation in a “cross-chain” sale governed by Section 304.2

But the court observed that situations involving partnerships, grantor trusts, or cross-chain structures are distinguishable from that of the First Chicago case. Moreover, the court reasoned, the partnership and grantor-trust examples alone explain why “directly” does not appear in the regulations. Therefore, except for those limited cases in which the IRS takes indirect ownership into account, the concept of “own” means direct and outright ownership.

Nevertheless, First Chicago contended that Regulation Section 1.1502-4(c) — the rule governing the computation of foreign tax credits when a consolidated tax return is filed — enables the company to aggregate the holdings of its affiliates. That’s because the regulation states that the tax credit shall be determined on a consolidated basis and that taxes paid or accrued to all foreign countries by members of the group shall be aggregated.

But the court disagreed. It noted that “read most naturally,” the regulation’s directive means only that the return consolidates the foreign tax credits determined in accordance with Section 902, which, as we have seen, denies credits if “the corporation” has less than 10% of the voting stock. The remaining arguments from the bank were given even shorter shrift, and the court found in favor of the IRS.

The First Chicago group, simply because it chose to spread its greater than 10% interest in the Dutch bank among several of its subsidiaries, was denied the ability to use the provisions of Section 902 to mitigate the impact of international double taxation.3

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for


1 See First Chicago NBD Corp. v. Commissioner, 135 F.3d 457 (7th Cir. 1998).

2 See Revenue Ruling 91-5, 1991-1 C.B. 114, in which P Corp., a domestic company, owns directly 100% of the stock of both DX Corp., a domestic corporation, and FX Corp., a foreign corporation.

3 See Revenue Ruling 79-74, 1979-1 C.B. 242, in which X Corp. (X), a domestic corporation, owns 10% of the voting shares and 5% of the nonvoting shares of Y Corp., a foreign corporation.

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