In Notice 2016-10 (the Notice), the IRS and Treasury describe regulations that they intend to issue under Sections 853 and 905(c) concerning the treatment of refunds of foreign taxes received by a regulated investment company (RIC)that had previously elected under Section 853 (the Election) to have the taxes treated as paid by the RIC's shareholders.

Statutory background

Section 853 generally provides shareholders of a RIC with either a foreign tax credit or deduction if the RIC makes an Election under that section. The Election is generally available to a RIC if more than 50% of the value of its assets at the close of the tax year consists of stocks or securities in foreign corporations. If the Election is made, the RIC forgoes a deduction or credit for taxes paid to foreign countries and US possessions. Instead, the RIC passes through to its shareholders (who can claim, subject to applicable limitations, either a foreign tax credit or deduction) the foreign taxes it paid during the tax year. Each shareholder must include in gross income from foreign sources its proportionate share of the foreign taxes and the portion of any dividend paid by the RIC representing income derived from foreign sources.

A RIC making the Election must furnish a written notice to its shareholders designating each shareholder's proportionate share of foreign taxes paid by the RIC and each shareholder's proportionate share of the RIC's gross income derived from foreign sources. The RIC must also file with its income tax return a statement setting forth: the total amount of income received from sources outside the US; the total amount of foreign taxes paid (including any amount ineligible for the Election); the date, form, and contents of the notice to its shareholders; and the proportionate share of this income received and those taxes paid during the tax year attributable to one share of its stock.

Under Section 905(c), if a taxpayer claims a credit for foreign tax paid or accrued, and that foreign tax is subsequently refunded, the taxpayer must notify the IRS, which will then re-determine the taxpayer's US tax liability. A RIC generally must translate the refunded foreign tax into US dollars using the same exchange rate that it used to translate the foreign taxes into dollars when such taxes were originally reported as paid.

Need for new guidance

RICs do not generally have changes to their foreign tax liabilities, because the amount of foreign tax and the appropriate exchange rate are generally ascertainable before the RIC files its income tax return and furnishes statements to its shareholders. However, a recent European Union (EU) Court of Justice decision — holding that EU member states could not impose withholding taxes on certain foreign investors unless substantially similar taxes were imposed on domestic investors — has resulted in numerous RICs seeking (in some cases successfully) refunds of foreign taxes paid. This has spurred a need for new guidance in the area.

The Notice explains that, while Section 905(c) applies to refunds of foreign taxes received by RICs, it is not clear how that Section applies to amounts that were treated as paid by the RIC's shareholders under Section 853, or how a RIC and its shareholders may satisfy their obligations under Section 905(c). In general, when a foreign tax is refunded, the taxpayer must notify the IRS, which redetermines the amount of the taxpayer's US tax liability for the year or years affected, and the taxpayer must pay any redetermined amount upon notice and demand. When RICs receive refunds of foreign taxes, however, providing adequate notification to shareholders and the IRS may be impractical because RICs may not know the identities or addresses of the shareholders who claimed foreign tax credits in previous years. Accordingly, to help avoid significant administrative costs and uncertainty for such RICs, as well as the US government, and to promote effective tax administration, the Notice suggests alternative methods on which RICs and their shareholders may rely on to satisfy their obligations under Sections 853 and 905(c).

New alternative methods

The Notice states that, in the regulations that the IRS and Treasury intend to issue, there will be two alternative methods under which RICs and their shareholders will be able to satisfy their obligations under Sections 853 and 905(c): (1) a netting method and (2) the obtaining of a closing agreement.

Netting method

The "netting method" is expected to apply if a RIC receives in a tax year a refund of foreign tax that had been paid in a tax year in which the RIC made the Election. RICs meeting the following requirements may elect this method in lieu of the general rules under Section 905(c): (1) 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); (2) the RIC was not held predominantly by entities described in Section 817(h)(4)(A) or (B) in the year in which the RIC paid the refunded foreign taxes; (3) the RIC makes a valid Election for the refund year; and (4) the RIC paid an amount of foreign taxes in the refund year that equals or exceeds the amount of the "foreign tax adjustment" (as defined below) for that year.

Under the anticipated regulations, a RIC applying this method would be required to 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 foreign tax adjustment for a refund year equals the sum of: (1) all foreign tax refunds received by the RIC in the refund year: and (2) all interest adjustments (as defined in the guidance).

Under this method: (1) the RIC shall not include the amount of the foreign tax adjustment as income from sources outside the US; (2) the shareholders of the RIC shall include in their gross income the amount of the current year foreign taxes that are offset by the interest adjustment component of the foreign tax adjustment — but not the amount offset by the foreign tax refund component of the foreign tax adjustment; and (3) the dividends paid deduction shall be determined by reducing, the amount of the foreign taxes paid in the refund year for which an addition to the dividends paid deduction otherwise would be allowed under Section 853(b)(1)(B) by the amount of the foreign tax adjustment for that tax year.

Finally, under this method, a RIC would be required to notify the IRS of each refund on a statement attached to a Form 1118, or its successor, for the refund year, detailing certain specified information.

Closing agreement

Under this alternative method, a RIC receiving a refund of foreign tax that had been paid in a prior tax year in which the Election was made 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. To show that such an agreement is in the interest of sound tax administration, a RIC must: (1) demonstrate that it is precluded from applying, or it is not reasonably practical for it to apply, either the general rules under Section 905(c) or the alternative netting method, and (2) 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 who were treated under Section 853 as paying the foreign tax.

Requests for closing agreements must comply with any applicable guidance relating to such requests. If a RIC has submitted a request for a closing agreement, but the IRS has not yet determined whether to grant it, then the RIC must attach a statement to its Form 1118 for the refund year containing certain specified information, 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.

Effective dates

The netting method regulations are expected to apply to any refund year ending on or after the date of publication of the Notice (scheduled to appear in Internal Revenue Bulletin dated February 8, 2016). The guidance describing the closing agreement method will apply to requests for closing agreements filed on or after that same date. For refund years ending before the issuance of any proposed regulations or temporary regulations described in the Notice, taxpayers may rely on the netting method rules. The Notice further states that the netting method regulations are expected to provide that a RIC may apply the regulations to refund years ending before the date of publication of the Notice, and that, if a RIC applies the netting method with respect to refund years ending before that date, then for such refund years the RIC may, as an alternative, apply the netting method described earlier, with certain modifications.

Implications

Given the uncertainty as to the treatment by certain RICs (in general, those whose refunds received are no more than current year foreign taxes paid) that had made the Election of the receipt of foreign tax refunds, the Notice provides welcome guidance. Taxpayers should note the qualification requirements of the proposed alternative methods and their respective effective dates to determine the method on which they can properly rely.

———————————————