For U.S. taxpayers, earning income abroad comes with a unique challenge: the risk of double taxation. Because the U.S. taxes its citizens and residents on worldwide income—regardless of where that income is sourced—U.S. taxpayers earning money abroad could face taxes both in the foreign country where the income is earned and in the United States. Fortunately, there are mechanisms in place to help prevent double taxation, with one of the most significant being the Foreign Tax Credit (FTC). However, certain complexities can arise, especially for taxpayers with more intricate financial arrangements abroad. One of these complexities involves something called “Foreign Tax Credit Splitters.”

Why Does the Foreign Tax Credit Exist?

The U.S. Foreign Tax Credit allows taxpayers to offset some or all of their U.S. tax liability with taxes paid to a foreign government. Under IRC Section 901, individuals and corporations can claim a credit for foreign income, war profits, and excess profits taxes paid, or other taxes that are “in lieu” of such taxes. Additionally, under IRC Section 902, a domestic corporation that owns at least 10% of a foreign corporation can claim a “deemed paid” credit. This credit applies to taxes paid by the foreign corporation, which are considered paid by the U.S. parent when earnings are distributed or included in the parent’s income. Together, these rules help prevent double taxation and encourage American individuals and businesses to operate internationally.

How Foreign Tax Credit Splitters Became an Issue

For many years, there was uncertainty over which entity should be considered as having “paid” a foreign tax. This issue came to a head in the 2007 Guardian Industries Corp. case, where a U.S. company used a Luxembourg-based subsidiary to claim foreign tax credits on taxes paid by entities in a Luxembourg consolidated group. Despite the IRS’s arguments to the contrary, the court sided with Guardian Industries, allowing the U.S. company to claim the credit.

Following this decision, the IRS introduced regulations to clarify that the person legally liable for the foreign tax is the one who can claim the credit. These changes aimed to ensure that tax credits reflect the true tax liability of U.S. entities, avoiding “split” arrangements where foreign taxes are claimed separately from the income that generates them.

Introduction to Foreign Tax Credit Splitters Under Sec. 909

Section 909 was added to the tax code to prevent situations where U.S. taxpayers can claim credits for foreign taxes without recognizing the related foreign income in the same period. This is known as a “splitter arrangement.” Under Sec. 909, when a splitter arrangement exists, foreign tax credits are “suspended” until the taxpayer recognizes the related income. The Guardian case is a classic example of a splitter arrangement: Guardian Industries’ Luxembourg parent was treated as liable for all taxes paid by the consolidated group, but not all related income was recognized by the U.S. parent for U.S. tax purposes. This mismatch allowed Guardian to split foreign taxes and income, gaining credits prematurely.

What Constitutes a Splitter Arrangement?

A foreign tax credit splitting event occurs when foreign taxes are paid but the income generating those taxes is attributed to another taxpayer or entity. Sec. 909 outlines what constitutes a “foreign tax credit splitting event,” which occurs in the following situations:

1. Ownership and Affiliation: If a taxpayer holds a 10% ownership interest in an entity, if another person holds a 10% ownership interest in the taxpayer, or if related parties under sections 267(b) or 707(b) are involved, the arrangement may qualify as a splitter.
2. Partnerships and S Corporations: For partnerships and S corporations, the anti-splitter rules apply at the partner level, meaning that individual partners may be affected by these rules even if they don’t own shares directly.

This is where things can get tricky, as complex corporate structures and foreign partnerships can easily trigger splitter events without clear planning and oversight.

Key Categories of Foreign Tax Credit Splitter Arrangements

To help taxpayers understand which arrangements may trigger these rules, the IRS issued guidelines identifying four main types of splitter arrangements:

1. Reverse-Hybrid Arrangements: In these setups, an entity is treated as a corporation for U.S. tax purposes but as a disregarded entity or branch for foreign tax purposes. This means taxes paid on foreign income may not align with income recognized for U.S. purposes, creating a split.
2. Loss-Sharing Arrangements: Countries with loss-sharing rules, like the United Kingdom, allow groups of companies to offset profits with losses across entities. When one entity in a foreign group takes on the losses of another, this could cause a mismatch for U.S. tax purposes, where each entity is usually taxed separately.
3. Hybrid Instrument Arrangements: Some financial instruments are treated differently in the U.S. and abroad. For example, if a debt instrument is considered equity abroad but remains debt in the U.S., it could create a split by shifting the timing of income and expenses across borders.
4. Partnership Interbranch Payments: When a partnership pays taxes on income assigned to specific branches, the U.S. partners may face challenges because the taxes might not align proportionally with their distributive shares of income. 

Notice 2010-92: Pre-2011 Arrangements

Notice 2010-92 clarified that Sec. 909 can apply to taxes accrued before 2011 but only for credits claimed after 2010. Four types of pre-2011 splitter arrangements are included under these rules:

• Reverse-hybrid structures
• Foreign consolidated groups
• Group relief with disregarded debt
• Hybrid instruments

These cases often involve complex structures or instruments, where tax treatment varies widely across countries. 

 Temporary Regulations and Practical Implications

The IRS issued temporary regulations in 2012, adding clarity and expanding the definition of splitter arrangements. These regulations further tightened the rules, requiring taxpayers to carefully track which entities in their structure pay foreign taxes and when related income is recognized. 

For many, the best defense against splitter arrangements is simplifying foreign structures to align taxes with income more directly. Large multinational corporations may need to dedicate significant resources to tracking foreign taxes, especially where complex pooling and income deferral strategies are used.

 Managing Foreign Tax Credit Splitter Risks

To comply with Sec. 909 and avoid the potential pitfalls of foreign tax credit splitters, U.S. taxpayers with foreign income should consider the following strategies:

1. Streamline Foreign Entities: Simplifying the ownership structure can make it easier to match foreign taxes to U.S.-reportable income. This may mean restructuring foreign entities so that taxes and income align more clearly.
2. Document Activities Thoroughly: Keeping clear and accurate records of tax payments and related income is essential for compliance. This is especially important for taxpayers with foreign consolidated groups or hybrid structures.
3. Consult International Tax Experts: Given the complexity of these rules, consulting with tax professionals who understand both U.S. and foreign tax laws can help avoid unintended splitters.
4. Monitor Regulatory Updates: The IRS has broad authority to issue additional guidance on Sec. 909. Staying up-to-date with new rules can help taxpayers anticipate changes and adjust their structures or tax strategies accordingly.

Staying Ahead of Foreign Tax Credit Splitter Rules

Sec. 909 and its accompanying regulations are part of the IRS’s broader efforts to ensure fair and consistent application of the Foreign Tax Credit. By suspending credits for foreign taxes until the associated income is recognized, these rules prevent companies from claiming credits prematurely. While compliance with Sec. 909 can be challenging, proactive planning and regular consultation with tax experts can help U.S. taxpayers minimize their exposure to double taxation while still making full use of the available credits.