Tier I Issue – Section 965 Foreign Earnings Repatriation Directive #3

LMSB Control No:  LMSB-4-0409-017
Impacted IRM: 4.51.5

May 26, 2009

On April 21, 2008, I issued a second Directive concerning Section 965 foreign earnings repatriations.  It discussed the impact of a Rev. Proc. 99-32 election on the Section 965 dividends received deduction.  Since then several questions were raised regarding the impact of the election and the processing of these cases.  As a result, this Directive is issued to provide guidance to the field for cases that involve both the Section 965 foreign earnings repatriation issue and a transfer pricing adjustment under Section 482.

Background:

Section 965 provides that a corporation that is a U.S. shareholder of a controlled foreign corporation (CFC) may elect, for one taxable year, an 85 percent dividends received deduction (DRD) for qualifying cash dividends received from its CFCs.  Section 965(b)(3) requires the amount of any dividend otherwise qualifying for the DRD to be reduced if the dividend is funded, directly or indirectly, by the U.S. shareholder.  The statute accomplishes this goal by comparing the amount of indebtedness (“related party indebtedness” or “RPI”) owed by the taxpayer’s CFCs to related persons (within the meaning of section 954(d)(3)), on two measurement dates.  Section 965(b)(3) provides that the “initial measurement date” means the close of October 3, 2004 (but see Notice 2005-38, section 7, which allows certain alternative dates to be used), and that the “last measurement date” means the close of the last day of the taxable year for which the taxpayer elects to apply Section 965.  If the RPI on the last measurement date exceeds the RPI on the initial measurement date, the U.S. shareholder is deemed to have funded some or all of the CFCs’ dividends, and the amount of qualifying cash dividends that otherwise would qualify for the DRD is reduced dollar-for-dollar by the amount of the increase in RPI.
Section 10.06 of Notice 2005-64, construing section 965, explicitly provides that Rev. Proc. 99-32 accounts payable (account) constitute RPI.  Most recently, on September 4, 2008, the IRS Office of Chief Counsel issued a generic legal advice memorandum (GLAM) addressing whether an account established by an election to apply Rev. Proc. 99-32 constitutes RPI under Section 965(b)(3) (No. AM2008-010).  The GLAM concluded that an account established pursuant to an election to apply Rev. Proc. 99-32 is treated as debt for all Federal income tax purposes, including Section 965(b)(3), and recommended that all closing agreements under Rev. Proc. 99-32 covering a taxable year in which the taxpayer elected the benefit of Section 965 include language stating that the account established in the closing agreement constitutes RPI for purposes of Section 965(b)(3).

Accounts established by a U.S. entity pursuant to Rev. Proc. 99-32 are deemed to be established on the last day of the tax year for which the transfer pricing adjustment is made.  Accordingly, such accounts may impact the computation of RPI under Section 965(b)(3) and decrease the amount of dividends that qualify for the Section 965 DRD.

Examination Guidance:

Accounts established under Rev. Proc. 99-32 by a taxpayer with respect to a related person (as defined in section 965(b)(3)) will be treated as RPI.  Examiners should recognize that adjustments to the computation of the Section 965 DRD will be warranted if adjustments are made under Section 482 with regard to that same taxpayer, and the taxpayer elects to apply the provisions of Rev. Proc. 99-32.

Examiners should supplement the pro forma Section 965 Information Document Request that was attached to Industry Directive #1 with the following two requests for information: 

• Whether a section 482 adjustment has been made for a taxable year ending on or prior to October 3, 2004 (or an alternative initial measurement date used by the taxpayer in accordance with Section 7 of Notice 2005-38), that may impact the initial measurement date related party indebtedness (RPI) balance for determining any increase in RPI under Section 965, and whether the taxpayer has elected to apply Rev. Proc. 99-32 in conjunction with that adjustment; and
  
  
• Whether, with respect to any Section 482 adjustment that would impact the calculation of RPI under Section 965(b)(3), the taxpayer has applied, or intends to apply (whether in examination, or during any consideration of the adjustment that may occur in Appeals or Competent Authority), Rev. Proc. 99-32 or the principles of Rev. Proc. 99-32. 

Guidance for Closing Cases:

The procedures set forth below should be followed when closing examination cases that include Section 482 adjustments that may affect the amount of the Section 965 DRD.  Adjustments in all tax years that may affect the RPI balances on the initial and last measurement dates need to be reviewed.  This may include tax years ending on or before the initial measurement date (i.e., on or about October 3, 2004).

(1) If a Section 482 adjustment proposed for tax years ending between the initial measurement date and last measurement date is agreed at the examination level and Rev. Proc. 99-32 is elected, the appropriate adjustment to Section 965 should also be made.

(2) If a Section 482 adjustment proposed for tax years ending between the initial measurement date and last measurement date is unagreed at the examination level, a protective adjustment should be made to the Section 965 DRD as if the taxpayer had elected to apply Rev. Proc. 99-32.  Doing so preserves the Service’s ability to make necessary adjustments to the DRD if the taxpayer later elects to apply Rev. Proc. 99-32 in Appeals, during Competent Authority consideration, or at some other later date as allowed by law.  However, if an examiner intends to make such a protective adjustment in a 30-day letter affording Appeals rights to the taxpayer, and the examiner has been informed that the taxpayer may apply for Competent Authority consideration as well, the examiner should contact the IMT for further guidance.   The IMT will coordinate the “hot interest” issue with Competent Authority, on behalf of exam, to determine if the issue should be included in the 30-day letter, until further guidance is provided.

(3) Examiners must also be aware that a Section 482 adjustment made for a taxable year ending on or before the initial measurement date may impact the calculation of RPI under Section 965 on the initial and/or last measurement dates.

i. If a Section 482 adjustment proposed for a tax year ending on or before the initial measurement date (a “pre-RPI measurement year”) has been resolved and if the taxpayer has elected to apply Rev. Proc. 99-32, examiners should recompute the Section 965 RPI balances in accordance with the Section 482 adjustments on the initial and last measurement dates, and redetermine the Section 965 DRD.

ii. If a Section 482 adjustment proposed for a pre-RPI measurement year remains unagreed after the last measurement date, examiners generally should not need to make any protective adjustment to the Section 965 RPI balances for the initial measurement date, because adjusting the RPI balances for the Rev. Proc. 99-32/Section 965 issue would result in identical increases to both the “initial” and “last” measuring date RPI balances, and so would have no net effect on the computation of RPI.  See Example 3 below for additional guidance for unagreed cases.

iii. Examiners may contact the Section 965 IMT for additional guidance/ clarifications for specific fact patterns that differ from those mentioned in this Directive or for other special circumstances.

(4) In unagreed cases, include sufficient comments in the Transmittal Letter (T-letter), the International Examiner’s report (IE report), and the Mutual Agreement Procedure report (MAP report), to ensure that Appeals or Competent Authority is aware of the existence of the impact of the Section 482 adjustment on the Section 965 DRD.  Examiners should also ensure that taxpayers have signed the requisite consents to extend the statute of limitations to ensure the statute is kept open for resolution of the Section 965 issue.  Restricted consents should be used only as authorized under Internal Rev. Manual section 25.6.22.8 and only after approved by Area Counsel.

(5) In cases agreed to at the Appeals level, Appeals will compute the Section   965 adjustment.

(6) In cases agreed to at the Competent Authority level, the case will be returned to either Appeals or Examination and the Section 965 adjustment will be finalized in whichever office writes and issues the final report in the case.

(7) In certain limited cases where there is strong evidence that the taxpayer’s transfer pricing position to which the section 482 adjustment relates was entered into with a principal purpose of avoiding the RPI rule of Section 965(b)(3), it may be appropriate to redetermine the Section 965 DRD even in the case of a taxpayer that does not elect to apply Rev. Proc. 99-32.   Examiners should consult with the Section 965 IMT for further guidance before proposing such an adjustment.

The following examples illustrate the guidance for closing cases set forth above.  In each example, USP is a U.S. corporation and A, B, and C are controlled foreign corporations (CFCs) wholly-owned by USP.  All four corporations use the calendar year as their taxable year.

Example 1:  As the result of an examination that concluded in 2007, the IRS has proposed transfer pricing adjustments under Section 482 between USP and CFC A of $100,000 in each of USP’s 2004 and 2005 tax years.  During 2005, USP elected Section 965 and repatriated a $500,000 dividend from CFC B.  USP elects to apply Rev. Proc. 99-32 for the transfer pricing adjustments in both 2004 and 2005, and these amounts are considered RPI under Section 965(b)(3).  The accounts established under Rev. Proc. 99-32 are deemed to be established on the last day of the taxable year to which they relate, i.e., December 31, 2004 and December 31, 2005.  Since its 2004 tax year ends after the initial measuring date (on or about October 3, 2004), the 2004 transfer pricing adjustment does not increase the initial measurement date balance under Section 965(b)(3).  However, both the 2004 and 2005 adjustments will be treated as RPI for purposes of the last measurement date (December 31, 2005).  Accordingly, as the result of the adjustments and the taxpayer’s election to apply Rev. Proc. 99-32, USP’s RPI will increase by $200,000.

Example 2:  Assume the same facts as in example 1, except that a transfer pricing adjustment under section 482 between USP and CFC A in the amount of $100,000 also was made for USP’s 2003 tax year, and that USP elects to apply Rev. Proc. 99-32 for that year.  Since the account under Rev. Proc 99-32 for tax year 2003 is deemed to have been established as of December 31, 2003, $100,000 will be included in the initial measurement date RPI balance and also in the last measurement date RPI balance.  The $200,000 accounts established under Rev. Proc. 99-32 for 2004 and 2005 also are included in the last measurement date RPI balance as in example 1 for purposes of determining any increase in related party indebtedness.  Therefore, the initial measurement date RPI balance will increase by $100,000 and the ending measurement date RPI balance will increase by $300,000.

Example 3:  Assume the same facts as in example 2, except that the taxpayer does not agree with any of the Service’s proposed adjustments under Section 482.  Because the proposed transfer pricing adjustment for USP’s 2003 tax year remains unagreed throughout the RPI measuring period, examiners need not make any protective adjustment to the Section 965 RPI balance for the initial measurement date.  However, examiners should make protective adjustments to the Section 965 DRD with respect to the proposed Section 482 adjustments for USP’s 2004 and 2005 tax years as if the taxpayer had elected Rev. Proc. 99-32.  As a result, the taxpayer’s initial measurement date RPI balance would remain the same and the taxpayer’s last measurement date RPI balance would be increased by $200,000. 
Questions regarding this directive or the development of any issues involving Section 965 foreign earnings repatriation should be directed to Technical Advisors, Nancy Johnson (primary), Rich LaRusso (backup) or Section 965 Industry Counsel, Glenn McLoughlin or Christine Irwin.

This Directive is not an official pronouncement of law or the position of the Service and cannot be used, cited, or relied upon as such.

 cc:  Commissioner, LMSB
        Deputy Commissioner, LMSB
        Division Counsel, LMSB
        Commissioner, SBSE
        Chief, Appeals
        Director, Planning Analysis and Support