SECTION 3. FOREIGN-INITIATED

ADJUSTMENT SPLITTER ARRANGEMENTS

.01 Splitter Arrangements Arising from the Application of Section 905(c) to Suc- cessor Entities

This section 3.01 describes regulations that the Treasury Department and the IRS intend to issue in order to address changes

in ownership structures that, in connection with a foreign-initiated adjustment, result in a foreign tax credit splitting event. These regulations will provide that a splitter arrangement arises when, as a result of a “covered transaction,” a section 902 corporation pays “covered taxes” during a taxable year (the “splitter year”).

For purposes of this notice, “covered taxes” are foreign income taxes that:

(1) are taken into account by adjusting

the payor’s pools of post-1986 undistributed earnings and post-1986 foreign income taxes in the taxable year paid pursuant to section 905 (c); and (2) result from a “specified foreign initiated adjustment” to the amount of foreign income tax accrued with respect to one or more prior taxable years (“relation-back years”). A “specified foreign-initiated adjustment” is a foreign-initiated adjustment (or series of related adjustments to more than one taxable year) that results in additional foreign income tax liability that is greater than $10 million, regardless of whether such liability is actually paid in one or more taxable years (due, for example, to an installment plan).

A “covered transaction” generally is any transaction or series of related transactions that meet the following conditions:

(1) The transaction or series of related

transactions results in covered taxes being paid by a payor that is a section 902 corporation and that is not the section 902 corporation that would have been the payor of the covered taxes (the predecessor entity) if the covered taxes had been paid or accrued in the relation-back year; and (2) The predecessor entity (or a succes sor of the predecessor entity) was a covered person with respect to the payor immediately before the transaction or series of related transactions, or, if the payor did not exist immediately before the transaction or series of related transactions, the predecessor entity (or a successor of the predecessor entity) was a covered person with respect to the payor immediately after the transaction or series of related transactions.

However, a transaction or series of related transactions will not be treated as a covered transaction if either of the following exceptions applies:

(1) The transaction or series of related

transactions results in the transfer of the earnings and profits of the predecessor entity to the payor pursuant to section 381(c)(2); or (2) The taxpayer demonstrates by clear

and convincing evidence that the transaction or series of related transactions were not structured with a principal purpose of separating covered taxes from the post1986 undistributed earnings of the predecessor entity that include the earnings to which the covered taxes relate. In the case of a splitter arrangement described in this section 3.01, “related income” equals the sum of the portions of the predecessor entity’s earnings and profits for each of the relation-back years that are:

(1) described in section 316(a)(2) (“sec tion 316(a)(2) earnings”); (2) in the separate category or catego ries to which covered tax is assigned; and (3) attributable to all activities that gave

rise to income (computed under foreign law) included in the foreign tax base that was adjusted pursuant to the specified foreign-initiated adjustment (“adjusted foreign tax base”), regardless of which particular activities gave rise to the adjustment. If foreign income tax is imposed on the combined income (within the meaning of §1.901–2(f)(3)(ii)) of two or more entities, including for this purpose disregarded entities, the principles of these rules will apply on an entity-by-entity basis.

The principles of §1.909–6(d) will apply to determine the amount of related income of the predecessor entity that is transferred to other persons or taken into account by a section 902 shareholder or the payor section 902 corporation (for example, due to a transaction that is described in section 381(a)(1) or (a)(2)) in any relation-back year or subsequent year before the splitter year.

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and profits attributable to income effectively connected with the conduct of a trade or business within the United States or otherwise subject to tax under chapter 1 in the hands of the payor) to a section 902 covered person; and (3) Was made with a principal purpose

of reducing the payor’s post-1986 undistributed earnings that included the earnings to which the covered taxes relate in advance of the payment of covered taxes. A distribution will be presumed to have been made with a principal purpose described immediately above if the sum of all distributions that would be covered distributions without regard to the principal purpose requirement is greater than 50 percent of the sum of (i) the payor’s post-1986 undistributed earnings as of the beginning of the payor’s taxable year in which the covered tax is paid, and (ii) the sum of all distributions that would be covered distributions without regard to the principal purpose requirement. A taxpayer may rebut this presumption with clear and convincing evidence that the distribution was not made with a principal purpose of reducing the payor’s post-1986 undistributed earnings that included the earnings to which the covered taxes relate in advance of the payment of covered taxes. For example, a taxpayer may rebut this presumption by demonstrating that the distributions were consistent with the payor’s pattern of distributions before the taxpayer reasonably anticipated the specified foreign-initiated adjustment. In the case of a distribution from a pool of post-1986 undistributed earnings that included earnings to which the covered taxes relate and 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.

In the case of a splitter arrangement described in this section 3.02, “related income” is determined by first determining the “initial related income” in the hands of the payor. The “initial related income” is the sum of the portions of the payor’s earnings and profits for each of the relation-back years that are:

In the case of a splitter arrangement described in this section 3.01, “split taxes” are the amount of the covered taxes that relate to the predecessor entity’s related income that was not transferred to the payor in the covered transaction, reduced by the ratable portion of the covered taxes that would no longer be treated as split taxes under the principles of §1.909– 6(e)(4) because a section 902 shareholder or the payor section 902 corporation took related income into account prior to the splitter year.

The following example illustrates the regulations described in this section 3.01. All dollar amounts in this example are in millions.

Example . (i) Facts . USP, a domestic corporation, wholly owns CFC1. CFC1 wholly owns CFC2. CFC1 and CFC2 are foreign corporations that were formed at the beginning of Year 1, are residents of Country X, and use the U.S. dollar as their functional currency. CFC1 wholly owns DE, a disregarded entity for U.S. federal income tax purposes that is organized in Country X and treated as a corporation for Country X tax purposes. CFC1 does not earn any income or pay any foreign taxes, other than through DE. For each of Years 1 through 5, DE earns $200 of earnings and profits with respect to which it accrues and pays no foreign tax. These earnings and profits constitute CFC1’s pool of post-1986 undistributed earnings, which equals $1,000 as of the end of Year 5. The earnings and profits are all in the general income category. In Year 6 (a year when DE earns no income), CFC1 transfers all of its interest in DE to CFC2 in exchange for CFC2 stock in a transaction that qualifies under section 351. In Year 8, after exhausting all effective and practical remedies to minimize its liability for Country X tax, DE pays $200 in foreign income taxes to Country X to settle a series of related adjustments proposed by Country X with respect to Years 1 through 5.

(ii) Splitter arrangement . CFC1’s transfer of its interest in DE to CFC2 in Year 6 and the payment of foreign income taxes by CFC2 through DE in Year 8 will give rise to a splitter arrangement under the rules described in section 3.01 of this notice, unless USP satisfies the principal purpose exception. The $200 of foreign income taxes paid by CFC2 are covered taxes because (1) they are added to CFC2’s pool of post-1986 foreign income taxes in Year 8 pursuant to section 905(c), and (2) they result from a specified foreign-initiated adjustment with respect to one or more relation-back years. Unless USP establishes by clear and convincing evidence that the transfer of CFC1’s interest in DE to CFC2 was not structured with a principal purpose of separating covered taxes from the post-1986 undistributed earnings of CFC1 that include the earnings to which the covered taxes relate, that transfer is a covered transaction because (1) it resulted in CFC2 being the payor of the covered taxes and CFC1 would have been the payor of the covered taxes if they were paid or accrued in the relation-back years; (2) immediately before the transfer, CFC1 was a covered person

with respect to CFC2; and (3) the transfer did not result in a transfer of CFC1’s earnings and profits to CFC2 pursuant to section 381(c)(2).

(iii) Related income . The related income equals $1,000, the sum of CFC1’s section 316(a)(2) earnings with respect to each of Years 1 through 5 that are attributable to the activities of DE that gave rise to income (computed under foreign law) included in the adjusted foreign tax base of DE. Because CFC1 made no distributions before Year 8, the full amount of the related income remains in CFC1’s pool of post-1986 undistributed earnings as of the beginning of Year 8, the splitter year.

(iv) Split taxes . The split taxes equal $200, the amount of the covered taxes paid by CFC2.

.02 Splitter Arrangements Arising From Distributions Made Before the Pay- ment of Additional Tax Pursuant to Foreign-Initiated Adjustments

Taxpayers could achieve a result similar to the arrangement described in section 3.01 of this notice by using distributions to, in effect, move post-1986 undistributed earnings from one section 902 corporation to another section 902 corporation before the first section 902 corporation makes a tax payment pursuant to a specified foreign-initiated adjustment. In such a case, the earnings to which the tax payment relates are first taken into account by the payor but, as a result of the distributions, are then taken into account by a covered person that is a section 902 corporation (“section 902 covered person”) before the first section 902 corporation pays the tax. Accordingly, the Treasury Department and the IRS intend to issue regulations that will provide that a splitter arrangement results when a payor that is a section 902 corporation pays covered taxes (as defined in section 3.01 of this notice) during a taxable year (the “splitter year”), and the payor (or a predecessor of the payor) has made a “covered distribution.”

A “covered distribution” is any distribution with respect to the payor’s stock to the extent such distribution:

(1) Occurred in a taxable year of the

payor to which the covered taxes relate or any subsequent taxable year up to and including the taxable year immediately before the taxable year in which the covered taxes are paid; (2) Resulted in a distribution or alloca tion (for example, pursuant to §1.312–10) of the payor’s post1986 undistributed earnings (but for this purpose not including earnings

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the covered distribution. Because CFC1 made no distributions in Year 11, the full amount of the related income remains in CFC1’s pool of post-1986 undistributed earnings as of the beginning of Year 12, the splitter year. (iv) Split taxes . The split taxes equal the covered taxes multiplied by a ratio, the numerator of which is the total amount of related income as of the beginning of the splitter year, and the denominator of which is the initial related income, or $135 ($180 � ($675/$900)).

Example 2 . (i) Facts . The facts are the same as in Example 1, except that USP wholly owns CFC3, which wholly owns CFC1. CFC3 is a foreign corporation resident in Country X. In Year 11, CFC1 distributes $300 to CFC3. Pursuant to section 954(c)(6), CFC3’s $300 of dividend income does not result in an income inclusion to USP.

(ii) Result . Because CFC1 made a distribution of $300 to CFC3 in Year 11, and CFC1’s $750 of post-1986 undistributed earnings consisted of related income and other income, CFC1 is treated as having distributed $270 ($300 - ($675/$750)) of related income to CFC3 under the principles of §1.909– 6(d). Accordingly, as of the beginning of Year 12, CFC3 has $270 of related income and CFC1 has $405 of related income. The amount of split taxes remains $135. .03 Conforming Revisions

Section 1.909–6(g)(3) provides that if a redetermination of foreign tax paid or accrued by a section 902 corporation occurs in a post-2010 taxable year and increases the amount of foreign income taxes paid or accrued by the section 902 corporation with respect to taxable years beginning on or before December 31, 2010 (a pre-2011 taxable year), such taxes will be treated for purposes of section 909 as being paid or accrued in a pre-2011 taxable year (pre-2011 taxes). Section 1.909–6(b) provides an exclusive list of splitter arrangements (which differs from the list provided in section 1.909–2(b)) that can give rise to foreign tax credit splitting events with respect to pre-2011 taxes. Section 1.909–6(g)(3) will be revised to provide that foreign tax redeterminations in a post-2010 taxable year with respect to pre-2011 taxes of a section 902 corporation in connection with a splitter arrangement described in section 3.01 or section 3.02 of this notice will not be treated as pre-2011 taxes for purposes of those sections.