IRS issues guidance on refunds of foreign tax to RICs

On Jan. 15, the IRS released Notice 2016-10, which announced the government’s intention to amend regulations under Sections 853 and 905(c) to provide guidance on regulated investment companies (RICs) obtaining administrative relief when a RIC received a foreign tax refund during a period in which it made a Section 853 election. The guidance provides two methods a RIC may use to account for foreign tax determination events (e.g., a refund of foreign taxes) under Section 905(c).

A RIC is an association taxable as a corporation for federal income tax purposes. Many mutual funds are organized as RICs for tax purposes. Certain eligible RICs may make an election under Section 853 to not claim a deduction or credit for its foreign taxes, but instead to pass the amounts of taxes paid and corresponding gross-ups through to shareholders, who may be eligible to credit or deduct such taxes. For a RIC to be eligible for this election, more than 50% of the value (as defined in Section 851(c)(4)) of its total assets at the close of the taxable year must consist of stock or securities in foreign corporations, and it must satisfy other requirements under Section 852(a).

The notice states that, generally speaking, RICs do not have changes to their foreign tax liabilities, as described in Section 905(c), both because foreign withholding taxes, which RICs generally pay, are usually determinable at the time the income from which the tax is withheld is paid or accrued, and because RICs must adhere to specific functional currency rules. However, after the European Union Court of Justice recently held that member states couldn't impose withholding taxes on foreign investors if similar domestic investors weren't subject to tax, many RICs sought and have received refunds of foreign taxes paid to EU member states. As RICs are often widely held, the IRS said Section 905(c) could lead to significant administrative costs and uncertainty for the U.S. government, and also for RICs and their shareholders, without guidance providing alternative procedures.

To alleviate this administrative burden, the notice provided two alternative procedures to the general procedures under Section 905(c).  The two methods the netting method and a closing agreement.

The netting method provides that a RIC may 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 as determined under the notice. This adjustment includes foreign tax refunds and an interest adjustment. The notice also contains specific requirements, which a RIC must satisfy to qualify for the netting method.

The closing agreement method provides that a RIC may request a closing agreement addressing the treatment of the refund. The notice states that 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.” The notice includes examples of when a request will be in the interest of sound tax administration (as when a RIC is either precluded from applying, or it is not reasonably practical for it to apply, the general rules under Section 905(c)).

This new guidance should be carefully reviewed by taxpayers that may be qualifying RICs as the guidance contains rules that significantly reduce the administrative burden when applying Section 905(c) to any refunds sought from EU member states. Except as otherwise provided in the notice, the notice is expected to apply to any refund year ending on or after Feb. 8, 2016.

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