What Are Section 909 Splitter Arrangements?

Internal Revenue Code Section 909 addresses “splitter arrangements” to ensure foreign tax credits are claimed in the correct year. These rules are about timing, designed to prevent a U.S. taxpayer from claiming a foreign tax credit in a year before the income related to that tax is reported for U.S. tax purposes. This mismatch can occur through various international business structures, and a splitter arrangement occurs when the party that pays a foreign tax is different from the party that recognizes the associated income in the U.S. tax system. The result is not a permanent disallowance of the credit, but a deferral.

The credit is suspended until the underlying income is properly reported, ensuring the credit reduces U.S. tax on that same income.

Identifying Foreign Tax Credit Splitter Arrangements

A foreign tax credit splitting event happens when foreign income taxes are paid or accrued, but the related income is, or will be, taken into account by a “covered person.” A covered person is specifically defined and includes entities where the taxpayer holds at least a 10% ownership interest, any person holding a 10% interest in the taxpayer, or other related parties under Internal Revenue Code sections 267 and 707.

The regulations under Section 1.909-2 provide an exclusive list of arrangements that are considered splitter arrangements. One of the most common is a reverse hybrid splitter arrangement. This involves an entity that is treated as a corporation for U.S. tax purposes but is viewed as transparent, like a partnership, under foreign law. In this scenario, the U.S. owner may not recognize the entity’s income until a distribution is made, but the foreign country imposes tax directly on the entity, creating a split.

Another defined arrangement is a loss-sharing splitter arrangement. This situation arises when a U.S. company is part of a foreign consolidated group or other loss-sharing regime. If a profitable U.S.-owned foreign entity uses the losses of another group member to reduce its foreign taxable income, a splitter arrangement can be created if those losses would not have been available to offset the income under U.S. tax principles.

Hybrid instrument arrangements also fall under these rules. A U.S. debt hybrid instrument splitter arrangement occurs when an instrument is treated as debt for U.S. tax purposes, allowing for an interest deduction, but is treated as equity for foreign tax purposes, meaning the payments are not deductible abroad. The foreign taxes paid by the issuer on the income used to make the non-deductible payment are considered split from the related income because the U.S. parent company has already benefited from an interest deduction related to that same payment.

The Suspension of Foreign Tax Credits

When a foreign tax credit splitter arrangement is identified, the consequence under Section 909 is the suspension of the associated foreign income taxes. This means the taxpayer cannot claim a credit or deduction for these specific taxes in the year they are paid or accrued. The suspended taxes are not included in the taxpayer’s pool of foreign taxes available for credit in the current year.

For a corporate taxpayer, this means the taxes are not available to be claimed as deemed-paid credits under Section 960. Similarly, the corporation’s earnings and profits are not reduced by the suspended tax amount, which ensures that the financial accounting for U.S. tax purposes reflects that the tax has not yet been utilized. The taxpayer is required to track these suspended taxes separately in a special account, which will increase as new splitter arrangements generate more suspended taxes. The balance of this account represents foreign taxes that have been paid but are not yet available to be claimed on a U.S. tax return.

The suspension applies only to the specific foreign income taxes that are determined to be “split” under the regulations. If a taxpayer pays other foreign taxes that are not connected to a splitter arrangement, those taxes are unaffected and can be credited in the normal course, subject to other limitations.

Associating Suspended Taxes with Related Income

The principle for releasing suspended foreign tax credits is the concept of “related income.” As defined in Section 909, related income is the income or earnings and profits to which a specific foreign income tax relates. The suspension of the tax credit is lifted, and the credit becomes available, in the taxable year when this related income is finally taken into account by the U.S. taxpayer.

The process of associating suspended taxes with related income requires identifying the specific block of income that was subject to the suspended foreign tax. When that same block of income is recognized for U.S. tax purposes, the corresponding suspended taxes are released. This recognition can happen in several ways, such as when a reverse hybrid entity makes a distribution to its U.S. owner or when a U.S. shareholder has an income inclusion from a controlled foreign corporation.

Consider this example: A U.S. corporation owns a reverse hybrid entity. In Year 1, the reverse hybrid earns $1,000 and pays $150 in foreign income tax. Because of the splitter arrangement, the $150 tax is suspended in Year 1. In Year 3, the reverse hybrid distributes the $850 of after-tax earnings to its U.S. parent. This distribution is the “related income,” and in Year 3, the U.S. parent can release the $150 of suspended taxes to claim a foreign tax credit.

The regulations provide specific rules for how to allocate the released taxes. If a distribution or income inclusion represents only a portion of the total related income, a proportional amount of the suspended taxes is released. This ensures that the credits are claimed in lockstep with the income being reported.

Reporting and Tracking Requirements

Taxpayers with suspended foreign tax credits under Section 909 have specific compliance and reporting obligations. These requirements are handled through Form 1116 for individuals and Form 1118 for corporations. The process demands meticulous record-keeping to track the movement of suspended taxes from one year to the next.

For corporate taxpayers using Form 1118, foreign income taxes that are suspended in the current year must be reported, which removes them from the calculation of currently available credits. When previously suspended taxes become creditable because the related income has been taken into account, they are then added to the pool of taxes eligible for the foreign tax credit in that year.

A taxpayer must maintain a detailed schedule that reconciles the suspended tax account from year to year. This supporting schedule should show:

• The beginning balance of suspended taxes.
• Any additions from new splitter arrangements during the year.
• Any taxes that were released and claimed during the year.
• The ending balance of suspended taxes.

This detailed tracking is necessary for accurate reporting and to provide support in case of an IRS examination.