United States: US Developments Regarding Hybrid Entities And Corporate Tax Shelters - Part 2

Temporary regulations, fleshing out the principles reflected in the examples above, were issued in March 1998. They and Notice 98-11 were the subject of widespread and sustained criticism from US multinationals, the financial markets, practitioners, and members of Congress who considered the Treasury to have overstepped its authority in trying to set policy without the legislature's imprimatur. Criticisms included the following:

• Although the targeted transactions reduced foreign tax, they did not affect total CFC income for US purposes. Total US tax owed on that income remained unchanged because the calculation of a CFC's income before foreign tax is not affected by whether the countries in which the entities in question are located and taxed treat the recipient of the interest as a separate entity and grant the CFC an interest deduction.
• In certain instances, the transactions described in Notice 98-11 could in fact have increased the amount of US tax on a CFC's foreign source income. If interest paid by the CFC reduced its effective foreign tax rate below 35%, the US could collect a residual tax on the income or on low-taxed income of another CFC when repatriated. This is because the amount of creditable foreign tax would be reduced by the amount advanced to the CFC, so that the US parent would pay more tax upon repatriation of the CFC's earnings. As a result, Notice 98-11 could have resulted in a shift of tax revenues from the US to foreign governments.
• Contrary to well-established principles, the Notice would have made US tax consequences dependent upon foreign law where there was no clear congressional mandate to do so. This would have increased the complexity in an already complicated area and would have flown in the face of the check the box regulations, the purpose and effect of which is to provide simplicity and improved predictability.
• In attempting to legislate by regulation the Treasury had overstepped its authority, which is typically restricted to the interpretation (rather than the imposition) of tax laws unless Congress expressly provides otherwise.
• US companies and their CFCs would have been put at a competitive disadvantage vis-à-vis foreign competitors, which would continue to use hybrid entities to reduce foreign tax burdens without paying additional tax at home.

In response to this criticism, and under pressure from certain members of Congress, the Treasury in June 1998 issued Notice 98-35, withdrawing Notice 98-11 and announcing its intention to withdraw the temporary regulations and replace them with revised proposed regulations. The Treasury also stated that it would not implement final regulations on the tax treatment of hybrids until 2000, in order to give Congress time to consider the issues and take legislative steps in the area if it wished to do so. In the summer of 1999, more than a year after Notice 98-35 was issued, the temporary regulations were removed but essentially restated as proposed regulations. The practical difference in this regard is that the proposed regulations do not have the force of law. They are merely an indication of the direction the Treasury intends to take and are meant to serve as the basis for consultation with taxpayers over the content of any final regulations that might ultimately be issued.

As is customary, the proposed regulations contain grandfathering provisions that would permanently exempt hybrid branch arrangements put in place before the release of Notice 98-35, on 19 June 1998, from the general treatment spelled out in the regulations. The permanent grandfathering for any arrangement entered into before 19 June 1998 would only be available if there has been no substantial modification to the arrangement since that date. For this purpose a substantial modification includes (i) any expansion of the arrangement, (ii) most greater than 50% changes in the US direct or indirect ownership of any entity that is a party to the arrangement, or (iii) any measure that provides material tax benefits. There is very little guidance, however, as to what these concepts exactly mean, although some indication is given of situations that do not constitute substantial modifications. They include, for example, the renewal of a loan, license, or rental agreement on the same terms and conditions as the original agreement without further action by a party to the agreement.

Perhaps most significant is the suggested effective date of the rules set forth in the proposed regulations. They would apply at the earliest to hybrid branch payments made in tax years beginning five years after the date on which final regulations are issued and, in line with what was said in Notice 98-35, final regulations will not be issued before 1 July 2000. This five-year moratorium on the implementation of substantive provisions means that hybrid branch payments, including those put in place on or after 19 June 1998, will continue to obtain beneficial tax treatment in the US until at least 2006.

Having at least suspended its assault on payments made to non-US hybrid branches, the Treasury in the latter part of 1999 switched its attention to certain instances in which such entities are sold or otherwise transferred with what it considers to be inappropriate US tax consequences.

In response to perceived abuses in the use of disregarded entities to manipulate the current income inclusion rules of Subpart F, the income sourcing and foreign tax credit limitation rules of the Code, and the US rules relating to outbound transfers of property in otherwise tax-free transactions, the Treasury in November 1999 issued proposed regulations invalidating elections to disregard non-US entities for US tax purposes in certain circumstances. According to the proposed regulations the IRS would be permitted to ignore an election to convert an otherwise eligible non-US entity into a tax-transparent branch for US purposes if the conversion occurs or is treated as occurring in the 12 months prior to the actual or deemed sale, exchange, transfer, or other disposal of the entity - referred to in the proposed regulations as an "extraordinary transaction". The result of this is that the entity would be treated as if it were always a corporation from a US tax perspective so that the extraordinary transaction would be treated as the sale, exchange, transfer or other disposal of the entity's shares, rather than its assets. A special rule would also apply to certain shelf entities that might be used to try to circumvent the 12 month rule.

It seems clear that the Treasury's principal concern in this area is the inconsistent classification of foreign entities under the tax laws of the US and other countries, which check the box has made so much more simple to achieve. The invalidation of branch elections that are made within 12 months of an excluded transaction does not apply to domestic entities and there is no attempt to alter the US tax treatment of transactions involving entities that have been physically liquidated (or been involved in other transactions that have legal effect under non-US law) within the prescribed time frame. An illustration of the type of situation involving a non-US entity that is targeted by the Treasury is included in the proposed regulations. US parent corporation (P) plans to sell its foreign subsidiary (F-1). P makes a check the box election for F-1 and then sells it. According to the proposed regulations the check the box election should be invalid and P should be treated as selling F-1's shares, rather than its assets, for US tax purposes.

Another example, not explicitly contained in the proposed regulations but implicated by them, is where P plans to transfer F-1 to another of its foreign subsidiaries, F-2. P makes a check the box election for F-1 in the hope that the transfer of it to F-2 will be treated as an asset transfer, rather than a transfer of shares for US tax purposes, thereby avoiding the need to enter into a binding agreement with the IRS that P will recognise any of the inherent gain in F-1 as of the date of transfer to F-2 if F-1 is sold or otherwise disposed of by F-2 within the following five years. Under the proposed regulations the check the box election with respect to F-1 would be invalid and its transfer to F-2 would be treated as a share transfer, so that P would have to execute a gain recognition agreement with the IRS. This result is at odds with a statement made in the preamble (the Treasury's introductory comments) to final regulations issued under Code section 367 in 1998 (which include the provisions governing gain recognition agreements made with the IRS) that a branch election made in such circumstances would be upheld.

The preamble to the proposed regulations states that they are targeted solely at inappropriate uses of check the box, although Treasury officials have been at pains to argue that the proposed regulations are not anti-abuse rules, and that they focus on tax consequences, rather than taxpayer intent. In this connection, the proposed regulations provide an exception for cases where it is established that the intended reclassification of an entity from corporate to branch treatment for US tax purposes does not materially alter the tax consequences of an extraordinary transaction. Regardless of whether they focus on tax results or taxpayer intent, though, the proposed regulations have been strongly criticised for the broad definition of what constitutes an extraordinary transaction.

One of the criticisms is that the definition of what constitutes an extraordinary transaction would seem to bring within its scope a large number of routine internal restructuring transactions that are customarily engaged in by large corporations and that pose no risk of improper US tax consequences. The only recourse offered under the proposed regulations is for taxpayers to seek an advance ruling from the IRS that each such transaction that they undertake is not subject to the general disallowance applicable to branch elections made within the prescribed 12 month period. This process, it is argued, would be very time-consuming and in many instances costly - an outcome that is inconsistent with the fundamental purpose of the check the box regulations, which was to ease the administrative burdens on both taxpayers and the US government. It has therefore been suggested that the proposed regulations should be modified to exclude transfers of interests in eligible foreign entities that otherwise qualify for tax-free treatment under the Code and do not involve parties outside a taxpayer's group of affiliated companies, where the only advantage gained by the taxpayer from a branch check the box election is the speedy and cost-effective implementation of bona fide business plans.

Another criticism of the proposed regulations is that the definition of an extraordinary transaction applies to any situation in which a 10% or greater interest is sold, exchanged, transferred, or otherwise disposed of in one or more transactions that occur or are treated as occurring within the prescribed period. The definition would therefore seem to apply to, and potentially disallow, any branch election that is made to treat an existing non-US corporation as a branch for US tax purposes. This is because other Treasury regulations which have been implemented in final form and have the force of law provide that a branch check the box election is deemed to result for US tax purposes in a liquidation of the entity in question into its immediate parent. Under established US tax principles this contemplates an exchange of the liquidating entity's assets to its parent. On its face, therefore, the proposed regulations seem to invalidate check the box elections to treat an existing foreign subsidiary as a branch of its parent for US tax purposes unless it can be shown that the US tax consequences of the extraordinary transaction - in this case, the deemed liquidation of the entity that results from the election itself - are not materially altered.

Here too lies another ambiguity as it is not clear how to determine the US tax consequences of an extraordinary transaction. The proposed regulations do not provide any guidance as to whether the analysis is confined to the tax consequences of the extraordinary transaction itself, or whether it also includes the consequences that follow from the transaction. If it is the former, the liquidation that is deemed to occur when a branch election is made for an existing eligible entity would not seem to have materially altered any tax consequences; as described above, those consequences are explicitly spelled out in the check the box regulations. But if it is the latter, most - if not practically all - branch elections would have materially altered tax consequences, based on the fundamental differences in the taxation of foreign corporations and branches in the US. These and various other problems with the proposed regulations must be rectified.

Another area that has seen much activity in the US in recent times is that relating to tax-oriented transactions, products, and techniques - generally referred to as tax shelters for corporations. By late 1998 these had literally become front-page news in the US. The cover story in the 14 December 1998 issue of Forbes magazine, for example, described and ranked a number of transactions by US movie standards, from PG-13 to X-rated. For years banks and investment banks had, with the assistance of some major law firms, developed tax-oriented products and transactions, often specifically tailored to the needs of a particular corporate client or directed to a small group of large and highly sophisticated corporations. More recently the large accounting firms had been promoting tax-advantaged techniques to a wider audience as more of a commodity, causing the traditional players to cast a wider net as well. In its 2000 budget proposals the Clinton Administration announced its intention to introduce sweeping new legislation to combat the expanding trade in corporate tax shelters.

The 2000 budget proposals represented a double-barreled approach. As in past legislative proposals, the first approach was to address particular perceived abuses and shut down offensive transactions. A second and novel approach was to introduce a series of general provisions giving the IRS extremely broad powers to tax or penalise both the participants in corporate tax shelters as well as those promoting them. The general provisions are discussed below.

In seeking to combat the perceived abuses of tax-oriented transactions the 2000 budget proposals advanced a number of important new definitions or concepts. A "corporate tax shelter" was to be defined as any entity, plan, or arrangement in which a direct or indirect corporate participant attempted to obtain a tax benefit in a tax avoidance transaction. A "tax benefit" was to include any reduction, exclusion, avoidance, or deferral of tax, or any increased tax refund, that was not clearly contemplated by an applicable provision of the Code. A "tax avoidance transaction" was to include (i) any transaction where the reasonably expected pre-tax profit (determined on a present value basis, after taking into account foreign taxes as expenses and transaction costs) was insignificant relative to the reasonably expected net tax benefits (i.e., the amount by which the transaction's tax benefits exceeded its tax cost, determined on a present value basis), and (ii) certain transactions involving the improper elimination or significant reduction of tax on economic income. And the term "tax indifferent party" was to include foreign persons and entities, tax-exempt organisations, and domestic corporations with expiring loss or credit carryforwards.

These concepts and definitions were to be woven into several new or existing provisions of the Code, some of which are summarised below.

One of the 2000 budget proposals called for the imposition of a 25% excise tax on fees received in connection with the purchase and implementation of, or the rendition of tax advice relating to, corporate tax shelters. This was intended as a direct attack on tax product developers and promoters. Arrangements providing success-based fees or containing elements of insurance against the failure of a technique or transaction (such as make-whole rescission clauses or guarantees of tax benefits) were also targeted. In addition, deductions would have been denied under the 2000 budget proposals for fees paid to the likes of investment bankers and lawyers by taxpayers in connection with tax avoidance transactions, on the principle that such payments do not constitute ordinary and necessary business expenses.

Another excise tax called for under the 2000 budget proposals was to be levied on the maximum payment provided for in any tax benefit protection (guaranteed payment) arrangement. The Treasury's reason for proposing this tax was to impose additional impediments to the purchase, promotion, and sale of corporate tax shelters by removing the benefit of provisions applicable to the transactions in question that effectively insulate purchasers from any meaningful economic risk.

Under Code section 6662 the IRS is authorised to impose certain penalties in cases where taxpayers substantially understate their US income tax, although these penalties can generally be avoided if a taxpayer demonstrates that there was a reasonable cause for the position taken on its tax return and that it acted in good faith. Reasonable cause can typically be established if the taxpayer relies on the advice of a qualified tax adviser or tax attorney. The 2000 budget proposals would have changed these rules for any item attributable to a corporate tax shelter (i) by increasing the penalty applicable to substantial understatements from 20% to 40% (unless the taxpayer disclosed certain details of the transaction in question to the IRS) and (ii) by eliminating the reasonable cause exception. The proposed elimination of the reasonable cause exception was significant as it would have meant that a favourable legal opinion with respect to a transaction would no longer have given protection against the assertion of penalties. The result would have been a 40% no fault penalty against which taxpayers could offer no defence.

The 2000 budget proposals also contained provisions calling for tax indifferent parties associated with corporate tax shelters to be subject to US income tax on any income allocable to them under such transactions, regardless of any statutory, regulatory, or treaty provision to the contrary. For example, tax on income or gain allocable to a non-US person would first have been determined without regard to any exclusion or exception that might ordinarily be applicable, and then any fixed or determinable, annual or periodic income or gain not sourced in the US would - contrary to the normal rules - nevertheless have been treated and subject to US tax as income effectively connected with the conduct of a US trade or business, regardless of its source.

To deal with situations involving a tax indifferent party beyond the reach of the IRS the 2000 budget proposals called for all other participants in any corporate tax shelter to be jointly and severally liable for the tax indifferent party's US tax liability. And, in order to avoid conflicts with tax treaty partners in this connection, the 2000 budget proposals stated that the new rules with respect to tax indifferent parties would not override existing treaty provisions otherwise excluding or exempting the imposition of US tax on foreign persons properly claiming treaty benefits. In other words, the tax on income earned by tax indifferent parties in corporate tax shelter transactions was instead intended to be collected from the US participants in those transactions.

According to another provision focusing on tax indifferent parties, a corporate taxpayer would not, under the 2000 budget proposals, have been able to take any position that the US tax treatment of a transaction differed from the form of the transaction if a tax indifferent party had a direct or indirect interest in the transaction. This rule would not have applied, though, (i) if the corporate taxpayer disclosed the inconsistent position on its tax return filed with the IRS, (ii) if reporting the substance, rather than the form, of the transaction more clearly reflected the taxpayer's income under generally applicable US substance over form principles, or (iii) to certain transactions identified in regulations to be prescribed by the Treasury (such as publicly available securities lending and sale repurchase transactions in which the form of the transaction is widely regarded as controlling for US tax purposes).

The terms included in the 2000 budget proposals raised a number of questions. What was an "insignificant" pre-tax profit? What were "reasonably expected" tax benefits? What was a "clearly contemplated" purpose of the Code? And, ultimately, what was the difference between good tax planning and proscribed tax avoidance? These types of issues are particularly important in financings and other leveraged and cross border transactions in which profits margins are, as an economic matter, often small and any tax benefits can seem comparatively large.

It was argued by many in the US tax community that the concept of corporate tax shelters reflected in the 2000 budget proposals went far beyond the X-rated transactions described in the Forbes article of late 1998. In some instances it was pointed out, the 2000 budget proposals seemed to call into question normal commercial transactions, as illustrated by the following examples:

• Cross Border Loan or Lease. A US financing source, such as a bank, enters into a cross border loan or lease, on which non-US taxes are paid. The profit margin on the transaction is 50 basis points, and the financing source would be out of pocket economically if the non-US taxes were treated as a deduction, rather than as a credit. The transaction also results in meaningful tax benefits.
• Creative Tax Planning. A tax practitioner realises that an existing Code section or Treasury regulation can be turned to a novel use in a transaction, resulting in slightly increased transaction costs but substantial tax savings.
• Cross Border Differences. The US tax law treats a cross border transaction in one way, while a foreign country treats it in another. The difference in characterisation results in overall tax savings to the US party to the transaction.

Opponents of the 2000 budget proposals noted that they would have given the IRS and Treasury far too much discretion in deciding what was a corporate tax shelter. It was also pointed out that, contrary to the normal rules of procedure in tax disputes, the budget proposals would have enabled the IRS and Treasury to take the initiative and presumptively invalidate transactions merely by challenging them on audit, thereby forcing taxpayers to shoulder the burden of proving the absence of a tax shelter. Another widely held view was that the 2000 budget proposals significantly undermined one of the fundamental tenets of US tax law, as described in a celebrated judicial opinion, that "[a]nyone may so arrange his affairs that his taxes shall be left as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one's taxes."

In response to the widespread criticism and commentary that the 2000 budget proposals attracted, both the Treasury and Congress' Joint Committee on Taxation (the JCT) conducted studies and, within less than a month of each other in the summer of 1999, presented reports discussing how to deal with corporate tax shelters. The Treasury's study (commonly referred to as the White Paper) was released on 1 July 1999. It set out a number of observations and ideas, retaining several of the concepts contained in the 2000 budget proposals but toning down and in some cases eliminating the more controversial proposals. In addition, the White Paper signaled a retreat from the attempt to define what constitutes a corporate tax shelter. The Treasury acknowledged that the definition proffered in the 2000 budget proposals was vague and essentially unworkable, and it appealed to Congress to provide a statutory economic substance test in the Code.

Instead, in the White Paper the Treasury proposed a regime under which taxpayers and those promoting and advising on tax-oriented transactions would be required to disclose the details of those transactions, coupled with the introduction of tough penalties and the denial of intended tax benefits in cases of nondisclosure. According to the White Paper the comments received on the 2000 budget proposals demonstrated almost universal recognition that mandatory disclosure would be essential for the IRS to learn of and then target transactions that are too aggressive. The obligation to disclose, it was suggested, should be determined by reference to certain hallmarks that are believed to be common to many corporate tax shelters - in effect, badges of abuse - including excessive advisor and promoter fees, book/tax disparities, and the participation of tax indifferent parties. The Treasury proposed that these would operate as a set of filters for determining when disclosure was required: the existence of a quantum of the hallmarks of shelters would then trigger the reporting requirement.

The goal, it seemed, was to create a culture of forced compliance, where the threat of heavy penalties meant that taxpayers could not afford not to disclose the details of their transactions. The risk of other sanctions was, however, in some instances removed. The White Paper suggested eliminating the 2000 budget proposals to deny deductions for fees paid in connection with corporate tax shelters, together with some of the proposals to impose excise taxes in certain cases. The Treasury acknowledged that these provisions would have proven unduly burdensome for taxpayers and other interested parties, and been difficult to administer.

The JCT report, published on 22 July 1999, contained many significant similarities to the White Paper. It too supported the identification and application of a series of filters. It also focused on the disclosure of transactions, backed up by a stiffer penalty regime, to deter the use of abusive tax shelters. Unlike the Treasury, though, the JCT did not favour the codification of the economic substance concept as a defining characteristic of legitimate transactions and none has been forthcoming from Congress.

The latest development in the corporate tax shelter area came on 28 February 2000, with the Treasury's issuance of temporary regulations establishing a broad network of compliance provisions relating to corporate tax shelters and tax-advantaged financial products that possesses many of the ideas presented in the White Paper. Under the temporary regulations corporate taxpayers must disclose on their US tax returns the tax benefits provided by such products, while the promoters of tax shelters are required to register them with the IRS and maintain customer lists. These regulations are generally effective for transactions entered into after 28 February 2000, although for certain "listed transactions" the effective date may be earlier.

The temporary regulations require corporate taxpayers that enter into any defined "reportable transaction" to file with its US tax return a disclosure statement explaining the transaction and the nature of the tax benefits obtained, and to send a copy of the statement to the IRS. Reportable transactions include certain listed transactions, described below, and other transactions where at least two of the following characteristics are present: (i) the taxpayer participated in the transaction under conditions of confidentiality, (ii) the taxpayer obtained protection against loss of the intended tax benefits, (iii) the promoter of the transaction received fees exceeding $100,000, (iv) the expected difference between US taxable income and book income resulting from the transaction exceeds $5 million for any taxable year, (v) the taxpayer knows or has reason to know that the transaction generates tax benefits because another party to the transaction is in a different tax position (e.g., that other party is a tax indifferent party, as defined in the 2000 budget proposals), and (vi) a party to the transaction will receive a different tax treatment outside the US.

Transactions are generally not subject to the disclosure requirements unless they will generate more than $5 million of tax benefits in any taxable year or $10 million for any combination of years. For listed transactions, these limits are reduced to $1 million and $2 million, respectively. Certain other narrow exceptions are provided. For example, it is not necessary to disclose to the IRS the details of any transaction that is entered into in the ordinary course of business in a form which is consistent with customary commercial practice. Another exclusion applies where the IRS would have no reasonable basis for denying any significant portion of the intended US income tax benefits. In no instance can these exceptions apply to listed transactions.

The listed transactions are set forth in separate Treasury guidance and may be supplemented from time-to-time. The initial list includes lease strips, lease-in-lease-out (LILO) transactions, and transactions in which the expected foreign tax credits far outweigh the expected economic profit. The disclosure regulation applies to all listed transactions that have not been reported on a tax return filed with the IRS on or before the 28 February 2000 release dat of the temporary regulations. The disclosure regulation would therefore apply to any listed transaction entered into in 1999 if it has not yet been reported on a US tax return.

The temporary regulations also require confidential corporate tax shelters to be registered with the IRS by their promoters or others in certain cases. The registration regulation applies to any corporate tax shelter that is offered to participants under conditions of confidentiality, where the promoter receives fees of more than $100,000 in aggregate, and where either (i) the transaction is a listed transaction (as described above), (ii) the expected pre-tax profits of one or more parties to the transaction are insignificant relative to the present value of the tax benefits resulting from the transaction, or (iii) the transaction has been structured to produce US income tax benefits that are an important part of the transaction's intended results and the promoter reasonably expects to offer the product in question to more than one party. The registration regulation provides narrow exceptions for transactions that are consistent with customary commercial practice or where the IRS has no reasonable basis to challenge the intended tax treatment; these parallel the similar exceptions to the disclosure requirement. In addition, a promoter may seek to obtain an IRS ruling exempting a transaction from registration.

Promoters of certain tax shelters must also maintain customer lists, including the name, taxpayer identification number, and other information (including a description of expected tax benefits and copies of written materials) for each person to whom a promoter (or a related person) sells an interest in a tax shelter. The same information must also be maintained with respect to any person whom a promoter knows or should know has acquired an interest in a tax shelter, including transferees of persons who purchased interests from the promoter (or a related person). The definition of a tax shelter for this purpose is based on the same criteria that apply under the registration regulation, except that the confidentiality and $100,000 fee requirements are excluded, so that a wider range of transactions are subject to the customer list requirement.

1A foreign entity formed before 1 January 1997 and on the list of per se corporations is generally classified as a corporation for US federal tax purposes unless it qualifies for another status under detailed "grandfathering" provisions contained in the regulations.

2According to the regulations an owner of a foreign eligible entity has limited liability only if it has no personal liability whatsoever for the debts of or claims against the entity as a result of its ownership interest. If any creditor may seek satisfaction of all or any portion of the entity's debts or claims on the basis of that ownership interest (as opposed, for example, to a pledge or guarantee) the owner has personal liability.

3Other specified circumstances in which the general five-year restriction on subsequent elections does not apply include those involving foreign check the box entities acquired by US multinational groups.

4A CFC is any foreign corporation in which one or more US shareholders own more than 50% of the total combined voting power of the corporation's voting shares or more than 50% of the total value of all classes of the corporation's shares. For this purpose, a US shareholder is any person (including a corporation) owning at least 10% of the total combined voting power of all classes of the corporation's voting shares.

5For example, if the losses were used to offset the income of certain affiliates in the non-US entity's home country, the US dual consolidated loss rules would generally prohibit those losses from being offset against the income of other members of the US person's consolidated group (generally affiliates with at least 80% common ownership).

6The entity's previously deducted losses would, however, generally be subject to recapture (i.e., resourcing as derived in the US) at that point.

7The foreign tax credit limitation, which sets a ceiling on the amount of foreign tax credits available to a US taxpayer in any given year, is equal to the total amount of US tax paid by the taxpayer multiplied by a fraction, the numerator of which is the taxpayer's foreign source income determined under US tax principles and the denominator of which is its total taxable income.

8UKS2's dividend to UKS1 would not be subject to current tax in the US on the basis of an exception -- the "same country exception" -- that applies and excludes certain items, including dividends, that would otherwise be currently taxable in the US under Subpart F when those items are paid between CFCs which are incorporated and operating in the same jurisdiction.