Treasury and IRS Issue Guidance Related to the Foreign Tax Credit

The information in BDO alerts is dependent on tax policies at the time they are published. The subject matter of this alert has since been updated. To find the latest information on this topic, read Eagerly Anticipated Proposed FDII Regulations Provide Taxpayers with Guidance.

Summary

On November 28, 2018, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) issued proposed regulations (the Proposed Regulations) that provide guidance relating to the determination of the foreign tax credit. The guidance relates to changes made to the applicable law by the 2017 tax reform, also known as the Tax Cuts and Jobs Act (TCJA), which was enacted on December 22, 2017, as well as other proposed changes to current regulations.  The Proposed Regulations and the preamble thereto discuss and/or address the following areas:

• Allocations and apportionment of deductions and the calculations of taxable income for purposes of Section 904(a)
  • Changes and clarifications to the definitions of exempt income and exempt assets
  • Allocation and apportionment of foreign taxes, the Section 250 deduction, and a distributive share of partnership deductions
  • A special rule for partnership loans
  • A revision to the CFC netting rule relating to hybrid debt
  • Valuation of assets for purposes of apportioning interest expense and other deductions (including the repeal of the fair market value method and transitional relief, clarifications of rules for adjusting stock basis in nonqualified 10-percent owned corporations for E&P, and the determination of stock basis in connection with Section 965(b))
  • Characterization of stock of certain foreign corporations under Reg. § 1.861-12 (including characterization of CFC stock to account for Section 951A category, treaty categories, and Section 904(b)(4), and treatment of gross tested income for tiers of CFCs)
  • Allocation and apportionment of R&E expenditures (limited guidance)
  • Section 904(b)(4) (including the effect of Section 904(b)(4) on the foreign tax credit limitation, income other than the amounts included under Section 951(a)(1) or Section 951A(a), expenses property allocable to dividend income, expenses property allocable to stock and coordination with the overall foreign losses (OFLs) and overall domestic losses (ODL) rules)
• The foreign tax credit limitation under Section 904
  • Transition rules in Prop. Regs.  §§ 1.904-2(j) and 1.904(f)-12(j) accounting for the increase in Section 904(d)(1) separate categories (including carryovers and carrybacks in Section 904(d)(1) separate categories and separate limitation losses (SLL), OFLs, and ODLs)
  • Separate categories of income (including the treatment of export financing interest, high taxed income, and financial services income, foreign branch category income, Section 951A category income, and items resourced under a treaty)
  • Noncontrolled 10-percent foreign corporations
  • Look-through rules
  • Allocation and apportionment of foreign taxes (including a special rule for base and timing differences, taxes imposed in connection with foreign branches, taxes deemed paid under Section 960 and creditable foreign tax expenditures)
• The treatment of subsequent reductions in tax in applying Section 954(b)(4)
• Deemed paid taxes under new Section 960 and new Section 78
  • Computational and grouping rules for purposes of calculating taxes deemed paid under Section 960 (including current year taxes, computational rules, and associating current year taxes with income groups)
  • Taxes deemed paid under Section 960(a) and (d) for subpart F inclusions and Section 951A inclusion amounts
  • Taxes deemed paid under Section 960(b) with respect to Section 959 distributions  (including previously taxed E&P (PTEP) groups in annual PTEP accounts and associated taxes, associating foreign income taxes with PTEP groups, and computational rules)
  • Rules relating to domestic partnerships
  • Rules relating to the Section 78 gross up
• Rules relating to the Section 965(n) election

These Proposed Regulations significantly overhaul the rules relating to calculating the foreign tax credit.  This alert discusses selected items relating to these changes. 

 

Details

Allocation of Expenses to the Global Intangible Low Taxed Income (GILTI) Basket

The Proposed Regulations generally apply the existing approach of the expense allocation rules to determine taxable income in the Section 951A^[1] category, as well as the new foreign branch category described in Section 904(d)(1)(B).^[2] However, the Proposed Regulations provide for exempt income and exempt asset treatment with respect to income in the Section 951A category that is offset by the deduction allowed under Section 250(a)(1)^[3] for inclusions under Section 951A(a) and a corresponding percentage of the stock of controlled foreign corporations (CFCs) that generates such income. This will generally have the effect of reducing the amount of expenses apportioned to the Section 951A category and thus potentially increasing the taxpayer’s foreign tax credit limitation in the Section 951A category.^[4]
 
The Proposed Regulations include rules for allocating and apportioning the Section 250 deduction. For these purposes, although the Section 250 deduction is a single deduction that equals the sum of the amounts specified in Section 250(a)(1)(A) and (B), the Proposed Regulations provide separate rules with respect to (i) the portion of the Section 250 deduction for FDII and (ii) the portion of the Section 250 deduction for the GILTI inclusion and the amount of the Section 78 gross up attributable to foreign taxes deemed paid with respect to the GILTI inclusion. The amount of each portion of the Section 250 deduction to be allocated and apportioned takes into account any reductions required under Section 250(a)(2)(B).^[5]

 

Repeal of the Fair Market Value Method for Apportioning Interest

As part of the TCJA, the fair market value method for apportioning interest was repealed for tax years beginning after December 31, 2017, and taxpayers using the fair market value method must switch to the tax book or alternative tax book value method for purposes of apportioning interest expense for the taxpayer’s first tax year beginning after December 31, 2017. Prop. Reg. §§1.861-8(c)(2) and 1.861-9(i)(2) provide that the Commissioner’s approval is not required for this change.
 
In light of the numerous amendments to the foreign tax credit rules made by the TCJA, the Proposed Regulations provide a one-time exception to the five-year binding election period to use either the sales or gross income method of apportionment with regards to research and experimental expenditures. Accordingly, under Prop. Reg. §1.861-17(e)(3), even if a taxpayer is subject to the binding election period, for the taxpayer’s first tax year beginning after December 31, 2017, the taxpayer may change its apportionment method without obtaining the Commissioner’s consent. This one-time change of method constitutes a binding election to use the method chosen for that year and for the next four taxable years.

 

Transition Rules

The Proposed Regulations also contain certain transition rules relating to the carryover and carryback of unused foreign taxes under Section 904(c).  Prop. Reg. §1.904-2(j)(1)(ii) provides that if unused foreign taxes paid or accrued or deemed paid with respect to a separate category of income are carried forward to a tax year beginning after December 31, 2017, those taxes are allocated to the same post-2017 separate category as the pre-2018 separate category from which the unused foreign taxes are carried. However, Prop. Reg. §1.904-2(j)(1)(iii) provides an exception that permits taxpayers to assign unused foreign taxes in the pre-2018 separate category for general category income to the post-2017 separate category for foreign branch category income, to the extent they would have been assigned to that separate category if the taxes had been paid or accrued in a post-2017 taxable year. Any remaining unused taxes are assigned to the post-2017 separate category for general category income.
 
The Proposed Regulations require taxpayers applying the exception in Prop. Reg. §1.904-2(j)(1)(iii) to analyze general category income earned in prior years in order to determine the extent to which the income would have been foreign branch category income under the rules described in Prop. Reg. §1.904-4(f). Unused foreign taxes in the general category arising in those prior years are then allocated and apportioned under Reg. §1.904-6 between the general category and the foreign branch category. This analysis does not require applying any other post-Act provisions to prior years (for example, the new expense allocation rules described in the Proposed Regulations would not be relevant to the analysis).
 
Additionally, Prop. Reg. §1.904-2(j)(2)(ii) and (iii) provides that any unused foreign taxes with respect to general category income or foreign branch category income in a post-2017 taxable year that are carried back to a pre-2018 taxable year are allocated to the pre-2018 separate category for general category income, and any excess foreign taxes with respect to passive category income or income in a specified separate category in a post-2017 taxable year that are carried back to a pre-2018 taxable year are allocated to the same pre-2018 separate category. No rule is included with respect to the post-2017 separate category for Section 951A category income (including a separate category for a GILTI inclusion that is resourced under a tax treaty), because carrybacks are not allowed for unused foreign taxes in that separate category.
 
Similar to the transition rules for carryovers and carrybacks of unused foreign taxes, the Proposed Regulations provide transition rules for recapture in a post-2017 taxable year of an OFL or SLL in a pre-2018 separate category that offset U.S. source income or income in another pre-2018 separate category, respectively, in a pre-2018 taxable year, as well as for recapture of an ODL that offset income in a pre-2018 separate category in a pre-2018 taxable year.
 
Prop. Reg. §1.904(f)-12(j) provides that any SLL or OFL accounts in the pre-2018 separate category for passive category income or income in a specified separate category remain in the same post-2017 separate category. Any SLL or OFL account in the pre-2018 separate category for general category income is allocated between the post-2017 separate categories for general category income and foreign branch category income in the same proportion that any unused foreign taxes with respect to the pre-2018 separate category for general category income are allocated to those post-2017 separate categories. Therefore, in the case of a taxpayer that does not apply the exception described in Prop. Reg. §1.904-2(j)(1)(iii), all of its SLL or OFL accounts in the pre-2018 separate category for general category income remain in the general category. In addition, if there were no unused foreign taxes in the pre-2018 general category to be allocated, Prop. Reg. §1.904(f)-12(j)(3)(i) provides that all SLL or OFL accounts in the pre-2018 separate category for general category income remain in the general category. Similar rules are provided with respect to the recapture of SLLs or ODLs that reduced income in a separate category in a pre-2018 taxable year, as well as for foreign losses that are part of a net operating loss that is incurred in a pre-2018 taxable year and carried forward to post-2017 taxable years.
 
Given the expansion of categories under Section 904(d)(1) to include foreign branch category and Section 951A category income, and the fact that Section 904(d)(2)(B)(iii) only provides that export financing interest and high-taxed income are not passive income, the Proposed Regulations provide that export financing interest and high-taxed income should be categorized based on whether the income otherwise meets the definition of foreign branch category income, Section 951A category income, or general category income. Therefore, the Proposed Regulations revise Reg. §1.904-4(c) and (h)(2) to provide that export financing interest and high-taxed income are assigned to separate categories other than passive category income based on the general rules in Reg. §1.904-4.
 
To coordinate the high-taxed income rules of Section 904(d)(2)(F) with the new rules for computing foreign income taxes deemed paid under Section 960, the Proposed Regulations revise the grouping rules of Prop. Reg. §1.904-4(c)(4) to group passive category income from dividends, subpart F and GILTI inclusions from each foreign corporation, and passive category income derived from each foreign qualified business unit (QBU), under the grouping rules in Prop. Reg. §1.904-4(c)(3) rather than by reference to the source of the corporation’s or QBU’s income.
 
Both before and after the TCJA, Section 904(d)(2)(C)(i) provides that certain financial services income is treated as general category income. However, the TCJA’s addition of foreign branch category and Section 951A category income, which are new and more specific categories, take precedence over the treatment of financial services income as general category income. Therefore, the Proposed Regulations provide that any financial services income not treated as foreign branch category income or Section 951A category income is generally treated as general category income.^[6]

 

Foreign Branch Category Income

The Proposed Regulations provide detailed guidance on the foreign branch category. Specifically, Prop. Reg. §1.904-4(f)(1)(i) provides that foreign branch category income means the gross income of a United States person (other than a pass-through entity) that is attributable to foreign branches held directly or indirectly through disregarded entities by the United States person. Foreign branch category income also includes a United States person’s (other than a pass-through entity) distributive share of partnership income that is attributable to a foreign branch held by the partnership directly or indirectly through another partnership or other pass-through entity. Similar principles apply for income of any other type of pass-through entity that is attributable to a foreign branch. All the income described is aggregated in a single foreign branch category; there are not separate categories for each foreign branch.
 
In general, gross income is attributable to a foreign branch to the extent it is reflected on a foreign branch’s separate set of books and records. For this purpose, items of gross income must be adjusted to conform to federal income tax principles. In addition, the Proposed Regulations provide several rules adjusting the gross income attributable to a foreign branch from what is reflected on the foreign branch’s separate set of books and records.
 
First, the Proposed Regulations provide that gross income attributable to a foreign branch does not include items arising from activities carried out in the United States.
 
Second, the Proposed Regulations provide that gross income attributable to a foreign branch does not include items of gross income arising from stock, including dividend income, income included under Section 951(a)(1), 951A(a), or 1293(a) or gain from the disposition of stock. An exception is provided for gain from the disposition of stock, where the stock would be dealer property.
 
Third, the Proposed Regulations provide that foreign branch category income does not include gain realized by a foreign branch owner on the disposition of an interest in a disregarded entity or an interest in a partnership or other pass-through entity. However, an exception is provided for the sale of a partnership interest if the gain is reflected on the books and records of a foreign branch and the interest is held in the ordinary course of the foreign branch owner’s trade or business.
 
Fourth, the Proposed Regulations provide anti-abuse rules relating to the reflection of income on the books and records of a branch. The preamble to the Proposed Regulations notes that Treasury is concerned that in certain cases gross income items could be inappropriately recorded on the books and records of a foreign branch or a foreign branch owner. Therefore, the Proposed Regulations include an anti-abuse rule providing for the reattribution of gross income if a principal purpose of recording, or failing to record, an item on the books and records of a foreign branch is the avoidance of federal income tax or avoiding the purposes of Section 904 or Section 250. The rule further provides a presumption that interest income received by a foreign branch from a related party is not gross income attributable to the foreign branch unless the interest income meets the definition of financial services income.
 
Finally, the Proposed Regulations provide that gross income attributable to a foreign branch that is not passive category income must be adjusted to reflect certain transactions that are disregarded for federal income tax purposes. This rule applies to transactions between a foreign branch and its foreign branch owner, as well as transactions between or among foreign branches, involving payments that would be deductible or capitalized if the payment were regarded for federal income tax purposes. For example, a payment made by a foreign branch to its foreign branch owner may, to the extent allocable to non-passive category income, result in a downward adjustment to the gross income attributable to the foreign branch and an increase in the general category gross income of the United States person. Each payment in a series of disregarded back-to-back payments, for example, a payment from one foreign branch to another foreign branch followed by a payment to the foreign branch owner, must be accounted for separately under these rules.
 
The Proposed Regulations do not treat disregarded transactions as “regarded” for federal income tax purposes; rather, they provide that certain disregarded transactions result in a redetermination of whether gross income of the United States person is attributable to its foreign branch or to the foreign branch owner. Thus, while disregarded transactions may allocate income between the foreign branch category and the general category, those transactions have no effect on the amount, character, or source of a United States person’s gross income. U.S. source gross income that is reallocated from the general category to the foreign branch category and that is properly subject to foreign tax may be eligible to be treated as foreign source income under the terms of an income tax treaty, in which case the resourced income would be subject to a separate foreign tax credit limitation for income resourced under a tax treaty.
 
The Proposed Regulations provide an exception from the special rules regarding disregarded transactions that applies to contributions, remittances, and payments of (including certain interest equivalents). Generally, contributions, remittances, and interest payments to or from a foreign branch reflect a shift of, or return on, capital rather than a payment for goods and services. However, the different treatment of contributions and remittances, on the one hand, and other disregarded transactions, on the other, could allow for non-economic reallocations of the amount of gross income attributable to the foreign branch category. To prevent this in connection with certain transactions, the Proposed Regulations require the amount of gross income attributable to a foreign branch (and the amount attributable to the foreign branch owner) to be adjusted to account for consideration that would be due in any disregarded transactions in which property described in Section 367(d)(4) is transferred to or from a foreign branch if the transactions were regarded, whether or not a disregarded payment is made in connection with the transfer. The Proposed Regulations further require that the amount of any adjustment under the disregarded payment provisions must be determined under the arm’s length-principle of Section 482 and the regulations under that section.
 
Therefore, the Proposed Regulations provide that the rules for allocating and apportioning deductions in Regs. §§1.861-8 through 1.861-17 that apply with respect to the other separate categories also apply to the foreign branch category.
 
The Proposed Regulations define a foreign branch by reference to the regulations under Section 989 (Section 989 regulations) by providing that a foreign branch is a QBU described in Reg. §1.989(a)-1(b)(2)(ii) and (b)(3) that carries on a trade or business outside the United States. In general, Reg. §1.989(a)-1(b)(2)(ii) provides rules for treating activities of a branch of a taxpayer as a QBU. Specifically, it provides that the activities of a corporation, partnership, trust, estate, or individual qualify as a separate QBU if the activities constitute a trade or business, and a separate set of books and records is maintained with respect to the activities. Reg. 1.989(a)-1(b)(3) includes a special rule treating activities generating income effectively connected with the conduct of a trade or business as a separate QBU.
 
In order to ensure that foreign branch category income does not include income reflected on the books and records of a QBU unless the QBU conducts a trade or business, the Proposed Regulations’ definition of foreign branch does not incorporate the Section 989 regulations’ per se QBU rules, and instead requires that a foreign branch carry on a trade or business. In addition, the Proposed Regulations include a special rule, as illustrated by an example, providing that a foreign branch may consist of activities conducted through a partnership or trust that constitute a trade or business conducted outside the United States, but for which no separate set of books and records is maintained.
 
The Proposed Regulations also modify the trade or business requirements in the Section 989 regulations for purposes of the foreign branch definition. Specifically, to constitute a foreign branch, a QBU must carry on a trade or business outside the United States. For this purpose, activities that constitute a permanent establishment in a foreign country under a bilateral U.S. tax treaty, whether or not the activities also rise to the level of a separate trade or business, are presumed to constitute a trade or business.
 
Additionally, the Proposed Regulations provide that, for purposes of determining whether a set of activities satisfy the trade or business requirement of Reg. §1.989(a)-1(c) in the context of the definition of a foreign branch, activities that relate to disregarded transactions are taken into account and may give rise to a trade or business for this purpose.

 

Section 78 Gross up and Section 986(c) Gain or Loss

Prop. Reg. §1.904-4(o) provides a rule consistent with existing Reg. §1.904-6(b)(3) that assigns the Section 78 gross up to the same separate category as the deemed paid taxes. Also, Prop. Reg. §1.904-4(p) provides a rule assigning gain or loss under Section 986(c) with respect to a distribution of previously taxed earnings and profits to the separate category from which the distribution was made.

 

Look-Through Rules

The Proposed Regulations provide that the look-through rules under Section 904(d)(3) provide look-through treatment solely for payments allocable to the passive category. Any other payments described in Section 904(d)(3) are assigned to a separate category other than the passive category based on the general rules in §1.904-4. Therefore, Prop. Reg. §1.904-5 revises the various look-through rules to reflect the application of look-through rules solely with respect to payments allocable to passive category income. Dividends, interest, rents, or royalties paid from a CFC to a U.S. shareholder thus are not assigned to a separate category (other than the passive category) under the look-through rules, but are assigned to the foreign branch category, a specified separate category described in Prop Reg. §1.904-4(m), or the general category under the rules of Prop. Reg. §1.904-4(d). Prop. Reg. §1.904-5(c)(6) provides that GILTI inclusions are treated as passive category income to the extent the amount so included is attributable to income received or accrued by the CFC that is passive category income.
 
Section 904(d)(3)(B) assigns amounts included under Section 951(a)(1)(A) (subpart F inclusions) to the passive category to the extent the inclusion is attributable to passive category income. The Proposed Regulations treat GILTI inclusions in the same manner as subpart F inclusions for purposes of Section 904(d)(3)(B). Therefore, Prop. Reg.  §1.904-5(c)(6) provides that GILTI inclusions are treated as passive category income to the extent the amount so included is attributable to income received or accrued by the CFC that is passive category income.
 
The look-through rules also do not apply to treat deductible payments made by a foreign branch that are allocable to foreign branch category income as foreign branch category income. Instead, the rules of Prop. Reg. §1.904-4 apply to characterize the income in the hands of the recipient.
 
Finally, the Proposed Regulations include a rule addressing income subject to the separate category required under Section 901(j)(1)(B). These rules ensure that income from sources within countries described in Section 901(j)(2) that is paid or accrued through one or more entities retains its source and therefore continues to be subject to the separate category described in Section 901(j)(1)(B).

 

GILTI Inclusion and Section 960(c)

The Proposed Regulations treat a GILTI inclusion amount as a subpart F inclusion for purposes of Section 960(c).^[7] Therefore, the Proposed Regulations modify §§1.960-4 and 1.960-5 to reflect the additional application of Section 960(c) to GILTI inclusion amounts.

 

Deemed Paid Taxes and Accrual

Foreign income taxes calculated on the basis of net income accrue in the U.S. taxable year of the CFC with or within which its foreign taxable year ends, and are eligible to be deemed paid in the taxable year of the U.S. shareholder with or within which the U.S. taxable year of the CFC ends, even if a portion of the foreign taxable year of the CFC falls within an earlier or later U.S. taxable year of the CFC or its U.S. shareholder. Current year taxes of a CFC that are imposed on an amount under foreign law that would be income under U.S. law in a different taxable year are eligible to be deemed paid in the year in which the foreign tax accrues, and not in the earlier or later year when the related income is recognized for U.S. tax purposes. The current taxable year of the CFC is its U.S. taxable year for which a domestic corporation that is a U.S. shareholder of the CFC has a subpart F or GILTI inclusion with respect to the CFC, or during which the CFC receives a Section 959(b) distribution or makes a Section 959(a) distribution or a Section 959(b) distribution.

 

No Deemed Paid Taxes for Section 951(a)(1)(B) (Section 956) Inclusions

Prop. Reg. §1.960-2(b)(1) provides that no foreign income taxes are deemed paid under Section 960(a) with respect to an inclusion under Section 951(a)(1)(B).^[8]

 

Section 78 Gross Up and the Interaction with Section 245A

Certain fiscal year taxpayers may have taken or may have been considering taking the position that Section 78 dividends that relate to taxable years of foreign corporations that begin before January 1, 2018, were eligible for the Section 245A dividends received deduction. The Proposed Regulations provide that these Section 78 dividends are not treated as dividends for purposes of Section 245A. Accordingly, Prop. Reg. §1.78-1(c) includes a special applicability date to prevent this potential disparate treatment and double benefit to taxpayers with fiscal year CFCs.
 
See the Proposed Regulations for further details on these rules including the applicability dates.

 

BDO Insights

The Proposed Regulations are extremely complex and address various technical issues including expense apportionment which generally follow what many tax practitioners were anticipating. BDO can assist clients with understanding and applying these complex rules.