United States: IRS Issues Regulations Limiting Creditability Of Foreign Income Taxes Following Covered Asset Acquisitions

On Dec. 6, 2016, the IRS and Treasury issued temporary (T.D. 9800) and proposed (REG-129128-14) regulations under Section 901(m). The new guidance addresses the creditability of foreign income taxes following certain transactions that are considered "covered asset acquisitions," as described below.  

Section 901(m) was enacted in 2010 and limits taxpayers' ability to claim foreign tax credits associated with "covered asset acquisitions." Generally, a covered asset acquisition is a transaction that is treated as an asset acquisition for U.S. federal income tax purposes, but is either treated as a stock acquisition or is disregarded for foreign income tax purposes. These types of transactions may result in an increase in tax basis for U.S. federal income tax purposes, but not for foreign tax purposes. The resulting basis differences may generate deductions (e.g., amortization or deprecation) for U.S. federal income tax purposes that exceed those afforded for foreign tax purposes. The result of this basis difference is often a higher income tax base and higher taxes paid for foreign tax purposes, and thus excess foreign tax credits on income that may never be recognized for U.S. federal tax purposes.

Section 901(m)(1) provides that, in the case of a covered asset acquisition, the disqualified portion of any foreign income tax determined with respect to the income or gain attributable to certain foreign assets will not be taken into account in determining the foreign tax credit allowed under various provisions of the tax code. Instead, the disqualified portion of any foreign income tax is permitted only as a deduction. Section 901(m)(3)(A) provides that the term "disqualified portion" means, with respect to any covered asset acquisition, the ratio of (i) the aggregate basis differences allocable to such taxable year, divided by (ii) the income on which the foreign income tax is determined.  

In July 2014, the government issued Notices 2014-44 and 2014-45 announcing that Treasury will issue regulations addressing the application of Section 901(m) to certain dispositions of assets following covered asset acquisitions. The notices were issued in response to certain taxpayers engaging in transactions shortly after a covered asset acquisitions with the intention of invoking the application of the statutory disposition rule under Section 901(m)(3)(B)(ii) to avoid the purposes of Section 901(m).

The temporary regulations recently issued implement these notices and provide guidance specifically excluding withholding taxes from the scope of Section 901(m). The preamble to the temporary regulations provides that a withholding tax should not be subject to disallowance under Section 901(m) because a withholding tax is a gross basis tax that is generally unaffected by changes in asset basis.  The exclusion of withholding tax represents a welcome clarification from the IRS.

As the temporary regulations relate back to the issuance of Notices 2014-44 and 2014-45, they generally apply to covered asset acquisitions occurring on or after July 21, 2014, and to covered asset acquisitions occurring before that date resulting from an entity classification election that is filed on or after July 29, 2014, and that is effective on or before July 21, 2014. The temporary regulations also apply to certain covered asset acquisitions occurring on or after Jan. 1, 2011, and before July 21, 2014 under certain transition period rules.

The proposed regulations provide much needed guidance for computing the disqualified portion of foreign income taxes under Section 901(m) and also provide several anti-abuse rules. The proposed regulations set forth numerous definitions and complex operating rules and introduce three new categories of transactions that will be treated as covered asset acquisitions and therefore be subject to Section 901(m). The three new categories of transactions consist of:

  • Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as an acquisition of assets for purposes of U.S. income tax and as the acquisition of an interest in a fiscally transparent entity for purposes of a foreign income tax
  • Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as a partnership distribution that causes either the U.S. basis of the partnership's remaining assets or distributed assets to be adjusted without a corresponding increase in the foreign basis of such assets
  • Any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as an acquisition of assets for purposes of both U.S. income tax and a foreign income tax, provided the transaction results in an increase in the U.S. basis without a corresponding increase in the foreign basis of one or more assets.

Other notable guidance in the proposed regulations include:

  • Simplification of statutory rules regarding the computation of disallowed taxes by allowing combined income taxes, thus avoiding the administrative and compliance burdens that would result from a requirement to trace amounts of income and identify the portion of foreign income taxes imposed on that income
  • Addition of de minimis rules under which certain basis differences are not taken into account for purposes of Section 901(m)
  • Addition of the "foreign basis election," pursuant to which the basis difference is equal to the U.S. basis in the relevant foreign asset less the foreign basis in the relevant foreign asset immediately after the covered asset acquisition (i.e., prevents the need for recomputing U.S. tax basis immediately prior to the covered asset acquisition on acquired assets).

These proposed regulations will apply to covered asset acquisitions occurring on or after the date of publication of the regulations adopting these rules as final regulations in the Federal Register. Taxpayers may, however, rely on the proposed regulations prior to the date the regulations are applicable provided that they are consistently applied.

The proposed regulations provide a substantial amount of clarity with regard to the calculations required under Section 901(m). However, with the additional clarity comes additional complexity. Taxpayers should be aware of the implications of making acquisitions subject to the rules under Section 901(m), and perform a thorough review to ensure the rules are being applied appropriately.  

Read Grant Thornton LLP's previous coverage on Notice 2014-44 here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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