On December 2, 2019, Treasury and the IRS released final and proposed regulations on the foreign tax credit. As expected, the final regulations finalize the 2018 proposed regulations relating mainly to the Tax Cuts and Jobs Act (TCJA) statutory changes and expense apportionment. (For a discussion of the 2018 proposed regulations, see our December 2018 article.) They also finalize the 2012 proposed regulations relating to overall foreign losses (OFLs) and separate limitation losses (SLLs) and portions of the expired 2007 temporary regulations relating to foreign tax credit redeterminations under § 905(c). The final regulations largely mirror the various proposed rules, with few significant changes.
The new proposed regulations, on the other hand, would make significant changes to existing regulatory rules, including new rules for the allocation and apportionment of R&E and stewardship expenses, and for assigning foreign income taxes to different income groups for various purposes. These rules will take on increased importance in the post TCJA tax environment. Treasury and the IRS also reproposed regulations on foreign tax redeterminations relating to foreign taxes paid by a foreign corporation, and certain other provisions from the 2007 temporary regulations. These rules will also be very important, given the repeal of § 902 and the elimination of pooling.
Treasury and the IRS have adopted aggressive effective dates for both the final and proposed rules. Many of the new proposed regulations are proposed to be effective for taxable years "ending on or after" December 17, 2019, the date they were published in the Federal Register. Thus, they would apply retroactively to all of 2019 for calendar year taxpayers. U.S. multinationals will need to consider the impact of the proposed regulations, as well as the final regulations, in preparing their 2019 year-end financial statements.
Allocation and Apportionment of Expenses
Allocating Expenses to the GILTI Basket
The final regulations adopt the proposed expense allocation rules without significant changes. In particular, the final regulations retain the rule that expenses must be allocated and apportioned to the GILTI basket, including the special rules for interest expense apportionment that (i) characterize CFC stock that produces GILTI as a partially exempt asset, and (ii) create a separate § 245A subgroup within each § 904(d) basket to allow for adjustments to the § 904 formula under § 1.904(b)-3.
Allocation of R&E Expense
The proposed regulations provide much-awaited guidance on the allocation and apportionment of R&E expense. The guidance takes the form of a wholesale revision of § 1.861-17 to fit the new post-TCJA tax environment.
The proposed regulations would repeal the optional gross income method of R&E expense apportionment, and require all taxpayers to use the sales method of apportionment. The existing 50 percent exclusive apportionment to the geographic location of R&D would remain in place, but the rules would clarify that the exclusive apportionment only applies for foreign tax credit limitation purposes. For other purposes, such as FDII, R&E expense would be apportioned based on the relevant sales alone. The special rules for legally mandated R&D and an increased exclusive apportionment (i.e., more than 50 percent) would both be eliminated.
Importantly, the proposed regulations introduce the concept of "gross intangible income"—defined as income from the sale or license of intangible property by the U.S. taxpayer—as the class of gross income to which R&E expense is allocated. GILTI and Subpart F income are specifically excluded from gross intangible income. Therefore, R&E expense will typically be allocated to the U.S. group's product sales (or services), which typically will produce U.S. source income. If the U.S. group licenses intangible property to its CFCs, R&E expense will typically also be allocated to the CFCs' products sales, which will typically produce foreign source general basket income. Thus, under the proposed rules, R&E expense will not be allocated against the GILTI basket. The theory behind this rule is that CFCs are obligated to pay arm's length royalties for the use of the U.S. parent's intangibles, and any net GILTI generated by a CFC after paying for the intangibles does not arise from the parent's R&D. Compare CCA 200243020 (July 16, 2002, addressing an analogous issue under the current regulations).
Under the sales method, the taxpayer is required to identify the related-party or unrelated party's revenue from the licensed product for apportionment purposes. In the case of a related CFC, the relevant sales are all of the CFC's sales in the product category. In the case of an unrelated party licensee, the taxpayer must use the licensee's actual sales of the product or make a reasonable estimate using the information available. Economic analysis under § 482 "must" be used in the case of products that are incorporated as components. As in the current regulations, one of the examples illustrates a case where the actual component sales are unknown, but a reasonable estimate, using § 482 principles, is 10 times the taxpayer's royalty. See proposed § 1.861-17(g), Example 4.
As under the current regulations, research activity that is covered by a cost-sharing arrangement under § 1.482-7 is not subject to the R&E allocation rules.
Allocation of Stewardship Expenses; Legal Damages and Settlements; NOLs
Stewardship expenses are associated with duplicative or shareholder activities of the U.S. parent, including costs associated with being a publicly traded company. Historically, these expenses were allocated for foreign tax credit purposes to dividend income from subsidiaries.
The preamble notes that taxpayers may be "taking the position" under the current regulations that dividends to which stewardship expenses are allocated do not include Subpart F or GILTI inclusions or the related § 78 gross-ups. The proposed regulations would provide that stewardship expenses are allocated to the class of gross income that includes these inclusions as well as actual dividends. Stewardship expenses would be apportioned using the same asset method as applies for interest expense. As with interest expense, the value of CFC stock would be measured using the tax book value method. Adjustments would be made for the 50 percent value of stock used to produce GILTI that is offset by a § 250 deduction.
U.S. parent companies typically file consolidated returns with their U.S. subsidiaries, and members of a consolidated group are treated as a single taxpayer for purposes of many of the expense allocation rules, including the new stewardship rules. Some commentators have speculated that stewardship expenses therefore must be allocated solely to the U.S. group's foreign source income from CFC stock. (The parent may have no U.S. subsidiary stock, because the U.S. group is treated as a single taxpayer.) That would be an unreasonable result. The expense allocation rules must reasonably reflect the factual relationship between expenses and income generating activities. The proportion of stewardship expenses allocated and apportioned to foreign source income should reasonably reflect the proportion of the stewardship activity that relates to that income. In this regard, if the U.S. group is treated as a single taxpayer, then "duplicative" expenses incurred on behalf of members of the group are not really duplicative—they are incurred for the benefit of the single taxpayer itself and should be apportioned under the supportive activities rule or another rule.
The preamble acknowledges that stewardship expenses are often difficult to distinguish from supportive expenses, which are allocated and apportioned under a different rule. For example, the preamble states, day-to-day management activities do not give rise to stewardship expenses and are typically more supportive in nature. Treasury and the IRS request comments on the definition of stewardship expenses and how to readily distinguish stewardship expenses from supportive expenses. Treasury and the IRS are also considering whether additional changes to the rules for allocating stewardship expenses are appropriate in light of the enactment of the TCJA, and in order to better reflect modern business practices that are increasingly global and mobile in nature, and also request comments on that topic.
The proposed regulations also provide guidance on the allocation and apportionment of litigation damages, settlement expenses, legal and accounting fees, and NOL carryovers. Following a position taken in previous field service advice, payments for claims arising out of the sale of products or services are allocated to the class of gross income generated by the sales. Litigation settlements related to general corporate actions, such as securities litigation, are allocated and apportioned based on the taxpayer's total assets. The source and separate category components of an NOL are determined in the year of the loss, to the extent they do not reduce income in other categories in that year, and retain their characteristics in the carry-to year.
Effective Dates of Expense Allocation Regulations
The final expense allocation regulations generally apply to taxable years that begin after December 31, 2017, and end on or after December 4, 2018.
The proposed regulations on the allocation of stewardship, legal damages, and NOLs would apply to taxable years that end on or after December 17, 2019, and thus would apply (once finalized) retroactively to the 2019 year for calendar year taxpayers. The proposed regulations on the allocation of R&E expenses would apply prospectively to taxable years beginning after December 31, 2019.
Assigning Foreign Taxes to Baskets and Income Groups
Final Rules on Base and Timing Differences
The final regulations retain the proposed rule on base and timing differences under § 1.904-6, restricting base difference taxes to a very narrow category: foreign taxes imposed on types of items that do not constitute income under U.S. tax principles, for example, gifts and life insurance proceeds. All other foreign taxes without a matching U.S. tax income item are treated as timing differences and are assigned to the § 904 basket and the § 960 income group, respectively, to which they would have been assigned if the income were recognized under federal income tax principles in the year in which the foreign taxes were imposed. However, Treasury and the IRS also proposed new rules, discussed below, that would alter these final regulations.
The final regulations provide that foreign taxes on base difference items are treated as imposed with respect to income "in the separate category described in § 904(d)(2)(H)(i)." The regulations do not further elaborate on the separate category so described. However, the preamble oddly states that taxes associated with base differences are assigned solely to the branch basket. If that statement were correct, it would produce the absurd result of taxes being assigned to the branch basket that have nothing to do with any branch, and where no branch even exists—in a CFC, for example.
Proposed Section 1.861-20
Under the TCJA, the assignment of foreign taxes to different § 904 baskets and other income groups carries increased importance. For example, taxes must be assigned to various Subpart F income groups, the tested income group, PTEP groups and, in certain cases, the residual income group to determine a U.S. shareholder's deemed paid foreign tax credit under § 960(a), (b), and/or (d). Therefore, in the proposed regulations, Treasury and the IRS moved the general rules of § 1.904-6 to new proposed § 1.861-20 and generalized them to apply for purposes of allocating and apportioning foreign income taxes to statutory and residual groupings for various purposes. Additionally, certain changes to §§ 1.904-6 and 1.960-1 are proposed to clarify and modify the application of proposed § 1.861-20 for purposes of computing the foreign tax credit limitation under § 904 and foreign income taxes deemed paid under § 960.
Proposed § 1.861-20 adopts the principles of current law § 1.904-6 but provides more detailed guidance. In general, foreign tax is assigned to groupings by (1) first, assigning items of foreign gross income to the groupings, (2) then, allocating and apportioning foreign law deductions to that income, and (3) finally, assigning the foreign tax to the groupings in accordance with foreign law.
An item of foreign gross income is generally assigned to a statutory or residual grouping based on its federal income tax characterization. If an item of foreign gross income corresponds to a U.S. loss (or zero), the foreign gross income is assigned to the same grouping to which a U.S. gain would have been assigned.
Proposed § 1.861-20(d)(2) sets forth extensive rules for assigning foreign gross income to a grouping if there is no corresponding U.S. item. The proposed rules are analogous to current law § 1.904-6(a)(1)(iv), relating to base and timing differences, but they are far more elaborate and detailed. Foreign gross income arising from a timing difference is generally assigned to the grouping to which the corresponding U.S. item would be assigned if it arose in the same U.S. taxable year in which the foreign tax is incurred. This rule would apply, for example, if foreign gross income arose from a U.S. nonrecognition transaction, or if the gross income from the transaction were taken into account in a different U.S. tax year.
With the exception of base difference items, discussed above, foreign gross income that is a type of income expressly excluded from gross income under federal income tax law is assigned to the grouping to which the gross income would be assigned if it were included in U.S. gross income. Base difference items would generally be assigned to the residual grouping, with the result that such taxes will often be noncreditable.
The proposed regulations would also provide an exclusive list of seven base difference items:
- Death benefits described in § 101;
- Gifts and inheritances described in § 102;
- Contributions to capital described in § 118;
- The receipt of money or other property in exchange for stock described in § 1032 (including by reason of a transfer described in § 351);
- The receipt of money or other property in exchange for a partnership interest described in § 721;
- The portion of a corporate distribution described in § 301(c)(2); and
- A distribution to a partner described in § 733.
It is ironic that in the wake of the TCJA, Treasury and the IRS have discovered new items to treat as base differences. For decades, the IRS has insisted that base differences are rare and unusual, and only exist where the U.S. would never tax the foreign income in question. See, e.g., 1997 FSA LEXIS 186 (May 28, 1997). Items 6 and 7 above in particular raise a number of questions. In ordinary circumstances, these items would appear to arise from timing differences. For example, a return of capital distribution described in § 301(c)(2) could arise from a difference in the distributing corporation's E&P as measured for U.S. and foreign tax purposes. Similarly, a partnership distribution described in § 733 would seem to arise most commonly from a check-the-box election. The partner would have been taxed currently on partnership income for U.S. tax purposes, but is not taxed under foreign law until the partnership distributes the income. In the case of a distribution of PTEP, the withholding tax is associated with the basket of the underlying income, whereas in the case of a return of capital distribution or distribution by a hybrid entity, the withholding tax would effectively be disallowed as a credit under the base difference rule.
Proposed § 1.861-20(d)(3) sets forth a number of special rules for assigning certain items of foreign gross income to groupings, including rules for items treated as distributions for both U.S. and foreign tax purposes, certain foreign law distributions such as consent dividends, inclusions under foreign law CFC regimes, disregarded payments, inclusions from reverse hybrids, and gain on the sale of a disregarded entity.
Given the number of disregarded entities in U.S. multinational structures, the proposed rules for disregarded payments are of particular importance. Under the proposed regulations, a disregarded payment made by a disregarded entity or other foreign branch is generally assigned to statutory and residual groupings based on the income of the branch, which is deemed to have arisen in the groupings in the same ratio as the tax book value of the branch's assets, while a disregarded payment made by a foreign branch owner is assigned to the residual grouping. As a result, taxes imposed on a payment by a branch owner to its branch would effectively be disallowed as a credit—a harsh and inappropriate outcome. Proposed § 1.904-6 would alter these general rules in certain ways, for example, for purposes of determining foreign branch basket income under § 904. See the discussion below.
Proposed § 1.861-20(g) includes 11 examples illustrating these rules. These examples are worth a careful read. They illustrate the complex undertaking many taxpayers will have to make to reconcile the U.S. and foreign tax bases in applying the foreign tax credit rules going forward.
Proposed § 1.861-20 is proposed to be effective prospectively, and would apply to taxable years beginning after December 31, 2019.
Foreign Tax Credit Limitation Under Section 904
Definition of Foreign Branch
The final regulations retain the proposed rule generally defining a foreign branch as the activities of a domestic corporation or its disregarded entities (or, in certain cases, a partnership or its disregarded entities) if those activities constitute a trade or business and a separate set of books and records is maintained.
The final regulations provide that when a foreign branch does not have a separate set of books and records, it is deemed to have a separate set of books and records with respect to its activities. Items of gross income, disregarded payments, and other items that would be reflected on those hypothetical books and records must then be determined. The principles of the DCL rules, § 1.1503(d)-5(c), apply for this purpose. The hypothetical books and records could be important, for example, in cases where a disregarded entity has a set of books and records that include both branch and non-branch activities.
Determining the Amount of Foreign Branch Income
For purposes of determining the amount of a domestic corporation's foreign branch income, the final regulations generally retain the complex "disregarded payment" rules of the 2018 proposed regulations, with modest changes, including the requirement to use § 367(d) principles to impute payments for certain transfers of intangible property in disregarded transactions with a foreign branch. However, the final regulations limit the § 367(d) rule to disregarded transfers occurring on or after December 7, 2018, the date the 2018 proposed regulations were published.
Importantly, the final regulations also provide that the § 367(d) rule does not apply to transfers by a foreign branch or foreign branch owner that (i) owns the IP only transitorily and (ii) does not develop, exploit, or otherwise utilize the IP in a trade or business, other than in the ordinary course of business during the period of transitory ownership. The transitory exception could be helpful for U.S. corporations that want to bring their IP back to the U.S. via a check-the-box election followed by an assignment of the IP from the newly created foreign branch. Under the final regulations, the transitory presence of IP in the branch would not give rise to imputed § 367(d) royalties.
The final regulations retain the rule that generally treats gain from the sale of a disregarded entity as falling outside of the branch basket. Interest income, other than that earned by a financial services entity, is also excluded from the branch basket.
Branch Basket Transition Rules
The final regulations modify the 2018 proposed rules on foreign tax credit carryovers and OFL/SLL carryovers from pre-TCJA to post-TCJA taxable years, providing certain safe harbors that were not included in the proposed rules. For example, the final rules allow for unused general basket foreign taxes from a pre-TCJA taxable year to be carried to a post-TCJA taxable year in the branch basket based on the ratio of the foreign income taxes that were paid or accrued by the taxpayer's foreign branches in the pre-TCJA year divided by the amount of all general basket foreign income taxes paid or accrued in that year. Taxpayers that do not choose to apply the safe harbor must determine the actual unused foreign taxes in the foreign branch basket as if that basket and all the rules in the final regulations had applied in the pre-TCJA year.
Other FTC Limitation Issues
The final regulations retain without change the GILTI basket rules of the 2018 proposed regulations. The final rules also generally retain the proposed rules on treaty resourced income, but extend the grouping rules for § 904(d)(6) resourced income to also apply to items resourced under § 865(h) or 904(h).
The final rules provide that a corporate general partner's distributive share of partnership income is assigned to a § 904 basket on a flow-through basis from the partnership, whether or not the corporate general partner owns a 10 percent interest in the partnership.
The final regulations generally retain without change the proposed rules limiting the effect of the § 904(d)(3) look-through rules to passive income only.
The proposed regulations would conform the definition of financial services income to make them consistent with similar definitions found in other sections of the Code and regulations—in the PFIC rules, for example.
Effective Dates of FTC Limitation Regulations
The final regulations under §§ 1.904-4 and 1.904-5 would apply to taxable years that begin after December 31, 2017, and end on or after December 4, 2018.
Foreign Tax Redeterminations Under Section 905(c)
Under the final rules, when a foreign tax redetermination occurs with respect to a foreign income tax claimed as a credit under § 901, other than deemed paid taxes under § 960, the taxpayer must redetermine its U.S. tax liability for the year the taxes were claimed as a credit and any carry-to year. However, a redetermination of U.S. tax liability is not required if the foreign income taxes are taken into account on an accrual basis but translated into dollars on the payment date, and the change in the dollar amount of foreign taxes with respect to each foreign country is attributable solely to currency fluctuations and is both (i) less than $10,000 and (ii) less than 2 percent of the dollar amount of the taxes initially accrued with respect to that country.
The final regulations also finalize the rules relating to the translation of foreign income taxes, generally without change, and move them from § 1.905-3 to § 1.986(a)-1. The final regulations clarify that a CFC can elect separately from any of its U.S. shareholders to translate certain nonfunctional currency taxes using the date of payment spot rate under § 986(a)(1)(D). The final regulations also clarify that whether taxes are denominated in a nonfunctional currency is determined by reference to the functional currency of the taxpayer, and not, for example, the functional currency of the QBU that may have directly incurred the taxes.
Treasury and the IRS have reproposed certain other rules from the expired 2007 temporary regulations. Under the 2007 rules, a foreign tax redetermination with respect to a CFC could often be addressed through an adjustment to the CFC's § 902 pools. With pooling eliminated, proposed § 1.905-3 provides that a redetermination of the U.S. shareholder's U.S. tax liability is required. The CFC's taxable income, E&P, and current-year taxes under § 1.960-1 must be adjusted for the post-TCJA year to which the foreign taxes relate and each subsequent year affected by the change, as well as any carry-to year. The U.S. shareholder's inclusions under §§ 951 and 951A must also be adjusted for the year to which the redetermined foreign tax relates. For example, if a CFC's foreign income taxes are refunded, the U.S. shareholder must reevaluate whether it still qualifies for the Subpart F (or proposed GILTI) high-tax exception.
Proposed § 1.905-5 provides similar rules if the foreign tax redetermination relates to a CFC's pre TCJA year. A redetermination of U.S. tax liability is required for the year to which the taxes relate and each subsequent year in which the U.S. shareholder received a distribution or inclusion from the CFC, as well as any carry-to year.
Treasury and the IRS also reproposed the notification rules under § 1.905-4. In general, an amended return is required to notify the IRS of a redetermination of U.S. tax liability. The special notification rules for taxpayers under LB&I examination are also reproposed, as are the penalty rules under § 301.6689-1 for failing to notify the IRS.
The final and proposed regulations generally apply to foreign tax redeterminations occurring in tax years ending on or after December 17, 2019. In the case of a CFC, the proposed regulations apply to foreign tax redeterminations occurring in any tax year of the CFC that ends with or within any tax year of the U.S. shareholder ending on or after December 17, 2019.
Oddly, Treasury and the IRS did not provide transition rules for the gap period between the expiration of the 2007 temporary regulations and the effective dates of the final and proposed regulations. Foreign tax redeterminations that occurred between 2011 and 2018 are thus not subject to the rules of any regulations.
Deemed Paid Taxes Under Section 960
The final regulations generally retain the proposed rules under § 960 without substantive change. For example, the final rules retain the "current year taxes" concept, and do not permit an allocation of current year taxes between U.S. tax years, except as already provided under § 1.901-2(f). The final rules also provide that no foreign taxes are deemed paid with respect to (i) an income group with no current year inclusion, (ii) a § 956 inclusion, or (iii) the residual income category.
The final regulations consolidate certain of the 16 PTEP groups described in Notice 2019-1, 2019-2 I.R.B. 275, resulting in 10 separate PTEP groups under § 1.960-3. The preamble states that Treasury and the IRS intend to issue further guidance on PTEP accounts and PTEP groups. The regulations under § 1.960-3 could be further amended as part of that guidance.
Proposed § 1.960-1 would provide that if current year taxes are assigned to a PTEP group under § 1.861-20, but that PTEP group is not treated as an income group for the current year (because there is no increase to PTEP in a receiving CFC), the taxes are instead assigned to the Subpart F income group or tested income group to which the CFC income underlying the PTEP would be assigned if it arose in the current year.
The final § 960 regulations apply to each taxable year of a foreign corporation that both begins after December 31, 2017, and ends on or after December 4, 2018. The proposed change to § 1.960-1 would apply to taxable years of a foreign corporation beginning after December 31, 2019. In each case, if the foreign corporation's tax year ends with, or during, a corporate U.S. shareholder's tax year, the relevant rules apply to the corporate U.S. shareholder's year.
OFLs and SLLs
The final regulations generally adopt the 2012 proposed OFL and SLL regulations without material changes.
The proposed regulations would add a "Step Nine" in § 1.904(g)-3(j) to coordinate § 904(f)(3) recapture with branch loss recapture and DCL recapture.
Updates to Consolidated Foreign Tax Credit Rules
Proposed § 1.1502-4 would amend the rules relating to the computation of the consolidated foreign tax credit, to reflect law changes. The proposed regulations would also provide that the amount of foreign source income in each § 904 basket is determined by applying the rules of § 1.1502-11, as well as §§ 904(f) and 904(g), on a group-wide basis, rather than applying those rules on a separate member basis and combining the results.
The proposed regulations would also add new rules for purposes of determining the source and separate category of a consolidated NOL, as well as the portion of a consolidated net operating loss that is apportioned to a separate return year of a member.
These rules are proposed to apply to taxable years for which the original consolidated return is due (without extensions) after December 17, 2019.
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.