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The Foreign Tax Credit – Final and Proposed Regulations Issued by Treasury and the IRS in December 2019 – Part 1

By: John V. Aksak Sonali Fournier Lauren Ansley Alexis Bergman David Flores |

On December 2, 2019, the US Treasury and IRS released final regulations (2019 Final Regulations) that provide guidance regarding the determination of foreign tax credits (FTCs), which generally allow individuals and businesses to claim a credit for income taxes paid or accrued to foreign governments.  The IRS also issued proposed regulations (2019 Proposed Regulations) relating to the allocation and apportionment of expenses, deductions and creditable foreign taxes, and issues related to the new foreign branch basket. The Final Regulations also finalize parts of the expired 2007 temporary regulations relating to Foreign Tax Redeterminations under section 905(c) and foreign currency translations.  Proposed regulations were released on December 7, 2018 (the 2018 Proposed Regulations).

In Part 1 of our analysis of the new FTC guidance, this article will highlight the key issues addressed by the Final Regulations related to foreign branch income and taxes, Foreign Tax Redeterminations, foreign currency, timing differences, and effective dates.  In Part 2 of our FTC analysis, we will highlight issues related to allocating expenses to the global intangible low-taxed income (GILTI) basket, Section 960 deemed-paid taxes, and carryforward and carryback for foreign taxes.  In Part 2, we also cover the new guidance included in the 2019 Proposed Regulations, which relates to the allocation and apportionment of research and experimentation (R&E), stewardship and other expenses, and the allocation and apportionment of taxes to income.

Summary

  • The 2019 Final Regulations generally adopt the approach of the 2018 Proposed Regulations with respect to foreign branches and determinations of income in the foreign branch category, including the limitation that such rules apply only for purposes of determining the category of income and not the source or character of such income.
  • The 2019 Final Regulations retain the proposed rule that defines a foreign branch as the activities of a domestic corporation or its disregarded entities (or, in certain cases, as partnership or its disregarded entities) if those activities constitute a trade or business and a separate set of books and records is maintained. A US person determines branch income on an aggregate basis and not on a branch-by-branch basis. 
  • The 2019 Final Regulations follow the rule in the 2018 Proposed Regulations that adjusts general category and foreign branch category income to reflect disregarded payments between a foreign branch and its foreign branch owner, or between foreign branches, with a few changes.
  • The 2019 Final Regulations also provide detailed rules for adjustments related to disregarded sales of property to or from a foreign branch, including adjustments for gain recognized on dispositions of property that was acquired by the foreign branch or foreign branch owner in a disregarded sale.
  • The 2019 Final Regulations also change the rule for assigning partners’ distributive share of partnership income to FTC baskets.
  • The 2019 Final Regulations address long-awaited final and re-proposed regulations under section 905(c), which governs the obligations of taxpayers regarding Foreign Tax Redeterminations.
  • The 2019 Final Regulations include rules that broaden the definition of a Foreign Tax Redetermination, which is a change in the liability for a foreign income tax, while including more detailed rules for translating the amount of foreign tax paid or accrued into US dollars. 
  • The 2019 Proposed Regulations also include rules to address Foreign Tax Redeterminations that reflect changes made by the TCJA, including the requirement that all Foreign Tax Redeterminations be taken into account in the tax year to which they relate, which would be the tax year in which the income subject to the relevant foreign law was recognized for foreign tax purposes.  
  • The 2019 Final Regulations include rules under section 986(a) related to the translation of foreign taxes, which are generally aligned with the 2007 Temporary Regulations. Some changes were made in response to taxpayer comments about changes to the treatment of inflationary currencies and the election to translate accrued taxes using the exchange rate on the date of payment.
  • Taxpayer comments requested additional guidance with respect to the rules in the 2018 Proposed Regulations about timing differences, e.g., where a CFC has a different taxable year than its US shareholder. Treasury and the IRS rejected these comments citing concerns regarding compliance and administrative burdens.

Background

The Tax Cuts and Job Act (TCJA) made systemic changes to the US taxation of international income that impact the foreign tax credit (FTC) calculation, including the introduction of a participation exemption through a dividends received deduction for certain dividends in section 245A and the introduction of global intangible low-taxed income (GILTI), which subjects to current US taxation foreign earnings that would have been deferred under prior law, albeit at a lower tax rate and subject to certain FTC restrictions.

The TCJA enacted significant changes to the foreign tax credit (FTC) provisions of the Internal Revenue Code (Code).  Congress repealed Section 902, which allowed deemed-paid credits in connection with dividend distributions based on foreign subsidiaries’ cumulative pools of earnings and foreign taxes.  The TCJA also added two new FTC baskets for GILTI and foreign branch income, and it changed how taxable income is calculated for purposes of the FTC limitation by disregarding certain expenses and repealing the use of the fair market value method for allocating interest expense.

Under the GILTI regime, a 10 percent US shareholder of one or more controlled foreign corporations (CFCs) will be required to include its GILTI currently as taxable income (in addition to any subpart F income), regardless of whether any amount is distributed to the US shareholder.  The GILTI tax results in a US shareholder being taxed on its current allocable share of CFC income to the extent such earnings exceed a 10% return on the shareholder’s allocable share of tangible assets held by CFCs.  Once the amount of GILTI has been determined, a US corporate taxpayer may claim a deduction, subject to certain limitations, equivalent to 50% of its GILTI (reduced to 37.5% for tax years starting after 2025).  This results in a 10.5% minimum tax on a corporate US shareholder’s GILTI.

Corporate shareholders can claim a FTC for 80% of the foreign taxes associated with GILTI.  The 2018 Proposed Regulations were issued to address, among other things, how foreign taxes are to be allocated between the categories of income, including subpart F and GILTI, and how expenses are to be allocated between FTC limitation baskets.

Congress did not revise some other provisions including the section 861 expense allocation rules, which arguably resulted in taxpayer uncertainty about this area of tax law.  The changes created complications for the FTC limitation calculation and resulted in a number of issues related to the interaction of the new FTC regime and other provisions in the TCJA including the new GILTI provision under section 951A.  Notably, the TCJA did not provide transition rules.

Section 904 includes certain limitations to the amount of FTCs allowable to a taxpayer, and those limitations must be calculated separately with respect to certain categories of income.  The TCJA added two new FTC baskets for GILTI and for foreign branch income.   Section 904 generally allows foreign taxes to be carried back one year and then carried forward ten years, but GILTI basket FTC carrybacks and carryforwards are not allowed under the TCJA.

Under section 960, US corporate taxpayers are entitled to tax credits for foreign taxes paid with respect to inclusions of subpart F income and GILTI.  The FTC, however, is limited to taxes “properly attributable” to subpart F income or income taxed currently under the GILTI rules.  The “pooling” rules that applied previously have been eliminated.

Section 905(c), which was amended by the TCJA, provides rules for what are called Foreign Tax Redeterminations, which are adjustments to accrued taxes when (1) the accrued taxes differ from the amounts claimed as credits by a taxpayer; (2) the accrued taxes are not paid before two years after the close of the taxable year to which the taxes relate, or (3) the taxes are paid or refunded in whole or in part.  Prior to the TCJA, Foreign Tax Redeterminations were generally taken into account prospectively by adjusting a foreign corporation’s pools of undistributed earnings and foreign taxes, but the new law amended section 905(c) to provide that such adjustments be taken into account retroactively.

Final Regulations

The Final Regulations generally follow and finalize the 2018 Proposed Regulations, but they do include some important changes in response to taxpayer comments.

Foreign Branch Income/Basket

The 2019 Final Regulations generally adopt the approach of the 2018 Proposed Regulations with respect to foreign branches and determinations of income in the foreign branch category, including the limitation that such rules apply only for purposes of determining the category of income and not the source or character of such income.   The Preamble outlines the policy goals underlying the rules, which are: (1) attribution of income in a manner commensurate with business activities; (2) administrability; (3) conformity with local country tax law; and (4) giving effect to the policies of limiting the deduction under section 250 and the credit under section 901 by reference to foreign branch income.

As included in the 2018 Proposed Regulations, the new guidance provides that branch income does not include (1) income arising from activities conducted in the US, (2) income arising from a stock investment (e.g., a dividend deemed inclusion under sections 951, 951A or 1293, or gain from the disposition of such stock), or (3) gain from the disposition of a partnership or other flow-through entity (e.g., a disregarded entity) unless it is in the ordinary course of the trade or business of the branch.  Interest income, other than that earned by a financial services entity, is also excluded from the branch basket.

The 2019 Final Regulations retain the proposed rule that defines 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.  A US person determines branch income on an aggregate basis and not on a branch-by-branch basis.  The 2019 Final Regulations determine the amount of a US person’s gross income allocable to the branch basket based on the branch’s books and records with some adjustments.

The 2019 Final Regulations follow the rule in the 2018 Proposed Regulations that adjusts general category and foreign branch category income to reflect disregarded payments between a foreign branch and its foreign branch owner, or between foreign branches, with a few changes.  Taxpayer comments led to the decision to change the 2018 Proposed Regulations approach that would have applied the principles of section 367(d) to disregarded transfers of intangible property between a branch and its owner.   The final rule explicitly carves out transitory transfers of property to a foreign branch.  In response to taxpayer comments, the new guidance limits the applicability of the rule to transfers occurring on or after the date the 2018 Proposed Regulations were published (December 7, 2018).

Comment The transitory exception could be used by US corporations that want to bring their intellectual property back to the US through a check-the-box election followed by an assignment of the intellectual property from the newly created foreign branch or in the case of a CFC that is treated as liquidating into its US shareholder as a result of a check-the-box election.

The 2019 Final Regulations also provide detailed rules for adjustments related to disregarded sales of property to or from a foreign branch, including adjustments for gain recognized on dispositions of property that was acquired by the foreign branch or foreign branch owner in a disregarded sale.

Comment:  Taxpayers should review positions they took with respect to the treatment of disregarded transactions involving foreign branches after the 2018 Proposed Regulations were first released.

The 2019 Final Regulations also change the rule for assigning partners’ distributive share of partnership income to FTC baskets.  The distributive share of a limited partner owning less than 10 percent in the partnership generally is assigned to the passive basket, while the distributive share of all other partners is assigned to the same basket as the partnership income of which it is a share (e.g., foreign branch category income, general category income, or income in a specified separate category).

With respect to allocation and apportionment of foreign taxes, the 2019 Final Regulations provide that foreign taxes associated with a base difference are assigned solely to the foreign branch category.  This guidance finalizes base and timing difference rules without change from the 2018 Proposed Regulations regarding what constitutes a base or timing difference, but new rules providing additional guidance are included in the 2019 Proposed Regulations.

The 2019 Final Regulations make a change to the 2018 Proposed Regulations rule related to permanent establishments (PEs) and the presumption that the trade or business standard of the foreign branch definition had been met.  The final rule provides that activities conducted outside the US that constitute a PE do meet the trade or business standard of the foreign branch definition.

The 2019 Final Regulations also include a standard to construct hypothetical books and records when a foreign branch does not have separate books and records.

The new guidance notes that Treasury and the IRS request comments on their consideration of what additional special rules may be needed to apply the foreign branch category to regulated financial institutions, specifically with respect to the treatment of disregarded payments of interest and allocation of interest expense.

Foreign Tax Redeterminations under Section 905(c)

The 2019 Final Regulations address long-awaited final and re-proposed regulations under section 905(c), which governs the obligations of taxpayers regarding Foreign Tax Redeterminations.  Proposed (2007 Proposed Regulations) and temporary regulations (2007 Temporary Regulations) were issued in 2007, and the 2019 Final Regulations adopt some of the rules included therein, while other rules have been re-proposed (as discussed below).  The 2019 Final Regulations  include rules that broaden the definition of a Foreign Tax Redetermination, which is a change in the liability for a foreign income tax, while including more detailed rules for translating the amount of foreign tax paid or accrued into US dollars.  Under the new guidance, a Foreign Tax Redetermination includes not only an event, such as a foreign tax settlement or refund, that increases or decreases a taxpayer’s foreign tax liability, but also payment of foreign tax after 24 months from the close of the relevant tax year and a change to a reasonably estimated accrual.  The 2019 Final Regulations make a number of minor changes, including stating that a Foreign Tax Redetermination occurs if any tax that is claimed as a credit or added to previously taxed earnings and profits (PTEP) group taxes is subsequently refunded.  The 2007 Temporary Regulations dealing with Foreign Tax Redeterminations of foreign taxes claimed as a direct credit by a US taxpayer were also finalized with additional guidance on how the rules apply when a taxpayer is in an excess credit position.

The 2019 Proposed Regulations also include rules to address Foreign Tax Redeterminations that reflect changes made by the TCJA, including the requirement that all Foreign Tax Redeterminations be taken into account in the tax year to which they relate, which would be the tax year in which the income subject to the relevant foreign law was recognized for foreign tax purposes.   Due to the repeal of the pooling system under section 902, section 905(c) was amended by the TCJA to remove the ability of taxpayers to make current year adjustments to account for changes in foreign taxes incurred at the CFC level rather than amending a prior year return.  The guidance states that the required adjustments that must be made as a result of a Foreign Tax Redetermination include not only changes to deemed paid taxes, but also adjustments to the foreign corporation’s earnings and profits, as well as any related subpart F or GILTI inclusions.  The new guidance provides rules for notifying the IRS of a Foreign Tax Redetermination, but the filing of an amended return reflecting the Foreign Tax Redetermination is treated as a notification.  Transition rules are included in the new guidance, as to which Treasury and the IRS have requested comments as well as with respect to the notification requirement.

Foreign Currency Issues under Section 986(a)

The 2019 Final Regulations include rules under section 986(a) related to the translation of foreign taxes, which are generally aligned with the 2007 Temporary Regulations.  Some changes were made in response to taxpayer comments about changes to the treatment of inflationary currencies and the election to translate accrued taxes using the exchange rate on the date of payment.  The new guidance provides that currency translation occurs at the partnership not the partner level.

Timing Differences

Taxpayer comments requested additional guidance with respect to the rules in the 2018 Proposed Regulations about timing differences, e.g., where a CFC has a different taxable year than its US shareholder.  The comments included several recommendations that would address timing differences, including some related to allocation and accrual methods, but Treasury and the IRS rejected these comments, citing concerns regarding compliance and administrative burdens, and also noting that they might produce results that were no more, and possible less, accurate than the current accrual rule.

Effective Dates

The 2019 Final Regulations relating to the TCJA generally apply to tax years beginning after December 31, 2017.  Other provisions that do not relate to the TCJA apply to tax years ending on or after December 4, 2018, which means that these rules could have a retroactive effect in some circumstances.  The 2019 Final Regulations as relates to sections 905(c) and 986(a) generally apply for taxable years ending on or after the date the final regulations were filed in the Federal Register (in 2019).

Transition Rules

The 2019 Final Regulations include transition rules for assigning carryforwards of unused foreign taxes paid or accrued in pre-2018 tax years to post-2017 separate categories, including the new categories for GILTI and foreign branch income.