True Partners Insights

Pillar Icon

The Foreign Tax Credit – Final and Proposed Regulations Issued by Treasury and the IRS in December 2019 – Part 2

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 2 of our analysis of the new FTC guidance, this article will highlight the key issues addressed by the Final Regulations 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.  We cover the new guidance included in the 2019 Proposed Regulations in Part 2 of our analysis, 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.  In Part 1 of our FTC analysis, we highlighted issues related to foreign branch income and taxes, Foreign Tax Redeterminations, foreign currency, timing differences, and effective dates.

Summary

  • The 2018 Proposed Regulations included guidance on how FTCs can be claimed against GILTI liability, but they did not provide for any exemption from the allocation of expenses to GILTI. The 2019 Final Regulations adopt the proposed expense allocation rules without significant changes, so there is no general exemption from allocation of expenses to GILTI.
  • The 2019 Final Regulations confirm that the look-through rules do not apply to characterize interest, rents, and royalties paid by a CFC to a US shareholder as GILTI category income, because GILTI income only includes amounts includible in gross income under section 951A, and look-through cannot give rise to section 951A category income.
  • The 2019 Final Regulations include a clarification related to expense allocations among assets that give rise to foreign derived intangible income (FDII), which is a new category of income created by the TCJA in section 250.
  • The 2019 Final Regulations generally follow the rules of the 2018 Proposed Regulations under section 960 with respect to whether foreign taxes are considered “properly attributable” to subpart F income, tested income, or previously taxed earnings and profits (PTEP). Foreign income taxes are allocated and apportioned in the single US taxable year in which the taxes accrue, even if those taxes relate to a foreign taxable year that straddles multiple US taxable years.
  • The 2019 Final Regulations leave in place the rules that do not allow the availability of deemed paid FTCs on inclusions under sections 956 and 951(a)(1)(B). The new guidance also updates the rules regarding the maintenance of (PTEP) groups consistent with the guidance in Notice 2019-01, while simplifying them by consolidating the number of groups from 16 to 10.
  • The 2018 Proposed Regulations provided a transition rule for carryforward and carrybacks of unused foreign taxes paid or accrued under the pre-TCJA foreign tax credit rules to post-TCJA tax years, especially in light of the creation of the GILTI and foreign branch baskets. The 2019 Final Regulations provide a safe harbor for purposes of the transition rule in the 2018 Proposed Regulations.
  • In responding to several taxpayer comments, the 2019 Proposed Regulations provide that no research & experimentation (R&E) expenses are allocated or apportioned to the GILTI basket for FTC purposes. The 2019 Proposed Regulations also eliminate the legally mandated R&E expenses rule, which required the allocation of R&E expenses to a single geographic region when the expenses are undertaken solely to meet legal requirements imposed by a governmental entity in that geographic region and such expenses are not reasonably expected to generate gross income outside of such geographic region. 
  • The 2019 Proposed Regulations address the allocation and apportionment of stewardship expenses, which were treated as definitely related and allocable to dividends received, or to be received from related corporations (with no specific apportionment method being prescribed) prior to the TCJA and the 2018 Proposed Regulations.
  • The new guidance clarifies that stewardship expenses are allocated to dividends or inclusions from related corporations, including amounts under subpart F, GILTI, section 78, and the passive foreign investment company regime.
  • The 2019 Final Regulations include the rules from the 2018 Proposed Regulations relating to the allocation and apportionment of taxes to the various FTC categories, including rules around base and timing differences, with no substantial changes. The 2019 Proposed Regulations, however, include new and comprehensive guidance on these issues in the new Treasury Regulation section 1.861-20 which will apply for purposes other than the FTC limitation.
  • Treasury and the IRS commented that future guidance may be necessary to address allocating and apportioning interest deductions.

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.

2019 Final Regulations

Allocating Expenses to the GILTI Basket under Section 951A

The 2018 Proposed Regulations included guidance on how FTCs can be claimed against GILTI liability, but they did not provide for any exemption from the allocation of expenses to GILTI.  Without the exemption, the allocation of expenses to GILTI may result in an increase of FTC limitations, thereby increasing the overall tax burden of US companies who might have mitigated the effect of the GILTI through high foreign tax rates.

The 2019 Final Regulations adopt the proposed expense allocation rules without significant changes, so there is no general exemption from allocation of expenses to GILTI.   Specifically, they retain the rule that expenses must be allocated and apportioned to the GILTI basket, including the special rules for interest expense apportionment that (1) characterize CFC stock that produces GILTI as a partially exempt asset, and (2) create a separate section 245A subgroup within each section 904(d) basket to allow for adjustments to the section 904 formula under §1.904(b)-3.

Taxpayers asked that US shareholder-level expenses not be allocated to the section 951A category based on the premise that the GILTI should function as a “minimum tax.”  Treasury and the IRS rejected that request and stated that taxpayers are required by statute to allocate and apportion expenses to the section 951A category.  They did provide, however, for proposed rules providing that research and development expenses do not have to be allocated against foreign income (including GILTI, dividends, and subpart F income).

The 2019 Final Regulations confirm that the look-through rules do not apply to characterize interest, rents, and royalties paid by a CFC to a US shareholder as GILTI category income, because GILTI income only includes amounts includible in gross income under section 951A, and look-through cannot give rise to section 951A category income.  Such income is assigned to a separate category other than the passive category as detailed in the 2019 Proposed Regulations.  Taxpayer comments requested changes to this rule, but they were rejected.

The 2019 Final Regulations include a clarification related to expense allocations among assets that give rise to foreign derived intangible income (FDII), which is a new category of income created by the TCJA in section 250.  This guidance retains the 2018 Proposed Regulations rule that for purposes of allocating expenses, the amount of a domestic corporation’s income that is entitled to a deduction under section 250 and any corresponding amount treated as a dividend under section 78 would be treated as exempt income based on the amount of the deduction.  Thus, the 2019 Final Regulations provide for exempt income and asset treatment for income in the GILTI basket that is offset by a section 250 deduction.

Comment:  The rules in the 2019 Final Regulations should provide taxpayers with more certainty about their ability to claim FTCs for their GILTI income.  The FDII income should result in a deduction at the corporate level but not a FTC, so taxpayers should consider how to maximize the benefits from both regimes.  Taxpayers may also want to review positions they took under the 2018 Proposed Regulations when they were issued.

Section 960 Deemed-Paid Taxes

The 2019 Final Regulations generally follow the rules of the 2018 Proposed Regulations under section 960 with respect to whether foreign taxes are considered “properly attributable” to subpart F income, tested income, or previously taxed earnings and profits (PTEP).  The new guidance provides that foreign income taxes paid or accrued by a foreign corporation are properly attributable to subpart F or tested income only (1) if allocable and apportioned to foreign taxable income that constitutes subpart F or tested income for US federal tax purposes; (2) if paid or accrued in the CFC’s US tax year that includes subpart F or tested income; and (3) in proportion to the CFC’s subpart F or tested income that is included in a US shareholder’s gross income.

In rejecting taxpayer comments to change the rule in the 2018 Proposed Regulations on timing differences, foreign income taxes are allocated and apportioned in the single US taxable year in which the taxes accrue, even if those taxes relate to a foreign taxable year that straddles multiple US taxable years.

The 2019 Final Regulations leave in place the rules that do not allow the availability of deemed paid FTCs on inclusions under sections 956 and 951(a)(1)(B).  The new guidance also updates the rules regarding the maintenance of PTEP groups consistent with the guidance in Notice 2019-01, while simplifying them by consolidating the number of groups from 16 to 10.

Carryforward and Carryback for Foreign Taxes

The 2018 Proposed Regulations provided a transition rule for carryforward and carrybacks of unused foreign taxes paid or accrued under the pre-TCJA foreign tax credit rules to post-TCJA tax years, especially in light of the creation of the GILTI and foreign branch baskets.  The 2019 Final Regulations provide a safe harbor for purposes of the transition rule in the 2018 Proposed Regulations such that the foreign taxes carried from a particular pre-2017 taxable year to the post-2018 foreign branch category may be allocated based on a ratio equal to the amount of foreign income taxes paid or accrued by the taxpayer’s foreign branches divided by the amount of all foreign income taxes assigned to the general category.

2019 Proposed Regulations

The 2019 Proposed Regulations make significant changes to existing rules, including new rules for the allocation and apportionment of research and experimentation (R&E) and stewardship expenses, and for assigning foreign income taxes to different income groups for various purposes.

Allocation of R&E Expense

In responding to several taxpayer comments, the 2019 Proposed Regulations provide that no R&E expenses are allocated or apportioned to the GILTI basket for FTC purposes.  Treasury and the IRS agreed with this approach noting that R&E expenses generally give rise to intangible property that generates gross intangible income in the US, so that the income is not considered GILTI income.  Because gross intangible income is not income assigned to the GILTI basket, they determined that R&E expenses should not be allocated or apportioned to the GILTI basket.

The 2019 Proposed Regulations also eliminate the legally mandated R&E expenses rule, which required the allocation of R&E expenses to a single geographic region when the expenses are undertaken solely to meet legal requirements imposed by a governmental entity in that geographic region and such expenses are not reasonably expected to generate gross income outside of such geographic region.  The proposed rules also eliminate the increased exclusive apportionment rule that allowed a taxpayer to demonstrate that a higher amount of R&E expenses should be exclusively apportioned to a geographic region.

Allocation of Stewardship Expenses and Certain Other Expenses

The 2019 Proposed Regulations address the allocation and apportionment of stewardship expenses, which were treated as definitely related and allocable to dividends received, or to be received from related corporations (with no specific apportionment method being prescribed) prior to the TCJA and the 2018 Proposed Regulations.  After the TCJA changes, a significant portion of the return on an investment in a foreign corporation is now taxed immediately under subpart F or GILTI, and dividends are generally exempt from tax.  The new guidance clarifies that stewardship expenses are allocated to dividends or inclusions from related corporations, including amounts under subpart F, GILTI, section 78, and the passive foreign investment company regime.  The stewardship expenses are apportioned based upon the relative value of a taxpayer’s stock assets.

The 2019 Proposed Regulations also provide rules for the allocation and apportionment of litigation damages awards, prejudgment interest, settlement payments, and net operating loss deductions.

Allocation and Apportionment of Taxes to Income

The 2019 Final Regulations include the rules from the 2018 Proposed Regulations relating to the allocation and apportionment of taxes to the various FTC categories, including rules around base and timing differences, with no substantial changes.  The 2019 Proposed Regulations, however, include new and comprehensive guidance on these issues in the new Treasury Regulation section 1.861-20 which will apply for purposes other than the FTC limitation.

The new section includes a narrowed definition of taxes on base differences, which will be defined to include only 7 items specified in the regulations, specifically: foreign taxes imposed on life insurance proceeds, gifts, contributions to capital under section 118, the receipt of money or property described in section 301(c)(2), and a distribution to a partner described in section 733.  Also, rather than including a single rule for timing differences that would apply to several factual cases, the new regulation also provides a number of specific rules to address not only timing differences, but also rules addressing  taxes paid on distributions and under foreign CFC regimes, taxes paid on disregarded payments, and taxes paid by owners of reverse hybrids.

Future Guidance on the Allocation of Expenses

Treasury and the IRS commented that future guidance may be necessary to address allocating and apportioning interest deductions.  They questioned whether rules for the capitalization and amortization of certain expenses are necessary solely for purposes of allocating and apportioning interest expense.  They also indicated that they are considering  whether additional rules for allocating and apportioning expenses to the foreign branch category or limiting the amount of gross income reallocated as a result of certain disregarded payments are necessary.