Proposed Foreign Tax Credit Regulations Provide New Rules for Allocation and Apportionment of Deductions and Creditable Foreign Taxes

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The Treasury Department and the IRS have issued highly anticipated guidance in the area of stewardship expenses and R&D expenses. The 2019 Proposed Regulations also provide extensive guidance on allocating and apportioning foreign taxes, including base and timing differences rules and somewhat surprising rules on allocating taxes related to disregarded payments. Taxpayers should be aware of these new rules regarding the allocation of foreign taxes, which could prevent taxpayers from obtaining foreign tax credits with respect to certain foreign taxes paid.

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On December 2, 2019, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed foreign tax credit regulations (the “2019 Proposed Regulations”) that address, among other items, the allocation and apportionment of deductions and creditable foreign taxes. Three key allocation and apportionment issues addressed in the 2019 Proposed Regulations include allocation and apportionment of (1) stewardship expenses, (2) research and experimentation (R&E) expenses, (3) foreign taxes, including base and timing difference rules and rules regarding taxes related to disregarded payments. Of note, rules for allocating foreign taxes include several entirely new provisions that could prevent taxpayers from obtaining foreign tax credits associated with disregarded payments.

Allocation and Apportionment of Stewardship Expenses

The 2019 Proposed Regulations provide that stewardship expenses are definitely related and allocable not only to actual dividends, but also to inclusions received or accrued from related corporations, such as inclusions under sections 951 and 951A, and the section 78 gross-up. The 2019 Proposed Regulations also require stewardship expenses to be apportioned based on the relative values of a taxpayer’s stock assets, using the same method used to allocate and apportion interest expense. As a result, the fair market value method, which is not allowed for interest expense, is no longer allowed for stewardship expenses; rather, the book value of the taxpayer’s stock assets must be used. The proposed regulations extend stewardship expenses to include expenses incurred with respect to partnerships.

The 2019 Proposed Regulations also include a conforming change to the rules regarding the allocation and apportionment of stewardship expenses of an affiliated group. Stewardship expenses of an affiliated group are generally allocated and apportioned as if all members were a single corporation. In view of the treatment of stewardship expenses described above, it is unclear whether the proposed regulations suggest that expenses related to stewardship of US group members should be allocated against dividends and inclusions from related foreign corporations, e.g., subpart F and GILTI inclusions, thereby reducing the group’s ability to claim foreign tax credits.

Treasury and the IRS have requested comments on whether the general allocation and apportionment rules should include exceptions for stewardship expenses that are incurred to facilitate compliance with reporting, legal, or regulatory requirements, noting that such expenses might more appropriately be treated as definitely related to the gross income produced by the particular asset whose ownership mandated the stewardship expense. Comments were also requested on whether the definition of stewardship expenses, which did not change, should be adjusted to distinguish between oversight-related stewardship expenses and day-to-day management activities that are supportive in nature (and therefore not stewardship expenses).  Finally, Treasury and the IRS requested comments on whether the stewardship allocation and apportionment rules should be further updated as a result of the Tax Cuts and Jobs Act, and increasingly global, and mobile, business practices.

Allocation and Apportionment of Research & Experimentation Expenses

The 2019 Proposed Regulations provide that no R&E expenses are allocated or apportioned to amounts included under section 951, 951A, or 1293.  Thus, no R&E expenses are allocated to the section 951A category. The rationale for this rule is that section 174 R&E expenses generally give rise to intangible property, and that under sections 367(d) and 482, the person incurring the R&E expenses must be compensated when such intangible property gives rise to income. Therefore, R&E expenses of a US person should not give rise to income in the section 951A category or to subpart F income or PFIC inclusions. The 2019 Proposed Regulations accomplish this result by providing that R&E expenses are definitely related to all gross intangible income reasonably connected with the relevant Standard Industrial Classification Manual code category of the taxpayer, where gross intangible income does not include dividends or any amounts included under section 951, 951A, or 1293. It is notable that this approach, if applicable for FDII regulations, could result in a greater amount of R&E expense allocated to reduce the amount eligible for the FDII deduction under section 250.

The 2019 Proposed Regulations eliminate the optional gross income method of allocating R&E expenses. Under the new rules, taxpayers must allocate R&E expenses (other than expenses exclusively apportioned to the place the R&E is performed under Treas. Reg. 1.861-17(b)) on the basis of relative amounts of gross receipts from sales and services.  The 2019 Proposed Regulations also eliminate (1) the legally mandated R&E rule, which provides that R&E expenses incurred solely to meet legal requirements in a specific jurisdiction and that cannot reasonably be expected to generate amounts of gross income outside a single geographic source, are allocated directly to gross income within that geographic source, and (2) the increased exclusive apportionment rule, which allows taxpayers to allocate a higher amount of R&E expenses exclusively to the specific geographic location where the R&D is performed.

The 2019 Proposed Regulations include other rules relating to R&E expenses, including rules relating to participants in cost sharing agreements and rules relating to taxpayers that own partnerships.

Foreign Taxes

The 2019 Proposed Regulations provide a detailed framework for allocating and apportioning foreign taxes in Prop. Reg. §1.861-20, including base and timing difference rules and rules for allocating taxes related to disregarded payments.

General Rules

The rules in the 2019 Proposed Regulations for allocating and apportioning foreign taxes are generally consistent with current law: taxes are allocated and apportioned on the basis of the income as computed under foreign law on which the tax is imposed. The 2019 Proposed Regulations provide more detailed guidance on how to apply this principle. In general, foreign gross income is assigned to the grouping to which the corresponding US item is assigned. If an item of foreign gross income arises from the same transaction as an item of gross income under US tax law, the foreign gross income item is assigned to the same statutory or residual grouping as the related US item. This concept is illustrated by several examples in the regulations. One example addresses a situation in which USP sells stock of CFC2 and recognizes $800 of local country gain and $800 of gain for US federal income tax purposes; the US gain is included in USP’s income as a dividend under section 1248. The $800 of local country gross income is assigned to the same separate category to which the US dividend would have been assigned, notwithstanding the fact that the local country gross income is treated for local purposes as gain from the sale of stock, not a dividend.

Timing Differences

Under Prop. Reg. § 1.861-20(d)(2), if there is no recognition of US gross income or loss in the US taxable year in which foreign gross income is included, the item of foreign gross income is characterized and assigned to the grouping to which the corresponding US item would be assigned if the foreign gross income were recognized in the US taxable year. Prop. Reg. §1.861-20(d)(2)(i). To illustrate how this rule works, assume $80 of foreign tax is imposed on $400 of foreign gross income in connection with the sale of an asset in Year 1, where there is no corresponding US item in that year. Assume further that if the $400 of foreign gross income were recognized for US tax purposes in Year 1, it would be assigned to the general category.   Under the timing difference rule, the $400 of foreign law income is therefore allocated to the general category, and the $80 of foreign tax is also allocated to the general category.

Moreover, if the foreign gross income is of a type that is excluded from US gross income under federal income tax (but the taxes are not attributable to a base difference), then the item of foreign gross income is assigned to the grouping to which the item of gross income would be assigned if it were included in US gross income. Prop. Reg. §1.861-20(d)(2)(ii)(A).

Exclusive List of Base Differences

The 2019 Proposed Regulations provide an exclusive list of items of foreign gross income that are attributable to a base difference. This list consists of: (1) section 101 death benefits; (2) section 102 gifts and inheritances; (3) section 118 contributions to capital; (4) section 1032 receipts of money or other property in exchange for stock (including in a section 351(a) exchange); (5) a section 721 receipt of money or other property in exchange for a partnership interest; (6) a section 301(c)(2) distribution of property by a corporation as a return of basis, and (7) a section 733 distribution to a partner. If an item of foreign gross income is attributable to a base difference, that foreign gross income is assigned to the residual grouping, such that that taxes paid by a CFC are not creditable. Prop. Reg. §1.861-20(d)(2)(ii)(A). It should be noted that, under these rules, foreign taxes on common transactions such as a partnership distribution to a CFC partner would not be creditable. Foreign taxes that are paid by a domestic corporation and attributable to a base difference are assigned to the category described in section 904(d)(2)(H)(i) (which cross-references foreign branch income). Prop. Reg. §1.904-6(b)(1).

Taxes on Disregarded Payments

The 2019 Proposed Regulations provide specific rules for foreign taxes imposed with respect to disregarded payments. Prop. Reg. §1.861-20(d)(3)(ii).  A disregarded payment by a foreign branch to its owner is assigned under section 987 principles to the statutory or residual grouping to which the income out of which the payment made is assigned (i.e., based on the type of income that the assets of the foreign branch generated). Prop. Reg. §1.861-20(d)(3)(ii)(A).  Example 9 in Proposed Regulation section 1.861-20(g)(10) illustrates the application of this rule: USP owns CFC1, which owns a foreign disregarded entity (FDE). FDE owns all the stock of CFC2. The tax book value of the assets of FDE, including CFC2, include 75% general category assets and 25% passive category assets. FDE makes a $400 disregarded payment of interest to CFC1, with respect to which CFC1 pays $80 tax. The $400 is treated as made ratably out of all of FDE’s after-tax income, which is deemed to have been 75% general category and 25% passive category income. Therefore, 75% of the $80 foreign tax, or $60, is apportioned to the general category and the remaining 25% ($20) is apportioned to the passive category.

Surprisingly, a disregarded payment by a CFC to a foreign branch is assigned to the residual grouping, and therefore foreign taxes on such a disregarded payment cannot be deemed paid under section 960. Prop. Reg. §§1.861-20(d)(3)(ii)(B); 1.904-6(b)(2)(ii).  The preamble to the 2019 Proposed Regulations provides no rationale for denying section 960 credits to such “southbound” disregarded payments.

In addition, the Proposed Regulations provide that foreign gross income attributable to foreign law gain on disregarded sales or exchanges of property is treated as a timing difference, and the foreign gross income is characterized and assigned to the grouping to which the US item would have been assigned if it had been recognized in that taxable year. Prop. Reg. §§1.861-20(d)(3)(ii)(C); 1.861-20(d)(2)(i).  The Proposed Regulations also provide special rules on items of foreign gross income included by the taxpayer in its capacity as a shareholder; reverse hybrids, and gain on the sale of a disregarded entity. Prop. Reg. §1.861-20(d)(3)(i), (iii), (iv).

Other Items

The 2019 Proposed Regulations also address other issues, including the definition of financial services income, foreign tax redeterminations under section 905(c), the disallowance of certain foreign tax credits under section 965(g), and the application of the foreign tax credit limitation to consolidated groups.

Takeaways

Following the Tax Cuts and Jobs Acts, the allocation and apportionment rules are more important because (1) the US corporate tax rate was reduced from 35% to 21%, which correspondingly reduces a taxpayer’s ability to claim foreign tax credits under section 904, and (2) foreign income taxes assigned to the section 951A category cannot be carried forward or back, so if the taxes in that category cannot be used in the current year because of the section 904 foreign tax credit limitation, they effectively disappear.

The 2019 Proposed Regulations provide highly anticipated guidance in the area of stewardship expenses and R&D expenses. The 2019 Proposed Regulations also provide extensive guidance on allocating and apportioning foreign taxes, including base and timing differences rules and somewhat surprising rules on allocating taxes related to disregarded payments. In particular, taxpayers should be aware of these new rules regarding allocation of foreign taxes, which could prevent taxpayers from obtaining foreign tax credits with respect to certain foreign taxes paid.