On November 12, 2020, the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) published proposed regulations (REG-101657-20) (the „2020 Proposed Regulations“) in the Federal Register that contain a new comprehensive set of rules addressing the allocation and apportionment of foreign income taxes relating to foreign gross income generated under foreign law by disregarded payments. Also on the same day, Treasury and the IRS published final regulations (TD 9922) (the „2020 Final Regulations“), which address foreign tax credits and related matters, but reserve on the allocation and apportionment of foreign income taxes on disregarded payments.
The rules provided in the 2020 Proposed Regulations would apply for purposes of assigning foreign taxes paid on disregarded payments to or from a foreign branch of a domestic corporation to a section 904 category (i.e., foreign branch category, section 951A category, passive category or general category). They also would apply for purposes of assigning foreign taxes paid by a controlled foreign corporation (CFC) on a payment to or from its disregarded entity to a section 904 category and an income group (e.g., a tested income group, a Subpart F income group or a residual income group) within the section 904 category. The income group to which a tax paid by a CFC is assigned determines whether, and to what extent, a US shareholder of the CFC may claim a deemed paid foreign tax credit.
The 2020 Proposed Regulations represent a significant departure from the approach taken in the prior proposed regulations published in the Federal Register on December 17, 2019 (REG-105495-19) (the „2019 Proposed Regulations“), as well as from 2019 final regulations (TD 9882) (the „2019 Final Regulations“) that generally apply a „timing difference“ rule (described below) to determine how taxes on certain types of disregarded transactions are categorized. (See: Treas. Reg. § 1.904-6(a)(1)(iv) (2019 Final Regulations).)
As a result, the 2020 Proposed Regulations may provide for significantly different availability of foreign tax credits than under the 2019 Final Regulations or the 2019 Proposed Regulations.
Allocation of Taxes Generally
In general, taxpayers are required to allocate and apportion foreign income taxes to or among the statutory and residual groupings (e.g., section 904 categories or a CFC’s income groups within a section 904 category) under the following steps: (i) first, assign foreign gross income items to statutory and residual groupings; (ii) second, allocate and apportion foreign law tax deductions to the foreign gross income in such statutory and residual groupings; and (iii) third, allocate and apportion the foreign income tax among such statutory and residual groupings. (See: Treas. Reg. § 1.861-20(c) (TD 9922).)
The most substantive and detailed rules for allocating and apportioning foreign taxes relate to the first step of assigning foreign gross income items to statutory and residual groupings. Foreign gross income items are items of income recognized for foreign law purposes, which may or may not correspond to items of income for US federal income tax purposes. Where there is a US gross income item corresponding to a foreign gross income item, the item of foreign gross income is categorized based on the categorization of the corresponding item of US gross income. (See: Treas. Reg. § 1.861-20(d)(2)(ii)(A).) Where there is no US gross income item corresponding to a foreign gross income item, the 2020 Final Regulations and the 2020 Proposed Regulations provide various rules for addressing the allocation and apportionment of foreign taxes associated with such foreign income items.
Foreign taxes imposed on disregarded payments are one category of transactions in which there is a foreign gross income item with no corresponding US item. Under the 2019 Final Regulations and prior regulations, a timing difference rule generally applied to categorize such foreign taxes based on the category to which the item would be allocated if it were recognized for US purposes in the year the tax was imposed (essentially by treating the payment as between regarded entities for foreign tax credit purposes). (A „timing difference“ generally arises where there is an item of income that constitutes income under US tax principles but is not recognized for US tax purposes in the current year.) Being very general, this rule was subject to uncertainty in its application to many common fact patterns.
The 2019 Proposed Regulations provided special rules for categorizing foreign gross income items included because of a taxpayer’s receipt of a disregarded payment. Broadly, the 2019 Proposed Regulations assigned foreign taxes associated with foreign gross income included by reason of a „northbound“ disregarded payment (i.e., a payment from a disregarded entity to its regarded owner) to the statutory and residual groupings based on the tax book value of the branch’s assets, and foreign taxes associated with foreign gross income included by reason of a „southbound“ disregarded payment (i.e. a payment from a regarded owner to its disregarded entity) to the residual grouping. (See: Prop. Reg. § 1.861-20(d)(3)(ii)(A) and (B) (2019 Proposed Regulations).) As described above, taxes imposed on foreign gross income assigned to a CFC’s residual income group may not be credited under section 960 or otherwise.
New Tracing Regime
In response to comments on the 2019 Proposed Regulations, including a number of comments criticizing the denial of foreign tax credits for „southbound“ payments, the 2020 Proposed Regulations introduce a detailed new tracing regime. At a high level, the new rules seek to assign foreign gross income items resulting from disregarded payments based on the category of US gross income items out of which the disregarded payments may be considered to be paid.
To determine the US gross income to which disregarded payments are considered attributable, the 2020 Proposed Regulations incorporate the foreign branch category income rules of Treas. Reg. § 1.904-4(f) (which apply to assign gross income to the foreign branch category or general category) for allocating foreign taxes of domestic corporations. For allocating foreign taxes of CFCs, the 2020 Proposed Regulations determine the US gross income to which disregarded payments are considered attributable based on the section 954(b)(4) high-tax exception proposed rules, which assign income to „tested units“ of a CFC for purposes of applying the high-tax exception (see our prior coverage of the section 954(b)(4) high-tax exception proposed regulations here).
The 2020 Proposed Regulations include specific rules for disregarded „reattribution payments,“ disregarded sales or exchanges of property, disregarded remittances and disregarded contributions. Each is discussed in turn below.
Reattribution payments generally mean disregarded payments to the extent they result in the reattribution of income from one „taxable unit“ to another. Generally, a disregarded payment causes gross income to be attributed from one taxable unit to another to the extent that a deduction for the payment, if regarded, would be allocated against the payor tested unit’s US gross income.
Statutory or residual groupings to which foreign gross income of a taxable unit is assigned is determined without regard to any reattribution payments made by the taxable unit. (See: Prop. Reg. § 1.861-20(d)(3)(v)(B)(3).) As a result, foreign taxes that are imposed on foreign gross income that is subject to these reattribution provisions will not be reattributed on account of the reattribution payment.
With respect to a domestic corporation, a foreign branch and a foreign branch owner are separate taxable units, and Treas. Reg. § 1.904-4(f) provides rules for reattributing income between a foreign branch owner and a foreign branch. Special rules apply in the case of payments to or from „non-branch taxable units“ (which include, inter alia, disregarded entities that are not foreign branches). With respect to a foreign corporation, a taxable unit means a tested unit as such term is defined in the high-tax exception proposed regulations.
For „reattribution payments“ (i.e., the portion of a disregarded payment that results in a reattribution of US gross income from the payor taxable unit to the recipient taxable unit), foreign gross income is assigned to the statutory and residual groupings to which the amount of US gross income that is reattributed (i.e., a „reattribution amount“) is initially assigned upon receipt of a disregarded payment by the taxable unit, before taking into account any reattribution payments made by the recipient taxable unit. (See: Prop. Reg. § 1.861-20(d)(3)(v)(B)(1).)
Once reattributed, such amounts are subject to certain attribution rules to assign foreign gross income items arising from the reattribution payment to the relevant statutory and residual groupings. For domestic corporations, the attribution rules relating to gross income attributable to the foreign branch category apply, and for foreign corporations, the attribution rules in the high-tax exception proposed regulations apply. (See: Prop. Reg. § 1.861-20(d)(3)(v)(B)(2); Treas. Reg. § 1.904-4(f)(2) and Prop. Reg. § 1.954-1(d)(1)(iii).)
The foreign branch category rules generally reattribute US gross income between the general category and foreign branch category for disregarded payments between a foreign branch and its regarded owner that, if regarded for US tax purposes, would be deductible against either general category or foreign branch category income. (See: Treas. Reg. § 1.904-4(f)(2).)
The high-tax exception proposed regulations adopt the attribution rules relating to gross income attributable to the foreign branch category, but with certain adjustments (e.g., treating disregarded interest payments as reattribution payments to the extent they are deductible in the country where the payor taxable unit is a tax resident). (See: Prop. Reg. § 1.954-1(d)(1)(iii)(B).)
The 2020 Proposed Regulations also include instructive examples of regarded payments made by one domestic corporation to the foreign branch of another affiliated domestic corporation. In one example, where the domestic affiliate does not file a consolidated return with the payor corporation, the intercompany payment is fully regarded for purposes of determining US and foreign source income of the two corporations. In the other example, the two corporations file a consolidated return; in this scenario, the example illustrates how the consolidated return rules apply to the intercompany payment (i.e., the payment is still regarded, but, under a single entity analysis provided for in the matching rule of Treas. Reg. § 1.1502-13(c), the overall US sourcing result for the consolidated group is the same as if the payment were made directly by a single domestic corporation to its foreign branch). (See: Prop. Reg. § 1.904-4(f)(4)(xv), Example 15.)
Finally, the Preamble to the 2020 Proposed Regulations notes that taxpayers are not required to apply these reattribution provisions to foreign gross basis taxes (e.g., withholding taxes) imposed on foreign gross income of a taxable unit if such foreign gross basis taxes are not otherwise reassigned pursuant to the above reattribution provisions. Treasury stated that the application of these rules could distort the effective foreign tax rate of the payor taxable unit, and that reattributing foreign gross basis taxes among taxable units by reason of reattribution payments would require complex ordering rules that would be unduly burdensome for taxpayers to apply.
Disregarded Sales or Exchanges of Property
The 2020 Proposed Regulations also have specific rules for disregarded sales or exchanges of property. Pursuant thereto, foreign gross income attributable to gain on a disregarded property sale is treated as a timing difference, and associated foreign taxes are assigned to the statutory and residual grouping to which the item of gross income would be assigned if it were included in US gross income. (See: Prop. Reg. § 1.861-20(d)(3)(v)(D); Treas. Reg. § 1.861-20(d)(2)(ii)(A).) Any foreign income resulting from gain recognized on a future regarded disposition of such property, however, must be assigned to a statutory or residual grouping in the same manner as the item of US gross income (or loss), if any, that arises from the same transaction or other realization event from which an item of foreign gross income also arises. (See: Prop. Reg. § 1.861-20(d)(3)(v)(D); Treas. Reg. §§ 1.861-20(d)(1); -20(b)(2) („corresponding U.S. item“).)
The 2020 Proposed Regulations treat a „northbound“ disregarded payment that is not a reattribution payment as a remittance for US tax purposes, and include certain provisions addressing foreign gross income arising from such remittances. Pursuant thereto, foreign gross income is assigned to the statutory and residual groupings based on the asset apportionment percentages of the payor taxable unit. This apportionment is based on the asset method as provided by the interest expense apportionment rules, but with modifications to (i) treat stock owned by the taxable unit as an asset of the remitting taxable unit; and (ii) reallocate assets from a payor taxable unit that gives rise to US gross income that is assigned to a recipient taxable unit pursuant to the reattribution rules described above. (See: Prop. Reg. § 1.861-20(d)(3)(v)(C)(1)(i) and (ii); Treas. Reg. § 1.861-9.) If the payor taxable unit has no assets, the foreign gross income associated with the remittance is allocated to the residual category, and no foreign tax credit is available. (See: Prop. Reg. § 1.861-20(d)(3)(v)(C)(1)(i).)
Contributions to disregarded entities must also be taken into account for purposes of allocating and apportioning foreign income taxes under the 2020 Proposed Regulations. Pursuant thereto, foreign gross income and the associated foreign tax resulting from the receipt of a contribution (i.e., a „southbound“ payment that is not a reattribution payment) must be assigned to the residual category. Thus, if such taxes are paid by a CFC, such taxes are not eligible to be claimed as a deemed paid foreign tax credit under section 960ry. (See Prop. Reg. § 1.861-20(d)(3)(v)(C)(2) and (3); Treas. Reg. § 1.960-1(e).) Treasury believes, according to the Preamble to the 2020 Proposed Regulations, that the rule allocating foreign taxes to the residual grouping will have limited application, since contributions are rarely subject to foreign tax. Regardless, given that a „contribution“ includes the portion of a disregarded payment in excess of a reattribution payment, taxpayers should review any „southbound“ disregarded payments made by CFCs in their structures (e.g., disregarded interest or royalty payments) to confirm if such payments could be captured by the contribution rules.
Certain ordering rules require that, in the case of foreign gross income and associated foreign taxes arising from a disregarded payment that includes both a reattribution and a remittance or contribution, taxpayers must first attribute such amounts to the reattribution payment, and any excess thereof is attributed to the remittance or contribution. (See: Prop. Reg. § 1.861-20(d)(3)(v)(E)(2); -20(d)(3)(v)(C)(2).) Although the Preamble to the 2020 Proposed Regulations does not offer an explanation, the application of these ordering rules may be limited to situations in which a deductible payment is disallowed under foreign tax law.
Treasury’s pivot to the tracing approach in the 2020 Proposed Regulations may, in many instances, yield a more favorable result than the 2019 Proposed Regulations. That said, the complexity of the provisions in the 2020 Proposed Regulations, and the expansive record-keeping requirements arising therefrom, no doubt add to the growing list of taxpayer administrative burdens deriving from the Tax Cuts and Jobs Act.
If finalized, the 2020 Proposed Regulations relating to disregarded payments will apply to taxable years that begin after December 31, 2019, and end after the date on which the regulations become finalized.