Final regulations relating to the determination of the foreign tax credit following the Tax Cuts and Jobs Act were released earlier this month. Though largely similar to the proposed regulations, taxpayers may be interested in the clarifications on expense allocation and apportionment, foreign branch income and deemed paid taxes under section 960.
On December 2, 2019, the Internal Revenue Service (IRS) and US Department of the Treasury (Treasury) released final regulations (TD 9882) (the Final Regulations) relating to the determination of the foreign tax credit following the Tax Cuts and Jobs Act (TCJA). The Final Regulations finalize proposed regulations that were published on December 7, 2018 (the Proposed Regulations), as well as proposed regulations on overall foreign losses that were published on June 25, 2012, and certain portions of proposed regulations published on November 7, 2007, relating to a US taxpayer’s obligation to notify the IRS of a foreign tax redetermination. The IRS and Treasury also released new proposed regulations that provide additional guidance on the foreign tax credit, which will be addressed in a separate On the Subject.
The Final Regulations are substantially similar to the Proposed Regulations, with several important clarifications and amendments. In particular, taxpayers may be interested in certain aspects of the Final Regulations relating to expense allocation and apportionment, foreign branch income, and deemed paid taxes under section 960, each of which is discussed below.
Expense Allocation and Apportionment
The Final Regulations do not change the approach of the Proposed Regulations in allocating and apportioning expenses to the section 951A category. Comments requested that US shareholder-level expenses should not be allocated to the section 951A category in order to ensure that GILTI functions as a “minimum tax.” Treasury and the IRS rejected these comments and determined that taxpayers are required by statute to allocate and apportion expenses to the section 951A category.
The Final Regulations retain the treatment of the section 250 deduction as creating exempt income and corresponding exempt assets.
The portion of GILTI that is offset by the section 250 deduction is generally treated as exempt income, with a corresponding portion of GILTI-producing assets (e., CFC stock) treated as exempt assets.
The Final Regulations clarify that gross foreign derived deduction eligible income (FDDEI) offset by the section 250 deduction (rather than FDII) is treated as exempt income, with a corresponding portion of gross FDDEI-producing assets treated as exempt assets. This recognizes that gross FDDEI, not FDII, reflects the gross income which the section 250 deduction is effectively exempting. The preamble notes that the Final Regulations will have the effect of significantly reducing the portion of assets that are exempt by reason of FDII. Taxpayers should consider reviewing their FDII and expense apportionment models to confirm whether these changes should be taken into account.
The Final Regulations eliminate the rule in the Proposed Regulations that excluded gross tested income from tiering up to higher-tier corporations for purposes of allocating and apportioning a CFC’s interest expense under the modified gross income method.
For purposes of allocating and apportioning research and experimental expenditures, the Proposed Regulations provided a one-time exception to the five-year binding election period by allowing taxpayers to switch between the sales method and gross income method in the first taxable year beginning after December 31, 2017. This exception was finalized without change in the Final Regulations. In addition, in view of changes in the new proposed foreign tax credit regulations to the sales method, the Final Regulations provide that taxpayers may change to the sales method up to their last taxable year that begins before January 1, 2020, without prior IRS consent.
Foreign Branch Category Income
The Final Regulations generally adopt the approach of the Proposed Regulations regarding the attribution of gross income to the foreign branch category.
The Final Regulations retain the rule in the 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 certain changes. Among other changes:
The Final Regulations modify the rule in the Proposed Regulations regarding the use of section 367(d) principles to impute payments, over time, to or from a foreign branch for certain transfers of intangible property in a disregarded transaction. The Final Regulations retain this rule, but provide that it does not apply to transfers that occurred before December 7, 2018, or to transfers by a foreign branch or foreign branch owner that has transient ownership of intangible property, subject to certain limitations. For example, a distribution of intangible property may qualify for this transitory ownership exception if a foreign subsidiary elects to be treated as a disregarded entity and immediately thereafter distributes intangible property to its US owner.
The Final Regulations provide detailed rules for adjustments related to disregarded sales of property to or from a foreign branch, including adjustments for gain recognized on regarded dispositions of property that was acquired by the foreign branch or foreign branch owner in a disregarded sale.
Consistent with the Proposed Regulations, the Final Regulations provide that taxes associated with base differences are assigned to the category specified in section 904(d)(2)(H)(i) (which cross-references the foreign branch category). Prior to the TCJA, taxes associated with base differences were assigned to the general basket under section 904(d)(2)(H)(i). Comments stated that Congress had inadvertently failed to revise the cross-reference in section 904(d)(2)(H)(i) (which, following the TCJA, cross-references the foreign branch basket) and recommended that regulations assign taxes associated with base differences to the general basket. Treasury and the IRS rejected this recommendation and noted in the preamble that section 904(d)(2)(H)(i) clearly cross-references the foreign branch basket. For more background, see our earlier insight: Deference Provided to Regulations When There’s a Drafting Error.
Deemed Paid Taxes under Section 960
The Final Regulations generally retain the approach of the Proposed Regulations in determining the deemed paid credit under section 960.
The Final Regulations clarify the operation of the “timing difference” rules for determining deemed paid credits where a timing “mismatch” exists between US income and the foreign income on which foreign taxes are imposed.
Because deemed paid credits under sections 960(a) and (d) are available only to the extent that the US shareholder has a current year subpart F or GILTI inclusion from a subpart F or GILTI income group, respectively, commenters observed that credits could be “lost” because of differences in the timing of the accrual of foreign taxes and the inclusion of income by a US shareholder due to, for example, a CFC’s differing US and foreign taxable years.
Commenters suggested several approaches to resolving these mismatches, including more precise rules than the timing difference rule in the Proposed Regulations to (1) pro-rate foreign taxes across US taxable years, (2) modify the normal accrual rules for foreign taxes, or (3) allow current year taxes to be associated with previously taxed earnings and profits (PTEP), which would permit these taxes to be deemed paid under section 960(b) upon a PTEP distribution.
Treasury and the IRS rejected these comments and generally followed the “blunt instrument” approach of the timing difference rule in the Proposed Regulations. Thus, under the Final Regulations, if foreign taxes are imposed on foreign income that is not recognized for US tax purposes in a CFC’s current US tax year, the Final Regulations require CFCs to assign those foreign taxes to income groups based on how the foreign income would be characterized if recognized for US tax purposes in the year the tax was imposed.
Consistent with this approach, Treasury and the IRS also clarified that if taxes are imposed on a CFC in a post-TCJA year on pre-TCJA income, the CFC assigns the taxes to the income group to which the taxes would be assigned if the pre-TCJA income were recognized in the year in which the taxes are paid. For example, if a CFC’s pre-TCJA income would be tested income if recognized in a post-TCJA year, any foreign taxes paid on those earnings in that post-TCJA year are assigned to the CFC’s tested income group. This is a welcome clarification for many fiscal-year taxpayers for their first year of tested income.
The Final Regulations consolidates the list of PTEP groups from 16 (as described in Notice 2019-01) to 10. The preamble notes that Treasury and the IRS intend to issue more comprehensive regulations addressing the maintenance of annual PTEP accounts and the PTEP groups in a separate notice of proposed rulemaking under section 959. It is anticipated that, as part of that guidance, further changes may be made to §1.960-3 in order to coordinate both sets of regulations.
The Final Regulations are substantially similar to the Proposed Regulations, with several important clarifications and amendments. In particular, in light of the Final Regulations and clarifications provided in the preamble, taxpayers may want to review positions they have taken under the Proposed Regulations with respect to allocating and apportioning expenses for FDII purposes, the treatment of disregarded transactions involving foreign branches, and the treatment of deemed paid taxes associated with timing differences.