On September 29, 2020, the US Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final foreign tax credit regulations (the “2020 Final Regulations”) that include the allocation and apportionment of: (1) stewardship expenses; and (2) research and experimentation (R&E) expenses. The 2020 Final Regulations come after the Treasury and IRS issued proposed regulations (the “2019 Proposed Regulations”) on December 17, 2019. The 2020 Final Regulations retain substantially the same rules as in the Proposed Regulations with respect to R&E expenses and significantly change the provisions on stewardship expenses.
Allocation and Apportionment of Stewardship Expenses
In response to comments, the Treasury and IRS made two important changes in the 2020 Final Regulations regarding stewardship expenses. First, the 2020 Final Regulations turn off the affiliated group rules for stewardship expenses. Thus, a taxpayer treats its US affiliates as separate entities in allocating and apportioning its stewardship expenses. As background, an issue arose under the 2019 Proposed Regulations when allocating and apportioning stewardship expense among the stock of a corporation’s affiliates. The 2019 Proposed Regulations instructed taxpayers to ignore stock of their US affiliates. Ostensibly, this could be interpreted as causing an exclusive allocation and apportionment of stewardship expenses to foreign source assets and thereby foreign source income (which in turn would reduce the taxpayer’s section 904(a) limitation and ability to obtain foreign tax credits). Under the 2020 Final Regulations, by treating a taxpayer’s US affiliates as separate entities, a taxpayer’s stewardship expenses would be allocated and apportioned to foreign stock and US stock.
Second, although the 2020 Final Regulations retain the rule for apportioning expenses among assets (similar to interest expense apportionment), the Final Regulations provide that the 50% tax-exempt asset concept that is taken into account for interest expense apportionment purposes is not taken into account for stewardship expense apportionment purposes.
In addition to the two important changes above, the 2020 Final Regulations also make a number of clarifications. For instance, the Final Regulations clarify that at the allocation step (before the apportionment rules), only the gross income derived from entities to which the taxpayer’s stewardship expense has a factual connection are included. This approach recognizes that stewardship activities are not fungible in the same manner as interest expense. Moreover, the 2020 Final Regulations clarify that “stewardship expenses” relates to all related business entities, including corporations, partnerships and disregarded entities (but not the taxpayer’s unincorporated branches).
Because of the significance of these changes, their effective date is delayed to taxable years beginning after December 31, 2019 (e.g., 2020 tax year for calendar year taxpayers). Absent this change, according to the 2019 Proposed Regulations, the rules would take effect beginning with taxable years ending on or after December 16, 2019 (e.g., 2019 tax year for calendar year taxpayers). For taxable years that both begin after December 31, 2017, and end on or after December 4, 2018, and also begin on or before December 31, 2019 (e.g., 2018 and 2019 tax years for calendar year taxpayers), the existing Treas. Reg. § 1.861-8(e)(4) as in effect on December 17, 2019, are applicable.
Allocation and Apportionment of Research & Experimentation Expenses
The 2020 Final Regulations by and large maintain the framework provided by the 2019 Proposed Regulations regarding the allocation and apportionment of R&E expenses, with some refined concepts and clarifications.
In particular, the 2020 Final Regulations retain the elimination of the gross income method for apportioning R&E expenses. This leaves taxpayers with only the sales method to apportion R&E expenses, which “results in substantially fewer distortions than the gross income method,” as explained by the Treasury and IRS in the preamble to the 2020 Final Regulations.
The 2020 Final Regulations continue to provide that R&E expenses relate, and can be allocated to, gross intangible income (GII), which the 2020 Final Regulations broadly define as income attributable to intangible property, and which excludes inclusions under sections 951, 951A and 1293. In response to comments to the 2019 Proposed Regulations, the Treasury and IRS reaffirmed their position that R&E expenses could not relate to inclusion under section 951 or 951A because subpart F or global intangible low-taxed income (GILTI) inclusions reflect income earned by a controlled foreign corporation (CFC) and not the taxpayer incurring the R&D expenses, and including deemed inclusions in GII would result in a mismatch between the R&D expenses and the income generated by such expenses. The Treasury and IRS also explained that, in contrast to GILTI or other inclusions attributable to ownership of stock in a CFC, income giving rise to foreign-derived intangible income (FDII) is included in GII.
The 2020 Final Regulations clarified some issues that commenters raised regarding disregarded payments. If a disregarded payment would trigger the reattribution of gross income from the general category to the foreign branch category, the disregarded payment will be GII in the foreign branch category. As a result, a portion of the taxpayer’s R&E expenses would be allocated to the foreign branch category. Further, the 2020 Final Regulations and the preamble clarify that disregarded royalty payments by a foreign branch to its US owner can change the separate category grouping to which the gross income of the foreign branch is assigned, but does not result in a change in the total amount, character or source of the US person’s gross income. Instead, GII related to the foreign branch is assigned to the general category in the amount of the disregarded payment, and the balance of the GII is assigned to the foreign branch category. Consequently, a proportionate amount of the foreign branch’s gross receipts is allocated to the general category.
The Treasury and the IRS did not incorporate comments requesting the application of exclusive apportionment of R&E expenses for purposes of computing FDII. Several comments to the 2019 Proposed Regulations requested that exclusive apportionment apply because Treasury and the IRS included FDII within GII. The comments argued that applying exclusive apportionment would be consistent with the goals of the Tax Cuts and Jobs Act (TCJA) to encourage R&E activity in the United States and eliminate tax incentives for moving intellectual property abroad and that there is a technological “lag” before products are exported to foreign markets. While maintaining that the exclusive apportionment would not apply to FDII, the Treasury and IRS addressed each of these comments. In the preamble to the 2020 Final Regulations, the Treasury and the IRS denied the commenters’ contention of Congress’s intent when it created section 250 as part of TCJA. Treasury and the IRS instead characterized FDII as a balance against the inherent advantage of GILTI to taxpayers with CFCs relative to those that would choose to operate through a domestic entity. Treasury and the IRS argue that to apply the exclusive apportionment of R&E expenses to FDII would break the parity between FDII and GILTI with respect to R&E expenses. Further, Treasury dismisses the commenters’ concerns regarding lag in exports to foreign markets. Treasury stated that the fact that the sales method uses current year sales as a proxy for the income that the R&E expense is reasonably expected to produce in the future already takes into account to some extent the potential for a lag between exploiting intangible property in the domestic market versus foreign markets.
The 2020 Final Regulations also provide additional refinement for applying the sales method. For example, under the 2019 Proposed Regulations, R&E expenses related to GII reasonably connected to a 3-digit SIC code category. Treasury recognized that R&E activity may be conducted with respect to more than one Standard Industrial Classification (SIC) code category. As a result, the 2020 Final Regulations allow taxpayers to aggregate R&E expenses under two or more SIC code categories within the same Major Group based on a 2-digit SIC. This provides greater flexibility to taxpayers who may choose between different aggregations of SIC code categories.
Although it requested comments on the issue, the Treasury declined to give clarity on the treatment of contract research expenditures under section 162 or 174. Treasury stated that such a determination was outside the scope of the 2020 Final Regulations. Given that the surrounding facts relating to contract research arrangements can vary from company to company, Treasury’s decision preserves taxpayer flexibility to make its own determination whether its contract research expenditures are subject to the rules for allocating and apportioning R&E expenditures.
The allocation and apportionment rules with respect to R&E expenses are not retroactive but are effective with taxable years beginning after December 31, 2019. Taxpayers may adopt these rules for their 2018 or 2019 taxable years; however, they must apply Treas. Reg. § 1.861-17 in its entirety and for any subsequent year beginning before January 1, 2020.