IRS Finalizes Foreign Tax Credit and Other Foreign-Related Regulations

(Parker Tax Publishing January 2020)

The IRS issued final regulations on calculating the foreign tax credit subsequent to changes made to those rules by the Tax Cuts and Jobs Act of 2017. The IRS also issued final regulations on the calculation of overall foreign losses and final regulations relating to a U.S. taxpayer's obligation to notify the IRS of a foreign tax redetermination. T.D. 9882.

Background

In December of 2018, the IRS issued proposed regulations (REG-105600-18) (2018 FTC proposed regulations) relating to the calculation of foreign tax credits as a result of changes made by the Tax Cuts and Jobs Act of 2017 (TCJA), including the addition of two new categories of income - the Section 951A category income and foreign branch category income.

On December 17, 2019, in T.D. 9882, the IRS issued (1) final regulations relating to the calculation of foreign tax credits; (2) final regulations on overall foreign loss recapture; and (3) final regulations relating to a U.S. taxpayer's obligation to notify the IRS of a foreign tax redetermination. With respect to the calculation of the foreign tax credit, the final regulations retain the basic approach and structure of the 2018 FTC proposed regulations, with certain revisions.

Allocation and Apportionment of Deductions

A taxpayer determines its foreign tax credit limitation under Code Sec. 904, in part, based on the taxpayer's taxable income from sources without the United States. The 2018 FTC proposed regulations provided that, in general, the regulations under Code Sec. 861 through Code Sec. 865 that provide rules for allocating and apportioning deductions to determine the taxpayer's taxable income from sources without the United States apply to income described in Code Sec. 904(d)(1)(A) (the Section 951A category). Some practitioners requested that the final regulations provide that no expenses should be allocated to the Code Sec. 951A category in order to ensure that income of a U.S. shareholder derived through a controlled foreign corporation (CFC) would be effectively exempt from additional U.S. tax if the foreign effective tax rate is greater than or equal to a particular rate. These practitioners generally cited language in the TCJA Conference Report illustrating that no U.S. "residual tax" applies to foreign earnings subject to a foreign effective tax rate of 13.125 percent or more. Their comments suggested that not requiring expenses to be allocated to the Code Sec. 951A category allows global intangible low-taxed income (GILTI) to function as a "minimum tax." The IRS rejected these comments, however, and concluded that the statute requires that expenses be allocated and apportioned to the Code Sec. 951A category. Citing the 2016 U.S. Model Treaty, the IRS said that this approach is also consistent with U.S. treaty obligations, which preserve the right of the United States to limit allowable foreign tax credits "in accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principles hereof)." Further, the IRS noted, this approach is confirmed by the Joint Committee on Taxation's Explanation of the TJCA, which states that Congress intended that the foreign tax credit limitation in the Code Sec. 951A category, like any other separate category, is calculated by taking into account expenses allocable to income in that category.

Under the proposed regulations, the portion of a domestic corporation's income that is foreign derived intangible income (FDII) or results from an inclusion under Code Sec. 951A(a) (a GILTI inclusion), and the corresponding amount treated as a dividend under Code Sec. 78 (Section 78 dividend), is treated as exempt income based on the amount of the Code Sec. 250 deduction allowed to the U.S. shareholder. The proposed regulations treated an equivalent portion of the domestic corporation's assets that give rise to FDII, or the stock of the CFC that gives rise to the GILTI inclusion, as an exempt asset. The final regulations adopt this rule.

The 2018 FTC proposed regulations also confirmed that earnings and profits excluded from income under Code Sec. 959 (i.e., previously taxed earnings and profits) do not result in any portion of the stock in a CFC being treated as an exempt asset. The final regulations adopt this rule.

With respect to the allocation and apportionment of the Code Sec. 250 deduction, the proposed regulations provided rules for allocating and apportioning (1) the portion of the Code Sec. 250 deduction for FDII, and (2) the portion of the Code Sec. 250 deduction for the GILTI inclusion and the amount of the Code Sec. 78 dividend attributable to foreign taxes deemed paid with respect to the GILTI inclusion. In particular, the proposed regulations provided that the portion of the Code Sec. 250 deduction for FDII is treated as definitely related and allocable to the specific class of gross income that is included in the taxpayer's foreign derived deduction eligible income (FDDEI), and that the deduction is apportioned between the statutory and residual grouping based on the FDDEI in each grouping. The final regulations adopt this rule.

A practitioner expressed concern that, to the extent that the portion of the Code Sec. 250 deduction for FDII is allocated to foreign source income, it would reduce the ability to claim foreign tax credits. The practitioner recommended not apportioning this portion of the deduction to FDDEI. The IRS observed that, under Code Sec. 861 and Code Sec. 862, a taxpayer must determine its taxable income by deducting from gross income the deductions properly apportioned or allocated thereto. Under Reg. Sec. 1.861-8, deductions are generally allocated and apportioned based on a factual relationship between the deductions and gross income. Because a portion of the Code Sec. 250 deduction for FDII is factually related to the taxpayer's FDDEI, under the principles of Reg. Sec. 1.861-8 that portion of the Code Sec. 250 deduction is allocated to that income, regardless of whether the FDDEI is U.S. or foreign source. Thus the comment was not adopted and the proposed regulation was finalized as is.

The 2018 FTC proposed regulations included rules addressing the source and separate category of interest income and expense related to loans to a partnership by a U.S. person (or a member of its affiliated group) that owns an interest (directly or indirectly) in the partnership. These loans are referred to as specified partnership loans. Under the proposed regulations, the lender in these transactions is generally required to match the source and separate category of the interest income and expense by assigning the interest income to the same statutory and residual groupings from which the interest expense is deducted. The portion of the loan that corresponds to the matched income and expense is not taken into account for purposes of allocating and apportioning the lender's remaining interest expense. The 2018 FTC proposed regulations also include anti-avoidance rules to extend the application of these provisions to certain back-to-back loans or loans made through CFCs.

One practitioner suggested modifying the language in the proposed regulations to clarify that the rules for specified partnership loans apply solely to match existing income and expense related to the loan, and therefore the rules do not create additional gross income. The final regulations clarified the language of the 2018 FTC proposed regulations consistent with this comment.

The IRS also addressed the anti-avoidance rule in the 2018 proposed regulations, which provided that certain loans to a partnership held by a CFC would be treated as held directly by the U.S. shareholder of the CFC if the loan was made or transferred with a principal purpose of avoiding the rules of the proposed regulations. The final regulations clarify the operation of Reg. Sec. 1.861-9(e)(8)(i), which generally requires that the U.S. person that owns a direct or indirect interest in the partnership disregard a portion of the loan receivable for purposes of allocating any other interest expense of the U.S. person. Where this anti-avoidance rule applies, the IRS said, the loan receivable is held by the CFC rather than its U.S. shareholder (which has the direct or indirect interest in the partnership), and thus merely disregarding the loan receivable would not affect the interest expense allocated by the U.S. shareholder because the relevant asset to the U.S. shareholder is the stock of the CFC that holds the loan receivable. Accordingly, the final regulations provide that appropriate adjustments are made to the value and characterization of the U.S. shareholder's stock in the CFC to reflect the amount of the loan that is disregarded.

Foreign Branch Category Income

With respect to calculating foreign branch category income, the IRS received several comments on a proposed rule under which gross income attributable to a foreign branch that is not passive category income must be adjusted to reflect disregarded payments between a foreign branch and its foreign branch owner, and between foreign branches (the disregarded payment rule). Some practitioners expressed support for the rule, while others indicated that they believed that the regulations would be more administrable without the disregarded payment rule. The IRS determined that the disregarded payment rule furthers the various policies related to the attribution of gross income to a foreign branch. The disregarded payment rules, the IRS noted, are designed to utilize information that is already available to taxpayers, making the rule more administrable. Taking disregarded payments into account will also give effect to the economic activity of a foreign branch (or a foreign branch owner) while reducing mismatches between the amount of gross income attributable to a foreign branch and the foreign tax base. Accordingly, the final regulations retain the disregarded payment rule, subject to certain modifications.

The IRS determined that disregarded payments should not be netted before making adjustments under the disregarded payment rule. The disregarded payment rule affects only the separate category of gross income, and not the source or character of a taxpayer's gross income. Accordingly, when a disregarded payment is made between a foreign branch owner and a foreign branch, the regulations provide that the payment must be allocated to gross income of the payor to determine the source and character of the amount that is reattributed. When there is an increase to the amount of gross income attributable to a foreign branch, for example, the final regulations provide that there must be a corresponding decrease to income of the foreign branch owner with the same source and character. Moreover, the disregarded payment rule only affects the assignment of gross income in the foreign branch category and the general category, or a specified separate category that is associated with the foreign branch or general categories. Passive income, for example, is always excluded from the foreign branch category. Thus, to the extent that a disregarded payment from a foreign branch owner to a foreign branch would be allocable to passive income of the foreign branch owner, there can be no adjustment as a result of that payment to the taxpayer's gross income in the passive category, even though the amount of passive category income that is attributable to the foreign branch (and the foreign branch owner) may change.

For a discussion of the foreign tax credit rules, see Parker Tax ¶101,900.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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