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Dec 16, 2019

Final and Proposed TCJA Foreign Tax Credit Regulations Create Traps and Opportunities

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On December 2, 2019, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) issued a pre-published version of final regulations (the “Final Regulations”) providing guidance with respect to determining the amount of allowable foreign tax credits and the proper manner of allocating those foreign tax credits to the applicable foreign tax credit baskets under section 904.[1] The Final Regulations are similar to proposed regulations that Treasury and the IRS issued on December 7, 2018 (the “2018 Proposed Regulations”) with certain exceptions. Although the Final Regulations address a number of technical issues raised by the 2018 Proposed Regulations, Treasury and the IRS generally declined to change their approach to the more controversial rules contained in the 2018 Proposed Regulations. Notably, the Final Regulations do not extend section 904(d)(3) look-thru treatment to the global intangible low-taxed income (“GILTI”) basket or section 960(b) treatment to foreign taxes imposed on disregarded distributions of previously taxed earnings and profits (“PTEP”).

In addition, Treasury and the IRS finalized proposed regulations issued on June 25, 2012 related to the allocation and recapture of overall foreign losses and overall domestic losses. Treasury and the IRS also finalized regulations and issued new proposed regulations related to foreign tax redeterminations under section 905(c). As discussed in more detail below, these regulations will likely result in many U.S. parented multinational groups being required to file amended U.S. federal tax returns in connection with resolving foreign tax audits. Finally, Treasury and the IRS issued proposed regulations related to a number of other issues involving foreign tax credits (the “2019 Proposed Regulations”). Specifically, the 2019 Proposed Regulations provide guidance with respect to research and experimental (“R&E”) expenses such that R&E expenses are generally precluded from being allocated and apportioned to the GILTI basket for foreign tax credit purposes.

Background

The Tax Cuts and Jobs Act (“TCJA”)[2] made a number of changes to the existing foreign tax credit regime. Prior to the TCJA, U.S. corporate taxpayers could claim a tax credit for foreign taxes paid on earnings of a controlled foreign corporation (“CFC”) and distributed or deemed distributed to a shareholder that is a domestic corporation by a 10% owned foreign corporation. As part of the TCJA, Congress enacted section 245A, which generally provides domestic corporations a dividends received deduction for the foreign-source portion of dividends received from a 10% owned foreign corporation. Because section 245A generally alleviates double taxation concerns when a U.S. corporate taxpayer receives a foreign-source dividend, the TCJA disallowed foreign tax credits under section 901 for taxes imposed on dividends from foreign corporations.

Additionally, the TCJA added a tax on GILTI of a U.S. shareholder under section 951A. The GILTI rules generally impose a current minimum tax on earnings of CFCs that prior to the enactment of the TCJA were not taxed until distributed as dividends. GILTI inclusions by a domestic corporation may, however, be offset by a deduction of 50% of such income under section 250.

U.S. corporate taxpayers remain entitled to tax credits for foreign taxes paid with respect to inclusions of subpart F income and GILTI under section 960. However, the foreign tax credit is limited to taxes “properly attributable” to subpart F income or income taxed currently under the GILTI rules. The “pooling” rules that applied previously have been eliminated.

Section 904 provides certain limitations to the amount of foreign tax credits allowable to a taxpayer. Limitations under section 904 must be calculated separately with respect to certain categories of income. The TCJA added two new foreign tax credit baskets—one for GILTI and one for foreign branch income. Notably, for purposes of GILTI, a U.S. corporate taxpayer is deemed to pay only 80% of the foreign taxes paid by a foreign corporation. While section 904 generally allows foreign taxes to be carried back one year and then carried forward ten years, the TCJA does not permit GILTI basket foreign tax credit carrybacks or carryforwards.

As part of the TCJA, section 905(c) was amended. Section 905(c) generally provides rules for adjustments to accrued taxes when either (i) the accrued taxes differ from the amounts claimed as credits by a taxpayer, (ii) the accrued taxes are not paid before two years after the close of the taxable year to which the taxes relate, or (iii) the taxes are paid or refunded in whole or in part (collectively, “Foreign Tax Redeterminations”). Prior to the TCJA, Foreign Tax Redeterminations were generally taken into account prospectively by adjusting a foreign corporation’s pools of undistributed earnings and foreign taxes. However, the TCJA amended section 905(c) to provide that such adjustments be taken into account retroactively. 

Overview of the Final Regulations

The Final Regulations generally follow the structure of the 2018 Proposed Regulations with few substantive revisions. Notably, Treasury and the IRS rejected comments from taxpayers requesting that the Final Regulations provide that no expenses should be allocated to the GILTI basket such that no residual tax on GILTI would occur in the case of a domestic corporation if the GILTI was subject to a foreign effective tax rate of 13.125%. Like the 2018 Proposed Regulations, the Final Regulations generally apply the same approach to expense allocation to the GILTI basket as to any other basket. The preamble to the Final Regulations asserted that this approach is consistent with the legislative history to the enactment of the TCJA.

In addition, for purposes of allocating expenses, the 2018 Proposed Regulations treated the portion of a domestic corporation’s income that is entitled to a deduction under section 250 and any corresponding amount treated as a dividend under section 78 as exempt income based on the amount of the deduction. The Final Regulations maintain this rule by providing exempt income and asset treatment for income in the GILTI basket that is offset by a section 250 deduction.

Section 904(d)(3) provides a look-thru rule such that dividends, interest, rents and royalties received or accrued from a CFC in which the recipient is a U.S. shareholder are not treated as passive income except to the extent that such income is attributable to passive category income of the CFC. Comments to the 2018 Proposed Regulations requested that regulations be amended to provide that the look-thru rule under section 904(d)(3) apply to characterize interest, rents and royalties attributable to tested income paid by a CFC to a U.S. shareholder as income in the GILTI basket. Treasury and the IRS did not adopt this proposal, stating that look-thru payments cannot give rise to GILTI income because such amounts are not included by the payee in gross income under GILTI. 

Comments to the 2018 Proposed Regulations also requested additional guidance with respect to timing differences, for example, when a CFC has a different taxable year than its U.S. shareholder. The comments included various suggestions to address timing differences; however, Treasury and the IRS generally rejected these comments because of concerns regarding compliance and administrative burdens. Treasury and the IRS also noted that the allocation and accrual methods suggested by comments “may produce results that are no more and possibly less accurate than the current accrual rule.”

The 2018 Proposed Regulations provided a transition rule for the carryforward and carrybacks of unused foreign taxes paid or accrued under the pre-TCJA foreign tax credit rules to post-TCJA tax years. As a result of the addition of the GILTI and foreign branch baskets, comments to the 2018 Proposed Regulations specifically requested a simplified rule for purposes of assigning a portion of the pre-2018 unused foreign taxes to the post-2017 foreign branch basket. Under the 2018 Proposed Regulations, a taxpayer may assign unused foreign taxes in the pre-2018 general category basket to the post-2017 foreign branch basket to the extent those taxes would have been assigned to that basket if the taxes had been paid or accrued in a post-2017 taxable year. The Final Regulations provide a safe harbor for purposes of the transition rule such that the foreign taxes carried from a particular pre-2017 taxable year to the post-2018 foreign branch category may be allocated based on a ratio equal to the amount of foreign income taxes paid or accrued by the taxpayer’s foreign branches divided by the amount of all foreign income taxes assigned to the general category. 

The Final Regulations also notably provide that if either a domestic corporation or a CFC receives a distribution of PTEP from a CFC or lower-tier CFC, respectively, any foreign taxes, such as withholding taxes on the distribution, will be deemed paid by the recipient under section 960(b). In addition, adjustments are made to the foreign tax credit limitation in the basket corresponding to such PTEP to facilitate the utilization of the resulting foreign tax credit. However, when an entity that is treated as a disregarded entity owned by a CFC for U.S. tax purposes distributes PTEP to another disregarded entity or its regarded CFC owner, any withholding taxes or income taxes imposed by the foreign jurisdiction on the distribution will not be treated as attributable to PTEP. While such taxes may be creditable under section 960(a) or section 960(d), foreign tax credit limitations are more likely to prevent U.S. shareholders from being able to use any resulting foreign tax credit.

The Final Regulations also finalized portions of the temporary regulations issued under sections 905(c) and 986. Specifically, Treasury and the IRS finalized: (i) the currency translation rules contained in Temp. Treas. Reg. § 1.905-3(b) and moved those rules to Treas. Reg. § 1.986(a)-1; (ii) the definition of foreign tax redetermination; (iii) the rules requiring a redetermination of a U.S. tax liability for foreign income taxes other than those deemed paid under section 960; and (iv) the rules related to foreign income taxes imposed on foreign tax refunds. As would be expected because of the repeal of section 902 and amendments to section 905(c) providing solely for retroactive adjustments with respect to foreign tax redeterminations, Treasury and the IRS did not finalize portions of the temporary regulations related to prospective pooling adjustments for a foreign tax redetermination. 

Overview of the 2019 Proposed Regulations

The 2019 Proposed Regulations provide additional guidance with respect to a number of issues where taxpayers had requested guidance. Notably, the 2019 Proposed Regulations provide guidance with respect to the allocation and apportionment of certain expenses, including R&E expenses, among foreign tax credit baskets. Additionally, the 2019 Proposed Regulations, among other items, provide guidance with respect to foreign tax redeterminations.

Several comments to the 2018 Proposed Regulations requested guidance for allocating R&E expenses. In particular, comments requested that regulations preclude the allocation and apportionment of R&E expenses to the GILTI basket. Treasury and the IRS agreed with the comment and noted that R&E expenses generally give rise to intangible property that generates gross intangible income in the United States such that the income is not considered GILTI income. Because gross intangible income is not income assigned to the GILTI basket, Treasury and the IRS determined that R&E expenses should not be allocated or apportioned to the GILTI basket. 

The 2019 Proposed Regulations also eliminate the legally mandated R&E expenses rule. This rule required the allocation of R&E expenses to a single geographic region when the expenses are undertaken solely to meet legal requirements imposed by a governmental entity in that geographic region and such expenses are not reasonably expected to generate gross income outside of such geographic region. In addition, the 2019 Proposed Regulations eliminate the increased exclusive apportionment rule that allowed a taxpayer to demonstrate that a higher amount of R&E expenses should be exclusively apportioned to a geographic region. 

In addition, the 2019 Proposed Regulations clarify the allocation and apportionment of certain expenses, such as stewardship expenses. Before the enactment of the TCJA and the issuance of the 2018 Proposed Regulations, stewardship expenses were definitely related and allocable to dividends received from related corporations. The 2019 Proposed Regulations clarify that for purposes of this rule stewardship expenses are allocated to inclusions under subpart F, GILTI, section 78 dividends and all amounts included under the passive foreign investment company regulations. Additionally, for purposes of apportionment, the 2019 Proposed Regulations provide that stewardship expenses are apportioned based upon the relative value of a taxpayer’s stock assets. In addition to providing rules for stewardship expenses, the 2019 Proposed Regulations provide rules for the allocation and apportionment of litigation damages awards, prejudgment interest, settlement payments and net operating loss deductions. 

Treasury and the IRS also stated that with respect to expense allocation, future guidance may be necessary to address allocating and apportioning interest deductions and questioned whether rules for the capitalization and amortization of certain expenses are necessary solely for purposes of allocating and apportioning interest expense. Additionally, Treasury and the IRS are considering whether additional rules for allocating and apportioning expenses to the foreign branch category or limiting the amount of gross income reallocated as a result of certain disregarded payments are necessary. 

As a result of the changes to section 905(c), the 2019 Proposed Regulations provide that in the event of a Foreign Tax Redetermination, not only must a U.S. shareholder make adjustments of its foreign taxes deemed paid and its related section 78 dividend, but a U.S. shareholder also must make adjustments to the foreign corporation’s earnings and profits and the amount of any inclusions under subpart F and GILTI. Additionally, the 2019 Proposed Regulations provide rules for notifying the IRS of a Foreign Tax Redetermination. If the taxpayer files an amended return reflecting the redetermination, such return will generally be treated as a notification.  

Conclusion

The Final Regulations are generally consistent with the 2018 Proposed Regulations. The Final Regulations and the 2019 Proposed Regulations create both unexpected pitfalls and opportunities, including with respect to the following:

  • No section 904(d)(3) look-through occurs with respect to the GILTI basket;
  • Domestic corporate U.S. shareholders of CFCs are entitled to deemed-paid foreign tax credits under section 960(b) for foreign taxes imposed on regarded PTEP distributions and will receive an increase in the relevant foreign tax credit limitation corresponding to the relevant PTEP category, but foreign taxes imposed on disregarded PTEP distributions may only be creditable under other portions of section 960 if the foreign tax credit limitation in the relevant PTEP category would otherwise permit such foreign tax credit to be utilized; 
  • Proposed regulations under section 905(c) related to foreign tax credits after a foreign tax audit will frequently require U.S. parented multinational groups to file amended tax returns upon settling foreign tax audits; and
  • R&E expense will not be allocated or apportioned to the GILTI basket. 

Please contact any member of the Shearman & Sterling LLP tax team for further information.

Footnotes

[1]   All section references are to the Internal Revenue Code of 1986, as amended (the “Code”), and “Treas. Reg. §” references are to the Treasury regulations issued thereunder.

[2]  Pub. L. No. 115-97 (2017).

Authors and Contributors

Michael Shulman

Partner

Tax

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+1 212 848 8080

New York

Jay M. Singer

Partner

Tax

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+1 202 508 8117

Washington DC

Nathan Tasso

Partner

Tax

+1 202 508 8046

+1 202 508 8046

Washington DC

Joshua Savey

Associate

Tax

+1 202 508 8024

+1 202 508 8024

Washington DC

Practices