The IRS released final regulations (Proposed regs would alter aspects of FTC landscape.”
The Tax Cuts and Jobs Act (TCJA) made several changes that impacted the foreign tax credit and related areas. The final regulations adopt, without substantive change, certain provisions in the foreign tax credit and expense allocation rules that were proposed in December 2019 along with rules addressing certain hybrid issues that were proposed in April 2020.
However, there are several areas where the final regulations clarify or depart from the proposed regulations, including the allocation and apportionment of stewardship expenses, the allocation and apportionment of research and experimental (R&E) deductions and foreign tax redeterminations. The final regulations also revise guidance on adjustments to hybrid deduction accounts, conduit financing arrangements and branch loss and dual consolidated loss recapture rules. Certain provisions not adopted in the in the final regulations were re-proposed.
A wide range of applicability dates apply to the final regulations. Many regulations apply to tax years ending on or after Dec. 31, 2019, however, there are certain rules that apply to earlier or later tax years depending on the specific provision. As a result, taxpayers will need to carefully assess how the final regulations affect their specific tax circumstances and apply them appropriately.
Foreign tax credits have become critically important to multinational companies, affecting all aspects of a company’s tax profile. These regulations finalize several advantageous provisions from the prior proposed regulations that provide potential planning opportunities but are not without their traps. Therefore, taxpayers should carefully assess the impact on their tax profile.
The U.S. foreign tax credit generally aims to shield U.S. taxpayers from being subject to double taxation on their foreign-source income. As such, the credit is generally not available to offset liabilities on U.S.-source taxable income. The foreign tax credit limitation (often referred to as the Section 904 limitation) is calculated separately for various categories of foreign-source income. For example, passive and general categories of income are separate income categories. The TCJA also introduced two new separate categories, income from a foreign branch and global intangible low-taxed income (GILTI). The limitation is generally determined separately with respect to each category:
The numerator of the foreign tax credit limitation computation includes foreign-source U.S. taxable income reduced by deductions allocated or apportioned to the income under Sections 861 through 865. If the allocation and apportionment of the deductions result in an overall loss in one or more categories, the separately computed losses will be allocated against net income in other categories, if any. When a net loss offsets net income of a different category, various loss recapture rules may apply.
The TCJA made numerous changes to the treatment of foreign source income and the associated foreign tax credit rules. It implemented the dividend received deduction under Section 245A, added new foreign tax credit limitation categories and repealed foreign tax credit pooling under Section 902. The addition of GILTI also dramatically increased the frequency with which taxpayers are required to compute a foreign tax credit and the complexity of such calculations.
The final regulations address an assortment of foreign tax credit related issues, including several important provisions clarifying the allocation and apportionment of expenses with respect to stewardship and R&E expenses, legal damages, net operating losses, and the Section 250 deduction. Highlights from the final regulations are summarized below.
Expense allocation and apportionment
The prior regulations provided that stewardship expenses are considered definitely related to “dividends received, or to be received” from related corporations. The 2019 proposed regulations clarified that stewardship expenses are to be allocated to inclusions under Sections 951 and 951A, Section 78 gross-up dividends and amounts included under the passive foreign investment company (PFIC) regime, in addition to dividends received or to be received. Specifically, the proposed rule specified that stewardship expenses are considered definitely related and allocable to “dividends and inclusions received or accrued, or to be received or accrued,” from a related corporation (as opposed to “dividends received, or to be received” under the previous regulations). The proposed regulations also provided that, once allocated, stewardship expenses are apportioned based upon the relative values of a taxpayer’s stock assets, in the same manner as used for apportioning interest.
The final regulations revise the proposed rules and make important clarifications in several areas. They maintain the pre-existing definition of stewardship expenses as a “duplicative activity” or activities that preserve a shareholder’s capital investment or facilitate compliance with reporting, regulatory or legal requirements. The final regulations provide that stewardship expenses incurred with respect to oversight of “business entities” (i.e. disregarded entities, partnerships and corporations) are subject to allocation and apportionment rules. However, the rules do not extend the definition of stewardship expenses to include oversight expenses incurred with respect to an unincorporated branch of the taxpayer, since the branch’s income is income of the taxpayer itself, not income of a separate entity in which the taxpayer is protecting its investment.
In a departure from the proposed regulations, the final regulations provide that stewardship expenses can be allocated and apportioned to income and assets of all affiliated and consolidated group members, and that the affiliated group rules in Treas. Reg. Sec. 1. 861-14 do not apply for purposes of allocating and apportioning stewardship expenses. Stewardship expenses incurred by one member of an affiliated group to oversee the activities of another member are allocated and apportioned by the investor taxpayer on a separate entity basis, with reference to the investor’s stock in the affiliated member. Furthermore, for purposes of determining the value of an entity, the final regulations provide that the value of the stock in an affiliated corporation is characterized as if the corporation were not affiliated and the stock is characterized by the taxpayer in the same ratios in which the affiliate’s assets are characterized for purposes of allocating and apportioning the group’s interest expense.
Because stewardship activities are not fungible, the final regulations clarify that, at the allocation step (but before applying the apportionment rules), only the gross income derived from entities to which the taxpayer’s stewardship expense has a factual connection are included. The regulations also provide notable guidance in other areas, including guidance on determining the tax book value of a taxpayer’s investment in a disregarded entity, clarification that the exempt income and asset rules do not apply for purposes of apportioning stewardship expenses and specific guidance on the application of the other rules described above.
Under the 2019 proposed regulations, R&E expenditures were generally considered as deductions that are definitely related to all “gross intangible income” reasonably connected with the relevant Standard Industrial Classification Manual (SIC) code categories of the taxpayer, and thus allocable to all items of gross intangible income related to the SIC code categories as a class.
The final regulations maintain the general approach provided for in the proposed regulations but make several changes. They modify the proposed definition of gross intangible income to clarify that gross intangible income includes the full amount of gross income from sales or leases of products or services, if the income is derived in whole or in part from intangible property. Under the new definition of gross intangible income, there is no bifurcation of sales income between a portion attributable to intangible property and other amounts such as distribution or marketing functions. The final regulations, however, maintain that gross intangible income should exclude GILTI or other inclusions attributable to ownership of stock in a controlled foreign corporation (CFC), but include income giving rise to foreign-derived intangible income (FDII). Also, while the final regulations provide that gross intangible income does not include disregarded payments, certain disregarded payments that would be allocable to gross intangible income, if regarded, may result in the reassignment of gross intangible income from the general category to the foreign-branch category, or vice versa.
The final regulations also modify the rules specifying under what circumstances the sales or services of uncontrolled or controlled parties are taken into account. In particular, the final regulations specify that the gross receipts are taken into account if the uncontrolled or controlled party is expected to acquire (through license, sale or transfer) intangible property arising from the taxpayer’s current R&E expenditures, products in which such intangible property is embedded or used in connection with the manufacture or sale of such products or services that incorporate or benefit from such intangible property.
The previous final regulations mentioned two-digit SIC code categories, or “Major Groups” in the terminology of the SIC Manual, but the proposed regulations omitted the reference to Major Groups. The final regulations allow a taxpayer to aggregate some or all three-digit SIC categories within the same Major Group. However, a taxpayer may not aggregate any three-digit SIC categories within different Major Groups.
Finally, the final rules provide that exclusive apportionment does not apply for purposes of allocating and apportion deductions when computing FDII and confirm the elimination of special rules for allocating and apportioning legally mandated R&E expenditures.
Grant Thornton Insight:
The final regulations provide welcome guidance regarding several areas related to the apportionment and allocation of expenses, notably with regard to stewardship and R&E expenses. However, many taxpayers had hoped that the final regulations would also allow exclusive apportionment to apply not only for purposes of calculating the foreign tax credit under Section 904, but also for purposes of FDII. The ability to apply exclusive apportionment for purposes of FDII may result in more income qualifying for the deduction under Section 250 in certain circumstances. However, the IRS rejected these comments and the preamble to the final regulations states that adopting an R&E allocation and apportionment rule solely for purposes of increasing the amount of the FDII deduction to incentivize R&E activity would be inconsistent with the legislative intent underlying the FDII regime.
Foreign income taxes In general, the final regulations adopt the provisions of the 2019 proposed regulations related to the allocation and apportionment of foreign income taxes, with a few changes:
- The final regulations remove from the list of base differences under the 2019 proposed regulations distributions described in Sections 301(c)(2) and 733, representing nontaxable returns of capital. The preamble to the final regulations provide that these distributions are timing differences, and generally associate a foreign-law dividend that gives rise to a return of capital with hypothetical earnings of the distributing corporation, measured based on the groupings to which the tax book value of the corporation’s stock is assigned.
- The final rules reserve on the allocation and apportionment of foreign tax on disregarded payments. The concurrently issued proposed regulations provide new rules, which are covered in our story, “Proposed regs would alter aspects of FTC landscape.”
Other expense allocation and apportionment rules The final regulations also make notable clarifications to the rules allocating and apportioning deductions related to litigation awards, prejudgment interest, settlement payments, net operating loss deductions and treatment of the Section 250 deduction. They also contain several allocation and apportionment rules specific to the insurance industry.
Foreign tax redeterminations of foreign corporations
The final regulations generally adopt the provisions of the 2019 proposed regulations related to foreign tax redeterminations. For example, the regulations adopt the clarification that the rules under Section 905(c) apply in cases in which foreign tax redeterminations affect U.S. tax liability even though there may be no change to the amount of foreign tax credits originally claimed. This may occur where a foreign tax redetermination impacts whether a taxpayer is eligible for the Subpart F of GILTI “high-tax exception.”
The final regulations adopt the proposed regulations approach to notification, which provides that, except in narrow situations, any taxpayer for which a redetermination of U.S. tax liability is required must notify the IRS of the foreign tax redetermination by filing an amended return. The preamble to the final regulations indicates that the IRS continue to study whether new processes or forms can be developed to streamline the filing requirements, while ensuring that the IRS receives the information necessary to verify that taxpayers have made the required adjustments to their U.S. tax liability.
Grant Thornton Insight:
Numerous commentators suggested that taxpayers should be allowed to report prior-year foreign tax redeterminations on an attachment to their federal income tax return for the taxable year in which the redetermination occurs, instead of filing amended tax returns for the taxable year in which the adjusted foreign tax was claimed as a credit and any intervening years in which the foreign tax redetermination affected U.S. tax liability. The IRS rejected these suggestions. The amended return approach adopted by the IRS is certain to materially increase the number of amended returns required by U.S. multinationals. This puts pressure on non-U.S. income tax calculations, and companies may benefit from increased focus on accuracy to avoid costly redetermination events.
Notably, the final regulations provide a transition rule that allows taxpayers time to file required notifications with respect to foreign tax redeterminations occurring in taxable years ending on or after Dec. 16, 2019, and before the date the regulations are published in the Federal Register. The final rules also include an irrevocable election to allow a foreign corporation’s controlling domestic shareholders to account for all foreign tax redeterminations that occur in taxable years ending on or after the filing of the regulations in the Federal Register, with respect to pre-2018 taxable years of foreign corporations, as if they occurred in the foreign corporation’s last taxable year beginning before Jan. 1, 2018 (i.e., the last pooling year, and generally the Section 965 inclusion year).
The final regulations also finalized certain rules related to previously proposed regulations addressing hybrid arrangements under Section 245A(e) and other sections of the Code. The final regulations generally follow the 2020 hybrid proposed regulations with certain revisions, including refinements to the computation of an adjusted Subpart F inclusion or adjusted GILTI inclusion with respect to a share of stock of a CFC, a rule that accounts for taxable income limitations under Section 250(a)(2) and other adjustments and clarifications to the computation of the hybrid deduction account.
The final regulations also finalize the conduit financing rules addressing the treatment of a hybrid instrument as a financing transaction for purposes of Section 881. The final regulations adopt without substantive change the rule that included as a financing transaction an instrument that is stock or a similar interest (including an interest in a partnership) for U.S. tax purposes but debt under the tax law of the country of which the issuer is a tax resident. In addition, the final regulations provide that if the issuer is not a tax resident of any country, such as an entity treated as a partnership under foreign tax law, the instrument is a financing transaction if the instrument is debt under the tax law of the country where the issuer is created, organized or otherwise established.
The final regulations’ applicability dates vary by applicable Code section. While several of the final regulations apply to tax years ending on or after Dec. 31, 2019, there are certain provisions that apply to earlier or later tax years depending on the provision. Specifically, the final regulations with respect to stewardship, R&E expenses and foreign income taxes are generally applicable to tax years that begin after Dec. 31, 2019. With respect to R&E, the final regulations provide some flexibility for tax years beginning on or after Jan. 1, 2018, and before Jan. 1, 2020. For these years, taxpayers may early adopt if applied consistently with respect to such taxable year and any subsequent taxable year.
The foreign tax redetermination rules under Section 905(c) are applicable to foreign tax redeterminations occurring in taxable years ending on or after Dec. 16, 2019. A transition rule in the final regulations, however, provides taxpayers an additional year to file required notifications under certain circumstances.
The hybrid rules under Section 245A(e) and the conduit financing rules under Section 881 generally apply to tax years ending (or payments made) on or after the date the final regulations are published in the Federal Register.
Foreign tax credits impact multinational company’s tax burden immensely, with far-reaching effects on all aspects of a company’s tax profile. The rules are complex, and without careful planning may result in double taxation or costly administrative requirements, including, but not limited to, amended returns. Notwithstanding, the regulations also finalize several advantageous provisions and make taxpayer favorable changes to others that provide potential planning opportunities. Taxpayers should carefully assess the impact and update their models accordingly.
David E. Sites
David leads the firm's International Tax practice, which focuses on global tax planning, cross border merger and acquisition structuring, and working with global organizations in a variety of other international tax areas.
Washington DC, Washington DC
- Technology and telecommunications
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- International tax
Washington DC, Washington DC
- Technology and telecommunications
- Private equity
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