The IRS released extensive proposed regulations (REG-105600-18
) on Nov. 28 to implement changes to the foreign tax credit regime brought about by the Tax Cuts and Jobs Act (TCJA), providing much needed relief in some areas but not going as far as some taxpayers had hoped in others.
The TCJA made numerous changes to the Tax Code with respect to the foreign tax credit rules and related rules for allocating and apportioning expenses for purposes of determining the foreign tax credit limitation. It implemented the dividend received deduction under Section 245A, added new foreign tax credit limitation categories, repealed Section 902, and made numerous other changes. Most importantly, the TCJA added Section 951A, or global intangible low-taxed income (GILTI), which subjects a U.S. shareholder of a controlled foreign corporation (CFC) to current taxation on certain foreign income.
The addition of the new GILTI regime in particular heightened importance of determining the foreign tax credit. Many taxpayers had hoped the proposed regulations would provide blanket relief from expense allocation and apportionment when calculating GILTI inclusions. However, the proposed regulations fall short of a full prohibition on expense allocation and apportionment to GILTI, but do include partial relief that may limit the amount of expenses apportioned to GILTI.
The proposed regulations were released under Sections 78, 861, 901, 904, 954, 960, and 965. Although they primarily implement changes made by the TCJA, they address other foreign tax credit issues and statutory changes pre-dating it as well. The regulations also provide guidance on the application of an election to forgo the use of net operating losses when computing an inclusion under Section 965. In addition to the breadth of the guidance, many of the rules are proposed to be retroactively effective for tax years beginning after Dec. 22, 2017. As such, taxpayers should carefully assess how the proposed regulations impact their specific tax circumstances.
The aforementioned issues and other select highlights from the proposed regulations are summarized below.
Significant overhaul of computational rules
The overhaul of the U.S. tax system significantly changed the rules governing foreign tax credits. The proposed regulations contain numerous changes and clarifications relating to the computational amendments to the regime. Some of the key computational changes contained in the proposed regulations are below.
Allocation and apportionment of deductions and calculation of taxable income for Section 904(a)
The foreign tax credit limitation under Section 904 is determined based on the taxpayer’s taxable income from sources without the United States. Foreign-source taxable income is determined after the allocation and apportionment of deductions applying the rules contained in Sections 861 through 865 and the applicable regulations. New proposed regulations amend existing regulations under Section 861 to clarify how deductions are allocated and apportioned and to provide new rules relating to Sections 864(e) and 904. Proposed regulations were also issued under Section 904(b)(4), which provide certain adjustments to the computation of the foreign tax credit limitation when a Section 245A deduction is claimed.
The proposed regulations contain new and modified rules addressing the treatment of exempt income and exempt assets. These rules generally provide that under Section 864(e)(3), GILTI income offset by the Section 250 deduction will be exempt income and also that a percentage of the CFC stock that generates GILTI income will be an exempt asset. This exempt treatment will generally reduce the allocation and apportionment of deductions to GILTI income, particularly interest expense allocations.
The proposed regulations also contain rules for allocating and apportioning the Section 250 deduction. They provide separate rules for the portion of the Section 250 deduction that pertains to foreign-derived intangible income and that pertains to GILTI. Generally, these rules provide that the Section 250 deduction is definitely related and allocable to the corresponding class of gross income (i.e., foreign-derived eligible income or the Section 951A income). If the income is allocated to a class of gross income that contains more than one category under Section 904(d), then it is ratably allocated to groupings within the class.
The proposed regulations also clarify that dividends reduced by a deduction under Section 245A are not subject to the exempt asset rules contained in Section 864(e)(3). Instead, Section 904(b)(4) provides for alternative rules, which assigns dividends and related expenses to a Section 245A subgroup. The dividends and deductions assigned to the Section 245A subgroup are disregarded for purposes of the Section 904 limitation. Disregarding expenses assigned to the Section 245A subgroup generally may have the effect of increasing the foreign tax credit limitation under Section 904(a) since the denominator is increased in the limitation formula, but the numerator in other foreign-source categories remains unchanged.
Section 960 deemed-paid credits
The package contains complex computational and grouping rules for foreign taxes deemed paid under Section 960. Generally, under Sections 960(a) and (d), a U.S. shareholder with an inclusion of any item of income with respect to a CFC under Sections 951(a)(1) and 951A, respectively, is deemed to have paid the amount of the foreign corporation’s tax that can be properly attributed to such income. Section 960(b) and (c) provides rules for taxes in connection with distributions of previously taxed income to either a U.S. shareholder that is a domestic corporation or to a shareholder that is a CFC.
Generally, to determine the amount of foreign taxes paid or accrued by a CFC that are properly attributable to current Subpart F or GILTI inclusions, the proposed regulations provide that current year taxes of the CFC are to be associated with the types of income earned by the CFC generating the inclusions. To accomplish this, the proposed regulations require the income of a CFC to be placed in categories and then further assigned to groups. Deductions, including current year taxes, are allocated and apportioned to each category and group to determine net income in each group and to determine the amount of income taxes that are attributable to the income in the respective groups. Properly attributable taxes must be paid or accrued in the U.S. taxable year of a CFC that includes the Subpart F or tested income. The taxes must also be in proportion to the CFC’s Subpart F or tested income included in gross income of the U.S. shareholder. The proposed regulations provide that no foreign income taxes are deemed paid under Section 960(a) with respect to an inclusion under Section 956.
Grant Thornton Insight: If finalized, the prevention of a deemed paid credit being carried by Section 956 inclusions would create a significant trap for the unwary. This change would place heightened importance on the Section 956 proposed regulations, and may necessitate early adoption of Section 956 proposed regulations. For more details on the Section 956 proposed regulations, see our Tax Flash.
The proposed regulations also contain a system for associating foreign income taxes deemed paid or accrued by a CFC with a Section 959 distribution of previously taxed earnings and profits. They require that a CFC establish separate annual accounts for its previously taxed earnings and profits (PTEP) for its current taxable year to which a Subpart F or GILTI inclusion is attributable. The PTEP of each account is assigned to one of 10 groups that serve as the mechanism for associating foreign income taxes deemed paid or accrued with a distribution out of PTEP. The proposed regulations also confirm that an excess limitation account may be established for GILTI and will be available to increase the Section 904 limitation for purposes of computing a foreign tax credit under Section 960(c).
Section 78 gross-up
The proposed regulations under Section 78 largely make conforming changes to implement the statute as amended by the TCJA. However, they do provide that a dividend under Section 78 that relates to the taxable year of a foreign corporation beginning prior to Jan. 1, 2018, should not be treated as a dividend for purposes of Section 245A. This rule prevents a fiscal taxpayer from claiming a Section 245A deduction with respect to a Section 78 dividend attributable to a U.S. shareholder’s Section 951(a) inclusion (including inclusions resulting from Section 965) for the CFC’s fiscal year ending in 2018.
The proposed regulations also provide a rule that assigns the Section 78 gross-up to the same separate category as the deemed paid taxes. This rule resolves taxpayer’s concerns that the Section 78 gross-up and the GILTI inclusion may be assigned to different categories.
The IRS received significant comments on the interaction between GILTI and the foreign tax credit limitation rules. The comments allege that Congress intended GILTI income of a U.S. shareholder derived through a CFC to be effectively exempt from U.S. tax if the foreign effective tax rate is at or above 13.125%. The IRS noted that many of these comments cite language in the legislative history illustrating that no U.S. “residual tax” applies to foreign earnings subject to a foreign effective tax rate of 13.125% or more.
However, law pre-dating TCJA contains rules that would limit a company’s ability to claim a credit. This limitation occurs, in part, from allocation and apportionment of expenses at the U.S.-shareholder level to the foreign income. The result of the interaction between GILTI and the pre-existing foreign tax credit limitation rules is that a U.S. shareholder’s foreign taxes paid may exceed the U.S. tax on its Section 951A category income, but, due to limitations, only a portion of the foreign taxes paid may be credited. In this circumstance, the resulting excess credits may result in residual U.S. tax.
In the preamble, the IRS disputes the claim that Congress intended to fully exempt foreign income subject to at or above 13.125%. It cites numerous factors and concludes that the “new [TCJA] provisions plainly contemplates that deductions will be allocated and apportioned to [GILTI].”
Despite lacking comprehensive relief, the proposed regulations do provide partial relief by limiting the allocation and appointment of certain expenses to GILTI when computing the foreign tax credit limitation. For example, a portion of the GILTI income is treated as exempt income and a portion of the CFC stock that generated the GILTI income is treated as an exempt asset when computing the foreign tax credit limitation. Generally, this will have the effect of reducing the amount of expenses allocated and apportioned to the GILTI basket, particularly interest expense.
The proposed regulations contain several rules targeting distortive or abusive transactions. For example, they provide specific guidance on the treatment of certain specified loans made to a partnership by a United States person (or affiliated group) that owns an interest (directly or indirectly) in the partnership. The proposed regulations address the distortion that can occur in the determination of the foreign tax credit limitation when the same person includes in income the interest income and deducts the corresponding expense allocated to it from the partnership. The proposed regulations prevent this distortion by providing that the lender in a specified partnership loan transaction assign the interest income to the same statutory or residual grouping as the interest expense.
The proposed regulations also modify the existing regulations, enacted prior to TCJA, relating to the high tax exception rule contained in Section 954(b)(4). The modification pertains to situations where CFCs have been formed in locations that utilize an “integration” tax regime. Under these regimes, all or substantially all of the tax paid by the CFC is refunded to the shareholder on a subsequent distribution of the earnings without an imposition of tax to the shareholder. Relying on the current regulations, taxpayers treated the subsequent reduction of corporate tax as not affecting the effective rate high-tax exception computation under Section 954(b)(4). The proposed regulations modify these rules and provide that, to the extent that foreign taxes are reasonably certain to be returned to a shareholder upon a subsequent distribution, those foreign taxes are not treated as taxes paid or accrued for purposes of Section 954(b)(4). The preamble indicates that the IRS may also challenge these arrangements under existing law as either a refund or a subsidy.
Definition of a foreign branch
The TCJA added Section 904(d)(1)(B), which created a new basket for foreign branch income. The proposed regulations provide that foreign branch category income includes the gross income of a U.S. person attributable to foreign branches held directly or indirectly through a disregarded entity. As a result, the rules do not apply to branches of foreign corporations. Foreign branch category income may also include a U.S. person’s share of partnership income that is attributable to a foreign branch held directly or indirectly by the partnership. All foreign branch income is aggregated into one category.
Foreign branch category income is generally attributable to a foreign branch to the extent reported on the foreign branch’s separate books and records, which may require adjustment to conform to U.S. income tax principles. From there, the proposed regulations provide other guidelines for adjusting gross income. For example, the rules exclude items of income from activities carried out in the United States, and gross income arising from stock, including dividends.
The proposed regulations also provide that certain disregarded transactions between a foreign branch and its owner or between foreign branches are considered for purposes of “redetermining” whether gross income should be attributable to a foreign branch or its owner. Such transactions may impact the category of income in which gross income is attributable, but not the amount. This may impact both the foreign tax credit limitation and the computation of deduction-eligible income under Section 250.
The proposed regulations generally preserve the pre-2018 separate baskets of foreign tax credit attributes carried forward into post-2017 taxable years. Accordingly, foreign tax credit carryovers, overall foreign losses, overall domestic losses, and separate loss limitations will generally remain in the same baskets as the pre-2018 separate category from which the unused attributes are carried.
The proposed regulations contain an exception that allows a taxpayer to allocate foreign tax credit carryforwards in the general basket to the post-2017 foreign branch basket to the extent that they would have been so allocated if the taxes had been paid or accrued in a post-2017 taxable year. If this choice is made, then similar rules apply to allocate overall foreign losses, overall domestic losses, and separate loss limitations.
In general, the portions of the proposed regulations that relate to statutory amendments made by TCJA apply to taxable years beginning after Dec. 22, 2017. Certain other portions not related to TCJA apply to taxable years ending after the date the regulations are published in the Federal Register. However, a number of provisions have "special applicability" dates that relate to the specific nature of the provision and the change.
The guidance contains significant, complex computational rules. Its breadth is also noteworthy, covering a broad swath of foreign tax credit related topics. Because many of the rules are proposed to be retroactively effective for tax years beginning after Dec. 22, 2017, taxpayers should carefully assess how the proposed regulations impact their specific tax circumstances.
Despite extensive guidance, unanswered questions remain. The proposed regulations contain nearly 20 individual requests for comments. Comments on the proposed regulations and requests for a public hearing must be received by 60 days after the date of publication in the Federal Register.
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