The IRS issued lengthy final regulations (T.D. 9882
) and proposed regulations (REG-105495-19
]) on Dec. 2 to implement changes to the foreign tax credit regime brought about by the Tax Cuts and Jobs Act (TCJA). The extensive guidance, which exceeds 600 pages, provides welcome relief in some areas and unfavorable results in others.
The final regulations adopt proposed regulations
published in 2018, with certain revisions. They also finalize proposed regulations
on overall foreign losses that were published in June 2012, and certain portions of proposed regulations
published in November 2007, relating to a U.S. taxpayer’s obligation to notify the IRS of a foreign tax redetermination.
Concurrently released proposed regulations also provide substantial new guidance, including:
- Rules on the allocation and apportionment of research and experimental deductions that will generally allow taxpayers subject to the Section 951A global intangible low-taxed income (GILTI) regime to increase their use of foreign tax credits
- Rules on the allocation and apportionment of stewardship expenses that expand apportionment to both dividend and deemed inclusions (previously it was only dividends) that may generally reduce a taxpayer’s ability to claim a foreign tax credit to offset tax on Subpart F and GILTI inclusions
- Extensive rules addressing foreign tax redeterminations that affect foreign taxes deemed paid under Section 960
Various applicability dates apply under the final and proposed regulations. However, many of the rules apply to tax years ending on or after the publication of the rules and some rules apply to earlier tax years. As a result, taxpayers should assess how the proposed regulations affect their specific tax circumstances and update modeling for any change from the prior versions of these regulations.
The aforementioned issues and other select highlights from the regulations are summarized below.
The U.S. foreign tax credit generally aims to prevent U.S. taxpayers from being subject to double taxation on their foreign source income. However, its availability is limited to prevent its use against 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 GILTI. The limitation is generally determined separately with respect to each category:
The numerator of the foreign tax credit limitation computation incudes foreign-source income subject to U.S. income tax reduced by deductions allocated or apportioned to the income under Sections 861- 865. If the allocation and apportionment of the deductions results 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 be apply.
The TCJA made numerous changes to the 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 foreign tax credit final regulations
The final regulations retain the basic approach and structure of the 2018 proposed regulations, with some revisions. They also include other revisions with respect to certain pre-TCJA proposed regulations, such as those relating to overall foreign-loss recapture on property dispositions as well as temporary regulations relating to foreign tax redeterminations under Section 905(c).
Allocation and apportionment of expenses and calculation of taxable income for Section 904(a)
The foreign tax credit limitation under Section 904 is calculated by reference to a taxpayer’s taxable income from sources outside the United States. This foreign-source taxable income is determined after the allocation and apportionment of deductions, applying the rules contained in Sections 861- 865 and the applicable regulations.
The final regulations generally adopt the rules from the 2018 proposed regulations and continue to require deductions be allocated and apportioned to all foreign tax credit categories, including GILTI. The preamble discussed a number of comments requesting exemptions from expense allocation to GILTI, but ultimately concluded that such an exemption is not consistent with legislative intent. However, as discussed below, concurrently issued proposed regulations offer some relief, precluding the allocation of certain research and experimentation expenses to GILTI.
The final regulations generally adopted the proposed 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 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 rules also treated income offset by a Section 250 deduction attributable to foreign-derived intangible income (FDII) as exempt income, and a percentage of assets that generate such income as exempt assets. The final regulations clarify that exempt assets are calculated based on the ratio of the Section 250 deduction relating to FDII to the taxpayer’s gross foreign-derived deduction-eligible income (FDDEI) instead of its FDII. This will have the effect of significantly reducing the portion of assets that are exempt by reason of FDII.
The final regulations generally adopt the complex rules in the proposed regulations that characterize the stock of certain controlled foreign corporations (CFC). However, they clarify that for purposes of characterizing the stock of a CFC in the various statutory groupings, the U.S. shareholder of the CFC must use the same method (either the asset method or modified gross income method) that the CFC uses to apportion its interest expense.
The final regulations retain the proposed rule that allows for a one-time exception to the five-year binding election period by allowing taxpayers to switch between the gross income or sales method for research and experimental (R&E) expense allocation. The regulations do not otherwise address the allocation of R&E expenses. However, the proposed regulations, discussed further below, provide a number of changes to the application of the allocation and apportionment rules for R&E expenditures.
The regulations finalize the proposed rules for allocating and apportioning the Section 250 deduction. They provide separate rules for the portion of the Section 250 deduction that pertains to FDII 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., FDDEI or GILTI).
The final regulations also retain complex rules that assign 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 may have the effect of increasing the GILTI foreign tax credit available in certain circumstances.
The 2018 proposed regulations included a transition rule that allowed 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. The rule requires a complex “reconstruction” of the branch basket and was adopted without change. However, the IRS recognized the challenges this rule may present and included a simplified safe harbor option. Under the safe harbor, the reconstruction option that allocates carryover foreign taxes from a particular pre-2017 taxable year to the post-2018 separate category for foreign branch category income is based on a ratio equal to the amount of foreign income taxes that were paid or accrued by the taxpayer’s foreign branches divided by the amount of all foreign income taxes assigned to the general category that were paid or accrued, or deemed paid by the taxpayer with respect to the taxable year.
The final regulations generally retain the rules related to the new foreign branch category under Section 904(d)(1)(B). These rules provide guidelines for adjusting gross income including rules that provide disregarded transactions between a foreign branch and its owner or between foreign branches are considered regarded for purposes of redetermining whether gross income should be attributable to a foreign branch or its owner. However, the final regulations modify and clarify a few aspects of these rules, including the treatment of intangible property, the treatment of disregarded payments that result in amortization or depreciation deductions, and the scope of what constitutes a trade or business.
Accounting for foreign tax determinations
The final regulations also included parts of previously proposed Section 905(c) regulations issued in 2007. Generally, Section 905(c) provides that a taxpayer is required to notify the IRS if accrued taxes differ from the amounts claimed as credits by a taxpayer and is also required to redetermine the amount of tax for the years affected (i.e., amending returns). Prior to the TCJA, in some instances, taxpayers could adjust pools of foreign income taxes and of undistributed earnings and profits in lieu of redetermining U.S. foreign tax credits claimed in prior years. As a result of the repeal of the pooling regime under Section 902 and related amendments to Section 905(c), U.S. tax redeterminations must now be made with respect to all foreign tax redeterminations, including those that result in adjustments to taxes deemed paid under Section 960.
The final regulations include several clarifying changes to what constitutes a foreign tax redetermination, revising the definition to include:
- Accrued taxes that are not paid on or before the date 24 months after the close of the taxable year to which such taxes relate (clarifying the prior rule that referred to two taxable years)
- Adjustments such as a correction to an accrual that determined the tax due with reasonable accuracy, but is revised after additional consideration to reflect the correct final tax liability
- Any tax that is claimed as a credit or added to previously taxed E&P (PTEP) group taxes is subsequently refunded, regardless of whether the tax was properly treated as paid when claimed as a credit or added to PTEP group taxes
The final regulations provide that, if a foreign tax redetermination occurs with respect to foreign tax claimed as a direct credit, then a redetermination of U.S. tax liability is required for the taxable year in which the credit was claimed and any year to which unused foreign taxes from such year were carried under Section 904(c). The final regulations also clarify a proposed de minimis
exception to a redetermination of U.S. tax liability. The regulations clarify that the exception to a redetermination of U.S. tax liability applies only if the $10,000 or 2% threshold is satisfied with respect to each and every foreign country for which a foreign tax redetermination occurs.
The final regulations provide that if a foreign receipt or return is in a foreign language, a certified translation of the receipt must be furnished by the taxpayer. The rule was inadvertently deleted during a prior amendment to the regulations, and is restored in the final regulations.
Deemed-paid taxes under Section 960
The 2018 proposed regulations contained 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. Despite numerous comments requesting relief in this area, the final regulations adopted the 2018 proposed regulations without change.
The final regulations retain the rule that reduces the amount of foreign income taxes deemed paid if a U.S. shareholder reduces its Subpart F inclusion by reason of a qualified deficit. They also clarify that in order to allocate and apportion a current year tax to the Section 904 categories and income groups within those categories, all of the foreign taxable income for the period with respect to which the tax is imposed under foreign law is characterized under federal income tax law and assigned to the categories or groups as though that foreign taxable income were recognized under federal income tax law in the year in which the tax is paid or accrued.
The final regulations update the list of the PTEP groups in Treas. Reg. Sec. 1.960-3 to include ten PTEP groups. The IRS intends to issue more comprehensive regulations addressing the maintenance of annual PTEP accounts and the PTEP groups in a separate notice of proposed rulemaking under Section 959. It is anticipated that, as part of that guidance, further changes may be made to Treas. Reg. Sec. 1.960-3 in order to coordinate both sets of regulations. The updated list includes fewer PTEP groups than provided in the previous guidance provided in Notice 2019-01
. For more details on PTEP groups, see our prior coverage
on Notice 2019-01.
The final regulations adopted the proposed rule providing that no foreign income taxes are deemed paid under Section 960(a) with respect to an inclusion under Section 956. The preamble explains that a Section 956 inclusion is not an inclusion of an “item of income” of the CFC but instead is an inclusion equal to an amount that is determined under the formula in Section 956(a). Therefore, Section 960(a), which, as amended by the TCJA, computes deemed paid taxes by reference to foreign taxes attributable to an “item of income,” does not allow for a deemed-paid credit.
Grant Thornton Insight: The prevention of a deemed-paid credit being carried by Section 956 inclusions may create significant issues for certain taxpayers. However, with recently finalized Section 956 regulations, the rule has less relevance to corporate taxpayers. Under the final Section 956 regulations, an inclusion amount otherwise determined under Section 956 is reduced to the extent the U.S. shareholder would have been allowed a deduction under Section 245A had the U.S. shareholder received an actual distribution from the controlled foreign corporation. A deduction under Section 245A is only available to certain domestic corporate shareholders, and is not available to individuals. For more details on final Section 956 regulations, see our prior coverage.
In general, no changes were made to the proposed applicability dates in the 2018 proposed regulations. Thus, rules relating to the amendments pertaining to TCJA generally apply to taxable years beginning after Dec. 31, 2017. Rules that do not relate to TCJA are generally applicable to taxable years ending on or after Dec. 4, 2019. Various other applicability dates also apply to certain specific provisions.
The foreign tax credit proposed regulations
In addition to the final regulations, the IRS issued proposed regulations that address an assortment of foreign tax credit related issues. Such topics include the allocation and apportionment of deductions under Sections 861 through 865, foreign tax redeterminations under Section 905(c), and various other items related to the computation of foreign tax credits.
Allocation and apportionment of deductions
The proposed regulations provide taxpayers with much-needed guidance on how to properly allocate and apportion stewardship expenses in a post-TCJA environment. The current regulations provide that stewardship expenses are considered definitely related to “dividends received, or to be received” from related corporations. As a result of TCJA, the majority of foreign-source income earned by foreign subsidiaries of U.S. multinationals is taxed currently under Section 951A, or is eligible for a dividends received deduction under Section 245A. There has been debate amongst the tax community as to whether “dividends received, or to be received” should include the Section 78 gross-up and inclusions under Sections 951(a)(1) and 951A.
The proposed regulations clarify 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. The proposed rule provides 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 current regulations). The proposed regulations also provide that, once allocated, stewardship expenses are apportioned based upon the relative values of a taxpayer’s stock assets, in the same manner as for apportioning interest.
In addition, the proposed regulations maintain the 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. They also extend the treatment of stewardship expenses to cover expenses incurred with respect to a partnership.
A number of significant changes were also proposed with respect to the allocation and apportionment of research and experimentation (R&E) expenses. Under the proposed regulations, R&E expenditures are ordinarily considered 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 are thus allocable to all items of gross intangible income related to the SIC code categories as a class. Gross intangible income is defined as all gross income earned by a taxpayer that is attributable, in whole or in part, to intangible property derived from R&E expenditures (e.g., sales, services, royalties, etc.) and does not include dividends or deemed inclusions.
The gross income method is also proposed to be eliminated for purposes of allocating and apportioning R&E expenditures. Additionally, the exclusive apportionment rule would only apply for purposes of computing the foreign tax credit limitation and rules addressing legally mandated R&E and increased exclusive apportionment of R&E have been eliminated.
Grant Thornton Insight: This is likely to be a welcome development for most taxpayers. Concerns were expressed that R&E costs may significantly restrict a taxpayer’s ability to offset tax on GILTI with foreign tax credits. Absent this change, there may have been an incentive to perform R&E functions outside of the United States. However, the proposed regulations make it clear that R&E will not be apportioned against a GILTI inclusion.
Finally, the proposed regulations provide specific allocation and apportionment rules for other expenses such as litigation awards, prejudgment interest, settlement payments, foreign income taxes and certain loans made by partnerships to partners that generate both interest income and interest expense to the partner. They also contain a number of allocation and apportionment rules specific to the insurance industry.
Foreign tax redeterminations under Section 905(c)
Portions of temporary regulations relating to Sections 905(c), 986(a), and 6689 issued in 2007 have been re-proposed to provide taxpayers the opportunity to comment in light of changes by TCJA. The rules being re-proposed include rules addressing foreign tax redeterminations that affect foreign taxes deemed paid under Section 960, procedural rules addressing IRS notification requirements of a foreign tax redetermination and rules addressing the penalty for failure to notify the IRS of a foreign tax redetermination. In addition, the proposed regulations contain a transition rule addressing foreign tax redeterminations of foreign corporations that relate to taxable years before the amendments made by the TCJA.
The proposed regulations provide a number of procedural clarifications with respect to foreign tax credit redeterminations. For example, the regulations clarify 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 “high-tax exception.” The proposed regulations were also amended to reflect the repeal of the Section 902 pooling approach to foreign tax credits. The proposed rules now provide that a U.S. tax redetermination is required in all cases to account for the effect of a foreign corporation’s foreign tax redetermination. They also include detailed procedural rules addressing penalties, amended return requirements, and special rules for LB&I taxpayers and pass-through entities, among others.
Grant Thornton Insight: Prior to the TCJA, Section 902 provided some flexibility with respect to redeterminations under Section 905(c). Many taxpayers could avoid amending returns when foreign tax redeterminations impacted indirect credits by making so called “pooling adjustments.” However, with the repeal of Section 902, many taxpayers may now be required to regularly amend income tax returns as required under Section 905(c) because the “Relation Back Doctrine” now generally applies to all foreign tax redeterminations. Under the Relation Back Doctrine, the taxpayer must recalculate the foreign tax credit as a result of the foreign tax redetermination event in the respective year(s) adjusted. This puts additional pressure on non-U.S. income tax calculations, and companies may benefit from increased focus on accuracy to avoid costly redetermination events.
A wide range of applicability dates apply to the proposed regulations. The rules in proposed Prop. Treas. Reg. Secs. 1.861-8, 1.861-9, 1.861-12, 1.861-14, 1.904-4(c)(7) and (8), 1.904(b)-3, 1.954-1, and 1.954-2 generally apply to taxable years that end on or after the date the rules are published in the Federal Register. The rules in Prop. Treas. Reg. Secs. 1.704-1(b)(4)(viii)(d)(1), 1.861-17, 1.861-20, 1.904-6, and 1.960-1 apply to taxable years beginning after Dec. 31, 2019. Other various applicability dates also apply to certain specific provisions.
With the enactment of the GILTI regime, foreign tax credits have become one of the most essential factors impacting companies’ global effective tax rates. Without careful planning, the foreign tax credit rules can result in double taxation or costly administrative requirements such as amended returns. The guidance included in the packages has far-reaching effects on all aspects of the foreign tax credit and related regimes. Taxpayers should carefully assess the impact, and update their models accordingly.
The regulations also include provisions that provide for planning opportunities. The pre-existing regulations required R&E expenses to be allocated to the GILTI category, and, in many cases, a significant amount of these expenses impeded a taxpayer’s ability to offset GILTI tax with foreign tax credits. This led some taxpayers to reconsider whether such services should be performed inside the United States. However, the proposed R&E rules eliminate the need to allocate such R&E expenses against GILTI, allowing for enhanced foreign tax credit utilization in the GILTI category.
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