The IRS issued proposed regulations (REG-101657-20
) on Sept. 29 that would substantially change longstanding pillars of the foreign tax credit regime. Most notably, the guidance would re-write the definition of foreign income taxes, with implications that could potentially extend to digital services taxes and other “extraterritorial taxes.” In addition to the proposed regulations, the IRS concurrently issued final and temporary regulations (TD 9922
) on the foreign tax credit. To learn more, see our story, “Final regs address wide range of FTC issues
The newly proposed regulations address a dozen discreet aspects of the foreign tax credit regime and related provisions, including issues relating to the Tax Cuts and Jobs Act and those that pre-date it. The regulations also include guidance on non-foreign tax credit related matters, such as the determination of foreign-derived deduction eligible income. The topics covered by the proposed regulations are as follows:
- Determination of foreign income taxes subject to disallowance under Section 245A(d)
- Determination of domestic versus foreign oil and gas extraction income and electronically supplied services for purposes of Section 250
- Impact of the repeal of Section 902 on the regulations under Section 367(b)
- Sourcing of Subpart F inclusions under Section 951, global intangible low-taxed income inclusions under Section 951A and qualified electing-fund inclusions under Section 1293
- Aspects of the allocation and apportionment rules for interest expense deductions under Section 861
- Allocation and apportionment of Section 818(f) expenses of life insurance companies
- Allocation and apportionment of foreign income taxes, including taxes imposed with respect to disregarded payments
- Definitions of a “foreign income tax” and “a tax in lieu of an income tax”
- Allocation of foreign income tax liabilities in connection with certain mid-year ownership transfers and reorganizations
- Transition rules to account for the effect on loss accounts of net operating loss carrybacks to pre-2018 taxable years that are allowed under the CARES Act
- Foreign branch category rules and definition of financial services entity for purposes of Section 904
- Timing rules for claiming a foreign tax credit
The proposed regulations are notably broad, covering a wide range of diverse topics, most of which are tied to the foreign tax credit regime. If finalized, they could result in markedly different outcomes than those under current law. The proposed rules are also complex, but, with a few exceptions, are generally not applicable until finalized. Taxpayers should carefully evaluate the rules and their potential impact on their tax profile, but have time to consider possible outcomes under various planning scenarios.
Highlights from the proposed regulations are summarized below.
Allocation and apportionment of expenses under Section 861
Election to capitalize R&E and advertising expenditures
Generally, when a taxpayer determines its foreign tax credit limitation under Section 904, gross income is reduced by expenses and other deductions properly allocated and apportioned to that income, and by a ratable portion of certain expenses or other deductions that cannot definitely be allocated to some item or class of gross income. Under Section 864(e)(2), interest expense is generally required to be allocated and apportioned on the basis of assets, rather than income. This formulaic approach to interest apportionment limits taxpayers’ flexibility in this regard.
While the IRS continues to study the rules for allocating and apportioning interest deductions, internally-developed intangible assets have been recognized as having a mismatch between the tax book value and the continuing economic value. Accordingly, taxpayers have been provided a proposed election under Treas. Reg. Sec. 1.861-9(k) allowing for the ability to capitalize and amortize research and experimental expenditures (and certain advertising expenses) incurred in a taxable year. In general, a taxpayer making this election must capitalize certain expenses paid or incurred during the taxable year (for purposes of apportioning interest expense under the asset method) and amortize the asset over a period of time. The capitalization of these items bears on the determination of the asset base for apportionment, thus impacting the sharing of interest expense among classes of gross income.
Under the December 2019 proposed regulations, rules were provided on the allocation and apportionment of foreign tax on disregarded payments between foreign branches and foreign-branch owners. The latest final regulations on the foreign tax credit, issued concurrently with the new proposed regulations, reserved on the allocation and apportionment of foreign tax on disregarded payments. Instead, the proposed regulations contain a new comprehensive set of rules addressing the allocation and apportionment of foreign income tax on disregarded payments.
The new proposed regulations make several changes to the disregarded payment rules. The new rules generally assign foreign gross income arising from the receipt of disregarded payments and the associated foreign tax to the recipient’s statutory and residual groupings based on the current or accumulated income of the payor out of which the disregarded payment is considered to be made. The application of the rules also broadens by the inclusion of payments made to or by “taxable units.” In the case of a taxpayer that is an individual or a domestic corporation, a taxable unit means a foreign branch, a foreign-branch owner or a non-branch taxable unit. In the case of a taxpayer that is a foreign corporation, a taxable unit means a tested unit defined in the proposed high-tax exception regulations under Section 954(b)(4) (for more details, see our story, “Final GILTI HTE regs provide flexibility
The rules are complex and apply differently to “reattribution payments” and “remittances.” A reattribution payment is the amount of gross income, computed under federal income tax law, that is initially assigned to a single statutory or residual grouping that includes gross income of a taxable unit but that is, by reason of a disregarded payment made by that taxable unit, attributed to another taxable unit). Remittances are, very generally, certain payments from a branch to its owner, among other things.
Similar to the prior proposed regulations, foreign gross income and the associated foreign tax that arise from the receipt of a “contribution” (e.g., a disregarded transfer that would be treated as a transaction described in Sections 118 or 351 if regarded) are assigned to the residual category in the case of a foreign corporate owner, or the foreign branch basket in the case of U.S. individual or corporate owners.
Grant Thornton Insight: The disregarded payment rules will undoubtedly add complexity to structures that include taxable units. Further, the rules may still result in certain taxes being assigned to the residual basket, and thus becoming not creditable. Taxpayers subject to these rules should carefully evaluate the potential implications. Although the rules appear to be an improvement over the prior version, the added complexity may require significant analysis on the part of taxpayers.
Creditability of foreign taxes under Sections 901 and 903
Generally, Section 901 allows a credit for foreign income, war profits and excess profits taxes. Section 903 provides that such taxes include a tax in lieu of a generally-imposed foreign income, war profits or excess profits tax. The existing regulations, which were issued in 1983, set forth rules for determining when foreign taxes qualify under Sections 901 or 903. The proposed regulations make several changes to improve or clarify these rules and to modernize the regulations to address issues that have arisen as a result of changes in global taxation post-1983.
Definition of foreign income tax
The proposed regulations modify the definitions of a “income tax” and a “tax in lieu of an income tax” in a number of respects. In the preamble, the IRS provides that modifications are necessary to require that a foreign tax conform to “traditional international norms” of taxing jurisdiction in order to qualify as an income tax in the U.S. sense, or as a tax in lieu of an income tax.
As a result of evolving non-U.S. tax law, the IRS has determined that in order to qualify as a creditable income tax, the foreign tax law must require a sufficient nexus between the foreign country and the taxpayer’s activities or investment of capital or other assets that give rise to the income being taxed. For example, a tax imposed by a foreign country on a taxpayer’s income that lacks a sufficient nexus to such country (such as the lack of operations, employees, factors of production, or management in that foreign country) is not an income tax in the U.S. sense and should not be eligible for a foreign tax credit if paid or accrued directly by U.S. taxpayers or deemed paid under Section 960 as a result of an interest in a controlled foreign corporation.
In order to achieve this result, the proposed regulations impose a “jurisdictional nexus requirement.” This requirement establishes that, in order for a foreign tax to qualify as an income tax, the tax must conform with established international norms, reflected in the Internal Revenue Code and related guidance, for allocating profit between associated enterprises, for allocating business profits of nonresidents to a taxable presence in the foreign country and for taxing cross-border income based on source or the situs of property. As a result of the jurisdictional nexus requirement, foreign digital services taxes and similar taxes may fall outside the scope of creditable foreign taxes under the proposed regulations. This could be a meaningful development for organizations faced with digital services taxes or similar tax regimes potentially lacking jurisdictional nexus.
The regulations also make several other changes to the rules, including changes to the “net gain requirement,” “realization requirement,” “gross receipts requirement” and the “cost recovery requirement.”
Amount of tax considered paid
For a taxpayer to be eligible for a foreign tax credit, the taxpayer must both owe and remit the foreign income taxes. The existing regulations provide rules for determining the amount of foreign tax that is considered paid and eligible for credit under Section 901. The proposed regulations clarify in several respects the amount of tax that is considered paid (or accrued) and eligible for credit.
The existing regulations provide that a payment to a foreign country is not treated as an amount of tax paid to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, abated or forgiven. The preamble indicates that the law is unclear in this area including as to whether credits allowed under foreign tax law that are computed with reference to amounts other than foreign tax payments (such as, investment or R&D tax credits) may be treated as a constructive receipt of cash by the taxpayer from the foreign country, followed by a constructive payment by the taxpayer of foreign income tax.
The proposed regulations intend to provide certainty on the treatment of credited amounts by eliminating the provision that suggests that an amount of tax is not treated as paid if it is allowed as a credit. Instead, the proposed regulations provide that foreign income tax is not considered paid if it is reduced by a tax credit, regardless of whether the amount of the tax credit is refundable in cash. Therefore, an amount allowed as a credit is not treated as a constructive payment of cash from the foreign country followed by a constructive payment of the tax that is reduced by the credit, even if the creditable amount is refundable in cash to the extent it exceeds the taxpayer’s liability for the tax that is reduced by the credit.
Grant Thornton Insight: This rule would represent a deviation from the current administrative guidance addressing refundable foreign tax credits. The IRS has afforded taxpayers an exception, and allowed constructive payment, in several situations where the credit provided by the foreign jurisdiction is refundable. For example, in Technical Advice Memorandum 200146001, the IRS concluded that a research credit offered by the French government did not reduce the pool of taxes available to be claimed as a foreign tax credit at the time a dividend was distributed to a U.S. parent company. The IRS ruled that the research credit was a means of payment by the French government because taxpayers could receive the credit from the French government in either cash or as an offset against future liability.
The regulations also address other aspects of the amount of tax considered paid, including the treatment of payments as noncompulsory payments.
Rules regarding when the foreign tax credit can be claimed
The proposed regulations would address several longstanding issues related to when the foreign tax credit can be claimed. These proposed regulations provide rules clarifying when a foreign tax credit may be taken for both cash method taxpayers and accrual method taxpayers, and in the case of accrual method taxpayers, clarify the application of the so-called “relation-back doctrine.” The proposed regulations also modify the period during which a taxpayer can change the choice to claim a credit or a deduction for foreign income taxes on an amended return to align with the different refund periods under Section 6511. The proposed regulations also clarify that a change from claiming a deduction to claiming a credit, or vice versa, for foreign income taxes results in a foreign tax redetermination under Section 905(c).
Rules addressing Section 250
For purposes of a foreign-derived intangible income (FDII) deduction under Section 250, the proposed regulations clarify the definition of electronically supplied services included in the final regulations (for more details on the final regulations, see our story, “Final FDII regs ease documentation standards
The final regulations define the term “electronically supplied service” to mean a general service (other than an advertising service) that is delivered primarily over the internet or an electronic network. The regulations could be interpreted in a manner that includes services applying some human effort or judgment (e.g., professional services that are provide through the internet). Hence, the proposed regulations clarify that, in order to be an electronically supplied service, the value of the service to the end-user must be derived primarily from the service’s automation or electronic delivery.
The proposed regulations include a wide range of applicability dates that vary by section. While many of the proposed regulations would apply to tax years beginning on or after the finalization of the rules, there are certain provisions that apply to earlier tax years. For example, the Section 250 regulations are proposed to apply to tax years beginning on or after Jan. 1, 2021, consistent with the Section 250 final regulations.
The proposed regulations significantly alter many aspects of the foreign tax credit landscape. The regulations bring clarity to many lingering questions, but don’t always land in favor of the taxpayer. Certain long-standing opportunities, such as the application of the current administrative guidance as it relates to refundable credits, may cease to exist upon finalization. Additionally, many taxes that are currently creditable, but don’t meet the jurisdictional nexus requirement, may no longer be creditable following the finalization of the regulations. Taxpayers should carefully assess how the proposed regulations would affect their specific tax circumstances.
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