Final Foreign Tax Credit Regulations Issued
By Andre Benayoun, Partner, Tax & Business Services
On Monday, December 2, the Internal Revenue Service issued final regulations regarding Foreign Tax Credits. These final regulations impact Internal Revenue Code Sections 78, 861, 901, 904, 960, and 965.
NOTE: (The IRS also finalized regulations from 2012 relating to overall foreign losses (“OFLs”) under Section 904(f)) and regulations from 2007 relating to taxpayers’ obligation to notify the Service of foreign tax re-determinations under Section 905. These additional rules on OFLs and foreign tax redeterminations are beyond the scope of this Tax Flash).
The foreign tax credit (“FTC”) regime is one of the hallmark regimes of international tax. In short, the U.S. generally has a worldwide tax system that requires U.S. taxpayers to pay U.S. federal income tax on all income wherever earned. In order to alleviate the double tax burden associated with a worldwide tax system, the U.S. permits U.S. taxpayers to reduce the tax owed to the U.S. for income taxes paid to another country. That being said, the ability to take a FTC is subject to limitation under Section 904.
The mechanics of Section 904 are quite complex, however; they generally only allow a taxpayer to take FTCs against their tentative U.S. tax liability (prior to FTC reduction) in proportion to how much of the net taxable income is coming from foreign sources. For example, if a U.S. taxpayer would owe $100 in taxes to the IRS prior to considering their FTCs, and such taxpayer earned 50% of their net taxable income from foreign sources, then up to $50 (i.e., 50% of 100) of U.S. tax liability may be reduced via FTCs.
To make matters more complicated, the ability to take a credit is not looked at with all foreign source income and all foreign taxes together. Instead, there are several baskets into which foreign source income and taxes must be broken down, and the ability to take a FTC is analyzed separately for each basket of income. These baskets (post-tax reform) include general basket, passive basket, GILTI (Global Intangible Low Tax Income) basket, foreign branch basket, and the treaty-resourced income basket.
The GILTI basket is the only one for which unused FTCs cannot be carried back or forward to other years. Also, certain foreign taxes in the GILTI basket are required to be reduced to 80% of their original amounts. Lastly, due to a special deduction allowed against GILTI income under Section 250 for certain taxpayers, some special rules have been passed to clarify how to allocate expenses to the GILTI basket. With respect to the other baskets, FTCs can generally be carried back one year and forward up to 10 years.
Finally, as part of tax reform, the government also passed Section 245A, which allows C corporations to receive dividend distributions from certain foreign corporations with no federal income tax due upon the receipt of such dividends. While these dividends are foreign-sourced, the fact that they are exempt from federal income tax has also required the FTC rules to be modified to account for this change.
Highlights of New Final FTC Regulations
- The final regulations confirm the language of the December 2018 proposed regulations regarding the requirement to allocate and apportion expenses against GILTI basket income. Confirming this requirement will result in potentially less net income in the GILTI basket, thus reducing the ability for taxpayers to take a FTC in such basket.
- The final regulations impose additional rules that result in the preclusion of certain R&D expenses from falling within the GILTI basket. This exclusion of expenses should generally increase the net income in the GILTI basket, resulting in a higher FTC being available in such basket.
- The final regulations clarify certain definitions with respect to exempt income or assets for purposes of calculating the Section 904 limit in the GILTI basket. The result of these rules is that less expenses are expected to be allocated to the GILTI basket, resulting in higher net foreign- source income in the GILTI basket and, ultimately, a higher limit for FTCs.
- The final regulations modify Prop. Reg. 1.861-8(d)(2)(ii)(C)(2) to refer to Foreign Derived Deductible Eligible Income (“FDDEI”) instead of Foreign Derived Intangible Income (“FDII”). The result of this change is that no additional requirements are imposed on U.S. taxpayers to identify assets that produce FDDEI beyond what is necessary to determine the amount of the Section 250 deduction.
- The final regulations confirm that previously taxed earnings of a foreign corporation do not result in some portion of the stock of such foreign corporation being treated as an exempt asset. The result is that more interest expense may be allocated to income from a foreign corporation than would otherwise be the case if a portion of the stock were treated as an exempt asset due to underlying previously taxed earnings. The additional interest expense allocated against foreign-source income of a foreign corporation is likely to reduce the net foreign-source income and also reduce the ability for a U.S. taxpayer to take a current FTC as a result of this rule.
- The final regulations confirm that the Section 250 deduction must be allocated and apportioned against income that generates FDII. The result is that net income related to FDII may be reduced and, ultimately, the Section 904 FTC limit would also be reduced, which would result in less FTCs being available against such income in the current year.
- The final regulations grant transition relief for U.S. taxpayers who are required to change their interest expense allocation and apportionment method (as the fair market value method was repealed as part of tax reform) to tax book value or modified tax book value. Such U.S. taxpayers may determine asset value using the end-of-first quarter value and year-end value of assets. Note that a change in method of allocating and apportioning interest expense may result in more or less interest expense being allocated against foreign-source income within a basket. A reduction of expense allocation and apportionment will result in a higher FTC limit while an increase to expense allocation and apportionment to a foreign-source income basket will reduce FTC limit for creditability purposes.
- Final regulations confirm a one-time exception (for 2018) to the 5-year binding election regarding the method of R&E expense allocation and apportionment.
- Final regulations adopt a new safe harbor allowing FTCs from the general basket to be moved to the new foreign branch basket. This safe harbor is based on the ratio of foreign taxes paid or accrued by the taxpayer’s foreign branches dividedby the amount of all foreign income taxes paid by the taxpayer in a given year. This is an easier method of reallocating foreign taxes from 2017 to a basket that did not exist at such time, than to have to go back and trace foreign tax credits in older years to which basket they would have gone to had these new rules existed at that point in time. The movement of these taxes from the general basket to the foreign branch basket may allow for creditability, while not moving such taxes could trap them in the general basket.
- Final regulations adopt several reconstruction and transition rules to reallocate overall foreign losses (“OFLs”) and overall domestic losses (“ODLs”) to the new foreign branch basket. Generally, OFLs reduce FTC limitation in the basket to which they apply such that less FTCs may be used, and ODLs increase the use of FTCs in the basket to which they apply. OFLs result from foreign-source losses, reducing U.S.-sourced income, while ODLs result from U.S.-source losses, reducing foreign-sourced income. Separate limitation losses (“SLLs”) may also arise in cases of income and losses among the different foreign-source baskets.
- Final regulations confirm, with modifications, the disregarded payment rule for foreign branch basket income. Generally, this rule pertains to disregarded payments between a branch and the head office for purposes of allocating income and expenses which will ultimately be part of the foreign branch basket for FTC purposes. For completeness purposes, interest payments between branches and head offices continue not to be subject to this rule (i.e., they remain disregarded), and the intangible property rule requiring a deemed royalty between a branch and a head office on the contribution of IP remains as well.
- Final regulations confirm various rules regarding deemed paid credits pursuant to Section 960. These rules allow U.S. C corporation taxpayers to access, for FTC purposes, foreign income taxes paid by controlled foreign corporations and take over the role of former Section 902 which was repealed as part of tax reform. Due to the length and complexity of these rules, as well as their limitation to C corporation taxpayers and individuals making a Section 962 election to be treated as U.S. corporations for the purposes of certain anti-deferral regimes (e.g., Subpart F, GILTI, etc.), it is currently anticipated that a separate Tax Flash will be prepared to cover deemed paid FTCs.
Marcum’s international tax advisors will keep you posted on this regulation and additional interpretations of the new regulation.