Proposed Foreign Tax Credit Regulations
January 25, 2019
By Charles Brezak and Gerry O’Beirne
On November 30, 2018 the Treasury released proposed foreign tax credit regulations to provide some clarity for calculating and using foreign tax credits with respect to changes made by the Tax Cuts and Jobs Act (“TCJA”), as well as other foreign tax credit issues. The effective dates of the proposed regulations differ depending on their specific provisions, but are generally to be effective for tax years beginning after December 22, 2017, the date of enactment of TCJA, for those portions of the proposed regulations that relate to statutory amendments made by TCJA.
The proposed regulations and the TCJA represent a substantial overhaul of the foreign tax credit rules that have been in place since the Tax Reform Act of 1986. Moreover, in the area of expense allocation, the Treasury has given notice that it will be revising these rules which have not essentially been changed since 1988. To assist in understanding the breadth of these changes, we have discussed selected topics of the proposed changes below.
Selected Topics Addressed by the Foreign Tax Credit Proposed Regulations
- Allocation of Expenses and Adjustments to the Foreign Tax Credit Limitations
- Two new categories of income were added to the foreign tax credit limitation rules under section 904(d), foreign branch income and global intangible low taxed income (“GILTI”). The proposed rules provide for the application of existing expense allocation rules to determine taxable income in the foreign branch and GILTI category. Observation: These allocation rules will probably create foreign tax credit limitations and a residual U.S. tax on GILTI. The proposed regulations reject the notion that if there is a foreign tax of at least 13.125% imposed on a foreign corporation’s GILTI, there is no GILTI tax liability, notwithstanding contrary commentary in the legislative history.
- The proposed rules treat the amount of GILTI that is reduced by the section 250 deduction as exempt income, thereby reducing the amount of expenses apportioned to GILTI. This is a favorable change for domestic corporate shareholders of a controlled foreign corporation (“CFC”).
- Similar rules would exempt a portion of a domestic corporation’s gross foreign derived intangible income for purposes of allocating expenses.
- Treasury will re-examine the existing approaches for allocating and apportioning expenses, including the apportionment of interest, research and experimentation, stewardship and general administrative expenses, among other related areas. It is anticipated that future regulations will modify these rules.
- Transition Rules for Foreign Tax Credit Carryback and Carryover Rules, Overall Foreign Loss (“OFL”), Separate Limitation Loss (“SLL”) and Overall Domestic Loss (“ODL”) Accounts
- As stated above, the TCJA added two categories of income to section 904, foreign branch income and GILTI. In a taxpayer-friendly move, the proposed regulations allow a taxpayer to elect to treat a portion of its pre-2018 unused general category foreign tax credits as foreign branch category taxes. This re-characterization will be limited to the extent the pre-2018 unused foreign taxes would have been foreign branch category taxes had the foreign branch category been in existence prior to 2018. This will require the taxpayer to re-compute its pre-2018 foreign tax credits as if the foreign branch category always existed. Any remaining unused taxes are assigned to post-2017 general category income.
- The election only applies to unused taxes that were paid or accrued and not to taxes deemed paid under section 960.
- In addition, the 2018 unused foreign branch category foreign tax credits can be carried back against 2017 general category taxes.
- If an election is made to re-compute the pre-2018 foreign tax credits as foreign branch taxes, then all pre-2018 general category tax attributes (OFL, SLL and ODL accounts) will be allocated to foreign branch income in the same proportion that the pre-2018 unused taxes were allocated.
- Foreign Branch Category Income
- Section 904 provides a new category for foreign branch category income.
- Detailed rules are outlined for determining foreign branch income for the new foreign tax credit basket, focusing on separate books and records of a branch and allowing recognition of transactions with disregarded entities in certain cases. Specifically, foreign branch income is defined as the business profits of a U.S. person attributable to a qualified business unit (“QBU”) in a foreign country.
- A foreign branch is defined by reference to the QBU rules in section 989, except partnerships would not be per se QBUs.
- Look-Through Rules
- Under pre-TCJA rules, dividends, interest, rents and royalties (look-through payments) received by a United States shareholder of a CFC were treated as passive income only to the extent the income was allocable to the passive income of the CFC. Otherwise, the pass-through payments defaulted to the general limitation category. Although TCJA added two categories of income to section 904(d), foreign branch income and GILTI, it did not change the look-through provisions of section 904(d)(3) to account for these two new categories.
- The proposed regulations apply the look-through rules only to income that is allocable to the passive category. All other income is allocable based on Reg. Sec. 1.904-4 rules. Under Reg. Sec. 1.904-4, payments of interest, rents and royalties received by a United States shareholder of a CFC from the CFC will not be allocable to GILTI. As amended by TCJA, a “United States shareholder” of a foreign corporation is a U.S. person who owns or is considered as owning 10% or more of the total combined voting power of all classes of stock entitled to vote, or 10% or more of the total value of shares of all classes of stock of the foreign corporation. Observation: Taxpayers were hoping that a payment of interest, rents or royalties that reduced tested income of a CFC would be considered GILTI in the hands of the shareholder. This would have increased the GILTI basket, thereby allowing for greater use of foreign tax credits allocated to the GILTI basket.
The proposed regulations go on to address such topics as the repeal of section 902 (taxes deemed paid by a domestic corporation owning more than 10% of a foreign corporation), calculations of the high taxed income exception to subpart F income under section 954(b)(4), the application of section 965(n) (election not to apply net operating loss deduction against a section 965 inclusion), the calculation of deemed paid credits under section 960, the gross up under section 78 and other rules addressing the changes made by TCJA.