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Temporary regs close loophole that inflates foreign tax credits

T.D. 9800, 12/06/2016; Reg. § 1.901(m)-1T, Reg. § 1.901(m)-2T, Reg. § 1.901(m)-4T , Reg. § 1.901(m)-5T, Reg. § 1.901(m)-6T

IRS has issued temporary regs under Code Sec. 901(m), that generally follow and expand upon rules contained in a pair of 2014 Notices, and that deny the foreign tax credit with respect to foreign income not subject to U.S. taxation because of covered asset acquisitions.

For contemporaneously issued proposed regs under Code Sec. 901(m), see ¶ 10.

Background—Code Sec. 901(m). Corporate taxpayers that make an election under Code Sec. 338(g) can treat a stock acquisition as an asset acquisition for U.S. tax purposes. One result of a Code Sec. 338 election is that a U.S. acquirer of a foreign company’s stock will obtain a fair market value (FMV) basis for the foreign company’s assets (assuming that bases of the assets were less than FMV).

A covered asset acquisition (CAA) is:

1. a qualified stock purchase to which Code Sec. 338 applies;
2. any transaction which is treated as an acquisition of assets for U.S. purposes, and is treated as the acquisition of stock of a corporation (or is disregarded) for purposes of the foreign income taxes of the relevant jurisdiction;
3. any acquisition of an interest in a partnership which has an election in effect under Code Sec. 754 (Code Sec. 743(b) CAA); and
4. to the extent provided by IRS, any other similar transaction. (Code Sec. 901(m)(2))

CAAs result in a step-up in the basis of the assets of the acquired entity to the FMV that was paid for the stock (or interest in the business entity). In the foreign context, this step-up usually exists only for U.S. tax purposes, and not for foreign tax purposes. As a result, depreciation for U.S. tax purposes exceeds depreciation for foreign tax purposes, so the U.S. taxable base is lower than the foreign taxable base. Because foreign taxes (and therefore foreign tax credit) are based on the foreign taxable base, the foreign tax credit would be overstated, i.e., it would be more than is necessary to avoid double tax on the U.S. tax base.

To reduce the foreign tax credit to the proper amount for CAAs, the “disqualified portion” of any foreign income tax determined with respect to the income or gain attributable to relevant foreign assets (RFAs) is (a) not taken into account in determining the foreign tax credit, and (b) in the case of a foreign income tax paid by a Code Sec. 902 corporation, not taken into account for purposes of the deemed paid credit under Code Sec. 902 or Code Sec. 960 . (Code Sec. 901(m)(1)) Instead, the disqualified portion of any foreign income tax is allowed as a deduction. (Code Sec. 901(m)(6))

The disqualified portion is, with respect to any CAA, for any tax year, the ratio of: (a) the aggregate basis differences (but not below zero) allocable to the tax year under Code Sec. 901(m)(3)(B) with respect to all RFAs, divided by (b) the income on which the foreign income tax is determined. If the taxpayer fails to substantiate the income to IRS’s satisfaction, the income is determined by dividing the amount of such foreign income tax by the highest marginal tax rate applicable to such income in the relevant jurisdiction. (Code Sec. 901(m)(3)(A))

An RFA is, with respect to any CAA, any asset with respect to the acquisition if income, deduction, gain, or loss attributable to the asset is taken into account in determining the foreign income tax. (Code Sec. 901(m)(4))

Basis difference means, with respect to any RFA, the excess of (i) the adjusted basis of such asset immediately after the CAA, over (ii) the adjusted basis of such asset immediately before the CAA (statutory basis difference). (Code Sec. 901(m)(3)(C)(i)) If the adjusted basis of an RFA immediately before the CAA exceeds the adjusted basis of the RFA immediately after the CAA (that is, where the adjusted basis of an asset with a built-in loss is reduced in a CAA), such excess is a basis difference of a negative amount. (Code Sec. 901(m)(3)(C)(ii))

Code Sec. 901(m)(3)(B)(i) provides the general rule that the basis difference with respect to any RFA will be allocated to tax years using the applicable cost recovery method for U.S. income tax purposes.

Code Sec. 901(m)(3)(B)(ii) (the statutory disposition rule) provides that, except as otherwise provided by IRS, if there is a disposition of any RFA, the basis difference allocated to the tax year of the disposition will be the excess of the basis difference of such asset over the aggregate basis difference of such asset that has been allocated to all prior tax years (unallocated basis difference). No basis difference with respect to such asset will be allocated to any tax year thereafter.

Background—Notice 2014-44 and Notice 2014-45. In Notice 2014-44, 2014-32 IRB 270 (Weekly Alert ¶  39  07/24/2014), IRS noted that certain taxpayers are engaging in transactions shortly after a CAA occurs, that are intended to invoke application of the statutory disposition rule to avoid the purpose of Code Sec. 901(m). These taxpayers take the position that the deemed liquidation constitutes a disposition of the RFAs for purposes of Code Sec. 901(m)(3)(B)(ii). They claim that all of the basis difference with respect to the RFAs is allocated to the final tax year of the foreign target that occurs by reason of the deemed liquidation, and that no basis difference with respect to the RFAs is allocated to any later tax year.

Therefore, IRS announced, in Notice 2014-44, that it would issue regs to close this perceived loophole, which taxpayers are using to avoid disallowance of the foreign tax credit with respect to the disposition of acquired property that has a higher basis for U.S. federal income tax purposes than for foreign tax law purposes. The rules in Notice 2014-44 described the definition of disposition that would be set forth in future regs, as well as the rules for determining the portion of basis difference that would be taken into account upon a disposition of an RFA (the disposition amount); provided special rules for a Code Sec. 743(b) CAA; and clarified the continuing application of Code Sec. 901(m) to the remaining basis difference.

Notice 2014-44 provided that the future regs would apply: (i) as to dispositions—to dispositions occurring on or after July 21, 2014; (ii) as to Code Sec. 743(b) CAAs—to Code Sec. 743(b) CAAs occurring on or after July 21, 2014, unless a taxpayer consistently applied those provisions to all Code Sec. 743(b) CAAs occurring on or after Jan. 1, 2011; and (iii) as to successor rules—to remaining basis difference with respect to an RFA as of July 21, 2014, and any basis difference with respect to an RFA that arises in a CAA occurring on or after July 21, 2014.

Notice 2014-45, 2014-34 IRB, (Weekly Alert ¶  14  07/31/2014) provided that, in order to prevent abuse, the regs described in Notice 2014-44 would also apply to determine the tax consequences under Code Sec. 901(m) of an entity classification election made under Reg. § 301.7701-3 that is filed on or after July 29, 2014, and that is effective on or before July 21, 2014, including whether a disposition results from the election for purposes of Code Sec. 901(m) and the treatment of any unallocated basis difference that results from such an election.

New guidance. IRS has now issued temporary and proposed regs regarding the calculation of the foreign tax credit where there is a CAA. As noted above, the proposed regs are covered at ¶ 10. Under the temporary regs:

CAAs and RFAs. .Reg. § 1.901(m)-2T(c) defines RFA just as Code Sec. 901(m)(4) does, but uses the phrase “subject to a CAA,” rather than “with respect to a CAA.” The Preamble provides that an asset is subject to a CAA, if, for example (i) in the case of a qualified stock purchase of a target corporation (as defined in Code Sec. 338(d)(3)) to which Code Sec. 338(a) applies, “new” target is treated as purchasing the asset from “old” target; (ii) in the case of a taxable acquisition of a disregarded entity that is treated as an acquisition of stock for foreign income tax purposes, the asset is owned by the disregard entity at that time of the purchase and therefore the buyer is treated as purchasing the asset from the seller; and (iii) in the case of a Code Sec. 743(b) CAA, the asset is attributable to the partnership interest transferred in the Code Sec. 743(b) CAA. (T.D. 9800)

Reg. § 1.901(m)-2T(d) provides that the statutory definitions under Code Sec. 901(m)(2) and Code Sec. 901(m)(4) apply to determine whether a transaction that occurred during the transition period (as defined under “Effective/applicability dates,” below) is a CAA and which assets are RFAs with respect to those CAAs, respectively.

Determining basis difference with respect to an RFA. A basis difference is computed separately with respect to each foreign income tax for which an asset is an RFA. Consistent with Code Sec. 901(m)(3)(C), Reg. § 1.901(m)-4T(b) provides the general rule that basis difference with respect to an RFA is the U.S. basis in the RFA immediately after the CAA, less the U.S. basis in the RFA immediately before the CAA. If, however, an asset is an RFA with respect to a Code Sec. 743(b) CAA, Reg. § 1.901(m)-4T(d) provides that basis difference with respect to the RFA is the resulting basis adjustment under Code Sec. 743(b) that is allocated to the RFA under Code Sec. 755 (allocation of basis upon transfer of partnership interest).

Basis difference taken into account. Reg. § 1.901(m)-5T provides rules for determining the amount of basis difference with respect to an RFA that is taken into account in a given U.S. tax year (allocated basis difference). The amount of basis difference taken into account in a U.S. tax year is used to compute a disqualified portion for the U.S. tax year. If an asset is an RFA with respect to more than one foreign income tax, basis difference with respect to each foreign income tax is separately taken into account under Reg. § 1.901(m)-5T.

Basis difference is taken into account in two ways: under an applicable cost recovery method or as a result of a disposition of the RFA. Consistent with Code Sec. 901(m)(3)(B)(i), Reg. § 1.901(m)-5T(b)(2) provides that a cost recovery amount for an RFA is determined by applying an applicable cost recovery method to the basis difference.

IRS says that the rule of Code Sec. 901(m)(3)(B)(ii) (see “Background—Code Sec. 901(m),” above) is appropriate when all the gain or loss from the disposition is recognized for both U.S. and foreign income tax purposes. In other cases, however, a disposition may not be the appropriate time for all of the unallocated basis difference to be taken into account. For example, it may not be appropriate for all of the unallocated basis difference to be taken into account upon a disposition that is fully taxable for U.S. income tax purposes but not for foreign income tax purposes. (T.D. 9800)

Reg. § 1.901(m)-1T(a)(10) defines a disposition for purposes of Code Sec. 901(m) as an event that results in gain or loss being recognized with respect to an RFA for purposes of U.S. income tax or foreign income tax, or both. Thus, the definition excludes certain transfers that might otherwise be considered dispositions under the ordinary meaning of that term.

Reg. § 1.901(m)-5T(c)(2) provides rules for determining a disposition amount. If a disposition of an RFA is fully taxable for U.S. and foreign income tax purposes, the disposition amount will be any remaining unallocated basis difference with respect to that RFA. This is because there generally will no longer be a disparity in the U.S. basis and the foreign basis of the RFA. (Reg. § 1.901(m)-5T(c)(2)(i))

If a disposition is not fully taxable for both U.S. and foreign income tax purposes, generally there will continue to be a disparity in the U.S. basis and the foreign basis following the disposition, and it will be appropriate for the RFA to continue to have unallocated basis difference. To the extent that the disparity in the U.S. basis and the foreign basis is reduced as a result of the disposition, however, a portion of the unallocated basis difference (or, in certain cases, all of the unallocated basis difference) is the disposition amount. Whether the disposition reduces the basis disparity will depend on whether the basis difference is positive or negative and the jurisdiction in which gain or loss is recognized. (Reg. § 1.901(m)-5T(c)(2)(ii))

The temporary regs also set out a rule that applies if an asset is an RFA by reason of a Code Sec. 743(b) CAA and subsequently there is a disposition of the RFA. (Reg. § 1.901(m)-5T(c)(2)(iii))

Successor rules for unallocated basis difference. Reg. § 1.901(m)-6T(b) provides that Code Sec. 901(m) continues to apply to any unallocated basis difference with respect to an RFA after there is a transfer of the RFA for U.S. income tax purposes (successor transaction), regardless of whether the transfer is a disposition, a CAA, or a non-taxable transaction. A successor transaction does not occur if, as a result of the transfer of an RFA, the entire unallocated basis difference is taken into account because, for example, the transfer results in all realized gain or loss in the RFA being recognized for U.S. and foreign income tax purposes.

Effective/applicability dates. The applicability dates of the temporary regs relate back to the issuance of Notice 2014-44 and Notice 2014-45. Accordingly, the temporary regs apply to CAAs occurring on or after July 21, 2014, and to CAAs occurring before that date resulting from an entity classification election made under Reg. § 301.7701-3 that is filed on or after July 29, 2014, and that is effective on or before July 21, 2014 (the general applicability date). (Reg. § 1.901(m)-1T(b)(2), Reg. § 1.901(m)-2T(f), Reg. § 1.901(m)-4T(g)(1) , Reg. § 1.901(m)-5T(i)(2), Reg. § 1.901(m)-6T(d)(1))

The temporary regs also apply to CAAs occurring on or after Jan. 1, 2011, and before the general applicability date (the transition period), but only if the statutory basis difference in one or more RFAs with respect to such a CAA had not been fully taken into account under Code Sec. 901(m)(3)(B) either: a) as of July 21, 2014, or b) in the case of an entity classification election made under Reg. § 301.7701-3 that is filed on or after July 29, 2014, and that is effective on or before July 21, 2014—prior to the transactions that are deemed to occur under Reg. § 301.7701-3(g) as a result of the change in classification. (Reg. § 1.901(m)-1T(b)(2))

Taxpayers also may choose to consistently apply Reg. § 1.901(m)-4T(d)(1) (regarding the determination of basis difference in an RFA with respect to a Code Sec. 743(b) CAA) to all Code Sec. 743(b) CAAs occurring on or after Jan. 1, 2011. (Reg. § 1.901(m)-4T(g)(1))

References: For limits on the foreign tax credit in the case of covered asset acquisitions, see FTC 2d/FIN ¶  O-4211.1; United States Tax Reporter ¶  9044.06.