Responding to an IRS request for public input on pending foreign tax credit (FTC) revisions, practitioners from a Big Four accounting firm weighed in on issues arising from an aspect of how foreign taxes are allocated and apportioned.
Final FTC regs issued late December 2021, under Reg § 1.861-20, set rules for the treatment of statutory and residual groupings through assigned foreign gross income (FGI) determined by the character of the U.S. gross income item in correspondence to FGI. Under the so-called reattribution asset rule, when income from a payor to a recipient is reattributed, then there must also be a reattribution of the tax book value (TBV) of the payer’s assets generating the reattributed income to the recipient’s taxable assets.
Proposed regs released November 2022 provide guidance on various matters, including the reattribution asset rule, as well as the cost recovery requirement and the attribution rule for withholding tax on royalty payments. In in the proposed regs’ preamble, the IRS explained that pursuant to current rules, “the character of the assets of the remitting taxable unit is a proxy for the character of the current and accumulated earnings out of which the remittance is made.”
However, the IRS then states that it and the Treasury Department decided that the reattribution asset rule “is not needed for allocating and apportioning foreign tax on a remittance in the case of disregarded property sales, and particularly with respect to disregarded sales of inventory property.” The proposed regs retain the general definition of “reattribution asset” but exclude any portion of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable unit. Stakeholder input was sought on whether similar adjustments should be made for other situations.
In comments submitted January 20, KPMG wrote that the use of TBV of assets as a proxy for accumulated earnings undermine an otherwise “sensible policy result” established by the previous final regs. “Although justified by the government on administrability grounds, the TBV method is a poor and distortive proxy that often results in permanently lost foreign tax credits,” according to the firm.
As for the IRS’ request on potentially doing away with the reattribution asset rule in other contexts beyond the limited situation portrayed in the proposed regs, KPMG warned of possible distortions under the “one-way” rule. The comments responded that “it is nonsensical to introduce further complexity to refine this aspect of the TBV method when the underlying method is inherently so distortive.”
Ahead of a February 15 virtual rulemaking hearing, KPMG Partner Danielle Rolfes outlined alternatives to the TBV method. Rolfes favors using a rolling three-year average of the earnings attributable to a remitting taxable unit, which she argued would be a more accurate proxy. Furthermore, this would not necessitate new rules for tracking accumulated earnings, according to Rolfes.
Should the government commit to the asset-based method, Rolfes suggested a special purpose rule be issued that would for the reg’s specific purpose, characterize cash with the earnings that generated that cash. She also offered the option of “revising the existing rules to characterize the portion of a taxable unit’s aggregate remittances in a taxable year that does not exceed the taxable unit’s earnings for that year by reference to those current earnings, and only applying the TBV method to characterize any excess remittances for the year.”
At the hearing, Rolfes during her 10-minute remarks reiterated that assets do not adequately serve as a proxy for accumulated earnings. Chief among her arguments, in citing her firm’s submitted comments, was that investors in a company expect active assets to generate higher returns than passive assets.
“The asset-based method inherently allocates more taxes to passive than would be warranted if you actually looked at the earnings, because the active assets generate disproportionally more earnings than the passive assets,” said Rolfes.
For more information about the allocation and apportionment of foreign income taxes, see Checkpoint’s Federal Tax Coordinator ¶O-11050.
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