TD 9871, Reg. § 1.704-1
IRS has issued final regs on the operation of the safe harbor rule in Reg. § 1.704-1(b)(4)(viii), which is used in determining whether allocations of partnership creditable foreign tax expenditures to partners are deemed to be in accordance with the partners’ interests in the partnership.
Background. Reg. § 1.704-1(b)(4)(viii) provides that partnership allocations of creditable foreign tax expenditures (CFTEs) do not have substantial economic effect, so a CFTE must be allocated in accordance with the partners’ interests in the partnership (see Weekly Alert ¶ 3 10/26/2006). The regs provide a safe harbor under which CFTE allocations are deemed to be in accordance with the partners’ interests in the partnership. In general, the purpose of the safe harbor is to match allocations of CFTEs with the income to which the CFTEs relate.
Under the safe harbor, a partnership must: (1) determine the partnership’s CFTE categories; (2) determine the partnership’s net income in each CFTE category; and (3) allocate the partnership’s CFTEs to each category. Reg. § 1.704-1(b)(4)(viii)(c)(2) requires a partnership to assign its income to activities and provides for the grouping of a partnership’s activities into one or more CFTE categories based generally on whether net income from the activities is allocated to partners in the same sharing ratios. Reg. § 1.704-1(b)(4)(viii)(c)(3) provides rules for determining the partnership’s net income (for US federal income tax purposes) in a CFTE category, including rules for allocating and apportioning expenses, losses, and other deductions to gross income. Reg. § 1.704-1(b)(4)(viii)(d) assigns CFTEs to the CFTE category that includes the related income under the principles of Reg. § 1.904-6 (dealing with the allocation and apportionment of taxes), with certain modifications. In order to satisfy the safe harbor, partnership allocations of CFTEs in a CFTE category must be in proportion to the allocations of the partnership’s net income in the CFTE category.
2016 temporary and proposed regs. In 2016, IRS issued temporary regs (TD 9748), the text of which also served as the text of contemporaneously issued proposed regs (Preamble to Prop Reg REG-100861-15, collectively referred to as the 2016 proposed regs), on the operation of the safe harbor rule under Reg. § 1.704-1(b)(4)(viii). See Temp regs issued on partnership’s allocation of creditable foreign tax expenditures (02/11/2016).
Final regs. The final regs adopt the 2016 proposed regs with one modification. The final regs add a cross reference to the disregarded payment rule for assigning income to an activity in Reg. §1.704-1(b)(4)(viii)(c)(3)(iv)(discussed below) to the paragraph that provides the basic definition of an activity to further highlight the interaction of those two paragraphs. (Reg. §1.704-1(b)(4)(viii)(c)(2)(iii))
The final regs further provide the following rules:
Effect of Section 743(b) adjustments. In the case of a transfer of a partnership interest that results in an adjustment under Code Sec. 743(b) (because the partnership has a Code Sec. 754 election in effect, or because there is a substantial built-in loss in the partnership), the partnership must adjust the basis of partnership property with respect to the transferee partner only (a Section 743(b) adjustment). No adjustment is made to the common basis of partnership property, and the Section 743(b) adjustment has no effect on the partnership’s computation of any item under Code Sec. 703. (Reg. § 1.743-1(j)(1)) The current final regs do not state whether a Section 743(b) adjustment is taken into account in computing the partnership’s net income in a CFTE category.
Reg. § 1.704-1(b)(4)(viii)(c)(3)(i) provides that, for purposes of computing a partnership’s net income in a CFTE category, the partnership determines its items without regard to any Section 743(b) adjustments that its partners may have to the basis of property of the partnership. IRS believes that a transferee partner’s Section 743(b) adjustment with respect to its interest in a partnership shouldn’t be taken into account in computing such partnership’s net income in a CFTE category because the basis adjustment is unique to the transferee partner and ordinarily wouldn’t be taken into account by a foreign jurisdiction in computing its foreign taxable base.
However, IRS also notes that a partnership that is a transferee partner may have a Section 743(b) adjustment in its capacity as a direct or indirect partner in a lower-tier partnership. Under Reg. § 1.704-1(b)(4)(viii)(c)(3)(i), such a Section 743(b) adjustment of the partnership is taken into account in determining the partnership’s net income in a CFTE category. IRS reasons that in the case of a Section 743(b) adjustment of a partnership that is a transferee partner, it may nevertheless be appropriate to alter the way in which the Section 743(b) adjustment is taken into account in determining the partnership’s net income in a CFTE category when the Section 743(b) adjustment gives rise to basis differences subject to Code Sec. 901(m) (which deals with the denial of a foreign tax credit for foreign income not subject to U.S. tax by reason of a covered asset acquisition). IRS intends to address Code Sec. 901(m) in separate guidance.
Disregarded payments. Since an item of gross income is assigned to the activity that generates the item of income that is recognized for US federal income tax purposes, consequently disregarded payments are not taken into account in determining the amount of net income attributable to an activity, although a special allocation of income used to make a disregarded payment may result in the subdivision of an activity into divisible parts. (Reg. §1.704-1(b)(4)(viii)(c)(3)(iv))
Nondeductible guaranteed payments. Under the safe harbor, Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii) provides a special rule that reduces the partnership’s net income in a CFTE category to the extent foreign law allows a deduction for an allocation (or payment of an allocated amount) to a partner. Accordingly, no special rule is necessary for deductible guaranteed payments under Code Sec. 707(c) which reduce the partnership’s net income in a CFTE category. However, to the extent that foreign law doesn’t allow a deduction for a guaranteed payment that is deductible under U.S. law, Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii) provides another special rule that requires an upward adjustment to the partnership’s net income in a CFTE category (this rule, together with the prior special rule, are collectively the “special rules”). An additional rule in Reg. § 1.704-1(b)(4)(viii)(c)(4) treats the guaranteed payment as a distributive share of the partnership’s net income in a CFTE category to the extent of the upward adjustment. However, the regs do not expressly address situations in which an allocation or distribution of an allocated amount or guaranteed payment gives rise to a deduction for purposes of one foreign tax, but is made out of income subject to another tax imposed by the same or a different foreign jurisdiction.
Reg. § 1.704-1(b)(4)(viii)(c)(4)(ii) provides that a partnership’s net income in a CFTE category from which a guaranteed payment that isn’t deductible in a foreign jurisdiction is made, must be increased by the amount of the guaranteed payment that is deductible for US federal income tax purposes. It also provides that that amount must be treated as an allocation to the recipient of the guaranteed payment for purposes of determining the partners’ shares of income in the CFTE category, but only for purposes of testing allocations of CFTEs attributable to a foreign tax that doesn’t allow a deduction for the guaranteed payment. However, for purposes of testing allocations of CFTEs attributable to a foreign tax that does allow a deduction for the guaranteed payment, a partnership’s net income in a CFTE category is increased only to the extent that the amount of the guaranteed payment that is deductible for US federal income tax purposes exceeds the amount allowed as a deduction for purposes of that foreign tax, and that excess is treated as an allocation to the recipient of the guaranteed payment for purposes of determining the partners’ shares of income in the CFTE category.
Similarly, Reg. § 1.704-1(b)(4)(viii)(c)(4)(iii) provides that, to the extent that a foreign tax allows a deduction from its taxable base for an allocation (or distribution of an allocated amount) to a partner, then solely for purposes of testing allocations of CFTEs attributable to that foreign tax, the partnership’s net income in the CFTE category from which the allocation is made is reduced by the amount of the foreign law deduction, and that amount isn’t treated as an allocation for purposes of determining the partners’ shares of income in the CFTE category. For purposes of testing allocations of CFTEs attributable to a foreign tax that doesn’t allow a deduction for an allocation (or distribution of an allocated amount) to a partner, the partnership’s net income in a CFTE category isn’t reduced.
In addition, Reg. § 1.704-1(b)(4)(viii)(c)(4)(ii) and Reg. § 1.704-1(b)(4)(viii)(c)(4)(iii) clarify that a guaranteed payment or preferential allocation is considered deductible under foreign law for purposes of the special rules if the foreign jurisdiction allows a deduction from its taxable base either in the current year or in a different tax year.
Inter-branch payments. For tax years beginning before Jan. 1, 2012, the special rule under Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii) included a cross-reference confirming that certain inter-branch payments that were described in Reg. § 1.704-1(b)(4)(viii)(d)(3) (inter-branch payment rule) were not subject to the special rules. On Feb. 14, 2012, temporary regs dealing with situations in which foreign income taxes have been separated from the related income were issued. As part of those regs, the inter-branch payment rule was removed because it allowed taxpayers to separate foreign income taxes and related income, and the cross-reference to the eliminated rule was removed from Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii) (see Weekly Alert ¶ 15 02/16/2012)
Reg. § 1.704-1(b)(4)(viii)(c)(4)(iii) clarifies that the special rule for preferential allocations applies only to allocations (or distributions of allocated amounts) to a partner that are deductible under foreign law, and not to other items that give rise to deductions under foreign law. For example, this special rule doesn’t apply to reduce income in a CFTE category by reason of a disregarded inter-branch payment, even if the income out of which the inter-branch payment is made is not subject to tax in any foreign jurisdiction. Because an inter-branch payment isn’t made to a partner, it can never be treated as a distributive share and is outside the scope of the special rules. The inclusion and subsequent removal of the cross-reference didn’t change the purpose of current Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii) or expand its scope to provide for reductions in income in a CFTE category if a partnership makes a disregarded payment that is deductible under foreign law.
In addition, IRS is aware of transactions involving serial disregarded payments in which taxpayers take the position that withholding taxes assessed on the first payment in a series of back-to-back disregarded payments don’t need to be apportioned among the CFTE categories that include the income out of which the payment is made. The final regs include new examples 2 and 3 clarifying that, under Reg. § 1.704-1(b)(4)(viii)(d)(1), withholding taxes must be apportioned among the CFTE categories that include the related income. (Reg. § 1.704-1(b)(6)(ii) and Reg. § 1.704-1(b)(6)(iii))
Effective date. Except as otherwise provided below, the provisions of Reg. § 1.704-1(b)(3)(iv) and Reg. § 1.704-1(b)(4)(viii) apply for partnership tax years beginning on or after October 19, 2006. However, taxpayers may rely on the provisions of Reg. § 1.704-1(b)(3)(iv) and Reg. § 1.704-1(b)(4)(viii) for partnership tax years beginning on or after April 21, 2004.
The provisions of paragraphs Reg. § 1.704-1(b)(4)(viii)(a)(1), Reg. § 1.704-1(b)(4)(viii)(c)(1), Reg. § 1.704-1(b)(4)(viii)(c)(2)(ii), Reg. § 1.704-1(b)(4)(viii)(c)(2)(iii), Reg. § 1.704-1(b)(4)(viii)(c)(3), Reg. § 1.704-1(b)(4)(viii)(c)(4), Reg. § 1.704-1(b)(4)(viii)(d)(1), and Examples 1, 2, and 3 (in Reg. § 1.704-1(b)(6)(i), Reg. § 1.704-1(b)(6)(ii), and Reg. § 1.704-1(b)(6)(iii)) apply for partnership tax years that both begin on or after January 1, 2016, and end after February 4, 2016. (Reg. § 1.704-1(b)(1)(ii)(b)(1))
The final regs also modify an existing transition rule (for certain inter-branch payments for partnerships whose agreements were entered into prior to Feb. 14, 2012) that provides that if there has been no material modification to their partnership agreements on or after Feb. 14, 2012, then, for tax years beginning on or after Jan. 1, 2012, the partnerships may apply Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii) and Reg. § 1.704-1(b)(4)(viii)(d)(3) (revised as of Apr. 1, 2011). That transition rule is modified to provide that for tax years that both begin on or after Jan. 1, 2016, and end after Feb. 4, 2016, these partnerships may continue to apply Reg. § 1.704-1(b)(4)(viii)(d)(3) but must also apply Reg. § 1.704-1(b)(4)(viii)(c)(3)(ii). For purposes of this transition rule, any change in ownership constitutes a material modification to the partnership agreement. This transition rule doesn’t apply to any tax year (and all subsequent tax years) in which related persons collectively have the power to amend the partnership agreement without the consent of any unrelated party. (Reg. § 1.704-1(b)(1)(ii)(b)(3)(ii))
References: For rules regarding partnership allocations of foreign tax credits, see FTC 2d/FIN ¶B-2903.1; United States Tax Reporter ¶7044.07.
