T.D. 9866; Reg §1.78-1, Reg §1.861-12, Reg §1.965-7
IRS has finalized certain of the foreign tax credit (FTC) proposed regs that it issued this past December. The final regs include changes to the rules that address the interaction between the FTC and Code Sec. 965(n)‘s rules on not applying the net operating loss deduction when computing the Code Sec. 965 transition tax.
The FTC regs were issued together with final regs on global intangible low-tax income (GILTI) and subpart F income. For discussion of the finalization of the GILTI and subpart F regs, see Final regs on global intangible low-tax income, subpart F income.
Background—the Code’s FTC provisions. Both the U.S. and foreign countries may tax the foreign source income of U.S. taxpayers. To ease this double taxation burden, the Code permits most U.S. taxpayers who pay income taxes to a foreign country to either deduct the taxes from gross income for U.S. purposes or credit them dollar for dollar against their U.S. income tax liability on foreign source income. (Code Sec. 901) The FTC is computed separately for certain categories (also referred to as “baskets”) of income.
The FTC rules were significantly revised by the Tax Cuts and Jobs Act (P. L. 115-97; the TCJA). Among other changes, the TCJA added two FTC limitation categories in Code Sec. 904(d) to the prior two categories of general and passive income, added Code Sec. 951A, which requires a United States shareholder of a controlled foreign corporation (CFC) to include certain amounts in income (the GILTI inclusion), and provided a new dividends-received deduction for dividends from foreign subsidiaries.
Background—December 2018 proposed FTC regs. In December 2018, IRS issued proposed regs that would provide guidance on the FTC for businesses and individuals. The proposed regs reflect changes made by the TCJA, including the expansion of the number of separate income categories for the FTC limitation, as well as other statutory amendments. (Preamble to Prop Reg REG-105600-18; see Proposed regs explain new foreign tax credit limitation income categories & provide transition rules)
IRS finalizes some of the proposed regs. IRS has now finalized several rules that were included in the FTC proposed regs.
Applicability date under Code Section 78. The FTC proposed regs provide that amounts treated as dividends under Code Sec. 78 (“ Code Sec. 78 dividends”) that relate to tax years of foreign corporations that begin before January 1, 2018 (as well as Code Sec. 78 dividends that relate to later tax years), are not treated as dividends for purposes of Code Sec. 245A‘s dividends-received deduction.
Comments questioned whether IRS has authority to treat Code Sec. 78 dividends relating to tax years of foreign corporations beginning before January 1, 2018, as ineligible for the dividends-received deduction under Code Sec. 245A, which generally applies to certain dividends paid after December 31, 2017. Although some comments acknowledged that allowing a dividends-received deduction for Code Sec. 78 dividends would provide taxpayers with a double benefit that clearly was not intended by Congress, the comments claimed that the statutory language directly provides for the dividends-received deduction, and therefore the rule applying Prop Reg §1.78-1(c) to tax years beginning before January 1, 2018, should be eliminated.
IRS determined that Code Sec. 7805(a), Code Sec. 7805(b)(2) and Code Sec. 245A(g) provide it with ample authority for the rule in the proposed regs and therefore finalized the proposed applicability date without change. Thus, a Code Sec. 78 gross-up is not treated as a dividend for purposes of Code Sec. 245A, effective for Code Sec. 78 gross-ups received after Dec. 31, 2017. (Reg §1.78-1(c))
Application a basis adjustment for purposes of characterizing certain stock. The Code Sec. 904 FTC limitation is determined, in part, based on a taxpayer’s taxable income from sources without the U.S. Regs under Code Sec. 861 through Code Sec. 865 provide rules for allocating and apportioning deductions to determine, among other things, a taxpayer’s taxable income from sources without the U.S. for Code Sec. 904 purposes.
Under Code Sec. 864(e)(4)(A) and Reg. § 1.861-12(c)(2)(i)(A), for purposes of apportioning expenses on the basis of the tax book value of assets, certain adjustments are made to the adjusted basis of stock in a 10% owned corporation based on the earnings and profits (or deficits in earnings and profits) of the corporation attributable to the stock. Prop Reg § 1.861-12(c)(2)(i)(B) confirmed that previously taxed earnings and profits are taken into account for purposes of the adjustment described in Reg. §1.861-12(c)(2).
Prop Reg §1.861-12(c)(2)(i)(B)(1)(ii) provided that, for purposes of Reg §1.861-12(c)(2), a taxpayer determines the basis in the stock of a specified foreign corporation as if it had made the election under Reg §1.965-2(f)(2)(i), even if the taxpayer did not in fact make the election, but does not include the amount included in basis under Reg §1.965-2(f)(2)(ii)(A) (because the amount of that increase would not be included if the increase was by operation of Code Sec. 961). For this purpose, the amount included in basis under Prop Reg §1.965-2(f)(2)(ii)(A)was determined without regard to whether any portion of the amount is netted against other basis adjustments under Prop Reg §1.965-2(h)(2). Prop Reg §1.861-12(c)(2)(i)(B)(1)(ii) applies to the tax year of the inclusion under Code Sec. 965 as well as to future tax years.
After issuance of the FTC proposed regs, final regs issued under Code Sec. 965 (T.D. 9846 (February 5, 2019)) altered the election under Reg §1.965-2(f)(2) to allow taxpayers to limit the reduction in basis with respect to an E&P deficit foreign corporation under the election to the amount of the taxpayer’s basis in the respective share of stock of the relevant foreign corporation.
To reflect the altered election under Reg §1.965-2(f)(2), the final regs provide that Reg §1.861-12(c)(2)(i)(B)(1)(ii) may cause the taxpayer’s adjusted basis in the stock of the corporation to be negative, as long as the adjustment for E&P provided for in Reg §1.861-12(c)(2)(i)(A) increases the taxpayer’s adjusted basis to zero or an amount above zero. If the taxpayer’s adjusted basis in the 10% owned corporation is still below zero after application of Reg §1.861-12(c)(2)(i)(A)(1) and Reg §1.861-12(c)(2)(i)(A)(2), then for purposes of Reg §1.861-12, the taxpayer’s adjusted basis in the 10% owned corporation is zero for the tax year. (Reg § 1.861-12(c)(2)(i)(A)(3); see also Reg §1.861-12(c)(2)(i)(C)(3) (Example 3) and Reg §1.861-12(c)(2)(i)(C)(4) (Example 4))
Additionally, the final regs modify Prop Reg §1.861-12(c)(2)(i)(B)(1)(ii) to make clear that the adjustment in Reg §1.861-12(c)(2)(i)(B)(1)(ii) may cause a taxpayer’s adjusted basis in stock in the 10% owned corporation to be negative, and to account for the changes made to Reg §1.965-2(f)(2).
Effect of Code Section 965(n) election. Under Code Sec. 965(n), a taxpayer may elect to exclude the amount of Code Sec. 965(a) inclusions (reduced by Code Sec. 965(c) deductions) and associated Code Sec. 78dividends in determining the amount of the net operating loss carryover or carryback that is deductible in the tax year of the inclusions. Reg § 1.965-7(e)(1), as added by T.D. 9846, provides that, if the taxpayer makes a Code Sec. 965(n) election, the taxpayer does not take into account the amount of the Code Sec. 965(a) inclusions (reduced by Code Sec. 965(c) deductions) and associated Code Sec. 78 dividends in determining the amount of the net operating loss for the tax year.
The final regs modify, to some extent the proposed regs regarding the interaction between Code Sec. 965(n) and the FTC limitation. Taxpayers that make a Code Sec. 965(n) election may not exclude the net Code Sec. 965 inclusion from the allocation and apportionment of expenses for Code Sec. 904 limitation purposes. They must, instead, treat the net operating loss that is not taken into account as a result of the Code Sec. 965(n)election as being composed of a proportionate amount of deductions in each of the Code Sec. 904 limitation categories. (Reg §1.965-7(e)(1))
Applicability dates. Under Reg §1.965-9(a), the provisions of Reg §1.965-7 contained in the final regs apply beginning the last tax year of a foreign corporation that begins before January 1, 2018, and with respect to a United States person, beginning the tax year in which or with which such tax year of the foreign corporation ends.
In general, Reg §1.78-1 applies to tax years of foreign corporations that begin after December 31, 2017, and to tax years of U.S. shareholders in which or with which such tax years of foreign corporations end. As noted above, a special applicability date is provided in §1.78-1(c) in order to apply the second sentence of Reg §1.78-1(a) to Code Sec. 78 dividends received after December 31, 2017, with respect to a tax year of a foreign corporation beginning before January 1, 2018. (Reg §1.78-1(c))
Reg §1.861-12(c) applies to tax years that both begin after December 31, 2017, and end on or after December 4, 2018. A special applicability date was provided in Prop Reg §1.861-12(k) in order to apply Reg §1.861-12(c)(2)(i)(B)(1)(ii) to the last tax year of a foreign corporation beginning before January 1, 2018, since there may be an inclusion under Code Sec. 965 for that tax year. In the final regs, this special applicability date is extended to Reg §1.861-12(c)(2)(i)(A) to accommodate the changes that were made to that rule to further implement the rule in Reg §1.861-12(c)(2)(i)(B)(1)(ii). (Reg §1.861-12(k))
References: For the FTC, see FTC 2d/FIN ¶ O-4000 et seq; United States Tax Reporter ¶ 9014.
