Preamble to Prop Reg REG-105600-18, Prop Reg § 1.78-1, Prop Reg § 1.861-8, Prop Reg § 1.861-9, Prop Reg § 1.861-10, Prop Reg § 1.861-11, Prop Reg § 1.861-12, Prop Reg § 1.861-13, Prop Reg § 1.861-14, Prop Reg § 1.861-17; Prop Reg § 1.901(j)-1, Prop Reg § 1.904-1, Prop Reg § 1.904-2, Prop Reg § 1.904-3, Prop Reg § 1.904-4, Prop Reg § 1.904-5. Prop Reg § 1.904-6, Prop Reg § 1.904(b)-3, Prop Reg § 1.904(f)-12, Prop Reg § 1.952-1, Prop Reg § 1.954-1, Prop Reg § 1.960-1, Prop Reg § 1.960-2, Prop Reg § 1.960-3, Prop Reg § 1.960-4, Prop Reg § 1.960-5, Prop Reg § 1.960-6, Prop Reg § 1.960-7, Prop Reg § 1.965-5, Prop Reg § 1.965-7
IRS has issued proposed regs that would provide guidance on the foreign tax credit (FTC) for businesses and individuals. The proposed regs reflect changes made by the Tax Cuts and Jobs Act, including the expansion of the number of separate income categories for the FTC limitation, as well as other statutory amendments. This article examines the proposed regs on the FTC limitation under Code Sec. 904.
For an article on the allocation and apportionment of deductions and adjustments to the FTC limitation, see here.
For an article on the determination of deemed paid credits under Code Sec. 960 and gross up under Code Sec. 78, see here.
Background. 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 foreign tax credit rules were significantly revised by the TCJA. Among other changes, the TCJA added two foreign tax credit 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 (referred to as a global intangible low-taxed income, or GILTI, inclusion), and provided a new dividends-received deduction for dividends from foreign subsidiaries. (For an article highlighting the key TCJA changes affecting foreign income and foreign persons, see 2017 Tax Reform: Checkpoint Special Study on foreign income, foreign persons tax changes in the “Tax Cuts and Jobs Act.”)
New proposed guidance on FTC limitation. The proposed regs update Reg. §1.904-1 through Reg. § 1.904-6 to eliminate deadwood and reflect statutory amendments made to Code Sec. 904 before the TCJA, including the repeal of the overall limitation and per-country limitation and the elimination of various separate categories in Code Sec. 904(d)(1).
Transition rules—new separate categories of income. The TCJA added two new separate FTC limitation categories—Code Sec. 951A category income and foreign branch category income—to the previously existing general and passive income categories. (Code Sec. 904(d)) The proposed regs provide a variety of transition rules for accouting for these new categories.
…Carryovers and carrybacks. The TCJA didn’t provide anyrules for assigning carryforwards of unused foreign taxes earned in pre-2018 tax years to a different separate category. Accordingly, under Prop Reg § 1.904-2(j)(1)(ii), if unused foreign taxes paid or accrued or deemed paid with respect to a separate category of income are carried forward to a tax year beginning after Dec. 31, 2017, those taxes are allocated to the same post-2017 separate category as the pre-2018 separate category from which the unused foreign taxes are carried.
However, to prevent double taxation from occurring in certain situations, Prop Reg § 1.904-2(j)(1)(iii) provides an exception that permits taxpayers to assign unused foreign taxes that were paid or accrued in the pre-2018 separate category for general category income to the post-2017 separate category for foreign branch category income to the extent they would have been assigned to that separate category if the taxes had been paid or accrued in a post-2017 tax year, with any remaining unused taxes assigned to the post-2017 separate category for general category income.
The proposed regs also provide that, since all income included in the post-2017 foreign branch income category would have been general category income if earned in a pre-2018 tax year, and since all income included in the post-2017 separate categories for general category income, passive category income, or income in a specified separate category would have been treated as general category income, passive category income, or income in a specified separate category, respectively, if earned in a pre-2018 tax year, any unused foreign taxes with respect to general category income or foreign branch category income in a post-2017 tax year that are carried back to a pre-2018 tax year are allocated accordingly to the pre-2018 separate category for general category income, with any excess foreign taxes with respect to passive category income or income in a specified separate category in a post-2017 tax year that are carried back to a pre-2018 tax year allocated to the same pre-2018 separate category. (Prop Reg § 1.904-2(j)(2)(ii))
…Loss recapture. The proposed regs provide transition rules for: (i) recapture in a post-2017 tax year of an overall foreign loss (OFL) or separate limitation loss (SLL) in a pre-2018 separate category that offset U.S. source income or income in another pre-2018 separate category, respectively, in a pre-2018 tax year, and (ii) recapture of an overall domestic loss (ODL) that offset income in a pre-2018 separate category in a pre-2018 tax year.
Specifically, under Prop Reg § 1.904(f)-12(j), any SLL or OFL accounts in the pre-2018 separate category for passive category income or income in a specified separate category remain in the same post-2017 separate category, and any SLL or OFL account in the pre-2018 separate category for general category income is allocated between the post-2017 separate categories for general category income and foreign branch category income in the same proportion that any unused foreign taxes with respect to the pre-2018 separate category for general category income are allocated to those post-2017 separate categories. If there were no unused foreign taxes in the pre-2018 general category to be allocated, all SLL or OFL accounts in the pre-2018 separate category for general category income remain in the general category. (Prop Reg § 1.904(f)-12(j)(3)(i))
Separate categories—how certain specific types of income are treated. The proposed regs provide amendments to the rules relating to the categorization of a number of specific types of income, as explained below.
…Export financing interest, high-taxed income, financial services income. Passive income does not include export financing interest and high-taxed income (Code Sec. 904(d)(2)(B)(iii) and was therefore treated under pre-TCJA as general category income. In light of the TCJA’s expansion of categories under Code Sec. 904(d)(1), the proposed regs provide that export financing interest and high-taxed income should be categorized based on whether the income otherwise meets the definition of foreign branch category income, Code Sec. 951A category income, or general category income. (Prop Reg §1.904-4(c), Prop Reg § 1.904-4(h)(2))
In addition, in light of the expanded categories, Prop Reg § 1.904-4(e) provides that certain financial services income, which was previously treated as general category income, is generally treated as general category income if it does not fit within one of the newer, more specific categories—i.e., foreign branch category income or Code Sec. 951A income.
…Foreign branch category income. Code Sec. 904(d)(1)(B) provides a new separate category for foreign branch category income, which is defined by Code Sec. 904(d)(2)(J) as the business profits of a U.S. person attributable to a qualified business unit (QBU) in a foreign country (excluding passive category income). The proposed regs further clarify this definition to provide that foreign branch category income is the gross income of a U.S. person, other than a pass-through entity, that is attributable to foreign branches (i.e., reflected on the foreign branch’s separate set of books and records) held directly or indirectly through disregarded entities by the U.S. person. (Prop Reg § 1.904-4(f)(1)(i))
The proposed regs also clarify that, with limited exceptions, gross income “attributable to a foreign branch does not include: items arising from activities carried out in the U.S. (Prop Reg § 1.904-4(f)(2)(ii)); items of gross income arising from stock, including dividend income, income included under section 951(a)(1), 951A(a), or 1293(a) or gain from the disposition of stock (Prop Reg §1.904-4(f)(2)(iii)(A)); or gain realized by a foreign branch owner on the disposition of an interest in a disregarded entity or an interest in a partnership or other pass-through entity. (Prop Reg § 1.904-4(f)(2)(iv)(A)) An anti-abuse rule also provides for the reattriution of gross income if a principal purpose of recording (or failing to record) an item on the books and records of a foreign branch was tax avoidance. (Prop Reg § 1.904-4(f)(2)(v))
The proposed regs generally define a foreign branch by reference to the regs under Code Sec. 989—i.e., as a QBU that carries on a trade or business outside of the U.S. (Prop Reg § 1.904-4(f)(3)(iii)). However, the proposed regs do not incorporate the rule in the Code Sec. 989 regs that treats trusts and partnerships as per se QBUs and instead requires that the foreign branch carry on a trade or business outside the U.S. (Prop Reg § 1.904-4(f)(4))
…Section 951A category income. As noted above, one of the new categories of income added by the TCJA was Code Sec. 951A category income, which the proposed regs generally define as the gross income of a U.S. shareholder from a GILTI inclusion. (Prop Reg § 1.904-4(g)) However, a GILTI inclusion that is allocable to passive category income under the look-through rules in Reg. § 1.904-5(c)(6) is excluded from Code Sec. 951A category income. (Prop Reg § 1.904-4(n)(1)(ii))
…Items re-sourced under a treaty. Under Code Sec. 904(d)(6)(A), if certain requirements are met, U.S. taxpayers can elect to treat income items that would ordinarily be treated as U.S. source income under U.S. tax law as foreign source income (i.e., “re-source”), and a separate FTC limitation applies to each item of re-sourced income without regard to the separate category to which the item would otherwise be assigned. The proposed regs provide a grouping methodolgy under which taxpayers must segregate income treated as foreign source under each treaty and then compute a separate foreign tax credit limitation for income in each separate category that is resourced under that treaty.(Prop Reg § 1.904-4(k)(2)) The proposed regs also provide special rules for certain income re-sourced under double taxation provisions in U.S. income tax treaties, and for income resourced pursuant to a competent authority agreement. (Prop Reg § 1.904-4(k)(4))
…Section 78 gross up; Section 986(c) gain or loss. Prop Reg § 1.904-4(o) assigns the gross up under Code Sec. 78 to the same separate category as the deemed paid taxes, and Prop Reg § 1.904-4(p) assigns gain or loss under Code Sec. 986(c) with respect to a distribution of previously taxed earnings and profits (PTEP) to the separate category from which the distribution was made.
…Conforming changes; look-through rules. The proposed regs make a number of conforming changes to reflect the change of Code Sec. 904(d)(2)(E) from the term “noncontrolled section 902 corporation” to “noncontrolled 10-percent owned foreign corporation” (Prop Reg § 1.904-5(a)(4)), as well as to reflect the repeal of Section 902 and revisions to Code Sec. 960.
The proposed regs also modify the application of the look-through rule under Code Sec. 904(d)(3) to account for the addition of the new FTC limitation categories and reflect that the look-through rules apply solely with respect to payments allocable to passive category income. (Prop Reg § 1.904-5)
Allocation and apportionment of foreign taxes. Code Sec. 904(d)(2)(H)(i) provides a special rule for allocating foreign tax that is imposed on an amount that does not constitute income under Federal income tax principles (a “base difference”). Special rules are also provided for timing differences.
The proposed regs clarify that base differences arise only in limited circumstances, such as in the case of categories of items that are excluded from income for Federal income tax purposes but may be taxed as income under foreign law. (Prop Reg § 1.904-6(a)(1)(iv)) In addition, the proposed regs clarify that the fact that a distribution of previously taxed earnings and profits is exempt from Federal income tax does not mean that a tax imposed on the distribution is attributable to a base difference. Instead, because the previously taxed earnings and profits were included in U.S. taxable income in a prior year, the tax imposed on the distribution is treated as attributable to a timing difference and is allocated to the separate category to which the earnings and profits from which the distribution was paid are attributable.
Under the proposed regs, a U.S. or foreign partnership does not characterize any of its income as foreign branch category income. Instead, a distributive share of a partnership’s income may be characterized as foreign branch category income in the hands of certain U.S. partners. In order to ensure that creditable foreign tax expenditures (CFTEs) that are allocated to a partner that has a distributive share of income that is assigned to the foreign branch category are appropriately assigned, Prop Reg §.904-6(b)(4) provides rules for allocating and apportioning CFTEs to the foreign branch category.
Effective/applicability dates: In general, the portions of the proposed regs that relate to statutory amendments made by the TCJA are proposed to apply to tax years beginning after Dec. 22, 2017. (Code Sec. 7805(b)(2), which provides that any regs issued within 18 months of the enactment of the statutory provision to which the reg relates may be issued retroactively) Other portions of the proposed regs that do not relate to the TCJA apply for tax years ending on or after the date filed for public inspection in the Federal Register. Portions of the proposed regs that contain rules that relate to the TCJA as well as rules that do not relate to the TCJA generally apply to tax years that satisfy both of the following two conditions: (1) the tax year begins after Dec. 22, 2017, and (2) ends on or after the date filed for public inspection in the Federal Register.
References: For the FTC in general, see FTC 2d/FIN ¶ O-4000 et seq; United States Tax Reporter ¶ 9014. For the separate FTC limitation categories, see FTC 2d/FIN ¶ O-4300 et seq; United States Tax Reporter ¶ 9044.01.
