For those of us not satisfied with only one voluminous set of regulations per week, the IRS has heard our cries. On Wednesday, the IRS released 312 pages (including the preamble) of proposed regulations on foreign tax credits (FTCs). This guidance provides the first insights into the IRS’s interpretation of numerous FTC related questions arising out of the transformation of the U.S. international tax system by the 2017 tax reform legislation. These rules not only address FTC-related questions surrounding the new tax on Global Intangible Low-Taxed Income (GILTI), but also feature substantial changes to legacy FTC rules, a necessary step to allow for the determination of FTCs in a post-Tax Cuts and Jobs Act (TCJA) environment.
Most notably, interest expense apportionment, including for GILTI purposes, continues to follow legacy section 861 principles, with certain modifications. In that regard, the Service declined to provide the complete exemption from expense allocation and apportionment to GILTI that so many taxpayers and commentators had requested. Beyond this, the proposed regulations provide vast and detailed guidance on the new section 904 (FTC limitation) income categories and on allocating foreign taxes to those categories. Although these proposed regulations provide many such long-awaited answers, they do not do so simply. These proposed regulations add great complexity, and the retroactive implications of the proposed regulations may be particularly burdensome for taxpayers faced with imminent year-end calculations. The following is a brief overview of some of the highlights.
- Treatment of CFC Stock Under Section 861: The proposed regulations include a special rule that treats a portion of CFC stock that gives rise to a GILTI inclusion as an exempt asset. A domestic corporation that is a United States shareholder (USSH) calculates the exempt portion of its CFC stock based on a fraction, the numerator of which is its allowable section 250 deduction and the denominator of which is its GILTI inclusion. For some taxpayers, this could mean up to 50 percent less interest apportionment to GILTI income than previously expected. In addition, the proposed regulations provide that the portion of a CFC’s stock (including stock of CFCs with current losses) deemed to generate GILTI is determined by reference to the taxpayer’s GILTI inclusion percentage.
- FTC Carryovers and Carrybacks: FTC carryovers from pre-2018 generally remain with the same section 904 category post-2017. However, taxpayers may assign unused general category FTCs to the new foreign branch category to the extent such taxes would have been in that category when incurred, had the branch category existed at that time. A taxpayer may elect to apply this exception on a timely filed return (including extensions). Similarly, in the first tax year beginning after 2017, taxpayers carry back excess FTCs in the foreign branch category to the general limitation category for the previous tax year.
- The Proposed Regulations provide similar rules for reallocation of Separate Limitation Losses (SLLs), Overall Foreign Losses (OFLs), and Overall Domestic Losses (ODLs).
- No Reallocations to or from the Section 904 GILTI Category: The GILTI category effectively starts fresh in 2018 in that none of the above reallocations (for FTC carryovers and carrybacks, SLLs, OFLs or ODLs) will apply to the GILTI category.
- Treatment of the “GILTI Gross-Up” Confirmed: The preamble to the first set of GILTI regulations alleviated pre-existing uncertainty regarding the section 78 gross-up on GILTI – explaining that further regulations would allocate it to the GILTI section 904 category. Last week’s proposed regulations confirm this treatment.
- Changes to the 904 Look-Through Rule: Historically, the 904 look-through rule re-assigned certain payments from a CFC to its USSH from the passive category and into the general category. Now, under the proposed regulations, the look-through rule re-assigns CFC to USSH payments from the passive category to either the new foreign branch category or the general category (i.e., but notably, not to GILTI).
- Section 245A Dividends Received Deduction (DRD): Unlike the section 250 deduction, the 100 percent DRD on dividends from certain foreign corporations to their USSH does not yield tax-exempt income under the sourcing rules, nor does it result in stock that is treated as an exempt asset. Taxpayers must allocate expenses to section 245A income and assets. However, formulaic mechanisms involving the section 904 limitation fraction ultimately disregard any such expense allocations (which can mitigate the effect on the FTC limitation).
- Ordering Rules for Section 960 Deemed Paid Taxes: The proposed regulations provide lengthy and complex new ordering rules. We will spare you the mind-numbing details at this time in favor of highlighting two key new concepts: Income Groups and Previously Taxed Income E&P (PTEP) Groups.
- Income Groups: Income groups will largely supplant the legacy pooling rules for allocating taxes to income. For example, income groups exist for each type of Subpart F (i.e., Foreign Base Company Sales or Services Income (FBCSI)) within the general category and for GILTI. The proposed regulations provide substantial rules for allocating foreign taxes to each category of income.
- PTEP Groups: Annually a CFC establishes a PTEP Group for its E&P to which Subpart F and GILTI inclusions of its USSH are attributable. There are 10 such possible groups to track each year for the deemed paid tax calculation, as well as for any distributions occurring between CFCs.
- Transition Rules for Companies using the FMV Method of Apportioning Interest: Under the TCJA, taxpayers may no longer use the FMV method to apportion interest under section 861 and must instead use the tax book or alternative tax book value method. Treasury has offered relief for this change by allowing taxpayers who are switching from the FMV method to determine asset values using an average of asset values as of the end of the first quarter and year-end for the first taxable year beginning after December 31, 2017. This alleviates the need to determine a tax book value or alternative tax book value for assets at the close of the prior tax year.
In addition to the above, there are many other important topics addressed within the proposed regulations including: the allocation and apportionment of the section 250 deduction (for FDII and GILTI), special rules for calculating foreign branch income, the treatment of treaty source income, adjusted tax basis of stock after section 965 inclusions, the elimination of the so-called “partnership multiplier” phenomenon and the treatment of hybrid debt. The complexity in these areas and in those outlined above will soon become even more apparent as the guidance undergoes further interpretation and implementation.
Next Steps for Tax Practitioners
The proposed regulations give us our first guidance on questions that have been outstanding for months, and tax professionals should be updating their foreign tax credit estimates for 2018 immediately. Some key areas to address include:
- Section 250 deduction: impact of exempt treatment.
- Sec. 245A deduction: impact of separate category treatment.
- Look-through rule: impact of income recharacterization.
- Section 960 ordering rules: impact on 2018 and future distributions (taxes borne on distributions).
FMV method of interest expense allocation: impact of the transition rules and gather information to calculate Q1 tax basis in assets.
Alvarez & Marsal Says:
Taxpayers have eagerly anticipated the answers provided in these proposed regulations all year and will have only a short period of time to adapt and apply this guidance. Implementation of a streamlined process is essential to tackle the complexities of these proposed regulations, which range from the retroactive application of certain provisions to the necessity for potentially unprecedented source data. To do so, taxpayers may heavily rely on new tools as they look to efficiently prepare upcoming tax provisions, estimated tax payments, and extension payments. A&M Taxand aims to ease this process with further detailed insights in the coming weeks – stay tuned.