Article featured on Thomson Reuters' Taxnet Pro, October 2020

On September 30th, Treasury and the IRS released finalized regulations (the “Final Regulations”) and proposed regulations (“2020 Proposed Regulations”) which make major changes to the calculation of foreign tax credits. The Final Regulations expand in important respects on proposed regulations released in 2019 (“2019 Proposed Regulations”), and will require taxpayers to develop new methods and procedures for return preparation. The 2020 Proposed Regulations re-propose some of the rules that were included in the 2019 Proposed Regulations (e.g., the allocation and apportionment of deductions for purposes of calculating foreign tax credits) and contain other notable rules. This alert highlights several of the key changes in the Final Regulations and provides observations on portions of the Proposed Regulations.

Stewardship Expenses

The tax treatment of stewardship expenses is often given scant attention by taxpayers in preparing their returns, but takes on increased significance under the Final Regulations. The 2019 Proposed Regulations expanded the definition of stewardship expenses to include costs related to ownership of partnership interests, in addition to the stock of corporations as under prior law. The Final Regulations further expand the scope of stewardship expenses to include expenses that are incurred with respect to foreign and domestic business entities of any kind, including disregarded entities (but not foreign branches). The Final Regulations also provide that stewardship expenses are allocated to interests in entities based on the factual relationship between the expense and the entities, and further apportioned based on the tax book value of the stock, partnership interests, or assets to which the expenses relate.

A&M Insight: The method prescribed in the Final Regulations provides a uniform approach to the allocation and apportionment of stewardship expenses attributable to domestic and foreign business entities. Because the definition of stewardship expenses has been significantly broadened, US multinationals should consider whether they will be required to change the way they allocate certain costs, particularly those incurred with respect to the ownership of partnership interests and disregarded entities. They should also determine whether the method they have followed in the past for allocating and apportioning stewardship expense is consistent with the new requirements. 

Research and Experimentation Expenses

As with stewardship expenses, the Final Regulations generally retain the significant changes included in the 2019 Proposed Regulations to the allocation and apportionment approach of research and experimentation (R&E) expenses. These include significant modifications to the manner in which R&E expenses are allocated and apportioned for foreign tax credit purposes. The regulations provide that R&E expenses are allocable to a new category of “gross intangible income” (GII) which includes all gross income earned by the taxpayer attributable to intangible property, including gross income from sales, services, royalties and amounts taken into account under Section 367(d)(relating to outbound transfers of intangible assets), but not dividends or inclusions as a result of subpart F or GILTI. R&E expenses will be allocated only to GII according to the SIC codes with which the GII is reasonably connected. The regulations eliminate the former “gross income” apportionment method, leaving the sales apportionment method as the only available method. As a result, taxpayers who relied on the gross income method will have to develop new procedures from scratch. It will be necessary to identify items (including disregarded payments) included in GII, the SIC codes to which they relate, and the foreign tax credit basket into which they fall. The Final Regulations clarify several other issues, including the interaction of the foreign branch basket rules with the new GII standard and the inapplicability of exclusive apportionment rules in determining a taxpayer’s foreign derived intangible income (FDII). In addition, the 2020 Proposed Regulations include an election by which taxpayers may capitalize and amortize their R&E (and advertising) expenses, strictly for the purposes of allocating and apportioning their interest expenses as part of the FTC limitation calculation, instead of having them claimed as a deduction. 

A&M Insight: In general, the Final Regulations approach to R&E expenses is taxpayer-favorable as it should result in a significantly larger portion of R&E expenses being allocated and apportioned against domestic income for FTC purposes (and away from foreign sourced income), thereby significantly reducing US tax leakage due to expense allocation that reduces the foreign tax credit limitation. However, many taxpayers will find it necessary to make significant updates to the allocation methodologies they have used in the past. US multinationals with significant allocable expenses, with emphasis on US R&E expenditures, should review and model the efficiency of their current supply chain and operating structures to consider whether these are optimal from an expense allocation, FTC, and possibly BEAT positions. 

Allocation and apportionment of foreign tax expenses

The Final Regulations eliminate one of the most controversial features of the 2019 Proposed Regulations, which was the treatment of US return of capital distributions by partnerships and corporations that were treated as base (as opposed to timing) differences. The Final Regulations provide that such return of capital corporate distributions that are dividends under foreign law will generally be associated with hypothetical earnings in the categories to which the basis of the company’s stock is assigned for purposes of allocating and apportioning interest expense. Similar rules regarding partnership distributions have been re-proposed as part of the 2020 Proposed Regulations, as have rules on taxes imposed on disregarded payments. 

A&M Insight: The proposed rules governing taxes imposed on disregarded payments are complex. For example, there are different rules governing (i) amounts of gross income, computed under federal income tax law, that is initially assigned to a single statutory or residual grouping that includes gross income of a taxable unit but that is, by reason of a disregarded payment made by that taxable unit, attributed to another taxable unit and (ii) remittances, which are very generally certain payments from a branch to its owner. Taxpayers that will be subject to these rules will need to perform significant analysis in order to appreciate how they apply. In the meantime, taxpayers should carefully evaluate the potential implications in order to determine whether their current structure is efficient.

Foreign tax creditability and technical taxpayer rules – response to digital services tax proposals

In response to recent attempts by foreign jurisdictions to unilaterally introduce “extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction”, the 2020 Proposed Regulations introduce a “jurisdictional nexus” requirement, under which, in order to qualify as a creditable income tax (or as a tax in lieu of an income tax), the foreign tax law must require a sufficient nexus between the foreign country and the taxpayer’s activities or investment of capital or other assets in that jurisdiction that give rise to the income being taxed. In determining nexus, the foreign tax law may not “take into account as a significant factor the location of customers, users, or any other similar destination-based criterion.” This last requirement takes dead aim at proposed digital services taxes.

The 2020 Proposed Regulations also modify the determination of the amount of foreign tax that is considered to have been paid for foreign tax credit purposes. For example, under the new rules, an amount of foreign tax that is satisfied by a credit, other than for overpayment of tax, would not be treated as paid for US tax purposes. The 2020 Proposed Regulations also modify the determination of whether a foreign tax is a compulsory amount. 

In addition to the changes proposed with respect to general creditability rules, the 2020 Proposed Regulations also include changes to the technical taxpayer rules with respect to the allocation of the liability for foreign taxes related to partnerships, including changes in a partner’s interest in a partnership during a taxable year; disregarded entities; and corporations that change their entity classification during a year, terminating the corporation’s taxable year for US purposes but not for foreign purposes. The regulations generally allocate taxes pro rata based on taxable periods, in contrast to the current rule that treats a tax as paid by the person who becomes liable for the tax when it accrues. The pro rata allocation rule, however, is not intended to apply to withholding taxes.

Other notable provisions

In addition to the items discussed above, the Final Regulations include: 

• allocation and apportionment rules for damage awards and related payments;
• rules treating partnership guaranteed payments as interest equivalents;
• rules relating to hybrid instruments, including treatment of a hybrid instrument as a financing transaction for purposes of the conduit financing transactions; and
• extensive updates to the rules on foreign tax redeterminations.

A&M Taxand Says

This was a highly anticipated regulations package and the Treasury and Service did not disappoint. While most of the more technical rules involving foreign tax credits and expense allocation are in line with prior guidance, the package also includes extremely significant changes and taxpayers must be aware of them. Between the foreign tax credit and expense allocation regulations package and the revisions to the rules governing creditability of a foreign tax, taxpayers are now more than ever encouraged to take a deep look into their foreign tax credit position and ensure that it is as efficient as it should be. 

Additionally, it is important to note that the Final Regulations are retroactive in nature: certain rules apply to taxable years ending on or after December 16, 2019, while other portions apply to taxable years beginning on after December 31, 2019. As a result, taxpayers are encouraged to review their foreign tax credit calculations for 2019 and beyond. A&M is happy to discuss the implications of these regulations for those calculations, as well as for taxpayers’ overall structures.