Key takeaways from the proposed foreign tax credit regulations

By Amanda Varma & Greg Kidder Steptoe & Johnson LLP, Washingon

The US government on November 23 released highly-anticipated proposed foreign tax credit regulations addressing the impact on the regime of the Tax Cuts and Jobs Act (TCJA).

Even after the introduction of a new participation exemption system, foreign tax credits remain critical to offsetting current US tax under the subpart F rules as well as the new global intangible low-taxed income (GILTI) regime. 

The proposed foreign tax credit regulations are long and complex and will take taxpayers and practitioners time to digest. This article provides an overview of the key issues addressed in the new regulations. 

Expense allocation rules may provide some relief

The new proposed regulations include expense allocation rules, one of the more anticipated areas because of the potential impact on the new GILTI rules in section 951A.

The expense allocation rules were important prior to the TCJA because of the way the foreign tax credit limitation rules work. Under section 904, a taxpayer’s ability to use foreign tax credits is limited by the taxpayer’s foreign source income.

Generally speaking, a taxpayer may not use more foreign tax credits than necessary to offset the US rate multiplied by the taxpayer’s foreign source income. This limitation prevents taxpayers from using foreign taxes to offset US tax on US source income. The expense allocation rules require taxpayers to allocate expenses between US source and foreign source income on the basis of different rules depending on the type of expense.

In addition, section 904(d) requires that foreign taxes be allocated to different categories (baskets) and that the foreign tax credit limitation rules must be applied on a basket by basket basis. Generally, depending on the expense, the allocation is done based on some combination of direct attribution and a division based on assets or income. 

These foreign tax credit expense allocation rules became even more important after the TCJA for several reasons.  First, the reduction in the US corporate rate generally means the overall foreign tax credit limitation will be lower, increasing the potential impact of a reduction in foreign source income as a result of expense allocation.

Second, the TCJA creates two new foreign tax credit baskets—one for GILTI income and one for foreign branch income. 

Third, the GILTI basket has its own specific foreign tax credit rules, including an 80% haircut and a prohibition against carryforwards. As a result, foreign taxes in the GILTI basket that may not be used because of the limitation rules are lost completely rather than carried forward to the following year. 

Foreign tax credit expense allocation & the GILTI basket

In particular, the interaction between the expense allocation rules and the GILTI rules has attracted significant attention because of the apparent inconsistency between the consequences of that interaction and how the GILTI rules were described in the legislative history of the TCJA.

Taxpayers commented that the application of the expense allocation rules to reduce foreign source income in the GILTI basket is inconsistent with Congress’s intent to enact a minimum tax. Taxpayers pointed to the language in the TCJA conference report asserting, “the minimum foreign tax rate, with respect to [GILTI], at which no US residual tax is owed by a domestic corporation is 13.125 percent.”

This sentence in the conference report was based on the fact that a US corporation is entitled to a 50 percent deduction against GILTI under section 250. Since the post-TCJA rate is 21%, the application of the deduction is sometimes described as instead applying a 10.5% rate to GILTI.

Because credits are limited to 80% of foreign taxes attributable to GILTI, a foreign tax rate of 13.125% would result in available credits of 10.5%, apparently sufficient to offset the US tax of 10.5%. This computation has led many to describe GILTI as imposing a 13.125% minimum tax, implying that if income is earned in a foreign jurisdiction with a tax rate of 13.125% or more, then GILTI should not result in any additional US tax.

Some relief

The proposed foreign tax credit regulations indicate that the IRS and Treasury do not agree with the comments, asserting that expense allocation would result in additional US “residual” tax. However, the proposed regulations do provide rules that allow some relief in some circumstances. 

The proposed regulations treat the portion of GILTI that is reduced by the section 250 GILTI deduction as effectively tax-exempt income produced by tax exempt assets. Under section 864(e), tax-exempt income and tax-exempt assets are not treated as receiving an allocation of expenses under the various allocation rules.

As a result, this rule provides some relief by reducing the amount of assets or income included in the computation to determine what portion of expenses must be allocated to the GILTI basket. Because the GILTI deduction under section 250 is currently 50%, generally only half of the assets and income will be included for expense allocation purposes. 

As a result, this rule provides some relief by reducing the amount of assets or income included in the computation to determine what portion of expenses must be allocated to the GILTI basket. Because the GILTI deduction under section 250 is currently 50%, generally only half of the assets and income will be included for expense allocation purposes. 

Note, however, that the portion of assets and income that generates a deduction for foreign-derived intangible income (FDII) is similarly treated as tax-exempt for purposes of expense allocation. As a result, there may be fewer expenses allocated to non-GILTI income (and therefore more expenses allocated to GILTI income). 

Special rules for CFCs

In addition, the proposed foreign tax credit regulations contain a rule to determine the percentage of income and assets of a controlled foreign corporation (CFC) that is attributable to GILTI.

The general rule, which existed prior to the TCJA, is that stock of a CFC is allocated across foreign income baskets based on the income and assets of the CFC. A CFC, however, does not have any GILTI.  Only a US shareholder in a CFC has a GILTI inclusion as a result of owning the CFC. Accordingly, in the absence of a special rule, no portion of CFC stock would be treated as a GILTI asset or generating GILTI income.  

The proposed regulations provide that special rule. First, income and assets are allocated to the general and passive income baskets that existed prior to the TCJA. Then, the portion that is allocated to the general basket is further allocated between GILTI and non-GILTI (with the non-GILTI treated as general).

The rule applies the “inclusion percentage” rule already included in the statutory GILTI foreign tax credit rules. That statutory rule limits the amount of foreign taxes deemed attributable to GILTI based on an“inclusion percentage” equal to GILTI divided by aggregate tested income. Thus, the percentage of taxes attributable to tested income that is treated as attributable to GILTI will be equal to the percentage of the non-passive income and assets of the CFC that is treated as GILTI. 

As a result of these new proposed rules, a US shareholder in a CFC must allocate expenses to the CFC stock, then further apportion the CFC stock between the passive and general baskets, then further divide the general basket between GILTI and non-GILTI, and finally treat a portion of the assets and income allocated to GILTI as exempt based on the section 250 deduction.

In addition, the proposed regulations provide rules on the application of section 904(b)(4). Section 904(b)(4) provides that, for purposes of the foreign tax credit limitation rules in section 904, section 245A dividends (i.e., those subject tot he participation exemption and not subject to additional US tax) and any deductions properly allocable or apportioned to income other than subpart F income or GILTI are disregarded.

Such income and expenses are disregarded for purposes of calculating both the numerator and the denominator of the foreign tax credit limitation fraction for each basket. Note that the section 245A dividend income and corresponding participation exemption deduction will offset. However, to the extent there are additional expenses attributable to the income that are disregarded also, that will impact the expense allocation. Disregarding expenses increases the amount of foreign source income in the particular basket and increases worldwide income generally. Thus, the limitation for the particular basket will increase, and the limitation for the other baskets will decrease.

Overall, the proposed expense allocation rules increase the complexity of the foreign tax credit limitation calculations, but provide a logical path to address the interaction of the new statutory rules under the TCJA with the existing limitation rules.

Calculating deemed paid taxes

Section 960 was revised in the TCJA to deem a US corporate shareholder as having paid certain foreign taxes paid by a CFC in the case of subpart F and GILTI inclusions as well as where the CFC distributes previously-taxed earnings and profits to a US corporation. The relevant statutory provisions look to whether the foreign taxes paid by the CFC are “properly attributable” to the income.

The proposed foreign tax credit regulations would establish a complex six-step process for calculating deemed paid taxes.

Very generally, starting with the lowest-tier CFC, the taxpayer must first assign a CFC’s income for the year to certain categories and income groups. Next, the taxpayer must reduce the CFC’s income in each group by deductions. Third, the taxpayer would determine the taxes that are properly attributable to subpart F income and to tested income under the GILTI rules. Fourth, the taxpayers must track previously-taxed earnings and profits from subpart F and GILTI inclusions within certain groups and accounts. Fifth, the taxpayer must repeat the first four steps for higher-tier CFCs. Sixth, when a CFC distributes previously-taxed earnings and profits to a US corporation, the US corporation is deemed to have paid the CFC foreign taxes properly attributable to the distribution with respect to that particular group and that have not previously been deemed paid, applying the properly attributable rules used in step 3.

Section 78 gross-up question resolved

The proposed foreign tax credit regulations fix a statutory glitch in the treatment of the section 78 gross-up for foreign taxes attributable to GILTI.

This glitch led to uncertainty about whether the deemed dividend under section 78 of foreign taxes properly attributable to tested income under the GILTI regime is included in the GILTI basket.

The proposed regulations assign the gross up to the same separate category as the deemed paid taxes so that such taxes are included in the GILTI basket.

Proposed foreign tax credit regulations & the new baskets

Prior to tax reform, the foreign tax credit rules, including the foreign tax credit limitation, generally applied separately with respect to two “baskets,” the passive income basket and the general income basket. The proposed foreign tax credit regulations provide guidance on several issues raised by the new foreign branch income basket and the GILTI basket. 

The proposed regulations provide transition rules to address existing foreign tax credit attributes, including carryovers and overall foreign loss, overall domestic loss, and separate limitation loss accounts. 

The proposed regulations would allow taxpayers to elect to treat a portion of their pre-2018 general category tax carryforwards as foreign branch taxes to the extent the taxes would have been foreign branch taxes if they had arisen post-2017.

The proposed regulations would allow taxpayers to elect to treat a portion of their pre-2018 general category tax carryforwards as foreign branch taxes to the extent the taxes would have been foreign branch taxes if they had arisen post-2017.

If the election is made, the re-allocation rule would also apply to other attributes in the pre-2018 general category. No taxes are re-allocated to the GILTI basket, which has no carryforward or back under the statute. The regulations would also allow taxpayers who generate excess taxes in the foreign branch basket after 2017 to carry them back to the general basket for the prior year. 

The proposed regulations also address the scope of the foreign branch basket. The regulations generally define foreign branch by reference to the section 989 regulations, including providing that a foreign branch must carry on a trade or business outside the United States and maintain a separate set of books and records. Foreign branch income is determined at the US corporate or individual level.

The proposed regulations also address when payments and transactions are regarded or disregarded for purposes of determining the income of a foreign branch and how foreign taxes related to disregarded payments are allocated and apportioned.

The addition of the GILTI basket raised questions about the application of the existing “look-through” rules of section 904(d)(3), which were not modified by TCJA. Some commentators had argued that interest, rent, and royalty payments made to US shareholders by CFCs that reduce tested income under the GILTI rules be considered GILTI basket income, which would have increased the GILTI basket foreign tax credit limitation. Treasury and the IRS did not adopt a look-through rule for such payments.

Deemed paid foreign taxes & section 956, high-tax exception

The proposed regulations also address several other issues, some of which were surprising. 

Under the regulations, foreign taxes would not be deemed to have been paid as a result of section 956 inclusions. This approach (and other recent proposed regulations under section 956 more generally) may have been driven in part by the government’s concern that taxpayers were using section 956 inclusions in connection with foreign tax credit planning, although the preamble to the regulations does not mention this issue.

The regulations also address the calculation of the high-tax exception under section 954(b)(4), a change identified in the preamble as in response to taxpayer planning.

Next steps for taxpayers

Taxpayers need to carefully examine the proposed foreign tax credit regulations to assess the potential impact. 

Taxpayers should also consider providing comments to Treasury and the IRS on the proposals, including any areas where the rules are ambiguous or would result in significant undue complexity. The government has also specifically requested feedback on several areas of the proposed regulations, including the potential changes to the expense allocation and apportionment rules and the foreign branch taxes carryover exception described above.

Amanda Varma is a partner at Steptoe & Johnson LLP, where she advises multinational corporations and high-net-worth individuals on U.S. international tax planning and controversies.

Greg Kidder is a partner at Steptoe & Johnson LLP, where his practice focuses on the taxation of corporate entities and cross-border transactions.

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