IRS Has Proposed Regs on Allocation/Apportionment of Creditable Foreign Taxes
The IRS recently proposed regulations that provide guidance on the allocation and apportionment of creditable foreign taxes. The regs also cover a variety of other issues, including those related to the foreign tax credit (FTC).
Allocation/Apportionment of Deductions
The proposed regs address the allocation and apportionment of deductions under Internal Revenue Code Sections 861 through 865. This includes new rules on the allocation and apportionment of research and experimentation (R&E) expenditures, and certain deductions of life insurance companies. The proposed regs would provide rules for:
- The allocation and apportionment of stewardship expenses,
- Litigation damages awards and settlement payments,
- Net operating losses, and
- Interest expenses.
The proposed regs would provide rules on the application of the exempt income/asset rule to insurance companies for certain dividends and tax-exempt interest. In addition, the proposals address the treatment of insurance company reserves for FTC purposes.
The proposed regs would also provide insurance companies with greater clarity on the effect of certain deduction limitations on the treatment of income and assets generating dividends-received deductions and tax-exempt interest.
The IRS has proposed to modify the regs to reflect that R&E expenditures that are deductible under Sec. 174 generally give rise to intangible property and that, under the rules in Sec. 367(d) and Sec. 482, the person incurring such R&E expenditures must be compensated properly when such intangible property gives rise to income. The proposed regs would coordinate the adjustments required under Sec. 904(b) with the net operating loss provisions.
Definition of Financial Services Income
The regs refine the definition of financial services income for purposes of the FTC limitation under Sec. 904. To promote simplification and greater consistency with other Internal Revenue Code provisions that have complementary policy objectives, the IRS proposes to modify the definition of a “financial services entity.” This would be done by adopting a definition of “predominately engaged in the active conduct of a banking, insurance, financing, or similar business” and “income derived in the active conduct of a banking, insurance, financing or similar business.”
Allocation and Apportionment of Expenses
A proposed regulation would provide rules for allocating and apportioning foreign tax expenses among the statutory and residual groupings by:
- Assigning foreign gross income on which a foreign tax is imposed to a grouping,
- Allocating and apportioning deductions under foreign law to that income, and
- Allocating and apportioning the foreign tax among the grouping.
The IRS is also proposing regulatory changes that would clarify and, in certain cases, modify the application of one proposed regulation for purposes of calculating the FTC limitation under Sec. 904 and foreign income taxes deemed paid under Sec. 960.
Foreign Tax Redeterminations
The regs clarify the effect of foreign tax redeterminations of foreign corporations on the application of the high-tax exception described in Sec. 954(b)(4). They also address required notifications to the IRS of foreign tax redeterminations and related penalty provisions.
The proposed regs would provide that a U.S. tax redetermination be required in all cases to account for the effect of a foreign corporation’s foreign tax redetermination. Additionally, they would clarify that the required adjustments by reason of a foreign tax redetermination of a foreign corporation include:
- Adjustments to the amount of foreign taxes deemed paid and the related Sec. 78 dividend,
- Adjustments to the foreign corporation’s income and earnings and profits, and
- The amount of the U.S. shareholder’s inclusions under Sec. 951 and Sec. 951A in the year to which the redetermined foreign tax relates.
Examples are included to illustrate these proposed rules.
The proposed regs also contain rules for when and how taxpayers must notify the IRS of a foreign tax redetermination, as well as rules on the penalty for failure to provide the IRS with such notification. These notification rules would require pass-through entities that report creditable foreign income tax to their partners, shareholders or beneficiaries to notify the IRS of a foreign tax redetermination.
In addition, the proposed regs would provide that a U.S. tax redetermination be required when a foreign tax redetermination affects whether a taxpayer is eligible for the subpart F high-tax exception. Therefore, the regs would stipulate that the subpart F high-tax exception be applied by considering the redetermined foreign tax in the adjusted year.
Application of FTC Disallowance Under Sec. 965(g)
The proposed regs clarify that existing principles would apply when determining the extent to which foreign income taxes are attributable to distributions of previously taxed earnings and profits.
For example, foreign withholding taxes imposed on an amount that’s recognized as a dividend for foreign — but not federal — income tax purposes are attributable to an item of income to which that amount would be assigned if recognized as a distribution for federal income tax purposes. To the extent a distribution would be a distribution of previously taxed earnings and profits, the tax would be associated with previously taxed earnings and profits and disallowed in part under Sec. 965(g).
Application of FTC Limitation to Consolidated Groups
The proposed regs include amendments to regulations under Sec. 1502 relating to the calculation of the consolidated FTC. The proposed amendments would update the regulations to reflect changes in the law, such as by eliminating out-of-date references to the per-country limitation.
For purposes of determining the FTC limitation, the proposed regulations also would provide that the amount of foreign source income in each separate category, used as the numerator in the FTC limitation fraction, be determined by applying the rules, as well as Sec. 904(f) and Sec. 904(g), on a groupwide basis, rather than applying those rules on a separate-member basis and combining the results.
Potential Changes, Possible Effects
Various applicability dates apply to specific regulations within the proposed regs. For more information on the potential changes and their possible effects on your tax situation, consult your Brady Ware International Tax expert.