On Nov. 12, 2020, the U.S. Department of the Treasury and the IRS finalized foreign tax credit (FTC) regulations that include rules on the allocation and apportionment of certain expenses referred to as stewardship expenses. While not clearly defined, stewardship expenses generally include expenses that are duplicative in nature or expenses that are related to shareholder activities without a meaningful benefit to a related party. Following are five things taxpayers should focus on when assessing the impact of the final FTC regulations on 2020 and later tax years.
1. Identifying stewardship expenses
The final FTC regulations continue to use the definition of stewardship expenses provided in the Section 482 regulations. Under this definition, stewardship expenses are U.S. expenses that duplicate expenses incurred by a related entity and that are incurred primarily to protect a taxpayer’s investment in another entity or facilitate the taxpayer’s compliance with its own reporting, legal, or regulatory requirements.
It can be difficult to distinguish between related-party transaction expenses that are properly classified as stewardship expenses and other related-party transaction expenses, such as controlled expenses or supportive expenses. The main difference is that stewardship expenses generally do not provide a benefit to the related party, but determining when and if a benefit is provided to a related party is a fairly subjective exercise.
2. Impact on foreign tax credit usage
U.S. expenses are allocated to various categories or “baskets” of income to determine the limitation, if any, on the amount of FTC a taxpayer can claim. The Tax Cuts and Jobs Act of 2017 (TCJA) created a new global intangible low-taxed income (GILTI) basket to compute the FTC limitation related to GILTI inclusions. Under the final FTC regulations, stewardship expenses are allocated and apportioned to the GILTI basket. As a result, the FTCs available to reduce the U.S. tax on the GILTI inclusion may be limited and the incremental U.S. tax cost of a taxpayer’s GILTI inclusion may increase, even where the local effective tax rate is more than the theoretical breakeven point of 13.125%, the point at which U.S. taxes are entirely offset by FTCs. The incremental U.S. tax on GILTI created by allocation and apportionment of stewardship expenses to the GILTI FTC limitation could be material to many taxpayers.
Additionally, the preamble to the final FTC regulations clarifies that stewardship expenses can be incurred with respect to all entities, including disregarded entities. Because U.S. expenses related to disregarded entities are allocated to the foreign branch basket, the same apportionment principles similarly could affect the limitation of FTCs applied to the foreign branch basket.