IRS Releases Regulations Related to the Foreign Tax Credit

On Dec. 17, 2019, the IRS issued final regulations focused on administering the foreign tax credit and related matters. On the same date, it issued related proposed regulations. The proposed and final regulations implement changes to the federal tax credit rules enacted under the international tax provisions in the Tax Cuts and Jobs Act of 2017 (TCJA), as well as proposed regulations that were published before enactment of the TCJA.

Final regulations

The final regulations adopt, in large part, the regulations proposed in November 2018 with some clarification and supplemental guidance. The final regulations also finalize certain overall foreign loss regulations proposed in 2012 and certain temporary regulations issued in 2007 related to the translation of foreign income taxes and foreign tax redeterminations. The most important changes from earlier guidance include:

The reduction of previously taxed earnings and profits categories from 16 (per IRS Notice 2019-1) to 10
The freedom to elect either the sales method or the optional gross income method for the allocation and apportionment of research and experimentation (R&E) expenses for each tax year beginning after Dec. 31, 2017, and before Jan. 1, 2020. This provision in the final regulations allows for adoption of the proposed regulation treatment of R&E allocation and apportionment.

The final regulations generally are effective for tax years beginning after Dec. 31, 2017, for provisions related to those enacted by the TCJA. However, for provisions included in the proposed regulations, the final regulations are effective for tax years ending on or after Dec. 4, 2018. Provisions not addressed in the proposed regulations generally are effective after Dec. 16, 2019.

Proposed regulations

The proposed regulations represent a recent trend of issuing final regulations at the same time as proposing new rules not addressed by the final regulations. The trend is a testimony to how rapidly the international tax provisions of the TCJA are evolving and how issues are identified after proposed regulations are published. Highlights of the proposed regulations follow:

Allocation and apportionment of expenses

Stewardship expenses are allocated to dividends received or to be received and to Subpart F, global intangible low-taxed income (GILTI), and passive foreign investment company (PFIC) inclusions from related corporations. Current regulations provide for allocation only to dividends received or to be received. Additionally, stewardship expenses, like interest expense, are apportioned based on the relative values of a taxpayer’s stock assets rather than on any reasonable basis.

R&E expenses are allocated to gross intangible income, which is split among categories reasonably connected with the relevant Standard Industrial Classification Manual code assigned to the taxpayer’s activities. “Gross intangible income” generally is defined as all income attributable to intangible property, excluding dividends and inclusions under Subpart F or GILTI. Furthermore, the optional gross income method for allocating and apportioning R&E expenditures is eliminated; the sales method is the sole method prescribed for these expenses.

R&E expenses are proposed to be effective for tax years beginning after Dec. 31, 2019, but taxpayers may adopt treatment under the proposed regulations for all GILTI years provided allocation of the R&E expenses is determined based on the sales method for allocation and apportionment. If adopted early under the proposed regulations, R&E expenses are not allocated to the Section 951A category, which would increase the foreign tax credit limitation related to GILTI. The final regulations allow taxpayers the opportunity to elect the sales method for relevant years, as discussed earlier.

The proposed regulations include rules for other expenses, including allocation and apportionment of litigation damages, prejudgment interest, settlement payments, and reserve expenses for consolidated groups.

Allocation and apportionment of creditable foreign taxes

Allocation and apportionment of creditable foreign taxes follows the assignment of gross income to statutory and residual groupings. The proposed regulations provide detailed guidance on how to attribute taxes to gross income in the event of differences in taxable base due to timing or permanent items under tax law of the foreign country vis-a-vis tax law of the United States.

Issues attendant to the computation of the foreign tax credit

The interaction of the branch loss and dual consolidated loss recapture rules

The effect of foreign tax redeterminations on the application of the high-tax exception described under Section 954(b)(4) and required notifications under Section 905(c)

The definition of “foreign personal holding company income” under Section 954

The application of the foreign tax credit disallowance under Section 965(g)

The application of the foreign tax credit limitation to consolidated groups

The proposed regulations will be effective, excluding certain exceptions, for tax years ending on or after the date the final regulations are published in the Federal Register.