On Dec. 7, 2016, temporary and proposed regulations were issued under IRC Section 901(m) related to the use of foreign tax credits in a covered asset acquisition (CAA). As background, a CAA is a transaction that is treated as an asset acquisition for U.S. tax purposes but as a stock transaction for foreign tax purposes. The U.S. treatment allows for a step-up in the basis of the assets of a company. Because there is no step-up in the basis for foreign purposes, asset basis differences exist in the two jurisdictions. The increase in the basis of a company’s assets for U.S. tax purposes may generate additional deductions for depreciation and amortization and result in lower earnings and profits for a foreign corporation. The additional deductions are not taken in the foreign jurisdiction, thus producing higher income and higher foreign taxes resulting in additional foreign tax credits. The purpose of Section 901(m) is to disqualify the foreign taxes related to the basis differences.
The temporary regulations were issued to prevent taxpayers from engaging in certain transactions following a CAA that cause the statutory disposition rule to apply, thereby avoiding the intentions of Section 901(m). Therefore, subject to certain exceptions, unless a disposition is taxable for both U.S. and foreign tax purposes, the taxpayer will be required to consider unallocated basis differences in later years. In addition, the temporary regulations exclude withholding taxes from the pool of potentially disallowed foreign taxes.
The proposed regulations were simultaneously issued with the temporary regulations and identify three new types of transactions that are CAAs and therefore subject to Section 901(m):
- Acquisitions treated as acquisitions of assets for U.S. tax purposes and an interest in a disregarded entity for foreign purposes
- Certain partnership asset distributions the basis of which is determined under Section 732(b) or Section 732(d), provided there is an increase in basis for U.S. tax purposes and no increase for foreign purposes
- Acquisitions of assets for U.S. and foreign tax purposes, provided there is an increase in U.S. tax basis and no increase in foreign basis
A favorable provision in the proposed regulations provides for an election that allows taxpayers to determine the basis difference with reference to the foreign basis as opposed to requiring a computation of the U.S. basis difference before and after the transaction. The election is made on an originally filed return for the first year in which the basis difference is relevant by using the foreign basis difference.
The proposed regulations also allow for de minimis rules where certain basis differences will not be included in the aggregate basis difference of the relevant foreign asset. In general, the de minimis rules offer a cumulative basis difference exemption or a relevant foreign asset exemption. The cumulative basis difference exemption excludes the basis difference of a single relevant foreign asset if the basis difference plus all other basis differences related to one covered asset acquisition is less than the greater of $10 million or 10 percent of the total U.S. basis of all relevant foreign assets following the covered asset acquisition.
The relevant foreign asset class exemption excludes basis differences if both of the following apply:
- A relevant foreign asset is included in a relevant foreign asset class.
- The sum of the basis differences of the assets in that class is less than the greater of $2 million or 10 percent of the total U.S. basis of all of the relevant foreign assets in that specific relevant foreign asset class following the covered asset acquisition.
The de minimis rules are adjusted when the parties of the covered asset acquisition are related. Instead of using $10 million and 10 percent in the cumulative basis difference exemption, the related-party rules change to $5 million and 5 percent. Also, instead of $2 million and 10 percent under the relevant foreign asset exemption, the test uses $1 million and 5 percent for related parties.