Overview
On January 4, 2022, the U.S. Department of the Treasury and the Internal Revenue Service (IRS) published its third set of final regulations on foreign tax credits (the “Final Regulations”) since the enactment of the Tax Cuts and Jobs Act. The Final Regulations include final regulations on the allocation and apportionment of foreign income taxes imposed with respect to disregarded payments (the “Final Disregarded Payment Rules”). As described below, the Final Disregarded Payment Rules are effective retroactively to tax years beginning after December 31, 2019, and that end on or after November 2, 2020. Thus, for calendar-year taxpayers, the Final Disregarded Payment Rules are effective starting in tax year 2020. This column describes the Final Disregarded Payment Rules.
Background on the Allocation and Apportionment ofForeign Income Taxes
As background, a foreign income tax is generally allocated and apportioned to the statutory and residual groupings that include the items of foreign gross income included in the base on which the tax is imposed under the following three-step process:
Step 1: Assign the items of foreign gross income to statutory and residual groupings,
Step 2: Allocate and apportion the deductions that are allowed under foreign law to the foreign gross income in the groupings, and
Step 3: Allocate and apportion the foreign income tax by reference to the foreign taxable income in the statutory and residual groupings.
Thus, in order to allocate and apportion foreign income tax to the statutory and residual groups (in step 3), items of foreign gross income must first be assigned to statutory and residual groupings (in step 1).
With respect to step 1, each item of foreign gross income is assigned to a statutory or residual grouping. The amount of the item is determined under foreign law. However, Federal income tax law applies to characterize the item and the transaction or other realization event from which the item arose, and to assign it to a grouping. If a “corresponding U.S. item” exists in the same year, foreign gross income is assigned to the same grouping as the corresponding U.S. item. If a corresponding U.S. item is not recognized, or is recognized in a different U.S. taxable year, foreign gross income is assigned to the grouping to which the corresponding U.S. item would be assigned as if the event giving rise to the foreign gross income resulted in the recognition of gross income or loss under U.S. Federal income tax law in the U.S. taxable year to which the foreign income tax is paid or accrued. A corresponding U.S. item is the item of U.S. gross income or U.S. loss, if any, that arises from the same transaction or other realization event from which an item of foreign gross income also arises. Special rules apply regarding the assignment of the item of foreign gross income in particular circumstances.
New Rules on Disregarded Payments
The Final Regulations add paragraph (d)(3)(v), which applies to assign to a statutory or residual grouping a foreign gross income item that a taxpayer includes by reason of the receipt of a disregarded payment (i.e., the Final Disregarded Payment Rules). The Final Disregarded Payment Rules generally follow the 2020 proposed regulations on allocating and apportioning foreign income tax imposed with respect to disregarded payments but make some adjustments. The Final Disregarded Payment Rules provide specific rules for the following disregarded payments: (1) “reattribution payments” (which are generally disregarded payments that are deductible under foreign law), (2) remittances, (3) contributions, and (4) disregarded sales or exchanges of property.
Reattribution Payments
Determination of Reattribution Payment
The amount of a “reattribution amount” received by the recipient taxable unit must first be determined by applying attribution rules. In the case of a taxpayer that is an individual or a domestic corporation, the attribution rules in Reg. §1.904-4(f )(2) apply to determine the reattribution amount received by a taxable unit. In the case of a taxpayer that is a foreign corporation, the attribution rules in Reg. §1.951A-2(c)(7)(iii)(B) apply to determine the reattribution amounts received by a taxable unit.
Effect on Recipient Taxable Unit
The statutory or residual grouping of a reattribution amount received by a taxable unit is the grouping that includes the U.S. gross income attributed to the taxable unit by reason of its receipt of the gross reattribution amount (regardless of whether, after taking into account disregarded payments made by the taxable unit, the taxable unit has an attribution item as a result of its receipt of the reattribution amount).
Effect on Payor Taxable Unit
For the payor of a reattribution payment, the statutory or residual grouping to which an item of foreign gross income of a taxable unit is assigned is determined without regard to reattribution payments made by the taxable unit (and without regard to whether the taxable unit has one or more attribution items after taking into account such reattribution payments).
Example
Figure 1 illustrates the reattribution rule with a controlled foreign corporation (CFC) taxpayer.
Remittance
The term remittance means the excess of a disregarded payment, other than an amount that is treated as a contribution, made by a taxable unit to a second taxable unit (including a second taxable unit that shares the same owner as the payor taxable unit) over the portion of the disregarded payment, if any, that is a reattribution payment. Thus, the term remittance generally means disregarded distributions. To the extent an upstream, downstream, or sideways payment is a reattribution payment, the payment is a reattribution
payment. In addition, the term remittance is a catch-all, such that if the payment is not a contribution or a reattribution payment, the payment is a remittance.
An item of foreign gross income that a taxpayer includes by reason of the receipt of a remittance by a taxable unit is assigned to the statutory or residual groupings of the recipient taxable unit that correspond to the groupings out of which the payor taxable unit made the remittance. A remittance paid by a taxable unit is considered to be made ratably out of all of the accumulated after-tax income of the taxable unit. The accumulated after-tax income of the taxable unit that pays the remittance is deemed to have arisen in the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the assets of the taxable unit are (or would be if the owner of the taxable unit were a U.S. person) assigned for purposes of apportioning interest expense under the asset method in Reg. §1.861-9 in the taxable year in which the remittance is made. If the payor taxable unit is determined to have no assets, then the foreign gross income that is included by reason of the receipt of the remittance is assigned to the residual grouping. The assets of a taxable unit are determined in accordance with Reg. §1.987-6(b), except that for purposes of applying Reg. §1.987-6(b)(2), a taxable unit is deemed to be a Code Sec. 987 QBU (within the meaning of Reg. §1.987-1(b)(2)). Assets of the taxable unit include stock held by the taxable unit, the portion of the tax book value of a reattribution asset that is assigned to the taxable unit, and the taxable unit’s pro rata share of the assets of another taxable unit.
Thus, an item of foreign gross income on a remittance by a taxable unit is assigned to the statutory or residual groupings based on the tax book value of the assets of the remitting taxable unit, and for this purpose, the assets of the remitting taxable unit include stock and assets of other taxable units owned by the remitting taxable unit. Note that assets of other taxable units that are resident in the same foreign country, as well as assets of other taxable units owned by that same-country taxable unit, might be taken into account. Also, because the groupings are based on the tax book value of the assets, there could be situations where assets have a basis that is disproportionate to the income produced by the assets, such as low-basis intangible property or interest-bearing cash deposits.
Contribution
A contribution is the excess of a disregarded payment made by a taxable unit to another taxable unit that the first taxable unit owns over the portion of the disregarded payment, if any, that is a reattribution payment. An item of foreign gross income that a taxpayer includes by reason of the receipt of a contribution by a taxable unit is assigned to the residual grouping. Thus, where the taxpayer is a CFC, taxes on a contribution would not be creditable under Code Sec. 960 and those taxes are permanently lost. However, taxes on certain “foreign branch group contributions” are assigned to the foreign branch category for purposes of applying Code Sec. 904 as the operative section.
Disregarded Sales
Generally, an item of foreign gross income attributable to gain recognized under foreign law by reason of a disregarded payment received in exchange for property is characterized and assigned under the rules of Reg. §1.861-20(d)(2) (which generally assigns income as if the event giving rise to foreign gross income occurred from a Federal income tax perspective in the U.S. taxable year in which the foreign income tax is paid or accrued).
Effective Date
As noted above, the Final Disregarded Payment Rules are effective retroactively to tax years beginning after December 31, 2019, and that end on or after November 2, 2020. Thus, for calendar-year taxpayers, the Final Disregarded Payment Rules are effective starting from tax year 2020. Taxpayers who have already filed the 2020 tax return may not be required to amend the filed tax returns. However, interactions with the IRS should be accurate (e.g., if the 2020 return were amended for another reason).
Conclusion
Taxpayers should consider how the Final Disregarded Payment Rules impact their foreign tax credit calculations, including the fact that the regulations are retroactive.
