Proposed and Temporary Regulations for Foreign Tax Limitation Purposes

Summary

The Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “Service”) have issued Proposed and Temporary Regulations under Internal Revenue Code (“IRC”) Section 901(m). The Proposed and Temporary Regulations contain rules that limit the ability to claim foreign tax credits that arise from certain types of transactions.
Background

On August 10, 2010, Section 212 of the Education Jobs and Medicaid Assistance Act added Section 901(m) to the Code. IRC Section 901(m)(1) provides that, in the case of a covered asset acquisition (“CAA”), the disqualified portion of any foreign income tax determined with respect to the income or gain attributable to relevant foreign assets (“RFAs”) will not be taken into account in determining the foreign tax credit allowed under IRC Section 901(a), and in the case of foreign income tax paid by a Section 902 corporation (as defined in IRC Section 909(d)(5)), will not be taken into account for purposes of IRC Section 902 or 960. Instead, the disqualified portion of any foreign income tax (the disqualified tax amount) is permitted as a deduction under IRC Section 901(m)(6).

Under IRC Section 901(m)(2), a CAA is:

A qualified stock purchase (as defined in IRC Section 338(d)(3)) to which IRC Section 338(a) applies;
Any transaction that is treated as an acquisition of assets for U.S. income tax purposes and as the acquisition of stock of a corporation (or is disregarded) for purposes of a foreign income tax;
Any acquisition of an interest in a partnership that has an election in effect under IRC Section 754; and
To the extent provided by the Secretary, any other similar transaction.
IRC Section 901(m)(3)(A) provides that the term “disqualified portion” means, with respect to any CAA, for any taxable year, the ratio (expressed as a percentage) of:

The aggregate basis differences (but not below zero) allocable to such taxable year with respect to all RFAs; divided by
The income on which the foreign income tax referenced in IRC Section 901(m)(1) is determined (or if the taxpayer fails to substantiate the income on which the foreign income tax is determined to the satisfaction of the Secretary, such income shall be determined by dividing the amount of such foreign income tax by the highest marginal tax rate applicable to the taxpayer’s income in the relevant jurisdiction).
IRC Section 901(m)(3)(B)(i) provides the general rule that the basis difference with respect to any RFA will be allocated to taxable years using the applicable cost recovery method for U.S. income tax purposes. IRC Section 901(m)(3)(B)(ii) provides that, except as otherwise provided by the Secretary, if there is a disposition of an RFA, the basis difference allocated to the taxable year on the disposition will be the excess of the basis difference of such asset over the aggregate basis difference of such asset that has been allocated to all prior taxable years. The statute further provides that no basis difference with respect to such asset will be allocated to any taxable year thereafter.

IRC Section 901(m)(3)(C)(i) provides that basis difference means, with respect to any RFA, the excess of:

The adjusted basis of such asset immediately after the CAA, over
The adjusted basis of such asset immediately before the CAA.
If the adjusted basis of an RFA immediately before the CAA exceeds the adjusted basis of the RFA immediately after the CAA (that is, where the adjusted basis of an asset with a built-in loss is reduced in a CAA), such excess is taken into account as a basis difference of a negative amount under IRC Section 901(m)(3)(C)(ii).

IRC Section 901(m)(4) provides that an RFA means, with respect to a CAA, an asset (including goodwill, going concern value, or other intangible) with respect to such acquisition if income, deduction, gain, or loss attributable to such asset is taken into account in determining the foreign income tax referenced in IRC Section 901(m)(1).

IRC Section 901(m)(7) provides that the Service may issue regulations or other guidance as is necessary to carry out the purpose of IRC Section 901(m).

In 2014, Treasury and the Service issued Notice 2014-44 (2014-32, IRB 270) and Notice 2014-45 (2014-34 IRB 388) (collectively, the “2014 Notices”), that announced their intention to issue regulations addressing the application of IRC Section 901(m) to dispositions of RFAs following CAAs and to acquisitions of an interest in a partnership which has an election in effect under IRC Section 754. Notice 2014-44 also announced that future regulations would provide successor rules for the continued application of IRC Section 901(m) after a subsequent transfer of an RFA with remaining basis difference.
Key Highlights to the Proposed and Temporary Regulations

The Proposed and Temporary Regulations under IRC Section 901(m) include the rules described in the 2014 Notices and also provide additional guidance regarding the calculation of the foreign tax credit when there is a CAA.

The Proposed Regulations were issued at the same time as the Temporary Regulations. In addition to cross-referencing the Temporary Regulations, the Proposed Regulations provide guidance under IRC Section 901(m) concerning issues not addressed in the Temporary Regulations.

Some of the key highlights to the Proposed and Temporary Regulations are discussed below.

Proposed Regulation Section 1.901(m)-1 and Temporary Regulation Section 1.901(m)-1T provide definitions that apply for purposes of the regulations.

Proposed Regulation Section 1.901(m)-2 and Temporary Regulation Section 1.901(m)-2T identify transactions that are CAAs and provides rules for identifying RFAs with respect to a CAA. Proposed Regulation Section 1.901(m)-2(b) identifies six categories of transactions that constitutes CAAs, three of which are specified in the statute (incorporated by cross reference to the Temporary Regulations) and three of which are additional categories of transactions that are identified as CAAs pursuant to the authority granted under IRC Section 901(m)(2)(D). The three newly identified CAAs would be any transaction (or series of transactions occurring pursuant to a plan) to the extent it is treated as:
i.  An acquisition of assets for purposes of U.S. income tax and as an acquisition of an interest in a fiscally transparent entity for purposes of a foreign income tax;

ii.  A partnership distribution of one or more assets the U.S. basis of which is determined by IRC Section 732(b) or IRC Section 732(d) or which causes the U.S. basis of the partnership’s remaining assets to be adjusted under IRC Section 734(b), provided the transactions result in an increase in the U.S. basis of one or more of the assets distributed by the partnership or retained by the partnership without a corresponding increase in the foreign basis of such assets; and

iii.  An acquisition of assets for purposes of both U.S. income tax and a foreign income tax provided the transaction results in an increase in the U.S. basis without a corresponding increase in the foreign basis of one or more assets.

Proposed Regulation Section 1.901(m)-3 provides rules for computing the disqualified portion of foreign income taxes, describes the treatment under IRC Section 901(m)(1) of the disqualified portion and provides rules for determining whether and to what extent basis difference that is assigned to a given taxable year is carried over to subsequent years.

Proposed Regulation Section 1.901(m)-4 and Temporary Regulation Section 1.901(m)-4T provides rules for determining basis difference with respect to an RFA. Temporary Regulation Section 1.901(m)-4T provides for a special rule for determining basis difference with respect to an RFA that arises as a result of an acquisition of an interest in a partnership that has a Section 754 election (a “Section 743(b) CAA)”).

Proposed Regulation Section 1.904(m)-4 provides rules for an election to use foreign basis for purposes of determining basis difference with respect to an RFA. In particular, Proposed Regulation Section 1.901(m)-4(c) provides for a foreign basis election, pursuant to which basis difference is equal to the U.S. basis in the RFA immediately after the CAA less the foreign basis in the RFA immediately after the CAA (including any adjustments to the foreign basis resulting from the CAA). Proposed Regulation Sections 1.901(m)-4(c)(2) through (4) provide rules for making a foreign basis election. A foreign basis election generally is made by the RFA owner (U.S.). A foreign basis election is made separately for each CAA and with respect to each foreign income tax and each foreign payor. If the RFA owner (U.S.) is a partnership, however, each partner in the partnership (and not the partnership) may independently make a foreign basis election. For this purpose, a series of CAAs occurring as part of a plan (referred to in the regulations as an “aggregated CAA transaction”) are treated as a single CAA. The Proposed Regulations contain examples illustrating the scope of the foreign basis election.
The election is made by using foreign basis to determine the basis differences for purposes of computing a disqualified tax amount and an aggregate basis difference carryover. Subject to certain exceptions, the election generally must be reflected on a timely filed original federal income tax return for the first U.S. taxable year that the foreign basis election is relevant.

Proposed Regulation Section 1.901(m)-5 and Temporary Regulation Section 1.901(m)-5T provide rules for taking into account basis difference under an applicable cost recovery method or as a result of a disposition of an RFA. Proposed Regulation Section 1.901(m)-5 includes rules for allocating that basis difference, when necessary, to one or more persons subject to IRC Section 901(m), and rules for assigning that basis difference to a U.S. taxable year.

Proposed Regulation Section 1.901(m)-6 and Temporary Regulation Section 1.901(m)-6T provides successor rules for applying IRC Section 901(m) to subsequent transfers of RFAs that have basis difference that has not yet been fully taken into account. Proposed Regulation Section 1.901(m)-6 includes rules for transferring an aggregate basis difference carryover of a person subject to IRC Section 901(m) either to another aggregate basis difference carryover account of such person or to another person subject to IRC Section 901(m).

Proposed Regulation Section 1.901(m)-7 provides de minimis rules under which certain basis differences are not taken into account under IRC Section 901(m). In general, a basis difference with respect to an RFA is not taken into account for purposes of IRC Section 901(m) under the de minimis rules if either:
i.  The sum of the basis differences for all RFAs with respect to the CAA is less than the greater of $10 million or 10 percent of the total U.S. basis of all RFA’s immediately after the CAA; or

ii.  The RFA is part of a class of RFAs for which the sum of the basis differences of all RFAs in the class is less than the greater of $2 million or 10 percent of the total U.S. basis of all RFAs in the class.

For this purpose, the classes of RFAs are the seven asset classes defined in Treasury Regulation Section 1.338-6(b).[1] Treasury and the Service decided that transactions between related parties should be more tightly regulated, and therefore, the threshold dollar amounts and percentages to meet the de minimis exemptions for related party CAAs are lower than those for unrelated party CAAs, replacing the terms “$10 million,” “10 percent,” and “$2 million” wherever they occur with the terms “$5 million,” “5 percent,” and “$1 million,” respectively. In addition, an anti-abuse provision at Proposed Regulation Section 1.901(m)-7(e) denies application of the de minimis exception to CAAs between related parties that are entered into or structured with a principal purpose of avoiding the application of Section 901(m).

Proposed Regulation Section 1.901(m)-8 provides guidance on the application of IRC Section 901(m) to pre-1987 foreign income taxes and anti-abuse rules relating to built-in loss assets.
For applicability dates of the Temporary Regulations see, Temporary Regulation Sections 1.901(m)-1T(b), 1.901(m)-2T(f), 1.901(m)-4T(g), 1.901(m)-5T(i) and 1.901(m)-6T(d).

The Proposed Regulations will apply to CAAs occurring on or after the date of publication of the Treasury decision adopting the rules in the Proposed Regulations as final regulations in the Federal Register. Taxpayers may, however, rely on the Proposed Regulations prior to the date the regulations are applicable provided that they both consistently apply Proposed Regulation Section 1.901(m)-2 (excluding Proposed Regulations Section 1.901(m)-2(d)) to all CAAs occurring on or after December 7, 2016 and consistently apply Proposed Regulation Section 1.901(m)-1 and Sections 1.901(m)-3 through 1.903(m)-8 (excluding Section 1.901(m)-4(e)) to all CAAs occurring on or after January 1, 2011. For this purpose, persons that are related (within the meaning of IRC Section 267(b) or 707(b)) will be treated as a single taxpayer. For details, see Proposed Regulation Sections 1.901(m)-1(b), 1.901(m)-2(f), 1.901(m)-3(d), 1.901(m)-4(g), 1.901(m)-5(i), 1.901(m)-6(d), 1.901(m)-7(g) and 1.901(m)-8(d).
Insights

We can assist our clients with understanding the complexities of the Proposed and Temporary Regulations under IRC Section 901(m) and also advise on how these rules may impact them from claiming foreign tax credits.

[1] The seven classes detailed in Treasury Regulation Section 1.338-6(b) include (1) cash and general deposits; (2) actively traded personal property within the meaning of IRC Section 1092(d)(1) and Treasury Regulation Section 1.1092(d)-1, certificates of deposits, and foreign currency; (3) debt instruments, including accounts receivable, and other assets that the taxpayer marks to market at least annually, with certain exceptions; (4) the taxpayer’s stock in trade or other property of a kind that would be properly included in the taxpayer’s inventory if on hand at the close of the taxable year, or property that the taxpayer holds primarily for sale to customers in the ordinary course of its trade or business; (5) all assets not in Classes (1) – (4); (6) all section 197 intangible assets other than goodwill and going concern value; and (7) goodwill and going concern value.