IRS issues temporary regulations on creditable foreign tax expenditures
TAX ALERT |
On Feb. 4, 2016, the IRS issued temporary and proposed regulations that will affect any partnership that pays or accrues foreign income taxes. The regulations modify certain safe harbor rules governing the way partnerships allocate creditable foreign tax expenditures (CFTEs) to their partners. In general, the regulations impact the way taxpayers must account for (1) certain adjustments required with respect to transfers of partnership interests (section 743(b) adjustments), (2) deductible allocations and nondeductible guaranteed payments, and (3) inter-branch payments in determining net income.
The regulations are generally effective for partnership taxable years beginning on or after Jan. 1, 2016, and ending after Feb. 4, 2016.
CFTE safe harbor
The IRS believes that CFTE allocations lack substantial economic effect and, therefore, they must be allocated in accordance with the partners’ interest in the partnership. Under a safe harbor, CFTE allocations are in accordance with the partner’s interest in the partnership if they match the income to which the CFTEs relate. Partnerships apply the safe harbor by (1) determining the CFTE categories, (2) determining net income in each CFTE category, and (3) allocating the partnership’s CFTEs to each category.
Section 743(b) adjustments
Prior to the issuance of the regulations it was unclear whether section 743(b) adjustments had any impact on the calculation of the partnership’s net income in each CFTE category. Section 743(b) adjustments arise in the case of a transfer of a partnership interest where there is either a substantial built-in-loss or a section 754 election in effect. Under special rules, a partnership must adjust the basis of the partnership property with respect to the transferee partner if that partner transfers property with a substantial built-in loss or if the partnership elects to step-up the basis of its properties. This adjustment applies to determine the tax treatment of only the contributing partner. However, the IRS generally believes that taking into account section 743(b) adjustments in applying the safe harbor may distort the amount of CFTEs properly allocable to the partners especially where foreign law does not take into account the adjustment. Therefore, the regulations provide that for purposes of calculating the net income in each CFTE category any section 743(b) adjustments are generally ignored except where the partner associated with any section 743(b) adjustments is itself a partnership.
Special rules in the safe harbor address how to calculate the net income in each CFTE category when a foreign deduction is allowed, or disallowed, for an allocation to a partner, such as when an allocation is determined to be a deductible interest expense or guaranteed payment. To the extent foreign law allows a deduction for a partner’s allocation, the safe harbor requires a reduction in the partnership’s net income in that CFTE category because the allocation did not form part of the foreign tax base. Conversely, where a deduction for a guaranteed payment is allowed in the United States but not in the foreign jurisdiction, an upward adjustment to the partnership’s net income in the CFTE category is required.
Many taxpayers have entered into transactions utilizing serial disregarded payments and take the position that foreign withholding taxes imposed on such payments do not need to be apportioned among the CFTE categories that include the related income. To address this, the regulations clarify that withholding tax from such inter-branch transactions must be apportioned among the CFTE categories that include the related income.