United States

Treasury issues foreign tax credit regulations

Temporary and proposed regulations deny foreign tax credits

TAX ALERT  | 

Treasury has issued temporary regulations and proposed regulations that provide elaborate rules governing the operation of the special rules that disallow foreign tax credit in situations where the taxpayer gets a ‘basis’ step-up in assets for U.S. tax purposes but not under foreign law. In 2010, Congress passed section 901(m) in order to prevent taxpayers from using such basis step-up transactions (covered assets acquisitions (CAAs)) from enhancing their ability to claim foreign credits. Section 901(m) generally provides that in the case of a CAA, the disqualified portion of any foreign income tax imposed with respect to ‘relevant’ foreign assets may not be taken as a credit against U.S. tax. This rule also applies to taxpayers claiming an indirect foreign tax credit. Instead, the taxpayer may deduct the foreign tax not allowed as a credit. Taxpayers who have engaged in CAAs on or after July 21, 2014 (or in some cases before) should review these regulations immediately.

A CAA includes:

  1. A qualified stock purchase under section 338 of the Code
  2. 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
  3. Any acquisition of an interest in a partnership that has an election in effect under section 754
  4. To the extent provided by Treasury, any other similar transaction

When a U.S. person purchases the assets of a foreign target through a CAA, the U.S. acquirer will receive a step-up in basis for U.S. income tax purposes but will not for foreign income tax purposes. Cost recovery methods utilized in the United States (e.g., depreciation and/or amortization) will result in an amount that will exceed the foreign depreciation amount. This results in a much lower U.S. taxable base relative to that of the foreign country. As a result, the foreign tax credit, which is based on foreign-source income base will be inflated. Section 901(m) reduces this ‘excess’ foreign tax credit by disallowing a credit for any portion of a foreign income tax attributable to the basis difference created by the CAA.

In general, the temporary regulations limit the ability of taxpayers to ‘purge’ a basis difference in assets that results from a CAA by entering into subsequent transactions. In addition, the rules specifically exempt withholding taxes from the scope of section 901(m) because such taxes are gross basis taxes that generally do not raise the same concerns arising from claiming credit for foreign taxes imposed on net income. The proposed regulations would expand the scope of section 901(m) significantly by including three new classes of transactions:

  1. An acquisition of assets for U.S. purposes treated as an acquisition of interests in a partnership for foreign purposes
  2. Partnership distributions resulting in a basis increase for U.S. purposes with no corresponding basis under foreign law
  3. Assert transfers that give rise to a basis increase for U.S. purposes with no increase for foreign purposes 

In addition, the proposed regulations set forth highly complex rules to be used to determine the disqualified portion of a foreign tax that will likely be challenging for taxpayers and their advisors alike to apply in practice.

Effective/applicability dates

Applicability dates of the temporary regulations relate back to Notices 2014-44 and 2014-45. The temporary regulations apply to:

  • CAAs occurring on or after July 21, 2014
  • CAAs occurring before  July 21, 2014, resulting from a U.S. check-the-box election that is filed on or after July 29, 2014, and that is effective on or before July 21, 2014

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