Proposed regulations contain key foreign tax credit transition rules

Apr 16, 2019
International tax

Proposed foreign tax credit (FTC) regulations released on Nov. 30, 2018 (the Proposed Regulations) set forth several transition rules and elections that may limit taxpayers’ ability to use excess FTCs going forward. The Proposed Regulations provide a comprehensive new framework for calculating available FTCs in response to changes made by the Tax Cuts and Jobs Act (TCJA). U.S. taxpayers will need to navigate a myriad of complex transition rules, some of which could dramatically impact the calculation of the foreign tax credit.  We discuss some of these rules below.

Overview of TCJA changes affecting the FTC

The TCJA made several significant changes to the FTC rules.  For example, the TCJA made significant changes to the determination of “deemed paid” FTCs. Historically, U.S. corporations receiving dividends from a 10 percent owned foreign corporation could claim a deemed paid FTC. However, TCJA repealed this deemed paid FTC rule (contained in old section 902) and established a new exemption from U.S. taxation for the foreign source portion of a dividend. This exemption is found in new section 245A.

Prior to the TCJA, a U.S. corporate shareholder was also deemed to have paid a portion of its controlled foreign corporation’s (CFC’s) foreign income tax if the corporate shareholder had to take into account any subpart F income. Changes made to section 960 by the TCJA now limit this deemed paid FTC to only those taxes that are “properly attributable to” foreign income that a U.S. corporate must take into account under subpart F or similar regime.

The TCJA provides a special rule that limits the amount of credit a U.S. corporate shareholder may claim with respect to foreign taxes imposed on inclusions of Global Intangible Low Taxed Income (GILTI).  In particular, only foreign taxes that are “properly attributable” to the tested income of a CFC are creditable. Moreover, the amount of eligible FTC must be reduced by 20 percent. This “haircut” is consistent with what many believe was the legislative intent to create a global minimum tax on GILTI income.

The TCJA also made changes that impact the determination of foreign source income and the rules for the calculation of the FTC limitation. Prior to TCJA, taxpayers had broad discretion in determining asset valuations for purposes of determining interest expense allocation/apportionment to items of foreign source income. Taxpayers could use one of three methods:

  1. The fair market value
  2. The tax book value
  3. The alternative tax book value method

Under post-TCJA rules, taxpayers no longer have a choice and must now allocate and apportion interest expense according to the adjusted basis of assets (i.e., the tax book value method). The TCJA also limits the FTC by excluding the foreign source portion of any dividend from certain foreign corporations from the calculation of the section 904 FTC limitation. Deductions allocated or apportioned to such income, or to the value of the stock of the foreign corporation that relates to excluded dividends  are also excluded from the FTC limitation calculation.

With regard to the determination of the section 904 limitation itself, the TCJA made a number of significant changes. Prior to TCJA, the FTC limitation was determined separately under two primary “baskets” or categories of income: one for passive category income, and the other for general category income. There was also a special category for items of income that the taxpayer elected to resource under an income tax treaty with the United States. The TCJA added two new baskets. The first is a new basket for GILTI income, but only to the extent that such income does not fall into the passive basket. The second is a new category for foreign branch income. Foreign branch income generally consists of the taxpayer’s foreign source income attributable to one or more qualified business units.

Carryover transition rule

The Proposed Regulations provide several important transition rules but perhaps the most significant rules relate to the carryforward, and carryback, of excess FTCs between pre-TCJA and post-TCJA taxable years. The TCJA did not directly address this issue.

Under the Proposed Regulations, the general rule is that unused FTCs are carried back, or forward, to the same pre-TCJA and post-TCJA separate baskets. Unused excess FTCs relating to the GILTI basket are not eligible for carryforwards or carrybacks. However, to the extent that GILTI income falls into the passive income basket, any post-TCJA excess foreign taxes relating to passive GILTI income could be carried back to the pre-TCJA passive income basket. Unused FTCs with respect to the new foreign branch category that are carried back to pre-TCJA taxable years are allocated to the general category income basket.

The Proposed Regulations allow taxpayers to elect to assign FTC carryovers in the pre-TCJA general income basket to the post-TCJA foreign branch basket, as long as they would have been assigned to that category if the taxes had been paid or accrued in a post-TCJA taxable year. This reallocation election is welcome relief as it provides for a carryforward to the foreign branch basket. However, the election as it is currently written in the Proposed Regulations is administratively burdensome and requires the reformulation of pre-TCJA baskets by reference to post-TCJA classification rules.

For example, in order to apply the election a taxpayer may have to analyze up to 10 years of pre-TCJA general basket income and characterize it as foreign branch basket income, making sure to properly apply the new foreign branch disregarded payment rules to each of the prior years’ transactions. Taxpayers may make the reallocation election simply by applying its rules to a timely filed original return, or on an amended return. Taxpayers making the reallocation election must do so for all unused FTCs.

What should impacted taxpayers do now?

Given the complexity of the Proposed Regulations FTC transition rules, taxpayers with significant pre-TCJA carryforward or post-TCJA carryback credits should speak to their tax advisors in order to understand how their unused FTCs may be limited. The Proposed Regulations, if finalized, would generally be effective for taxable years ending on or after Dec. 4, 2018. However, the FTC regulations may not be finalized before 2018 tax year payments are due. Therefore, it is crucial that taxpayers understand how these Proposed Regulations may impact their 2018 tax return.

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