Global Tax Alert | 9 February 2016

US IRS amends regulations allocating partnership foreign tax expense

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Executive summary

On 4 February 2016, the US Internal Revenue Service (IRS) published temporary regulations (the Temporary Regulations, and the preamble to such Temporary Regulations, the Preamble) in T.D. 9748 that expand and clarify the rules relating to the allocation of creditable foreign tax expenditures (CFTEs) by a partnership, and specifically address the safe harbor under Treas. Reg. Section 1.704(b)(4)(viii) for determining whether those allocations are deemed to be in accordance with the partners’ interests in the partnership (the Safe Harbor).1 As stated in the Preamble, the purpose of the Safe Harbor is, in general, to match allocations of CFTEs with the income to which the CFTEs relate.

The Temporary Regulations apply for partnership tax years that both begin on or after 1 January 2016, and end after 4 February 2016. The text of the Temporary Regulations also serves as the text of contemporaneously issued proposed regulations (REG-100861-15).

The Temporary Regulations provide guidance on: (i) how to determine a partnership’s net income in a CFTE category when a Section 743(b) adjustment has been made; (ii) how to determine a partnership’s net income in a CFTE category for purposes of testing allocations of CFTEs with respect to certain allocations and guaranteed payments; and (iii) how to address certain disregarded inter-branch payments, including the allocation of withholding tax on back-to-back payments, within the partnership for CFTE purposes. The Temporary Regulations also make some other changes clarifying how items of income under US federal income tax law are assigned to an activity and how a partnership’s net income in a CFTE category is determined.

Detailed discussion

Overview

Because a partnership is not subject to US federal income tax, items of taxable income, gain, loss, deduction, and credit generated by the partnership flow through to the individual partners. Under Section 704(b), a partner’s distributive share of income, gain, loss, deduction or credit (or item thereof) will be determined in accordance with the partner’s interest in the partnership if: (i) the partnership agreement does not provide as to the partner’s distributive share of income, gain, loss, deduction or credit (or item thereof); or (ii) the allocation to a partner under the agreement of income, gain, loss, deduction or credit (or item thereof) does not have substantial economic effect.

The current final regulations state that allocations of CFTEs cannot have substantial economic effect, so such expenditures must be allocated in accordance with the partners’ interests in the partnership.2 Under the Safe Harbor, CFTE allocations are deemed to be in accordance with the partners’ interests in the partnership. In general, the purpose of the Safe Harbor is to match allocations of CFTEs with the income to which the CFTEs relate.

Under the current final regulations, in order to apply the Safe Harbor, a partnership must: (i) determine the partnership’s CFTE categories;3 (ii) determine the partnership’s net income in each CFTE category;4 and (iii) allocate the partnership’s CFTEs to each CFTE category.5 In order to satisfy the Safe Harbor, partnership allocations of CFTEs in a CFTE category must be in proportion to the allocations of the partnership’s net income in the CFTE category.

Section 743(b) adjustments

For a transfer of a partnership interest that results in an adjustment under Section 743(b) (because the partnership has a Section 754 election in effect, or because there is a substantial built-in loss in the partnership), the partnership must adjust the basis of partnership property with respect to the transferee partner (a Section 743(b) adjustment). No adjustment is made to the common basis of partnership property, and the Section 743(b) adjustment has no effect on the partnership’s computation of any item under Section 703.6 The current final regulations under Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3) do not state whether an adjustment under Section 743(b) is taken into account in computing the partnership’s net income in a CFTE category.

The Temporary Regulations add provisions that expressly determine how a Section 743(b) adjustment to basis is taken into account for purposes of determining the partnership’s net income in a CFTE category. Specifically, Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(3)(i) provides that, for purposes of computing a partnership’s net income in a CFTE category, the partnership determines its items without regard to any Section 743(b) adjustments that its partners may have to the basis of property of the partnership.

The rationale provided in the Preamble for this approach is that the basis adjustment is unique to the transferee partner, ordinarily would not be taken into account by a foreign jurisdiction in computing its foreign taxable base. Thus, taking a transferee partner’s Section 743(b) adjustment into account could change the partners’ relative shares of net income in a CFTE category and their allocable shares of CFTEs under the Safe Harbor solely as a result of the transfer of the partnership interest (i.e., not as a result of a change under the partnership agreement).

In addition, for a partnership that has a Section 743(b) adjustment in its capacity as a direct or indirect partner in a lower-tier partnership, Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(3)(i) of the Temporary Regulations provides that such Section 743(b) adjustment of the partnership that is a transferee partner is taken into account in determining the partnership’s net income in a CFTE category.

The Preamble states that the Treasury Department and the IRS intend to address in a separate guidance project when a Section 743(b) adjustment gives rise to basis differences subject to Section 901(m).

Deductible allocations and non-deductible guaranteed payments

The Temporary Regulations revise the rules in the current final regulations addressing the treatment of certain types of payments that are deductible under either US federal income tax law or foreign law. The current final regulations provide a special rule reducing the partnership’s net income in a CFTE category to the extent foreign law allows a deduction for an allocation (or payment of an allocated amount) to a partner (e.g., because foreign law characterizes a preferential allocation of gross income as deductible interest expense).7 The Preamble states that this rule is intended to exclude from a CFTE category any income that has not been included in a foreign taxable base because an allocation (or payment of an allocated amount) to a partner of that income results in a foreign law deduction.

Deductible guaranteed payments under Section 707(c) reduce the partnership’s net income in a CFTE category. Although, in the case of a guaranteed payment that results in a deduction under both US and foreign law, no special rule reducing the partnership’s net income in a CFTE category is provided, to the extent that foreign law does not allow a deduction for a guaranteed payment that is deductible under US law, the current final regulations include another special rule requiring an upward adjustment to the partnership’s net income in a CFTE category (these rules and the rules described in the preceding paragraph are referred to, collectively, in the Preamble as the Special Rules).8 The Preamble explains that adding the amount of a guaranteed payment that is not deductible under foreign law to the partnership’s net income in a CFTE category results in CFTEs attributable to tax imposed on the income out of which the guaranteed payment is made following the payment for purposes of the Safe Harbor. An additional rule in the current final regulations9 treats the guaranteed payment as a distributive share of the partnership’s net income in a CFTE category to the extent of the upward adjustment.

As the Preamble explains, the current final regulations do not expressly address when an allocation or distribution of an allocated amount or guaranteed payment gives rise to a deduction for purposes of one foreign tax, but is made out of income subject to another tax imposed by the same or a different foreign jurisdiction. The Preamble provides as an example a case in which a partnership makes a preferential allocation of gross income that is deductible in the foreign jurisdiction in which the partnership is a resident out of income earned by a disregarded entity or branch owned by the partnership that is subject to net basis tax in the jurisdiction in which the disregarded entity or branch is located. In response, the Temporary Regulations revise the Special Rules to address when allocations (or distributions of allocated amounts) and guaranteed payments that give rise to foreign law deductions are made out of income with related CFTEs. Specifically, Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(4)(ii) of the Temporary Regulations provides that a partnership’s net income in a CFTE category from which a guaranteed payment that is not deductible in a foreign jurisdiction is made shall be increased by the amount of the guaranteed payment that is deductible for US federal income tax purposes, and such amount will be treated as an allocation to the recipient of the guaranteed payment for purposes of determining the partners’ shares of income in the CFTE category, but only for purposes of testing allocations of CFTEs attributable to a foreign tax that does not allow a deduction for the guaranteed payment. For purposes of testing allocations of CFTEs attributable to a foreign tax that does allow a deduction for the guaranteed payment, however, a partnership’s net income in a CFTE category increases only to the extent that the amount of the guaranteed payment that is deductible for US federal income tax purposes exceeds the amount allowed as a deduction for purposes of that foreign tax, and such excess is treated as an allocation to the recipient of the guaranteed payment for purposes of determining the partners’ shares of income in the CFTE category.

Similarly, the Temporary Regulations, in Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(4)(iii), provide that, to the extent that a foreign tax allows a deduction from its taxable base for an allocation (or distribution of an allocated amount) to a partner, then, solely for purposes of testing allocations of CFTEs attributable to that foreign tax, the partnership’s net income in the CFTE category from which the allocation is made is reduced by the amount of the foreign law deduction, and that amount is not treated as an allocation for purposes of determining the partners’ shares of income in the CFTE category. For purposes of testing allocations of CFTEs attributable to a foreign tax that does not allow a deduction for an allocation (or distribution of an allocated amount) to a partner, the partnership’s net income in a CFTE category is not reduced.

Finally, the current final regulations provide that the adjustment to income attributable to an activity for a preferential allocation depends on whether the allocation of the item of income (or payment thereof) “results” in a deduction under foreign law. The Temporary Regulations, in Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(4)(ii) and (iii), clarify that a guaranteed payment or preferential allocation is considered deductible under foreign law for purposes of the special rules if the foreign jurisdiction allows a deduction from its taxable base either in the current year or in a different tax year (e.g., when the foreign jurisdiction allows a deduction only upon a subsequent payment of accrued interest).

Inter-branch payments

For tax years beginning before 1 January, 2012, the Special Rules included a cross-reference confirming that certain inter-branch payments described in Treas. Reg. Section 1.704-1(b)(4)(viii)(d)(3) (the inter-branch payment rule) were not subject to the Special Rules. Under the temporary regulations published in T.D. 9577, addressing when foreign income taxes have been separated from the related income, however, the inter-branch payment rule was removed. The Preamble states that the removed rule allowed taxpayers to separate foreign income taxes and related income. In conjunction with the removal of the inter-branch payment rule, the cross-reference to the eliminated rule was removed from Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3)(ii).

The Preamble states that some taxpayers claim that the inclusion and subsequent removal of the cross-reference created uncertainty regarding the application of the Special Rules to disregarded payments among branches of a partnership. Because an inter-branch payment is not made to a partner, however, it can never be treated as a distributive share, and is outside the scope of the Special Rules. By its terms, Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3)(ii) applies only to partnership allocations that are deductible under foreign law, guaranteed payments that are not deductible under foreign law, and income that is excluded from a foreign tax base as a result of the status of a partner. To address these situations, the Temporary Regulations under Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(4)(iii) clarify that the Special Rule for preferential allocations applies only to allocations (or distributions of allocated amounts) to a partner that are deductible under foreign law, and not to other items that give rise to deductions under foreign law. For example, the Special Rules do not apply to reduce income in a CFTE category by reason of a disregarded inter-branch payment, even if the income out of which the inter-branch payment is made is not subject to tax in any foreign jurisdiction.

In addition, the Preamble states that taxpayers have been taking the position that transactions involving serial disregarded payments in which withholding taxes assessed on the first payment in a series of back-to-back disregarded payments do not need to be apportioned among the CFTE categories that include the income out of which the payment is made. The Temporary Regulations include new examples illustrating that, under the rule in the current final regulations at Treas. Reg. Section 1.704-1(b)(4)(viii)(d)(1), withholding taxes must be apportioned among the CFTE categories that include the related income.10 The Preamble refers to such examples as “clarifying” the operation of that existing rule.

Other revisions

The Temporary Regulations make certain changes described in the Preamble as organizational changes and non-substantive clarifications to the regulations. For instance, the language in the current final regulations at Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(2)(iii) was revised to clarify: (i) when income from a divisible part of a single activity must be treated as income from a separate activity, and (ii) that a guaranteed payment or preferential allocation of income that is determined by reference to all the income from a single activity generally will not result in dividing a single activity into separate activities. In addition, current final regulations under Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3), which explain how to determine a partnership’s net income in a CFTE category, have been reorganized and subdivided. The Temporary Regulations state in Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(3)(iv) that disregarded payments are never taken into account in determining the amount of net income attributable to an activity, and that, therefore, an item of gross income is assigned to the activity generating the item of income that is recognized for US federal income tax purposes. Finally, the term “distributive share of income” in the current final regulations is replaced in the Temporary Regulations, at Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(4)(i), with the term “CFTE category share of income.” The Preamble states that no change in meaning or purpose was intended by the change.

Effective date and transition rule

The Temporary Regulations apply for partnership tax years that both begin on or after 1 January 2016, and end after 4 February 2016. Under Treas. Reg. Section 1.704-1T(b)(1)(ii)(b)(3)(B), the Temporary Regulations modify an existing transition rule with respect to certain inter-branch payments for partnerships whose agreements were entered before 14 February 2012. The current transition rule provides that, if there has been no material modification to their partnership agreements on or after 14 February 2012, then, for tax years beginning on or after 1 January 2012, these partnerships may apply the provisions of Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3)(ii) and (d)(3) (revised as of 1 April 2011). That transition rule is modified to provide that, for tax years that both begin on or after 1 January 2016, and end after 4 February 2016, these partnerships may continue to apply the provisions of Treas. Reg. Section 1.704-1(b)(4)(viii)(d)(3) (revised as of 1 April 2011), but must apply the provisions of Treas. Reg. Section 1.704-1T(b)(4)(viii)(c)(3)(ii).

Implications

The Temporary Regulations may cause CFTEs to be allocated among partners differently than what was expected when the partnership agreement was entered. Further, US multinational groups with supply chains that include back-to-back payments between foreign disregarded entities owned by a partnership should assess the potential effect of the Temporary Regulations on the allocation of withholding and other taxes imposed on those entities. Although the Preamble treats the revisions and additions to the rules in the current final regulations as intended to clarify the appropriate allocation of CFTEs when guidance was ambiguous or lacking, some taxpayers may have been interpreting the current final regulations inconsistently with the approach in the Temporary Regulations and should consider the effect of the Temporary Regulations on their positions accordingly.

Endnotes

1. Under Treas. Reg. Section 1.704-1(b)(4)(viii)(b), a CFTE is a foreign tax paid or accrued by a partnership that is eligible for a credit under Section 901(a) or an applicable US income tax treaty. A foreign tax is a CFTE for these purposes without regard to whether a partner receiving an allocation of such foreign tax elects to claim a credit for such tax. Foreign taxes paid or accrued by a partner with respect to a distributive share of partnership income, and foreign taxes deemed paid under Section 902 or 960 by a corporate partner with respect to stock owned, directly or indirectly, by or for a partnership, are not taxes paid or accrued by a partnership and, therefore, are not CFTEs subject to the rules of Treas. Reg. Section 1.704-1(b)(4)(viii).

2. Treas. Reg. Section 1.704-1(b)(4)(viii)(a).

3. See Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(2).

4. See Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3).

5. See Treas. Reg. Section 1.704-1(b)(4)(viii)(d).

6. Treas. Reg. Section 1.743-1(j)(1).

7. Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(3)(ii).

8. Id.

9. Treas. Reg. Section 1.704-1(b)(4)(viii)(c)(4).

10. See Treas. Reg. Section 1.704-1T(b)(5), Examples 36 and 37.

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services, Washington, DC
  • Natan Leyva
    +1 202 327 6798
    natan.leyva@ey.com
Ernst & Young LLP, Business Tax Advisory, Washington, DC
  • Barksdale Penick
    +1 202 327 8787
    barksdale.penick@ey.com
Ernst & Young LLP, International Tax Services, Chicago
  • Joe Ryan
    +1 312 879 6112
    joe.ryan@ey.com
Ernst & Young LLP, International Tax Services, New York
  • Ryan Walsh
    +1 212 773 1528
    ryan.walsh2@ey.com

EYG no. CM6233