INSIGHT: New Foreign Tax Credit Regulations: In Need of a Redetermination—Part 1

For those who were light on holiday reading, the IRS and Treasury published in December proposed and final regulations dealing with various aspects of the foreign tax credit. Included in those regulations were new rules to address foreign tax redeterminations (FTRs).

INTRODUCTION

Guidance on FTRs was clearly needed: The most recent set of operative rules were temporary regulations that expired in 2010. Further, taxpayers were unsure how to deal with FTRs of indirect foreign tax credits in light of the repeal of Section 902 and changes made to Section 960 by the Tax Cuts and Jobs Act (TJCA).

Still, for a 12-year wait, the new FTR regulations leave a lot to be desired. The problem is not so much with the final regulations. The final regulations have a fairly limited scope and do not depart much from the 2007 proposed regulations they finalize. The new proposed regulations are where the most problematic aspects lurk, and those will need to be mitigated before those proposed regulations are finalized.

This article discusses the impact the new FTR regulations will have on taxpayers and the issues that will arise if the proposed regulations are finalized as drafted.

Section 905(c) and the Foreign Tax Credit Generally

To prevent double taxation, a person who is subject to U.S. income tax on a net income basis is generally permitted a credit against its U.S. federal income tax for foreign taxes imposed on the person’s foreign-source income. A variety of restrictions and limitations apply to the foreign tax credit, an understatement comparable to saying “Odysseus had some trouble getting home from Troy.”

One such restriction is imposed by Section 905(c). Section 905(c)(1) provides that a taxpayer must notify the IRS if any of the following occur:

• Accrued taxes when paid differ from the amounts claimed as credits by the taxpayer;

• Accrued taxes are not paid before the date two years after the close of the taxable year to which such taxes relate; or

• Any tax paid is refunded in whole or in part.

Upon notification, Section 905(c)(1) requires the Internal Revenue Service to redetermine the amount of tax for the year or years affected. Section 905(c)(2) provides a special rule for accrued taxes not paid within two years, particularly the exchange rate to be used when they are actually paid.

The rules of Section 905(c) exist to ensure that foreign tax credits are claimed only for taxes actually paid. For a variety of reasons, a taxpayer may need to file a U.S. tax return before a final determination of foreign tax liability is known. This could be because the taxpayer has elected the accrual basis for foreign tax credit purposes, and the foreign taxes claimed as a credit are not actually paid before the U.S. return is due. Or, the taxpayer or a foreign tax authority may determine that the amount of foreign taxes originally paid by the taxpayer is incorrect and that the taxpayer owes more or less that than originally paid. In any case, for the taxpayer to claim, as a foreign tax credit, no more or less than the foreign taxes actually paid, Section 905(c) requires the amount of foreign taxes the taxpayer originally claimed as a credit to be redetermined and the taxpayer’s U.S. taxes recomputed to reflect the redetermined amount of foreign taxes paid.

Section 905(c) creates a framework but leaves the mechanics and details to the IRS. Section 905(c)(3) simply states that the amount of tax (if any) due on any redetermination shall be paid by the taxpayer on notice and demand and the amount of tax overpaid (if any) shall be credited or refunded to the taxpayer in accordance with Section 6511 and the other provisions of Subchapter B of Chapter 66 of the tax code. Because the taxpayer’s obligation to pay additional federal income tax is subject to the notice and demand of the IRS without any reference to time limits but the taxpayer’s right to receive a refund or pay less federal income tax is subject to Section 6511, the statute sets up the possibility of an asymmetrical rule. Section 905(c) does not mandate such one-sided results, however. Rather, the statute, by leaving it to the IRS’s “notice and demand,” gives the IRS discretion in designing the taxpayer’s payment obligations.

New Regulations

On Dec. 17, 2019, the IRS published in the Federal Register final regulations addressing a variety of foreign tax credit issues. These final regulations (the “2019 final regulations”) include a new Treasury Regulations Section 1.905-3. New Treas. Reg. Section 1.905-3 addresses adjustments to U.S. tax liability necessary as a result of an FTR, and it applies to FTRs occurring in 2019 for taxpayers with calendar year taxable years and to FTRs occurring in taxable years ending on or after Dec. 17, 2019, for taxpayers with non-calendar year fiscal years.

Also on Dec. 17, 2019, the IRS published in the Federal Register proposed foreign tax credit regulations (the “2019 proposed regulations”). For FTRs, the 2019 proposed regulations are much more detailed and, for many taxpayers, more onerous. The IRS and Treasury to their credit recognized this—indeed, they state in the preamble that they are issuing the regulations in proposed form to give taxpayers a chance to comment on them. Like the 2019 final regulations, the new rules under Section 905(c) and Section 6689 (which imposes a penalty on failures to notify the IRS of an FTR) in the 2019 proposed regulations generally would apply to FTRs occurring in taxable years ending on or after Dec. 17, 2019.

FTRs Generally

Sometimes a taxpayer expects a change in foreign tax liability and perhaps even knows the amount of the expected FTR. For example, a taxpayer may be subject to a withholding tax but expects the withholding tax to be refunded once the taxpayer shows that it is eligible for the exemption or lower withholding rate provided by a treaty. Or, the taxpayer may have paid a tax under protest or to stop interest and penalties, and now expects to be refunded. Such a payment may be a noncompulsory payment and therefore not creditable under Treas. Reg. Section 1.901-1(e)(5) as a result. But, if the foreign tax was properly creditable when paid or accrued, the taxpayer expects to have an FTR once the amount is refunded.

More often, though, the taxpayer does not know whether an FTR will occur. A taxpayer may be under audit and not have a good idea of how the items at issue in the audit will be resolved. Or, the taxpayer may in the course of preparing its tax return discover an error in an earlier return that affects the amount of foreign tax owed in that earlier year. In these “unexpected” FTR circumstances, even if the taxpayer knows that the amount of foreign taxes taken into account on an earlier return is incorrect, the taxpayer may not know the correct amount (i.e., how much of an FTR the taxpayer should expect or possibly even which direction the FTR will run) until a much later point in time. Thus, FTRs are often difficult to deal with under the best of circumstances and the new regulations̄especially the 2019 proposed regulations̄make that task nearly impossible.

IMPACT OF THE 2019 FINAL REGULATIONS

Regarding FTRs, the 2019 final regulations finalize only Treas. Reg. Section 1.905-3, and their effect is limited to “direct” credits claimed under Section 901. As under the 2007 temporary and proposed regulations, Treas. Reg. Section 1.905-3(b)(1)(i) generally requires a redetermination of U.S. tax liability in the taxable year in which the tax was claimed as a credit; however, it also now requires a redetermination in “any year to which unused foreign taxes from such year were carried under section 904(c).”

To illustrate this redetermination requirement, assume that a taxpayer has an FTR that relates to the 2017 year. The taxpayer had a loss in 2017 and did not claim any foreign tax credit in 2017. Rather, the taxpayer carried its 2017 foreign taxes back to 2016 and forward to 2018. As under the 2007 proposed and temporary regulations, the 2019 final regulations require the taxpayer to amend its 2017 return to account for the FTR. In addition, the 2019 final regulations require the returns for the relevant carryover years (i.e., 2016 and 2018) to be amended as well to account for the carryover of the redetermined 2017 foreign taxes.

The 2019 final regulations generally adopt the definition of “foreign tax redetermination” used in the expired 2007 temporary regulations, with some clarifying changes. The clarifications to the definition of FTR in Treas. Reg. Section 1.905-3(a) have the effect of broadening it, however. For example, the 2019 final regulations, like the 2007 proposed and temporary regulations, state that accrued taxes that are not actually paid within the two-year window of Section 905(c)(1)(B) are treated as an FTR. The 2019 final regulations go further, however, providing that any amount of accrued tax that is not paid on or before the date that is 24 months after the close of the taxable year to which they relate is treated as refunded on that date. Because the 2019 final regulations apply to FTRs occurring in taxable years ending on or after Dec. 17, 2019, this rule will apply (for calendar year taxpayers) to accrued 2017 taxes that were not paid at the end of 2019. So, if the amount of foreign taxes a taxpayer accrued on its 2017 return exceeds the amount of foreign tax the taxpayer paid through the end of 2019, then an FTR for the Section 901 taxes has occurred at the end of 2019 and is subject to new Treas. Reg. Section 1.905-3(a). The taxpayer must file an amended 2017 tax return to take into account the FTR and amended returns for the years to which accrued but unpaid taxes were carried back or forward.

IMPACT OF THE 2019 PROPOSED REGULATIONS

The 2019 proposed regulations expand the definition of FTR and the actions that a taxpayer must take in response to an FTR.

Definition of FTR

The 2019 proposed regulations would substantially broaden the definition of FTR in Treas. Reg. Section 1.905-3(a) to include not just changes in the foreign tax credit but anything that affects U.S. tax liability. This includes:

• the amount of distributions the taxpayer is considered to receive from a foreign corporation,

• the taxpayer’s inclusions under Subpart F, GILTI (Global Intangible Low-Taxed Income), and the PFIC (Passive Foreign Investment Company) Qualified Electing Fund rules,

• whether and how the Section 954(b)(4) high-tax exception applies, and

• increases in tax liability under Section 1291.

Compared to the language in the 2019 final regulation, this broadening of what constitutes an FTR would significantly increase the number (and complexity) of amended returns that taxpayers must file.

For direct credits under Section 901, the proposed broader definition applies to FTRs occurring in 2019 for taxpayers with calendar year fiscal years (for those taxpayers on a non-calendar year fiscal year, to FTRs occurring in taxable years ending on or after Dec. 17, 2019). FTRs that involve a foreign corporation (e.g., Section 960 credits and the non-foreign-tax-credit-related changes), the broader definition generally applies to FTRs of foreign corporations occurring in taxable years that end with or within a taxable year of a U.S. shareholder ending on or after Dec. 17, 2019, and that relate to taxable years of foreign corporations beginning after Dec. 31, 2017. However, as discussed below, the broader definition of FTR winds up applying to pre-2018 years through Prop. Treas. Reg. Section 1.905-5.

Taking Into Account an FTR

Compared to the 2007 proposed and temporary regulations, the 2019 proposed regulations make several significant changes in how taxpayers take into account an FTR. One is unavoidable: TCJA’s repeal of Section 902 vitiated the approach taken in the 2007 proposed and temporary regulations regarding adjusting the pools of post-1986 undistributed earnings and post-1986 tax. Instead, as the preamble notes, for post-2017 years a foreign corporation’s FTR means that its U.S. shareholders have to redetermine their U.S. tax liability in that year as well. The remaining changes in the 2019 proposed regulations reflect the decision to define FTR in such a way that it includes any change in U.S. tax liability, and not just changes in the foreign tax credit. Accordingly, a redetermination of U.S. tax liability is required not only if an FTR changes the amount of foreign taxes deemed paid (and the related Section 78 dividend), but also if the FTR changes the amount of a U.S. shareholder’s Subpart F or GILTI inclusion in the year to which the FTR relates. As the examples below show, this broader definition of FTR can have wide-ranging effects.

The 2019 proposed regulations require a redetermination of U.S. tax liability even when an FTR has an indirect effect on U.S. tax liability. A redetermination of U.S. tax liability of a U.S. shareholder (as defined in Section 951(b)) is required if an FTR affects the Subpart F income, tested income, and E&P of a controlled foreign corporation in the year to which the FTR relates because such an FTR affects the amount of the shareholder’s Subpart F or GILTI inclusion in such year. Alternatively, an FTR may affect whether the shareholder is eligible for the high-tax exception under Section 954(b)(4) in the year to which the redetermined foreign tax relates.

These rules in the 2019 proposed regulations would apply to FTRs occurring in 2019 for calendar year taxpayers. If that effective date holds, the regulations finalizing the 2019 proposed regulations will apply retroactively.

Special Rules for FTRs That Relate to Years Affected by Repeal of Section 902

Proposed Treas. Reg. Section 1.905-5 would apply to FTRs of foreign corporations that relate to pre-2018 (i.e., pre-TCJA) taxable years. This “transition rule”̄as the preamble styles Prop. Treas. Reg. Sections 1.905-3(b)(2)(iv) and 1.905-5̄provides that post-2017 redeterminations of pre-2018 foreign income taxes must be accounted for by adjusting the foreign corporation’s taxable income, E&P, post-1986 undistributed earnings, and post-1986 foreign income taxes (or pre-1987 accumulated profits and pre-1987 foreign income taxes, as applicable) in the pre-2018 year to which the redetermined foreign taxes relate. The 2019 proposed regulations require a redetermination of U.S. tax liability to account for the effect of the FTRs on foreign taxes deemed paid by domestic corporate shareholders of the foreign corporation in the relation-back year and any subsequent pre-2018 year in which the domestic corporate shareholder computed a deemed-paid credit under Section 902 or Section 960 with respect to the foreign corporation, as well as any year to which unused foreign taxes from any such year were carried.

Further, affected U.S. shareholders of the foreign corporation must determine their applicable U.S. tax liability to account for the effect of the FTR on the E&P and taxable income of the foreign corporation and the taxable income of the U.S. shareholder. Recognizing the complexity of this approach, the preamble requests comments “on whether an alternative adjustment to account for post-2017 foreign tax redeterminations with respect to pre-2018 taxable years of foreign corporations, such as an adjustment to the foreign corporation’s taxable income and earnings and profits, post-1986 undistributed earnings, and post-1986 foreign income taxes as of the foreign corporation’s last taxable year beginning before January 1, 2018, may provide for a simplified and reasonably accurate alternative.”

Notifying the IRS of an FTR

Proposed Treas. Reg. Section 1.905-4 sets forth the new general notification rules. The notification rules in the 2019 proposed regulations are broadly consistent with the notification rules in the 2007 proposed and temporary regulations. They require the taxpayer to file an amended return with a Form 1116 or 1118 (as applicable), with a required explanatory statement. There are special rules to deal with multiple redeterminations in the same taxable year and special rules to address taxpayers under audit, and the 2019 proposed regulations includes tweaks and revisions to those previously published in the 2007 proposed and temporary regulations. These revisions include new detailed rules for owners of pass-through entities and a placeholder for the IRS to permit alternative notification procedures.

Generally, if an FTR increases U.S. tax liability, the taxpayer must file a separate notification by the due date (with extensions) of the original return for the taxpayer’s taxable year in which the FTR occurs. On the other hand, if an FTR decreases U.S. tax liability, the taxpayer generally must file its claim for refund within the relevant period set forth in Section 6511. No amended return is required for a particular taxable year if the FTR does not change U.S. tax liability for that taxable year. Instead, the taxpayer adjusts the amount of unused foreign taxes carried over from that year. Even though no amended return may be required for a year, the taxpayer must attach a statement containing the information described in Treas. Reg. Section 1.904-2(f) to the taxpayer’s timely-filed (with extensions) original return for the taxpayer’s taxable year in which the FTR occurs.

The 2019 proposed regulations also include a new proposed Treas. Reg. Section 301.6689-1 to deal with penalties for failure to make the required notifications.

Until the 2019 proposed regulations are finalized, though, it raises the question as to what notification procedures a taxpayer is supposed to follow. This is particularly confounding in instances where the 2019 final regulations provide no guidance, such as for FTRs that affect pre-2018 taxable years and for which indirect foreign tax credits were claimed. The fact that the 2019 proposed regulations replace the 2007 proposed and temporary regulations raises real questions as to what taxpayers are supposed to do between now and finalization of the 2019 proposed regulations. The preamble to the proposed regulations does not state that taxpayers can rely on them, and they replace the proposed regulations that accompanied the expired temporary regulations. This seems to be an issue of temporary uncertainty, assuming that the regulations finalizing the 2019 proposed regulations allow taxpayers to apply the recently-finalized regulations retroactively.

The effects, both intended and unintended, of the 2019 final regulations and the 2019 proposed regulations are probably best illustrated through examples. Part II of the article will set forth examples illustrating these new rules and the conclusions to draw from them.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

John Harrington is the leader of Dentons’ U.S. Tax practice. He advises clients on inbound and outbound transactional and compliance issues; international tax legislative, regulatory and treaty matters; and a variety of domestic tax issues. John has extensive experience in dealing with the foreign tax credit, with Subpart F, and cross-border activities of companies and individuals and with other international tax issues.