INSIGHT: New Foreign Tax Credit Regulations: In Need of a Redetermination—Part 2

Part I of this article described the new foreign tax redetermination (FTR) rules in the final and proposed regulations published in the Federal Register on Dec. 17, 2019. Part II of this article illustrates the effect of those final and proposed rules and notes aspects of the proposed regulations that need to be modified or otherwise addressed.

EXAMPLES

For the sake of simplicity, assume that

• TP is a domestic corporation that owns 100% of FC, a corporation formed in Country Z.

• Both TP and FC have calendar year taxable years for U.S. and foreign tax purposes.

• TP claims foreign tax credits on an accrual basis.

• FC’s functional currency is the “u,” and one u equals one U.S. dollar at all times.

• TP claims both direct credits under Section 901 and indirect credits under Section 960 for foreign taxes paid to Country Z.

These facts and assumptions understate much of the complexity of the 2019 final regulations and (especially) the 2019 proposed regulations, given that the facts assume away the need to apply currency conversion, multiple redeterminations, and other special rules. However, my goal is to illustrate the basic thrust of the new rules, which can be obscured if the examples get too complicated.

A. Country Z audit adjustment in 2020 for the 2015 taxable year

1. Direct credit.
Assume that TP directly received the Country Z audit adjustment, and so the FTR affects TP’s Section 901 credit.
Consider first a reduction in Country Z tax. Assume that the FTR is a decrease in Country Z taxes and that TP claimed some or all of those decreased Country Z taxes as a credit on its 2015 Form 1120. The decrease in Country Z tax is an FTR requiring a redetermination of TP’s 2015 U.S. tax liability because TP now has a smaller 2015 foreign tax credit. This result would be the case under the 2019 final regulations or under the 2019 proposed regulations. Because no statute of limitations applies, TP would file an amended 2015 Form 1120, with the applicable Form 1118, showing the revised foreign tax credit, and pay any additional U.S. tax owed. If TP does not owe any additional U.S. tax in 2015 because TP carried its 2015 foreign taxes forward to 2016 and 2017 (or back to 2014), then TP would also need to file amended 2016 and 2017 Forms 1120 (or 2014 Form 1120) with the relevant Forms 1118 to the extent the disallowed foreign taxes were used in those years.

Alternatively, assume that the FTR is an increase in Country Z taxes. The increase in Country Z tax is an FTR requiring a redetermination of TP’s 2015 U.S. tax liability because TP is eligible for a larger 2015 foreign tax credit. That is the case under the 2019 final regulations or the 2019 proposed regulations. Because the 10-year period of Section 6511(d)(3) should apply, TP would file an amended 2015 Form 1120, with the applicable Form 1118, showing the revised foreign tax credit. If TP did not credit all of its 2015 Country Z income taxes in 2015 and carried some of them forward to 2016 and 2017 (or back to 2014), then TP would also need to file amended 2016 and 2017 Forms 1120 (or 2014 Form 1120) with the relevant Forms 1118 to the extent that the FTR increased the foreign tax credit claimed in those years.

In sum, in this direct credit scenario, there is no real difference between the 2019 final regulations and the 2019 proposed regulations, other than the 2019 proposed regulations’ inclusion of guidance regarding timing and procedure for the filing of the amended returns.

2. Indirect FTRs.
Now, let’s assume that FC has the FTR with respect to its 2015 Country Z taxes. Assume further that in 2015, FC had 100 u of income, all of which is Subpart F income, and made a $200 distribution to TP, treating $100 as a dividend and $100 of which was treated as previously taxed earnings and profits (PTEP), all before taking into account foreign tax credits under Section 902 and Section 960.

The final regulations do not provide direct guidance in this case. They explicitly exclude taxes deemed paid under Section 960 from the operative rules of Treas. Reg. Section 1.905-3(b)(1)(i). Given the repeal of Section 902, the absence of a reference to Section 902 in Treas. Reg. Section 1.905-3(b)(1)(i) strongly implies that they do not apply to Section 902 credits either, and all of the examples in Treas. Reg. Section 1.905-3(b)(1)(ii) address direct credits.

By implication, though, TP’s required action in this case should be limited to adjusting the amount of its indirect foreign tax credit. The definition of FTR in the 2019 final regulations limits FTRs to those that affect the taxpayer’s foreign tax credit. So, under the definition of FTR in the final regulations, the need to account for an FTR in this case should be limited to changes in the amount of foreign tax credit under Section 902 and Section 960, and not the amount of Subpart F inclusions, amounts owed under the PFIC rules, etc.

The 2019 proposed regulations, on the other hand, provide a direct answer. Prop. Reg. Section 1.905-5, as its title helpfully points out, is directly on point. Because the FTR relates to a taxable year beginning before Jan. 1, 2018, FC’s taxable income and E&P, post-1986 undistributed earnings, and post-1986 foreign taxes must be adjusted for the 2015 taxable year. The consequences of implementing these adjustments can be wide-ranging, as the following scenarios show.

First, assume that the FTR is a refund of 2015 Country Z tax. The refund of Country Z tax increases FC’s Subpart F income, E&P, and post-1985 undistributed earnings in 2015 by the functional currency amount of the foreign tax refund. From TP’s standpoint, the Country Z tax refund increases TP’s Subpart F inclusion (assuming that the high-tax exception of Section 954(b)(4) does not apply following the FTR) but would reduce any credit claimed under Section 960. Because the foreign tax refund may also reduce TP’s Section 902 credit, TP’s Section 78 dividend may also decrease as well although the amount of U.S. tax on the dividend paid by FC, net of Section 902 credit, may increase. To the extent that the 2015 Country Z taxes had been carried forward or back to another year, or the FTR affects the calculation of inclusions or distributions in another year, TP’s tax liability in those years would need to be recalculated as well.

If the FTR was an increase in 2015 Country Z tax, then FC’s Subpart F income, E&P, and post-1985 undistributed earnings would be decreased in 2015 by the functional currency amount of the increase in Country Z tax. From TP’s standpoint, the increase in Country Z tax decreases TP’s Subpart F inclusion (either incrementally or because TP is now eligible for the high-tax exception of Section 954(b)(4)) but would increase any credit claimed under Section 960. Because the higher Country Z taxes may also increase TP’s Section 902 credit, TP’s Section 78 dividend may also increase although the amount of U.S. tax on the dividend, net of Section 902 credit, may decrease. To the extent that the 2015 taxes are now carried forward or back to another year, or the FTR affects the calculation of inclusions or distributions in another year, TP’s tax liability in those years would need to be recalculated as well.

B. Country Z audit adjustment in 2020 for the 2018 taxable year

1. Direct credit.
Assume that TP directly received the Country Z audit adjustment, and so the FTR affects TP’s Section 901 credit. From a direct credit standpoint, the 2019 final and 2019 proposed regulations do not distinguish between FTRs that occur in pre-2018 years and post-2017 years. Granted, there are different foreign tax credit baskets to take into account when one moves from pre-TCJA to post-TCJA taxable years, but the mechanics of taking into account the FTR would be the same as those described above.

Once again, consider first a reduction in Country Z tax. If the FTR is a decrease in Country Z taxes and TP claimed some or all of those decreased Country Z taxes as a credit on its 2018 Form 1120, then the decrease in Country Z tax is an FTR requiring a redetermination of TP’s 2018 U.S. tax liability because TP has a smaller 2018 foreign tax credit. This result is the case under the 2019 final regulations or under the 2019 proposed regulations. Because no statute of limitations applies, TP would file an amended 2018 Form 1120, with the applicable Form 1118, showing the revised foreign tax credit, and pay any additional U.S. tax owed. Under the 2019 proposed regulations, that amended 2018 Form 1120, with Form 1118, must be filed by the due date (with extensions) of TP’s 2020 Form 1120. If TP does not owe any additional U.S. tax in 2018 because TP carried its 2018 foreign taxes forward to 2019, then TP would also need to file, along with its amended 2018 Form 1120, an amended 2019 Form 1120 with the relevant Form 1118 to the extent the disallowed foreign taxes were used in 2019.

If the FTR is an increase in Country Z taxes, then the increase in Country Z tax is an FTR requiring a redetermination of 2018 U.S. tax liability because TP is eligible for a larger 2018 foreign tax credit. That is the case under the 2019 final regulations or the 2019 proposed regulations. TP must file its amended 2018 Form 1120 and relevant Form 1118 within the 10-year period of Section 6511(d)(3). If TP does not credit all of its 2018 Country Z income taxes in 2018 and carries some of them forward to 2019, then TP would also need to file, along with its amended 2018 Form 1120, an amended 2019 Form 1120 with the relevant Form 1118 to the extent that the FTR increased the foreign tax credit claimed in 2019.

2. Indirect FTRs.
Under the final 2019 regulations, if TP claimed a Section 960 credit, TP’s accounting for FTRs would be the same under pre-2018 and post-2017 years. The main difference is that GILTI applies in post-2017 years, making the calculation of the revised foreign tax credit more complicated.

The 2019 proposed regulations would apply in a way that can boggle the mind, however. This means that it is impossible to show a simple but realistic example of their effect. The following examples will err on the side of simplicity, but the examples in Prop. Treas. Reg. Section 1.905-3(b)(2)(v) provide good, detailed examples of how TP would implement the new, broader definition of FTR.

First, assume that the FTR is a refund of 2018 Country Z tax paid by FC. The refund of Country Z tax increases FC’s Subpart F income, tested income, and E&P in 2018 by the functional currency amount of the foreign tax refund. The refund should increase TP’s Subpart F inclusion and/or GILTI inclusion and decrease TP’s Section 78 dividend if TP claimed a credit under Section 960. Alternatively, the lower foreign taxes may cause TP no longer to qualify for the high-tax exception of Section 954(b)(4). To the extent that the 2018 taxes had been carried forward or back to another year, TP’s Subpart F inclusions, Section 960 credits, Section 78 dividends, amount of distributions, and other components of tax liability in those years would need to be recalculated as well. Because the net result is an increase in federal income tax liability, the 2019 proposed regulations would require TP to file the amended 2018 1120 and relevant Form 1118 (and other years’ returns, if applicable) by the due date for TP’s 2020 Form 1120.

If the FTR was an increase in 2018 Country Z tax, then FC’s Subpart F income, tested income, and E&P would be decreased in 2018. TP’s Subpart F inclusion and/or GILTI inclusion should be reduced and Section 78 dividend increased if TP claims a credit under Section 960. Alternatively, the higher foreign taxes may cause TP to qualify for the high-tax exception of Section 954(b)(4). To the extent that the 2018 taxes are carried forward or back to another year, TP’s Subpart F inclusions, Section 960 credits, Section 78 dividends, amount of distributions, and other components of tax liability in those years would need to be recalculated as well. Any adjustments that are, on net, taxpayer favorable may require TP to file its amended returns within the period required by Section 6511.

In the best case scenario, all of the amended returns to reflect all of the redeterminations of U.S. tax liability would be a lot of work for what may be a small change in net U.S. tax liability. In the worst case scenario, the asymmetrical rules for FTRs can mean that what should be a small increase or decrease in U.S. tax becomes a large increase in U.S. tax. Consider the example above but assume that the FTR for the 2018 taxable year occurs in 2022. In the case of a refund of foreign taxes, the Internal Revenue Service takes the position that no time limit applies to a redetermination that increases U.S. tax liability, and so TP must pay tax on the additional GILTI and Subpart F. In the case of an additional payment of foreign tax by FC that reduces TP’s GILTI or Subpart F inclusion, the standard three-year statute of limitation of Section 6511 will have already run. So, unless TP has done something to keep its potential refund claim alive, it cannot file for a refund of any overpayment of U.S. tax in 2018 due to its overstatement of GILTI and Subpart F income.

Absent some tolling or netting rule, the result can be indefensibly harsh. Consider a simple timing difference, with identical overpayments and underpayments of foreign tax. Assume that the Country Z tax authority determines in 2023 that FC should have reported 100 u in income in 2018 that it instead reported in 2019 and shifts the timing of FC’s taxation accordingly. Let’s assume that this FTR means that TP’s gross Subpart F income or tested income increased $25 in 2019 (to reflect the lower Country Z tax paid) but decreased $25 in 2018 (to reflect the higher Country Z tax paid). This FTR means that TP must increase its U.S. tax liability in 2019 (to account for the reduced Country Z taxation in 2019) but is time-barred from claiming an identical refund from its U.S. taxes in 2018. Even the most conscientious taxpayer will blanch at complying with a rule that unfair.

Putting aside the question whether the 2019 proposed regulations are fair or unfair, the final question is what taxpayers do until the proposed regulations are finalized. Technically, they are not reliance regulations, but they are the only guidance taxpayers have, given that they replace the 2007 temporary and proposed regulations.

CONCLUSIONS

The 2019 proposed regulations’ broader definition of FTR and new rules for taking into account an FTR exacerbate the pre-existing problem that Section 905(c) requires an FTR that favors the government (i.e., a refund of foreign tax) to be implemented by a taxpayer, notwithstanding the otherwise applicable statute of limitations. In contrast, an FTR that favors the taxpayer (i.e., an increase in foreign tax paid) must be implemented within the time period of Section 6511. Given that some of the changes in U.S. tax liability required to be taken into account as a result of an FTR are not foreign tax credit-related, that generally means that a taxpayer cannot take advantage of an increase in foreign taxes that affects U.S. tax liability outside the foreign tax credit area (e.g., to claim the high-tax exception or a smaller Subpart F or GILTI inclusion) unless the claim is filed within the regular three-year period of Section 6511. The preamble to the 2019 proposed regulations suggests that this is intentional: Without the rules in the 2019 proposed regulations, “taxpayers would have an incentive to overpay their CFC’s foreign tax in the origin year, claim the high-tax exception to avoid subpart F or GILTI inclusions, wait for the 3 year statute of limitations to pass, and then claim a foreign tax refund with the foreign authorities.”

This misguided view that FTRs are a problem for the government but not for taxpayers permeates the 2019 proposed regulations. The preamble to the 2019 proposed regulations makes no bones about that, clearly coming across as more concerned about taxpayers taking advantage of an FTR than it is with the burden taxpayers face in dealing with FTRs. I know taxpayers and tax practitioners complain about burdens imposed by tax rules, and we complain more loudly when the burden is due to enforcing a taxpayer-unfavorable provision than we do when the burden is due to substantiating eligibility for a taxpayer-favorable provision. And, to a certain extent, a burden on taxpayers is unavoidable in this area, given the statutory rules. Still, the new FTR regulations are sufficiently unbalanced that they raise a serious compliance risk. FTRs generally rely on self-policing by taxpayers, and as some of the examples above show, reasonable taxpayers will wonder why they are expected to assist in this heads-the-government-wins-tails-the-taxpayer-loses regime.

In addition, affected taxpayers would be right to wonder about the value of the financial and compliance burden imposed on them by the 2019 proposed regulations. It is hard to see how the IRS can effectively administer these rules, especially for taxpayers that operate in multiple jurisdictions and who suffer complicated audits that last for years. Unless the IRS is going to devote substantial resources to reviewing all of the amended returns required by the 2019 proposed regulations, the 2019 proposed regulations will force taxpayers to comply with new complex and onerous rules and file multiple returns that will rarely be reviewed in more than a superficial way. That seems like a high price for taxpayers to pay just so the regulations can track a literal reading of Section 905(c).

The broad definition of FTR in the 2019 proposed regulations, along with the different time limits for addressing overpayments and underpayments of federal income tax, will also force taxpayers to file protective refund claims or take other steps to preserve their rights in future FTRs. It is unclear how a plethora of amended returns (in part due to the rule that unpaid but accrued taxes are treated as refunded at the end of the two-year period) and protective amended returns and refund claims is in the interest of tax administration. If the IRS and Treasury want to retain this approach, they must provide taxpayers with guidance as to how taxpayers file protective refund claims so that taxpayers will not be whipsawed by the new rules. Failure to do so will only hurt tax compliance. It is unreasonable to expect taxpayers to comply with a costly and burdensome approach for FTRs that “works” only half the time, and that half of the time is when it hurts 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.