# Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2019-24847

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** December 17, 2019
- **Citation:** 84 FR 69124

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 301
[REG-105495-19]
RIN 1545-BP21
Guidance Related to the Allocation and Apportionment of Deductions and Foreign Taxes, Financial Services Income, Foreign Tax Redeterminations, Foreign Tax Credit Disallowance Under Section 965(g), and Consolidated Groups

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

This document contains proposed regulations that provide guidance relating to the allocation and apportionment of deductions and creditable foreign taxes, the definition of financial services income, foreign tax redeterminations, availability of foreign tax credits under the transition tax, and the application of the foreign tax credit limitation to consolidated groups.

DATES:

Written or electronic comments and requests for a public hearing must be received by February 18, 2020.

ADDRESSES:

Send electronic submissions via the Federal eRulemaking Portal at
www.regulations.gov
(indicate IRS and REG-105495-19) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (the “Treasury Department”) and the IRS will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy. Send hard copy submissions to: CC:PA:LPD:PR (REG-105495-19), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-105495-19), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations under §§ 1.861-8, 1.861-9(b), 1.861-12, 1.861-14, 1.861-17, and 1.954-2(h), Jeffrey P. Cowan, (202) 317-4924; concerning §§ 1.704-1, 1.861-9(e), 1.904-4(e), 1.904(b)-3, 1.904(g)-3, 1.1502-4, and 1.1502-21, Jeffrey L. Parry, (202) 317-4916; concerning §§ 1.861-20, 1.904-6, 1.960-1, and 1.960-7, Suzanne M. Walsh, (202) 317-4908; concerning §§ 1.904-4(c), 1.905-3, 1.905-4, 1.905-5, 1.954-1, 301.6227-1, and 301.6689-1, Larry R. Pounders, (202) 317-5465; concerning §§ 1.965-5 and 1.965-9, Karen J. Cate, (202) 317-4667; concerning submissions of comments and requests for a public hearing, Regina Johnson, (202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On December 7, 2018, the Treasury Department and the IRS published proposed regulations (REG-105600-18) relating to foreign tax credits in the
Federal Register
(83 FR 63200) (the “2018 FTC proposed regulations”). Those regulations addressed several significant changes that the Tax Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054, 2208 (2017)) (the “TCJA”) made with respect to the foreign tax credit rules and related rules for allocating and apportioning deductions in determining the foreign tax credit limitation. The preamble to those proposed regulations requested comments on how to modify the existing approaches for allocating and apportioning deductions, including in particular the rules under § 1.861-17 for allocating and apportioning research and experimentation (“R&E”) expenditures. The 2018 FTC proposed regulations are finalized in the Rules and Regulations section of this issue of the
Federal Register
(the “2019 FTC final regulations”).

On June 25, 2012, the
Federal Register
published a notice of proposed rulemaking at 77 FR 37837 (the “2012 OFL proposed regulations”) proposing rules for the coordination of the rules for determining high-taxed passive income with required adjustments to the foreign tax credit limitation in respect of capital gains and the allocation and recapture of overall foreign losses and overall domestic losses, as well as the coordination of the recapture of overall foreign losses on certain dispositions of property and other rules concerning overall foreign losses and overall domestic losses. The 2012 OFL proposed regulations are finalized in the 2019 FTC final regulations.

On November 7, 2007, the
Federal Register
published temporary regulations (T.D. 9362) at 72 FR 62771 and a notice of proposed rulemaking by cross-reference to the temporary regulations at 72 FR 62805 relating to sections 905(c), 986(a), and 6689. Portions of these temporary regulations are finalized in the 2019 FTC final regulations.

This document contains proposed regulations (the “proposed regulations”) addressing the following issues: (1) The allocation and apportionment of deductions under sections 861 through 865, including new rules on the allocation and apportionment of R&E expenditures and certain deductions of life insurance companies; (2) the definition of financial services income under section 904(d)(2)(D); (3) the allocation and apportionment of creditable foreign taxes; (4) the interaction of the branch loss and dual consolidated loss recapture rules with sections 904(f) and (g); (5) the effect of foreign tax redeterminations of foreign corporations on the application of the high-tax exception described in section 954(b)(4) (including for purposes of determining tested income under section 951A(c)(2)(A)(i)(III)), and required notifications under section 905(c) to the IRS of foreign tax redeterminations and related penalty provisions; (6) the definition of foreign personal holding company income under section 954; (7) the application of the foreign tax credit disallowance under section 965(g); and (8) the application of the foreign tax credit limitation to consolidated groups.

Explanation of Provisions

I. Allocation and Apportionment of Deductions and the Calculation of Taxable Income for Purposes of Section 904(a)

A. Stewardship Expenses, Litigation Damages Awards and Settlement Payments, Net Operating Losses, and Interest Expense

1. Stewardship Expenses

Under § 1.861-8(e)(4)(i), stewardship expenses are definitely related and allocable to dividends received or to be received from related corporations. This reflects a determination that stewardship expenses are, at least in part, intended to protect the shareholder's capital investment and thus are factually related to the income that arises from the investment. Before the enactment of the TCJA, taxpayers with foreign subsidiaries often included in their income foreign source income only when that income was distributed to the taxpayer. However, as a result of the enactment of sections 951A and 245A, a significant portion of the foreign source income of foreign subsidiaries is included in income on a current basis or not at all. The Treasury Department and the IRS are aware that some taxpayers may be interpreting the “dividends received, or to be received” phrase in § 1.861-8(e)(4)(ii) to exclude the gross up amount treated as a dividend under section 78 (the “section

78 dividend”), as well as inclusions under section 951(a)(1), section 951A, and similar provisions, even though the stewardship expenses may be factually related to such gross income.

With respect to the allocation of stewardship expenses, income arising because of one's capital investment in a foreign corporation's stock ordinarily includes not only dividends, but also inclusions under sections 951 and 951A, as well as amounts included under sections 1291, 1293, and 1296 (the “passive foreign investment company provisions”). Therefore, the proposed regulations provide that stewardship expenses are allocated to dividends and inclusions received or accrued, or to be received or accrued, from related corporations.
1

Thus, stewardship expenses are also allocated to inclusions under sections 951 and 951A, section 78 dividends, and all amounts included under the passive foreign investment company provisions.

1
Duplicative activities or shareholder activities giving rise to stewardship expenses can only be performed with respect to members of a controlled group as described in § 1.482-9(l)(3)(iii)-(iv). Accordingly, relatedness in the context of stewardship expenses includes taxpayers that are members of the same controlled group as defined in § 1.482-1(i)(6). A taxpayer could incur stewardship expenses with respect to a related foreign corporation that is a passive foreign investment company (in addition to a related foreign corporation that is a controlled foreign corporation).

With respect to apportionment, the current regulations do not provide an explicit rule but instead provide examples of permissible methods. The Treasury Department and the IRS have determined that an explicit rule would provide certainty for taxpayers and the IRS on the appropriate methodology for apportioning stewardship expenses while ensuring that stewardship expenses are apportioned to gross income in a manner that reflects the purpose of the expenses to protect capital investments or to facilitate compliance with reporting, legal, or regulatory requirements. Therefore, the proposed regulations provide that stewardship expenses are apportioned based upon the relative values of a taxpayer's stock assets, as determined and characterized under § 1.861-9T(g) (and, as relevant, §§ 1.861-12 and 1.861-13) for purposes of allocating and apportioning the taxpayer's interest expense. Therefore, a taxpayer will be required to use the same method to characterize and value its stock assets for purposes of allocating and apportioning its interest and stewardship expenses, and, in some cases as described in Part 1.A.2 of this Explanation of Provisions, certain damages payments. Accordingly, since the fair market value method may not be used for interest allocation and apportionment, it may also not be used for stewardship and certain damages payments. Conforming changes are also proposed with respect to § 1.861-14T(e)(4), which provides rules for the treatment of stewardship expenses with respect to an affiliated group. See also § 1.861-8(g)(18) (
Example 18
) for an example illustrating the application of the proposed rules for stewardship expenses.

The Treasury Department and the IRS are aware that stewardship expenses that are incurred to facilitate compliance with reporting, legal, or regulatory requirements may be more appropriately treated as definitely related to the gross income produced by the particular asset, or assets, whose ownership required the stewardship expenditure. For example, the owner of an entity in a particular jurisdiction might have unique reporting requirements not triggered by the ownership of a similar entity in a different jurisdiction. The Treasury Department and the IRS request comments regarding exceptions to the general rule for the allocation and apportionment of stewardship expenses where it is more appropriate to treat stewardship expenses as definitely related to a more limited class of gross income. Comments are also requested on whether it is more appropriate in certain cases to allocate and apportion stewardship expenses on a separate entity, rather than an affiliated group, basis.

The proposed regulations maintain the definition of stewardship expenses as a duplicative activity (as defined in § 1.482-9(l)(3)(iii)) or a shareholder activity (as defined in § 1.482-9(l)(3)(iv)).
See
proposed § 1.861-8(e)(4)(ii)(A). In particular, shareholder activities are those that preserve the shareholder's capital investment or facilitate compliance with reporting, regulatory, or legal requirements.
See
§ 1.482-9(l)(3)(iv). However, the Treasury Department and the IRS are aware that it may be difficult for taxpayers to distinguish between stewardship expenses that result from oversight functions and expenses that are supportive in nature, as described in § 1.861-8(b)(3), and are concerned that expenses may be misclassified as either stewardship or supportive expenses in certain cases. For example, day-to-day management activities do not give rise to stewardship expenses and are typically more supportive in nature. However, the distinction between day-to-day management and oversight may change over time as a taxpayer's investments change. Given these concerns, the Treasury Department and the IRS request comments regarding the definition of stewardship expenses and how to readily distinguish such expenses from supportive expenses that are allocated and apportioned under § 1.861-8(b)(3).

The proposed regulations extend the treatment of stewardship expenses to cover expenses incurred with respect to a partnership.
See
proposed § 1.861-8(e)(4)(ii)(D). Rules similar to those with respect to corporations apply to allocate and apportion stewardship expenses incurred with respect to partnerships.

Finally, the Treasury Department and the IRS are considering whether additional changes to the rules for allocating and apportioning stewardship and similar expenses are appropriate in light of the enactment of the TCJA, and in order to better reflect modern business practices that are increasingly global and mobile in nature. Comments are requested on this topic.

2. Litigation Damages Awards, Prejudgment Interest, and Settlement Payments

The current rule for the allocation and apportionment of legal and accounting fees and expenses in § 1.861-8(e)(5) does not specifically address damages awards, prejudgment interest, or settlement payments arising from product liability and similar claims. The Treasury Department and the IRS are aware that large, unplanned, and relatively rare expenses can have a significant effect on the calculation of a taxpayer's taxable income and foreign tax credit limitation, and, in the absence of clear rules, disputes have arisen regarding the proper treatment of such expenses. Proposed § 1.861-8(e)(5) provides that deductions for damages awards, prejudgment interest, and settlement payments arising from product liability and similar or related claims are allocated to the class or classes of gross income produced by the specific sales of products or services that gave rise to the claims for damage or injury. Damages, prejudgment interest, and settlement payments related to events incident to the production of goods or provision of services, such as damages for injuries caused by industrial accidents, are allocated to the class of gross income produced by the assets involved in the event and, if necessary, apportioned between groupings based on the relative value of the assets in such groupings. In the case of claims made by investors that arise from corporate negligence, fraud, or other malfeasance, the

proposed regulations provide that damages, prejudgment interest, and settlement payments paid by the corporation are allocated and apportioned based on the value of all the corporation's assets. In general, the deductions are allocated and apportioned to the statutory or residual groupings to which the related income would be assigned if recognized in the taxable year in which the deductions are allowed.

3. Net Operating Loss Deductions

Under current rules, a net operating loss deduction is allocated and apportioned in the same manner as the deductions giving rise to the net operating loss deduction. However, the rule does not specify how the statutory and residual grouping components of a net operating loss are determined.
See
§ 1.861-8(e)(8). The proposed regulations provide that a net operating loss is assigned to the statutory and residual groupings by reference to the losses in each statutory or residual grouping (determined without regard to adjustments made under section 904(b)) that are not allocated to reduce income in a different grouping in the taxable year of the loss.
See
proposed § 1.861-8(e)(8)(i). Furthermore, the proposed regulations clarify that a net operating loss deduction for a taxable year is allocated and apportioned by reference to the statutory and residual grouping components of the net operating loss that is deducted in the taxable year.
See
proposed § 1.861-8(e)(8)(ii). Finally, the proposed regulations provide that except as provided in regulations, for example, in § 1.904(g)-3, a partial net operating loss deduction is treated as ratably comprising the components of the net operating loss.
2

See
id.

2
A partial net operating loss deduction occurs when the full net operating loss is not deductible in the carryover year.

In connection with the proposed regulations under section 250, comments requested clarification on the application of § 1.861-8(e)(8) with respect to net operating losses arising prior to the enactment of the TCJA when the net operating loss is deducted in a post-TCJA year for purposes of applying section 250 as the operative section.
See
84 FR 8188 (March 6, 2019). These comments will be addressed as part of finalizing those proposed regulations.

4. Application of the Exempt Income/Asset Rule to Insurance Companies in Connection With Certain Dividends and Tax-Exempt Interest

As explained in Part II.B.2 of the Summary of Comments and Explanation of Revisions to the 2019 FTC final regulations, one comment to the 2018 FTC proposed regulations suggested that insurance companies reduce exempt income and assets to reflect prorated amounts of dividends and tax exempt interest.
See
sections 805(a)(4), 807, 812, and 832(b)(5)(B). The 2019 FTC final regulations do not address this issue, and the proposed regulations do not adopt this comment.

Under subchapter L, a nonlife insurance company includes in income its underwriting income, which consists of premiums earned on insurance contracts during the taxable year less losses incurred and expenses incurred. The proration rules reduce the company's losses incurred by the “applicable percentage” of tax exempt interest or deductible dividends received.
See
section 832(b)(5)(B). For a life insurance company, the proration rules apply in the case of tax exempt interest by reducing the closing balance of reserve items by the “policyholder's share” (currently a fixed percentage, originally intended to be the portion of tax favored investment income used to fund the company's obligations to policyholders) of tax exempt interest.
See
sections 807(b)(1)(B) and 812. Similarly, a life insurance company is allowed a dividends received deduction (DRD) for intercorporate dividends from non-affiliates only in proportion to the “company's share” of the dividends, but not for the policyholder's share.
See
section 805(a)(4)(A). Fully deductible dividends from affiliates are excluded from proration for life insurance companies if the dividends are not themselves distributions from tax exempt interest or from dividend income that would not be fully deductible if received directly by the taxpayer.

While the mechanics of the proration rules differ depending on whether a company is a life or nonlife insurance company and whether the amount relates to dividends or tax exempt interest, the purpose of those provisions is the same. That is, the policyholder's share or applicable percentage of dividends and tax exempt interest should not create a double benefit by reason of a DRD or section 103 tax exemption for interest in the first instance and a reduction to income (via increases in unpaid losses and reserves during the taxable year) in the second. Regardless of the mechanics, however, the policyholder's share and applicable percentage adjustments do not change the fact that tax exempt interest and (for a nonlife insurance company) the applicable percentage of dividends eligible for DRDs remain exempt from U.S. tax. Including those exempt amounts and the corresponding exempt assets in the apportionment formula in allocating expenses under § 1.861-8T(d)(2)(i)(B), as the comment suggests, would effectively apportion reserve deductions (which already do not include the disallowed deductions deemed to be attributable to the exempt income, except in the case of the policyholder's share of life insurance DRDs) to exempt U.S. source income, with the result that those deductions would reduce unrelated U.S. source income, in contravention of the rule in § 1.861-8T(d)(2)(i)(B).
See also Travelers Insurance Company
v.
United States,
303 F.3d 1373 (2002).

The current regulations already provide the appropriate rules in this area. Section 1.861-8T(d)(2)(ii)(B) provides that the policyholder's share of dividends received by a life insurance company is treated as tax exempt income notwithstanding the partial disallowance of the DRD, and § 1.861-14T(h) provides for the direct allocation to the dividends of an amount of reserve expenses equal to the disallowed portion of the DRDs. The current regulations do not provide a special rule for either tax exempt interest of a life insurance company or DRDs and tax exempt interest of a nonlife insurance company because, when a policyholder's share or applicable percentage is accounted for as either a reserve adjustment or a reduction to losses incurred, no further modification to the generally applicable rules is required to ensure that the appropriate amount of expenses are apportioned to U.S. source income.

Nevertheless, in order to provide greater clarity, the proposed regulations provide in proposed § 1.861-8(d)(2)(ii)(B), (d)(2)(v), and (e)(16) the effect of certain deduction limitations on the treatment of income and assets generating dividends received deductions and tax exempt interest held by insurance companies. More specifically, the proposed regulations provide that in the case of insurance companies, the term exempt income includes dividends for which a deduction is provided by sections 243(a)(1) and (2) and 245, without regard to the proration rules disallowing a portion of the deduction. Similarly, the term exempt income includes tax exempt interest without regard to the proration rules. These provisions apply on a company wide basis and therefore include each separate account of the company. Two examples are provided in proposed § 1.861-8(d)(2)(v)(B) that illustrate the application of these rules.

5. Other Requests for Comments on Expense Allocation

The Treasury Department and the IRS continue to study the rules for allocating and apportioning interest deductions. In addition, the Treasury Department and the IRS expect the implementation of section 864(f) (which is effective for taxable years beginning after December 31, 2020) will have a significant impact on the effect of interest expense apportionment and will necessitate a reexamination of the existing expense allocation rules. Therefore, the Treasury Department and the IRS are studying whether further guidance with respect to allocation and apportionment of interest expense, taking into account the changes made by the TCJA and the future implementation of section 864(f), is required. Comments are requested on this topic.

The Treasury Department and the IRS are also considering whether rules providing for the capitalization and amortization of certain expenses solely for purposes of § 1.861-9 may better reflect asset values under the tax book value method. For example, solely for purposes of § 1.861-9, research and experimental expenditures and advertising expenses could be treated as if they were capitalized and amortized. Comments are requested on this topic.

As noted in Part III.B.4.iii of the Summary of Comments and Explanation of Revisions to the 2019 FTC final regulations, the Treasury Department and the IRS are studying whether additional rules for allocating and apportioning expenses to foreign branch category income or limiting the amount of the gross income reallocated as a result of certain disregarded payments are appropriate. Comments are requested on whether such special rules would more accurately reflect the business profits of a foreign branch, while maintaining administrability for taxpayers and the IRS.

B. Certain Loans Made by Partnerships to Partners

The 2018 FTC proposed regulations included rules addressing the source and separate category of interest income and expense related to loans to a partnership by a U.S. person (or a member of its affiliated group) that owns an interest (directly or indirectly) in the partnership. These rules were finalized in the 2019 FTC final regulations.
See
§ 1.861.9(e)(8).

As discussed in Part II.C.1 of the Summary of Comments and Explanation of Revisions of the 2019 FTC final regulations, several comments to the 2018 FTC proposed regulations requested that the rules under § 1.861-9(e)(8) with respect to specified partnership loans be expanded to cover loans made by a partnership to a partner (an “upstream partnership loan”). The Treasury Department and the IRS agree with comments that rules addressing upstream partnership loans would reduce distortions that could otherwise affect the foreign tax credit limitation. Therefore, the comments are adopted in proposed § 1.861-9(e)(9)(ii), which generally provides that, to the extent the borrower in an upstream partnership loan transaction takes into account both interest expense and interest income with respect to the same loan, the interest income is assigned to the same statutory and residual groupings as those groupings from which the matching amount of interest expense is deducted, as determined under the allocation and apportionment rules in §§ 1.861-9 through 1.861-13. Additionally, proposed § 1.861-9(e)(9)(i) provides that, for purposes of applying the allocation and apportionment rules, the borrower does not take into account as an asset its proportionate share of the loan, as otherwise provided under § 1.861-9(e)(2) and (3). Proposed § 1.861-9(e)(8)(iv) also applies the upstream partnership loan rules to transactions that are not loans but that give rise to deductions that are allocated and apportioned in the same manner as interest expense under § 1.861-9T(b). An anti-avoidance rule similar to the rule in § 1.861-9(e)(8)(iii) is included to cover back-to-back third-party loans that are intended to circumvent the purposes of the rules.
See
proposed § 1.861-9(e)(8)(iii). These rules are being proposed in order to provide taxpayers an additional opportunity to comment on the rule.

Additionally, the Treasury Department and the IRS are aware that some taxpayers may be converting existing partnership debt structures that were used to increase a taxpayer's foreign tax credit limitation before the issuance of § 1.861-9(e)(8) from partnership debt into partnership equity that provides for guaranteed payments for the use of capital. The taxpayer then takes the position that the guaranteed payments are neither allocated and apportioned under the rules in § 1.861-9 nor included in subpart F income by reason of § 1.954-2(h).

Guaranteed payments for the use of capital are similar to a loan from the partner to the partnership because the payment is for the use of money and is generally deductible.
See
section 707(c). Because these arrangements raise the same policy concerns as ordinary debt instruments, the proposed regulations revise § 1.861-9(b) and § 1.954-2(h)(2)(i) explicitly to provide that guaranteed payments for the use of capital described in section 707(c) are treated similarly to interest deductions for purposes of allocating and apportioning deductions under §§ 1.861-8 through 1.861-14 and are treated as income equivalent to interest under section 954(c)(1)(E). No inference is intended as to whether or not § 1.861-9T(b) or § 1.954-2(h)(2) include guaranteed payments for taxable years before the proposed regulations are applicable.

C. Treatment of Assets Connected With Capitalized, Deferred, or Disallowed Interest

Section 1.861-12T(f)(1) provides that, in certain circumstances, where interest expense that is capitalized, deferred, or disallowed under a provision of the Code, the adjusted basis or fair market value of the asset to which the interest expense is connected is reduced by the principal amount of the interest that is capitalized, deferred, or disallowed. One comment with respect to the 2018 FTC proposed regulations recommended that the Treasury Department and the IRS consider narrowing the scope of the rule in § 1.861-12T(f)(1) to prevent taxpayers from taking overly expansive views of the rule in order to minimize the value of controlled foreign corporation (“CFC”) stock that attracts interest expense to reduce the foreign tax credit limitation. In response to the comment, the proposed regulations clarify what it means for an asset to be connected with indebtedness, modify the existing example, and add a new example.
See
proposed § 1.861-12(f).

D. Treatment of Section 818(f) Reserve Expenses for Consolidated Groups

Section 818(f)(1) provides that the deduction for life insurance reserves and certain other deductions (“section 818(f) expenses”) are treated as items which cannot definitely be allocated to an item or class of gross income. Therefore, when a life insurance company computes its foreign tax credit limitation, its section 818(f) expenses generally reduce its U.S. source income and foreign source income ratably. However, issues arise as to how to allocate and apportion section 818(f) expenses if the life insurance company is a member of an affiliated group of corporations (including both life and nonlife members) (the group, “life-nonlife consolidated group”) that join in filing a consolidated return.

The Treasury Department and the IRS are aware of at least five potential

methods for allocating section 818(f) expenses in a life-nonlife consolidated group. First, the expenses might be allocated solely among items of the life insurance company that has the reserves (“separate entity method”). Second, to the extent the life insurance company has engaged in a reinsurance arrangement that constitutes an intercompany transaction (as defined in § 1.1502-13(b)(1)), the expenses might be allocated in a manner that achieves single entity treatment between the ceding member and the assuming member (“limited single entity method”). Third, the expenses might be allocated among items of all life insurance members (“life subgroup method”). Fourth, the expenses might be allocated among items of all members of the consolidated group (including both life and non-life members) (“single entity method”). Fifth, the expenses might be allocated based on a facts and circumstances analysis (“facts and circumstances method”).

In response to the request for comments in the 2018 FTC proposed regulations, the Treasury Department and the IRS have received comments advocating for certain of the aforementioned allocation methods. One comment recommended an allocation method similar to the single entity method. The comment proposed that, if all members of a consolidated group were treated as a single corporation, and if that corporation would constitute a life insurance company, then section 818(f) expenses might be allocated and apportioned to all members of the consolidated group, including nonlife members of a life-nonlife consolidated group.

Two other comments disagreed with the single entity method. These comments proposed that section 818(f) expenses generally be allocated on the separate entity method. However, if the facts and circumstances demonstrate a sufficient factual relationship between the expense and the income of more than one life insurance company, these comments proposed that such expenses might be allocated based on the facts and circumstances method. The comments did not provide examples of when facts and circumstances would demonstrate a sufficient relationship to qualify for this treatment.

The Treasury Department and the IRS decline to adopt the single entity method in the proposed regulations. Section 818(f) only applies to a life insurance company; thus, section 818(f) expenses should not be allocated to nonlife members of a consolidated group. The Treasury Department and the IRS also decline to adopt the facts and circumstances method because a broad facts and circumstances approach would introduce substantial uncertainty into the tax system and would be difficult to administer.

The Treasury Department and the IRS considered adopting the life subgroup method in the proposed regulations. This method would reflect a single entity approach for life insurance companies that operate businesses and manage assets and liabilities on a group basis. Under this paradigm, section 818(f) expenses would be treated as not definitely related to an item or class of gross income of the entire life subgroup for purposes of calculating the foreign tax credit limitation, and therefore generally ratably reduce U.S. source income and foreign source income of the life subgroup.

The Treasury Department and the IRS also considered adopting the separate entity method. The separate entity method would allocate and apportion section 818(f) expenses on a separate company basis. This method is consistent with the Code because section 818(f) expenses generally are computed on a separate company basis and relate to the liabilities of a specific life insurance company. In addition, this method is consistent with the treatment of reserves when members of a consolidated group engage in an intercompany transaction. Under § 1.1502-13(e)(2)(ii)(A), direct insurance transactions between members of a consolidated group are accounted for by both members on a separate entity basis. For example, if one member provides life insurance coverage for another member with respect to its employees, the premiums, reserve increases and decreases, and death benefit payments are determined and taken into account by both members on a separate entity basis (rather than on a single entity basis under the general rules of § 1.1502-13).
See also
§ 1.1502-13(e)(2)(ii)(B)(
2
) (providing that reserves resulting from intercompany reinsurance transactions are determined on a separate entity basis).

After considering both methods, proposed § 1.861-14(h)(1) adopts the separate entity method. As noted previously, this method generally is consistent with section 818(f) and with the separate entity treatment of reserves under § 1.1502-13(e)(2). Nevertheless, the Treasury Department and the IRS are concerned that this method may create opportunities for consolidated groups to use intercompany transactions to shift their section 818(f) expenses and achieve a more desirable foreign tax credit result. Accordingly, the Treasury Department and the IRS request comments on whether a life subgroup method more accurately reflects the relationship between section 818(f) expenses and the income producing activities of the life subgroup as a whole, and whether the life subgroup method is less susceptible to abuse because it might prevent a consolidated group from inflating its foreign tax credit limitation through intercompany transfers of assets, reinsurance transactions, or transfers of section 818(f) expenses. The Treasury Department and the IRS also request comments on whether an anti-abuse rule may be appropriate to address concerns with the separate entity method, and regarding the appropriate application of § 1.1502-13(c) to neutralize the ancillary effects of separate-entity computation of insurance reserves, such as the computation of limitations under section 904.

E. Allocation and Apportionment of R&E Expenditures

Part I.G of the Explanation of Provisions of the 2018 FTC proposed regulations discussed the interaction between the current rules for allocating and apportioning R&E expenditures and the changes made to section 904(d) by the TCJA, and requested comments on how the regulations should be revised to account for the new category in section 904(d)(1)(A) (the “section 951A category”). The comments received are addressed in this Part I.E.

1. Relevant Class of Gross Income and Application of the Gross Income Method

Several comments to the 2018 FTC proposed regulations recommended that the regulations for allocating and apportioning R&E expenditures under § 1.861-17 be revised to preclude allocation and apportionment of R&E expenditures to the section 951A category. The comments stated that R&E expenditures are incurred by a U.S. taxpayer to develop intangible property that cannot generate income in the section 951A category, which is limited to inclusions under section 951A (“GILTI inclusions”) and the related section 78 dividend in respect of deemed paid taxes. Further, to the extent a GILTI inclusion is attributable to a CFC's income derived from intangible property developed by the worldwide group, the comments stated that the intangible property must have either been developed by the CFC or a CFC affiliate (in which case the R&E expenditures were not borne by the U.S. taxpayer), or licensed or acquired by the CFC from a U.S. affiliate, which would

require that the U.S. affiliate take into account an arm's length royalty, gain on transfer, or a deemed income amount under section 367(d) to which its R&E expenditures should be allocated.

The Treasury Department and the IRS agree with the comments that the rules under § 1.861-17 should be modified to reflect the fact that R&E expenditures that are deductible under section 174 generally give rise to intangible property, and that under the rules in sections 367(d) and 482, the person incurring such R&E expenditures must be compensated properly when such intangible property gives rise to income. Therefore, proposed § 1.861-17(b) provides that the rules in that section are premised on the fact that successful R&E expenditures ultimately result in the creation of intangible property (as defined in section 367(d)(4)) and, therefore, R&E expenditures ordinarily are considered deductions that are definitely related to all gross intangible income reasonably connected with the relevant Standard Industrial Classification Manual code (“SIC code”) category (or categories) of the taxpayer and so are allocable to all items of gross intangible income related to the SIC code category (or categories) as a class. Gross intangible income is defined as all gross income earned by a taxpayer that is attributable, in whole or in part, to intangible property derived from R&E expenditures and does not include dividends or any amounts included under section 951, 951A, or 1293.
See
proposed § 1.861-17(b)(2). As a result, when applying § 1.861-17 to section 904 as the operative section, because a U.S. taxpayer's gross intangible income, as defined in the proposed regulations, does not include income assigned to the section 951A category, none of its R&E expenditures are allocated or apportioned to the section 951A category.

Under § 1.861-17(c) and (d), a taxpayer may elect to apportion R&E expenditures, in excess of amounts exclusively apportioned to the place the R&E is performed under § 1.861-17(b), on the basis of either sales or gross income. In contrast to the sales method, the gross income method of apportioning R&E expenditures (1) limits taxpayers to exclusively apportion only 25 percent of R&E expenditures based on the place of research activities (instead of 50 percent under the sales method), and (2) requires the apportionment to or among the statutory groupings to be at least half of what would have been apportioned under the sales method. These limits reflect concerns that the gross income method could produce inappropriate results in cases where the types of gross income recognized by the taxpayer in the statutory and residual groupings in a SIC code category are different. For example, if a taxpayer sells products incorporating its intangible property in the United States but earns royalties from licensing its intangible property used by others to make sales abroad, comparing the gross income from sales, which includes value attributable to other factors in addition to intangible property, to the gross royalty income will generally distort the extent to which the R&E expenditures produce U.S. and foreign source income from intangible property. In such cases, the gross income method is inconsistent with the general principle under § 1.861-8T(c) that the method of apportionment “reflect to a reasonably close extent the factual relationship between the deduction and the grouping of gross income.” In comparison, the sales method requires that taxpayers use a single, consistent measure—gross receipts from sales and services—to attribute R&E expenditures to their various groupings and, therefore, more clearly reflects the anticipated income expected to be derived from successful R&E expenditures.

Therefore, the proposed regulations eliminate the optional gross income method and require R&E expenditures in excess of the amount exclusively apportioned under § 1.861-17(b) to be apportioned among the statutory and residual groupings within the class of gross intangible income on the basis of the relative amounts of gross receipts from sales and services in each grouping.
See
proposed § 1.861-17(d). For this purpose, gross receipts are assigned to the grouping to which the gross intangible income attributable to the sale or service is assigned. For example, where the taxpayer licenses intangible property to a CFC which, in turn, sells products or services incorporating the intangible property, the gross receipts of the CFC are assigned to a grouping based on the source and character of the related royalty included by the taxpayer. Proposed § 1.861-17(d)(1)(iii). This rule addresses concerns that the Treasury Department and the IRS have had since before the TCJA's enactment that taxpayers would assign the gross receipts from CFC sales to U.S. customers to the residual grouping for U.S. source income while arguing that the related royalty income earned by the U.S. company that owns the intangible property can be treated as foreign source income, with the mismatch resulting in an inflation of R&E expenditures apportioned to U.S. source income. The proposed regulations also clarify that the sales method applies to income from services.

Under § 1.861-17(a)(2)(ii), the relevant SIC code categories are determined by reference to the three digit classification of the SIC code. Proposed § 1.861-17(b)(3)(iv) clarifies the rules relating to goods or property that are described in the SIC code category for “wholesale trade” or “retail trade.” The purpose of this rule is to match R&E expenditures with a taxpayer's core business and minimize the number of a taxpayer's SIC code categories. This rule provides that vertically integrated taxpayers that perform upstream activities (for example, extraction or manufacturing) before downstream wholesale and retail functions must aggregate their wholesale and retail R&E expenditures and sales with their R&E expenditures and sales in the most closely related three-digit SIC code category. A taxpayer cannot use a SIC code category within the wholesale or retail trade divisions unless its business is generally limited to sales-related activities. Taxpayers engaged in both wholesale and retail trade, but not related upstream activities, are not required to aggregate their wholesale and retail R&E expenditures and sales.

Comments are requested on whether a different classification method that takes into account more recent changes in the economy and business practices should be used. For example, comments are requested on whether NAICS codes would be more appropriate.

Comments to § 1.861-17 were also received in connection with the proposed regulations under section 250.
See
84 FR 8188 (March 6, 2019). Further changes to the rules for allocating and apportioning R&E expenditures will be considered as part of addressing comments in finalizing those regulations.

2. Elimination of Legally Mandated R&E and Increased Exclusive Apportionment of R&E

Under § 1.861-17(a)(4), R&E expenditures that are undertaken solely to meet legal requirements (“legally mandated R&E”) imposed by a political entity and that cannot reasonably be expected to generate amounts of gross income (beyond de minimis amounts) outside a single geographic source are allocated directly to gross income within the geographic source imposing the requirement. A rule similar to the legally mandated R&E rule existed in regulations issued in 1977 that allocated

and apportioned R&E expenditures (“the 1977 regulations”).

Since the adoption of the legally mandated R&E rule in the 1977 regulations, the Treasury Department and the IRS have observed that taxpayers rarely rely on the legally mandated R&E rule. In particular, legal requirements for certain products may significantly overlap between multiple jurisdictions because those jurisdictions have similar legal requirements that relate to areas such as consumer safety, pollution, or pharmaceutical products. In addition, multiple jurisdictions may have similar legal requirements because of multilateral trade and investment agreements or because taxpayers choose to sell their products only in markets with similar requirements. See, for example, IRS Coordinated Issue Biotech and Pharmaceutical Industries Legally Mandated R&E Expense (June 18, 2003) (discussing the International Conference on Harmonization, subsequently the International Council for Harmonization, and its role in rationalizing and harmonizing pharmaceutical regulations in multiple jurisdictions). To reflect the changing international business environment and simplify the regulations with respect to R&E, the proposed regulations eliminate the legally mandated R&E rule.

Under § 1.861-17(b), an exclusive apportionment of R&E expenditures is made if activities representing more than 50 percent of the R&E expenditures were performed in a particular geographic location, such as the United States. Under § 1.861-17(b)(1)(ii), for taxpayers electing the gross income method, 25 percent of R&E expenditures is exclusively apportioned to the geographic location where the R&E activities accounting for more than 50 percent of the deductible expenses were incurred. Under § 1.861-17(b)(1)(i), for taxpayers electing the sales method, 50 percent of R&E expenditures are exclusively apportioned to the geographic location where the R&E activities accounting for more than 50 percent of the deductible expenses were incurred. After this initial exclusive apportionment, the remainder of the taxpayer's R&E expenditures are apportioned under either the sales or gross income methods.

The 1977 regulations also included a rule similar to a rule in the current regulations at § 1.861-17(b)(2). Under this rule, taxpayers may demonstrate to the satisfaction of the Commissioner that an even higher amount of R&E expenditures should be exclusively apportioned to a geographic location. According to the current regulations, the exclusive apportionment rules are based on the understanding that R&E may be more valuable where it is undertaken because R&E benefits products all of which may be sold in the nearest market but only some of which may be sold in foreign markets, and R&E is often used in the nearest market first before it is used in other markets. Therefore, under the increased exclusive apportionment rule, a taxpayer may establish to the satisfaction of the Commissioner that one or both of these conditions are satisfied—that is, its research is expected to have a particularly limited or long delayed application outside the geographic area where the research is performed, such that a greater amount of R&E expenditures should be initially exclusively apportioned.

Similar to the legally mandated rule, the Treasury Department and the IRS have observed that taxpayers have rarely used the current increased exclusive apportionment rule since the issuance of the 1977 regulations. Moreover, when it has been used, the facts and circumstances nature of the analysis has caused hard-to-resolve disagreements between the Commissioner and taxpayers. Changes in the international business environment have also contributed to the decreased utilization of this rule. Accordingly, the proposed regulations eliminate the increased exclusive apportionment rule.

Finally, proposed § 1.861-17(b) clarifies that the exclusive apportionment rule applies only to section 904 as the operative section.
See also
Part I.E.1 of this Explanation of Provisions (noting that comments were received in connection with proposed regulations under section 250 and that further changes will be considered as part of addressing comments in finalizing those regulations).

3. Sales Made by Other Entities

The sales method for apportioning R&E expenditures provides that gross receipts from sales of products or provision of services within a relevant SIC code category by controlled parties of the taxpayer are taken into account in apportioning the taxpayer's R&E expenditures if the controlled party is reasonably expected to benefit from the taxpayer's research and experimentation. Under § 1.861-17(c)(3)(iv), the sales of controlled parties that enter a valid cost sharing arrangement (“CSA”) with a taxpayer are excluded from the apportionment formula because the controlled party is not expected to benefit from the taxpayer's remaining R&E expenditures.

Proposed § 1.861-17 clarifies the treatment of CSAs in two respects. First, consistent with § 1.482-7, the taxpayer's R&E expenditures allocated and apportioned under § 1.861-17 do not include any amounts that are not deductible by reason of the second sentence under § 1.482-7(j)(3)(i) (relating to cost sharing transaction payments from a controlled party). Second, the proposed regulations clarify that the exclusion of the controlled party's gross receipts applies only for purposes of apportioning those R&E expenditures that are intangible development costs with respect to the CSA. If a taxpayer who enters a CSA also incurs R&E expenditures that are not intangible development costs with respect to the CSA, then those expenses would be apportioned under the generally applicable rules, including the rules concerning controlled party sales.
See
proposed § 1.861-17(d)(4)(v).

One comment suggested that § 1.861-17 be modified to provide that a taxpayer's R&E expenditures that are funded by a foreign affiliate under a contract research arrangement should be directly allocated to the taxpayer's income from such arrangements. The terms of the contract research arrangement are not clear from the comment, and it is unclear whether the described expenditures that are reimbursed by a foreign affiliate are paid or incurred by the taxpayer to develop or improve a product in connection with the taxpayer's trade or business.
See
§§ 1.174-1 and 1.174-2. If the expenditures are not paid or incurred by the taxpayer to develop or improve a product in connection with its trade or business, the taxpayer may not deduct them under section 174. As a result, § 1.861-17 would not apply to these expenditures. The expenditures would instead be allocated and apportioned under the general rules in § 1.861-8 on the basis of the factual relationship of deductions to gross income.
See
§ 1.861-8(a)(2). The Treasury Department and the IRS request comments on whether contract research arrangements involving expenditures reimbursed by a foreign affiliate are generally paid or incurred by the taxpayer in connection with its trade or business such that a deduction under section 174 is allowable, and whether a special rule for such expenditures should be considered.

Another comment suggested a special rule for “licensor models” whereby CFCs pay royalties to compensate for a taxpayer's R&E expenditures. The comment suggested that in order to avoid allocation and apportionment of R&E expenditures to the section 951A category, the activities of the licensee CFC should be excluded for purposes of apportioning the licensor's R&E

expenditures and should be treated similarly to cost sharing arrangements. The comment suggested in the alternative that if the CFC sales are not excluded entirely, that R&E expenditures should be netted against the royalty income to which the R&E expenditures are apportioned.

The Treasury Department and the IRS agree that R&E expenditures should be allocated and apportioned solely with respect to the gross intangible income of the taxpayer rather than the net income of a licensee, and therefore not allocated and apportioned to the section 951A category.
See
Part I.D.1 of this Explanation of Provisions. Unlike in the case of a CSA, however, a licensor earns royalties or other forms of gross intangible income from the use of its intangible property, and it would not be appropriate to exclude such royalties in allocating R&E expenditures of the licensor. The proposed regulations require the use of the sales method, which would effectively attribute R&E expenditures to the taxpayer's royalty income based on the proportion of the gross receipts of the licensees over the total gross receipts of the taxpayer and its licensees. This approach is preferable to the comment's alternative recommendation of netting R&E expenditures against the amount of royalties because taxpayers may earn different types of gross intangible income (for example, from sales of property as well as royalties) and comparing such amounts could lead to distortive results.

Finally, under § 1.861-17(c)(3)(ii) and (f)(3), sales made by controlled corporations and partnerships taken into account to apportion R&E expenditures are reduced to reflect the taxpayer's percentage ownership of such entities. This reduction is inappropriate because the taxpayer's gross intangible income is not dependent on its percentage ownership of the entity to which it transfers intangible property. The proposed regulations, therefore, eliminate the rule reducing sales of controlled corporations that are taken into account and include partnership sales to the same extent as those made by controlled corporations.

F. Application of Section 904(b) to Net Operating Losses

The 2018 FTC proposed regulations included a rule in § 1.904(b)-3(d) coordinating the application of section 904(b)(4) with sections 904(f) and 904(g), which apply after section 904(b)(4). This rule is finalized substantially as proposed in the 2019 FTC final regulations. However, the 2018 FTC proposed regulations did not coordinate any of the adjustments required under section 904(b) with the net operating loss provisions. Therefore, the proposed regulations include a coordination rule. Under proposed § 1.904(b)-3(d)(2), for purposes of determining the source and separate category of a net operating loss, the separate limitation loss and overall foreign loss rules of section 904(f) and the overall domestic loss rules of section 904(g) are applied without taking into account the adjustments required under section 904(b). The Treasury Department and the IRS have determined this rule is appropriate because the amount of the net operating loss eligible to be carried to another year under section 172 is not affected by the adjustments required by section 904(b).

II. Foreign Tax Credit Limitation Under Section 904

A. Definition of Financial Services Entity

Section 904(d)(2)(D) provides that financial services income can only be received by a person “predominantly engaged in the active conduct of a banking, insurance, financing, or similar business.” Under current law, the principal significance of this provision is that under section 904(d)(2)(C), passive income of such a person is not assigned to the passive category. The preamble to the 2018 FTC proposed regulations noted that the Treasury Department and the IRS were considering modifications to the gross income-based test for determining financial services entity (“FSE”) status and requested comments in this regard. One comment was received requesting that any future modifications not affect the classification of income derived by a substantial (and genuinely active) financial services group. The Treasury Department and IRS agree that a substantial and genuinely active financial services group should be included in the definition of an FSE.

However, numerous places in the Code use similar concepts and, at times, the same terms, but provide different definitions (even when largely overlapping in application). The Treasury Department and IRS have determined that interpretive guidance should be simplified and made consistent where possible and appropriate. For example, section 954(h) in the subpart F rules defines “predominantly engaged in the active conduct of a banking, financing, or similar business” (which in the case of a lending or finance business, requires more than 70 percent of the gross income be derived directly from transactions with unrelated customers); section 1297(b)(2)(B) in the passive foreign investment company (“PFIC”) rules defines “active conduct of an insurance business by a qualifying insurance corporation”; and section 953(e)(3) defines the term “qualifying insurance company” in order to determine the amount of passive income excluded from subpart F income as income derived in the active conduct of an insurance business under section 954(i).

In order to promote simplification and greater consistency with other Code provisions that have complementary policy objectives, proposed § 1.904-4(e)(2) modifies the definition of an FSE by adopting a definition of “predominantly engaged in the active conduct of a banking, insurance, financing, or similar business” and “income derived in the active conduct of a banking, insurance, financing, or similar business” that is generally consistent with sections 954(h), 1297(b)(2)(B), and 953(e). Conforming changes are made to the rules for affiliated groups in proposed § 1.904-4(e)(2)(ii) and partnerships in proposed § 1.904-4(e)(2)(i)(C).

Comments are requested on whether additional guidance is needed with respect to section 954(h) (including in particular section 954(h)(2)(B)(ii), which authorizes the Treasury Department to issue regulations regarding corporations not licensed as a bank in the United States) and section 952(c)(1)(B)(vi) (defining a qualified financial institution for purposes of the qualified deficit rules).

In addition, when the regulations defining an FSE were originally promulgated in 1988, section 904(d)(1)(C) assigned financial services income to its own separate category. This separate category was repealed in 2004, effective for taxable years beginning after 2006, but the rules in section 904(d)(2)(C) and (D) were retained. The proposed regulations make additional clarifying changes to reflect the repeal of the separate category for financial services income.

Finally, in 2004, a definition of financial services group was added in section 904(d)(2)(C)(ii) which was based on the definition of an affiliated group under section 1504(a) but expanded to include insurance companies and foreign corporations. While the current regulations already include foreign corporations as part of an affiliated group, proposed § 1.904-4(e)(2)(ii) conforms the definition of an affiliated group to also include insurance companies referenced in section 1504(b)(2).

B. Allocation and Apportionment of Foreign Income Taxes

As explained in Part III.G of the Summary of Comments and Explanation of Revisions to the 2019 FTC final regulations, the Treasury Department and the IRS have determined that additional guidance regarding the allocation and apportionment to separate categories of creditable foreign income taxes in § 1.904-6 is warranted. As a result of changes made by the TCJA, the accurate allocation and apportionment of foreign income taxes to the gross income to which they relate has taken on increased importance. See, for example, sections 245A(d), 960, 965(g), and § 1.861-8(e)(6) (allocating the deduction for foreign income taxes, including at the level of a CFC, to statutory and residual groupings). Therefore, taxpayers will benefit from increased certainty on how to match foreign income taxes with income, particularly in the case of differences in how a U.S. taxable base and foreign taxable base are computed with respect to the same transaction. Furthermore, because these rules are relevant in numerous contexts outside of section 904, the general rules in § 1.904-6 (which address allocating and apportioning taxes to separate categories) have been moved to new proposed § 1.861-20 and generalized to apply for purposes of allocating and apportioning foreign income taxes to statutory and residual groupings. Rules specific to the allocation and apportionment of foreign income taxes to separate categories remain in proposed § 1.904-6. Conforming changes are proposed to §§ 1.704-1(b)(4)(viii)(
d
)(
1
) and 1.960-1(d), which currently rely on the “principles of” § 1.904-6, as well as § 1.965-5(b)(2) (in the case of foreign corporation taxable years beginning after December 31, 2019).

Current § 1.904-6 provides that the allocation and apportionment of foreign tax expense to a section 904 separate category is made on the basis of the income as computed under foreign law on which the tax is imposed; foreign tax is allocated to the separate category to which the income included in the foreign tax base would be assigned under Federal income tax principles.
See
1.904-6(a)(1). If the foreign tax base includes income in more than one separate category, the tax is apportioned among the separate categories on the basis of the relative amounts of foreign taxable income in each category. In making this determination, foreign law rules apply, with certain modifications, to determine the foreign law deductions that reduce the foreign law gross income to compute the foreign law amount of taxable income in each separate category.
See
§ 1.904-6(a)(1)(ii).

Proposed § 1.861-20 adopts the principles of § 1.904-6 but provides more detailed guidance on how to apply those principles, which are illustrated by several examples. Proposed § 1.861-20(c) provides that foreign tax expense is allocated and apportioned among the statutory and residual groupings by first assigning the items of gross income under foreign law (“foreign gross income”) on which a foreign tax is imposed to a grouping, then allocating and apportioning deductions under foreign law to that income, and finally allocating and apportioning the foreign tax among the groupings.
See
proposed § 1.861-20(c).

Proposed § 1.861-20(d)(1) provides a general rule for assigning foreign gross income to a statutory or residual grouping. Under this rule, a foreign gross income item is assigned to a grouping by characterizing the item under Federal income tax law. If an item of gross income or loss arises under Federal income tax law from the same transaction or realization event from which the foreign gross income item arose (a “corresponding U.S. item”), the foreign gross income item is assigned to the same statutory or residual grouping as the corresponding U.S. item. In the case of a corresponding U.S. item that is an item of loss (or zero), the foreign gross income is assigned to the same grouping to which an item of gain would be assigned had the transaction or realization event given rise to an item of gain under Federal income tax law.
See
proposed § 1.861-20(d)(1).

Proposed § 1.861-20(d)(2) sets forth rules for assigning a foreign gross income item to a grouping if there is no corresponding U.S. item in the U.S. taxable year in which the taxpayer paid or accrued the foreign income tax imposed on foreign taxable income that includes the foreign gross income item. Proposed § 1.861-20(d)(2)(i) generally addresses the circumstance in which there is no corresponding U.S. item either because the event giving rise to the foreign gross income is a nonrecognition event under Federal income tax law or because the recognition event giving rise to the foreign gross income occurred under Federal income tax law in a different U.S. taxable year. In both cases, proposed § 1.861-20(d)(2)(i) assigns the foreign gross income to the grouping to which the corresponding U.S. item would be assigned if the event giving rise to the foreign gross income resulted in the recognition of gross income or loss under Federal income tax law in the same U.S. taxable year in which the foreign income tax is paid or accrued.

Proposed § 1.861-20(d)(2)(ii) provides guidance regarding the treatment of foreign gross income items that are either excluded from gross income under Federal income tax law or attributable to base differences. Under § 1.861-20(d)(2)(ii)(A), with the exception of base difference items, foreign gross income that is a type of income expressly excluded from gross income under Federal income tax law is assigned to the grouping to which the gross income would be assigned if it were included in U.S. gross income. Proposed § 1.861-20(d)(2)(ii)(B) provides an exclusive list of items that are excluded from U.S. gross income and that, if taxable under foreign law, are treated as base differences. The items are death benefits described in section 101, gifts and inheritances described in section 102, contributions to capital described in section 118 and the receipt of property in exchange for stock described in section 1032, the receipt of property in exchange for a partnership interest described in section 721, returns of capital described in section 301(c)(2), and distributions to partners described in section 733. The Treasury Department and the IRS have determined that foreign tax on these items, which are excluded from U.S. gross income, is particularly difficult to associate with a particular type of U.S. gross income. Accordingly, foreign tax on base difference items is assigned to the residual grouping, with the result that no credit is allowed if the tax is paid by a CFC, and the tax is assigned to the separate category described in section 904(d)(2)(H)(i) if paid (or treated as paid) by a taxpayer claiming a direct credit under section 901. Comments are requested on whether the list should be expanded to include other items that have no logical analogue to items included in U.S. gross income, or whether a different assignment of any of these types of foreign gross income would be more appropriate.

Proposed § 1.861-20(d)(3) sets forth special rules that apply for purposes of assigning certain items of foreign gross income to a grouping, including rules for distributions that both Federal income tax law and foreign law recognize, certain foreign law distributions such as consent dividends, inclusions under foreign law CFC regimes, disregarded payments, inclusions from reverse hybrids, and gain on the sale of a disregarded entity.

In the case of a distribution from a non-hybrid corporation that is recognized for both Federal income tax

law and foreign tax law purposes, proposed § 1.861-20(d)(3)(i)(B) treats foreign gross income arising from the distribution as a dividend and as capital gain to the extent of the portions of the distribution that are, under Federal income tax law, characterized as a dividend and capital gain, respectively. The foreign gross income is assigned to the same statutory and residual groupings as the corresponding amounts of dividend and capital gain as computed for U.S. tax purposes. Foreign gross income arising from the portion of the distribution that is a return of capital under Federal income tax law is treated as a base difference under proposed § 1.861-20(d)(2)(ii)(B).

If foreign law, but not Federal income tax law, recognizes a deemed distribution or consent dividend (a “foreign law distribution”), proposed § 1.861-20(d)(3)(i)(C) assigns the resulting foreign gross income to a statutory or residual grouping by applying proposed § 1.861-20(d)(3)(i)(B) as though Federal income tax law recognized the distribution in the U.S. taxable year in which the taxpayer paid or accrued tax with respect to the foreign law distribution. For example, if a taxpayer recognizes foreign gross income arising from a foreign law distribution, and proposed § 1.861-20(d)(3)(i)(B) (as applied for purposes of section 904 as the operative section) would treat the distribution as made out of general category section 965(a) previously taxed earnings and profits if the distribution had also occurred under Federal income tax law, the foreign gross income is assigned to the general category.

If a taxpayer (including an upper-tier CFC) includes an item of foreign gross income by reason of a foreign law regime similar to the subpart F provisions under sections 951 through 959 (a “foreign law subpart F regime”), proposed § 1.861-20(d)(3)(i)(D) assigns that item to the same statutory or residual grouping as the gross income (determined under the foreign law subpart F regime) of the foreign law CFC that gave rise to the foreign gross income of the taxpayer. The taxpayer's gross income included under the foreign law subpart F regime is, in other words, treated as the foreign gross income of the foreign law CFC, and the general rules of proposed §§ 1.861-20(d)(1) and (2) apply to characterize that foreign gross income and assign it to the statutory and residual groupings. For example, in applying proposed § 1.861-20(d)(3)(i)(D) in applying section 960 as the operative section where an upper-tier CFC is the taxpayer, the upper-tier CFC's foreign law subpart F inclusion is treated as the foreign gross income of the foreign law CFC, which is treated as if it were the taxpayer. If the foreign law CFC has a corresponding U.S. item of subpart F income for which its United States shareholder elects to apply the high tax exception under section 954(b)(4), the foreign gross income and the associated foreign tax paid by the upper-tier CFC are assigned to a residual income group under § 1.960-1(d). In addition, § 1.904-6(f) includes a special rule assigning certain items of foreign gross income recognized by a United States shareholder of a CFC that is also a foreign law CFC to the section 951A category for purposes of applying section 904 as the operative section.

Proposed § 1.861-20(d)(3)(ii) addresses the assignment of foreign gross income arising from disregarded payments between a foreign branch (as defined in § 1.904-4(f)(3)) and its owner. If the foreign gross income item arises from a payment made by a foreign branch to its owner, proposed § 1.861-20(d)(3)(ii)(A) generally assigns the item to the statutory and residual groupings by deeming the payment to be made ratably out of the after-tax income, computed for Federal income tax purposes, of the foreign branch, and deeming the branch income to arise in the statutory and residual groupings in the same ratio as the tax book value of the assets, including stock, owned by the foreign branch. If the item of foreign gross income arises from a disregarded payment to a foreign branch from its owner, proposed § 1.861-20(d)(3)(ii)(B) generally assigns the item to the residual grouping. However, proposed § 1.861-20(d)(3)(ii)(C) assigns an item of foreign gross income attributable to gain recognized under foreign law with respect to the receipt of a disregarded payment in exchange for property under the rule in § 1.861-20(d)(2)(i). In addition, proposed § 1.904-6(b)(2) includes special rules assigning foreign gross income items arising from certain disregarded payments for purposes of applying section 904 as the operative section.

Proposed § 1.861-20(d)(3)(iii) addresses the assignment to a statutory or residual grouping of foreign gross income that a taxpayer includes by reason of its ownership of a reverse hybrid. Under this rule, the foreign gross income that a taxpayer recognizes from a reverse hybrid is assigned to the statutory and residual groupings by treating that foreign gross income as the income of the reverse hybrid and applying the general rules of proposed § 1.861-20(d). However, § 1.904-6(f) includes a special rule assigning certain items of foreign gross income recognized by a United States shareholder of a controlled foreign corporation that is a reverse hybrid to the section 951A category for purposes of applying section 904 as the operative section. The Treasury Department and the IRS request comments on whether additional rules are needed to address other fact patterns in which the U.S. and a foreign country tax different persons on the same item of income, for example, in the case of a sale-repurchase agreement.

Finally, under proposed § 1.861-20(d)(3)(iv), if a taxpayer recognizes an item of foreign gross income that is gain from the sale of a disregarded entity, and Federal income tax law characterizes the transaction as a sale of the assets of the disregarded entity, the foreign gross income is assigned to the statutory and residual groupings in the same proportion as the gain that the taxpayer would have recognized if foreign law also treated the transaction as a sale of assets.

Changes to § 1.904-6 and § 1.960-1 are proposed to clarify and, in certain cases, modify the application of proposed § 1.861-20 for purposes of computing the foreign tax credit limitation under section 904 and foreign income taxes deemed paid under section 960.

Proposed § 1.904-6(b)(1) assigns foreign gross income that is attributable to a base difference, and the associated tax, to the separate category described in section 904(d)(2)(H)(i). Proposed § 1.904-6(b)(2)(i) generally provides that if a foreign branch makes a disregarded payment to another foreign branch or to its owner that causes the taxpayer's gross income under Federal income tax law that is otherwise attributable to the foreign branch to be attributed to another foreign branch or to the foreign branch owner under § 1.904-4(f)(2)(vi)(A) or § 1.904-4(f)(2)(vi)(D), the foreign gross income that arises by reason of the disregarded payment is assigned to the same category as the reattributed U.S. gross income. Under proposed § 1.904-6(b)(2)(ii), items of foreign gross income that a taxpayer includes solely by reason of the receipt by a foreign branch of a disregarded payment from its foreign branch owner that is a United States person are generally assigned to the foreign branch category (or, in the case of a foreign branch owner that is a partnership, to the partnership's general category income that is attributable to the foreign branch). However, items of foreign gross income attributable to gain recognized under foreign law with respect to the receipt of a disregarded payment in exchange for property are characterized

and assigned under the rules of § 1.861-20(d)(2)(i). Under proposed § 1.904-6(b)(3), if a taxable disposition of property acquired in a disregarded sale results in the recognition of U.S. gross income that is reattributed to or from a foreign branch under § 1.904-4(f)(2)(vi)(A) or § 1.904-4(f)(2)(vi)(D), any foreign gross income arising from that disposition of property under foreign law is assigned to the same separate category as the corresponding U.S. item of gain under § 1.861-20(d)(1) without regard to the reattribution of U.S. gross income. This rule is intended to better match income and taxes in situations where the foreign country only taxes gain that arises during the period that follows the disregarded sale.

Finally, § 1.904-6(f) addresses the circumstance in which a United States shareholder pays or accrues foreign income tax with respect to foreign gross income that it recognizes because it owns a foreign law CFC or a reverse hybrid. The foreign income tax is allocated and apportioned to a category by treating the foreign gross income of the United States shareholder as the foreign gross income of the foreign law CFC or reverse hybrid under proposed §§ 1.861-20(d)(3)(i)(D) or 1.861-20(d)(3)(ii)(B). Proposed § 1.904-6(f) reassigns to the section 951A category the foreign gross income that, if the foreign law CFC or reverse hybrid recognized the foreign gross income instead of the United States shareholder, would be assigned to the general category tested income group of the foreign law CFC or reverse hybrid to which an inclusion under section 951A is attributable. The amount of the foreign gross income that is reassigned is based upon the inclusion percentage, as defined in § 1.960-2(c)(2), of the United States shareholder.

The Treasury Department and the IRS are continuing to study the allocation and apportionment of foreign income tax that is imposed on foreign gross income that is associated with the general category tested income group of a foreign law CFC or reverse hybrid under proposed §§ 1.861-20(d)(3)(i)(D) and 1.861-20(d)(3)(ii)(B), respectively. Comments are requested on the proper treatment of such foreign income tax in the circumstance in which some or all of the tax is not assigned to the section 951A category under proposed § 1.904-6(f) because no inclusion is attributable to the tested income group, or the inclusion percentage of the United States shareholder is less than 100 percent. In particular, comments are requested on the interaction of proposed § 1.904-6(f) with sections 245A(g) and 909.

Proposed § 1.960-1(d)(3)(ii) makes conforming changes and in addition clarifies that, if proposed § 1.861-20 would otherwise apply to assign foreign gross income to a PTEP group that is not increased as a result of a distribution described in section 959(b), the foreign taxable income is assigned to the income group to which the income, computed under Federal income tax law, that gave rise to the PTEP would be assigned if recognized under Federal income tax law in the year in which tax was imposed.

The Treasury Department and the IRS are also studying whether additional guidance should be provided on allocating and apportioning foreign taxes described in section 903 (tax in lieu of income tax), and foreign income taxes for which the foreign taxable base is computed formulaically with respect to a unitary business. The Treasury Department and the IRS are also studying whether the rules in § 1.861-8(e)(6) for allocating and apportioning state income taxes should be revised in light of changes made by the TCJA and changes to state rules for taxing foreign income. Comments are requested on these topics.

C. Overall Foreign Loss Recapture on Property Dispositions

One comment was received with respect to the 2012 OFL proposed regulations, which recommended addressing dispositions that result in additional income recognition under branch loss recapture and dual consolidated loss recapture rules. The comment pointed out that these additional income recognition amounts are determined after first determining the additional recognition amount under section 904(f)(3) and therefore recommended adding the coordination of these rules as a new Step Nine in the ordering rules of § 1.904(g)-3. The comment recommended that the additional income recognition amounts resulting from branch loss recapture and dual consolidated loss recapture should not be subject to the overall foreign loss (OFL) recapture rules.

The branch loss recapture rules under section 367(a) referenced by the comment letter were repealed by the TCJA (subject to a special savings clause that applies with respect to losses incurred before January 1, 2018) and replaced with a new set of branch loss recapture rules in section 91. One of the principal differences between the two regimes is that previously the branch loss recapture amounts were treated as foreign source income, whereas under new section 91(d) they are treated as U.S. source income. Accordingly, although the branch loss recapture amounts for losses incurred after December 31, 2017, are no longer subject to the OFL recapture rules or separate limitation loss (SLL) recapture rules, they are now potentially subject to the overall domestic loss (ODL) recapture rules, and therefore ordering rules are still needed for the application of the branch loss recapture rules, including the rules for losses incurred before January 1, 2018, that are subject to the special savings clause.

The Treasury Department and the IRS agree with the recommendation to add a new Step Nine to § 1.904(g)-3 to clarify that additional income amounts recognized by reason of branch loss recapture and dual consolidated loss recapture are not taken into account for purposes of the ordering rules until after the section 904(f)(3) amounts are determined. However, the Treasury Department and the IRS do not agree that those additional income amounts should not be subject to the OFL or ODL recapture rules. The fact that a loss recapture rule may provide that the additional income amount is treated as U.S. source income does not mean it should be treated any differently than any other U.S. source income that is subject to the ODL recapture rules. The same reasoning applies to additional income amounts that are treated as foreign source income and therefore subject to the OFL recapture rules. Accordingly, Step Nine in proposed § 1.904(g)-(3)(j) provides that like section 904(f)(3) recapture amounts addressed in Step Eight, the additional income recognized by reason of branch loss and dual consolidated loss recapture will be subject to the first seven steps of the ordering rules. However, Step Nine applies only to additional income amounts with respect to branch loss and dual consolidated loss recapture that are determined after taking into account an offset for a section 904(f)(3) recapture amount. For example, if a taxpayer has a dual consolidated loss recapture in a year in which there is no section 904(f)(3) recapture, then there is only one application of Steps One through Seven, which takes into account the additional income, and Steps Eight and Nine will not apply.

When Step Nine applies, the proposed regulations provide that for purposes of determining how much of the additional income with respect to branch loss and dual consolidated loss recapture will be subject to the ODL, OFL or SLL recapture rules, any increases to an ODL, OFL or SLL account balance in the current year due to the original application of Steps One

through Seven (prior to the application of Steps Eight or Nine) are taken into account.

In addition, if any additional income with respect to a branch loss or dual consolidated loss recapture is foreign source income in a separate category for which there is a remaining OFL account balance after Steps One through Eight, a special rule applies for purposes of determining the OFL recapture amount under § 1.904(f)-2(c) (the lesser of the maximum potential recapture or 50 percent of total foreign source income). The special rule provides that a taxpayer must first determine a hypothetical OFL recapture amount, which is the OFL recapture amount that would have been determined in the original application of Steps One through Seven (prior to the application of Steps Eight and Nine) if the additional income in Step Nine were also taken into account. From that hypothetical OFL recapture amount, the taxpayer subtracts the actual OFL recapture amount that was determined in the original application of Steps One through Seven (without taking into account the additional income in Step Nine). The remainder is then the OFL recapture amount with respect to the additional income in Step Nine. This special rule is necessary because a simple reapplication of the OFL recapture amount rules in § 1.904(f)-2(c) to just the additional income in Step Nine could result in requiring an excessive amount of recapture, because the same amount of foreign source income in other separate categories may be used twice to increase the OFL recapture amount (once in the original calculation and again in the second calculation with respect to the additional income).

III. Foreign Tax Redeterminations Under Section 905(c)

As discussed in Part III of the Background section of the 2019 FTC final regulations, portions of the temporary regulations relating to sections 905(c), 986(a), and 6689 (TD 9362) (the “2007 temporary regulations”) are being reproposed in order to provide taxpayers an additional opportunity to comment on those rules in light of the changes made by the TCJA. References in this preamble to the 2007 temporary regulations are understood to refer to the corresponding provisions of the accompanying proposed regulations, which were issued by cross-reference to the 2007 temporary regulations at 72 FR 62805.

In particular, the rules being reproposed are: (1) § 1.905-3T(d)(2), which addresses foreign tax redeterminations that affect foreign taxes deemed paid under section 960, (2) § 1.905-4T, which in general provides the procedural rules for how to notify the IRS of a foreign tax redetermination, and (3) § 301.6689-1T, which provides rules for the penalty for failure to notify the IRS of a foreign tax redetermination. In addition, the proposed regulations contain a transition rule in proposed §§ 1.905-3(b)(2)(iv) and 1.905-5 to address foreign tax redeterminations of foreign corporations that relate to taxable years before the amendments made by the TCJA.
See
Part III.D of this Explanation of Provisions.

A. Adjustments to Foreign Taxes Paid by Foreign Corporations

Section 1.905-3T(d)(2) of the 2007 temporary regulations reflects the law in effect before the TCJA, which generally required foreign tax redeterminations of foreign corporations to be taken into account by prospectively adjusting the foreign corporations' pools of post-1986 undistributed earnings and post-1986 foreign income taxes, rather than by adjusting the calculation of deemed-paid taxes and the United States shareholder's (“U.S. shareholder”) U.S. tax liability in the prior year or years in which the adjusted foreign tax was included in the calculation of foreign taxes deemed paid. Section 1.905-3T(d)(3) of the 2007 temporary regulations provides exceptions to the pooling adjustment rules that required redeterminations of the U.S. shareholder's U.S. tax liability in situations where refunds or other downward adjustments to a foreign corporation's foreign tax liability would otherwise cause a substantial overstatement of deemed paid taxes. With the repeal of the pooling regime and related amendments to section 905(c) in the TJCA, the statute now requires U.S. tax redeterminations to reflect all foreign tax redeterminations, including those that result in adjustments to foreign taxes deemed paid. Accordingly, proposed § 1.905-3(b)(2)(i) provides that a U.S. tax redetermination is required in all cases to account for the effect of a foreign corporation's foreign tax redetermination.

Section 1.905-3T(d)(3)(ii), illustrated by an example in § 1.905-3T(d)(3)(iii), provides that the required U.S. tax redetermination is made by taking the foreign tax redetermination into account in the prior year to which the redetermined foreign tax relates, and further provides that a U.S. tax redetermination is also required for any subsequent year in which the domestic corporate shareholder received or accrued a distribution or inclusion from the foreign corporation, which under pre-TCJA law would have resulted in foreign taxes deemed paid. Under these rules, the amount of the adjusted foreign tax was deemed to “relate back” and adjust the foreign corporation's earnings and profits, as well as its creditable foreign taxes, in the adjusted year.

In any case where a U.S. tax redetermination and adjustment to deemed paid taxes is required, an adjustment to the foreign corporation's taxable income and earnings and profits in the functional currency amount of the adjusted foreign tax (whether upward to reflect a refund or downward to reflect an additional payment of foreign tax) in the relation-back year is necessary in order to coordinate the computation of the U.S. shareholder's inclusions with the amount of the section 78 dividend in the amount of the adjusted foreign taxes deemed paid. This is because under sections 954(b)(5) and 951A(c)(2)(ii), the creditable foreign tax reduces the foreign corporation's subpart F income, tested income, and earnings and profits, so that the amount included in the U.S. shareholder's income under sections 951 and 951A is an after-foreign-tax amount; the section 78 dividend prevents the effective allowance of both a deduction and a credit for an amount of foreign tax that both reduces the inclusion and is allowed as a deemed paid foreign tax credit. If the foreign corporation's deduction from income and earnings and profits in respect of foreign taxes were adjusted in a different year than the year in which its creditable foreign taxes were adjusted, the amount of foreign tax that reduces the U.S. shareholder's inclusion and the amount added to income under section 78 in respect of the deemed paid tax would not match, such that the U.S. shareholder's income would be understated or overstated by the amount of the foreign tax adjustment.

Accordingly, proposed § 1.905-3(b)(2)(ii) clarifies that the required adjustments by reason of a foreign tax redetermination of a foreign corporation include not only adjustments to the amount of foreign taxes deemed paid and related section 78 dividend, but also adjustments to the foreign corporation's income and earnings and profits and the amount of the U.S. shareholder's inclusions under sections 951 and 951A in the year to which the redetermined foreign tax relates. The TCJA amendments, by eliminating deemed paid taxes under section 902 with respect to dividends and basing deemed paid taxes under section 960

with respect to subpart F and GILTI inclusions on current year income and taxes rather than multi-year pools, will require more redeterminations of U.S. tax liability to adjust deemed paid credits under section 960, but fewer adjustments to intervening years, since a foreign tax adjustment to one year will generally no longer affect the calculation of deemed paid taxes with respect to inclusions in other years. New examples at proposed § 1.905-3(b)(2)(v) illustrate these rules.

Section 905(c)(1)(B) and (C) require a redetermination of U.S. tax if accrued taxes remain unpaid after two years, or if any tax paid is refunded in whole or in part. These provisions are not limited to cases in which the foreign tax redetermination reduces the amount of the foreign tax credit. Accordingly, proposed §§ 1.905-3(a) and 1.905-3(b)(2)(ii) also provide that the rules under section 905(c) apply in cases in which foreign tax redeterminations affect U.S. tax liability even though there may be no change to the amount of foreign tax credits originally claimed. For example, under the proposed regulations a redetermination of U.S. tax liability is required when a foreign tax redetermination affects whether or not a taxpayer is eligible for the high-tax exception under section 954(b)(4) (the “subpart F high-tax exception”) in the year to which the redetermined foreign tax relates. Similarly, a foreign tax redetermination could affect the subpart F income, tested income, and earnings and profits of a CFC in the year to which the tax relates, see proposed § 1.905-3(b)(2)(ii), and therefore affect the amount of a U.S. shareholder's inclusion under section 951 or section 951A with respect to the adjusted year. Corresponding amendments are proposed to the rules in §§ 1.904-4(c)(7) and 1.954-1(d).

B. Foreign Tax Redeterminations of Successor Entities

The proposed regulations at § 1.905-3(b)(3) add a rule clarifying that if at the time of a foreign tax redetermination the person with legal liability for the tax (the “successor”) is a different person than the person that had legal liability for the tax in the year to which the redetermined tax relates (the “original taxpayer”), the required redetermination of U.S. tax liability is made as if the foreign tax redetermination occurred in the hands of the original taxpayer. This could occur, for example, if a disregarded entity is sold to a different taxpayer, or if a CFC liquidates into another CFC that has transferee liability for the liquidated CFC's foreign tax. The proposed regulations further provide that Federal income tax principles apply to determine the tax consequences if the successor remits, or receives a refund of, a tax that in the year to which the redetermined tax relates was the legal liability of, and thus considered paid by, the original taxpayer. Thus, for example, when the original taxpayer owns the successor which remits a tax that was the legal liability of, and considered paid by, the original taxpayer (for example, if a controlled foreign corporation that was formerly a disregarded entity pays additional tax after a foreign audit), then a distribution can result from the successor to the original taxpayer.
See Herbert Enoch,
57 T.C. 781 (1972) (finding constructive dividend when a corporation discharged its shareholder's personal liability on debt). The Treasury Department and the IRS request comments on whether additional rules are required to address situations involving predecessors or successors.

C. Notification to the IRS of Foreign Tax Redeterminations and Related Penalty Provisions

Proposed § 1.905-4 contains rules for notifying the IRS of a foreign tax redetermination. Proposed § 301.6689-1 contains rules regarding the penalty for failure to notify the IRS of a foreign tax redetermination. This Part III.C describes changes made to §§ 1.905-4 and 301.6689-1 relative to the rules that were contained in the 2007 temporary regulations.

1. Notification Through Amended Returns

Section 1.905-4T(b)(1)(iv) of the 2007 temporary regulations provides that, if more than one foreign tax redetermination requires a redetermination of U.S. tax liability for the same taxable year of the taxpayer (the affected year) and those redeterminations occur within two consecutive taxable years, the taxpayer generally may file for the affected year one amended return, Form 1118 (Foreign Tax Credit—Corporations) or Form 1116 (Foreign Tax Credit), and one statement under § 1.905-4T(c) with respect to all of the redeterminations. Proposed § 1.905-4(b)(1)(iv) clarifies that, if more than one foreign tax redetermination requires a redetermination of U.S. tax liability for the same affected year and those redeterminations occur within the same taxable year or within two consecutive taxable years, the taxpayer may file for the affected year one amended return and one statement under proposed § 1.905-4(c) with respect to all of the redeterminations. Proposed § 1.905-4(b)(1)(iv) also provides that the due date of the amended return and statement varies depending on whether the net effect of the foreign tax redeterminations reduces or increases the U.S. tax liability in the affected taxable year.

Section 1.905-4T(b)(1)(v) of the 2007 temporary regulations provides that, if a foreign tax redetermination requires a redetermination of U.S. tax liability that otherwise would result in an additional amount of U.S. tax due, but such amount is eliminated as a result of a carryback or carryover of an unused foreign tax under section 904(c), the taxpayer may, in lieu of applying the rules of §§ 1.905-4T(b)(1)(i) and (b)(1)(ii), notify the IRS of such redetermination by attaching a statement to the original return for the taxpayer's taxable year in which the foreign tax redetermination occurs. Section 1.905-4T(b)(1)(v) of the 2007 temporary regulations does not apply if the foreign tax redetermination does not change the U.S. tax liability for the taxable year to which the tax relates for a reason other than the carryback or carryover of an unused foreign tax. Section 1.905-4T(b)(1)(v) of the 2007 temporary regulations also does not apply if more than one foreign tax redetermination occurring within the same taxable year or two consecutive taxable years requires a redetermination of U.S. tax liability for the same taxable year but, taking into account all such foreign tax redeterminations on a net basis, results in no additional amount of U.S. tax liability due for such taxable year.

Proposed § 1.905-4(b)(1)(v) provides that, if a foreign tax redetermination (either alone or in combination with certain other foreign tax redeterminations as provided in proposed § 1.905-4(b)(1)(iv)) does not result in a change to the amount of U.S. tax due for a taxable year, for reasons including but not limited to a carryover or carryback of unused foreign taxes under section 904(c), no amended return is required for such year. Instead, appropriate adjustments are made to the amounts carried over from that year (for example, unused foreign taxes). If no amended return is required for any year, the taxpayer must attach a statement containing the information described in § 1.904-2(f) to the taxpayer's timely filed (with extensions) original return for the taxpayer's taxable year in which the foreign tax redetermination occurs.

2. Foreign Tax Redeterminations of Pass-Through Entities

The 2007 temporary regulations did not specifically provide guidance for

pass-through entities that report creditable foreign taxes to their partners, shareholders, or beneficiaries and subsequently have a foreign tax redetermination with respect to such foreign taxes. The proposed regulations provide rules whereby these entities can satisfy their obligations under section 905(c). Proposed § 1.905-4(b)(2) generally provides that a pass-through entity that reports creditable foreign income tax to its partners, shareholders, or beneficiaries, is required to notify the IRS and its partners, shareholders, or beneficiaries if there is a foreign tax redetermination with respect to such foreign income tax. See proposed § 1.905-4(c) for the information required to be provided with the notification.

Additionally, in 2015, Congress introduced the centralized audit partnership regime, which requires that certain adjustments be made at the level of the partnership, rather than by partners.
See
sections 6221 through 6241 (enacted in § 1101 of the Bipartisan Budget Act of 2015, Pub. L. 114-74 (“BBA”) and as amended by the Protecting Americans from Tax Hikes Act of 2015, Pub. L. 114-113, div Q, and by sections 201 through 207 of the Tax Technical Corrections Act of 2018, contained in Title II of Division U of the Consolidated Appropriations Act of 2018, Pub. L. 115-141). Under this regime, in order to make an adjustment to a partnership-related item (as defined in section 6241(2)), the partnership must file an administrative adjustment request (“AAR”). Sections 6227(d) and 6235(a) contemplate that these rules will be coordinated with the application of section 905(c).

On June 14, 2017, the Treasury Department and the IRS published in the
Federal Register
(82 FR 27334) a notice of proposed rulemaking and on November 30, 2017, the Treasury Department and the IRS published in the
Federal Register
(82 FR 56765) another notice of proposed rulemaking. Each notice of proposed rulemaking requested comments on how a partnership subject to the centralized partnership audit regime should fulfill the requirements of section 905(c). One comment was received with respect to this issue and it recommended that partnerships satisfy their obligations under section 905(c) by filing an AAR under section 6227 and by following the procedures under that section to take necessary adjustments into account. Consistent with this request and with sections 6227(d) and 6235(a), proposed § 1.905-4(b)(2)(ii) provides that if a redetermination of U.S. tax liability would require a partnership adjustment as defined in § 301.6241-1(a)(6), the partnership must file an AAR under section 6227 without regard to the time restrictions on filing an AAR in section 6227(c).
See also
§ 1.6227-1(g).

The use of the AAR process, even if the period under section 6227(c) is closed, is intended to further the purpose of sections 905(c), 6227(d), 6235(a), and 6241(11). An AAR is analogous to an amended return, which is required from other taxpayers who have a foreign tax redetermination, and provides an administrable process whereby a partnership, and its partners, can satisfy their obligations under section 905(c). The Treasury Department and the IRS request comments on any further coordination that may be required between sections 905(c) and 6227 in order to carry out the purposes of the foreign tax credit and the centralized partnership audit regime.

3. Alternative Notification Requirements

Proposed § 1.905-4(b)(3) provides that an amended return and Form 1118 (Foreign Tax Credit—Corporations) or Form 1116 (Foreign Tax Credit), is not required to notify the IRS of a foreign tax redetermination and redetermination of U.S. tax liability if the taxpayer satisfies alternative notification requirements that may be prescribed by the IRS through forms, instructions, publications, or other guidance. For example, as provided in Notice 2016-10, 2016-1 I.R.B. 1, the Treasury Department and the IRS intend to issue regulations providing for alternative notification procedures in the case of tax refunds received by regulated investment companies making the election to pass through foreign tax credits under section 853. The Treasury Department and the IRS request comments on additional alternative approaches to complying with the notification requirements in section 905(c) that minimize burdens to both taxpayers and the IRS.

4. Foreign Tax Redeterminations of LB&I Taxpayers

Section 1.905-4T(b)(3) of the 2007 temporary regulations provides a special rule for U.S. taxpayers under the jurisdiction of the Large and Mid-Size Business Division. The proposed regulations reflect the organization's name change to Large Business and International Division (LB&I).

Under the special rule for U.S. taxpayers under LB&I jurisdiction (“LB&I rule”), such taxpayers are required, in limited circumstances, to provide to their examiners notice of a foreign tax redetermination that requires a redetermination of U.S. tax, in lieu of filing an amended return. One of the threshold requirements of § 1.905-4T(b)(3) of the 2007 temporary regulations is that the taxpayer must provide the statement describing the foreign tax redetermination no later than 120 days after the latest of (1) the date the foreign tax redetermination occurs, (2) the opening conference of the examination for the affected taxable year, or (3) the hand-delivery or postmark date of the opening letter concerning the examination. In no case, however, can the alternative notification procedure apply if the 120-day period within which notification must be made would start after the due date of the return for the taxable year in which the foreign tax redetermination occurs.

The LB&I rule contained in the proposed regulations is generally the same as the rule in the 2007 temporary regulations, and the Explanation of Provisions of the 2007 temporary regulations contains an explanation of the rules. However, one change has been made with respect to § 1.905-4T(b)(3) of the 2007 temporary regulations. Section 1.905-4T(b)(3) provides that, if that provision applies to permit notification during an audit, in lieu of filing an amended return a taxpayer must provide to the examiner the statement described in § 1.905-4T(c) of the 2007 temporary regulations, which contains information that enables the IRS to verify and compare the original computations with respect to a claimed foreign tax credit, the revised computations resulting from the foreign tax redetermination, and the net changes resulting therefrom. In order to satisfy the requirements of § 1.905-4T(c), a taxpayer is required to recompute its U.S. tax liability during the course of an examination, rather than only at the conclusion of the audit. To minimize administrative burdens, the statement requirement at proposed § 1.905-4(b)(4)(iii) requires the taxpayer to provide to the examiner the original amount of foreign taxes paid or accrued in the year to which the foreign tax redetermination relates, the revised amount of foreign taxes paid or accrued, and documentation with respect to the revisions, including exchange rates and dates of accrual and/or payment. This information must be provided with a penalties-of-perjury declaration signed by a person authorized to sign the return of the taxpayer.

In order to clarify when the special rules for LB&I taxpayers apply, the proposed regulations reorganize certain portions of the 2007 temporary regulations into a list of conditions, all of which must be met in order for § 1.905-4(b)(4) to apply. These

conditions are as follows: (1) A foreign tax redetermination occurs while the U.S. taxpayer is under the jurisdiction of LB&I (or a successor division); (2) the foreign tax redetermination results in a downward adjustment to the amount of foreign tax paid or accrued, or included in the computation of foreign taxes deemed paid; (3) the foreign tax redetermination requires a redetermination of U.S. tax liability and accordingly, but for § 1.905-4(b)(4), the taxpayer would be required to notify the IRS of such foreign tax redetermination under § 1.905-4(b)(1)(ii) by filing an amended return; (4) the return for the taxable year for which a redetermination of U.S. tax liability is required is under examination; and (5) the due date specified in § 1.905-4(b)(1)(ii) for providing notice of such foreign tax redetermination is not before the latest of the opening conference or the hand-delivery or postmark date of the opening letter concerning the examination of the return for the taxable year for which a redetermination of U.S. tax liability is required by reason of such foreign tax redetermination.

5. Penalty Provisions

Section 6689 provides that a taxpayer may be subject to a penalty if it fails to notify the IRS of a foreign tax redetermination on or before the date prescribed by regulations. Section 301.6689-1T(a) (issued in TD 8210 on June 22, 1988) states that the penalty may apply if a taxpayer fails to notify the IRS of a foreign tax redetermination “on or before the date prescribed in regulations.” However, the preamble of the 2007 temporary regulations, in describing section 6689, provides that, “Under section 6689, a taxpayer that fails to notify the IRS of a foreign tax redetermination in the time
and manner
prescribed by regulations for giving such notice is subject to a penalty.” (Emphasis added.) Because it is implicit in section 6689 that the required notification must comply with the requirements of section 905(c), the proposed regulations conform to the preamble description in the 2007 temporary regulations. Accordingly, proposed § 301.6689-1(a) provides that the penalty may apply if a taxpayer fails to notify the IRS of a foreign tax redetermination “on or before the date and in the manner prescribed in regulations.”

The penalty under section 6689 is generally computed by reference to the amount of the deficiency resulting from a foreign tax redetermination. If a partnership fails to timely file an AAR as required under proposed § 1.905-4(b)(2)(ii) such that the penalty under section 6689 is applicable there is ambiguity regarding the correct base upon which the penalty is computed because partnerships do not generally have deficiencies in chapter 1 tax. Under the centralized partnership audit regime enacted by the BBA, if an adjustment is made to a partnership-related item of a partnership that is subject to the BBA (either by the IRS or by the partnership upon the filing of an AAR), the default rule is that the partnership is liable for an imputed underpayment calculated on the adjustments, which is an approximate substitute for the amount of chapter 1 tax that would have been owed by its partners.
See
sections 6221(a) and 6225. The fact that section 6689 is silent as to the proper base for calculating a section 6689 penalty for a partnership that is subject to BBA creates a special enforcement consideration and requires clarification. Therefore, consistent with the principles of section 6233(a)(3) (which treats the imputed underpayment as an understatement or underpayment for purposes of computing a penalty) and the requirement in section 6227(d) that regulations coordinate the application of sections 905(c) and 6227, proposed § 301.6689-1 provides that in computing the amount of the penalty imposed under section 6689, the penalty is calculated on a deficiency or by reference to the amount of the imputed underpayment that results from the foreign tax redetermination.

Finally, because section 6662 may apply if a taxpayer's U.S. tax liability is understated on an original return even if section 6689 applies to a failure to notify the IRS of a subsequent foreign tax redetermination, the proposed regulations eliminate the reference in § 301.6689-1(b) to section 6653(a) (the predecessor to section 6662).

D. Transition Rule Relating to the TCJA

The TCJA repealed the pooling rules of section 902 and related provisions of section 905(c) that mandated prospective pooling adjustments to account for redeterminations of foreign taxes paid by foreign corporations that were eligible to be deemed paid by domestic corporate shareholders of the foreign corporations. Proposed §§ 1.905-3(b)(2)(iv) and 1.905-5 provide a transition rule providing that post-2017 redeterminations of pre-2018 foreign income taxes must be accounted for by adjusting the foreign corporation's taxable income and earnings and profits, 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. A redetermination of U.S. tax liability is required to account for the effect of the foreign tax redetermination 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 960 with respect to the foreign corporation, as well as any year to which unused foreign taxes from any such year were carried. The proposed regulations generally apply the currency translation rules applicable under prior law and the notification requirements of proposed § 1.904-4 to redeterminations of U.S. tax liability required by proposed § 1.905-3(b)(2)(iv) in these circumstances.

The Treasury Department and the IRS request 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.

IV. Foreign Income Taxes Taken Into Account Under Section 954(b)(4)

As discussed in Part III.A of this Explanation of Provisions, proposed § 1.905-3(b)(2) provides that a U.S. tax redetermination is required when a foreign tax redetermination affects whether or not a taxpayer is eligible for the subpart F high-tax exception. Proposed § 1.954-1(d)(3)(iii) therefore provides that the subpart F high-tax exception is applied by taking into account the redetermined foreign tax in the adjusted year.

The proposed regulations also include an additional clarification relating to schemes involving jurisdictions that do not impose corporate income tax on a CFC until its earnings are distributed. The Treasury Department and the IRS are aware that certain taxpayers claim that taxes are treated as paid or accrued for purposes of § 1.954-1(d)(3) even in the absence of any distribution triggering foreign tax. The IRS may challenge this position under existing law. Furthermore, the proposed regulations clarify that foreign income taxes that have not accrued because they are contingent on a future distribution are not taken into account for purposes

of determining the amount of foreign income taxes paid or accrued with respect to an item of income. However, if a redetermination of U.S. tax liability is required under proposed §§ 1.905-3(a) and 1.905-3(b)(2)(ii) when tax is imposed on the foreign corporation in connection with a distribution, the redetermined foreign tax is taken into account in applying § 1.954-1(d)(3) in the adjusted year.

V. Disallowance of Foreign Tax Credits Under Section 965(g)

The Treasury Department and the IRS are aware that certain taxpayers may have engaged in certain transactions that are intended to avoid the disallowance of foreign tax credits under section 965(g) with respect to distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits. For example, certain U.S. shareholders of specified foreign corporations may incur foreign income taxes on distributions recognized for foreign tax purposes that are not recognized for U.S. tax purposes (for example, consent dividends). When the section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits are distributed for U.S. tax purposes, no foreign income tax is imposed by the foreign jurisdiction. The taxpayers may argue that the foreign income taxes on the foreign distributions are not associated with a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits for U.S. tax purposes, and, accordingly, the credit need not be reduced by the section 965(g) disallowance.

Proposed § 1.965-5(b)(2) clarifies that the principles of § 1.904-6 apply in determining the extent to which foreign income taxes are attributable to distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits for purposes of § 1.965-5(b)(1). For example, under the principles of § 1.904-6, foreign withholding taxes imposed on an amount that is recognized as a dividend for foreign, but not Federal income, tax purposes are attributable to an item of income to which that amount would be assigned if recognized as a distribution for Federal income tax purposes. To the extent a distribution would be a distribution of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits if it were recognized for U.S. tax purposes, under proposed § 1.965-5(b)(2) the tax would be associated with section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits and disallowed in part by reason of section 965(g). For foreign corporation taxable years beginning after December 31, 2019, § 1.861-20 applies in lieu of § 1.904-6.

The IRS may challenge the credits claimed for foreign income taxes imposed on distributions recognized solely for foreign tax purposes in prior years to the extent that such foreign income taxes would be considered imposed on distributions of section 965(a) previously taxed earnings and profits or section 965(b) previously taxed earnings and profits had such distributions been recognized for U.S. tax purposes.

VI. Updates to Consolidated Foreign Tax Credit Rules

Proposed § 1.1502-4 includes amendments to regulations under section 1502 relating to the computation of the consolidated foreign tax credit. The proposed amendments update the regulations to reflect changes in the law, such as by eliminating out-of-date references to the per-country limitation. For purposes of determining the foreign tax credit limitation, the proposed regulations also provide that the amount of foreign source income in each separate category, used as the numerator in the foreign tax credit limitation fraction, is determined by applying the rules of § 1.1502-11, as well as sections 904(f) and 904(g), on a group-wide basis, rather than applying those rules on a separate member basis and combining the results.

The proposed regulations also add new rules for purposes of determining the source and separate category of a consolidated NOL, as well as the portion of a consolidated net operating loss (“CNOL”) that is apportioned to a separate return year of a member. The Treasury Department and the IRS have determined that, when characterizing a CNOL that is apportioned to a separate return year, it is generally appropriate to link the source and separate category of the CNOL with the member's assets that are expected to produce income with that same source and separate category so as to minimize the creation of loss accounts under sections 904(f) and 904(g) in the year in which the CNOL is used. The proposed regulations achieve this result formulaically through a two-step process that generally determines a CNOL's source and separate category by reference to the statutory and residual groupings described in § 1.861-8 for purposes of applying section 904 as the operative section, which are foreign source income in each separate category, and the residual grouping, which is U.S. source income.

First, the member determines a tentative apportionment, which is a proportionate share of the amount of the CNOL in each grouping based on a comparison of the value of the member's assets in that grouping to the value of the group's total assets in the grouping. Because the total of tentative apportionments of the CNOL does not necessarily equal the member's total share of the CNOL, an adjustment is provided. If the total tentative apportionments exceed the CNOL attributable to the member, the tentative apportionment in each grouping is reduced by a pro rata share of the excess, in proportion to the amount of the tentative apportionment in that grouping over the total tentative apportionments. In contrast, if the total tentative apportionments are less than the CNOL attributable to the member, the tentative apportionment in each grouping is increased by a pro rata share of that deficiency, in proportion to the remaining CNOL in that grouping (after subtracting the tentative apportionment) over the total remaining CNOL in all groupings.

VII. Applicability Dates

The rules in proposed §§ 1.861-8, 1.861-9, 1.861-12, 1.861-14, 1.904-4(c)(7) and (8), 1.904(b)-3, 1.954-1, and 1.954-2, generally apply to taxable years that end on or after December 16, 2019.

The rules in proposed §§ 1.704-1(b)(4)(viii)(
d
)(
1
), 1.861-17, 1.861-20, 1.904-6, and 1.960-1 apply to taxable years beginning after December 31, 2019. However, taxpayers that are on the sales method for taxable years beginning after December 31, 2017, and before January 1, 2020, may rely on proposed § 1.861-17 if they apply it consistently. Therefore, a taxpayer on the sales method for its taxable year beginning in 2018 may rely on proposed § 1.861-17 but must also apply the sales method (relying on proposed § 1.861-17) for its taxable year beginning in 2019.

Proposed §§ 1.904-4(e) and 1.904(g)-3 apply to taxable years ending on or after the date the final regulations are filed with the
Federal Register
.

In general, proposed §§ 1.905-3, 1.905-4, 1.905-5, and 301.6689-1 apply to foreign tax redeterminations (as defined in § 1.905-3(a)) occurring in taxable years ending on or after December 16, 2019, and to foreign tax redeterminations of foreign corporations occurring in taxable years that end with or within a taxable year of a U.S.

shareholder ending on or after December 16, 2019. In the case of foreign tax redeterminations of foreign corporations, proposed § 1.905-3 is limited to foreign tax redeterminations that relate to taxable years of foreign corporations beginning after December 31, 2017, and proposed § 1.905-5 is limited to foreign tax redeterminations that relate to taxable years of foreign corporations beginning before January 1, 2018.

Proposed § 1.965-5(b)(2) app

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2019-24847. Public record. Not legal advice.