# Foreign Tax Credit Guidance Related to the Tax Cuts and Jobs Act, Overall Foreign Loss Recapture, and Foreign Tax Redeterminations

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2019-24848

## Record

- **Collection:** Federal Register
- **Document type:** Rule
- **Published:** December 17, 2019
- **Citation:** 84 FR 69022

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9882]
RIN 1545-BP19; 1545-BK55; 1545-AC09
Foreign Tax Credit Guidance Related to the Tax Cuts and Jobs Act, Overall Foreign Loss Recapture, and Foreign Tax Redeterminations

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Final and temporary regulations, and removal of temporary regulations.

SUMMARY:

This document contains final regulations that provide guidance relating to the determination of the foreign tax credit under the Internal Revenue Code. The guidance relates to changes made to the applicable law by the Tax Cuts and Jobs Act, which was enacted on December 22, 2017. This document finalizes the proposed regulations published on December 7, 2018. This document also finalizes proposed regulations on overall foreign losses that were published on June 25, 2012, and finalizes certain portions of proposed regulations published on November 7, 2007, relating to a U.S. taxpayer's obligation to notify the IRS of a foreign tax redetermination.

DATES:

Effective Date:
These regulations are effective on December 17, 2019.

Applicability Dates:
For dates of applicability, see §§ 1.861-8(h), 1.861-9(k), 1.861-10(f), 1.861-11(h), 1.861-13(d), 1.861-17(i), 1.901(j)-1(b), 1.904-1(e), 1.904-2(k), 1.904-3(h), 1.904-4(q), 1.904-5(o), 1.904-6(d), 1.904(b)-3(f), 1.904(f)-12(j)(6), 1.904(g)-3(l), 1.905-3(d), 1.954-1(h), 1.960-7, 1.965-9(c), and 1.986(a)-1(f).

FOR FURTHER INFORMATION CONTACT:

Concerning §§ 1.861-8 through 1.861-13, 1.861-17, and 1.904(b)-3, Jeffrey P. Cowan, (202) 317-4924; concerning §§ 1.901(j)-1, 1.904-1 through 1.904-6, 1.904(f)-12, 1.904(g)-3, 1.905-3, 1.954-1, 1.986(a)-1, Jeffrey L. Parry, (202) 317-4916, or Larry R. Pounders, (202) 317-5465; concerning § 1.960-1 through 1.960-7, Suzanne M. Walsh, (202) 317-4908; concerning §§ 1.965-5 and 1.965-9, Karen J. Cate, (202) 317-4667 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

I. Proposed Regulations Implementing the TCJA

On December 7, 2018, the Department of the Treasury (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”). The 2018 FTC proposed regulations relate to changes made by the Tax Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054, 2208 (2017)) (the “TCJA”) and other foreign tax credit issues. Terms used but not defined in this preamble have the meaning provided in these regulations (the “final regulations”).

A public hearing on the proposed regulations was scheduled for March 14, 2019, but it was not held because there were no requests to speak. The Treasury Department and the IRS also received written comments with respect to the 2018 FTC proposed regulations. Certain portions of the proposed regulations relating to §§ 1.78-1, 1.861-12(c)(2), and 1.965-7(e) were finalized as part of TD 9866, published in the
Federal Register
(84 FR 29288) on June 21, 2019. Comments received that do not pertain to the rules in the proposed regulations or that are otherwise outside the scope of this rulemaking are generally not addressed in this preamble but may be considered in future guidance projects addressing the issues discussed in the comments. All written comments received in response to the 2018 FTC proposed regulations are available at
www.regulations.gov
or upon request.

II. Proposed Regulations Relating to Overall Foreign Loss Recapture on Property Dispositions

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 income with capital gains adjustments 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. One comment was received concerning the 2012 OFL proposed regulations. A public hearing was not requested and none was held.

III. Proposed and Temporary Regulations Under Sections 905(c) and 986(a)

On June 23, 1988, the
Federal Register
published a notice of proposed rulemaking by cross-reference to temporary regulations (TD 8210) (the “1988 temporary regulations”) at 53 FR 23659 and 53 FR 23611, respectively, relating to a taxpayer's obligation under section 905(c) to notify the IRS of a foreign tax redetermination or to make adjustments to the pools of post-1986 undistributed earnings and foreign income taxes of the taxpayer's foreign subsidiaries. The 1988 temporary regulations also provided guidance regarding the civil penalty under section 6689 for failure to file the notice required under section 905(c). In response to the written comments received on the 1988 temporary regulations, on March 16, 1990, the Treasury Department and the IRS issued Notice 90-26, 1990-1 C.B. 336, which suspended the portion of the 1988 temporary regulations that provided rules for accounting for foreign tax redeterminations that affect the calculation of the indirect foreign tax credit under sections 902 and 960.

On May 15, 2006, the Treasury Department and the IRS issued Notice 2006-47, 2006-1 C.B. 892, which provides interim rules allowing a taxpayer that otherwise would be required to use an average exchange rate translation convention to elect to translate foreign income taxes into U.S. dollars (dollars) using the exchange rates when the taxes were paid, either for all foreign income taxes or only for those foreign income taxes denominated in nonfunctional currency that are attributable to qualified business units within the meaning of section 989(a) (QBUs) with dollar functional currencies.

On November 7, 2007, the
Federal Register
published new temporary regulations (T.D. 9362) (the “2007 temporary regulations”) at 72 FR 62771 and published a partial withdrawal of the notice of proposed rulemaking relating to the 1988 temporary regulations and a new notice of proposed rulemaking by cross-reference to the 2007 temporary regulations at 72 FR 62805. Corrections to the temporary and proposed regulations were published on December 19, 2007, in the
Federal Register
(72 FR 71787 and 72 FR 71842, respectively). Comments were received concerning the 2007 temporary regulations. A public hearing was not requested and none was held. The 2007 temporary regulations expired on November 5, 2010.

As part of the TCJA, section 905(c) was amended to reflect the repeal of section 902, by eliminating the provisions allowing for adjustments to pools of post-1986 undistributed earnings and foreign income taxes. The TCJA made no changes to section 986(a) or 6689.

This Treasury decision adopts certain portions of the proposed regulations under sections 905(c) and 986(a) that were published in connection with the 2007 temporary regulations. References in this preamble to the 2007 temporary regulations are understood to refer to the corresponding provisions of the accompanying proposed regulations. In particular, this Treasury decision finalizes (1) the currency translation rules (which are moved from § 1.905-3T(b) to § 1.986(a)-1)), (2) the definition of foreign tax redetermination in § 1.905-3T(c), (3) the rules under § 1.905-3T(d)(1) requiring a redetermination of U.S. tax liability with respect to foreign income taxes other than those that are deemed paid under section 960, and (4) the rules in § 1.905-3T(e) relating to foreign income taxes imposed on foreign tax refunds. Portions of the 2007 temporary regulations relating to prospective pooling adjustments are not included in the final regulations in light of the TCJA's repeal of section 902 and related amendments to section 905(c).

Section 1.905-3T(d)(2), which addresses redeterminations that affect foreign taxes deemed paid under section 960, § 1.905-4T, which in general provides the procedural rules for how to notify the IRS of a foreign tax redetermination, and § 301.6689-1T, which provides rules for the penalty for failure to notify the IRS of a foreign tax redetermination, are not included in this Treasury decision. Although the underlying substantive rule requiring redeterminations of U.S. tax liability has not changed, in light of the elimination of prospective pooling adjustments (which in many cases obviated the need for U.S. tax redeterminations), the Treasury Department and the IRS anticipate that there will be significantly more instances in which taxpayers must redetermine their U.S. tax liability with respect to a prior taxable year by reason of a foreign tax redetermination with respect to a controlled foreign corporation (“CFC”). As a result, the Treasury Department and the IRS have determined that the rules under §§ 1.905-3T(d)(2), 1.905-4T, and 301.6689-1T should be reissued as a notice of proposed rulemaking in order to allow taxpayers an additional opportunity to comment on those rules. These regulations are available in a notice of proposed rulemaking in the Proposed Rules section of this issue of the
Federal Register
(the “2019 FTC proposed regulations”).

IV. Technical Amendment to Regulations Issued Under Section 905

This Treasury Decision also makes a technical amendment to § 1.905-2(a)(2). Regulations issued under § 1.905-2 address the forms, information, and evidence required to claim a foreign tax credit. On December 31, 1964, the
Federal Register
published changes (T.D. 6789) at 29 FR 19241 to the then existing regulations under § 1.905-2, including a sentence at § 1.905-2(a)(2) providing that if a foreign receipt or return is in a foreign language, a certified translation thereof must be furnished by the taxpayer. On January 27, 1998, the
Federal Register
published additional changes (T.D. 8759) at 63 FR 3812 to § 1.905-2. However, the
Federal Register
inadvertently deleted the sentence in § 1.905-2(a)(2) requiring certified translations of a foreign receipt or return in a foreign language. This Treasury Decision restores the inadvertently deleted sentence to § 1.905-2(a)(2).

Summary of Comments and Explanation of Revisions

I. Overview

The final regulations retain the basic approach and structure of the 2018 FTC proposed regulations, with certain revisions. Parts I through III and V of this Summary of Comments and Explanation of Revisions discuss those revisions as well as comments received in response to the solicitation of comments in the 2018 FTC proposed regulations. Part III.I of this Summary of Comments and Explanation of Revisions discusses the revisions and comments received with respect to the 2012 OFL proposed regulations. Part IV of this Summary of Comments and Explanation of Revisions discusses the revisions with respect to the 2007 temporary regulations relating to sections 905(c) and 986(a). Finally, Part VI of this Summary of Comments and Explanation of Revisions addresses the applicability dates for the final regulations.

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

A. Allocation of Expenses to Section 951A Category

A taxpayer determines its foreign tax credit limitation under section 904, in part, based on the taxpayer's taxable income from sources without the United States. The 2018 FTC proposed regulations provide that, in general, the regulations under sections 861 through 865 that provide rules for allocating and apportioning deductions to determine the taxpayer's taxable income from sources without the United States apply to income described in section 904(d)(1)(A) (the “section 951A category”).

Some comments requested that regulations provide that no expenses should be allocated to the section 951A category in order to ensure that income of a United States shareholder (“U.S. shareholder”) derived through a CFC would be effectively exempt from additional U.S. tax if the foreign effective tax rate is greater than or equal to a particular rate. These comments generally cite language in H.R. Rep. 115-466 (2017) (the “Conference Report”) illustrating that no U.S. “residual tax” applies to foreign earnings subject to a foreign effective tax rate of 13.125 percent or more. These comments suggest that not requiring expenses to be allocated to the section 951A category allows GILTI to function as a “minimum tax.” Alternatively, some comments suggested that expense allocation be eliminated if the taxpayer establishes that net CFC tested income is subject to a minimum foreign effective tax rate of 13.125 percent, or that expense allocation to the section 951A category be eliminated until section 864(f)(1) (providing an election to allocate interest expense on a worldwide basis) becomes effective. One comment suggested a fundamentally different approach to expense allocation that would allow taxpayers to prorate the allocation of expenses to certain foreign source income based on a ratio of the foreign tax rate with the U.S. tax rate, and recalculate U.S. income tax liability after disallowing the prorated expenses allocated to foreign source income. One comment suggested that after the TCJA the United States no longer relies on the general principle of a foreign tax credit to relieve double taxation, and that allocation of any expenses to section 951A category income is therefore inconsistent with U.S. treaty obligations to exempt the income from U.S. tax. One comment agreed with the approach of the proposed regulations requiring expense allocation to the section 951A category, noting that the application of the expense allocation rules is important to minimize the potential for base erosion.

As explained in Part I of the Explanation of Provisions section of the 2018 FTC proposed regulations, the TCJA did not provide for any changes to

how the generally applicable rules for computing taxable income within each separate category should apply with respect to the new section 951A category, and other provisions added in the TCJA are inconsistent with the notion that Congress intended effectively to exempt section 951A category income that was subject to a certain foreign effective tax rate. Therefore, the Treasury Department and the IRS have determined that the statute requires that expenses be allocated and apportioned to the section 951A category. This approach is also consistent with U.S. treaty obligations, which preserve the right of the United States to limit allowable foreign tax credits “in accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principles hereof) . . . ” See Article 23, Par. 2 of the 2016 U.S. Model Treaty.

This approach is confirmed by the Joint Committee on Taxation's Explanation of the TJCA, which states that Congress intended that the foreign tax credit limitation in the section 951A category, like any other separate category, is calculated by taking into account expenses allocable to income in that category.
See
Joint Comm. on Tax'n, General Explanation of Public Law 115-97, at 381 n. 1753 (“As under the law prior to enactment of the Act, U.S. shareholders are required to allocate expenses to foreign-source income for foreign tax credit limitation purposes based on principles applicable prior to the enactment of the Act.”). The Joint Committee's explanation also elaborates on the statement cited in the Conference Report that is cited by the comments, and clarifies that the ability to fully utilize foreign tax credits to eliminate U.S. tax liability at a foreign effective tax rate of 13.125 percent is possible only if it is assumed, “among other things, . . . that the domestic corporation has no expenses.”
Id.
at 381. The Explanation acknowledges that absent the assumption of there being no expenses, “the results . . . may change.”
Id.

Accordingly, the final regulations do not alter the requirement under the Code for deductions to be allocated and apportioned to the section 951A category. However, the 2019 FTC proposed regulations provide certain additional rules under §§ 1.861-8 through 1.861-17, including rules that will have the effect of precluding the allocation and apportionment of certain research and experimentation expenses to the section 951A category. In addition, Part I.A.5 of the Explanation of Provisions of the 2019 FTC proposed regulations states that the Treasury Department and the IRS are studying whether further guidance with respect to the allocation and apportionment of interest expenses is necessary, and request comments on this topic.

B. General Rules Relating to the Allocation and Apportionment of Expenses

1. Definitions of Exempt Income and Exempt Asset

The 2018 FTC proposed regulations make certain clarifying changes to the definitions of exempt income and exempt asset in proposed § 1.861-8(d)(2)(ii). Additionally, those regulations address the treatment of the deduction under section 250(a)(1) (the “section 250 deduction”) for purposes of the exempt income and assets rule. Under proposed § 1.861-8(d)(2)(ii)(C)(
1
), the portion of a domestic corporation's income that is foreign derived intangible income (“FDII”) or results from an inclusion under section 951A(a) (a “GILTI inclusion”), and the corresponding amount treated as a dividend under section 78 (“section 78 dividend”), is treated as exempt income based on the amount of the section 250 deduction allowed to the U.S. shareholder. Proposed § 1.861-8(d)(2)(ii)(C)(
2
) treats an equivalent portion of the domestic corporation's assets that give rise to FDII, or the stock of the CFC that gives rise to the GILTI inclusion, as an exempt asset.

One comment argued that the full allocation of expenses to the section 951A is needed to prevent base erosion. The comment recommended that the rules in proposed § 1.861-8(d)(2)(ii)(C) that treat income offset by the section 250 deduction as exempt income and the assets that give rise to that income as exempt assets are inappropriate and should be withdrawn. Another comment agreed with the approach of the proposed regulations.

The Treasury Department and the IRS have determined that the treatment of the section 250 deduction as giving rise to exempt income is consistent with the legislative history, which states that Congress “intends for the [section 250 deduction to] be treated as exempting the deducted income from tax.”
See
Senate Committee on Finance, Explanation of the Bill, S. Prt. 115-20 at 376 n.1210 (November 22, 2017). The approach is also consistent with the treatment under section 864(e)(3) of certain deductions allowed under sections 243 and 245(a). Accordingly, the final regulations adopt the rules from the 2018 FTC proposed regulations regarding the treatment of the section 250 deduction for purposes of the exempt income and asset provisions.
See
§ 1.861-8(d)(2)(ii)(C).

One comment requested that the final regulations clarify the requirement to identify assets that produce gross income included in FDII for purposes of determining the portion of a taxpayer's assets that are treated as exempt by reason of having FDII. In particular, the comment stated that it would be difficult to identify assets that produce FDII, and that tangible assets should be treated differently due to the exemption for qualified business asset investment (“QBAI”) under section 250(b)(2)(B). As a result, the comment recommended that FDII-related assets should not be treated as exempt assets. Alternatively, the comment recommended a formulary approach, which would take into account only basis of intangible assets that gave rise to either deduction eligible income (as defined in section 250(b)(3)) or foreign derived deduction eligible income (“FDDEI”) (as defined in section 250(b)(4)). Another comment suggested that the rule be modified to refer to assets that produce FDDEI rather than FDII.

Following the issuance of the 2018 FTC proposed regulations, the Treasury Department and the IRS issued rules under section 250 providing that the determination of FDDEI requires applying §§ 1.861-8 through 1.861-14T and 1.861-17 to allocate and apportion deductions between gross income derived from sales and services that are FDDEI (“gross FDDEI”) versus gross income that is not gross FDDEI.
See
proposed § 1.250(b)-1. In light of these changes, the Treasury Department and the IRS agree with the comment that proposed § 1.861-8(d)(2)(ii)(C)(
2
) should be revised to refer to assets that produce gross FDDEI. As a result of this change, the final regulations generally do not impose any additional requirements for identifying assets that produce gross FDDEI beyond what is necessary in order to determine the amount of the section 250 deduction. In addition, the final regulations do not limit application of the exempt asset rule to intangible assets because the effect of QBAI is already taken into account in determining the amount of the section 250 deduction and therefore reduces the fraction used in § 1.861-8(d)(2)(ii)(C)(
2
) to determine the portion of an asset that is exempt.

Under proposed § 1.861-8(d)(2)(ii)(C)(
1
), the amount of income treated as exempt as a result of the section 250 deduction is the amount of gross income offset by the section 250

deduction. In order to conform the exempt asset rule with respect to FDII to the exempt income rule, § 1.861-8(d)(2)(ii)(C)(
2
) provides that the portion of assets that produce gross FDDEI which is treated as exempt is determined by dividing the portion of the section 250 deduction relating to FDII by the taxpayer's gross FDDEI, instead of its FDII. This recognizes that gross FDDEI, and not FDII, reflects the gross income which the section 250 deduction is effectively exempting. The final regulations will have the effect of significantly reducing the portion of assets that are exempt by reason of FDII and, therefore, the revisions address the comments that the 2018 FTC proposed regulations' approach overstated the portion of assets that are exempt by reason of the section 250 deduction with respect to FDII.

The 2018 FTC proposed regulations also confirm that earnings and profits excluded from income under section 959 (“previously taxed earnings and profits”) do not result in any portion of the stock in a CFC being treated as an exempt asset. Proposed § 1.861-8(d)(2)(iv). One comment suggested adding the word “solely” to proposed § 1.861-8(d)(2)(iv) in order to clarify that stock that is not exempt by reason of earnings and profits described in section 959(c)(1) or (c)(2) can nonetheless be partially exempt under other rules. The adjustment to stock value in respect of earnings and profits under section 864(e)(4) and § 1.861-12(c)(2) precedes the application of the exempt asset rules of section 864(e)(3) and § 1.861-8(d)(2), and the determination of whether stock is exempt is unrelated to whether the value of the stock was adjusted by reference to previously taxed earnings and profits. Proposed § 1.861-8(d)(2)(iv) was merely intended to clarify existing law in order to preclude taxpayers from taking unreasonable positions inconsistent with section 864(e)(4), and the rule is clear that it is limited to precluding arguments that stock is exempt “by reason of” an adjustment under § 1.861-12(c)(2) for previously taxed earnings and profits. Therefore, the addition of the word “solely” is unnecessary, and the comment is not adopted.

2. Application to Insurance Companies in Connection With Certain Dividends and Tax-Exempt Interest

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). This comment is addressed in Part I.A.4 of the Explanation of Provisions of the 2019 FTC proposed regulations.

3. Allocation and Apportionment of the Section 250 Deduction

Proposed § 1.861-8(e)(13) and (14) provide rules for allocating and apportioning (i) the portion of the section 250 deduction for FDII and (ii) the portion of the section 250 deduction for the GILTI inclusion and the amount of the section 78 dividend attributable to foreign taxes deemed paid with respect to the GILTI inclusion. In particular, proposed § 1.861-8(e)(13) provides that the portion of the section 250 deduction for FDII is treated as definitely related and allocable to the specific class of gross income that is included in the taxpayer's FDDEI, and that the deduction is apportioned between the statutory and residual grouping based on the FDDEI in each grouping.

A comment expressed concern that, to the extent that the portion of the section 250 deduction for FDII is allocated to foreign source income, it would reduce the ability to claim foreign tax credits. The comment recommended not apportioning this portion of the deduction to FDDEI. Under sections 861 and 862, a taxpayer must determine its taxable income by deducting from gross income the deductions properly apportioned or allocated thereto. Under § 1.861-8, deductions are generally allocated and apportioned based on a factual relationship between the deductions and gross income. Because a portion of the section 250 deduction for FDII is factually related to the taxpayer's FDDEI, under the principles of § 1.861-8 that portion of the section 250 deduction is allocated to that income, regardless of whether the FDDEI is U.S. or foreign source. Accordingly, this comment is not adopted.

4. Allocation and Apportionment of State Income Taxes

The 2018 FTC proposed regulations did not make any changes to the rules in § 1.861-8(e)(6) for allocating and apportioning state income taxes, which were finalized in 1991 (T.D. 8337). The final regulations also make no changes to these rules but remove
Examples 28
through
33
in § 1.861-8(g), which apply the rules in § 1.861-8(e)(6) to fact patterns involving foreign subsidiaries, pending further study by the Treasury Department and the IRS as to whether the rules in § 1.861-8(e)(6) should be revised. See Part II.B of the Explanation of Provisions to the 2019 FTC proposed regulations (requesting comments on § 1.861-8(e)(6)).

C. Allocation and Apportionment of Interest Expense

1. Special Rule for Specified Partnership Loans

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 loans are referred to as specified partnership loans. Proposed § 1.861-9(e)(8)(vi)(C). Under proposed § 1.861-9(e)(8)(ii), the lender in these transactions is generally required to match the source and separate category of the interest income and expense by assigning the interest income to the same statutory and residual groupings from which the interest expense is deducted. The portion of the loan that corresponds to the matched income and expense is not taken into account for purposes of allocating and apportioning the lender's remaining interest expense. Proposed § 1.861-9(e)(8)(i). The 2018 FTC proposed regulations also include anti-avoidance rules to extend the application of these provisions to certain back-to-back loans or loans made through CFCs.
See
proposed § 1.861-9(e)(8)(iii) and (iv).

One comment suggested modifying the language in proposed § 1.861-9(e)(8)(ii) to clarify that the rules for specified partnership loans apply solely to match existing income and expense related to the loan, and therefore the rules do not create additional gross income. The final regulations clarify the language of the 2018 FTC proposed regulations consistent with the comment.
See
§ 1.861-9(e)(8)(ii).

The same comment requested clarification with respect to the anti-avoidance rule in proposed § 1.861-9(e)(8)(iii). Proposed § 1.861-9(e)(8)(iii) provides that if instead of loaning directly to a partnership, a partner instead enters into a back-to-back loan structure through an unrelated person, then the series of loans will be recharacterized as a direct loan to the partnership if there was a principal purpose of avoiding the rules in proposed § 1.861-9(e)(8). A per se rule provides that a series of loans will be subject to the recharacterization rule without regard to the principal purpose test if the loan to the unrelated person would not have been made or maintained on substantially the same terms irrespective of the loan of funds

by the unrelated person to the partnership. The comment requested that the per se rule be converted to an adverse factor in determining whether a principal purpose of avoidance exists.

The Treasury Department and the IRS have determined that a loan to an unrelated person that would not have been made or maintained on substantially the same terms if the unrelated person did not loan the funds to the partnership in which the original lender (or an affiliate of the original lender) has a direct or indirect interest is necessarily made with a principal purpose of avoiding the rules in § 1.861-9(e)(8). In addition, this rule is parallel to a similar anti-avoidance rule in § 1.861-11T(e)(3) that applies to loans between members of an affiliated group. The Treasury Department and the IRS have determined that a similar standard should apply in both cases. Therefore, the comment is not adopted.

The comment also requested clarification with respect to the anti-avoidance rule in proposed § 1.861-9(e)(8)(iv), which provides that certain loans to a partnership held by a CFC will be treated as held directly by the U.S. shareholder of the CFC if the loan was made or transferred with a principal purpose of avoiding the rules of proposed § 1.861-9(e)(8). The comment requested further guidance as to when a CFC loan to a partnership is considered to have a principal purpose of avoidance. The final regulations do not provide further guidance on the determination of principal purpose, which is a highly factual and case specific inquiry. The comment further requested clarification as to the tax consequences that arise when the loan is deemed to be held by the U.S. shareholder under the rule, and requested an example that would illustrate the operation of these rules. The final regulations clarify the operation of § 1.861-9(e)(8)(i), which generally requires that the U.S. person that owns a direct or indirect interest in the partnership disregard a portion of the loan receivable for purposes of allocating any other interest expense of the U.S. person. Where this anti-avoidance rule applies, the loan receivable is held by the CFC rather than its U.S. shareholder (which has the direct or indirect interest in the partnership), and thus merely disregarding the loan receivable would not affect the interest expense allocated by the U.S. shareholder because the relevant asset to the U.S. shareholder is the stock of the CFC that holds the loan receivable. Accordingly, the final regulations provide that appropriate adjustments are made to the value and characterization of the U.S. shareholder's stock in the CFC to reflect the amount of the loan that is disregarded under § 1.861-9(e)(8)(i). The final regulations also provide examples that illustrate the application of § 1.861-9(e)(8) in general.
See
§ 1.861-9(e)(8)(vii).

Several comments requested that the rules for specified partnership loans be expanded to cover loans made by a partnership to a partner (“upstream partnership loans”) so that the treatment of loans by partners to partnerships and vice versa would be parallel for purposes of determining the source and separate category of the associated interest income and expense. The Treasury Department and the IRS agree that providing similar rules for upstream partnership loans is appropriate. Therefore, the 2019 FTC proposed regulations provide similar rules for determining the source and separate category of interest income and expense with respect to upstream partnership loans. These rules are being proposed in order to provide taxpayers an additional opportunity to comment on the rule. To better coordinate the terminology between § 1.861-9(e)(8) and the rules addressing upstream partnership loans in the 2019 FTC proposed regulations, all references in the final regulations to a specified partnership loan, or SPL, are changed to downstream partnership loan, or DPL, respectively.

2. Treatment of Limited Partners Under § 1.861-9(e)(4)

Proposed § 1.861-9(e)(4)(i) requires that limited partners and corporate general partners with less than 10 percent ownership in a partnership directly allocate their distributive share of partnership interest expense to their share of partnership gross income, which is generally treated as passive category income under proposed § 1.904-4(n)(1)(ii). One comment requested that the direct allocation rule be revised such that individuals that are partners with less than 10 percent ownership in a limited liability company or limited liability partnership be treated per se as limited partners.

Whether a partner is a general partner or limited partner is determined under general partnership law principles and therefore further guidance on this issue is outside the scope of the regulations. Accordingly, the comment is not adopted.
See also
Part III.E of this Summary of Comments and Explanation of Revisions for changes conforming the treatment of corporate and individual general partners.

3. Direct Allocation of Interest Expense for Certain Financing Companies

The general method to allocate and apportion interest expense, as provided in § 1.861-9T(a), is based on the principle that money is fungible and interest expense is attributable to all activities and property regardless of any specific purpose for incurring an obligation on which interest is paid.
See
H.R. Rep. No. 99-426, at 374 (1986) (“With limited exceptions, the committee believes that it is appropriate for taxpayers to allocate and apportion interest expense on the basis that money is fungible.”). The 2018 FTC proposed regulations do not alter this approach. However, one comment requested that a finance company that borrowed money to fund loans to customers should be permitted to directly allocate the expense to the extent of interest income from the financing activity. The comment does not identify any reasons why debt of a financing company cannot be used to fund income of the entire group (either directly through the proceeds or by freeing up capital elsewhere in the group). To the extent the financing entity is a “financial corporation,” the rules in § 1.861-11T(d)(4) allow for separate treatment of income of financial corporations versus nonfinancial corporations. Therefore, the Treasury Department and the IRS have determined that an exception to the general rule of fungibility for finance companies is unwarranted.

4. Election To Use the Alternative Tax Book Value Method

One comment requested that the final regulations suspend restrictions on changing any elections under either the foreign tax credit or expense allocation rules, including any elections included in these final regulations, whether from year-to-year or a retroactive basis, for a three-year period beginning in 2018. The only election identified by the comment letter is the election to use the alternative tax book value method for apportioning interest expense.

Allowing annual or retroactive changes to the decision to use the alternative tax book value method would create significant compliance concerns for taxpayers and administrability concerns for the IRS because each change in method will require adjusting asset bases and depreciation schedules to reflect the new method. Therefore, the comment is not adopted. However, the final regulations provide additional time for taxpayers to change between the sales and gross income methods for purposes of allocating and apportioning research

and experimental (“R&E”) expenditures.
See
Part II.D. of this Summary of Comments and Explanation of Revisions.

5. Valuation of Assets for Purposes of Apportioning Interest Expense

In general, under the tax book value method or alternative tax book value method of interest apportionment, a taxpayer must determine the value of its assets based on an average of the tax book value of the asset at the beginning and end of the year.
See
proposed § 1.861-9(g)(2)(i)(A). Before the TCJA, taxpayers could elect to use the fair market value method, which required a determination of the fair market value of the asset as of the last day of the year. However, the fair market value method was repealed as part of the TJCA.
See
section 864(e)(2). In order to provide transitional relief with respect to the TJCA's repeal of the fair market value method, proposed § 1.861-9(g)(2)(i)(A) provides that for the first taxable year beginning after December 31, 2017, a taxpayer that had been using the fair market value method may choose to determine asset values using an average of the end of the first quarter and the year-end values of its assets, provided that all the members of an affiliated group (as defined in § 1.861-11T(d)) make the same choice and no substantial distortion would result.

One comment requested that for a given asset, taxpayers be permitted to average the prior taxable year's end of year fair market value with the current year-end value, which would be based on tax book value. This approach, however, would be inconsistent with the repeal of the fair market value method for interest apportionment as part of the TCJA. Furthermore, because the fair market value and tax book value methods rely on different methodologies, this approach could lead to a substantial distortion. Therefore, the comment is not adopted.

Another comment requested either that taxpayers be permitted to rely solely on the year-end tax book value of assets (and thus not requiring averaging) or that taxpayers electing to use first quarter values be permitted to do so without the earnings adjustment under § 1.861-12(c)(2)(i)(A) when the asset being valued is stock in a 10 percent owned corporation. The comment argues that this is necessary because otherwise taxpayers would have to determine the amount of the earnings adjustment at the end of the taxpayer's first quarter, which would be burdensome to comply with. However, the regulations already provide that taxpayers do not need to determine the earnings adjustment described in § 1.861-12(c)(2)(i)(A) as of the end of the first quarter. Under proposed § 1.861-9(g)(2)(ii)(B), with respect to stock in a 10 percent owned corporation, the tax book value of the stock at the end of the first quarter is determined before the adjustment required by § 1.861-12(c)(2)(i)(A), and a single earnings and profits adjustment is made based on the earnings and profits determined as of the end of the taxable year. This rule is maintained in the final regulations.

6. Clarification of Application of the Asset Method Under § 1.861-9T(g)

Section 1.861-9T(g) provides rules for purposes of allocating and apportioning interest expense of a CFC under the asset method, which also apply to characterize the stock of a first-tier CFC under § 1.861-12 for purposes of allocating and apportioning expenses of the CFC's U.S. shareholders. Under the rules in § 1.861-12, the adjusted basis of the stock of the first-tier CFC is adjusted by the earnings and profits of the CFC and other lower-tier foreign corporations owned by the CFC.

One comment requested that the asset method under § 1.861-9T(g) be clarified to confirm that when applying § 1.861-9 at the level of a CFC, the rules in § 1.861-12 apply for purposes of characterizing stock owned directly and indirectly by the CFC, and that such rules apply for all operative sections, not just section 904. The Treasury Department and the IRS agree that in applying the asset method at the level of a CFC (including for purposes of characterizing CFC stock in applying section 904 as the operative section), the CFC must apply the rules in § 1.861-12(c) with respect to any lower-tier CFCs. For example, a CFC applying the asset method must make basis adjustments to reflect earnings and profits of lower-tier corporations when valuing and characterizing the assets of the CFC. Otherwise, the value of the lower-tier corporations would be under- or over-represented in characterizing the assets of the CFC. Furthermore, any lower-tier CFCs must also apply the same rules, starting with the lowest-tier CFC and moving up.

Therefore, the final regulations provide in § 1.861-9(g)(4) that § 1.861-12 applies to characterize lower-tier stock in the hands of a CFC. Consistent with the 2018 FTC proposed regulations, § 1.861-12(a) clarifies that the rules of that section apply for all operative sections and are not limited to section 904.

7. Treatment of Tested Income in Allocating and Apportioning Interest Expense of a CFC Under the Modified Gross Income Method

Section 1.861-9T(j)(2) provides rules for purposes of allocating and apportioning interest expense of a CFC under the modified gross income method, which also apply to characterize the stock of a first-tier CFC under § 1.861-12 for purposes of allocating and apportioning expenses of the CFC's U.S. shareholders. In general, § 1.861-9T(j)(2) requires each CFC in a chain of ownership, beginning with the lowest-tier CFC, to allocate and apportion its interest expense and then tier up its income (net of interest expense) to the next-highest CFC in the chain, which then allocates and apportions its interest expense. Under proposed § 1.861-9(j)(2)(ii), gross tested income (net of interest expense) of a lower-tier corporation does not tier up to a higher-tier corporation, which is consistent with how the rules applied to subpart F income before the TCJA. One comment recommended that the regulations be revised to allow upper-tier CFCs to take into account gross tested income (net of interest expense) of lower-tier CFCs, noting that this would be consistent with the group-based approach of section 951A, would minimize differences between the modified gross income method and the asset method in § 1.861-9T(g), and would eliminate distortions that could arise in the case of an upper-tier holding company. The Treasury Department and the IRS agree with the comment, and therefore § 1.861-9(j)(2)(ii) eliminates the rule that excludes gross tested income from tiering up to higher-tier corporations for purposes of allocating and apportioning interest expense of the CFC. Additionally, modifications were made to § 1.861-13(c)(3) (Example 3) to reflect this change.

8. Characterization of Stock of Certain Foreign Corporations Under Proposed §§ 1.861-12(c)(3) and 1.861-13

Proposed § 1.861-12(c)(3) provides rules for characterizing the stock of a CFC for purposes of allocating and apportioning expenses under an asset method. If the operative section is not section 904, the stock of a CFC is characterized under either the asset method or the modified gross income method. Proposed § 1.861-12(c)(3)(i)(A). Where section 904 is the operative section, proposed § 1.861-13 applies to characterize the stock of the CFC as producing foreign source income in the separate categories or as producing U.S. source income. Proposed § 1.861-

12(c)(3)(i)(B). Under proposed § 1.861-13(a)(1), the stock of the CFC is first characterized according to the described statutory groupings under the asset method or the modified gross income method. If the CFC owns stock in a noncontrolled 10-percent owned foreign corporation, the assets or income of the foreign corporation is assigned to a gross subpart F income grouping to the extent the income of the foreign corporation, when distributed to the CFC, would be gross subpart F income of the CFC. The stock of the CFC is then assigned to the section 951A category, a treaty category, or other separate category under subsequent steps. The stock of the CFC may be assigned, in whole or in part, to the section 951A category if the CFC has gross tested income, even if the CFC has a tested loss.
See
proposed § 1.861-13(a)(2).

One comment requested that proposed § 1.861-13 provide that stock of a noncontrolled 10-percent owned foreign corporation owned by a CFC is instead assigned to the groupings for specified foreign source general category income or specified foreign source passive category income (as described in proposed § 1.861-13(a)(1)(i)(A)(
9
)). The comment notes this would be appropriate because proposed § 1.861-13 characterizes stock based on the income to which the stock gives rise, and a distribution by a noncontrolled 10-percent owned foreign corporation to a CFC should be eligible for the dividends received deduction in section 245A (the “section 245A deduction”) under § 1.952-2.

As noted in Part III.B of the Explanation of Provisions to the temporary regulations under section 245A, the Treasury Department and the IRS intend to address issues related to the application of § 1.952-2, taking into account various comments received in connection with the TCJA (including in connection with regulations issued under section 951A), in a future guidance project.
See
T.D. 9865; 84 FR 28405. This guidance will clarify that, in general, any provision that is expressly limited in its application to domestic corporations does not apply to CFCs by reason of § 1.952-2. The Treasury Department and the IRS continue to study whether, and to what extent, proposed regulations should be issued that provide that dividends received by a CFC are eligible for a section 245A deduction notwithstanding the fact that the deduction is only available to domestic corporations. Given that no proposed regulations have been issued, the Treasury Department and the IRS have determined that it is appropriate to continue to characterize the stock of a noncontrolled 10-percent owned foreign corporation as giving rise to subpart F income, and accordingly, the comment is not adopted. Any changes that may be necessary to § 1.861-13 if proposed regulations under section 245A are issued providing that dividends received by a CFC are eligible for a section 245A deduction will be considered as part of that guidance.

Another comment suggested that the gross income and assets of tested loss CFCs should be exempt from the expense apportionment rules due to the existence of special rules for tested loss CFCs in the context of calculating GILTI, including the disallowance of any foreign tax credits related to the tested loss under section 960(d)(3). Section 864(e)(2) requires that interest expense be apportioned on the basis of the adjusted bases of assets. Whether or not a CFC is profitable does not change the fact that a taxpayer's borrowings can fund the operations of the CFC. In addition, a CFC may be highly valuable (and have a large and positive amount of accumulated earnings and profits) even if it happens to be in a loss position for a particular year. Exempting the assets of tested loss CFCs would also result in distortive incentives whereby a CFC with a small amount of tested income would have an incentive to shift into a tested loss in order to have the entire value of the CFC be excluded for purposes of interest expense apportionment. Finally, the special treatment of tested losses in the determination of the GILTI inclusion is already accounted for by reducing the value of the stock of any CFC that is assigned to the section 951A category based on the inclusion percentage.
See
§ 1.861-13(a)(2). Accordingly, this comment is not adopted.

Finally, the final regulations clarify in § 1.861-13(a)(1)(i) and (ii) that for purposes of characterizing the stock of a CFC in the various statutory groupings, the U.S. shareholder of the CFC must use the same method (either the asset method or modified gross income method) that the CFC uses to apportion its interest expense. This is consistent with the rule in existence before the 2018 FTC proposed regulations, which is still reflected in § 1.861-12(c)(3)(i)(A).

9. Assets Funded by Disallowed Interest

Under § 1.861-12T(f)(1), to the extent that interest expense is capitalized, deferred, or disallowed, the adjusted basis of an asset connected to the interest expense is reduced to account for the interest that was capitalized, deferred, or disallowed. One comment suggested a revision to clarify, and narrow, the scope of this rule. The Treasury Department and the IRS agree that this rule should be clarified and have proposed changes in the 2019 FTC proposed regulations.

D. Allocation and Apportionment of Research and Experimental Expenditures

Proposed § 1.861-17 provides a one-time exception to the five-year binding election period by allowing taxpayers to switch between the sales method and gross income method in the first taxable year beginning after December 31, 2017. This exception is finalized without change.

Comments requested revisions to the approach for allocating and apportioning R&D expenditures under § 1.861-17, which the 2018 FTC proposed regulations do not otherwise modify. These comments are discussed in the 2019 FTC proposed regulations, which propose changes to the application of the sales method and allow taxpayers that are on the sales method to rely on those changes for taxable years before the proposed rulemaking is in effect. In order to give taxpayers an additional opportunity after the 2019 FTC proposed regulations have been issued to switch to the sales method, the final regulations provide that taxpayers may change to the sales method up to their last taxable year that begins before January 1, 2020, without the prior consent of the Commissioner.

E. Section 904(b)(4)

Section 904(b)(4) makes certain adjustments to both the taxpayer's foreign source taxable income and the taxpayer's entire taxable income for purposes of computing the applicable foreign tax credit limitation, based on the foreign-source portion (as defined in section 245A(c)) of any dividend from a specified 10-percent owned foreign corporation (as defined in section 245A(b)) and the deductions allocated and apportioned to, in general, income with respect to stock of the foreign corporation that will generally be eligible for a section 245A deduction or the stock of the foreign corporation that gives rise to that income. Proposed § 1.904(b)-3(c)(1) and (2) provide rules for determining what amount of the stock of the foreign corporation gives rise to income that, if distributed, is generally eligible for a section 245A deduction. The rules subdivide a portion of the value of the stock into a section 245A subgroup and a non-section 245A subgroup within each separate category.

One comment requested that the regulations clarify the treatment of stock basis of a CFC that is associated with a hybrid instrument when the stock would give rise to dividends for which a deduction is disallowed under section 245A(e), and suggested that the amount of the basis of that stock should be assigned to the non-section 245A subgroup.

Under proposed § 1.861-13(a)(5), stock is assigned to a section 245A subgroup without regard to whether a dividend paid (either in the current or future year) with respect to the stock may actually qualify for a section 245A deduction (for example, the deduction could be disallowed due to section 245A(e) or section 246(c)). The Treasury Department and the IRS considered a rule that would assign a portion of stock to a section 245A subgroup only if the earnings and profits reflected in the stock's value were allowed (or would be allowed in the future) a section 245A deduction. However, taxpayers generally could not know in a current year whether a distribution of the current earnings and profits would be allowed a section 245A deduction in a future year, and a rule requiring taxpayers to recalculate their section 245A subgroups through amended returns would create compliance burdens for taxpayers and administrative burdens for the IRS. Therefore, the final regulations retain the rules in the 2018 FTC proposed regulations, which determine the amount of stock in a section 245A subgroup without regard to whether a section 245A deduction is or would be allowed with respect to dividends paid with respect to the stock.

The comment also suggested that stock associated with hybrid instruments owned directly by a U.S. shareholder should be assigned to the non-section 245A subgroup due to a concern that the value of stock assigned to a section 245A subgroup would be excluded for purposes of valuing the stock under the beginning- and end-of-year averaging rule in § 1.861-9(g)(2). However, neither § 1.861-13(a)(5) nor § 1.904(b)-3 provides that stock assigned to the section 245A subgroup is excluded. Instead, deductions allocated and apportioned to stock assigned to the section 245A subgroup are added back to the numerator and denominator determined under section 904(a). Therefore, contrary to the comment, the assignment of stock to the section 245A subgroup (as opposed to the non-section 245A subgroup) does not impact the calculation of the total value of stock under the beginning- and end-of-year averaging rule in § 1.861-9(g)(2). Thus, the comment is not adopted.

Another comment recommended that proposed § 1.904(b)-3 be amended to provide that the treatment of deductions allocated and apportioned to the section 245A subgroup not be added back to entire taxable income for purposes of applying section 904(a) to section 951A category income. The comment is not adopted. Section 904(b)(4) is clear that deductions described in that provision are disregarded for purposes of “entire taxable income,” which means that the computation under section 904(a) (which describes a fraction, the denominator of which is “entire taxable income”) with respect to all separate categories, including the section 951A category, are affected by deductions allocated and apportioned to the section 245A subgroup. However, the amount of income in the section 951A category (the numerator of the section 904(a) fraction when section 904(a) applies to that category) is not affected by deductions allocated and apportioned to the section 245A subgroups of other separate categories.

III. Foreign Tax Credit Limitation Under Section 904

A. Transition Rules Accounting for New Separate Categories

1. Carryovers and Carrybacks of Unused Foreign Taxes Under Section 904(c)

The 2018 FTC proposed regulations provide transition rules for assigning carryforwards of unused foreign taxes paid or accrued, or deemed paid or accrued, in pre-2018 taxable years to post-2017 separate categories, which include new categories for section 951A category income and foreign branch category income. Proposed § 1.904-2(j)(1)(ii) provides that if unused foreign taxes paid or accrued or deemed paid with respect to a separate category of income are carried forward to a taxable year beginning after December 31, 2017, those taxes are allocated to the same post-2017 separate category as the pre-2018 separate category from which the unused foreign taxes are carried. Proposed § 1.904-2(j)(1)(iii) provides an exception that permits taxpayers to assign unused foreign taxes in the pre-2018 separate category for general category income to the post-2017 separate category for foreign branch category income to the extent they would have been assigned to that separate category if the taxes had been paid or accrued in a post-2017 taxable year. Any remaining unused taxes are assigned to the post-2017 separate category for general category income.

Several comments requested a simplified rule for assigning a portion of the pre-2018 unused foreign taxes to the post-2017 separate category for foreign branch category income. One comment recommended a simplified rule under which unused foreign taxes are assigned to the foreign branch category in the same proportions as foreign taxes paid or accrued by the taxpayer's foreign branches in the relevant pre-2018 year bear to all foreign taxes paid or accrued by the taxpayer in that year. Another comment recommended a simplified rule that assigns the pre-2018 unused foreign taxes to the post-2017 separate categories by reference to a single year. Another comment recommended either allowing taxpayers to allocate pre-2018 unused foreign taxes freely between the post-2017 separate categories for general category income and foreign branch category income, or in the alternative, using any reasonable method. Finally, one comment recommended that if the reconstruction option is maintained in the final regulations that it be simplified by not requiring taxpayers to reconstruct disregarded payments between a branch and its owner.

After considering the comments, the Treasury Department and the IRS agree that a simplified safe harbor option with respect to the reconstruction option should be provided. Section 1.904-2(j)(1)(iii)(B) provides a safe harbor that allocates unused foreign taxes from a particular pre-2017 taxable year to the post-2018 separate category for foreign branch category income based on a ratio equal to the amount of foreign income taxes that were paid or accrued by the taxpayer's foreign branches divided by the amount of all foreign income taxes assigned to the general category that were paid or accrued, or deemed paid by the taxpayer with respect to the taxable year. The Treasury Department and the IRS adopt this recommendation because it combines administrative convenience, a low potential for manipulation, and a reasonable approximation of a full reconstruction. Furthermore, in light of the addition of a safe harbor option, no changes are made to the requirements for reconstruction if the safe harbor option is not chosen. Taxpayers that do not choose the safe harbor must determine the unused foreign taxes with respect to foreign branch category income as if that separate category (and thus, all the rules in § 1.904-4(f)) had applied in the year the taxes were paid or accrued.

Another comment requested that when applying the reconstruction option, the final regulations provide that for purposes of determining whether excess credits relate to direct or indirect

foreign taxes, taxpayers may treat indirect credits as having been used first. However, under the reconstruction option, taxpayers must allocate unused foreign taxes by applying the rules for foreign branch category income to the origin year and determining the amount of taxes that would have been unused foreign taxes and would have been allocated to foreign branch category income had the foreign branch category applied for that year. Because deemed paid taxes can never relate to the foreign branch category, no deemed paid taxes will be treated as giving rise to unused foreign taxes that would have been allocated to foreign branch category income. Therefore, the Treasury Department and the IRS have determined that no special rules are needed.
See
§ 1.904-2(j)(1)(iii).

Another comment requested that taxpayers be allowed to apply the general category exception in proposed § 1.904-2(j)(1)(iii) to post-2017 tax years on a year-by-year basis, rather than to all post-2017 tax years. The Treasury Department and the IRS have determined that the use of different methods in different years could result in inconsistent allocations of the same foreign tax credit carryovers and create significant complexity for taxpayers and the IRS. Accordingly the comment is not adopted.

2. Separate Limitation Losses, Overall Foreign Losses, Overall Domestic Losses, and Net Operating Loss Carryforwards

Proposed § 1.904(f)-12(j) generally provides that any separate limitation loss (“SLL”) or overall foreign loss (“OFL”) accounts in a pre-2018 separate category remain in the same post-2017 separate category. However, to the extent there are any unused foreign taxes with respect to the pre-2018 separate category for general category income that are allocated between the post-2017 separate categories for general category income and foreign branch category income, then any SLL or OFL account in the pre-2018 separate category for general category income is allocated to those post-2017 separate categories in the same proportion that the unused foreign taxes were allocated. Similar rules were provided in the 2018 FTC proposed regulations with respect to the recapture of SLLs or overall domestic losses (each an “ODL”) that reduced income in a separate category in a pre-2018 taxable year, as well as for foreign losses that are part of a net operating loss that is incurred in a pre-2018 taxable year and carried forward to post-2017 taxable years.

One comment suggested that it was not clear that the allocation of losses should follow the allocation of unused foreign taxes, and that it was inflexible not to allow an allocation of losses with respect to the pre-2018 separate category for general category income between the post-2017 separate categories for general category income and branch category income when there were no unused foreign taxes with respect to that category to be allocated. The comment suggested that a true reconstruction of the losses would be too complex, but requested that the Treasury Department and the IRS consider some other unspecified approach that was independent from the allocation of unused foreign taxes.

Another comment on the same issue requested that the Treasury Department and the IRS allow taxpayers to elect to reconstruct the losses. In other words, this approach would allow taxpayers to allocate a portion of loss accounts with respect to the pre-2018 separate category for general category income to the post-2017 separate category for foreign branch category income to the extent they were attributable to losses that either related to, or offset, pre-2018 general category income that would have been foreign branch category income if recognized in a post-2017 taxable year, regardless of the taxpayer's treatment of unused foreign taxes.

The Treasury Department and the IRS agree that additional options should be added under the transition rules for loss accounts that relate to the pre-2018 separate category for general category income. Accordingly, § 1.904(f)-12(j)(2) provides that a SLL or OFL account incurred in the pre-2018 separate category for general category income by default remains in the general category, but that the taxpayer may choose to reconstruct how much of the loss account would have been in the foreign branch category had that category been in effect before 2018. As an alternative to reconstruction, a safe harbor provides that the taxpayer may instead recapture the pre-2018 loss account by recharacterizing the first available income in the post-2017 separate category for either general category income or foreign branch category income. To the extent the income in both separate categories available for recapture exceeds the balance in the loss account, the loss account is recaptured proportionately from each separate category. An ordering rule provides that the balance in a pre-2018 loss account is recaptured before any post-2017 additions to the account. This safe harbor follows similar transition rules provided in § 1.904(f)-12(a) for pre-1987 loss accounts.

Similarly, § 1.904(f)-12(j)(3) provides that an SLL or OFL that reduced pre-2018 general category income is by default recaptured in post-2018 years as general category income, but that a taxpayer may choose to reconstruct how much of the balance in the loss account would have offset foreign branch category income had that separate category applied in the year the loss was incurred, and recapture that amount in post-2017 taxable years as income in the foreign branch category. As an alternative to reconstruction, the final regulations retain the rule in proposed § 1.904(f)-12(j)(3)(ii) as a safe harbor, which provides that the taxpayer may instead recapture the balance in the loss account in subsequent taxable years ratably as income in the taxpayer's post-2017 separate categories for general category and foreign branch category income based on the proportion in which any unused foreign taxes in the pre-2018 separate category for general category income are allocated under the transition rules in § 1.904-2(j)(1)(iii)(A) or (B).

Section 1.904(f)-12(j)(4) provides that foreign losses that are part of general category net operating losses incurred in pre-2018 taxable years which are carried forward to post-2017 taxable years are by default treated as general category net operating losses, but that the taxpayer may choose to reconstruct how much of that loss would have been attributable to the foreign branch category had that separate category applied in the year the net operating loss arose. As an alternative to reconstruction, a safe harbor provides that the taxpayer may instead choose to treat the net operating loss carryforward as attributable to the general category and foreign branch category to the extent of any general category income and foreign branch category income, respectively, that is available in the year to be offset by the net operating loss carryforward (the carryforward year). To the extent the net operating loss carryforward offsets any other income in the carryforward year, it is treated as attributable to the general category. If the sum of taxpayer's general category income and foreign branch category income in the carryforward year exceeds the amount of the net operating loss carryforward, then the amount of each type of separate category income that is offset by the net operating loss carryforward, and therefore the separate category treatment of the net operating loss carryforward, is determined on a proportionate basis. An ordering rule provides that a pre-2018 general

category net operating loss is applied before any post-2017 general category net operating loss.

Finally, § 1.904(f)-12(j)(5) sets forth a coordination rule that provides that for purposes of applying the transition rules for unused foreign taxes or any of the rules for loss accounts, the choice whether to default to the general category or to reconstruct must be made consistently in all cases. However, if the taxpayer chooses to reconstruct, the choice to apply a safe harbor may be made independently under each set of transition rules.

B. Foreign Branch Category Income

1. Policy Considerations

Comments recommended that the final regulations, or preamble to the final regulations, include a discussion of the tax policy considerations relevant to proposed § 1.904-4(f). In general, proposed § 1.904-4(f) defines the term foreign branch category income, which affects both the limitation on foreign tax credits under section 904 and the deduction for FDII under section 250(a)(1)(A). Under section 904(d)(2)(J), foreign branch income is defined as the business profits attributable to one or more QBUs in one or more foreign countries, with the amount of business profits attributable to a QBU determined under rules established by the Secretary. Accordingly, the 2018 FTC proposed regulations provide guidance regarding the attribution of profits to a foreign branch.

The legislative history to the TCJA does not discuss the attribution of business profits to a QBU. In drafting the 2018 FTC proposed regulations, the Treasury Department and the IRS balanced various policy objectives, including: Attributing gross income to a foreign branch in a manner that is commensurate with its business activities; administrability for taxpayers and the IRS; conformity with local country tax law; and giving effect to the policies of sections 250(b)(3)(A)(i)(VI) and 904(d)(1)(B), which limit, respectively, the deduction under section 250 and the allowance of a credit under section 901 by reference to the amount of business profits attributable to a QBU.

The Treasury Department and the IRS have determined that the 2018 FTC proposed regulations' approach to attributing gross income to a foreign branch strikes the appropriate balance among those goals. In general, the 2018 FTC proposed regulations attribute gross income by reference to the books and records maintained with respect to a foreign branch, subject to certain adjustments (including adjustments to reflect Federal income tax principles). Proposed § 1.904-4(f)(2)(i). Reliance on a foreign branch's books and records promotes administrability for both taxpayers and the IRS. In addition, gross income reflected on the books and records of a foreign branch generally reflects payments for economic activity of that foreign branch, such that the proposed regulations' approach is broadly consistent with the policy of attributing gross income based on the relative economic activity of a foreign branch. Furthermore, the rule will promote conformity between the income attributed to a foreign branch under § 1.904-4(f) and the income subject to tax in the foreign jurisdiction.

To further those policies, the 2018 FTC proposed regulations also give effect to payments made in connection with certain transactions that are disregarded for Federal income tax purposes (such payments, “disregarded payments”). Proposed § 1.904-4(f)(2)(vi). These payments are generally reflected on the books and records of a foreign branch, represent compensation for economic activity performed by or for a foreign branch, and are frequently given effect for foreign income tax purposes. Accordingly, giving effect to those transactions generally aligns with the policies furthered by the general rule for attributing gross income to a foreign branch. For additional discussion regarding the policies and rules relating to disregarded payments, see Part III.B.2 of this Summary of Comments and Explanation of Revisions.

2. Disregarded Payments

i. In General

Several comments were received regarding proposed § 1.904-4(f)(2)(vi), under which gross income attributable to a foreign branch that is not passive category income must be adjusted to reflect disregarded payments between a foreign branch and its foreign branch owner, and between foreign branches (the “disregarded payment rule”). Some comments expressed support for the rule, while others indicated that they believed that proposed § 1.904-4(f) would be more administrable without the disregarded payment rule. As described in Part III.B.1 of this Summary of Comments and Explanation of Revisions, the Treasury Department and the IRS have determined that the disregarded payment rule furthers the various policies related to the attribution of gross income to a foreign branch. The disregarded payment rules are designed to utilize information that is already available to taxpayers, making the rule more administrable. Taking disregarded payments into account will also give effect to the economic activity of a foreign branch (or a foreign branch owner) while reducing mismatches between the amount of gross income attributable to a foreign branch and the foreign tax base. Accordingly, the final regulations retain the disregarded payment rule, subject to the modifications described in this Part III.B.2 of the Summary of Comments and Explanation of Revisions.

ii. Source and Character of Income Allocated in Connection With Disregarded Payments

Comments recommended that the character and source of gross income that is reattributed under the disregarded payment rule be determined by reference to the disregarded transaction giving rise to the reattribution. For example, if a foreign branch owner earned $50 of U.S. source royalty income, and made a $50 disregarded payment to its foreign branch for services performed that if regarded would be allocable to the royalty income under the 2018 FTC proposed regulations, the proposed regulations would attribute $50 of U.S. source royalty income to the foreign branch. Because attributing U.S. source royalty income to the foreign branch would not increase the taxpayer's limitation under section 904(d)(2)(B) (the foreign branch category), the comments recommended that the source and character of the reattributed gross income be determined by reference to the disregarded payment, such that the $50 of U.S. source royalty income would be converted to foreign source services income, potentially increasing the creditability of taxes attributable to the foreign branch (including taxes imposed by reason of the disregarded transaction).

The Treasury Department and the IRS have determined that it would be inappropriate to issue rules under section 904 converting the source and character, as opposed to the separate category, of a taxpayer's gross income. Generally, section 904(d) and the regulations under § 1.904-4(f) provide rules regarding the separate application of section 904 with respect to certain categories of regarded gross income of a taxpayer. The Treasury Department and the IRS have determined that section 904 does not provide for the redetermination of the character or source of a taxpayer's gross income. Converting U.S. source income to foreign source income would also be inconsistent with the purpose of section

904, which is to ensure that the foreign taxes may not be used as a credit against U.S. tax on U.S. source income. Finally, rules allowing taxpayers to increase foreign source income through transactions with foreign branches would be prone to significant manipulation. Accordingly, the final regulations do not include special rules for determining the source and character of gross income that is reattributed under the disregarded payment rule. Similarly, the final regulations clarify that § 1.904-4(f) does not affect the analysis of whether an amount of gross income can be resourced under an applicable bilateral tax treaty. Such analysis is based solely on the treaty text and related authorities.

iii. Netting of Disregarded Payments

Comments recommended that disregarded payments be netted before determining the amount of gross income attributable to a foreign branch and its owner. For example, under a netting rule, if a foreign branch made a $100 disregarded payment to its foreign branch owner, and the foreign branch owner made an $85 disregarded payment to the foreign branch during the same year, no more than $15 of the gross income reflected on the books and records of the foreign branch would be attributed to the foreign branch owner, regardless of the factual relationship between the two payments. Similarly, if a foreign branch owner made a $50 disregarded payment to one branch, and received a $50 disregarded payment from a second branch, none of the gross income reflected on the books and records of the second foreign branch would be attributed to its owner and none of the gross income earned by the foreign branch owner would be attributed to the first foreign branch.

The Treasury Department and the IRS have determined that disregarded payments should not be netted before making adjustments under the disregarded payment rule. As described in Part III.B.2.ii of this Summary of Comments and Explanation of Revisions, the disregarded payment rule affects only the separate category of gross income, and not the source or character of a taxpayer's gross income. Accordingly, when a disregarded payment is made between a foreign branch owner and a foreign branch, the payment must be allocated to gross income of the payor to determine the source and character of the amount that is reattributed. When there is an increase to the amount of gross income attributable to a foreign branch, for example, there must be a corresponding decrease to income of the foreign branch owner with the same source and character. Moreover, the disregarded payment rule only affects the assignment of gross income in the foreign branch category and the general category, or a specified separate category that is associated with the foreign branch or general categories. Passive income, for example, is always excluded from the foreign branch category. Thus, to the extent that a disregarded payment from a foreign branch owner to a foreign branch would be allocable to passive income of the foreign branch owner, there can be no adjustment as a result of that payment to the taxpayer's gross income in the passive category, even though the amount of passive category income that is attributable to the foreign branch (and the foreign branch owner) may change.

Netting disregarded payments would distort these rules by preventing the disregarded payment rule from accurately identifying the source and character of gross income that is attributable to the foreign branch and its owner, respectively. For example, if a foreign branch earned $100 of foreign source royalty income that was initially attributable to the foreign branch, and made a $90 disregarded payment to its foreign branch owner that if regarded would be allocable to that foreign source royalty income, only $10 of that foreign source royalty income should be treated as foreign branch category income. Under a netting rule, however, a $90 disregarded payment by the foreign branch owner to that foreign branch (or another foreign branch of the foreign branch owner) that would be allocable to U.S. source passive category income of the foreign branch owner would offset the payment, such that U.S. source passive category income that could not increase foreign branch category income itself would effectively increase foreign branch category income, by increasing the non-passive foreign source royalty income attributable to a foreign branch. Accordingly, to prevent this and similarly arbitrary outcomes under the disregarded payment rule, the final regulations do not include a rule netting disregarded payments between a foreign branch owner and its foreign branches.

A comment further recommended that disregarded payments between foreign branches should be disregarded, and stated that taking those transactions into account added administrative complexity to the 2018 FTC proposed regulations without changing the categorization of any item of gross income as foreign branch category income. The Treasury Department and the IRS have determined that this comment is incorrect, and the final regulations retain the 2018 FTC proposed regulations' rules regarding transactions between foreign branches. The items of gross income attributable to a particular foreign branch vary based on the nature of the disregarded transaction, which could include multiple back-to-back disregarded payments between foreign branches and the foreign branch owner; further, the amount, character, and source of gross income allocable to a particular foreign branch may vary, and knowing which gross income items are attributable to a particular foreign branch is necessary to determine the amount, character, and source of gross income that is attributed to a foreign branch or the foreign branch owner as the result of a particular disregarded payment. The final regulations clarify this point, including through clarifications to the ordering rule in § 1.904-4(f)(2)(vi)(F), and a new example illustrating the effects of transactions between foreign branches.
See
§ 1.904-4(f)(4)(xi) (Example 11). However, the final regulations also clarify that in the case where there is no disregarded payment between the foreign branch and foreign branch owner, disregarded payments between foreign branches have no effect.
See
§ 1.904-4(f)(2)(vi)(A).

iv. Interest and Other Financial Transactions

Under the proposed regulations, the disregarded payment rules do not apply to disregarded payments of interest or interest equivalents (“disregarded interest payments”).
See
proposed § 1.904-4(f)(2)(vi)(C)(
1
). The preamble to the 2018 FTC proposed regulations stated that, like remittances from a foreign branch or contributions to a foreign branch, disregarded interest payments reflect a shift of, or return on, capital. Several comments disagreed with that statement, arguing that disregarded interest payments reflect business profits with respect to the payee, particularly with respect to the financial services industry. Comments also indicated that distinguishing among different types of disregarded payments based on their character presented administrative challenges. Finally, a comment noted that failing to reattribute gross income on the basis of disregarded interest payments resulted in incongruities between the gross income attributed to a foreign branch for section 904 purposes and the gross income subject to tax under foreign law.

The final regulations adopt the 2018 FTC proposed regulations' approach to disregarded interest payments. The Treasury Department and the IRS have

determined that a general rule reattributing gross income by reference to disregarded interest payments would be inappropriate. As one comment noted, reattributing gross income by reference to disregarded interest payments, but not by reference to remittances and contributions, would allow taxpayers to “strip” the foreign branch category, potentially resulting in manipulation of the limitations in sections 250(b)(3)(A)(i)(VI) and 904(d)(1)(B). Similarly, a taxpayer seeking to increase foreign branch category income could instead borrow money from the foreign branch and shift income from the general category through disregarded interest payments made to the foreign branch. However, as described in Part III.B.4.iii of this Summary of Comments and Explanation of Revisions, the Treasury Department and the IRS are considering future guidance providing special rules for certain financial institutions, including rules that would provide for adjustments to the attribution of gross income by reference to disregarded interest payments.

v. Disregarded Transfers of Intangible Property

Proposed § 1.904-4(f)(2)(vi)(D) (the “intangible property rule”) requires the use of section 367(d) principles to impute payments, over time, for certain transfers of intangible property in a disregarded transaction. Comments requested that the intangible property rule be withdrawn, either in whole or in part (for example, by limiting the application of the rule to transfers from a foreign branch owner to a foreign branch). The comments argued that (i) there is no compelling policy rationale for the intangible property rule; (ii) the intangible property rule undermines a legislative objective of the TCJA, which was to achieve neutrality as to whether to locate intellectual property in a domestic corporation or its foreign subsidiary; (iii) the anti-abuse rule in § 1.904-4(f)(2)(v) is sufficient to prevent abusive tax-avoidance through disregarded remittances or contributions; (iv) the absence of a similar rule for tangible property or money evidences the lack of a need for a special rule for certain intangible property; (v) the intangible property rule would result in mismatches between the gross income attributable to a foreign branch and the gross income of the foreign branch for foreign tax purposes; and (vi) the rule would present administrative and compliance challenges. Certain comments acknowledged that the intangible property rule may be theoretically accurate, but argued that the compliance burdens that the rule posed outweighed its benefits.

The Treasury Department and the IRS have determined that retaining the intangible property rule is appropriate, and that it should apply to any disregarded transfer between a foreign branch owner and a foreign branch, as well as to transfers between foreign branches. While the intangible property rule may increase compliance burdens and increase the disparity between the gross income attributable to a foreign branch and the gross income taxable by a foreign country, the Treasury Department and the IRS have determined that those concerns are outweighed by the benefits derived from the rule. In general, § 1.904-4(f)(2)(vi)(A) adjusts the attribution of gross income when disregarded payments are made between a foreign branch and a foreign branch owner, or between foreign branches. Disregarded remittances or contributions, however, do not result in the reattribution of gross income. Section 1.904-4(f)(2)(vi)(C)(
2
) and (
3
). Accordingly, when a disregarded transaction with a foreign branch may be structured as either a remittance or contribution, on the one hand, or as a sale, exchange, or license, on the other hand, the amount of gross income attributed to a foreign branch could be manipulated. This concern is heightened when the property in question is highly mobile and highly valuable, as is generally true of intangible property (and less frequently true of tangible property). In light of the higher risk of manipulation for transfers of intangible property, the Treasury Department and the IRS have determined that the anti-abuse rule in § 1.904-4(f)(2)(v) does not sufficiently protect against manipulation, necessitating the more specific and mechanical intangible property rule.

The Treasury Department and the IRS have, however, modified the intangible property rule in response to comments. First, comments recommended that the intangible property rule be limited to disregarded transfers occurring after the enactment of the TCJA, after the date on which the proposed regulations were issued, or after the date on which the final regulations become effective. In response to these comments, the final regulations provide that the intangible property rule does not apply to transfers that occurred before December 7, 2018 (the date on which the proposed regulations were published). Section 1.904-4(f)(2)(vi)(D)(
2
). The Treasury Department and the IRS have determined that limiting the application of the intangible property rule to transfers occurring on or after the date on which the rule was proposed strikes the appropriate balance between providing taxpayers with sufficient notice regarding the intangible property rule, on the one hand, and preventing manipulation of the amount of gross income attributable to a foreign branch, on the other hand.

Second, several comments indicated that the intangible property rule inappropriately captures transient ownership of intangible property that was neither developed nor exploited by the foreign branch (or foreign branch owner) before a transfer. For example, several comments suggested that the intangible property rule would apply to certain repatriations of intangible property from a foreign subsidiary that elected to be treated as a disregarded entity (within the meaning of § 1.904-4(f)(3)(iv)), and immediately thereafter distributed intangible property to its U.S. owner. The Treasury Department and the IRS have determined that the potential distortions that the intangible property rule addresses generally are not implicated in the situation described in the comments. Accordingly, the final regulations adopt the recommendation. Specifically, the final regulations provide that the intangible property rule does not apply to transfers by a foreign branch or foreign branch owner that owns the intangible property transitorily, subject to certain limitations.
See
§ 1.904-4(f)(2)(vi)(D)(
3
)(
i
) through (
iii
). For this purpose, whether or not a foreign branch owner that is a transferor of intangible property is treated as satisfying the transitory ownership requirements is determined by reference to both the foreign branch owner transferor and any predecessor to the foreign branch owner.
See
§ 1.904-4(f)(2)(vi)(D)(
3
)(
iv
).

Finally, comments requested additional guidance and examples illustrating the application of section 367(d) principles in the context of a remittance of intangible property from a foreign branch to the foreign branch owner. In response to the comments, the final regulations specify that if a foreign branch remits property described in section 367(d)(4) to its foreign branch owner, the foreign branch is treated as having sold the transferred property to the foreign branch owner in exchange for annual payments contingent on the productivity or use of the property, the amount of which are determined under the principles of section 367(d) and the regulations under that section. The final regulations also include an example illustrating the application of the intangible property rule to a remittance

of intangible property from a foreign branch to a foreign branch owner.
See
§ 1.904-4(f)(4)(xii) (Example 12). The final regulations do not address comments regarding the operation of section 367(d), which are outside of the scope of the final regulations.

vi. Special Rule for Certain Disregarded Payments

A comment recommended that the final regulations clarify that disregarded payments that would be capitalized into amortizable or depreciable basis may produce adjustments under § 1.904-4(f)(2)(vi) in the year or years that the amortization or depreciation deductions would be allowed if those payments had been regarded. The final regulations adopt this recommendation.
See
§§ 1.904-4(f)(2)(vi)(B)(
1
) (specifically including disregarded cost recovery deductions, such as depreciation and amortization, in the disregarded payment allocation rules) and 1.904-4(f)(2)(vi)(B)(
3
) (clarifying the timing of those reattributions).

The final regulations also provide additional guidance regarding certain disregarded payments that would, if regarded, not be deductible, including guidance regarding disregarded sales of property that reattribute gross income when basis would be recovered other than through depreciation, amortization, or other disregarded cost recovery deductions. Under these rules, for example, a foreign branch owner's sale of property with a zero basis to its foreign branch for $100, followed by a sale by the foreign branch of that property to a third party for $110, would generally result in $110 of income that is reflected on the books and records of a foreign branch. The final regulations clarify that, in this example, $100 of gross income must be attributed to the foreign branch owner. Specifically, the foreign branch would be treated as having an adjusted disregarded basis in the property of $100, resulting in $10 of gain from the sale of the property being attributed to the foreign branch, and $100 of adjusted disregarded gain being attributed to its foreign branch owner.
See
§ 1.904-4(f)(2)(vi)(B)(
2
) (concerning disregarded sales of property). Attributions of income under this rule are adjusted to the extent that the basis would otherwise have been recovered by the transferee (for example, through a disregarded cost recovery deduction).
See
§ 1.904-4(f)(3)(i) (defining adjusted disregarded basis).

vii. Certain Disregarded Transactions

The 2018 FTC proposed regulations provide for certain adjustments to the amount of gross income that would otherwise be attributed to a foreign branch under proposed § 1.904-4(f)(2)(i). For example, gross income attributable to a foreign branch generally does not include gain attributable to a sale of stock by the foreign branch.
See
proposed § 1.904-4(f)(2)(iii). The final regulations clarify that consistent adjustments must be made when attributing income under the disregarded payment rule.
See
§ 1.904-4(f)(2)(vi)(C)(
4
). Thus, for example, a disregarded payment from a foreign branch owner to its foreign branch with respect to a disregarded sale of stock from the foreign branch to the foreign branch owner would not result in adjustments to the attribution of gross income between the foreign branch owner and the foreign branch.

3. Foreign Branch Definition

i. Trade or Business Requirement

The proposed regulations define a foreign branch by reference to the definition of a QBU in § 1.989(a)-1(b)(2)(ii) and (b)(3), which require that the branch maintain a separate set of books and records with respect to its activities and conduct of a trade or business outside of the United States (among other things). For this purpose, the trade or business standard described in § 1.989(a)-1(c) applies, subject to certain modifications.
See
proposed § 1.904-4(f)(3)(iii). The proposed regulations provide that activities conducted outside the United States that constitute a permanent establishment under the terms of an income tax treaty between the United States and the country in which the activities are carried out are presumed to constitute a trade or business conducted outside the United States for purposes of determining whether the activities meet the trade or business standard of the foreign branch definition.

A comment indicated that it is not clear when activities that constitute a permanent establishment should ever be treated as failing to satisfy this requirement. The Treasury Department and the IRS have determined that, consistent with the policy of promoting conformity between the gross income attributable to a foreign branch and the gross income subject to tax in a foreign jurisdiction, no exception to this rule is warranted. Accordingly, the final regulations provide that activities conducted outside the United States that constitute a permanent establishment under the terms of an income tax treaty between the United States and the country in which the activities are carried out constitute a trade or business conducted outside the United States for purposes of determining whether the activities meet the trade or business standard of the foreign branch definition, and do not adopt the presumption rule in the proposed regulations. § 1.904-4(f)(3)(vii)(B).

ii. Separate Set of Books and Records

The proposed regulations include a special rule treating a partnership as maintaining a separate set of books and records with respect to the activities of a foreign trade or business, whether or not a separate set of books and records was actually maintained.
See
proposed § 1.904-4(f)(3)(iii)(C)(
2
). Thus, for example, a foreign branch exists when a partnership records on a single set of books income from a trade or business conducted outside the United States and also income earned from unrelated investment activity. The proposed regulations deem the partnership to maintain a separate set of books and records with respect to the trade or business conducted outside the United States, and the taxpayer must determine, as the context requires, the items that would be reflected on such books and records.
Id.

A comment recommended that the final regulations provide additional guidance regarding the attribution of income items to any deemed set of books and records. In particular, the comment recommended that the principles of sections 864(c)(2), (c)(4), and (c)(5) should apply in constructing any deemed books and records in a manner analogous to the approach taken under the dual consolidated loss regulations with respect to genuine branches (although the comment recommended that the rule apply whether the QBU was a genuine branch or was held in a disregarded entity).
See
§ 1.1503(d)-5(c)(2)(i). The Treasury Department and the IRS agree that, when a foreign branch does not have a separate set of books and records, the regulations should include a standard to construct hypothetical books and records. Accordingly, the final regulations adopt the recommendation.
See
§ 1.904-4(f)(3)(vii)(C)(
2
).

4. Other Comments and Revisions

i. Attribution of Gain or Loss on Disposition of a Foreign Branch

To the extent that gross income (as adjusted to conform to Federal income tax principles) is reflected on the books and records of a foreign branch, the 2018 FTC proposed regulations generally treat the income as attributable to a foreign branch. Thus,

for example, gain from the sale of an asset held by a foreign branch that is reflected on the books and records of the foreign branch is generally attributable to the foreign branch under proposed § 1.904-4(f)(2)(i). Similarly, gain from the sale of all of the assets of a foreign branch would, to the extent reflected on the books and records of the foreign branch, generally be attributable to the foreign branch. By contrast, when a foreign branch owner sells its interests in a disregarded entity through which it operates a foreign branch, and the gain or loss is not reflected on the books and records of a foreign branch, the income would not generally be attributable to the foreign branch under proposed § 1.904-4(f)(2)(i). Furthermore, the regulations provide a special rule providing that gross income from the disposition of an interest in a partnership or other pass-through entity, or an interest in a disregarded entity, generally is not included in the foreign branch category.
See
proposed § 1.904-4(f)(2)(iv)(A).

Comments recommended that gain or loss from the disposition of a foreign branch be treated as attributable to a foreign branch whether or not the gain or loss is reflected on the books and records of a foreign branch, including the disposition of a foreign branch held through a disregarded entity. The Treasury Department and the IRS have determined that the rules for attributing gain from the sale of an interest in a foreign branch in the proposed regulations are appropriate. In general, the proposed regulations' treatment of the disposition of a foreign branch promotes conformity with local country taxation. Gain on the sale of assets properly reflected on the books of a foreign branch will generally be included in the taxable income of the foreign branch in its local country, and will generally reflect income associated with the trade or business activities of the foreign branch. In contrast, a foreign branch owner's sale of an entity that includes a foreign branch will not be reflected on the books of the foreign branch being sold, and will generally not give rise to local country tax on the transferred entity. Furthermore, proposed § 1.904-4(f)(2)(i), which relies on the books and records of a foreign branch, sets forth a rule that is administrable for taxpayers and the IRS.

In the case of a sale by a foreign branch of another entity that includes a foreign branch, the sale generally reflects gain that is not associated with the selling branch's trade or business activities, except when there is a sufficiently close business connection between the selling branch and the entity being sold. As described in Part III.B.4.ii of this Summary of Comments and Explanation of Revisions, the proposed and final regulations include an exception that allows gain or loss on the sale of another entity to be included in foreign branch category income when that connection exists.

The exception to this rule in proposed § 1.904-4(f)(2)(iv)(A) (excluding the disposition of certain interests reflected on the books and records of a foreign branch), appropriately prevents gain from the sale of interests unrelated to the trade or business conducted by a foreign branch from being treated as the “business profits” of the foreign branch. Accordingly, the final regulations adopt the rules set forth in the proposed regulations, subject to the modifications described in Part III.B.4.ii of this Summary of Comments and Explanation of Revisions.

ii. Ordinary Course of Business Exception

The proposed regulations provide that the disposition of an interest in a partnership or other pass-through entity is treated as occurring in the ordinary course of the foreign branch's active trade or business to the extent that the foreign branch “engages in the same or a related trade or business as the partnership or other pass-through entity (other than through a less than 10 percent interest)” (the “same or related trade or business rule”). Proposed § 1.904-4(f)(2)(iv)(B). A comment suggested that the reference to a “10 percent interest” in the same or related trade or business rule is unclear. To address the comment, the final regulations clarify that the same or related trade or business rule applies only when the foreign branch owns 10 percent or more of the interests in the partnership or other pass-through entity, and the foreign branch directly engages in the same, or a related, trade or business as that partnership or other pass-through entity.

iii. Comments Outside the Scope of the Final Regulation; Future Guidance

Several comments to proposed § 1.904-4(f) were received that are outside the scope of this rulemaking, including: Comments related to the allocation of expenses to foreign branch category income; comments relating to the trade or business and books and records standards of § 1.989(a)-1(c) and (d); comments relating to the interaction of § 1.1502-13 with § 1.904-4(f); comments relating to the operation of section 367(d); and comments relating to the application of the step transaction doctrine. These comments are not addressed in this Summary of Comments and Explanation of Revisions, but may be considered in future guidance projects addressing the issues discussed in the comments.

In particular, the Treasury Department and the IRS intend to issue future guidance coordinating the allocation and apportionment of expenses with the determination of foreign branch category income. In particular, the Treasury Department and the IRS are considering proposing rules applicable to regulated financial institutions regarding the allocation of interest expense to foreign branch category income. Under one approach, interest expense on demand deposits of a foreign banking branch would be directly allocated to foreign branch category income that is denominated in the same currency. Interest expense with respect to U.S. dollar-denominated demand deposits could similarly be directly allocated to interest income earned on U.S. dollar-denominated assets. Assets and liabilities would then be adjusted and residual interest expense would be allocated fungibly under the generally-applicable rules. This approach would take account of the fact that regulated financial institutions typically invest foreign currency-denominated deposits in interest-bearing assets denominated in the same currency, in part because interest rates vary across different currencies and this practice is more likely to yield a predictable return.

Under another approach, interest expense would be allocated to the foreign branch category using an approach similar to the rules applicable to foreign corporations that are engaged in the conduct of a trade or business within the United States. Generally, those rules provide for the allocation of interest expense by reference to the liabilities reflected on the books and records of a branch, and make adjustments to the amount of interest expense allocable to a branch by reference to the leverage ratio of the taxpayer as a whole.
See generally
§ 1.882-5. Under this approach to allocating interest expense to foreign branch category income, it is anticipated that the amount of interest expense allocated to the foreign branch category would take into account both regarded and disregarded transactions reflected on the books and records of the foreign branch. Furthermore, in connection with this approach, disregarded interest payments would be subject to the general disregarded payment rule, resulting in adjustments to the attribution of gross income by reason of disregarded interest payments.

The Treasury Department and the IRS also recognize that the existing expense allocation rules, including with respect to R&E expenditures, depreciation, or losses, when applied to allocate and apportion expenses to gross income that has been reattributed under the disregarded payment rule in § 1.904-4(f)(2)(vi), may lead to results that are inconsistent with the policy goal of identifying income attributable to the foreign branch that is commensurate with its business activities. 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 adjustments to the attribution of gross income as a result of certain disregarded payments are appropriate.

The Treasury Department and the IRS welcome comments on issues relating to allocation and apportionment of expenses to the foreign branch category. Comments on this topic should be submitted as part of the notice and comment process for the 2019 FTC proposed regulations. See Part I.A.5 of the Explanation of Provisions to the 2019 FTC proposed regulations.

C. Section 951A and Passive Category Income

Proposed § 1.904-4(g) generally provides that section 951A category income means amounts included in the gross income of a United States person (“U.S. person”) under section 951A(a), but does not include passive category income.
See also
section 904(d)(1)(A). Additionally, proposed § 1.904-4(c)(1) provides that passive income that is considered to be high-taxed income under section 904(d)(2)(B)(iii)(II) (“the section 904 high-tax kickout”) is treated as general category income, foreign branch category income, section 951A category income, or income in a specified separate category, depending on the application of the general rules in § 1.904-4. One comment suggested that the regulations should provide that income included under section 951A is never assigned to the passive category. The comment also suggested that passive category income that qualifies for the section 904 high-tax kickout should never be assigned to the section 951A category. The comment assumed that all passive category income earned by a CFC was necessarily foreign personal holding company income and therefore could never be included under section 951A.

The Treasury Department and the IRS note that although it is generally unlikely that passive category income would be included under section 951A, nothing in section 904 eliminates this possibility. To the contrary, the parenthetical in section 904(d)(1)(A) contemplates that all or part of a GILTI inclusion could be passive category income by expressly excluding passive category income from the section 951A category. Further, to the extent that income included under section 951A is excluded from passive category income under the section 904 high-tax kickout, it is appropriate under the rules of section 904(d) and § 1.904-4 that the income be reclassified as section 951A category income rather than income in another separate category. The section 904 high-tax kickout does not specify the category to which high-taxed income is assigned; it merely specifies that the high-taxed income is not passive category income. Therefore, the comment is not adopted.

Additionally, under section 904(c) as amended by the TCJA, unused foreign taxes with respect to section 951A category income may not be carried back or carried forward. Proposed § 1.904-2(a) incorporated this statutory change into the regulations. One comment recommended that unused foreign taxes with respect to section 951A category income should be eligible to be carried back or carried forward. However, because the statutory language of section 904(c) is clear, the comment is not adopted.

D. Items Resourced Under Treaties

The 2018 FTC proposed regulations include rules regarding section 904(d)(6), which applies when a taxpayer elects the benefits of a treaty obligation to resource an item of income. Proposed § 1.904-4(k)(2) adopts a grouping methodology for purposes of section 904(d)(6) whereby the relevant portions of sections 904, 907, and 960 apply separately to the aggregate amount of items of income that are in a single separate category and resourced under a particular treaty rather than separately to each item resourced under the treaty. The proposed regulations also provide that § 1.904-6 applies to allocate foreign income taxes to a separate category determined under section 904(d)(6). The preamble to the 2018 FTC proposed regulations requested comments on whether special rules should apply to limit the taxes allocated to a separate category determined under section 904(d)(6) to taxes imposed by the foreign jurisdiction that was a party to the relevant treaty, or whether taxes imposed by a third-party jurisdiction should continue to be allocated to the separate category determined under section 904(d)(6).

One comment addressed the issue of foreign taxes imposed by third-party jurisdictions, noting that any rule that allocated such taxes away from the income on which it was imposed under § 1.904-6 would be a departure from the framework of the foreign tax credit regime, which generally aims to attribute foreign taxes to the income to which they relate. The Treasury Department and the IRS agree with the comment, and therefore the final regulations reaffirm that taxes imposed by a third-party jurisdiction should continue to be allocated to the separate category determined under section 904(d)(6) or 865(h).
See
§ 1.904-4(k)(1)(iii) and (k)(2).

Another comment recommended that the final regulations apply the approach under section 904(d)(6) to income resourced under section 865(h). The comment indicated that there was no compelling reason why similar grouping rules should not also be extended to income subject to section 865(h). The Treasury Department and the IRS agree that consistent application of the similar rules in sections 865(h) and 904(d)(6) that assign items of income resourced under a treaty to a separate category is appropriate. Accordingly, the final regulations provide that, with respect to gains described in section 865(h)(2)(A), the provisions of section 904(a), (b), (c), (d), (f), and (g), and sections 907 and 960 are applied separately with respect to each treaty under which the taxpayer has claimed benefits and, within each treaty, to each separate category of income.
See
§ 1.904-4(k)(2). Therefore, if a taxpayer recognizes gain described in section 865(h)(2)(A) from multiple sales and other U.S. source income that is resourced and subject to section 904(d)(6), the gains and other income are all passive category income, and the gains and other income are resourced under the same treaty, then the aggregate amount of the resourced gains are included in a single section 865(h) separate category for passive category income resourced under a tax treaty, and the other passive income is included in a single section 904(d)(6) separate category for passive category income resourced under a tax treaty. In addition, the high-taxed income rules of section 904(d) (including the grouping rules in § 1.904-4(c)) apply separately to the items of income included in each separate category for passive category income resourced under a particular tax treaty.

E. Distributive Shares of Partnership Income

Under former § 1.904-5(h) (as in effect before the final regulations) and

proposed § 1.904-4(n), a partner's distributive share of partnership income is characterized as passive income to the extent that the distributive share is a share of income earned or accrued by the partnership in the passive category. However, this rule does not apply to any limited partner or corporate general partner that owns less than 10 percent of the value in a partnership. Instead, that partner's entire distributive share of partnership income is assigned to the passive category. The preamble to the proposed regulations requested comments on whether this rule should be modified. One comment stated that, if a general partner is a CFC, its distributive share should be characterized on a look-through basis by referencing the income earned or accrued by the partnership, regardless of whether the CFC owns 10 percent of the value in a partnership, and that consideration should be given to making this rule elective. The comment also suggested considering a look-through approach for all corporate general partners that own less than 10 percent of the partnership.

The Treasury Department and the IRS agree that in the case of corporate general partners in a partnership, the corporation's distributive share of income of the partnership should be characterized based on the income of the partnership regardless of the corporate partner's ownership threshold. The rule in former § 1.904-5(h) assigning income of a less than 10-percent partner to the passive category reflected the concern that partners would have difficulty obtaining information from the partnership in order to determine the partnership's income. However, the comment states that corporate general partners are generally able to obtain information to determine their distributive shares of the partnership's income. In addition, with respect to CFCs, section 951A requires the CFC to determine whether each item of partnership income is tested income, subpart F income, or excluded from tested income under section 951A(c)(2)(A)(i)(I) through (V) regardless of the CFC's ownership percentage in the partnership. Furthermore, with respect to individuals, the prior final regulations at § 1.904-5(h)(1) already provided that general partners with less than 10 percent ownership in the partnership apply a look-through approach. Therefore, there is minimal administrative benefit to assigning all of a less-than-10-percent corporate general partner's income to the passive category rather than following the general rule that assigns the distributive share based on the income of the partnership. Therefore, § 1.904-4(n)(1)(ii) provides that all general partners apply the general rule even if the partner owns less than 10 percent of the partnership. The same change is made to the expense allocation rules under § 1.861-9(e)(4), which provides rules for assigning partnership interest expense in the case of a less-than-10-percent limited partner or corporate general partner.

F. Look-Through Rules

1. Section 951A Category

The proposed regulations generally provide that the look-through rules under section 904(d)(3) provide look-through treatment solely with respect to payments allocable to the passive category.
See
proposed § 1.904-5. Other payments described in section 904(d)(3) are assigned to a separate category other than the passive category based on the general rules in § 1.904-4. Proposed § 1.904-5(b)(1). Accordingly, dividends, interest, rents, or royalties paid from a CFC to a U.S. shareholder are not assigned to the section 951A category, because only amounts included in the gross income of a U.S. shareholder under section 951A (and the related gross-up amount for foreign taxes deemed paid) are assigned to the section 951A category.

Comments requested that § 1.904-4 be revised to provide that the look-through rules under section 904(d)(3) apply to characterize interest, rents, and royalties paid by a CFC to a U.S. shareholder as income in the section 951A category. However, section 904(d)(3) provides that look-through payments not allocable to passive category income are not treated as passive category income, but does not assign the income to a particular category. Section 904(d)(1) generally defines the separate categories, and section 904(d)(1)(A) is clear that only amounts includible in gross income under section 951A are assigned to the section 951A category. Accordingly, under the clear terms of the statute, look-through payments cannot give rise to section 951A category income and must be assigned to other separate categories, such as the foreign branch category (if described in section 904(d)(1)(B)), a separate category for income described in section 901(j) or income resourced under a tax treaty, or the general category. Therefore, the comment is not adopted.

2. Treatment of Interest Deductions That Are Disallowed

Proposed § 1.861-9(c)(5) provides that if a taxpayer's deduction for business interest expense is disallowed under section 163(j) in a given year but permitted in a future taxable year, that the deduction for the business interest expense is apportioned under the rules of § 1.861-9 as though it were incurred in the year in which the expense is deductible. This is consistent with the existing general rule in § 1.861-9T(c) that in order for interest expense to be allocated and apportioned, the expense must be currently deductible.
See also
§ 1.861-9T(c)(3) (applying the same rule to interest deductions deferred under section 163(d)).

One comment requested guidance on how to apply the look-through rules, which require allocating and apportioning interest expense under § 1.861-9 in order to match the interest with gross income of the payor, when the interest expense is not allowed as a deduction at the CFC level. The comment noted that the disallowance at the CFC level does not defer a recipient income inclusion that must be assigned to a separate category.

In response to the comment, the final regulations provide in § 1.904-5(c)(2)(i) that the allocation and apportionment rule described in § 1.904-5(c)(2)(ii) is applied in the year the interest income is taken into account even if the interest expense is not actually deductible by the CFC in that year.

G. Allocation and Apportionment of Foreign Taxes

Proposed § 1.904-6(a) provides rules for the allocation and apportionment of taxes to the separate categories of income. Consistent with section 904(d)(2)(H)(i), proposed § 1.904-6(a)(1)(iv) provides that foreign taxes imposed with respect to base differences are assigned to the separate category in section 904(d)(1)(B), which is the foreign branch category. Comments stated that Congress had inadvertently failed to revise the cross-reference in section 904(d)(2)(H)(i) and that the regulations should assign taxes associated with base differences to the general category, or should provide a rule assigning the taxes to the general category or the foreign branch category depending on the types of income that the taxpayer earns. Because the statute is clear that taxes associated with base differences are assigned solely to the foreign branch category, the final regulations confirm that such taxes are assigned to the category specified in section 904(d)(2)(H)(i).

Several comments to the 2018 FTC proposed regulations requested additional guidance clarifying the allocation and apportionment of foreign income taxes under § 1.904-6. These

rules apply not only for purposes of assigning taxes to separate categories, but also apply under § 1.960-1(d) for purposes of associating foreign income taxes with income groups and PTEP groups in determining the amount of deemed paid credits under section 960. In particular, the comments requested additional rules clarifying the meaning of base and timing differences as well as new examples, and rules on assigning taxes incurred with respect to disregarded payments, and clarification on how those rules interact with the foreign branch category rules.

The Treasury Department and the IRS have determined that proposed § 1.904-6(a)(1)(iv) generally reflects the appropriate principles regarding what constitutes a base or timing difference, but agree that additional guidance regarding how those principles apply in specific fact patterns is warranted. In order to provide final rules for taxpayers to apply, while also providing an additional opportunity for taxpayers to comment on the new additional guidance, the final regulations finalize the rules in the 2018 FTC proposed regulations in § 1.904-6(a)(1)(iv). New rules relating to the allocation and apportionment of foreign income taxes are contained in the 2019 FTC proposed regulations.

H. Separate Limitation Loss and Overall Foreign Loss Rules Under Section 904(f)

Other than a provision coordinating the application of the adjustments in proposed § 1.904(b)-3 with the ordering rules for allocation and recapture of losses, including SLLs and OFLs,
see
proposed § 1.904(b)-3(d), the 2018 FTC proposed regulations did no

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2019-24848. Public record. Not legal advice.