# Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2020-21818

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** November 12, 2020
- **Citation:** 85 FR 72078

## Text

DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-101657-20]
RIN 1545-BP70
Guidance Related to the Foreign Tax Credit; Clarification of Foreign-Derived Intangible Income

AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

This document contains proposed regulations relating to the foreign tax credit, including guidance on the disallowance of a credit or deduction for foreign income taxes with respect to dividends eligible for a dividends-received deduction; the allocation and apportionment of interest expense, foreign income tax expense, and certain deductions of life insurance companies; the definition of a foreign income tax and a tax in lieu of an income tax; transition rules relating to the impact on loss accounts of net operating loss carrybacks allowed by reason of the Coronavirus Aid, Relief, and Economic Security Act; the definition of foreign branch category and financial services income; and the time at which foreign taxes accrue and can be claimed as a credit. This document also contains proposed regulations clarifying rules relating to foreign-derived intangible income. The proposed regulations affect taxpayers that claim credits or deductions for foreign income taxes, or that claim a deduction for foreign-derived intangible income.

DATES:

Written or electronic comments and requests for a public hearing must be received by February 10, 2021.

ADDRESSES:

Commenters are strongly encouraged to submit public comments electronically. Submit electronic submissions via the Federal eRulemaking Portal at
www.regulations.gov
(indicate IRS and REG-101657-20) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The IRS expects to have limited personnel available to process public comments that are submitted on paper through mail. The Department of the Treasury (the “Treasury Department”) and the IRS will publish for public availability any comment submitted electronically, and to the extent practicable on paper, to its public docket. Send paper submissions to: CC:PA:LPD:PR (REG-101657-20), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulations under §§ 1.245A(d)-1, 1.336-2, 1.338-9, 1.861-3, 1.861-20, 1.904-6, 1.960-1, and 1.960-2, Suzanne M. Walsh, (202) 317-4908; concerning §§ 1.250(b)-1, 1.861-8, 1.861-9, and 1.861-14, Jeffrey P. Cowan, (202) 317-4924; concerning § 1.250(b)-5, Brad McCormack, (202) 317-6911; concerning §§ 1.164-2, 1.901-1, 1.901-2, 1.903-1, 1.905-1, and 1.905-3, Tianlin (Laura) Shi, (202) 317-6987; concerning §§ 1.367(b)-3, 1.367(b)-4, and 1.367(b)-10, Logan Kincheloe, (202) 317-6075; concerning §§ 1.367(b)-7, 1.861-10, 1.904-2, 1.904-4, 1.904-5, and 1.904(f)-12, Jeffrey L. Parry, (202) 317-4916; concerning submissions of comments and requests for a public hearing, Regina Johnson, (202) 317-5177 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

On December 7, 2018, the Treasury Department and the IRS published proposed regulations (REG-105600-18) relating to foreign tax credits in the
Federal Register
(83 FR 63200) (the “2018 FTC proposed regulations”). Those regulations addressed several significant changes that the Tax Cuts and Jobs Act (Pub. L. 115-97, 131 Stat. 2054, 2208 (2017)) (the “TCJA”) made with respect to the foreign tax credit rules and related rules for allocating and apportioning deductions in determining the foreign tax credit limitation. On December 17, 2019, portions of the 2018 FTC proposed regulations were finalized in TD 9882, published in the
Federal Register
(84 FR 69022) (the “2019 FTC final regulations”). On the same date, new proposed regulations were issued addressing changes made by the TCJA as well as other related foreign tax credit rules (the “2019 FTC proposed regulations”). Correcting amendments to the 2019 FTC final regulations and the 2019 FTC proposed regulations were published in the
Federal Register
on May 15, 2020, see 85 FR 29323 (2019 FTC final regulations) and 85 FR 29368 (2019 FTC proposed regulations). The 2019 FTC proposed regulations are finalized in the Rules and Regulations section of this issue of the
Federal Register
(the “2020 FTC final regulations”).

On July 15, 2020, the Treasury Department and the IRS finalized regulations under section 250 (the “section 250 regulations”) in TD 9901, published in the
Federal Register
(85 FR 43042).

This document contains proposed regulations (the “proposed regulations”) addressing: (1) The determination of foreign income taxes subject to the credit and deduction disallowance provision of section 245A(d); (2) the determination of oil and gas extraction income from domestic and foreign sources and of electronically supplied services under the section 250 regulations; (3) the impact of the repeal of section 902 on certain regulations issued under section 367(b); (4) the sourcing of inclusions under sections 951, 951A, and 1293; (5) the allocation and apportionment of interest deductions, including rules for allocating interest expense of foreign bank branches and certain regulated utility companies, an election to capitalize research and experimental expenditures and advertising expenses for purposes of calculating tax basis, and a revision to the controlled foreign corporation (“CFC”) netting rule; (6) the allocation and apportionment of section 818(f) expenses of life insurance companies that are members of consolidated groups; (7) the allocation and apportionment of foreign income taxes, including taxes imposed with respect to disregarded payments; (8) the definitions of a foreign income tax and a tax in lieu of an income tax, including the addition of a jurisdictional nexus requirement and changes to the net gain requirement, the treatment of certain tax credits, the treatment of foreign tax law elections for purposes of the noncompulsory payment rules, and the substitution requirement under section 903; (9) the allocation of the liability for foreign income taxes in connection with certain mid-year transfers or reorganizations; (10) transition rules to account for the effect on loss accounts of net operating loss carrybacks to pre-2018 taxable years that are allowed under the Coronavirus Aid, Relief, and Economic Security Act, Public Law 116-136, 134 Stat. 281 (2020); (11) the foreign branch category rules in § 1.904-4(f) and the definition of a financial services entity for purposes of section 904; and (12) the time at which credits for foreign income taxes can be claimed pursuant to sections 901(a) and 905(a).

Explanation of Provisions

I. Foreign Income Taxes With Respect to Dividends for Purposes of Section 245A(d)

Section 245A(d)(1) provides that no credit is allowed under section 901 for any taxes paid or accrued (or treated as paid or accrued) with respect to any

dividend for which a deduction is allowed under that section. Section 245A(d)(2) disallows a deduction under chapter 1 for any tax for which a credit is not allowable under section 901 by reason of section 245A(d)(1). Section 245A(e)(3) also provides that no credit or deduction is allowed for foreign income taxes paid or accrued with respect to a hybrid dividend or a tiered hybrid dividend.

Proposed § 1.245A(d)-1(a) generally provides that neither a foreign tax credit under section 901 nor a deduction is allowed for foreign income taxes (as defined in § 1.901-2(a)) that are “attributable to” certain amounts. For this purpose, the proposed regulations rely on the rules in § 1.861-20, contained in the 2020 FTC final regulations and proposed to be modified in these proposed regulations, that allocate and apportion foreign income taxes to income for purposes of various operative sections, including sections 904, 960, and 965(g). Specifically, proposed § 1.245A(d)-1 provides that § 1.861-20 (which includes portions contained in these proposed regulations as well as in the 2020 FTC final regulations) applies for purposes of determining foreign income taxes paid or accrued that are attributable to any dividend for which a deduction is allowed under section 245A(a), to a hybrid dividend or tiered hybrid dividend, or to previously taxed earnings and profits that arose as a result of a sale or exchange that by reason of section 964(e)(4) or 1248 gave rise to a deduction under section 245A(a) or as a result of a tiered hybrid dividend that by reason of section 245A(e)(2) gave rise to an inclusion in the gross income of a United States shareholder (collectively, such previously taxed earnings and profits are referred to as “section 245A(d) PTEP”).

In addition, the rules apply to foreign income taxes that are imposed with respect to certain foreign taxable events, such as a deemed distribution under foreign law or an inclusion under a foreign law CFC inclusion regime, even though such event does not give rise to a distribution or inclusion for Federal income tax purposes. Proposed § 1.245A(d)-1(a) provides that foreign income taxes that are attributable to “specified earnings and profits” are also subject to the disallowance under section 245A(d). Under proposed § 1.245A(d)-1(b), § 1.861-20 applies to determine whether foreign income taxes are attributable to specified earnings and profits. Under § 1.861-20, foreign income taxes may be allocated and apportioned by reference to specified earnings and profits, even though the person paying or accruing the foreign income tax does not have a corresponding U.S. item in the form of a distribution of, or income inclusion with respect to, such earnings and profits. See, for example, § 1.861-20(d)(2)(ii)(B), (C), or (D) (foreign law distribution or foreign law disposition and certain foreign law transfers between taxable units), (d)(3)(i)(C) (income from a reverse hybrid), (d)(3)(iii) (foreign law inclusion regime), and proposed § 1.861-20(d)(3)(v)(C)(
1
)(
i
) (disregarded payment treated as a remittance). Specified earnings and profits means earnings and profits that would give rise to a section 245A deduction (without regard to the holding period requirement under section 246 or the rules under § 1.245A-5 that disallow a deduction under section 245A(a) for certain dividends), a hybrid dividend, or a tiered hybrid dividend, or a distribution sourced from section 245A(d) PTEP if an amount of money equal to all of the foreign corporation's earnings and profits were distributed. Therefore, for example, a credit or deduction for foreign income taxes paid or accrued by a domestic corporation that is a United States shareholder (“U.S. shareholder”) with respect to a distribution that is not recognized for Federal income tax purposes (for example, in the case of a consent dividend under foreign tax law that is not regarded for Federal income tax purposes, or a distribution of stock that is excluded from gross income under section 305(a) but is treated as a taxable dividend under foreign tax law) is not allowed under section 245A(d) to the extent those foreign income taxes are attributable to specified earnings and profits.

An anti-avoidance rule is included in proposed § 1.245A(d)-1 to address situations in which taxpayers engage in transactions with a principal purpose of avoiding the purposes of section 245A(d), which is to disallow a foreign tax credit or deduction with respect to foreign income taxes imposed on income that is effectively exempt from tax (due to the availability of a deduction under section 245A(a)) or with respect to foreign income taxes imposed on a hybrid dividend or tiered hybrid dividend. Such transactions may include transactions to separate foreign income taxes from the income to which they relate in situations that are not explicitly covered under § 1.861-20 (including, for example, loss sharing transactions under group relief regimes). Such transactions may also include successive distributions (under foreign law) out of earnings and profits that, under the rules in § 1.861-20, are treated as distributed out of previously taxed earnings and profits (and therefore foreign income taxes attributable to such amounts are not generally subject to the disallowance under section 245A(d)), when there is no reduction of such previously taxed earnings and profits due to the absence of a distribution under Federal income tax law. See proposed § 1.245A(d)-1(e)(4) (
Example 3
). The Treasury Department and the IRS are concerned that because the rules in § 1.861-20(d) addressing foreign law distributions and dispositions do not currently make adjustments to a foreign corporation's earnings and profits to reflect distributions that are not recognized for Federal income tax purposes, such foreign law transactions could be used to circumvent the purposes of section 245A(d). Comments are requested on potential revisions to § 1.861-20(d) that could address these concerns, including the possibility of maintaining separate earnings and profits accounts, characterized with reference to the relevant statutory and residual groupings, for each taxable unit whereby the accounts would be adjusted annually to reflect transactions that occurred under foreign law but not under Federal income tax law.

II. Clarifications to Regulations Under Section 250

A. Definition of Domestic and Foreign Oil and Gas Extraction Income

Section 250 provides a domestic corporation a deduction (“section 250 deduction”) for its foreign-derived intangible income (“FDII”) as well as its global intangible low-taxed income (“GILTI”) inclusion amount and the amount treated as a dividend under section 78 that is attributable to its GILTI inclusion. The section 250 deduction attributable to FDII is calculated in part by determining the foreign-derived portion of a corporation's deduction eligible income (“DEI”). DEI is defined as the excess of gross DEI over the deductions (including taxes) properly allocable to such gross income. See section 250(b)(3)(A) and § 1.250(b)-1(c)(2). Gross DEI is determined without regard to domestic oil and gas extraction income (“DOGEI”), which is defined as income described in section 907(c)(1) determined by substituting “within the United States” for “without the United States.” See section 250(b)(3)(B) and § 1.250(b)-1(c)(7). Similarly, foreign oil and gas extraction income (“FOGEI”) as defined in section 907(c)(1) is excluded from the computation of gross tested

income which is used to determine a U.S. shareholder's GILTI inclusion amount. See § 1.951A-2(c)(1)(v).

The Treasury Department and the IRS have determined that it would be inappropriate for taxpayers to use inconsistent methods to determine the amounts of DOGEI and FOGEI from the sale of oil or gas that has been transported or processed. Taxpayers with both types of income may have an incentive to minimize their DOGEI in order to maximize their potential section 250 deduction attributable to FDII, while in contrast maximizing their FOGEI in order to minimize their gross tested income, even though this would also decrease the amount of the section 250 deduction attributable to their GILTI inclusion amount. Accordingly, the proposed regulations provide that taxpayers must use a consistent method for purposes of determining both DOGEI and FOGEI. See proposed § 1.250(b)-1(c)(7). Similarly, for purposes of allocating and apportioning deductions, taxpayers are already required under existing regulations to use the same method of allocation and the same principles of apportionment where more than one operative section, for example sections 250 and 904, apply. See § 1.861-8(f)(2)(i).

B. Definition of Electronically Supplied Service

Section 1.250(b)-5(c)(5) defines the term “electronically supplied service” to mean a general service (other than an advertising service) that is delivered primarily over the internet or an electronic network, and provides that such services include, by way of examples, cloud computing and digital streaming services.

Since the publication of the section 250 regulations, the Treasury Department and the IRS have determined that the definition of electronically supplied services could be interpreted in a manner that includes services that were not primarily electronic and automated in nature but rather where the renderer applies human effort or judgment, such as professional services that are provided through the internet or an electronic network. Therefore, these proposed regulations clarify that the value of the service to the end user must be derived primarily from the service's automation or electronic delivery in order to be an electronically supplied service. The regulations further provide that services that primarily involve the application of human effort by the renderer to provide the service (not including the effort involved in developing or maintaining the technology to enable the electronic service) are not electronically supplied services. For example, certain services for which automation or electronic delivery is not a primary driver of value, such as legal, accounting, medical, or teaching services delivered electronically and synchronously, are not electronically supplied services.

III. Carryover of Earnings and Profits and Taxes When One Foreign Corporation Acquires Assets of Another Foreign Corporation in a Section 381 Transaction

Section 1.367(b)-7 provides rules regarding the manner and the extent to which earnings and profits and foreign income taxes of a foreign corporation carry over when one foreign corporation (“foreign acquiring corporation”) acquires the assets of another foreign corporation (“foreign target corporation”) in a transaction described in section 381 (the combined corporation, the “foreign surviving corporation”). See § 1.367(b)-7(a). Before the repeal of section 902 in the TCJA, these rules were primarily relevant for determining the foreign income taxes of the foreign surviving corporation that were considered deemed paid by its U.S. shareholder with respect to a distribution or inclusion under section 902 or 960, respectively.

Section 1.367(b)-7 applies differently with respect to “pooling corporations” and “nonpooling corporations.” A pooling corporation is a foreign corporation with respect to which certain ownership requirements were satisfied in pre-2018 taxable years and that, as a result, maintained “pools” of post-1986 undistributed earnings and related post-1986 foreign income taxes. See § 1.367(b)-2(l)(9). In general, if the foreign surviving corporation was a pooling corporation, the post-1986 undistributed earnings and post-1986 foreign income taxes of the foreign acquiring corporation and the foreign target corporation were combined on a separate category-by-separate category basis. See § 1.367(b)-7(d)(1). However, the regulations required the foreign surviving corporation to combine the taxes related to a deficit in a separate category of post-1986 undistributed earnings of one or both of the foreign acquiring corporation or foreign target corporation (a “hovering deficit”) with other post-1986 foreign income taxes in that separate category only on a pro rata basis as the hovering deficit was absorbed by post-transaction earnings in the same separate category. See § 1.367(b)-7(d)(2)(iii). Similarly, a hovering deficit in a separate category of post-1986 undistributed earnings could offset only earnings and profits accumulated by the foreign surviving corporation after the section 381 transaction. Under § 1.367(b)-7(d)(2)(ii), the reduction or offset was generally deemed to occur as of the first day of the foreign surviving corporation's first taxable year following the year in which the post-transaction earnings accumulated.

A nonpooling corporation is a foreign corporation that is not a pooling corporation and, as a result, maintains “annual layers” of pre-1987 accumulated profits and pre-1987 foreign income taxes. See § 1.367(b)-2(l)(10). In general, a foreign surviving corporation maintains the annual layers of pre-1987 accumulated profits and pre-1987 foreign income taxes, and the taxes related to a deficit in an annual layer cannot be associated with post-section 381 transaction earnings of the foreign surviving corporation.

As a result of the repeal of section 902 in the TCJA, post-1986 foreign income taxes and pre-1987 foreign income taxes of foreign corporations are generally no longer relevant for taxable years beginning on or after January 1, 2018. In addition, consistent with the TCJA, the Treasury Department and the IRS issued regulations under section 960 clarifying that only current year taxes are taken into account in determining taxes deemed paid under section 960. See § 1.960-1(c)(2). Current year tax means certain foreign income tax paid or accrued by a controlled foreign corporation in a current taxable year. See § 1.960-1(b)(4).

In light of the changes made by the TCJA and subsequent implementing regulations, the proposed regulations provide rules to clarify the treatment of foreign income taxes of a foreign surviving corporation in taxable years of foreign corporations beginning on or after January 1, 2018, and for taxable years of U.S. shareholders in which or with which such taxable years of foreign corporations end (“post-2017 taxable years”). The proposed regulations provide that all foreign target corporations, foreign acquiring corporations, and foreign surviving corporations are treated as nonpooling corporations in post-2017 taxable years and that any amounts remaining in the post-1986 undistributed earnings and post-1986 foreign income taxes of any such corporation as of the end of the foreign corporation's last taxable year beginning before January 1, 2018, are treated as earnings and taxes in a single pre-pooling annual layer in the foreign corporation's post-2017 taxable years.

The proposed regulations also clarify that foreign income taxes that are

related to non-previously taxed earnings of a foreign acquiring corporation and a foreign target corporation that were accumulated in taxable years before the current taxable year of the foreign corporation, or in a foreign target corporation's taxable year that ends on the date of the section 381 transaction, are not treated as current year taxes (as defined in § 1.960-1(b)(4)) of a foreign surviving corporation in any post-2017 taxable year. Furthermore, the proposed regulations clarify that foreign income taxes related to hovering deficits are not current year taxes in the year that the hovering deficit is absorbed, in part because the hovering deficit is not considered to offset post-1986 undistributed earnings until the first day of the foreign surviving corporation's first taxable year following the year in which the post-transaction earnings accumulated. In addition, because such taxes were paid or accrued by a foreign corporation in a prior taxable year, they are not considered paid or accrued by the foreign corporation in the current taxable year and therefore are not current year taxes under § 1.960-1(b)(4). Finally, foreign income taxes related to a hovering deficit in pre-1987 accumulated profits generally will not be reduced or deemed paid unless a foreign tax refund restores a positive balance to the associated earnings pursuant to section 905(c); therefore, such foreign income taxes are never included in current year taxes.

In addition to the proposed changes to § 1.367(b)-7, the proposed regulations remove some references to section 902 in other regulations issued under section 367(b) that are no longer relevant as a result of the repeal of section 902. For example, pursuant to § 1.367(b)-4(b)(2), a deemed dividend inclusion is required in certain cases upon the receipt of preferred stock by an exchanging shareholder, in order to prevent the excessive potential shifting of earnings and profits, notwithstanding that the exchanging shareholder's status as a section 1248 shareholder is preserved. One of the conditions for application of the rule requires a domestic corporation to meet the ownership threshold of section 902(a) or (b) and, thus, be eligible for a deemed paid credit on distributions from the transferee foreign corporation. § 1.367(b)-4(b)(2)(i)(B). These proposed rules generally retain the substantive ownership threshold of this requirement, but without reference to section 902 and by modifying the ownership threshold requirement to consider not only voting power but value as well. Specifically, § 1.367(b)-4(b)(2)(i)(B) is revised to require that a domestic corporation owns at least 10 percent of the transferee foreign corporation by vote or value.

Comments are requested as to whether further changes to § 1.367(b)-4 or 1.367(b)-7, or any changes to other regulations issued under section 367, are appropriate in order to clarify their application after the repeal of section 902. In addition, the Treasury Department and the IRS are studying the interaction of § 1.367(b)-4(b)(2) with section 245A and other Code provisions and considering whether additional revisions to the regulation are appropriate in light of TCJA generally. Comments are specifically requested with respect to the proposed revisions to § 1.367(b)-4(b)(2), including whether there is a continuing need to prevent excessive potential shifting of earnings and profits through the use of preferred stock in light of the TCJA generally. For example, the Treasury Department and the IRS are considering, and request comments on, the extent to which, in certain transactions described in § 1.367(b)-4(b)(2), (1) an exchanging shareholder who would not qualify for a deduction under section 245A could potentially shift earnings and profits of a foreign acquired corporation to a transferee foreign corporation with a domestic corporate shareholder that would qualify for a deduction under section 245A, or (2) a domestic corporate exchanging shareholder of a foreign acquired corporation with no earnings and profits could access the earnings and profits of a transferee foreign corporation.

IV. Source of Inclusions Under Sections 951, 951A, 1293, and Associated Section 78 Dividend

Sections 861(a) and 862(a) contain rules to determine the source of certain items of gross income. Section 863(a) provides that the source of items of gross income not specified in sections 861(a) and 862(a) will be determined under regulations prescribed by the Secretary. As a result of changes to section 960 made by the TCJA, the Treasury Department and the IRS revised the regulations under section 960. As part of that revision, the Treasury Department and the IRS removed former § 1.960-1(h)(1), which contained a source rule for the amount included in gross income under section 951 and the associated section 78 dividend. Section 1.960-1(h)(1) provided that, for purposes of section 904, the amount included in gross income of a domestic corporation under section 951 with respect to a foreign corporation, plus any section 78 dividend to which such section 951 inclusion gave rise by reason of taxes deemed paid by such domestic corporation, was derived from sources within the foreign country or possession of the United States under the laws of which such foreign corporation, or the first-tier corporation in the same chain of ownership as such foreign corporation, was created or organized.

Although section 904(h)(1) treats as from sources within the United States certain amounts included in gross income under section 951(a) that otherwise would be treated as derived from sources without the United States, absent former § 1.960-1(h)(1), no rule specifies the source of inclusions under section 951 before the application of section 904(h)(1). In addition, the rule in former § 1.960-1(h)(1) only provided for the source of a domestic corporation's section 951 inclusions for purposes of section 904. A similar lack of guidance exists with respect to the source of inclusions under section 951A. See section 951A(f)(1)(A) (requiring the application of section 904(h)(1) with respect to amounts included in gross income under section 951A(a) in the same manner as amounts included under section 951(a)(1)(A)). The removal of former § 1.960-1(h)(1) also left uncertain the source of amounts included in gross income as a result of an election under section 1293(a), because under section 1293(f)(1), such amounts are treated for purposes of section 960 as amounts included in gross income under section 951(a).

To clarify the source of income inclusions after the removal of former § 1.960-1(h)(1), the proposed regulations include a new rule in § 1.861-3(d), which provides that for purposes of the sourcing provisions an amount included in the gross income of a United States person under section 951 is treated as a dividend received by the United States person directly from the foreign corporation that generated the inclusion.

This proposed rule differs from former § 1.960-1(h)(1) in two respects. First, former § 1.960-1(h)(1) provided that if the foreign corporation that generated the income included under section 951 was held indirectly through other foreign corporations, the amount included was treated as if it had been paid through such intermediate corporations and as received from the first-tier foreign corporation. The Treasury Department and the IRS have determined that, in light of the repeal of section 902, and because a section 951 inclusion with respect to a lower-tier CFC is not treated as a deemed distribution through the first-tier CFC,

the source of the inclusion should be determined by reference to the lower-tier CFC.

Second, former § 1.960-1(h)(1) treated the entire amount of the inclusion under section 951 as derived from sources without the United States. However, the Treasury Department and the IRS have determined that because dividends and inclusions of the same earnings and profits should be sourced in the same manner, the general rule for inclusions under section 951 should be consistent with the rule in section 861(a)(2)(B) and § 1.861-3(a)(3) that treats dividends as derived from sources within the United States to the extent that the dividend is from a foreign corporation with significant income effectively connected with the conduct of a trade or business in the United States. This is particularly appropriate in circumstances in which effectively connected income is not excluded from subpart F income under section 952(b) (which could arise as a result of a treaty obligation of the United States precluding the effectively connected income from being taxed by the United States in the hands of the CFC). In addition, the Treasury Department and the IRS have determined that the source of a taxpayer's gross income from an inclusion of CFC earnings that are subject to a high rate of foreign tax should be the same, regardless of whether the taxpayer includes the income under subpart F or elects the high-taxed exception of section 954(b)(4) and repatriates the earnings as a dividend. Therefore, the proposed regulations provide that the source of an inclusion under section 951 is determined under the same rules as those for dividends. However, the resourcing rules in section 904(h) and § 1.904-5(m) independently operate to ensure that dividends and inclusions under section 951(a) that are attributable to U.S. source income of the CFC retain that U.S. source in the hands of the United States shareholder.

The proposed regulations also clarify that the source of section 78 dividends associated with inclusions under section 951 follows the rules for sourcing dividends. See also § 1.78-1(a).

Finally, and consistent with sections 951A(f)(1)(A) and 1293(f)(1), the proposed regulations apply the same rules with respect to inclusions under sections 951A and 1293 and the associated section 78 dividend.

V. Allocation and Apportionment of Expenses Under Section 861 Regulations

A. Election To Capitalize R&E and Advertising Expenditures

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. Taxable income from sources without the United States is determined by deducting from the items of gross income from sources without the United States the expenses, losses, and other deductions properly allocated and apportioned to that income, and a ratable part of any expenses, losses, or other deductions that cannot definitely be allocated to some item or class of gross income. See section 862(b). Section 864(e)(2) generally requires taxpayers to allocate and apportion interest expense on the basis of assets, rather than income. Under the asset method, a taxpayer apportions interest expense to the various statutory or residual groupings based on the average total value of assets within each grouping for the taxable year as determined under the asset valuation rules of § 1.861-9T(g).

The preamble to the 2019 FTC proposed regulations stated that the Treasury Department and the IRS continue to study the rules for allocating and apportioning interest deductions, and requested comments on a potential proposal to provide for the capitalization and amortization of certain expenses solely for purposes of § 1.861-9 to better reflect asset values under the tax book value method. One comment supported the adoption of such a rule.

The Treasury Department and the IRS recognize that internally-developed intangible assets (including intangible assets such as goodwill that are created as a result of advertising) that have no tax book value because the costs of generating them have been currently deducted may nevertheless have continuing economic value, and that debt financing may support the generation and maintenance of that value. Accordingly, proposed § 1.861-9(k) provides an election for taxpayers to capitalize and amortize their research and experimental (“R&E”) and advertising expenditures incurred in a taxable year. This election is analogous to the election under § 1.861-9(i) to determine asset values based on the alternative tax book value method, since both elections allow taxpayers to determine the tax book value of an asset in a manner that is different from the general rules that apply under Federal income tax law, but solely for purposes of allocating and apportioning interest expense under § 1.861-9, and not for any other Federal income tax purpose (such as determining the amount of any deduction actually allowed for depreciation or amortization).

Proposed § 1.861-9(k)(1) and (2) generally provides that for purposes of allocating and apportioning interest expense under § 1.861-9, an electing taxpayer capitalizes and amortizes its R&E expenditures under the rules in section 174 as contained in Public Law 115-97, title I, § 13206(a), which generally requires that beginning in taxable years beginning in 2022, R&E expenditures must be capitalized and then amortized.

Similarly, proposed § 1.861-9(k)(1) and (3) generally requires an electing taxpayer to capitalize and amortize its advertising expenditures. The definition of advertising expenditures and the method of cost recovery contained in proposed § 1.861-9(k)(3) is based on prior legislative proposals (which have not been enacted) proposing that certain advertising expenditures be capitalized. See, for example, H.R.1, 113th Cong. Section 3110 (2014). Comments are requested on whether a different definition of advertising expenditures or a different method of cost recovery should be adopted for purposes of the election in proposed § 1.861-9(k).

B. Nonrecourse Debt of Certain Utility Companies

Section 1.861-10T provides certain exceptions to the general asset-based apportionment of interest expense requirement under section 864(e)(2), including rules that directly allocate interest expense to the income generated by certain assets that are subject to “qualified nonrecourse indebtedness.” See § 1.861-10T(b).

A comment to the 2019 FTC proposed regulations asserted that interest expense incurred on certain debt of regulated utility companies should be directly allocated to income from assets of the utility business because the debt must be approved by a regulatory agency and relates directly to the underlying needs of the utility business. The comment suggested that the existing rules for qualified nonrecourse indebtedness were insufficient because utility indebtedness is often subject to guarantees and cross collateralizations that permit the lender to seek recovery beyond any identified property, and because the cash flows of a regulated utility company used to support utility indebtedness are broader than the permitted cash flows described in § 1.861-10T(b).

In response to this comment, the proposed regulations provide that certain interest expense of regulated utility companies is directly allocated to assets of the utility business. See proposed § 1.861-10(f). The type of utility companies that qualify for the rule, and the rules for tracing debt to assets, are modeled on similar rules provided in regulations under section 163(j). See §§ 1.163(j)-1(b)(15) and 1.163(j)-10(d)(2). Consistent with the approach taken in § 1.163(j)-10(d)(2), the proposed regulations expand the scope of permitted cash flows under § 1.861-10T(b) but do not modify the requirement that the creditor look to particular assets as security for payment on the loan because unsecured debt generally is supported by all of the assets of the borrower. See also Part XI.L.2 of the Summary of Comments and Explanation of Revisions to TD 9905 (85 FR 56686).

C. Revision to CFC Netting Rule Relating to CFC-to-CFC Loans

Section 1.861-10(e)(8)(v) provides that for purposes of applying the CFC netting rule of § 1.861-10(e), certain loans made by one CFC to another CFC are treated as loans made by a U.S. shareholder to the borrower CFC, to the extent the U.S. shareholder makes capital contributions directly or indirectly to the lender CFC, and are treated as related group indebtedness. No income derived from the U.S. shareholder's ownership of the lender CFC stock is treated as interest income derived from related group indebtedness, including subpart F inclusions related to the interest income earned by the lender CFC. As a result, no interest expense is generally allocated to income related to the CFC-to-CFC debt, but the debt may nevertheless increase the amount of allocable related group indebtedness for which a reduction in assets is required under § 1.861-10(e)(7).

The Treasury Department and the IRS have determined that the failure to account for income related to the CFC-to-CFC debt can distort the general allocation and apportionment of other interest expense under § 1.861-9. Therefore, the proposed regulations revise § 1.861-10(e)(8)(v) to provide that CFC-to-CFC debt is not treated as related group indebtedness for purposes of the CFC netting rule. Proposed § 1.861-10(e)(8)(v) also provides that CFC-to-CFC debt is not treated as related group indebtedness for purposes of determining the foreign base period ratio, which is based on the average of related group debt-to-asset ratios in the five prior taxable years, even if the CFC-to-CFC debt was otherwise properly treated as related group indebtedness in a prior year. This is necessary to prevent distortions that would otherwise arise in comparing the ratio in a year in which CFC-to-CFC debt was treated as related group indebtedness to the ratio in a year in which the CFC-to-CFC debt is not treated as related group indebtedness.

D. Direct Allocation of Interest Expense for Foreign Bank Branches

Under §§ 1.861-8 through 1.861-13, the combined interest expense of a domestic corporation and its foreign branches is allocated and apportioned to income categories on the basis of the tax book value of their combined assets. Comments received with respect to the 2018 and 2019 FTC proposed regulations asserted that special rules were needed for financial institutions for allocating and apportioning interest expense to foreign branch category income. The comments asserted that the general approach under §§ 1.861-8 through 1.861-13 fails to take into account the fact that foreign branches of financial institutions have assets and liabilities that reflect interest rates that differ from interest rates related to assets and liabilities of the home office held in the United States. As a result, the general approach results in over- or under-allocation of interest expense to the foreign branch category income.

In response to this comment, the proposed regulations provide that interest expense reflected on a foreign banking branch's books and records is directly allocated against the foreign branch category income of that foreign branch, to the extent it has foreign branch category income. The proposed regulations also provide for a corresponding reduction in the value of the assets of the foreign branch for purposes of allocating other interest expense of the foreign branch owner. See proposed § 1.861-10(g).

Comments are requested as to whether additional rules are needed to account for disregarded interest payments between foreign branches and between a foreign branch and a foreign branch owner. Comments are also requested as to whether adjustments to the amount of foreign branch liabilities subject to this rule are necessary to account for differing asset-to-liability ratios in a foreign branch and a foreign branch owner.

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

Section 818(f)(1) provides that a life insurance company's deduction for life insurance reserves and certain other deductions (“section 818(f) expenses”) are treated as items which cannot definitely be allocated to an item or class of gross income. Proposed § 1.861-14(h) in the 2019 FTC proposed regulations provided that section 818(f) expenses are allocated and apportioned on a separate company basis instead of on a life subgroup basis. In the 2020 FTC final regulations, this rule was withdrawn in response to comments. As discussed in Part I.C of the Summary of Comments and Explanation of Revisions to the 2020 FTC final regulations, the Treasury Department and the IRS have determined that there are merits and drawbacks to both the separate company and the life subgroup approaches.

These proposed regulations provide that section 818(f) expenses must be allocated and apportioned on a life subgroup basis, but that a one-time election is allowed for consolidated groups to choose instead to apply a separate company approach. A consolidated group's use of the separate entity method constitutes a binding choice to use the method chosen for that year for all members of the group and all taxable years thereafter.

F. Allocation and Apportionment of Foreign Income Taxes

1. Background

These proposed regulations repropose certain of the 2019 FTC proposed regulations in order to provide more detailed and comprehensive guidance regarding the assignment of foreign gross income, and the allocation and apportionment of the associated foreign income tax expense, to the statutory and residual groupings in certain cases. Comments to the 2019 FTC proposed regulations had requested more detailed guidance regarding the assignment to the statutory and residual groupings of foreign gross income arising from transactions that are dispositions of stock under Federal income tax law. In response to these comments, the Treasury Department and IRS have determined that it is appropriate to propose a comprehensive set of rules for dispositions of both stock and partnership interests, as well as rules that, similar to rules in the 2020 FTC final regulations for distributions with respect to stock, provide detailed rules for transactions that are distributions with respect to a partnership interest under Federal income tax law. The proposed regulations also address comments requesting that the rules for the assignment to the statutory and residual groupings of foreign gross income arising from disregarded payments distinguish between disregarded payments that would be

deductible if regarded under Federal income tax law and disregarded payments that would, if the payor (or recipient) were a corporation under Federal income tax law, be distributions with respect to stock or contributions to capital. See also Part IV.B of the Summary of Comments and Explanation of Revisions in the 2020 FTC final regulations.

2. Dispositions of Stock

Proposed § 1.861-20(d)(3)(i)(D) contains rules assigning to statutory and residual groupings the foreign gross income and associated foreign tax that arise from a transaction that is treated for Federal income tax purposes as a sale or other disposition of stock. These rules assign the foreign gross income first to the statutory and residual groupings to which any U.S. dividend amount, a term that applies in the disposition context when there is an amount of gain to which section 1248(a) or 964(e) applies, is assigned, to the extent thereof. Foreign gross income is next assigned to the grouping to which the U.S. capital gain amount is assigned, to the extent thereof.

Any excess of the foreign gross income recognized by reason of the transaction over the sum of the U.S. dividend amount and the U.S. capital gain amount is assigned to the statutory and residual groupings in the same proportions as the proportions in which the tax book value of the stock is (or would be if the taxpayer were a United States person) assigned to the groupings under the rules of § 1.861-9(g) in the U.S. taxable year in which the disposition occurs. This rule, which uses the asset apportionment percentages of the tax book value of the stock as a surrogate for earnings of the corporation that are not recognized for U.S. tax purposes, associates foreign tax on a U.S. return of capital amount (that is, foreign tax on foreign gain in excess of the amount of gain recognized for U.S. tax purposes) with the same groupings to which the tax would be assigned under § 1.861-20(d)(3)(i)(B)(
2
) of the 2020 FTC final regulations if the item of foreign gross income arose from a distribution made by the corporation, rather than a sale or other disposition of the stock.

As discussed in Part III.B of the Summary of Comments and Explanation of Revisions to the 2020 FTC final regulations, the Treasury Department and the IRS have determined that it is appropriate to treat foreign tax on a U.S. return of capital amount resulting from a distribution as a timing difference in the recognition of corporate earnings. The proposed regulations adopt the same rule in the case of a foreign tax on a U.S. return of capital amount resulting from a disposition of stock. The Treasury Department and the IRS have determined that this result is appropriate because a foreign country generally recognizes more gain on a disposition of stock than is recognized for U.S. tax purposes when the shareholder's tax basis in the stock is greater for U.S. tax purposes than for foreign tax purposes, and this disparity typically occurs when the shareholder's U.S. tax basis in the stock has been increased under section 961 to reflect subpart F or GILTI inclusions of earnings attributable to the stock. Comments are requested on whether other situations more commonly result in this disparity, such that different rules might be appropriate for distributions and sales in order to better match foreign tax on income included in the foreign tax base with income included in the U.S. tax base.

3. Partnership Transactions

The proposed regulations contain new rules on the treatment of distributions from partnerships and sales of partnership interests, including partnerships that are treated as corporations for foreign law purposes. In general, these rules follow similar principles as the rules for distributions from corporations and sales of stock.

The rule in proposed § 1.861-20(d)(3)(ii)(B), like the rule for assigning foreign tax on a return of capital with respect to stock, uses the asset apportionment percentages of the tax book value of the partner's distributive share of the partnership's assets (or, in the case of a limited partner with less than a 10 percent interest, the tax book value of the partnership interest) as a surrogate for the partner's distributive share of earnings of the partnership that are not recognized in the year in which the distribution is made for U.S. tax purposes. Proposed § 1.861-20(d)(3)(ii)(C) similarly associates foreign tax on a U.S. return of capital amount in connection with the sale or other disposition of a partnership interest with a hypothetical distributive share. The Treasury Department and the IRS have determined that this rule is appropriate because foreign tax on a return of capital distribution from a partnership most commonly occurs in the case of hybrid partnerships (that is, entities that are treated as partnerships for U.S. tax purposes but as corporations for foreign tax purposes). In this case, earnings that have been recognized and capitalized into basis by the partner for U.S. tax purposes as a distributive share of income in prior years are not subject to foreign tax until the earnings are distributed. Similarly, the higher U.S. tax basis in an interest in a hybrid partnership accounts for the most common cases where the amount of foreign gross income that results from a sale of a partnership interest exceeds the amount of taxable gain for U.S. tax purposes. Comments are requested on whether a different ordering rule or matching convention may better match foreign tax on income included in the foreign tax base with income included in the U.S. tax base. Comments are also requested on whether special rules are needed to associate foreign gross income and the associated foreign tax on distributions from partnerships and sales of partnership interests with items that are subject to special treatment for U.S. tax purposes (such as gain recharacterized as ordinary income under section 751).

4. Disregarded Payments

i. Background

The proposed regulations contain a new comprehensive set of rules addressing the allocation and apportionment of foreign income taxes relating to disregarded payments. In general, the 2019 FTC proposed regulations assigned foreign gross income included by reason of a disregarded payment by a branch owner to the residual grouping and assigned foreign gross income included by reason of a disregarded payment by a branch to its owner by reference to the asset apportionment percentages of the tax book value of the branch assets in the statutory and residual groupings. Comments noted that this rule, in the context of section 960, could lead to the assignment of foreign income taxes to the residual grouping rather than a grouping to which an inclusion under section 951 or 951A is attributable, resulting in the disallowance of foreign tax credits. Comments requested that, for purposes of assigning foreign gross income included by reason of a disregarded payment to a statutory or residual grouping, the rule should identify disregarded payments that should be treated as made out of current earnings, and distinguish those payments from other types of disregarded payments.

ii. Reattribution Payments

Proposed § 1.861-20(d)(3)(v) contains new rules that generally assign foreign gross income arising from the receipt of disregarded payments and the associated foreign tax to the recipient's statutory and residual groupings based on the current or accumulated income

of the payor (as computed for U.S. tax purposes) out of which the disregarded payment is considered to be made. For this purpose, the regulations refer to disregarded payments made to or by a taxable unit. In the case of a taxpayer that is an individual or a domestic corporation, a taxable unit means a foreign branch, a foreign branch owner, or a non-branch taxable unit, as defined in proposed § 1.904-4(f)(3). In the case of a taxpayer that is a foreign corporation, a taxable unit means a tested unit as such term is defined in proposed § 1.954-1(d)(2), as contained in proposed regulations (REG-127732-19) addressing the high-tax exception under section 954(b)(4), published in the
Federal Register
(85 FR 44650) on July 23, 2020 (the “2020 HTE proposed regulations”). See proposed § 1.861-20(d)(3)(v)(A) and (d)(3)(v)(E)(
10
).

Proposed § 1.861-20(d)(3)(v)(B)(
1
) addresses the assignment of foreign gross income that arises from the portion of a disregarded payment that results in a reattribution of U.S. gross income from the payor taxable unit to the recipient taxable unit. Under proposed § 1.861-20(d)(3)(v)(B)(
1
), the foreign gross income is assigned to the statutory and residual groupings to which the amount of U.S. gross income that is reattributed (a “reattribution amount”) is initially assigned upon receipt of the disregarded payment by a taxable unit, before taking into account reattribution payments made by the recipient taxable unit. For this purpose, under proposed § 1.861-20(d)(3)(v)(B)(
2
), in the case of a taxpayer that is an individual or a domestic corporation, the attribution rules in § 1.904-4(f)(2) apply to determine the section 904 separate categories of reattribution amounts received by foreign branches, foreign branch owners, and non-branch taxable units. In the case of a taxpayer that is a foreign corporation, the attribution rules in proposed § 1.954-1(d)(1)(iii) (as contained in the 2020 HTE proposed regulations)
1

apply to determine the reattribution amounts received by a tested unit in the tested income and subpart F income groupings of its tested units for purposes of the applying the high-tax exception of section 954(b)(4). Under proposed § 1.861-20(d)(3)(v)(B)(
2
), the rules in the 2020 HTE proposed regulations for attributing U.S. gross income to tested units also apply to attribute items of foreign gross income to tested units for purposes of allocating and apportioning the associated foreign income taxes in computing the amount of an inclusion and deemed-paid taxes under sections 951, 951A, and 960.

1
References to § 1.954-1(d) in these proposed regulations are to proposed § 1.954-1(d) as contained in the 2020 HTE proposed regulations.

For purposes of applying all other operative sections, the U.S. gross income that is attributable to a taxable unit is determined under the principles of the foreign branch category rules (for U.S. taxpayers) or the high-tax exception rules (for foreign corporations). The foreign branch category rules of § 1.904-4(f)(2) generally attribute U.S. gross income to taxable units on the basis of books and records, as modified to reflect Federal income tax principles, and reattribute U.S. gross income between the general category and the foreign branch category by reason of certain disregarded payments between a foreign branch and its owner, or another foreign branch, that would be deductible if regarded for Federal income tax purposes. The reattribution is made by reference to the statutory and residual groupings of the payor to which the disregarded payment would be allocated and apportioned if it were regarded for Federal income tax purposes.

Proposed § 1.954-1(d)(1)(iii), as contained in the 2020 HTE proposed regulations, generally adopts the principles of § 1.904-4(f)(2) for purposes of assigning U.S. gross income to tested units of a controlled foreign corporation for purposes of the high-tax exception. However, although § 1.904-4(f)(2)(vi) does not treat disregarded interest payments as a disregarded reallocation transaction, under proposed § 1.954-1(d)(1)(iii)(B) of the 2020 HTE proposed regulations, disregarded interest payments are treated as reattribution payments to the extent they are deductible for foreign law purposes in the country where the payor taxable unit is a tax resident. Proposed § 1.954-1(d)(1)(iii)(B)(
4
) provides that these disregarded interest payments are treated as made ratably out of the payor's current year U.S. gross income to the extent thereof, and provides ordering rules when the same taxable unit both makes and receives disregarded interest payments. Comments are requested on additional ordering rules that should be included in the final regulations, including rules that apply when multiple taxable units both make and receive disregarded payments, such as rules for determining the starting point for assigning reattribution payments received by taxable units, and the order in which particular types of disregarded payments made by taxable units are allocated and apportioned to U.S. gross income (including income attributable to reattribution payments received by the payor taxable unit) of the payor taxable unit. In addition, because proposed § 1.861-20(d)(3)(v) more clearly coordinates with the provisions in proposed § 1.954-1(d)(1), the proposed regulations propose to update proposed § 1.954-1(d)(1)(iv)(A) (as contained in the 2020 HTE proposed regulations) to clarify that the rules in § 1.861-20 (rather than the principles of § 1.904-6(b)(2)) apply in the case of disregarded payments. In order to achieve consistency with the new tested unit rules in proposed § 1.954-1(d) and taxable unit rules in § 1.861-20(d)(3)(v), the proposed regulations also contain a modification to the high-tax kickout rules in § 1.904-4(c)(4) to provide that the grouping rules at the CFC level are applied on a tested unit (instead of foreign QBU) basis.

Proposed § 1.861-20(d)(3)(v)(B)(
3
) provides that the statutory or residual grouping to which foreign gross income of a taxable unit (including foreign gross income that arises from the receipt of a disregarded payment) is assigned is determined without regard to reattribution payments made by the taxable unit, and that no item of foreign gross income is reassigned to another taxable unit by reason of a reattribution payment that reattributes U.S. gross income of the payor taxable unit to another taxable unit by reason of such reattribution payments. Under this rule, if foreign gross income is associated under § 1.861-20(d)(1) with a corresponding U.S. item initially attributed to a payor taxable unit, that foreign gross income is always assigned to the grouping that includes the U.S. gross income of that payor taxable unit. The effect of this rule and proposed § 1.861-20(d)(3)(v)(B)(
1
) is to allocate and apportion foreign tax imposed on foreign gross income that is associated either with a corresponding U.S. item that is initially attributed to a payor taxable unit or with a reattribution amount that is attributed to a recipient taxable unit (before taking into account reattribution payments made by the recipient taxable unit) to the grouping that includes the U.S. gross income of the taxable unit that paid the foreign tax; no portion of the foreign tax is associated with U.S. gross income that is reattributed to another taxable unit by reason of a reattribution payment.

In the case of foreign income tax imposed on the basis of foreign taxable income for a taxable period (that is, net basis taxes), this rule will generally produce appropriate results because foreign gross income of a taxable unit will generally be reduced by foreign law deductions for disregarded payments

made by that taxable unit, so that the amount of the payor's foreign taxable income will approximate the amount of U.S. taxable income attributed to the taxable unit after accounting for reattribution payments made and received by that taxable unit. Foreign gross basis taxes (such as withholding taxes) imposed on foreign gross income of a taxable unit, if not reassigned along with the associated U.S. gross income that is reattributed to another taxable unit as the result of a reattribution payment, however, may in some cases distort the effective foreign tax rate of the payor taxable unit. The Treasury Department and the IRS have determined that rules reattributing foreign gross basis taxes among taxable units by reason of reattribution payments would require complex ordering rules that would be unduly burdensome for taxpayers to apply and for the IRS to administer. Comments are requested on whether the final regulations should include different rules, including anti-abuse rules, to account for the assignment of foreign gross basis taxes paid by taxable units that make disregarded payments.

iii. Remittances and Contributions

Similar to the rules in the 2019 FTC proposed regulations, proposed § 1.861-20(d)(3)(v)(C)(
1
)(
i
) assigns foreign gross income that arises from a disregarded payment that is treated as a remittance for U.S. tax purposes by reference to the statutory and residual groupings to which the assets of the payor taxable unit are assigned (or would be assigned if the taxable unit were a United States person) under the rules of § 1.861-9 for purposes of apportioning interest expense. This rule uses the payor's asset apportionment percentages as a proxy for the accumulated earnings of the payor taxable unit from which the remittance is made. Proposed § 1.861-20(d)(3)(v)(C)(
1
)(
ii
) provides that for this purpose the assets of the taxable unit making the remittance are determined in accordance with the rules of § 1.987-6(b) that apply in determining the source and separate category of exchange gain or loss on a section 987 remittance, as modified in two respects.

First, for purposes of § 1.860-20(d)(3)(v)(C)(
1
)(
i
) the assets of the remitting taxable unit include stock owned by the taxable unit, even though for purposes of section 987 such stock may be treated as owned directly by the owner of the taxable unit. This rule helps to ensure that foreign tax on remittances are properly associated with earnings of corporations that may be distributed through the taxable unit.

Second, proposed § 1.861-20(d)(3)(v)(C)(
1
)(
ii
) modifies the determination of assets under § 1.987-6(b)(2) to provide that the assets of a taxable unit that give rise to U.S. gross income that is assigned to another taxable unit by reason of a reattribution payment are treated as assets of the recipient taxable unit. The Treasury Department and the IRS have determined that reassigning the tax book value of assets among taxable units in proportion to the U.S. gross income attributed to a taxable unit, after taking into account all reattribution payments made and received by the taxable unit, for purposes of determining the statutory and residual groupings to which foreign tax on a remittance is assigned is appropriate to properly match the foreign tax with the accumulated earnings out of which the remittance is made. In addition, because it uses asset values that are already required to be computed and maintained for other Federal income tax purposes, this reattribution rule is less complicated to apply than a rule that would treat disregarded assets and liabilities as if they were regarded for U.S. tax purposes in applying this rule.

However, the Treasury Department and the IRS acknowledge that any asset method for associating foreign gross income included by the remittance recipient with the payor's accumulated earnings may lead to inexact determinations of the groupings of the accumulated earnings out of which a remittance is paid, particularly when a taxable unit makes a remittance in conjunction with reattribution payments. The potential for distortions exist to the extent the tax book value of assets does not reflect their income-producing value, as in the case of self-developed intangibles the costs of which are currently expensed, as well as to the extent the characterization of the tax book value of an asset based on the income generated by the asset in the current taxable year does not reflect the characterization of the income generated by the asset over time. Comments are requested on whether a different method of determining the statutory and residual groupings to which a remittance is assigned, such as the maintenance of historical accounts of accumulated earnings of taxable units, including adjustments to reflect disregarded payments among taxable units, could produce more accurate results without unduly increasing administrative burdens.

Similar to the rule in the 2019 FTC proposed regulations, proposed § 1.861-20(d)(3)(v)(C)(
2
) provides that foreign gross income and the associated foreign tax that arise from the receipt of a contribution are assigned to the residual category, except as provided under the rules for an operative section (such as under proposed § 1.904-6(b)(2)(ii), which assigns foreign tax on contributions to a foreign branch to the foreign branch category). Proposed § 1.861-20(d)(3)(v)(E)(
2
) defines a contribution as a disregarded transfer of property that would be treated as a transaction described in section 118 or 351 if the recipient taxable unit were treated as a corporation for Federal income tax purposes, or the excess amount of a disregarded payment made to a taxable unit that the payor unit owns over the amount that is treated as a reattribution payment.

Foreign tax paid by a foreign corporation that is allocated and apportioned to the residual category is not eligible to be deemed paid under section 960. See § 1.960-1(e). However, because proposed § 1.861-20(d)(3)(v) treats most disregarded payments as reattribution payments or remittances, and contributions (as characterized for corporate law purposes) are rarely subject to foreign tax, the Treasury Department and the IRS expect this rule will have limited application.

Proposed § 1.861-20(d)(3)(v)(C)(
3
) provides an ordering rule attributing the amount of foreign gross income that arises from the receipt of a disregarded payment that includes both a reattribution payment and a remittance or contribution first to the portion of the disregarded payment that is a reattribution payment. Any excess amount of the foreign gross income item is attributed to the portion of the disregarded payment that is a remittance or contribution.

In addition, proposed § 1.861-20(d)(2)(ii)(D) provides that if an item of foreign gross income arises from an event that for foreign law purposes is treated as a distribution, contribution, accrual, or payment between taxable units, but that is not treated as a disregarded payment for Federal income tax purposes (for example, a consent dividend from a disregarded entity), the foreign gross income and associated foreign tax are assigned in the same way as if a transfer of property in the amount of the foreign gross income item resulted in a disregarded payment in the year the foreign tax is paid or accrued.

Finally, in light of the heightened importance of the rules in § 1.904-4(f), which are being applied in connection with § 1.861-20 as well as the high-tax exception rules in § 1.951A-2(c)(7), the proposed regulations include some technical changes to the rules in § 1.904-4(f) that will facilitate this

interaction. See Part XI.A of this Explanation of Provisions.

iv. Disregarded Payments With Respect to Disregarded Sales of Property

Proposed § 1.861-20(d)(3)(v)(D) clarifies that an item of foreign gross income attributable to gain recognized under foreign law by reason of a disregarded payment received in exchange for property is characterized and assigned under § 1.861-20(d)(2)(ii)(A) of the 2020 FTC final regulations, that is, as a timing difference in the taxation of the property's built-in gain. Proposed § 1.861-20(d)(3)(v)(D) further provides that if a taxpayer recognizes U.S. gross income as a result of a disposition of property that was previously received in exchange for a disregarded payment, any item of foreign gross income that the taxpayer recognizes as a result of that same disposition is assigned to a statutory or residual grouping under the U.S. corresponding item rules in § 1.861-20(d)(1) of the 2020 FTC final regulations. Because in this situation the seller's basis in the property initially acquired in a disregarded sale is not adjusted for U.S. tax purposes, but is assumed to reflect the purchase price for foreign tax purposes, the assignment of the foreign gross income resulting from the regarded sale of the property is made without regard to any reattribution of the gain that is recognized for U.S. tax purposes under § 1.904-4(f)(2)(vi)(A) or (D), which apply to attribute U.S. gross income in the amount of the property's built-in gain at the time of the initial acquisition to the foreign branch or foreign branch owner that originally transferred the property in the disregarded sale. The same result obtains with respect to all taxable units under proposed § 1.861-20(d)(3)(v)(B)(
3
).

5. Group-Relief Regimes

The Treasury Department and the IRS are concerned about the use of certain foreign law group-relief regimes (that is, regimes that allow for the sharing of losses of one member of a group with another member) to create a mismatch in how foreign income taxes are characterized under § 1.861-20 for purposes of various operative sections, including sections 245A(d), 904, and 960. Comments are requested on the appropriate treatment of foreign income taxes paid or accrued in connection with the sharing of losses.

VI. Creditability of Foreign Taxes Under Sections 901 and 903

A. Definition of Foreign Income Tax

1. Background and Overview

Section 901 allows a credit for foreign income, war profits, and excess profits taxes, and section 903 provides that such taxes include a tax in lieu of a generally-imposed foreign income, war profits, or excess profits tax.
2

Section 1.901-2, which was originally promulgated in 1983 in TD 7918 (the “1983 final regulations”), sets forth conditions for determining when a foreign levy is a foreign income, war profits, and excess profits tax (collectively, an “income tax”) that is creditable under section 901. Under the existing regulations, a foreign levy is an income tax if and only if (1) it is a tax, and (2) the predominant character of that tax is that of an income tax in the U.S. sense. See § 1.901-2(a)(1). Under § 1.901-2(a)(3), the predominant character of a foreign tax is that of an income tax in the U.S. sense if it meets two requirements: (1) The foreign tax is likely to reach net gain in the normal circumstances in which it applies (the “net gain requirement”), and (2) it is not a “soak-up” tax. To satisfy the net gain requirement, a tax must meet the realization, gross receipts, and net income requirements in § 1.901-2(b)(2), (3), and (4), respectively. Under § 1.901-2(a)(1), a foreign tax either is or is not a foreign income tax, in its entirety, for all persons subject to the foreign tax. This all-or-nothing rule ensures consistent outcomes for taxpayers and minimizes the administrative burdens on the IRS that would result if the creditability of a foreign tax instead varied depending on each taxpayer's particular facts.

2
Taxpayers may generally claim a deduction instead of a credit for these foreign taxes, as well as for certain other foreign taxes that do not qualify for the foreign tax credit. See section 164(a).

The Treasury Department and the IRS have determined that it is necessary and appropriate to require that a foreign tax conform to traditional international norms of taxing jurisdiction as reflected in the Internal Revenue Code in order to qualify as an income tax in the U.S. sense, or as a tax in lieu of an income tax. As discussed in more detail in Part VI.A.2 of this Explanation of Provisions, this requirement will ensure that the foreign tax credit operates in accordance with its purpose to mitigate double taxation of income that is attributable to a taxpayer's activities or investment in a foreign country.

In addition, the Treasury Department and the IRS have determined that it is necessary and appropriate to revise the net gain requirement in order to better align the regulatory tests with norms reflected in the Internal Revenue Code that define an income tax in the U.S. sense, as well as to simplify and clarify the application of the rules. In particular, the existing regulations provide that the net gain requirement is met if a foreign tax reaches net gain in the “normal circumstances” in which it applies. However, this rule leads to inappropriate results and presupposes an empirical analysis requiring access to information that is difficult for taxpayers and the IRS to obtain. Therefore, the proposed regulations narrow the situations in which an empirical analysis is relevant in analyzing the nature of a foreign tax. See Part VI.A.3 of this Explanation of Provisions.

The proposed regulations make other changes to improve or clarify the rules, and to address issues that have arisen since the 1983 final regulations were issued. In particular, the proposed regulations introduce the term “net income tax” to describe foreign levies described in section 901 and the term “foreign income tax” to describe foreign levies described in section 901 or 903. See also Part X.F of this Explanation of Provisions (describing conforming changes made to §§ 1.960-1 and 1.960-2). Conforming changes to the terms and definitions cross-referenced in other regulations will be made when the proposed regulations are finalized.

The proposed regulations specifically address the treatment of surtaxes and the circumstances in which a source-based withholding tax on cross-border income can qualify as a foreign income tax. The proposed regulations also reorganize the existing regulations to address soak-up taxes as part of the determination of the amount of tax paid, rather than as part of the definition of a foreign income tax, and clarify the rules for determining when a foreign tax is a separate levy. The proposed regulations addressing the amount of tax paid also modify the treatment of refundable credits, clarify the interaction between the rules addressing refundable amounts and multiple levies, and clarify the application of the noncompulsory payment rules with respect to foreign tax law elections. Finally, the proposed regulations revise the definition of a tax in lieu of an income tax. These rules are described in more detail in Parts VI.A.3.v, VI.A.4, VI.A.5, VI.B, and VI.C of this Explanation of Provisions.

The proposed regulations do not include proposed amendments to the rules in § 1.901-2A addressing dual

capacity taxpayers. However, certain proposed changes to §§ 1.901-2 and 1.903-1 may impact § 1.901-2A. For example, when the proposed regulations are finalized, certain terms that are defined in § 1.901-2 and cross-referenced in § 1.901-2A will need to be updated. Comments are requested on whether additional changes to § 1.901-2A are appropriate in light of the proposed revisions to §§ 1.901-2 and 1.903-1.

2. Jurisdictional Nexus Requirement

As a dollar-for-dollar credit against U.S. income tax, the foreign tax credit is intended to mitigate double taxation of foreign source income. This fundamental purpose is served most appropriately if there is substantial conformity in the principles used to calculate the base of the foreign tax and the base of the U.S. income tax. This conformity extends not just to ascertaining whether the foreign tax base approximates U.S. taxable income determined on the basis of realized gross receipts reduced by allocable expenses, but also to whether there is a sufficient nexus between the income that is subject to tax and the foreign jurisdiction imposing the tax. Although prior regulations under section 901 did contain jurisdictional limitations on the definition of an income tax, see § 4.901-2(a)(1)(iii) (1980) (requiring that a foreign tax follow “reasonable rules regarding source of income, residence, or other bases for taxing jurisdiction”), the existing regulations do not contain such a rule.

In recent years, several foreign countries have adopted or are considering adopting a variety of novel extraterritorial taxes that diverge in significant respects from traditional norms of international taxing jurisdiction as reflected in the Internal Revenue Code. In addition, the Treasury Department and the IRS have received requests for guidance on whether the definition of foreign income tax includes a jurisdictional limitation, and recommending that the regulations adopt a rule requiring that income subject to foreign tax bear an appropriate connection to a foreign country for a foreign tax to be eligible for the foreign tax credit. In light of these developments, the Treasury Department and the IRS have determined that it is appropriate to revisit the regulatory definition of a foreign income tax to ensure that to be creditable, foreign taxes in fact have a predominant character of “an income tax in the U.S. sense.”

The Treasury Department and the IRS have determined that in order to qualify as a creditable income tax, the foreign tax law must require a sufficient nexus between the foreign country and the taxpayer's activities or investment of capital or other assets that give rise to the income being taxed. For example, a tax imposed by a foreign country on a taxpayer's income that lacks a sufficient nexus to such country (such as the lack of operations, employees, factors of production, or management in that foreign country) is not an income tax in the U.S. sense and should not be eligible for a foreign tax credit if paid or accrued by U.S. taxpayers. Such a nexus is required in order for persons and income to be subject to U.S. income tax, and so a similar nexus reflecting the foreign country's exercise of taxing jurisdiction consistent with Federal income tax principles should be required in order for foreign taxes to be eligible for a dollar-for-dollar credit against U.S. income tax.

The proposed regulations therefore require that for a foreign tax to qualify as an income tax, the tax must conform with established international norms, reflected in the Internal Revenue Code and related guidance, for allocating profit between associated enterprises, for allocating business profits of nonresidents to a taxable presence in the foreign country, and for taxing cross-border income based on source or the situs of property (together, the “jurisdictional nexus requirement”). Proposed § 1.901-2(c)(1)(i) generally provides that in the case of a foreign country imposing tax on nonresidents, the foreign tax law must determine the amount of income subject to tax based on the nonresident's activities located in the foreign country (including its functions, assets, and risks located in the foreign country). Thus, for example, rules that are consistent with the rules under section 864(c) for taxing income effectively connected with a U.S. trade or business, or with Articles 5 and 7 of the U.S. Model Income Tax Convention for taxing profits attributable to a permanent establishment, will meet this requirement. However, foreign countries that, for example, impose tax by using as a significant factor the location of customers, users, or any other similar destination-based criterion to allocate profit (for example, by deeming a taxable presence based on the existence of customers) will not satisfy the jurisdictional nexus requirement.

If the foreign tax law imposes tax on a nonresident's income based on the income arising from sources in the foreign country (for example, tax imposed on interest, rents, or royalties sourced in the foreign country and paid to a nonresident), proposed § 1.901-2(c)(1)(ii) requires the sourcing rules of the foreign tax law to be reasonably similar to the sourcing rules that apply for Federal income tax purposes. For the avoidance of doubt, the proposed regulations provide that in the case of income from services, the income must be sourced based on the place of performance of the services, not the location of the services recipient.

The jurisdictional nexus requirement for taxing gains from sales or other dispositions of property is separately addressed in proposed § 1.901-2(c)(1)(iii), which provides that income from sales or other dispositions of property by nonresidents that do not meet the activities requirement in proposed § 1.901-2(c)(1)(i) satisfy the jurisdictional nexus requirement only with respect to gains on the disposition of real property in the foreign country or movable property forming part of the business property of a taxable presence in the foreign country (or from interests in certain entities holding such property). This rule is consistent with the fact that Federal income tax law generally does not tax gains of nonresidents that do not have a trade or business in the United States. See, for example, section 865(a)(2) and (e)(2); § 1.871-7(a)(1); see also U.S. Model Income Tax Convention (2016), Art. 13.

A similar rule applies under proposed § 1.901-2(c)(2) with respect to determining the income of a resident taxpayer in cases where income of a related entity may be allocated under transfer pricing rules to the resident taxpayer. For the jurisdictional nexus requirement to be satisfied in such a case, the foreign tax law's transfer pricing rules must be determined under arm's length principles. Thus, for example, foreign tax laws that contain transfer pricing rules that are consistent with the arm's length standard under the section 482 regulations, or with the arm's length principle under the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, will satisfy this requirement. However, foreign transfer pricing rules that allocate profits by taking into account as a significant factor the location of customers, users, or any other similar destination-based criterion will not satisfy the jurisdictional nexus requirement. Comments are requested on whether special rules are needed to address foreign transfer pricing rules that allocate profits to a resident on a formulary basis (rather than on the basis of arm's length prices), such as through the use of fixed margins in a manner that is not consistent with arm's length principles. The jurisdictional nexus

requirement is not violated when a foreign country imposes tax on the worldwide income of a resident taxpayer, including under controlled foreign corporation regimes that deem income to be included (or distributed) to a resident shareholder (as opposed to allocated directly to the resident under a transfer pricing adjustment). For this purpose, the terms resident and nonresident are defined in proposed § 1.901-2(g)(6) and in the case of an entity, the classification is generally based on the entity's place of incorporation or management.

As part of its response to the extraterritorial tax measures referred to in this Part VI.A.2 of the Explanation of Provisions, the Treasury Department has been actively engaged in negotiations with other countries, as part of the OECD/G20 Inclusive Framework on BEPS, to explore the possibility of a new international framework for allocating taxing rights.
3

If an agreement is reached that includes the United States, the Treasury Department recognizes that changes to the foreign tax credit system may be required at that time.

3
See Statement by the OECD/G20 Inclusive Framework on BEPS on the Two-Pillar Approach to Address the Tax Challenges Arising from the Digitalisation of the Economy (January 2020), available at
https://www.oecd.org/tax/beps/statement-by-the-oecd-g20-inclusive-framework-on-beps-january-2020.pdf
.

No inference is intended as to the application of existing §§ 1.901-2 and 1.903-1 to the treatment of novel extraterritorial foreign taxes such as digital services taxes, diverted profits taxes, or equalization levies. In addition, the proposed regulations, when finalized, would not affect the application of existing income tax treaties to which the United States is a party with respect to covered taxes (including any specifically identified taxes) that are creditable under the treaty. Comments are requested on the extent to which the new jurisdictional nexus requirement may impact the treatment of other types of foreign taxes, and on alternative approaches the Treasury Department and the IRS may consider to modify the rules to achieve the policy objectives described in this Part VI.A.2 of the Explanation of Provisions.

3. Net Gain Requirement

i. Use of Empirical Analysis

The existing regulations provide that the net gain requirement is met if a foreign tax reaches net gain in the “normal circumstances” in which it applies. See § 1.901-2(a)(1). As noted in the preamble to the 1983 final regulations, this rule is based on the standard set forth in
Inland Steel Company
v.
United States,
677 F.2d 72 (Ct. Cl. 1982),
Bank of America Nat'l Trust and Savings Ass'n
v.
United States,
459 F.2d 513 (Ct. Cl. 1972) (
“Bank of America I”
), and
Bank of America Nat'l Trust and Savings Ass'n
v.
Comm'r,
61 T.C. 752 (1974),
aff'd,
538 F.2d 334 (9th Cir.1976) (“
Bank of America II”
). See TD 7918, 48 FR 46272-01 (1983).

The Treasury Department and the IRS have determined that, in some respects, the empirical analysis contemplated by the existing regulations is unnecessary to identify the essential elements of an income tax in the U.S. sense. In addition, in the absence of specific rules and thresholds in the regulations on how to evaluate empirical data (if even available), both taxpayers and the IRS have had difficulties in applying the existing regulations to foreign taxes in a consistent and predictable manner. In some cases, the reliance on empirical data to determine whether the requirements of the existing regulations are met creates uncertainty and undue burdens for taxpayers and the IRS, considering challenges in obtaining the necessary information. Therefore, the proposed regulations limit the relevance of the “normal circumstances” in which the tax applies, as well as the role of the predominant character analysis, in determining whether a tax meets the various components of the net gain requirement. These changes will lead to more accurate and consistent outcomes and reduce the compliance and administrative burdens of the existing law requirement that taxpayers and the IRS obtain from the foreign government empirical information, such as tax return information for persons subject to the tax, to determine the normal circumstances in which the tax applies.

Instead, proposed § 1.901-2(b)(1) generally provides that whether a tax is a foreign income tax is determined under the terms of the foreign tax law, taking into account statutes, regulations, case law, and administrative rulings or other official pronouncements, as modified by treaties. Accordingly, whether a tax satisfies the net gain requirement is generally based on whether the terms of the foreign tax law governing the computation of the tax base meet the realization, gross receipts, and cost recovery requirements that make up the net gain requirement under § 1.901-2(a)(3). This approach will better allow taxpayers and the IRS to evaluate the nature of the foreign tax based on objective and readily available information (that is, based on the terms of the foreign tax law, rather than how it is applied in practice), to achieve more consistent and predictable outcomes. Evaluation of the normal circumstances in which the tax applies is still a factor in determining whether specific elements of the net gain requirement are satisfied, but the proposed regulations specifically identify the elements of the requirement for which this type of empirical evidence is relevant.

ii. Realization Requirement

Under the existing regulations, a foreign tax generally satisfies the realization requirement if, judged on the basis of its predominant character, it is imposed upon or after the occurrence of events (“realization events”) that would result in the realization of income under the Code, or in certain cases, it is imposed on the occurrence of a pre-realization event, such as in the case of a foreign law mark-to-market regime. See § 1.901-2(b)(2)(i).

As discussed in Part VI.A.3.i of this Explanation of Provisions, due to the burdens resulting from the requirement to perform an empirical analysis to ascertain the nature of a tax, the proposed regulations provide more specific rules regarding the elements of the requirement for which this type of empirical evidence is relevant. In particular, the Treasury Department and the IRS have determined that the inclusion in the foreign tax base of insignificant amounts of gross receipts that do not meet the realization requirement should not prevent an otherwise-qualifying foreign tax from qualifying as an income tax. Accordingly, proposed § 1.901-2(b)(2) provides that if a foreign tax generally meets the various realization requirements described in proposed § 1.901-2(b)(2)(i)(A) through (C), except with respect to one or more specific and defined classes of nonrealization events, the tax may still be treated as meeting the realization requirement if the incidence and amounts of gross receipts attributable to the nonrealization events are minimal relative to the incidence and amounts of gross receipts attributable to events covered by the foreign tax that do meet the realization requirement. This determination is made based on the application of the foreign tax to all taxpayers subject to the foreign tax (rather than on a taxpayer-by-taxpayer basis). Therefore, for example, if a foreign tax contains all of the same realization requirements as the Code, but also imposes tax on imputed rent with respect to owner-occupied housing, the foreign tax may still qualify as a foreign income tax if, relative to all of the income of all taxpayers that are subject to the tax, imputed rental

income comprises a relatively small amount (even if for some taxpayers, all of their income may constitute imputed rent). Comments are requested on whether the regulations could substitute a more objective standard for identifying acceptable deviations from the realization requirement that would avoid the need for empirical analysis.

Proposed § 1.901-2(b)(2)(i)(C) consolidates the rules relating to pre-realization timing differences, including the rule currently in § 1.901-2(b)(2)(ii) that foreign taxes imposed on a shareholder on deemed distributions or inclusions (such as inclusions similar to those imposed by U.S. law under subpart F) of income realized by the distributing entity satisfy the realization requirement, so long as a second tax is not imposed on the shareholder on the same income upon the occurrence of a later event (such as an actual distribution). Under proposed § 1.901-2(b)(2)(i)(C), because a shareholder-level tax on a distribution from a corporation is imposed on a different taxpayer, the shareholder-level tax is not treated as a second tax on the corporation's income (including income arising from a pre-realization event). For this purpose, proposed § 1.901-2(b)(2)(i)(C) provides that a disregarded entity is treated as a taxpayer separate from its owner. Comments are requested on whether there are additional categories of pre-realization timing differences that should be included in the final regulations.

Finally, the Treasury Department and the IRS expect to update the examples illustrating the realization requirement that are contained in § 1.901-2(b)(2)(iv) and include them in the regulations when proposed § 1.901-2(b)(2) is finalized.

iii. Gross Receipts Requirement

Under existing § 1.901-2(b)(3), a foreign tax satisfies the gross receipts requirement if, judged on the basis of its predominant character, it is imposed on the basis of (1) gross receipts; or (2) gross receipts computed under a method that is likely to produce an amount that is not greater than the fair market value of actual arm's length gross receipts (“the alternative gross receipts test”). See § 1.901-2(b)(3)(ii)
Examples 1
and
2.

The proposed regulations modify the alternative gross receipts test to provide that it is satisfied in the case of tax imposed on deemed gross receipts arising from pre-realization timing difference events described in proposed § 1.901-2(b)(2)(i)(C) (that is, a mark-to-market regime, tax on the physical transfer, processing, or export of readily marketable property, or a deemed distribution or inclusion), or on the basis of gross receipts from a non-realization event that is insignificant and therefore does not cause the foreign tax to fail the realization requirement in proposed § 1.901-2(b)(2). Therefore, taxes on insignificant non-realization events or pre-realization timing difference events that satisfy the realization requirement in proposed § 1.901-2(b)(2)(i)(C) also satisfy the gross receipts test.

However, the proposed regulations remove the provision referring to gross receipts computed under a method that is “likely” to produce an amount not greater than gross receipts. This rule purports to allow for foreign taxes to be imposed on an amount greater than the amount of income actually realized, or the value of the property being taxed, and the Treasury Department and the IRS have determined that such a tax should not be considered to be a tax on income, since it can be imposed on amounts in excess of actual gross receipts. In addition, the Treasury Department and the IRS have determined that the test is vague, unduly burdensome, and has given rise to controversies requiring taxpayers and the IRS to conduct an empirical evaluation to determine whether a nonconforming statutory method of determining alternative gross receipts is likely not to exceed the fair market value of actual gross receipts. See, for example,
Phillips Petroleum
v.
Comm'r,
104 T.C. 256 (1995) (applying the former § 1.901-2T (1980) TD 7739). The Treasury Department and the IRS have determined that, other than in the case of insignificant non-realization events, only a tax base determined with reference to realized gross receipts or, in the case of a pre-realization timing difference event, the value or amount of a deemed inclusion or accrual (and not an approximation of gross receipts), should qualify as an income tax in the U.S. sense. In contrast, a tax based on alternative measurements of gross receipts, such as a foreign tax that requires gross receipts to be calculated by applying a markup to costs, fundamentally diverges from the measurement of realized gross receipts under the Internal Revenue Code, and could result in a taxable base that exceeds the amount of income properly attributable to the taxpayer's activities or investment in the foreign country. The revised rule will also minimize the need for empirical analyses, making it simpler for both taxpayers and the IRS to determine whether a tax satisfies the net gain requirement.

This rule is not intended to implicate the allocation of gross income under transfer pricing or branch profit attribution rules, which are instead addressed under proposed § 1.901-2(c). Proposed § 1.901-2(b)(3)(i) provides that in determining a taxpayer's actual gross receipts, amounts that are properly allocated to such taxpayer under the jurisdictional nexus rules in proposed § 1.901-2(c), such as pursuant to transfer pricing rules that properly allocate income to a taxpayer on the basis of costs incurred by that entity, are treated as the taxpayer's actual gross receipts.

iv. Cost Recovery Requirement

Under the net income requirement in the existing regulations, foreign tax law must permit the recovery of the significant costs and expenses attributable, under reasonable principles, to gross receipts included in the taxable base. A foreign tax law permits the recovery of significant costs and expenses even if such costs and expenses are recovered at a different time than they would be under the Code, unless the time of recovery is such that under the circumstances there is effectively a denial of recovery. Under the “nonconfiscatory gross basis tax” rule in § 1.901-2(b)(4) of the existing regulations, which reflects the standard described in
Bank of America I,
a foreign tax whose base is gross receipts or gross income does not satisfy the net income requirement except in the “rare situation” when the tax is almost certain to reach some net gain in the normal circumstances in which it applies because costs and expenses will almost never be so high as to offset gross receipts or gross income, respectively, and the rate of the tax is such that after the tax is paid persons subject to the tax are almost certain to have net gain. Thus, a tax on the gross receipts or gross income of businesses can satisfy the net income requirement in the existing regulations if businesses subject to the tax are almost certain never to incur a loss (after payment of the tax).

The Treasury Department and the IRS have determined that to constitute an income tax for U.S. tax purposes, that is, a tax on net gain, the base of a foreign tax should conform in essential respects to the determination of taxable income for Federal income tax purposes. See, for example,
Keasbey & Mattison Co.
v.
Rothensies,
133 F.2d 894, 895 (3d Cir. 1943) (holding that the criteria prescribed by U.S. revenue laws are determinative of the meaning of the term “income taxes” in applying the former version of section 901); and
Comm'r
v.
American Metal Co.,
221

F.2d 134, 137 (2d Cir. 1955) (providing that “the determinative question is `whether the foreign tax is the substantial equivalent of an `income tax' as that term is understood in the United States' ”). The Treasury Department and the IRS have determined that any foreign tax imposed on a gross basis is by definition not an income tax in the U.S. sense, regardless of the rate at which it is imposed or the extent of the associated costs.

In addition, the Treasury Department and the IRS have determined that the empirical standards contained in
Bank of America I
and that are contemplated by the nonconfiscatory gross basis tax rule in the existing regulations create substantial compliance and administrative burdens for taxpayers and the IRS when evaluating whether a foreign tax is an income tax in the U.S. sense. For example, the IRS and taxpayers must obtain foreign tax return information with respect to all persons subject to the tax to determine if persons subject to the tax are almost certain never to incur an after-tax loss. See, for example,
PPL Corp.
v.
Comm'r,
135 T.C. 304 (2010),
rev'd,
665 F.3d 60 (3d Cir. 2011),
rev'd,
569 U.S. 329 (2013);
Texasgulf, Inc.
v.
Comm'r,
107 T.C. 51 (1996),
aff'd,
172 F.3d 209 (2d Cir. 1999); and
Exxon Corp.
v.
Comm'r,
113 T.C. 338 (1999) (applying the empirical analysis required by the regulations).

Therefore, the proposed regulations remove the nonconfiscatory gross basis tax rule. Instead, the proposed regulations provide that whether a tax meets the net gain requirement is made solely on the basis of the terms of the foreign tax law that define the foreign taxable base, without any consideration of the rate of tax imposed on that base. See proposed § 1.901-2(b)(1). In addition, the cost recovery requirement in proposed § 1.901-2(b)(4) requires the deductions allowed under the foreign tax law to approximate the cost recovery provisions of the Internal Revenue Code in order for the foreign tax to qualify as an income tax in the U.S. sense. Under proposed § 1.901-2(b)(4)(i)(A), a tax that is imposed on gross receipts or gross income, without reduction for any costs or expenses attributable to earning that income, cannot qualify as a net income tax, without regard to whether the empirical impact of the tax is confiscatory, and even if in practice there are no or few costs and expenses attributable to all or particular types of gross receipts included in the foreign tax base. Under this rule, the cost recovery requirement is not satisfied for taxes such as payroll taxes on gross income from wages, but may be satisfied in the case of a personal income tax similar to that imposed under section 1 of the Code on all gross income (including wages), if the foreign country allows taxpayers to reduce such gross income by the substantial costs and expenses that are reasonably attributable to such gross income (taking into account any reasonable deduction disallowance provisions).

Under the “alternative allowance rule” in § 1.901-2(b)(4) of the existing regulations, a foreign tax that does not permit recovery of one or more significant costs or expenses, but that provides allowances that effectively compensate for nonrecovery of such significant costs or expenses, is considered to permit recovery of such costs or expenses. The Treasury Department and IRS have determined, however, that the alternative allowance rule fundamentally diverges from the approach to cost recovery in the Internal Revenue Code, and so is inconsistent with an essential element of an income tax in the U.S. sense. Moreover, it is unduly burdensome, and may be impossible as a practical matter, for taxpayers and the IRS to determine whether an alternative allowance under foreign tax law effectively compensates for the nonrecovery of significant costs or expenses attributable to realized gross receipts under that foreign law. The alternative allowance rule in the existing regulations has given rise to controversies between taxpayers and the IRS, and different interpretations by the courts, over whether the rule requires taxpayers to demonstrate that the alternative allowance exceeds disallowed expense deductions for a majority of persons potentially subject to the tax, a majority of persons that actually pay the tax, or for taxpayers in the aggregate, determined by comparing the aggregate amounts of disallowed deductions and alternative allowances reported on the foreign tax returns of all persons subject to the tax. See, for example,
Texasgulf, Inc.
v.
Comm'r,
107 T.C. 51 (1996),
aff'd,
172 F3d 209 (2d Cir. 1999); and
Exxon Corp.
v.
Comm'r,
113 T.C. 338 (1999). Therefore, the proposed regulations at § 1.901-2(b)(4)(i)(A) modify the alternative allowance rule to treat alternative allowances as meeting the cost recovery requirement only if the foreign tax law expressly guarantees that the alternative allowance will equal or exceed actual costs (for example, under a provision identical to percentage depletion allowed under section 613).

The proposed regulations at § 1.901-2(b)(4)(i)(B)(
1
) retain the existing rule that foreign tax law is considered to permit the recovery of significant costs and expenses even if the costs and expenses are recovered at a different time than they would be if the Internal Revenue Code applied, unless the time of recovery is so much later (for example, after the property becomes worthless or is disposed of) as effectively to constitute a denial of such recovery. The regulations clarify that the different time can be either earlier or later than it would be if the Code applied, and that time value of money considerations relating to the economic cost (or value) of accelerating (or deferring) a foreign tax liability are not relevant in determining the amount of recovered costs and expenses.

The proposed regulations also add a new rule to allow a tax to satisfy the cost recovery requirement even if recovery of all or a portion of certain costs or expenses is disallowed, if such disallowance is consistent with the types of disallowances required under the Internal Revenue Code. See proposed § 1.901-2(b)(4)(i)(B)(
2
). For example, foreign tax law is considered to permit the recovery of significant costs and expenses even if such law disallows interest deductions equal to a certain percentage of adjusted taxable income similar to the limitation under section 163(j) or disallows interest and royalty deductions in connection with hybrid transactions similar to those subject to section 267A. This new provision is consistent with the rule that principles of U.S. law apply to determine whether a tax is a creditable income tax. See § 1.901-2(a)(1)(ii); see also, for example,
Keasbey,
133 F.2d at 897; and
American Metal,
221 F.2d at 137.

Finally, proposed § 1.901-2(b)(4)(i)(B)(
2
) provides that an empirical analysis of a foreign tax is still pertinent, in part, in determining whether a cost or expense is significant for purposes of the cost recovery requirement. In particular, the significance of a cost or expense is determined based on whether, for all taxpayers to which the foreign tax applies, the item of cost or expense constitutes a significant portion of the total costs or expenses. However, proposed § 1.901-2(b)(4)(i)(B)(
2
) adds certainty by providing that costs or expenses related to capital expenditures, interest, rents, royalties, services, and research and experimentation are always treated as significant costs or expenses. The Treasury Department and the IRS have determined that these types of costs represent a substantial portion of expenses typically deducted in computing taxable income for U.S. tax purposes. Requiring a foreign tax law to allow recovery of these costs will

increase assurances that the income subject to U.S. and foreign tax is actually subject to double taxation. Because interest expense in particular is a significant cost that under section 864(e)(2) is allocable to all of a taxpayer's worldwide income-producing activities regardless of where it is incurred, a foreign levy that allows, for example, no deduction for interest expense is not an income tax in the U.S. sense, even if U.S. taxpayers record minimal interest expense in foreign countries that restrict its deductibility.

v. Qualifying Surtax

The Treasury Department and the IRS have received questions on the appropriate treatment of certain foreign taxes that are computed as a percentage of the tax due under a separate levy that is itself an income tax. To address the treatment of these taxes, proposed § 1.901-2(b)(5) adds a rule providing that a foreign tax satisfies the net gain requirement if the base of the foreign tax is the amount of a foreign income tax.

4. Soak-Up Taxes

The proposed regulations move the soak-up tax rule from the rules that define a creditable levy to the rules for determining the amount of creditable tax that is considered paid. See proposed § 1.901-2(e)(6). Because the rules at existing §§ 1.901-2(a)(3)(ii) and 1.903-1(b)(2) treat an otherwise creditable levy as a soak-up tax only to the extent it would not be imposed but for the availability of a credit, this change is more consistent with the general structure of the regulations that determine whether a separate levy as a whole qualifies as a creditable tax, and then identifies the amount of a particular taxpayer's foreign tax liability that is paid or accrued and can be claimed as a foreign tax credit.

In addition, the proposed regulations omit the special rule in § 1.903-1(b)(2) that limits the portion of a tax in lieu of an income tax that is a soak-up tax to the amount by which the foreign tax exceeds the income tax that would have been paid if the taxpayer had instead been subject to the generally-imposed income tax. The Treasury Department and the IRS have determined that this rule is inconsistent with the rationale for making soak-up taxes not creditable, which is to ensure that the foreign country does not impose a soak-up tax liability that under the existing regulations could be allowed as a foreign tax credit to reduce the taxpayer's U.S. tax liability.

Finally, the Treasury Department and the IRS are reconsidering the examples illustrating the soak-up tax rules that are contained in §§ 1.901-2(c)(2) and 1.903-1(b)(3) (
Examples 6
and
7
) and expect to include updated examples in the regulations when proposed § 1.901-2(e)(6) is finalized. Comments are requested on whether additional issues are presented by currently applicable soak-up taxes that should be addressed in the final regulations.

5. Separate Levy Determination

Whether a foreign levy is an income tax is determined independently for each separate foreign levy. For purposes of sections 901 and 903, whether a single levy or separate levies are imposed by a foreign country depends on U.S. principles and not on whether foreign law imposes the levy or levies in a single or separate statutes. Section § 1.901-2(d)(1) of the existing regulations provides that, where the base of a levy is different in kind, and not merely in degree, for different classes of persons subject to the levy, the levy is considered for purposes of sections 901 and 903 to impose separate levies for such classes of persons.

The proposed regulations revise § 1.901-2(d)(1) to clarify the determination of whether a foreign levy is separate from another foreign levy for purposes of determining if a levy meets the requirements of section 901 or 903. The Treasury Department and the IRS have determined that the standards under the existing regulations for making this determination are unclear. In one place the existing regulations state that the only differentiating factor is if the base of the levy is different in kind, as opposed to degree. See, for example, § 1.901-2(d)(1) (“foreign levies identical to the taxes imposed by sections 11, 541, 881, 882, 1491, and 3111 of the Internal Revenue Code are each separate levies, because the base of each of those levies differs in kind, and not merely in degree”). However, in the same sentence, the regulations suggest that one levy may be separate from another levy if a different class of taxpayers is subject to each levy, regardless of whether the base of the two levies is different in kind. See, for example, id. (“a foreign levy identical to the tax imposed by section 871(b) of the Internal Revenue Code is a separate levy from a foreign levy identical to the tax imposed by section 1 of the Internal Revenue Code
as it applies to persons other than those described in section 871(b)”
(emphasis added)).

The proposed regulations modify the rules for determining whether a foreign levy is a separate levy to clarify how U.S. principles are relevant in determining whether one foreign levy is separate from another foreign levy. In general, the proposed regulations identify separate levies as those that include different items of income and expense in determining the base of the tax, but in certain circumstances separate levies may result even if the taxable base of each levy is the same. In particular, proposed § 1.901-2(d)(1)(i) provides that a foreign levy is always separate from another foreign levy if the levy is imposed by a different foreign tax authority, even if the base of the tax is the same. Proposed § 1.901-2(d)(1)(ii) provides the general rule that separate levies are imposed on particular classes of taxpayers if the taxable base is different for those taxpayers. For example, the proposed regulations provide that a foreign levy identical to the tax imposed by section 3101 (employee tax on wage income) is a separate levy from the foreign levy identical to the tax imposed by section 3111 (employer tax on wages paid). Proposed § 1.901-2(d)(1)(ii) also provides that income included in the taxable base of a separate levy may also be included in the taxable base of another levy (which may or may not also include other items of income); and separate levies are considered to be imposed if the taxable bases are not combined as a single taxable base. Therefore, a foreign levy identical to the tax imposed by section 1411 is a separate levy from a foreign levy identical to the tax imposed by section 1 because tax is separately imposed on the income included in each taxable base.

Additionally, the proposed regulations at § 1.901-2(d)(1)(iii) provide that a foreign levy imposed on nonresidents is treated as a separate levy from that imposed on residents of the taxing jurisdiction, even if the base is the same for both levies, and even if the levies are treated as a single levy under foreign tax law. These changes are intended to ensure that, in general, if a generally-imposed income tax on residents is also imposed on an extraterritorial basis on some nonresidents, in violation of the jurisdictional nexus requirement, only the portion of the levy that applies to nonresidents will not be treated as a foreign income tax. Otherwise, a foreign country's general income tax regime could fail to qualify as a net income tax if the tax was also imposed on an extraterritorial basis on some nonresidents.

Finally, proposed § 1.901-2(d)(1)(iii) provides that a withholding tax on gross income of nonresidents is treated as a separate levy with respect to each class of gross income (as listed in section 61) to which it applies. This special rule is

provided in order to allow withholding taxes that are imposed on several classes of income, based on sourcing rules that meet the jurisdictional nexus requirement with respect to only some of the classes of income, to be analyzed as separate levies under the covered withholding tax rule in § 1.903-1(c)(2). See Part VI.C.3 of this Explanation of Provisions.

B. Amount of Tax That is Considered Paid

1. Background

As discussed in more detail in Part X of this Explanation of Provisions, section 901 allows a credit for foreign income taxes in either the year the taxes are paid or the year the taxes accrue, according to the taxpayer's method of accounting for such taxes. See section 905(a). Regardless of the year in which the credit is allowed, the taxpayer must both owe and actually remit the foreign income tax to be entitled to a foreign tax credit for such tax. See section 905(b);
Chrysler
v.
Comm'r,
116 T.C. 465, 469 n.2 (2001),
aff'd,
436 F.3d. 644 (6th Cir. 2006). The taxpayer's liability for the tax may become fixed and determinable in a different taxable year than that in which the tax is remitted, so that the taxpayer's entitlement to the credit may be perfected in a taxable year after the taxable year in which the credit is allowed.

Section 1.901-2(e) of the existing regulations provides rules for determining the amount of foreign tax that is considered paid and eligible for credit under section 901. The existing regulations at § 1.901-2(g)(1) and proposed § 1.901-2(g)(5) clarify that the word “paid” as used in § 1.901-2(e) means “paid” or “accrued,” depending on whether the taxpayer claims the foreign tax credit for taxes paid (that is, remitted) or accrued (that is, for which the liability becomes fixed) during the taxable year. The proposed regulations clarify in several respects the amount of tax that is considered paid (or accrued, as the case may be) and eligible for credit. These clarifications are explained in Parts VI.B.2 and 3 of this Explanation of Provisions.

2. Refundable Amounts, Credits, and Multiple Levies

Under § 1.901-2(e)(2)(i) of the existing regulations, a payment to a foreign country is not treated as an amount of tax paid to the extent that it is reasonably certain that the amount will be refunded, credited, rebated, abated, or forgiven. That regulation further provides that it is not reasonably certain that an amount will be refunded, credited, rebated, abated, or forgiven if the amount is not greater than a reasonable approximation of the final tax liability to the foreign country.

Current law is unclear whether an amount that is not treated as an amount of tax paid under § 1.901-2(e)(5)(i) because it is reasonably certain to be credited against a taxpayer's tentative liability for a second foreign tax should be treated as a constructive refund of the credited amount from the foreign country, followed by a constructive payment by the taxpayer of the second foreign tax. The law is similarly unclear as to whether credits allowed under foreign tax law that are computed with reference to amounts other than foreign tax payments (such as, for example, investment tax credits) may be treated as a constructive receipt of cash by the taxpayer from the foreign country, followed by a constructive payment by the taxpayer of foreign income tax. The results have sometimes differed depending on whether the credit is refundable under foreign law, that is, whether taxpayers are entitled to receive a cash payment from the foreign country to the extent the credit exceeds the taxpayer's foreign income tax liability. See, for example, Rev. Rul. 86-134, 1986-2 C.B. 104 (investment incentives reduced tentative Dutch income tax liability during period in which such incentives could only be claimed as an offset against the income tax liability, rather than as a refundable credit).

The Treasury Department and the IRS have determined that the current uncertainty as to how to properly account for tax credits leads to varying and inconsistent interpretations and that a single, clear rule regarding the treatment of tax credits would improve the consistency in outcomes for taxpayers. In addition, the Treasury Department and the IRS are concerned that if the use of tax credits can be treated as a means of payment of a foreign income tax for foreign tax credit purposes, then foreign countries, rather than reducing their tax rates, could instead offer tax credits that would have the same economic effect without reducing the amount of foreign income tax that is treated as paid by taxpayers for purposes of the foreign tax credit. The Treasury Department and the IRS have also determined it is too administratively challenging to determine whether a foreign country whose law provides for nominally refundable credits in practice actually issues cash payments to taxpayers that do not have income tax liabilities equal to the credit. In addition, the Treasury Department and the IRS have determined that the rule in § 1.901-2(e)(2)(i) with respect to amounts that will be “credited” is ambiguous. Section 1.901-2(e)(4)(i) of the existing regulations provides that if, under foreign law, a taxpayer's tentative liability for one levy (the “first levy”) is or can be reduced by the amount of the taxpayer's liability for a different levy (the “second levy”), then the amount considered paid by the taxpayer to the foreign country pursuant to the second levy is an amount equal to its entire liability for that levy, and the remainder of the amount paid is considered paid pursuant to the first levy. However, § 1.901-2(e)(2)(i) suggests that the credited amount of the second levy is not considered paid.

Therefore, proposed § 1.901-2(e)(2)(i) provides certainty on the treatment of credited amounts by eliminating the provision that suggests that an amount of tax is not treated as paid if it is allowed as a credit. Instead, proposed § 1.901-2(e)(2)(ii) provides that foreign income tax is not considered paid if it is reduced by a tax credit, regardless of whether the amount of the tax credit is refundable in cash. Therefore, an amount allowed as a credit (including, but not limited to, an amount paid under one levy that is credited against an amount due under another levy) is not treated as a constructive payment of cash from the foreign country (or a constructive refund of the levy that is paid) followed by a constructive payment of the levy that is reduced by the credit, even if the creditable amount is refundable in cash to the extent it exceeds the taxpayer's liability for the levy that is reduced by the credit. However, proposed § 1.901-2(e)(2)(iii) provides that overpayments of tax (which exceed the taxpayer's liability and so are not treated as an amount of tax paid) that are refundable in cash at the taxpayer's option and that are applied in satisfaction of the taxpayer's liability for foreign income tax may qualify as an amount of such foreign income tax paid.

Comments are requested on whether additional rules should be provided for government grants

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2020-21818. Public record. Not legal advice.