On November 28, 2018, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations concerning foreign tax credit determinations and related issues (Proposed Regulations) to take into account changes to the Internal Revenue Code made by the Tax Cuts and Jobs Act (TCJA). The Proposed Regulations were highly anticipated because their application will significantly impact the practical cost to taxpayers of many provisions of the TCJA, most notably the new Global Intangible Low-Taxed Income (GILTI) provisions.

In general, except in the case of short taxable years, the Proposed Regulations will only apply to taxable years beginning after December 22, 2017. Specifically, the Proposed Regulations, depending on the provision, are proposed to be effective for taxable years beginning after December 22, 2017, for taxable years ending on or after the date the Proposed Regulations are published in the Federal Register, or for taxable years that satisfy both of those tests. Written or electronic comments and requests for a public hearing have been requested, and must be received within 60 days after the regulations are published in the Federal Register. This legal alert provides a high-level overview of the Proposed Regulations, as well as certain preliminary observations.

US taxpayers generally are entitled to offset their US income taxes with credits for foreign income taxes paid or accrued, subject to various limitations computed separately based on the net income in certain specific foreign-source income categories after taking into account a portion of the expenses incurred at the US shareholder level.

The TCJA made several changes relevant to the calculation of foreign tax credits, including:

  • adding foreign tax credit limitation categories for foreign branch income and amounts subject to tax under the GILTI provisions;
  • eliminating the fair market value method for interest expense apportionment;
  • modifying the required calculations to reflect the new 100% dividends received deduction available for certain foreign source dividends under section 245A; and
  • making significant changes to how taxes paid by foreign subsidiaries are deemed paid by their US shareholders, including eliminating multi-year pooling and deemed-paid foreign tax credits related to taxable dividends.

Some preliminary observations on the Proposed Regulations include:

  • GILTI Rules. The Proposed Regulations require that expenses are allocated and apportioned to the GILTI limitation category, in addition to the other foreign source income categories.
    • However, the amount of expenses apportioned to the GILTI limitation category is reduced (and therefore the cost to many taxpayers is correspondingly reduced) by
      • treating a portion of stock as related to a category other than the GILTI limitation category to the extent the stock relates to income that is “tested income” for GILTI purposes but not included under the GILTI provision (because it is offset by the “tested loss” of another controlled foreign corporation (CFC) or by the allowance related to qualified business asset investments), and
      • treating up to 50% of the stock that is related to the GILTI limitation category as an exempt asset, such that no expenses are apportioned to it.
  • CFC Look-Through. The Proposed Regulations provide that look-through treatment under section 904(d)(3) applies to dividends, interest, rents and royalties only if such payments are allocable to the passive limitation category, and therefore such payments will not be treated as GILTI limitation category income.
  • Section 245A Rules. The Proposed Regulations provide detailed rules and examples addressing new section 904(b)(4), which generally will reduce the foreign tax credit limitation for categories other than the general limitation category and may significantly impact the calculation of foreign tax credits.
  • Deemed Paid Taxes Guidance. The Proposed Regulations make clear that, with respect to CFCs, only foreign taxes properly attributable to either subpart F income, GILTI income or distributions of previously taxed income are creditable. Under the Proposed Regulations, foreign taxes paid with respect to earnings included in income of a US shareholder under section 956 are not creditable.
    • The Proposed Regulations provide detailed rules for associating foreign taxes paid by CFCs with specific earnings and inclusions by the US shareholder based on subsets of income in the limitation categories, including for purposes of the high-tax exception. For example, foreign base company income and foreign base company services income are in different groups for this purpose.
    • The Proposed Regulations clarify that the section 78 gross-up for foreign taxes of CFCs deemed paid by a US shareholder is allocated to the same category as the income to which it relates, including taxes allocated to GILTI inclusions.
  • Foreign Branch Income Category. Guidance is provided on what income is included in the new foreign branch income category, which is relevant not only to foreign tax credit calculations, but also for purposes of determining what income is eligible for the new deduction related to foreign-derived intangible income.
  • Transition Rules. The transition rules applicable to foreign tax credit carryovers and relevant loss accounts generally require continuity of treatment for pre- and post-TCJA periods, but:
    • provide that general limitation category overall foreign losses will not be recaptured as a result of GILTI limitation category income, and
    • provide an election to relate certain pre-TCJA items to the new foreign branch income category where the item would have been in such category had such category existed prior to the TCJA.
  • Additional Transition Tax Guidance. The Proposed Regulations also provide additional guidance regarding the application of the section 965(n) election to not apply net operating loss deductions to offset certain transition tax liabilities.
  • Base and Timing Difference Rules. New rules concerning base and timing differences are provided, which generally treat most differences as timing differences. Significantly, foreign taxes of a CFC attributable to a base difference will not be eligible to be treated as deemed paid.
  • Non-TCJA Rules. Unrelated to changes made by the TCJA, the Proposed Regulations address certain planning techniques taxpayers had used under prior law to optimize their foreign tax credit positions, including using hybrid instruments under the “interest netting rule” and through loans to foreign partnerships held by US shareholders.

Although the Proposed Regulations are 312 pages in length, only 184 of those pages are devoted to the text of the Proposed Regulations. The remaining pages include significant explanatory narrative paragraphs, including a number of requests for comments on specific aspects of the Proposed Regulations. Finally, the Proposed Regulations include detailed analyses presumably intended to satisfy various Special Analyses provisions, including review by the Office of Information and Regulatory Affairs, the requirements of various Executive Orders including EO 13563, EO 12866 and EO 13172 (Federalism), the Paperwork Reduction Act, the Regulatory Flexibility Act, and the Unfunded Mandates Reform Act.