The Treasury Department and IRS today released for publication in the Federal Register temporary regulations (T.D. 9748), and by cross-reference, proposed regulations (REG-100861-15) relating to the allocation by a partnership of creditable foreign tax expenditures among its partners. These regulations modify final regulations published in 2006 (T.D. 9292) and amended in 2015 (T.D. 9710). As explained in the preamble to today’s release, the temporary regulations are necessary to improve the operation of the regulatory safe harbor rule that is used for determining whether allocations of creditable foreign tax expenditures are deemed to be in accordance with the partners’ interests in the partnership.
Comments or requests for a public hearing are due by a date that is 90 days after February 4, 2016 (the scheduled date of publication of these regulations in the Federal Register).
In general, the temporary regulations are effective for partnership tax years both beginning on or after January 1, 2016, and ending after February 4, 2016.
The temporary regulations also modify an existing transition rule with respect to certain inter-branch payments for partnerships whose agreements were entered into prior to February 14, 2012. That transition rule is modified to provide that for tax years that both begin on or after January 1, 2016, and end after February 4, 2016, eligible partnerships may continue to apply the provisions of Reg. section 1.704-1(b)(4)(viii)(d)(3) (revised as of April 1, 2011) but must apply the provisions of Reg. section 1.704-1T(b)(4)(viii)(c)(3)(ii) to prevent a mismatch between the allocation income and related taxes.
Section 704(a) grants taxpayers a great deal of flexibility to craft the economic terms of their partnerships by providing that a partner's distributive share of income, gain, loss, deduction, or credit will—except as otherwise provided—be determined by the partnership agreement. The broad flexibility granted in section 704(a) is limited by section 704(b), which provides that a partner's distributive share of income, gain, loss, deduction, or credit (or item thereof) will be determined in accordance with the partner's interest in the partnership (determined by taking into account all facts and circumstances) if the allocation to a partner under the partnership agreement of income, gain, loss, deduction, or credit (or item thereof) does not have substantial economic effect. Generally speaking, this requirement is designed to provide that partnership allocations have real economic consequences and are not driven entirely by tax considerations.
The existing section 704(b) regulations are premised on the assumption that an allocation of foreign taxes can never have substantial economic effect, and thus must be allocated in accordance with the partner’s interest in the partnership. The regulations then provide a safe harbor under which an allocation of creditable foreign tax expenditures (CFTEs) is deemed to be in accordance with the partner’s interest in the partnership and thus respected.
Two conditions must be met to satisfy the safe harbor:
To apply the safe harbor, a partnership first allocates its income to one or more CFTE categories based on the partnership’s activities. Second, the partnership determines its net income in each CFTE category generally based on U.S. tax principles, and third, the partnership allocates its CFTEs to each category by looking to the foreign tax base. The intent of the safe harbor is to determine that allocations of CFTEs are matched with the income to which they relate. A CFTE is a foreign tax paid or accrued by a partnership that is eligible for a credit under section 901(a) or an applicable U.S. income tax treaty, regardless of whether the partner actually elects to credit foreign taxes.
The temporary regulations modify the safe harbor rules with respect to section 743(b) adjustments, deductible income allocations, and nondeductible guaranteed payments. In addition, the temporary regulations make other mainly clarifying changes to the existing regulations.
Effect of section 743(b) adjustments: The existing regulations provide that in determining net income in a CFTE category, a partnership takes into account all partnership items attributable to the relevant activity or group of activities, including items of gross income, gain, loss, deduction, and expense, and items allocated under 704(c). The existing regulations do not address whether an adjustment under section 743(b) is taken into account in computing the partnership’s net income in a CFTE category.
The temporary regulations provide that a partnership must determine its net income in a CFTE category without regard to any section 743(b) adjustment of its partners. The preamble explains that the IRS and Treasury believe that a transferee partner’s section 743(b) adjustment with respect to its interest in a partnership is not to be taken into account in computing the partnership’s net income in a CFTE category because: (1) the basis adjustment is unique to the transferee partner; and (2) the basis adjustment ordinarily would not be taken into account by a foreign jurisdiction in computing its foreign taxable base.
However, the temporary regulations provide when an upper-tier partnership has a section 743(b) adjustment to the basis of the assets in a lower-tier partnership, in such an instance, the upper-tier partnership’s section 743(b) adjustment is taken into account in determining the upper-tier partnership’s net income in a CFTE category.
The preamble to today’s regulations notes that a section 743(b) adjustment may give rise to basis differences subject to section 901(m). The IRS and Treasury plan to address section 901(m) issues in separate future guidance.
Finally, the preamble requests comments on how other adjustments that are specific to a partner are to be taken into account in computing net income in a CFTE category. In addition, the IRS and Treasury have requested comments on whether the application of the safe harbor is to differ with respect to CFTEs that are determined by taking into account partner-specific adjustments that are similar to those that apply for U.S. tax purposes in computing the foreign taxable base of a partnership.
Special rules for deductible allocations and nondeductible guaranteed payments: The existing regulations provide for a reduction to the partnership’s net income in a CFTE category to the extent that the partnership is entitled to a deduction under foreign law for an amount allocated to a partner. The rule aligns the U.S. tax treatment with foreign law—because no CFTE’s are imposed on the income against which a deduction is allowed, the income is not to be in the allocation base which is determined under foreign law. Similarly, when U.S. law allows a deduction for a guaranteed payment to a partner under section 707(c), but foreign law does not allow a deduction, the amount is added back to partnership net income in a CFTE category.
The temporary regulations address permutations on the basic rules that are not covered in the existing regulations. For example, the regulations address the treatment of preferential allocations of gross income and guaranteed payments when the laws of two jurisdictions are involved, and only one allows a deduction (e.g., when country X partnership makes preferential allocation of gross income that is deductible in X but is made out of income of a country Y branch and is subject to Y tax). Reg. section 1.704-1T(b)(5), Example 25, as modified by the temporary regulations, illustrates these rules.
The temporary regulations also clarify that the rules apply regardless of the timing of a foreign law deduction (e.g., whether a foreign jurisdiction allows a deduction in the current year or a later year). The preamble explains that the intent of the changes is to provide more appropriate matching of CFTEs and the income to which they relate.
Other changes: The temporary regulations clarify the impact of inter-branch payments that are disregarded for U.S. tax purposes on CFTE categories and CFTEs. First, the preamble explains that the special rules for preferential allocations and guaranteed payments apply only to payments made to a partner, and not to other amounts that may be deductible under foreign law. Thus, income in a CFTE category is not reduced by reason of an inter-branch payment that is disregarded for U.S. tax purposes, even if the income out of which the payment is made is not subject to foreign tax. Second, withholding taxes on disregarded payments must be apportioned to CFTE categories that include the related income. See Reg. section 1.704-1T(b)(5), Examples 36 and 37.
The regulations also clarify when income from a divisible part of a single activity must be treated as income from a separate activity, and thus included in a separate CFTE category. Income from a divisible part of a single activity is treated as income from a separate activity whenever the income is subject to different allocations. Finally, the temporary regulations make certain organizational and other non-substantive changes, to clarify how items of income under U.S. federal income tax law are assigned to an activity and how a partnership’s net income in a CFTE category is determined. Notably, the term “distributive share of income” in these regulations is changed to “CFTE category share of income” to avoid confusion with the term “distributive share” as used more generally to describe amounts received from a partnership. No difference in meaning or purpose is intended.
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