Part 6 : Foreign Tax Credit Proposed Regulation
The IRS and Treasury released proposed regulations (Proposed Regs) on 28 November 2018. The Proposed Regs. are the first form of guidance issued following changes to the foreign tax credit (FTC) regime in the 2017 Tax Reform Act.
Among other things, Tax Reform doubled the number of statutory FTC “baskets” by adding two additional categories. The Proposed Regs. provide guidance on allocating income and taxes to these new baskets, as well as clarifying a number of other issues for US individuals and corporations.
In this article, we highlight some areas that will affect individual taxpayers.
Global Intangible Low Taxed Income (‘GILTI’) basket
The 2017 Tax Reforms created a new basket to categorise income for amounts includible as Global Intangible Low Taxed Income (‘GILTI’) income under Section 951A. The Proposed Regs. simply define this as income included under section 951A (GILTI inclusion) and on gross-up for deemed foreign taxes paid. The addition of this basket is a blow for US taxpayers living outside the US hoping to use the excess foreign tax credits they have built up in the general basket.
As discussed in Part 3 earlier in this US Tax Reform series, there is no provision for individuals to claim foreign tax credits for the corporation tax paid by the CFC. The Proposed Regs. did not comment on this issue so our assumption is that this position will remain as it is.
Credits for tax on CFC distributions
The Proposed Regs. clarify how foreign tax on CFC distributions (dividends) are grouped. This is already a complex area and the Proposed Regs. add further complexity by vastly increasing the number of groups which taxpayers with CFC income must now track.
Income, deductions and current year taxes would be grouped in one of ten groups based on the type of inclusion that generated the income. The important point here is that foreign tax on distributions which have been taxed previously as GILTI income, should go into the GILTI basket.
The Proposed Regs. do not provide any ordering rules if the distribution consists of more than one type of income, for example if the CFC has earnings and profits taxed as GILTI income and earnings and profits taxed in prior years. Further guidance to be issued in early 2019 is expected to address this issue.
Foreign Branch Basket
Tax Reform also created a new basket for foreign branch income, which is defined as “business profits of a US person attributable to one or more qualified business units (QBU) in one or more foreign countries”.
A QBU, within the meaning of section 989(a), means any separate and clearly identified unit of a trade or business of a taxpayer which maintains separate books and records. However, the Proposed Regs. provided a change from the general rule for partnerships. The foreign activities of a partnership that carries on a trade or business outside the US will be treated as a foreign branch even if the partnership does not maintain separate books and records.
This new basket will generally capture income from a self-employment carried on outside the US, including US citizen partners in professional services firms based outside the US.
The Proposed Regs. confirm that the foreign branch income basket is determined on an aggregate basis and not branch-by-branch, and that only branches of a US person (as opposed to a branch of a foreign corporation) are within the definition.
Pre-2018 FTC carry forward balances
The Proposed Regs. include an election whereby a taxpayer can re-allocate a portion of their general limitation FTC carry forwards to the foreign branch basket. This is because previously this type of income would generally have been included in the general basket and excess foreign tax credits may have accrued in that basket, leaving a balance of carry forward FTCs.
The amount available to be re-allocated is the amount of FTCs that would have been allocated to the foreign branch basket if it had existed prior to 2018.
As expected there is little relief for US taxpayers subject to the GILTI rules. The Proposed Regs. confirm that GILTI income will be allocated to the new GILTI basket, preventing taxpayers using their carried forward foreign tax credits to reduce the tax on GILTI income.
With the addition of the new baskets and rules on CFC distributions, it is now increasingly important to analyse and categorise income into the relevant groups and baskets.
Individuals may want to utilise the election to re-allocate pre-2018 FTC carry forwards to the foreign branch basket. To do so, it would be necessary to analyse the make-up and character of the FTC carry forwards and the income basket to which they would have been included as if the foreign branch basket had existed in prior years.
The exercise to re-allocate pre-2018 FTC could result in a time consuming and costly exercise if taxpayers have FTC carry forwards from the previous 10 years. However, the benefit of reallocating FTC carry forwards to the foreign branch basket would need to be considered with other factors such as anticipated future foreign branch basket profits and the expected level of foreign tax payable on those profits.
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