IRS issues proposed regulations on allocation/apportionment of deductions and creditable foreign taxes

Allocation/apportionment of deductions

The proposed regulations address the allocation and apportionment of deductions under Internal Revenue Code sections 861 through 865. This includes new rules on the:

  • Allocation and apportionment of research and experimentation (“R&E) expenditures
  • Allocation and apportionment of stewardship expenses
  • Allocation and apportionment of damages and settlement payments and
  • Allocation and apportionment of foreign income taxes
  1. Research and Experimentation Expenditures (“R&E”)

The IRS has proposed to modify the regulations to reflect that R&E expenditures that are deductible under section 174 generally give rise to intangible property and that, under the rules in section 367(d) and section 482, the person incurring such R&E expenditures must be compensated properly when such intangible property gives rise to income.

R&E expenditures ordinarily are considered deductions that are definitely related to all gross intangible income reasonably connected to the relevant Standard Industrial Classification Manual code (“SIC Code”) of the taxpayer. Gross intangible income is defined as all gross income earned by a taxpayer that is attributable to intangible property derived from R&E expenditures and does not include dividends or any amounts included under sections 951, 951A or 1293. As the U.S. taxpayers gross intangible income does not include income assigned to section 951A category, none of its R&D expenditures are allocated or apportioned to the section 951A category.

2.      Stewardship Expenses

The proposed regulations provide that stewardship expenses are allocated to inclusions under sections 951 and 951A, section 78 dividends and all amounts included under the passive foreign investments company provisions. The expenses are apportioned based upon the relative values of a taxpayer’s stock assets as determined under the same rules applicable to interest expense (fair market value may not be used).

3.      Litigation Damage Awards, Prejudgement Interest and Settlement Payments

The proposed regulations provide such payments are allocated to the class or classes of gross income produced by the specific sales of products or services that gave rise to the claims for damage or injury and

4.      Foreign Tax Expense

Significant additional guidance focuses on situations of mismatch (i.e. the different year for recognition between the host country and federal, entity classification, etc.)

The proposed regulation provides rules for allocating and apportioning foreign tax expenses among the statutory and residual groupings by:

  1. Assigning foreign gross income on which a foreign tax is imposed to a grouping,
  2. Allocating and apportioning deductions under foreign law to that income, and
  3. Allocating and apportioning the foreign tax among the grouping.
Foreign tax redeterminations

The regulations clarify the effect of foreign tax redeterminations of foreign corporations on the application of the high-tax exception described in section 954(b)(4). They also address required notifications to the IRS of foreign tax redeterminations and related penalty provisions.

The proposed regulations provide that a U.S. tax redetermination be required in all cases to account for the effect of a foreign corporation’s foreign tax redetermination. Additionally, they would clarify that the required adjustments by reason of a foreign tax redetermination of a foreign corporation include:

  • Adjustments to the amount of foreign taxes deemed paid and the related section 78 dividend,
  • Adjustments to the foreign corporation’s income and earnings and profits, and
  • The amount of the U.S. shareholder’s inclusions under section 951 and section 951A in the year to which the redetermined foreign tax relates.

The proposed regs also contain rules for when and how taxpayers must notify the IRS of a foreign tax redetermination, as well as rules on the penalty for failure to provide the IRS with such notification. These notification rules would require pass-through entities that report creditable foreign income tax to their partners, shareholders or beneficiaries to notify the IRS of a foreign tax redetermination.

In addition, the proposed regulations would provide that a U.S. tax redetermination be required when a foreign tax redetermination affects whether a taxpayer is eligible for the subpart F high-tax exception. Therefore, the regulations would stipulate that the subpart F high-tax exception be applied by considering the redetermined foreign tax in the adjusted year.

Application of foreign tax credit disallowance under section 965(g)

The proposed regulations clarify that existing principles would apply when determining the extent to which foreign income taxes are attributable to distributions of previously taxed earnings and profits.

For example, foreign withholding taxes imposed on an amount that’s recognized as a dividend for foreign — but not federal — income tax purposes are attributable to an item of income to which that amount would be assigned if recognized as a distribution for federal income tax purposes. To the extent a distribution would be a distribution of previously taxed earnings and profits, the tax would be associated with previously taxed earnings and profits and disallowed in part under section 965(g).

Application of foreign tax credit limitation to consolidated groups

The proposed regulations include amendments to regulations under section 1502 relating to the calculation of the consolidated foreign tax credit. The proposed amendments would update the regulations to reflect changes in the law, such as by eliminating out-of-date references to the per-country limitation.

For purposes of determining the foreign tax credit limitation, the proposed regulations also would provide that the amount of foreign source income in each separate category, used as the numerator in the foreign tax credit limitation fraction, be determined by applying the rules, as well as section 904(f) and section 904(g), on a groupwide basis, rather than applying those rules on a separate-member basis and combining the results.

Potential changes, possible effects

Various applicability dates apply to specific regulations within the proposed regulations. For more information on the potential changes and their possible effects on your tax situation, consult your Elliott Davis advisor.