The Tax Cuts and Jobs Act has changed the rules for allocating and apportioning expenses for determining section 904’s foreign tax credit limitation. Taxpayers will lose some discretion under new proposed regs and face narrower FTC limitation silos.
New proposed regs (REG 105600-18) address the allocation and apportionment of deductions under sections 861 through 865 to determine taxable income from foreign sources. Most significantly, the proposed regs illustrate how new sections 951A (global intangible low-taxed income) and 245A (participation exemption) are absorbed into FTC limitation calculations.
Section 1.861-12 provides guidance on applying the asset method to apportion expenses to income categories in computing the FTC limitation. The rules characterize the stock by reference to the corporation’s income. For controlled foreign corporations, the rules generally look through to the income generated by the CFC’s assets.
Before the TCJA, CFC income was assigned to the same category that would be assigned if it were earned directly by the U.S. shareholder. This occurred because the categories for a CFC and a U.S. person were the same, and the look-through rules under section 904(d)(3) ensured that after income was assigned to a category, the assignment was maintained when the income was subsequently distributed to, or otherwise included by, the CFC’s owner.
New prop. reg. section 1.861-13, however, includes a new five-step process in which a taxpayer assigns portions of its CFC stock’s tax book value to one of 10 statutory groupings under the asset or modified gross income method based on the type of income the CFC generates. Each of the 10 statutory groupings generally belongs in one of three categories, and each category has two subcategories.
The 5-Step Process
Step 1 of prop. reg. section 1.861-13(a) characterizes CFC stock as generating income in statutory groupings under the asset or modified gross income method. The ten statutory groupings in prop. reg. section 1.861-13(a)(1)(A) generally separate income into foreign and U.S. source:
foreign-source gross tested income;
U.S.-source tested income resourced under a treaty;
U.S.-source tested income not resourced;
foreign-source subpart F income;
U.S.-source subpart F income resourced under a treaty;
U.S.-source subpart F income not resourced;
foreign-source section 245(a)(5) income;
U.S.-source section 245(a)(5) income;
any other foreign-source income (general or passive); or
any other U.S.-source income (general or passive).
Step 2 assigns stock value that was characterized as general category foreign-source gross tested income in step 1 to the section 951A category by using the U.S. shareholder’s inclusion percentage.
Only a portion of the tested income stock value is assigned to the section 951A category because the amount of the GILTI inclusion may be less than the CFC’s tested income due to offsets from another CFC’s tested loss or net deemed tangible income return.
The inclusion percentage in section 960(d)(2) considers the percentage of net CFC tested income that is a GILTI inclusion. Gross tested income not included as GILTI is assigned to the general category. A U.S. shareholder with no GILTI inclusion has an inclusion percentage of zero and none of its CFC stock value is assigned to the section 951A category.
Moreover, a portion of the stock value assigned to the section 951A category may be treated as an exempt asset. The portion of the CFC stock treated as an exempt asset equals the portion of CFC stock value characterized as a GILTI inclusion multiplied by a fraction that equals the U.S. shareholder’s deduction allowed under section 250(a) (taking into account section 250(a)(2)(B) reductions) divided by its GILTI inclusion amount.
Step 3 assigns stock value characterized as tested or subpart F income resourced under a treaty to a treaty category. One treaty can have multiple groupings, and one grouping can have multiple treaties.
Step 4 aggregates stock value from the statutory groupings into three income categories: general, passive, and residual U.S. source.
Step 5 determines the section 245A and non-section 245A subgroups for each of the general, passive, and U.S.-source categories from step 4. Generally, the portion of stock value that does not generate income included under section 951A(a) or 951(a)(1) and does not represent income described in section 245(a)(5) (which causes a dividends received deduction under section 245 instead of section 245A) is assigned to a section 245A subgroup.
The section 245A subgroup of the general category includes tested income not assigned to section 951A and foreign-source general income. The section 245A subgroup of the passive category includes foreign-source passive tested income multiplied by 100 minus the inclusion percentage and specified foreign-source passive income. The remainder is assigned to the non-section 245 subgroup of the general and passive categories.
Examples
An example in prop. reg. section 1.861-8(d)(2)(C)(5) provides guidance on calculating the exempt asset amount when a CFC has a GILTI inclusion. The example is useful in understanding how to address CFC value assigned to a section 951A category in step 2 of the five-step process.
USP wholly owns CFC1 and CFC2, which have tax book values of $10,000 and $9,000, respectively. $6,100 of CFC1’s stock value and $4,880 of CFC2’s stock value is assigned to the section 951A category, and their remaining value is assigned to the general category (indicating inclusion percentages of 61 percent and 54.2 percent, respectively).
USP’s GILTI inclusion amount is $610, and the portion of USP’s section 250(a) deduction is $305, which is exempt income for purposes of apportioning deductions to calculate section 904’s FTC limitation.
The GILTI inclusion CFC1 and CFC2 stock is in the section 951A category. The portion treated as an exempt asset is the value of GILTI inclusion stock multiplied by 50 percent ($305/$610); therefore, the exempt portions for CFC1 and CFC2 are $3,050 and $2,440, respectively. The CFC1 stock taken into account for purposes of apportioning deductions is $3,050 of nonexempt section 951A category stock and $3,900 of general category stock. CFC2’s stock value is apportioned between the (nonexempt) section 951A category ($2,440) and the general category ($4,120). (See Table 1.)
| CFC1 | CFC2 |
|---|---|---|
Tax book value | $10,000 | $9,000 |
$6,100 | $4,880 | |
General | $3,900 | $4,120 |
Exempt asset portion ($305/$610) | $3,050 | $2,440 |
Example 1
Example 1 of prop. reg. section 1.861-13(c) illustrates how to use the five-step asset method in a tiered structure to allocate CFC stock among statutory groupings, categories, and subcategories of income. USP wholly owns CFC1, has a tax book value in CFC1’s stock of $20,000, and has a 70 percent inclusion percentage. CFC1 wholly owns CFC2 with a tax book value of $5,000.
CFC1’s and CFC2’s asset values as determined under reg. sections 1.861-9(g) and 1.861-9T(g) are in Table 2 (CFC1’s total assets include its $5,000 tax book value in CFC2’s stock).
| CFC2 | CFC1 |
|---|---|---|
Tax book value | $5,000 | $20,000 |
General tested | $0 | $4,000 |
General subpart F | $2,250 | $1,000 |
General | $750 | $3,000 |
Passive subpart F | $0 | $2,000 |
Total assets | $3,000 | $15,000 |
In step 1, CFC2’s $5,000 tax book value is prorated among the statutory groupings of income generated by its assets:
$5,000 * ($750/$3,000) = $1,250 general tested income; and $5,000 * ($2,250/$3,000) = $3,750 general subpart F income
A similar calculation is performed for CFC1’s $20,000 tax book value, considering the results of CFC2’s lower-tier allocations.
For example, $20,000 * (($4,000 + $750)/$15,000) = CFC1’s total $6,333 general subpart F income.
In step 2, USP’s 70 percent inclusion percentage is used to assign a portion of CFC1’s general tested income to the section 951A category (70 percent * $5,333 = $3,733), with the remainder ($1,600) staying a general category asset. USP may treat a portion of that $3,733 as an exempt asset depending on the percentage of its GILTI inclusion that is absorbed by its section 250 deduction.
In step 3, no portion of the stock of CFC1 is treated as resourced gross income in any treaty category.
In step 4, the total portion of the value of CFC1’s stock that is general category stock is $13,600 ($1,600 + $5,667 + $6,333), and the portion that is passive category stock is $2,667. No portion is U.S.-source category stock.
Finally, in step 5, the value of the CFC1 stock assigned to the section 245A subgroup of general category stock is $7,267 ($1,600 + $5,667). The remainder of general category stock is assigned to the non-section 245A subgroup of general category stock.
No portion of passive category stock is in the tested income or specified foreign-source passive category statutory grouping, so no portion of CFC1’s value is assigned to the section 245A subgroup of passive category stock. The $2,667 in the passive category is assigned to the non-section 245A subgroup.
All section 951A category stock, or $3,733, is also assigned to the non-section 245A subgroup of section 951A category stock. These results are shown in Table 3.
| CFC2 | CFC1 |
|---|---|---|
General tested | $0 | $5,333 |
General subpart F | $3,750 | $6,333 |
General | $1,250 | $5,667 |
Passive subpart F | $0 | $2,667 |
$0 | $3,733 | |
$0 | $7,267 | |
Non-section 245A | $0 | $12,733 |
Example 2
Example 2 shows how to use the asset method when a non-controlled 10-percent-owned foreign corporation is in the structure. Example 2 assumes the same facts as Example 1, except that instead of owning all the stock of CFC2, CFC1 owns only 20 percent of the stock of FC2, a foreign corporation with a tax book value of $5,000.
FC2 owns $3,000 in assets that generate general category income that if distributed to CFC1 as a dividend would be CFC1 subpart F income in the general category.
In step 1, since all FC2’s assets generate income that would be general subpart F income if distributed to CFC1, all $5,000 of FC2’s assets are assigned to the subpart F general category. This amount is rolled up and added to CFC1’s $1,000 subpart F general category. CFC1’s general subpart F income allocation is:
$20,000 * (($5,000 + $1,000)/$15,000) = $8,000
The analysis for steps 2 and 3 is the same as in Example 1.
The $1,250 of CFC2’s stock that was assigned to the general category in Example 1 has moved to FC2’s subpart F general category in Example 2. As a result, in step 4, the total value of general category stock is still $13,600 and the value of passive category stock is still $2,667.
In step 5, however, stock value assigned to the section 245A subgroup of the general category in Example 1 is lowered to $5,600 ($1,600 + $4,000), as the $8,000 subpart F general category stock value is assigned to the non-section 245A subgroup in Example 2. The $2,667 in the passive category remains in the non-section 245A subgroup, as does the section 951A category stock. These results are shown in Table 4.
| FC2 | CFC1 |
|---|---|---|
General tested | $0 | $5,333 |
General subpart F | $5,000 | $8,000 |
General | $0 | $4,000 |
Passive subpart F | $0 | $2,667 |
$0 | $3,733 | |
$0 | $5,600 | |
Non-section 245A | $0 | $14,400 |
Example 3
Example 3 allocates stock value to the groupings, categories, and subgroups through the modified gross income method, rather than the asset value method.
USP owns all stock of CFC1, which has a tax book value of $100,000 and an inclusion percentage of 100 percent. CFC1 owns all CFC2 stock.
USP uses the modified gross income method in reg section 1.861-12(c) to characterize the stock in CFC1. The types of income earned by CFC1 and CFC2 and their interest expense are in Table 5.
| CFC2 | CFC1 |
|---|---|---|
General tested | $3,000 | $1,500 |
General subpart F | $2,000 | $0 |
General | $1,000 | $0 |
Passive subpart F | $0 | $500 |
Total | $6,000 | $2,000 |
Interest expense | ($3,000) | ($200) |
In step 1, CFC2’s interest expense is apportioned among the groupings to determine each grouping’s income net of interest expense:
$3000 interest expense * (income in group/$6000 total gross income) = interest expense allocated to that group
These calculations leave CFC2 with $1,500 of net general tested income, $1,000 of net general subpart F income, and $500 of net general income.
Before including the subpart F and tested income of CFC2, CFC1 has total gross income of $2,500 including $500 of CFC2’s general income that is combined with CFC1’s gross income. CFC1’s $200 interest expense is apportioned among CFC1’s groupings to determine the income net of interest expense in each grouping, and CFC2’s $500 of general income is included in the denominator:
$200 interest expense * (income in group/$2500 total gross income) = interest expense allocated to that group
These calculations leave CFC1 with $1,380 of general tested income, $460 of passive subpart F income, and $460 of general income before including CFC2’s income items.
After including CFC2’s tested and subpart F income, CFC1 has $2,880 of general tested income, $1,000 of general subpart F income, $460 of general category income, and $460 of passive subpart F income. These amounts are used to prorate CFC1’s total book value of $100,000 among the groupings assuming a total of $4,800 gross income net of interest expense:
$100,000 * (income in grouping/$4,800 total income) = value of CFC1’s stock assigned to that grouping
In step 2, the value of CFC1 stock that is general tested income is $60,000, and the inclusion percentage is 100 percent, so the total amount is allocated to section 951A and none remains in the general tested category. Again, a portion of the $60,000 may be treated as an exempt asset depending on the percentage of the GILTI inclusion absorbed by the section 250 deduction.
In step 3, no portion of the stock is resourced income in any treaty category.
In step 4, the total value of stock assigned to the general category is $30,417, which is the general subpart F category plus the other general categories; and the total value in the passive category is $9,583. No portion is U.S.-source category stock.
In step 5, all of the value of general category tested income was assigned to the section 951A category, so the value of the stock assigned to the general category section 245A subgroup is $9,583. The rest of the general category stock is assigned to the non-section 245A subgroup. No portion of the passive category stock is in the gross tested income grouping or the foreign-source passive category income, so no portion is assigned to the section 245A subgroup.
All section 951A category stock is assigned to the non-section 245A subgroup, as shown in Table 6.
| CFC2 | CFC1 |
|---|---|---|
General tested | $1,500 | $0 |
General subpart F | $1,000 | $20,834 |
General | $500 | $9,583 |
Passive subpart F | $0 | $9,583 |
$0 | $60,000 | |
$0 | $9,583 | |
Non-section 245A | $0 | $90,417 |
Generally, increased asset values assigned to a statutory group increase the expenses allocated to income in that group, reducing the section 904 FTC limitation and increasing the likelihood of excess FTCs. This is especially unfavorable for the general tested income category, as only 80 percent of FTC’s on GILTI are creditable, and excess FTCs on GILTI inclusions cannot be carried forward.