Carrie Brandon Elliot is a contributing editor with Tax Notes International.
In this article, Elliot reviews the rules for assigning disregarded payments to foreign tax credit limitation income categories when the payments are made or received by non-branch taxable units.
Reg. section 1.904-4(a)-(q) governs the separate application of the section 904 foreign tax credit limitation to categories of income. Published January 2, T.D. 9959 added guidance to the rules in reg. section 1.904-4(f) that govern the FTC limitation for the foreign branch income category.
Section 901 allows a credit for taxes paid to foreign countries. The FTC is limited by section 904 to a fraction of U.S. tax expense equal to the taxpayer’s foreign-source taxable income divided by its entire taxable income. Taxpayers must determine four separate FTC limitations for four categories of income listed in section 904(d)(1)(A)-(D):
global intangible low-taxed income inclusions under section 951A;
foreign branch income;
passive category income; and
general category income.
Reg. section 1.904-4(f)(1)-(4) addresses the foreign branch income category. The guidance includes:
a definition of foreign branch category income;
a description of gross income attributable to a foreign branch;
13 definitions; and
16 examples.
Reg. section 1.904-4(q)(3) provides that paragraph (f) of reg. section 1.904-4 applies to tax years that begin after December 31, 2019, and end on or after November 2, 2020. This article focuses on disregarded payments involving non-branch taxable units. Previous articles addressed disregarded transfers of property between foreign branches and their owners (Tax Notes Int’l, Apr. 4, 2022, p. 16) and adjustments to foreign branch income for disregarded payments between foreign branches and their owners (Tax Notes Int’l, Mar. 28, 2022, p. 1495).
Foreign Branch Category Income
Reg. section 1.904-4(f)(1)(i)-(iv) describes foreign branch category income. Reg. section 1.904-4(f)(1)(i)(A)-(C) generally provides that foreign branch category income is income of a U.S. person other than a passthrough entity that is:
attributable to the U.S. person’s foreign branches held directly or indirectly through disregarded entities;
a distributive share of partnership income attributable to foreign branches held by the partnership directly or indirectly through disregarded entities, or held indirectly by the partnership through another partnership or other passthrough entity that holds the foreign branches directly or indirectly through disregarded entities; and
income of other passthrough entities determined under principles like those described above in paragraph (B).
Reg. section 1.904-4(f)(1)(ii)-(iv) provides exclusions from foreign branch category income for:
passive category income;
income arising from U.S. activities; and
income arising from stock of a corporation.
Income Attributable to a Foreign Branch
Reg. section 1.904-4(f)(2)(i)-(vi) describes gross income attributable to a foreign branch (paragraphs (ii) and (iii) are reserved). The guidance includes:
a general rule that gross income reflected on a branch’s books and records is attributable to the branch;
an exception for gain from the branch’s disposition of an interest in a partnership, passthrough, or disregarded entity;
an antiavoidance rule; and
adjustments to gross income for disregarded payments allocable to income that would be attributable to a foreign branch.
Under reg. section 1.904-4(f)(2)(i), gross income is attributable to a foreign branch to the extent that it is reflected on the separate set of foreign branch books and records (as defined in reg. section 1.989(a)-1(d)(1) and (2)). Gross income that is not attributable to the foreign branch and is therefore attributable to the foreign branch owner is income in a separate category (other than the foreign branch category).
Reg. section 1.904-4(f)(2)(vi)(A)-(G) requires attribution of gross income to which disregarded payments are allocable. The guidance contains:
a general rule requiring adjustments to gross income when a disregarded payment is allocable to the income;
rules for allocating disregarded payments to gross income;
an exclusion of specified disregarded payments from the attribution rules;
the treatment of intangible property transfers;
rules for determining the amount of a disregarded payment;
the treatment of multiple disregarded payments made in one tax year; and
the treatment of disregarded payments made or received by non-branch taxable units.
This article focuses on the rules in reg. section 1.904-4(f)(2)(vi)(G) that govern the adjustments to gross income under paragraph (A) and allocation of disregarded payments under paragraph (B) when non-branch taxable units are present.
Adjustments to Gross Income
Reg. section 1.904-4(f)(2)(vi)(A) applies when a foreign branch makes a disregarded payment to its owner, or a second foreign branch, and the disregarded payment is allocable to gross income that would be attributable to the foreign branch under the rules in reg. section 1.904-4(f)(2)(i)-(v). The taxpayer must adjust gross income attributable to the payer foreign branch downward (but not below zero) to reflect the allocable amount of the disregarded payment. The taxpayer must also adjust the gross income attributable to the recipient foreign branch owner or the second foreign branch upward by the same amount as the downward adjustment.
Similarly, if a foreign branch owner makes a disregarded payment to its foreign branch and the disregarded payment is allocable to gross income attributable to the foreign branch owner, the taxpayer adjusts gross income attributable to the payer foreign branch owner downward (but not below zero) and the gross income attributable to the recipient foreign branch upward by the same amount as the downward adjustment.
An adjustment to the amount of attributable gross income under reg. section 1.904-4(f)(2)(vi) does not change the total amount, character, or source of a U.S. person’s gross income; does not change the amount of a U.S. person’s income in any separate category other than the foreign branch and general categories (or a specified separate category associated with the foreign branch and general categories); and has no bearing on the analysis of whether an item of gross income is eligible to be re-sourced under an income tax treaty.
Allocation of Disregarded Payments
Reg. section 1.904-4(f)(2)(vi)(B)(1)-(3) governs the determination of whether a disregarded payment is allocable to gross income. A disregarded payment is allocable to gross income attributable to a foreign branch or gross income attributable to its owner. The source and separate categories of the gross income to which the disregarded payment is allocable are determined under rules in reg. section 1.904-4(f)(2)(vi)(B)(1)(i) and (ii) that distinguish between payments from an owner to its branch and payments from a branch to its owner.
Disregarded payments from a foreign branch owner to its foreign branch are allocable to gross income attributable to the foreign branch owner to the extent that a deduction for that payment or any disregarded cost recovery deduction relating to that payment, if regarded, would be allocated and apportioned to gross income attributable to the foreign branch owner under reg. section 1.861-8 through -14T and -17 (without regard to exclusive apportionment). Taxpayers must treat foreign-source gross income and U.S.-source gross income in each separate category as a statutory grouping.
Disregarded payments from a foreign branch to its foreign branch owner or to another foreign branch are allocable to gross income attributable to the payer foreign branch to the extent that a deduction for that payment or any disregarded cost recovery deduction relating to that payment, if regarded, would be allocated and apportioned to gross income attributable to the payer foreign branch under reg. section 1.861-8 through -14T and -17 (without regard to exclusive apportionment). Again, taxpayers must treat foreign-source gross income and U.S.-source gross income in each separate category as a statutory grouping.
Reg. section 1.904-4(f)(2)(vi)(B)(3)(i) and (ii) addresses the timing of gross income reattribution.
The gross income attributable to the foreign branch is generally adjusted only in the tax year that a disregarded payment, if regarded, would be allowed as a deduction (including a disregarded cost recovery deduction), or otherwise would be taken into account as an increase to cost of goods sold.
The gross income attributable to a foreign branch property disposition is adjusted only in the tax year in which gain is recognized by the disposition of property with an adjusted disregarded basis in a transaction that is regarded under U.S. tax law.
Non-Branch Taxable Units
Reg. section 1.904-4(f)(2)(vi)(G)(1)-(3) provides guidance on determining the amount, source, and character of gross income attributable to a foreign branch and its owner under reg. section 1.904-4(f)(2) when a non-branch taxable unit is present. “Non-branch taxable unit” is defined in reg. section 1.904-4(f)(3)(xi) by cross-reference to reg. section 1.904-6(b)(2)(i)(B).
The regs in section 1.904-6 govern allocation and apportionment of foreign income tax expense to income categories. Reg. section 1.904-6(a) generally provides that foreign income taxes assigned to a separate income category include only those foreign income taxes that are allocated and apportioned to the separate category under the rules of reg. section 1.861-20. Reg. section 1.904-6(b)(1) and (2) provides guidance on assigning foreign gross income to separate categories in cases in which the income is attributable to a base difference or a disregarded payment.
Reg. section 1.904-6(b)(2) applies when a taxpayer that is an individual or a domestic corporation includes an item of foreign gross income upon receipt of a disregarded payment by a foreign branch or foreign branch owner (as defined in reg. section 1.904-4(f)(3)), or by a non-branch taxable unit. In that case, the foreign gross income item is assigned to a separate category under reg. section 1.861-20(d)(3)(v), which contains rules for assigning foreign gross income from receipt of a disregarded payment to statutory and residual groupings.
A non-branch taxable unit is a person or an interest described in reg. section 1.904-6(b)(2)(i)(B)(1) or (2), respectively.
A non-branch taxable unit is a person:
that is not otherwise a foreign branch owner and is a U.S. individual, a domestic corporation, or a foreign or domestic partnership (or other passthrough entity as defined in reg. section 1.904-5(a)(4)); and
an interest in which is owned directly or indirectly (through partnerships or other passthrough entities) by a U.S. individual or a domestic corporation.
A non-branch taxable unit is also an interest of a foreign branch owner or an interest of a person described above that is:
not otherwise a foreign branch; and
either a disregarded entity or a branch as defined in reg. section 1.267A-5(a)(2), including a branch described in reg. section 1.951A-2(c)(7)(iv)(A)(3) (modified by substituting “person” for “controlled foreign corporation”).
Reg. section 1.267A-5(a)(2) defines the term “branch” as a taxable presence of a tax resident in a country other than its country of residence, as determined under either the tax resident’s tax law or the other country’s tax law. Reg. section 1.951A-2(c)(7)(iv)(A)(3) refers to a branch as described in reg. section 1.267A-5(a)(2), the activities of which are carried on directly or indirectly (through one or more passthrough entities) by a CFC.
Under reg. section 1.904-4(f)(2)(vi)(G)(1), reg. section 1.904-4(f)(2) applies to treat a non-branch taxable unit as though it were a foreign branch or a foreign branch owner, as appropriate. This is required to attribute gross income to the non-branch taxable unit and to then further attribute the income of a non-branch taxable unit to one or more foreign branches or to a foreign branch owner (see Example 16). Special rules in reg. section 1.904-4(f)(2)(vi)(G)(2) and (3) apply to foreign branch group income and foreign branch owner group income.
The income of a foreign branch group is attributed to the foreign branch that owns the group. The income of a foreign branch group is the aggregate of the U.S. gross income that is attributed to each member of the foreign branch group, determined after accounting for all disregarded payments made and received by each member of the foreign branch group.
The income of a foreign branch owner group is attributed to the foreign branch owner that owns the group. The income of a foreign branch owner group is the aggregate of the U.S. gross income that is attributed to each member of the foreign branch owner group, determined after accounting for all disregarded payments made and received by each member of the foreign branch owner group.
Definitions
Reg. section 1.904-4(f)(3)(i)-(xiii) contains definitions in effect for the rules in reg. section 1.904-4(f), including the definitions of non-branch taxable unit (described above), foreign branch group, foreign branch owner, and foreign branch owner group.
Foreign branch group is a foreign branch and one or more non-branch taxable units (other than an individual or a domestic corporation), to the extent that the foreign branch owns the non-branch taxable unit directly or indirectly through one or more other non-branch taxable units.
Foreign branch owner is the person (including a foreign or domestic partnership or other passthrough entity) that owns the foreign branch either directly or indirectly through one or more disregarded entities. Foreign branch owner does not include the foreign branch or another foreign branch of the person that owns the foreign branch.
Foreign branch owner group means a foreign branch owner and one or more non-branch taxable units (other than an individual or a domestic corporation), to the extent that the foreign branch owner owns the non-branch taxable unit directly or indirectly through one or more other non-branch taxable units.
Examples
The examples in reg. section 1.904-4(f)(4) illustrate the application of the reg. section 1.904-4(f) definitions and income adjustments. Examples 13-16 accompany the rules for non-branch taxable units in reg. section 1.904-4(f)(2)(vi)(G).
Example 13 illustrates a disregarded payment from a domestic corporation to its own foreign branch and forms the basis for examples 14-16. Domestic corporation P owns FDE, a disregarded entity that is a foreign branch having the U.S. dollar as its functional currency.
In year 1 P accrues, records on its books, and records under U.S. tax law $400 of U.S.-source gross income from the license of intellectual property to unrelated parties that is not passive category income. P also accrues $600 of foreign-source passive category interest income.
P compensates FDE for services that FDE performs in a foreign country with an arm’s-length payment of $350 recorded on FDE’s books and records. The transaction is disregarded under U.S. tax law.
Without the adjustment rules in reg. section 1.904-4(f)(2)(vi), the $400 of gross income P earned from the license would be general category income not attributable to FDE. If the $350 disregarded payment from P to FDE were regarded under U.S. tax law, the deduction for the payment would be allocated and apportioned entirely to P’s $400 U.S.-source general category gross licensing income under reg. section 1.861-8 and -8T (treating U.S.-source general category gross income and foreign-source passive category gross income each as a statutory grouping). P and FDE incur no other expenses.
The $350 disregarded payment from P, a U.S. person, to FDE, its foreign branch, is not recorded on FDE’s separate books and records under reg. section 1.904-4(f)(2)(i) because it is disregarded under U.S. tax law. The disregarded payment is allocable to gross income attributable to P because a deduction for the payment, if it were regarded, would be allocated and apportioned to the $400 of P’s U.S.-source licensing income.
Therefore, under the adjustment rules in reg. section 1.904-4(f)(2)(vi)(A) and the timing rules in reg. section 1.904-4(f)(2)(vi)(B)(3), the amount of gross income attributable to the FDE foreign branch (and the gross income attributable to P) is adjusted in year 1 to account for the disregarded payment. The $350 of P’s $400 U.S.-source general category gross income from the license is attributable to the FDE foreign branch; and so $350 of the U.S.-source gross income that P earned from its license in year 1 is assigned to the foreign branch category. The remaining $50 remains U.S.-source general category income. P’s $600 of foreign-source passive category interest income is unchanged.
Example 14 illustrates a regarded payment from a nonconsolidated domestic corporation to a foreign branch not directly owned by the payer corporation. The facts are the same as in Example 13, except P wholly owns USS, and USS (rather than P) owns FDE. P and USS do not file a consolidated return. USS has no gross income other than the $350 foreign-source services income from the $350 payment it receives from P (through FDE).
The $350 services payment from P, a U.S. person, to FDE, a foreign branch of USS, is not a disregarded payment because the transaction is regarded under U.S. tax law. Under reg. section 1.861-8 and -8T, P’s $350 deduction for the services payment is allocated and apportioned to its U.S.-source general category gross income.
The payment of $350 from P to USS through FDE is services income attributable to FDE and foreign branch category income of USS under reg. section 1.904-4(f)(2)(i). Therefore, USS has $350 of foreign-source foreign branch category gross income. P has $600 of foreign-source passive category income and $400 of U.S.-source general category gross income offset by a $350 deduction for the services payment. The net result is $50 of U.S.-source general category taxable income to P.
Example 15 is described in the regs’ preamble as illustrating the matching rule in reg. section 1.1502-13 to a regarded intercompany payment from a member of an affiliated group to a foreign branch owned by a different member of the group. Reg. section 1.1502-13(a)-(m) provides rules for determining income, gain, deduction, and loss of consolidated group members from intercompany transactions. Its purpose is to reflect taxable income and tax liability of a group as a whole by preventing intercompany transactions from creating, accelerating, avoiding, or deferring consolidated taxable income or tax liability.
The facts in Example 15 are the same as in Example 14, except that P and USS are members of an affiliated group that files a consolidated return under section 1502.
Intercompany Transaction
Reg. section 1.1502-13(b)(1) defines an intercompany transaction as a transaction between corporations that are members of the same consolidated group immediately after the transaction. Therefore, the $350 services payment from P to FDE, a foreign branch of USS, is an intercompany transaction between P and USS. USS is the selling member, and P is the buying member. P has a $350 deduction for the services payment that is a corresponding item, and USS has $350 of income that is an intercompany item. The payment is not a disregarded payment because the transaction is regarded under U.S. tax law.
Timing and Attributes
Reg. section 1.1502-13(a)(2) provides that the selling member and the buying member are treated either as separate entities or as divisions of a single corporation, depending on the determination at issue. The amount and location of seller and buyer’s intercompany items are determined on a separate-entity basis. The timing and attributes (like character and source) of the intercompany items are initially determined on a separate-entity basis but are then redetermined to produce the effect of transactions between divisions of a single corporation.
Under a separate-entity analysis, the result is the same as in Example 14, in which P has $600 of foreign-source passive category income and $50 of U.S.-source general category income, while USS has $350 of foreign-source foreign branch category income.
In contrast, under a single-entity analysis, the result is the same as in Example 13, in which P has $600 of foreign-source passive category income, $50 of U.S.-source general category income, and $350 of U.S.-source foreign branch category income.
The Matching Rule
Under the matching rule in reg. section 1.1502-13(c)(1), the timing, character, source, and other attributes of USS’s $350 intercompany item and P’s $350 corresponding item are redetermined to produce the effect of transactions between divisions of a single corporation, as if the services payment had been made to a foreign branch of that corporation. Accordingly, all of USS’s foreign-source income of $350 is redetermined to be U.S.-source (not foreign-source) income.
Therefore, under reg. section 1.1502-4(c)(1) (governing calculation of a group’s FTC limitation), the P group has $600 of foreign passive category income, $50 of U.S.-source general category income, and $350 of U.S.-source foreign branch category income.
Example 16 illustrates a disregarded payment made by a non-branch taxable unit. The facts are the same as those in Example 13, except that P also wholly owns FDE1, a disregarded entity that is a non-branch taxable unit. FDE1 (rather than P) accrues and records on its books and records the $400 of U.S.-source general category income from the license of IP and the $600 of foreign-source passive category interest income. Moreover, FDE1 (rather than P) is the entity that makes the $350 payment to FDE for services, which is disregarded under U.S. tax law.
Under reg. section 1.904-4(f)(2)(vi)(G), the rules of reg. section 1.904-4(f)(2) apply to attribute gross income to FDE1, a non-branch taxable unit, as though FDE1 were a foreign branch. Under these rules, the $400 of licensing income and the $600 of interest income are initially attributable to FDE1. This income is adjusted in year 1 to account for the $350 disregarded payment, which is allocable to the $400 of licensing income of FDE1.
Accordingly, $50 of the $400 of U.S.-source general category licensing income is attributable to FDE1, and $350 of this income is attributable to the FDE foreign branch. To determine the income that is attributable to P, the foreign branch owner, and FDE, the foreign branch, the income that is attributed to FDE1, after taking into account all the disregarded payments that it makes and receives, must be further attributed to one or more foreign branches or a foreign branch owner under reg. section 1.904-4(f)(2)(vi)(G).
Under reg. section 1.904-4(f)(2)(vi)(G), the income of FDE1 is attributed to the foreign branch group or foreign branch owner group of which it is a member. Because FDE1 is wholly owned by P, FDE is a member solely of the foreign branch owner group that is owned by P (see definition of foreign branch owner group in reg. section 1.904-4(f)(3)).
All the income that is attributed to FDE1 under reg. section 1.904-4(f)(2) — namely, the $50 of U.S.-source general category licensing income and the $600 of foreign-source passive category interest income — is further attributed to P under reg. section 1.904-4(f)(2)(vi)(G)(3). Therefore, the result is the same as in Example 13.
Preamble
While the final regs’ preamble contains very little commentary on the rules for non-branch taxable units, the preamble to the proposed regs finalized in T.D. 9959 (REG-101657-20) explains their rationale and operation. The reallocation rules apply to disregarded payments made to and from non-branch taxable units defined generally as persons and interests that do not meet the definition of a foreign branch or foreign branch owner. For example, disregarded payments may occur among foreign branches, foreign branch owners, and disregarded entities that have no trade or business and are therefore not foreign branches.
Disregarded payments to and from non-branch taxable units must be reattributed to the same extent as disregarded payments to and from foreign branches and foreign branch owners. Therefore, the gross income attributed to a non-branch taxable unit must be further attributed to a foreign branch (if the non-branch taxable unit is part of a foreign branch group) or a foreign branch owner (if the non-branch taxable unit is part of a foreign branch owner group). Reattribution is done after accounting for all disregarded payments that the non-branch taxable unit makes and receives.
A non-branch taxable unit is part of either a foreign branch group or a foreign branch owner group to the extent that it is owned (including indirectly through other non-branch taxable units) by a foreign branch or a foreign branch owner. Gross income attributed to the members of a foreign branch group is attributed to the foreign branch that owns the group. Gross income attributed to the members of a foreign branch owner group is attributed to the foreign branch owner that owns the group.