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New Regs Address High-Taxed Income Exceptions When Foreign Tax Reduced

Posted on Apr. 17, 2020

Motivated by Tax Cuts and Jobs Act provisions, recently released proposed regs increase taxpayer certainty by expanding guidance on treatment of high-taxed income under the section 904 foreign tax credit limitation, section 954 subpart F inclusions, and section 951A global intangible low-taxed income inclusions.

The sections 954 and 951A high-taxed income exceptions to subpart F income and GILTI inclusions overlap with the section 904 high-taxed income exception to passive category income treatment for calculating the FTC limitation. The proposed section 904 regs specifically address how foreign tax reductions on distributions of earnings affect the high-tax income determinations.

The proposed regs (REG-105495-19) were released December 17, 2019, and cover the following eight topics:

  • the allocation and apportionment of deductions under sections 861 through 865, including research and experimentation expenses and life insurance company deductions;

  • the definition of financial services income under section 904(d)(2)(D);

  • the allocation and apportionment of creditable foreign taxes;

  • the branch loss and dual consolidated loss recapture rules’ interaction with section 904(f) and (g);

  • the effect of foreign tax redeterminations on the section 954(b)(4) high-tax exception, IRS notification requirements, and penalty provisions;

  • the definition of foreign personal holding company income (FPHCI) under section 954;

  • the application of the FTC disallowance under section 965(g); and

  • the application of the FTC limitation to consolidated groups.

On December 7, 2018, Treasury and the IRS published proposed regs (REG-105600-18) addressing TCJA changes made to the FTC rules. The proposed regs were finalized in the same December 2019 issue of the Federal Register that published the new proposed regs (T.D. 9882).

This article addresses how reductions in the foreign tax levied on distribution of earnings can affect the high-taxed income determination for FTC limitation purposes in section 904, and for the high-taxed income exceptions to subpart F and GILTI.

High-Taxed Income

The new proposed regs revise and supplement reg. section 1.904-4(c)(7)(i) through (iii), which guides taxpayers on how to implement high-taxed income exception rules when foreign taxes are reduced upon distribution of earnings that met the high-taxed income requirements in the year earned.

Section 904(a) establishes the FTC limitation and provides that the total FTC taken under section 901(a) cannot exceed the percentage of total tax that the taxpayer’s foreign-source taxable income bears to the entire taxable income:

FTC limitation = total tax liability * (foreign-source taxable income/total taxable income)

Under section 904(d), the FTC limitation is calculated separately for each of four income categories (also called baskets):

  • section 951A GILTI inclusions;

  • foreign branch income;

  • passive category income; and

  • general category income.

Before TCJA enactment, the FTC limitation generally applied to two categories for passive and general category income. The TCJA added two new categories for GILTI and foreign branch income.

Section 904(d)(2)(B) defines passive income as income that would be FPHCI as defined in section 954(c) (dividends, interest, royalties, rents, and annuities with some exceptions). However, passive income does not include high-taxed income for section 904 FTC limitation purposes.

Section 904(d)(2)(F) defines high-taxed income as income that would otherwise be passive income, except that the sum of foreign tax paid and deemed paid (under section 960) by the taxpayer exceeds the highest tax rate in section 1 (individuals) or 11 (corporations) when multiplied by the income, including any section 78 dividend.

While section 904 removes high-taxed income from the passive category for FTC limitation purposes, sections 954 and 951A have their own rules for high-taxed income under subpart F and GILTI. Section 954(b)(4) provides that subpart F income does not include income subject to an effective foreign tax rate greater than 90 percent of the maximum tax rate in section 11; and section 951A(c)(2)(A)(i)(III) provides that tested income does not include high-taxed income excluded from subpart F income under section 954(b)(4). The threshold effective tax rate for high-taxed income in subpart F and GILTI is lower (90 percent of the highest U.S. tax rate) than the threshold for the FTC exception (100 percent of the highest U.S. tax rate).

Reg. section 1.904-4(c) offers guidance on high-taxed income. The general rule in paragraph (c)(1) provides that income that would otherwise be passive income is not treated as passive if it is high-taxed income. Instead, the income is treated as general, foreign branch, section 951A, or specified separate category income (as listed in reg. section 1.904-4(m)); and taxes imposed on the income are in the same category under reg. section 1.904-6. Only foreign-source income is relevant to whether income is high taxed.

Paragraphs (2) through (6) of reg. section 1.904-4(c) provide guidance on:

  • grouping income items to determine whether passive income is high taxed (paragraph (c)(2));

  • treatment of passive income items received by U.S. persons (paragraph (c)(3));

  • treatment of dividends and inclusions from foreign corporations and qualified business units (paragraph (c)(4));

  • special rules for rents, royalties, partnership income, currency gains or losses, and coordination with section 954(b)(4) (paragraph (c)(5)); and

  • additional taxes paid in the year previously taxed income is received (paragraph (c)(6)).

Reg. section 1.904-4(c)(5) directs taxpayers to reg. section 1.904-4(c)(7) for guidance on coordination with the subpart F high-taxed income exception. Paragraph (c)(7) includes guidance on foreign tax reductions that occur when income is distributed and is the only paragraph in reg. section 1.904-4(c) that had its rules revised by the new proposed regs, mainly to incorporate references to section 905 regulations and GILTI high-taxed income provisions. The proposed regs also add four new examples to the eight previously available in reg. section 1.904-4(c)(8).

Foreign Tax Reductions

Prop. reg. section 1.904-4(c)(7)(i) generally provides that if the foreign effective tax rate on a foreign corporation’s income included in the taxpayer’s gross income is reduced under foreign law upon distribution, the rules in paragraph (c) apply when the taxpayer includes the income, without regard to the possibility of a subsequent reduction of foreign tax on a distribution.

If the inclusion is high-taxed income, the taxpayer must initially treat the inclusion as general category, GILTI category, foreign branch category, or income in a specified separate category, as required by the general rule in reg. section 1.904-4(c)(1).

When the foreign corporation distributes the previously included earnings and profits and the foreign tax on the inclusion is reduced, the taxpayer must determine whether the revised inclusion (if any) is high-taxed income if a redetermination of U.S. tax liability is required under prop. reg. section 1.905-3(b)(2).

Section 905(c) requires taxpayers to notify the Treasury secretary when taxes paid are refunded in whole or in part. Proposed section 905 regs require a redetermination of U.S. tax liability to reflect a redetermination or refund of foreign tax taken into account by a foreign corporation.

If the inclusion would not have been high-taxed income after the foreign tax reduction, then in redetermining its U.S. tax liability the taxpayer must treat the inclusion and the taxes (as reduced on the distribution) as passive category income and taxes.

For this purpose, the foreign tax on an inclusion under sections 951 (subpart F) and 951A (GILTI) is reduced on distribution of the E&P associated with the inclusion, if the total taxes paid and deemed paid on the inclusion and distribution are less than the total taxes that were deemed paid in the inclusion year (taking into account any reductions in income tax or withholding tax).

Any foreign currency gain associated with the distribution is not considered in determining whether there is a reduction of tax requiring a redetermination of whether the inclusion is high-taxed income.

Prop. reg. section 1.904-4(c)(7)(ii) addresses allocation of foreign tax reductions. If foreign law does not attribute a tax reduction to a particular year or years, then the reduction is attributable on an annual last-in, first-out basis, first to foreign taxes potentially subject to reduction that are associated with previously taxed income, then on a LIFO basis to foreign taxes associated with income that remains passive income under prop. reg. section 1.904-4(c)(7)(iii) but was excluded from subpart F income or tested income under the high-taxed income exception in section 954(b)(4) or section 951A(c)(2)(A)(i)(III).

In applying the section 959(c) ordering rules for distribution allocations, distributions are made on a LIFO basis, first out of earnings in section 959(c)(1) and (2), then on E&P associated with income remaining passive under prop. reg. section 1.904-4(c)(7)(iii) but excluded from subpart F income or GILTI, and finally on a LIFO basis out of other E&P.

For these purposes, foreign law is not considered to attribute a tax reduction to a particular year or years if it attributes the tax reduction to a pool or group of income from more than one year, and the pool or group is defined by a characteristic of the income (like the tax rate on the income) rather than by the tax year in which the income is derived.

Prop. reg. section 1.904-4(c)(7)(iii) addresses treatment of income excluded from subpart F under section 954(b)(4) or tested income under section 951A(c)(2)(A)(i)(III) (that is, under their respective high-taxed income exceptions). If the effective tax rate of foreign tax on a foreign corporation’s income is reduced under foreign law upon distribution of the income, these rules are applied in the year of inclusion without regard to the possibility of a subsequent foreign tax reduction.

If a taxpayer excludes passive income from a controlled foreign corporation’s FPHCI or tested income under these high-taxed income exceptions, the income is still considered to be passive income until it is distributed. If after the redetermination required under prop. reg. section 1.905-3(b)(2) the taxpayer still elects to exclude the passive income under these rules, then prop. reg. section 1.904-4(c)(7)(iii) applies to determine whether the income is high-taxed income upon distribution and therefore in another separate category.

To determine whether a tax reduction is attributable to tax on income excluded under these rules, paragraph (c)(7)(ii) applies. It also applies for purposes of ordering distributions to determine whether the distributions are out of E&P associated with the excluded income.

Examples

Prop. reg. section 1.904-4(c)(8) adds four new examples (examples 5 through 8) that illustrate the application of the rules in paragraph (c)(7)(i) through (iii).

Example 5 illustrates a reduction in taxes on distribution of income that still qualifies as high-taxed income under section 954 after the distribution, but not under section 904. It assumes a CFC wholly owned by domestic corporation USP. Both have calendar tax years. In year 1, CFC earns $200 pretax passive income in Country X that is FPHCI. Country X law reduces the corporate tax upon distribution of these earnings and imposes no withholding tax.

In year 1, CFC pays $100 of foreign tax and USP does not elect to exclude this income from subpart F under section 954(b)(4). USP includes $200 in gross income ($100 of FPHCI plus a $100 section 78 gross-up dividend) and does not distribute any earnings. At the time of USP’s inclusion, the income is high-taxed income under reg. section 1.904-4(c)(1) and (c)(6)(i) and is general category income to USP, because the $100 foreign tax is greater than $42, or 21 percent of $200.

In year 2, CFC has no earnings, distributes the $100 of after-tax earnings from year 1, and receives a $60 tax refund from Country X attributable to a corporate tax reduction on the year 1 earnings. The refund is a foreign tax redetermination that requires a redetermination of CFC’s year 1 subpart F income under prop. reg. section 1.905-3(b), the application of section 954(b)(4), USP’s year 1 subpart F inclusion, USP’s deemed paid taxes under section 960(a), and USP’s year 1 U.S. tax liability.

As recomputed given the $60 refund, CFC’s year 1 passive category net FPHCI is increased by $60 to $160; and its foreign income tax is reduced from $100 to $40. The income still qualifies for exclusion under the high-taxed income exception to subpart F income in section 954(b)(4), because $40 is greater than $37.80, or 90 percent of 21 percent of $200. Assuming USP does not change its year 1 election, USP’s year 1 inclusion is increased by $60 to $160 and its section 78 dividend is reduced from $100 to $40.

Under prop. reg. section 1.904-4(c)(7)(i), USP must redetermine whether its adjusted year 1 inclusion is high-taxed income given the $60 refund. The inclusion is not high-taxed income since $40 is less than $42, or 21 percent of $200. USP must treat the $200 inclusion ($160 FPHCI plus $40 section 78 dividend) and the $40 of foreign tax as passive category income and tax and must comply with the procedures in prop. reg. section 1.905-4.

Example 6 illustrates the result when a U.S. shareholder elects to exclude high-taxed income from its subpart F inclusion. It assumes the same facts as Example 5 except that USP elects to exclude CFC’s FPHCI from its subpart F inclusion before and after CFC’s year 1 subpart F income and USP’s year 1 U.S. tax liability are recomputed as required by the $60 refund in year 2. Although the income is not subpart F income, it remains passive category income until distribution under paragraph (c)(7)(iii).

In year 2, the $100 distribution is a dividend to USP because CFC has $160 of accumulated E&P described in section 959(c)(3)($100 of earnings plus $60 refund). USP must determine whether the dividend income is high-taxed income in year 2. Treatment of the dividend as passive category income is relevant in determining deductions allocable or apportioned to the dividend income or related stock that will be excluded in the computation of USP’s FTC limitation under section 904(a) in year 2. Under the reg. section 1.904-4(c)(1) general rule, dividend income is passive category income to USP because the foreign taxes paid and deemed paid by USP ($0) do not exceed the highest U.S. tax rate on the income.

Example 7 illustrates the effect of a withholding tax. It assumes the same facts as Example 5 except that the year 2 distribution is subject to a $25 withholding tax. USP must redetermine whether its year 1 inclusion is high-taxed income because there is a net $35 tax reduction ($100 tax minus $60 refund plus $25 withholding tax).

Considering both the reduction in corporate tax and the additional withholding tax, the inclusion is still high-taxed income to USP in year 1 ($65 tax is greater than $42, or 21 percent of $200). USP must comply with the section 905(c) procedures. USP must also redetermine its U.S. tax liability for year 1; however, the year 1 inclusion and the $65 in total foreign tax ($40 deemed paid tax and $25 withholding tax) will continue to be treated as general category income and taxes.

Example 8 illustrates the effect of differences in the U.S. and foreign tax bases and the ordering rules. It assumes the same ownership structure as Example 5, but CFC operates in Country G, which imposes a 50 percent income tax on CFC’s earnings that is reduced to 30 percent on distribution. There is no withholding tax. In year 1, CFC’s only earnings are FPHCI earned in Country G. CFC has U.S. taxable income of $110 and Country G taxable income of $100 subject to $50 of Country G tax.

USP does not elect to exclude CFC’s income from subpart F and includes $110 of gross income ($60 net FPHCI plus $50 section 78 dividend). The highest rate of U.S. tax in year 1 is 34 percent, so at the time of the subpart F inclusion, the income is high-taxed income and therefore USP general category income. CFC does not distribute any of its earnings in year 1.

In year 2, CFC earns general category income that is not subpart F or tested income. CFC again has $110 U.S. taxable income, $100 Country G taxable income, and pays $50 Country G income tax. In year 3, CFC has no taxable income or earnings, distributes $60 of its total $120 after-tax U.S. earnings to USP, and receives a $24 foreign tax refund.

The $24 refund is a foreign tax redetermination under the section 905 proposed regs that requires redetermination of CFC’s year 1 subpart F income, USP’s deemed paid taxes, and USP’s year 1 U.S. tax liability. Country G treats the distribution as paid out of the 50 percent tax rate pool of $200 in earnings accumulated in years 1 and 2 (defining the pool by the tax rate instead of the year derived).

However, under U.S. law in paragraph (c)(7)(ii), the distribution and tax reduction are treated as first attributable to the $60 previously taxed passive category income in year 1. None of the distribution is treated as made out of the $60 earnings in year 2 not previously taxed.

Country G’s reduction in tax rates from 50 percent to 30 percent is considered a 40 percent tax reduction. Because 40 percent of the $50 in foreign taxes attributable to the $60 of year 1 passive earnings is refunded, 40 percent of the $24 refund ($20) reduces foreign taxes on CFC’s year 1 passive income from $50 to $30. The other $4 of refund reduces the foreign taxes imposed in year 2 on CFC’s general category income from $50 to $46.

Under prop. reg. section 1.904-4(c)(7), USP must redetermine whether its year 1 subpart F inclusion was high-taxed income. After the foreign tax reduction, the inclusion is increased by $20 from $60 to $80, the deemed paid taxes are reduced by $20 from $50 to $30, and the inclusion is not high-taxed income, as $30 is less than 34 percent of $110 ($37.40).

Therefore, USP must treat the revised subpart F inclusion and the associated foreign taxes as passive category income and taxes in year 1. USP must comply with the prop. reg. section 1.905-4 procedures.

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