On December 6, 2016, the Treasury Department and the IRS issued temporary and proposed regulations under Section 901(m). Congress enacted Section 901(m) in 2010, together with a package of changes to the international provisions of the Code, including the foreign tax credit splitting rules in Section 909 and the anti-hopscotching rules in Section 960(c), along with several others. Section 901(m) disallows foreign tax credits following a covered asset acquisition (a CAA).

The temporary regulations are generally consistent with existing guidance. Specifically, they are consistent with Notices 2014-44 and 2014-45, in which the IRS provided guidance under Section 901(m) for the first time.¹ Unlike the Notices, however, they exclude withholding taxes from the category of disqualified foreign income taxes. The temporary regulations generally apply to CAAs occurring on or after July 21, 2014, but also have limited applicability to transactions occurring after January 1, 2011.

The proposed regulations would expand on the statute and the Notice, and provide comprehensive guidance under Section 901(m). Many of the provisions of the proposed regulations address definitional and computational issues. The proposed regulations would also make several substantive additions to the statutory provisions. For example, they add three additional categories of transactions treated as CAAs to the original statutory definition of CAAs. These new categories are:

(1) Any transaction that is treated: (A) as an acquisition of assets for US income tax purposes; and (B) as an acquisition of an interest in a fiscally transparent entity for foreign income tax purposes

(2) Any transaction treated for US income tax purposes as a distribution of assets from a partnership, which causes an increase in the basis of either the distributed assets or the remaining partnership assets

(3) Any transaction treated as an asset acquisition for both US and foreign income tax purposes.

The second and third categories apply only if there is an increase to US tax basis without a corresponding increase to foreign tax basis.

In addition, the proposed regulations would permit a "foreign basis election," under which a taxpayer may elect to use foreign tax basis for purposes of determining the "basis difference" following a CAA. Absent the election, and under the rule in the statute, a taxpayer would use the transferor's US tax basis in the "relevant foreign asset" as determined immediately prior to the CAA for purposes of determining the "basis difference" following a CAA.

Further, the proposed regulations include several anti-abuse rules, provide several simplifying rules and conventions and would add a de minimis rule for certain transactions.

The proposed regulations would be effective only prospectively, on the date they are published as final regulations in the Federal Register. Taxpayers may, however, rely on them before that time if they apply them consistently (including the additional categories of CAAs).

Background

Section 901(m) provides that, after a CAA, the "disqualified portion" of any foreign income tax applicable to a relevant foreign asset (an RFA) is not allowed as a foreign tax credit under Sections 901, 902 or 960.

A CAA is generally a transaction that increases or decreases the US tax basis of assets without correspondingly increasing or decreasing the foreign tax basis of the assets. The increase or decrease in US tax basis is referred to as a "basis difference." The statute sets forth an exclusive list of three transactions that are CAAs, but provides regulatory authority for Treasury and the IRS to create more. The disqualified portion of any foreign income tax for any year equals the ration of: (1) the basis difference allocated to that year divided by; (2) the income or gain in such year with respect to RFAs.

If there is a "disposition" of an RFA before the basis difference has been fully recovered, the entire remaining basis difference is allocated to the tax year of the disposition and no basis difference with respect the RFA is allocated to tax years subsequent to its disposition.Notices 2014-44 and 2014-45 announced that regulations would be issued to define the term "disposition" as an event that results in gain or loss being recognized with respect to an RFA for US tax purposes, foreign tax purposes or both. The Notices also set forth additional rules that would apply under Section 901(m). For a detailed description of the Notices, see Tax Alert 2014-1334 and Tax Alert 2014-1384.

Temporary regulations

The temporary regulations are generally consistent with Notices 2014-44 and 2014-45. They also provide, however, that withholding taxes are not included in the category of disqualified foreign income taxes. According to the preamble to the temporary regulations, this rule was included because withholding taxes are gross basis taxes that are generally unaffected by changes in asset bases.

The temporary regulations define CAA in the same way as the statute. Namely, a CAA is any of the following transactions:

1. A qualified stock purchase to which Section 338(a) applies

2. Any transaction that is treated as an acquisition of assets for US income tax purposes, but as an acquisition of stock of a corporation (or the transaction is disregarded) for foreign income tax purposes

3. Any acquisition of an interest in a partnership that has an election in effect under Section 754

An RFA is defined as "any asset (including [intangible assets]) … that is relevant in determining foreign income for purposes of the foreign income tax." The "basis difference" is the difference between the US basis immediately before the CAA and the US basis immediately after the CAA. A basis difference is allocated among affected tax years by applying the applicable cost recovery method to the basis difference. The temporary regulations do not specify how to apply of the applicable cost recovery method to the RFA. For example, they do not indicate how to apply this rule to the acquisition of a trade or business that includes multiple assets subject to different recovery periods. Further, the temporary regulations do not specify how the allocable basis difference applies to determine the "disqualified tax amount."

The temporary regulations contain detailed rules related to dispositions of RFAs, which generally follow Notice 2014-44 (Tax Alert 2016-1334) and 2014-45 (Tax Alert 2014-1384). In general, the temporary regulations define a "disposition" as an event in which gain or loss is recognized for US income tax purposes, foreign tax purposes or both. In the event of a disposition, all or a portion of the previously unallocated basis difference will be allocated to the year of the disposition. If the disposition is a fully taxable transaction for both US and foreign income tax purposes, then the full amount of the unallocated basis difference will be allocated to the year of the disposition. If the disposition is not fully taxable for both purposes, then the unallocated basis difference will be allocated to the year of the disposition only to the extent that the US and foreign income tax basis disparity is reduced.

The temporary regulations also contain rules on successors after a disposition of an RFA. In general, such successors remain subject to Section 901(m).

Proposed regulations

The proposed regulations would expand on the statute and the temporary regulations by adding three new categories of CAA and several anti-abuse rules. They also contain detailed definitional and computational provisions, which are generally required by the complex nature of the statute. In a few instances, they attempt to simplify complications arising under the statute. Simplification attempts consist of: (1) permitting taxpayers a foreign tax basis election for purposes of computing the basis difference of any RFA; (2) allowing a Section 901(m) payor to combine all foreign income taxes, rather than trace taxes to a particular RFA; and (3) excluding de minimis basis differences from Section 901(m).

Covered asset acquisitions

The proposed regulations would retain the three categories of transactions that are considered CAAs under the statute and add three new categories as follows:

(1) Any transaction that is treated as: (A) an acquisition of assets for US income tax purposes and (B) an acquisition of an interest in a fiscally transparent entity for foreign income tax purposes

(2) Any transaction treated for US income tax purposes as a distribution of assets from a partnership, which causes an increase in the basis of either the distributed assets or the remaining partnership assets

(3) Any transaction treated as an asset acquisition for both US and foreign income tax purposes

The second and third categories would apply only if there were an increase to US tax basis without a corresponding increase to foreign tax basis.

RFAs

The proposed regulations would expand on the definition of RFA by defining when an asset is "relevant" for Section 901(m) purposes. An asset is relevant if income, deduction, gain or loss with respect to that asset is taken into account in determining foreign income immediately after the CAA. The proposed regulations also provide an anti-abuse rule that would treat an asset as relevant if, under a transaction or series of transactions that have a principal purposes of avoiding the application of Section 901(m), an asset that was not relevant immediately after the CAA becomes relevant at a later time. Such a principal purpose would be deemed to occur if an asset became relevant within one year after the CAA.

Disqualified tax amount

The proposed regulations provide that the "disqualified tax amount" is not taken into account in determining the allowable foreign tax credit, whether under Section 901, 902 or 960. The disqualified tax amount is the lesser of the "tentative disqualified tax amount" for any year and the foreign income tax paid or accrued in that year.The tentative disqualified tax amount equals the foreign income taxes paid in that year, multiplied by a fraction equal to the "aggregate basis difference," divided by the "allocable foreign income."

The proposed regulations set forth a complex set of rules to determine aggregate basis difference and allocable foreign income. These calculations must be done separately for each separate category as defined in Section 904-4(m). Generally, however, it should be noted that, while the statute requires tracing income and taxes to each RFA, the proposed regulations would allow each Section 901(m) payor to combine all of its foreign income and foreign taxes, which the preamble indicates was a choice made to reduce administrative burdens.

Determination of basis difference

Under the statute and the temporary regulations, a Section 901(m) payor's basis difference is the difference between the US basis in an RFA immediately before the CAA and the US basis in that RFA immediately after the CAA. The proposed regulations would add a "foreign basis election" to the rules in the temporary regulations. Under the foreign basis election, the basis difference equals the US income tax basis immediately after the CAA minus the foreign income tax basis immediately after the CAA (rather than the US income tax basis immediately before the CAA). For a partnership, the foreign basis election would be made at the partner level. This election will doubtlessly reduce complexity for foreign targets that were never before relevant for US income tax purposes, or that otherwise did not compute tax basis of their assets for US income tax purposes.

Basis difference taken into account

The portion of the basis difference taken into account in any year would be determined under the cost recovery method that generally applies to the RFA for US income tax purposes (e.g., the applicable depreciation or amortization method). If multiple cost recovery methods could apply to an RFA, then each method would be applied on a proportionate basis. For example, if an RFA consisted of two assets with different useful lives, the basis difference would be bifurcated and each component recovered under the relevant useful life.

The rules that would allocate basis differences to different years are complex. Special rules would apply when the owner of the RFA is fiscally transparent (a partnership or disregarded entity), when mid-year transactions occur, when the owner of the RFA is a reverse hybrid, and in other circumstances.

In certain circumstances, a basis difference allocated to a particular year would be carried over to a subsequent year. For example, if the disqualified tax amount in any year were zero, then the basis difference for that year would be carried over to the next year (and so on).

Successor rules

The successor rules in the proposed regulations generally conform the rules in the temporary regulations to the sections described previously (e.g., the foreign basis election).

De minimis rules

The proposed regulations contain de minimis rules. Under those rules, a basis difference would generally not be taken into account under Section 901(m), in a transaction between unrelated parties, if the basis difference for any CAA were less than the greater of $10 million or 10% of the total US basis immediately after the CAA. Stricter rules would apply to transactions between related parties.

Effective date

The temporary regulations generally apply to CAAs occurring on or after July 21, 2014, but also have limited applicability to transactions occurring after January 1, 2011. The proposed regulations would apply only after they are published as final regulations. Taxpayers may, however, rely on the proposed regulations if they consistently apply all of their provisions.

Implications

The temporary regulations are generally consistent with existing guidance under Section 901(m). Notably, however, they exclude withholding taxes from disqualified foreign income taxes, because withholding taxes are gross basis taxes that are generally unaffected by changes in asset bases.

The proposed regulations provide comprehensive guidance under Section 901(m). The regulations are complex. They will likely impose significant compliance and recordkeeping burdens on affected companies.

While the proposed regulations will be effective only when published as final regulations, they may be relied on by taxpayers that choose to apply all of their provisions consistently. Taxpayers should therefore determine whether relying on the proposed regulations would be beneficial, taking into account for example the new categories of CAAs, the foreign basis elections and the simplifying conventions, among other provisions of the proposed regulations.

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ENDNOTES

¹ For a detailed discussion of the prior guidance, see Tax Alert 2014-1334.