IRS Changes Allocation Rules for Partners' Foreign Taxes

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By Laura Davison

Feb. 3 — The special rule for preferential allocations of creditable foreign tax expenditures in a partnership applies only to allocations to a partner that are deductible under foreign law, and not to other items that give rise to deductions under foreign law, the IRS said in temporary and proposed rules.

The guidance, under tax code Section 704(b), is intended to clear up ambiguities in the way partnerships address creditable foreign tax expenditures, or CFTEs. The final and temporary regulations (T.D. 9748, RIN 1545-BM57) make some substantive changes and are necessary to improve the operation of an existing safe harbor used to determine if allocations of CFTEs are in line with partners' interests, the Internal Revenue Service said Feb. 3.

“The special rules were not intended to permit taxpayers to adjust or fail to adjust income in a CFTE category in a manner that distorts a partner's share of the income to which the CFTEs assigned to that category relate,” the rules, effective Feb. 4, said.

For example, the rule can't be used to reduce income in a CFTE category using disregarded inter-branch payment, even if the income stemming from the payment isn't subject to tax in any foreign jurisdiction.

Complications Abound

“Very simply, these are a a very complicated set of provisions,” Richard Lipton, a partner at Baker & McKenzie LLP in Chicago, Ill. told Bloomberg BNA. “It is very premature to determine whether the new rules work properly or not.”

The rules also seek to stop transactions involving serial disregarded payments where taxpayers don't apportion withholding taxes assessed on the first payment in a series among the CFTE categories that include the income out of which the payment is made. The rules clarify that the withholding taxes must be apportioned among the CFTE categories that include related income.

The regulations also make some non-substantive clarifications to “more clearly describe when income from a divisible part of a single activity must be treated as income from a separate activity.”

The rules also say that a guaranteed payment or preferential allocation determined by all the income from a single activity will usually not result in dividing a single activity into separate activities.

Single Activity Rules

The rules provide that income from a divisible part of a single activity will be treated as income from a separate activity if necessary to prevent separating CFTE from the related foreign income. For example, the rule would treat a special allocation of income paid to one disregarded entity as a means to reflect a disregarded inter-branch payment made from the entity to a second disregarded entity as separate activities.

A guaranteed payment determined by all the income from a single activity will not result in dividing an activity, the rules said.

These rules will require significant study to look at potential scenarios, altering the payments made between related foreign entities and the taxes imposed by different countries, to determine if they reach the correct economic result, Lipton said.

The proposed regulations (REG-100861-15, RIN 1545-BM56) incorporate the temporary rules. The IRS asked for comments by May 4—including whether final rules should provide more guidance on how to compute a partnership's net income in a CFTE category.

The temporary regulations apply to partnership taxable years that both begin on or after Jan. 1, 2016, and end after Feb. 4. The rules provide for a transition rule for certain inter-branch payments for some partnerships.

T.D. 9748 is scheduled to appear in the Federal Register Feb. 4.

To contact the reporter on this story: Laura Davison in Washington at ldavison@bna.com

To contact the editor responsible for this story: Brett Ferguson at bferguson@bna.com

For More Information

Texts of T.D. 9748 and REG-100861-15 are in TaxCore.