On November 6, 2007, the IRS issued new temporary and proposed regulations under Secs. 905(c) and 6689, which update the 1988 temporary regulations governing a taxpayer’s obligations with respect to a foreign tax redetermination (FTR) (T.D. 9362 and REG-209020-86). The 2007 temporary regulations address problems under the 1988 regulations and promulgate rules to account for statutory changes made to Secs. 905(c) and 986(a) in 1997 and 2004. Specifically, the new regulations provide for updates and changes in the following areas:
- Definition of an FTR;
- Foreign currency translation rules;
- Determination of U.S. tax adjustments;
- Timing and manner of filing IRS notifications; and
- Interest and penalty provisions.
Foreign Tax Credit OverviewIn general, Sec. 905(c) defines a foreign tax redetermination as a change in a foreign tax liability that may affect the U.S. tax liability resulting from a foreign tax credit claimed by a U.S. taxpayer. The foreign tax credit may be claimed as a direct tax credit under Sec. 901, subject to certain limitations under Sec. 904, when a U.S. taxpayer pays or accrues foreign taxes. In addition, under Secs. 902 or 960, an eligible U.S. corporation may claim a foreign tax credit for taxes paid or accrued by a foreign subsidiary when a dividend or a deemed dividend under subpart F is included in taxable income by the U.S. corporate shareholder.
Rules Under the 1988 RegulationsThe 1988 regulations provide guidelines regarding the occurrence of an FTR and the applicable notification requirements and associated interest and penalties, if any, that arise on the occurrence of an FTR. Under the 1988 regulations, an FTR arises with the following events:
- The refund of foreign taxes;
- The differences occurring between the amounts for foreign taxes accrued and foreign taxes actually paid; and
- The differences between the amount of foreign taxes accrued and actually paid arising due to foreign currency fluctuations (1988 Temp. Regs. Sec. 1.905-3T(c)).
There is an exception that applies for FTRs arising from currency fluctuations in which the change in the foreign tax liability is less than the lesser of $10,000 or 2% of the foreign tax initially accrued. When an FTR arises under Secs. 902 or 960 (deemed paid taxes), as a general rule the 1988 regulations require the U.S. corporation to make an adjustment to the pools of post-1986 undistributed earnings and post-1986 foreign income taxes for the year the FTR occurs, subject to certain exceptions (1988 Temp. Regs. Secs. 1.905-3T(d)(2)–(4) and (f)).
In 1997 and 2004, the IRS added new rules under Sec. 905(c). The first substantial rule was added to conform Sec. 905(c) to the rule in Sec. 986(a)(1) (as amended in 1997), to allow the taxpayer to translate foreign taxes at an average exchange rate for the accrual year, as long as those taxes are paid within two years after the close of the accrual year (Temp. Regs. Sec. 1.905-3T(b)(1)(ii)). The second substantial change under the 2004 provisions was to add a new type of FTR where accrued foreign taxes have not been paid within two years after the close of the accrual year (Sec. 905(c)(1)(B)). The new Sec. 905(c)(1) under the 2004 provisions requires the taxpayer to notify the IRS for such a failure.
New Temp. Regs. Under Sec. 905(c)The new 2007 temporary regulations under Secs. 905(c) and 6689 revise the nearly 20-year-old 1988 temporary regulations that have never been finalized. The new regulations update the 1988 regulations and provide valuable guidance to reflect the legislative changes to Secs. 905(c) and 986(a) made in 1997 and 2004.
Some of the more important issues addressed in the new regulations about FTRs are the foreign currency translation rules, accounting for foreign tax redeterminations, and the notification requirements.
Currency translation rules: Reflecting the 1997 and 2004 legislative changes to Sec. 986(a), the new regulations provide that, with five exceptions, taxpayers must translate foreign taxes paid or accrued in foreign currency using the average exchange rate for the U.S. tax year to which those foreign taxes relate (Temp. Regs. Sec. 1.905-3T(b)(1)). The five statutory exceptions under Sec. 986(a) are:
- Taxes paid more than two years after the close of the accrual year;
- Prepaid taxes;
- Taxes paid by a regulated investment company (RIC) that takes income into account on an accrual basis;
- Taxes denominated in inflationary currencies; and
- Taxes that the taxpayer elects to translate at the spot rate.
Those taxes that are denominated in an inflationary currency must be translated using the spot rate on the payment date of the foreign taxes. The 2007 regulations adopt the rule in the 1988 temporary regulations in providing that tax pools in foreign subsidiaries cannot be adjusted, but amended returns must be filed if a foreign subsidiary’s tax liability is denominated in a hyperinflationary currency. Under the 1988 temporary regulations, a hyperinflationary currency is defined as a currency subject to a cumulative inflation of 100% over a 36- month base period (1988 Temp. Regs. Sec. 1.905-3T(d)(4)(i)).
The new 2007 temporary regulations also provide an exception to the general rule that foreign taxes must be translated at the average exchange rate for the year of accrual for taxes denominated in an “inflationary currency.” The regulations define an inflationary currency as a currency subject to cumulative inflation of 30% over a 36-month base period (Temp. Regs. Sec. 1.905-3T(b)(1)(ii)(c)).
The effect of both rules is to prevent distortions that can arise if the value of the currency is changing rapidly when taxes are accrued on one date and paid on a different one. Under the new regulations, currencies of several Latin American countries in recent years, including Argentina, Brazil, and Venezuela, as well as the currencies of Indonesia, Iran, Turkey, and Russia, will be considered inflationary. Moreover, the new regulations fail to address the taxpayer’s tax years beginning before the applicability date of the new regulations that have never been subject to the 1997 Taxpayer Relief Act’s inflationary currency exception (Sec. 986(a)(1)(C)).
When taxes are paid more than two years after the close of the U.S. tax year to which they relate, the new regulations do not address short years caused due to a reorganization under Sec. 381(b) or a change in a tax year due to Sec. 898 or otherwise. In these cases, the issue is whether “two years” is interpreted to be 24 months or two tax years.
Accounting for foreign tax redeterminations under the 2007 regulations: The 2007 regulations retain the same rules as in the 1988 regulations regarding the notification requirements of an FTR under Sec. 901 taxes (direct taxes). However, for Secs. 902 or 960 taxes (deemed paid taxes), the 2007 regulations retain the same rules as in the 1988 regulations, subject to four exceptions, in which an adjustment to a foreign subsidiary’s tax pools cannot be made and amended returns must be filed instead.
Specifically, the general rule provides that a U.S. corporation must adjust the foreign subsidiary’s post-1986 undistributed earnings and post-1986 foreign income tax pools in the year the FTR occurs, rather than filing an amended return for the year to which the FTR relates. The 1988 temporary regulations provide four exceptions to the general rule requiring pool adjustments for a redetermination of a foreign corporation’s tax liability. The new regulations retain three of the exceptions under the old regulations and update the fourth one. The four exceptions are:
- Taxes denominated in hyperinflationary currency;
- Redeterminations that would give rise to negative tax pools;
- Reductions of foreign taxes due to distributions of previously taxed earnings; and
- Refunds of taxes on distributions of previously taxed earnings (Temp. Regs. Sec. 1.905-3T(d)(3)).
The new regulations replace this discretionary 2% rule with an objective 10% overaccrual rule (Temp. Regs. Sec. 1.905- 3T(d)(3)(ii)). Under the new rule, pooling adjustments are not permitted if an FTR occurs with respect to taxes paid by a foreign subsidiary and the FTR reduces the foreign taxes deemed paid by the domestic corporation shareholder under Secs. 902 and 960 by more than 10% with respect to a distribution or income inclusion due to subpart F.
Under the new rule, if a foreign subsidiary distributes a dividend or earns subpart F income (in the case of a controlled foreign corporation) either in the year to which an FTR relates or in a subsequent year prior to the year in which the FTR occurs, then in order to determine whether the 10% overaccrual rule applies, the U.S. shareholder must recompute its tax liability for each of the prior years in which it receives a distribution or includes subpart F income. For any intervening years in which there was no distribution or inclusion, the foreign subsidiary must make pooling adjustments. This 10% overaccrual rule in the new regulations can add a significant compliance burden for U.S. corporations that regularly receive distributions or include amounts of subpart F income from controlled foreign corporations.
Notification requirements under the new regulations: The 2007 temporary regulations adopt more favorable rules than those in the 1988 temporary regulations with respect to reporting FTRs. Under the new regulations, if an FTR arises relating to deemed paid taxes (under Secs. 902 or 960), the taxpayer is not required to attach a notice to each year’s tax return reporting any pooling adjustments, as it is required to do under 1988 regulations. Instead, under the new regulations, the taxpayer can now wait to reflect the adjustments on a Form 1118, Adjustments to Separate Limitation Income (Loss) Categories, for the first year in which the adjustment affects the computation of deemed paid taxes (Temp. Regs. Sec. 1.905-4T(b)(2)).
If an FTR must be reported through an amended return and the FTR results in an increase in U.S. tax liability, the new regulations require IRS notification via an amended return by the due date (including extensions) of the original return for the tax year in which the foreign tax redetermination occurs (Temp. Regs. Secs. 1.905-4T(b)(1)(i) and (ii)). In addition, in the case of a taxpayer having multiple FTRs that increase its U.S. tax liability— and such FTRs occur within two consecutive tax years—the new regulations allow the taxpayer to file one amended return reflecting all the FTRs (Temp. Regs. Sec. 1.905-4T(b)(1)(iv)). This is a departure from the 1988 regulations, which require the taxpayer to notify the IRS within 180 days after the date of the relevant foreign tax redeterminations for each FTR, possibly resulting in multiple amended returns. This could occur in the case of a taxpayer operating in multiple foreign jurisdictions.
The new regulations also state that if an FTR results in additional U.S. tax liability, the taxpayer may not have to amend the return for that year if the taxpayer has unused foreign tax credits that can be carried back or forward to offset the additional U.S. tax liability completely for such year. In that case, the taxpayer may notify the Service of the FTR by attaching a statement to an original return for the tax year in which the FTR occurs that provides the pertinent information relating to the excess foreign tax credits (Temp. Regs. Sec. 1.905-4T(b)(v)).
When the FTR results in a decrease in U.S. tax liability, such as in the case of an additional assessment of foreign taxes, the 2007 regulations retain the same rule as under the old regulations requiring a taxpayer to notify the IRS within the 10-year period of limitation under Sec. 6511(d)(3)(A) (Temp. Regs. Sec. 1.905-4T(b)(1)(iii)).
Effective dates: The new temporary regulations under Sec. 905(c) are generally applicable for foreign tax redeterminations occurring in tax years of U.S. taxpayers beginning on or after November 7, 2007, when the redetermination affects the amount of foreign taxes paid or accrued by a U.S. taxpayer.
The new regulations also contain special notification rules for taxpayers that have failed to notify the Service of a foreign tax redetermination under the 1988 temporary regulations for redeterminations occurring in the three-year period before the effective date of the new regulations (regardless of the year to which the redetermination relates) (Temp. Regs. Sec. 1.905-4T(f)(2)). Generally, this notification must be attached to amended returns for the year(s) for which a redetermination of U.S. tax is required. The special notification generally must be made by the due date (with extensions) of the taxpayer’s first tax year following the tax year in which the regulations are first applicable.
ConclusionThe new 2007 temporary regulations under Sec. 905(c) make several significant changes to the 1988 proposed and temporary regulations. However, the 2007 rules are more complex, and taxpayers should carefully determine how to address an FTR in the event that one occurs. Even though the 2007 temporary regulations address many problems that the 1988 regulations did not, several issues still remain unresolved.
Kevin F. Reilly, J.D., CPA, is a member of PKF Witt Mares in Fairfax, VA.
Unless otherwise noted, contributors are members of or associated with PKF North American Network.
For additional information about these items, contact Mr. Reilly at (703) 385-8809 or firstname.lastname@example.org.