Sec. 901(m): Potential Trap for Partnership Transactions

Editor: Kevin D. Anderson, CPA, J.D.

Foreign Income & Taxpayers

In 2010, President Barack Obama signed P.L. 111-226, enacting new Sec. 901(m), which limits the creditability of foreign taxes in certain acquisition transactions where a taxpayer receives a basis step-up for U.S. tax purposes but no corresponding basis step-up for foreign tax purposes. Soon, the IRS is expected to issue regulations under Sec. 901(m) that will, among other things, clarify what types of covered asset acquisitions are considered “any other similar transaction” for purposes of Sec. 901(m).

Basic Application of Sec. 901(m)

Sec. 901(m) limits the creditability of foreign taxes in “covered asset acquisitions” (CAAs). A CAA is defined in Sec. 901(m)(2) as:

1. A qualified stock purchase to which Sec. 338(a) applies;
2. Any transaction that is treated as an acquisition of assets for U.S. income tax purposes and is treated as an acquisition of stock of a corporation (or is disregarded) for foreign income tax purposes (i.e., the acquisition of interests in a hybrid entity that is recognized as a disregarded entity for U.S. tax purposes but is recognized as a corporation for foreign tax purposes);
3. Any acquisition of an interest in a partnership that has a Sec. 754 election in effect; and
4. Any other similar transaction, to the extent provided by the IRS.

The disqualified portion of a foreign income tax is defined in Sec. 901(m)(3)(A) as the ratio (expressed as a percentage) of:

1. The aggregate basis difference (but not below zero) allocable to the tax year for all relevant foreign assets, divided by
2. The income on which the foreign tax is assessed.

Sec. 901(m)(6) provides that any foreign taxes disqualified under Sec. 901(m) may still be deducted by the taxpayer.

Essentially, the purpose of Sec. 901(m) is to limit the ability of taxpayers to claim foreign tax credits with respect to transactions that create permanent differences between a taxpayer’s foreign tax base and U.S. tax base by disallowing foreign tax credits for foreign taxes paid on income that is not also subject to U.S. income tax.

Sec. 704(c) Allocations

As noted above, Sec. 901(m)(2) includes within the scope of a CAA “any other similar transaction” that creates a permanent difference between the foreign tax base and the U.S. tax base. Without clarification from the IRS, transactions that create a Sec. 704(c) or reverse Sec. 704(c) allocation could fall within the catch-all provision because such allocations could create a permanent difference between the U.S. and foreign tax bases. For example, when a partner contributes appreciated property to a partnership, the noncontributing partner may receive the equivalent of a step-up for U.S. tax purposes under Sec. 704(c)(1) with respect to the partner’s distributive share of cost recovery deductions, and gain or loss attributable to the contributed property.

While an allocation under Sec. 704(c)(1) may create a difference between the foreign tax base and the U.S. tax base to the noncontributing partner, the impact of a limitation under both Secs. 704(c) and 901(m) may result in unintended adverse consequences to the noncontributing partner. In considering the upcoming regulations, the IRS may address a number of outstanding issues and questions. Hopefully, the guidance will exclude Sec. 901(m) from applying to transactions that create a Sec. 704(c) or reverse Sec. 704(c) allocation. The intended purpose of Sec. 901(m) (i.e., disallowing foreign tax credits for foreign taxes paid on income that is not also subject to U.S. tax) is already effectively accomplished in such transactions by the regulations under Sec. 704.

Example: A U.S. corporation (USCO) and a foreign corporation (FORCO) form a hybrid entity (FP) that is recognized as a partnership for U.S. tax purposes and a corporation for foreign country purposes, with USCO and FORCO each owning 50% of the interests in FP. USCO contributes $1,000 cash for its FP interests, and FORCO contributes depreciable property with an adjusted basis of $500 and a fair market value of $1,000 for its FP interests. The property has a remaining useful life of five years, and FP is entitled to an annual depreciation deduction of $100. Assume that FP earns $500 of income each year. For foreign country tax purposes, FP earns $500 of income and deducts $100 as a depreciation expense for net taxable income of $400. Also assume that FP is subject to a 30% foreign tax rate and pays $120 of foreign taxes.

Under Sec. 901(b)(5), USCO, subject to certain limitations, may claim a credit for its proportionate share of foreign income taxes paid by FP. Sec. 702(a)(6) provides that each partner shall take into account separately a distributive share of the partnership’s foreign income taxes, and Sec. 703(b)(3) provides that any election under Sec. 901 (relating to foreign income taxes) will be made by each partner separately.

For U.S. tax purposes, USCO is allocated all of FP’s depreciation deduction for the year under Sec. 704(c)(1)(A) so that USCO receives the equivalent of a step-up in the basis of the contributed property to fair market value in determining its allocable share of the depreciation. USCO’s position in this example is superficially similar to the position it would have been in if it had instead purchased FP interests and FP had a Sec. 754 election in effect (a listed CAA), which would have entitled USCO to a Sec. 743(b) step-up to the basis of partnership assets. Because of that similarity and current lack of guidance from the IRS, a transaction that includes a Sec. 704(c) or reverse Sec. 704(c) allocation could fall within the catch-all “any other similar transaction” of Sec. 901(m)(2).

Even though a difference between the foreign tax base and the U.S. tax base of the asset as it relates to USCO is created because of the depreciation allocation under Sec. 704(c)(1)(A), and such a transaction may potentially be considered “any other similar transaction” to a CAA, Regs. Sec. 1.704-1(b)(4)(viii) should limit USCO’s ability to credit foreign taxes paid by FP, thereby making the application of Sec. 901(m) to such transactions unnecessary.

Regs. Sec. 1.704-1(b)(4)(viii) generally requires creditable foreign tax expenditures to be allocated among the partners in the same proportion as the distributive share of partnership income (as determined for U.S. income tax purposes) to which the foreign taxes relate. Thus, if a partner contributes a built-in gain asset to a partnership, when the noncontributing partner receives a disproportionately large allocation of the depreciation deductions (and is consequently allocated a smaller portion of the partnership’s income), the noncontributing partner will also receive a smaller allocation of the creditable foreign tax expenditures.

In the example above, for U.S. tax purposes, USCO would generally be allocated $250 of income and the entire $100 of depreciation deduction under Sec. 704(c)(1)(A), for $150 of net taxable income. USCO would not be allocated 50% of the foreign taxes paid by FP, but rather, USCO should be allocated 37.5% ($150 of USCO’s distributive share of FP income ÷ $400 total partnership income) of the foreign taxes paid by FP (i.e., $120 foreign taxes × 37.5% ratio of distributive partnership income = $45 of creditable foreign tax expenditures). By allocating foreign creditable tax expenditures in the same proportion as the distributive share of partnership income, the regulations under Sec. 704 prohibit USCO from crediting foreign taxes paid on income that is not also subject to U.S. tax.

The allocation of creditable foreign tax expenditures in the above example is not entirely certain, as it may cause the capital accounts to differ from the intended economic deal. See, e.g., Regs. Sec. 1.704-1(b)(5), Example (25), which notes that an allocation of other partnership items may be needed to ensure that the tax consequences of the partnership’s allocations are consistent with the partners’ contemplated economic arrangement over the term of the partnership. Nevertheless, it is clear that the regulations under Sec. 704(c) limit the allocation of creditable foreign tax expenditures in a manner similar to that illustrated in the example.

Now, using the same facts as above, assume instead that Regs. Sec. 1.704-1(b)(4)(viii) does not apply and foreign taxes are allocated based on ownership percentages. For purposes of this comparison, also assume that such an allocation of foreign taxes has substantial economic effect. As in the example above, FP should be subject to tax on $400 of net income and pay $120 of foreign income tax. For U.S. tax purposes, USCO should be allocated net income of $150. If Regs. Sec. 1.704-1(b)(4)(viii) did not apply, USCO would be allocated 50% of the foreign taxes paid ($120 × 50% = $60). Also for comparison purposes, assume such foreign taxes are limited by Sec. 901(m).

Under Sec. 901(m), 25% ($50 basis difference allocable to the year ÷ $200 income subject to foreign tax) of the $60 foreign tax, or $15, would be disallowed under Sec. 901(m). Ultimately, USCO would be entitled to a foreign tax credit of $45 ($60 allocable foreign taxes – $15 of foreign taxes disallowed under Sec. 901(m)). As the comparison illustrates, Sec. 901(m) and the regulations under Sec. 704 limit USCO’s ability to credit foreign taxes in the same fashion by prohibiting USCO from crediting foreign taxes imposed on income that is not also subject to U.S. tax.

Conclusion

Given the lack of clarity regarding the scope of the term “any other similar transaction” in Sec. 901(m), it is anticipated that the IRS will provide additional guidance on what similar transactions are considered CAAs. The guidance will hopefully exclude from Sec. 901(m) any transactions that create a Sec. 704(c) or reverse Sec. 704(c) allocation. The regulations under Sec. 704 should properly limit the creditability of foreign taxes imposed on income that is also not subject to U.S. tax in a manner similar to Sec. 901(m). Including transactions that include a Sec. 704(c) or reverse Sec. 704(c) allocation in the catch-all “any other similar transaction” of Sec. 901(m)(2) would be duplicative and unnecessary.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO USA LLP, in Bethesda, Md.

For additional information about these items, contact Mr. Anderson at 301-634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO USA LLP.