Rules for Partnership Allocations of Creditable Foreign Taxes Are Amended

Temporary regulations issued by the IRS amend an existing safe harbor that is used for determining whether allocations of creditable foreign tax expenditures (CFTEs) are deemed to be in accordance with the partners’ interests in the partnership (T.D. 9748).

Sec. 743(b) Adjustments

Because allocations of CFTEs do not have substantial economic effect, the partnership allocation rules require them to be allocated in accordance with the partners’ interest in the partnership. An existing safe-harbor rule deems an allocation to be in accordance with the partners’ interest in the partnership if the partnership matches allocations of CFTEs to the income to which they relate. To do this, the partnership must determine the partnership’s “CFTE categories” and the partnership’s net income in each CFTE category, and allocate the partnership’s CFTEs to each category.

Existing Regs. Sec. 1.704-1(b)(4)(viii)(c)(3) provides rules for determining the partnership’s net income in a CFTE category, including rules for allocating and apportioning expenses, losses, and other deductions to gross income. The safe harbor requires partnership allocations of CFTEs in a CFTE category to be in proportion to the allocations of the partnership’s net income.

The new regulations clarify that Sec. 743(b), which requires an adjustment to the basis of partnership property when a Sec. 754 election is in effect, should not be taken into account in computing a partnership’s net income in a CFTE category because the adjustment is unique to the partner and normally would not be taken account of by the foreign jurisdiction in determining its foreign taxable base.

Special Rules

The current regulations, for purposes of the safe harbor, contain a number of special rules relating to deductible allocations and nondeductible guaranteed payments, which the temporary regulations modify. First, the temporary regulations provide that a partnership’s net income in a CFTE category from which a guaranteed payment that is not deductible in a foreign jurisdiction is made will be increased by the amount of the guaranteed payment that is deductible for U.S. federal income tax purposes, and that amount will be treated as an allocation to the recipient of the guaranteed payment for purposes of determining the partners’ shares of income in the CFTE category, but only for purposes of testing allocations of CFTEs attributable to a foreign tax that does not allow a deduction for the guaranteed payment.

In addition, the temporary regulations provide that to the extent that a foreign tax allows a deduction from its taxable base for an allocation (or distribution of an allocated amount) to a partner, then solely for purposes of testing allocations of CFTEs attributable to that foreign tax, the partnership’s net income in the CFTE category from which the allocation is made is reduced by the amount of the foreign law deduction, and that amount is not treated as an allocation for purposes of determining the partners’ shares of income in the CFTE category. However, for purposes of testing allocations of CFTEs attributable to a foreign tax that does allow a deduction for the guaranteed payment, a partnership’s net income in a CFTE category is increased only to the extent that the amount of the guaranteed payment that is deductible for U.S. federal income tax purposes exceeds the amount allowed as a deduction for purposes of that foreign tax, and the excess is treated as an allocation to the recipient of the guaranteed payment for purposes of determining the partners’ shares of income in the CFTE category.

Similarly, the temporary regulations provide that, to the extent a foreign tax allows a deduction from its taxable base for an allocation (or distribution of an allocated amount) to a partner, then solely for purposes of testing allocations of CFTEs attributable to that foreign tax, the partnership’s net income in the CFTE category from which the allocation is made is reduced by the amount of the foreign law deduction, and that amount is not treated as an allocation for purposes of determining the partners’ shares of income in the CFTE category. For purposes of testing allocations of CFTEs attributable to a foreign tax that does not allow a deduction for an allocation (or distribution of an allocated amount) to a partner, the partnership’s net income in a CFTE category is not reduced.

Finally, the temporary regulations clarify that a guaranteed payment or preferential allocation is considered deductible under foreign law for purposes of the special rules if the foreign jurisdiction allows a deduction from its taxable base either in the current year or in a different tax year.

Interbranch Payments

The IRS indicated in the preamble to the temporary regulations it had become aware that there was uncertainty regarding the application of the special rules to disregarded payments among branches of a partnership. Thus, the temporary regulations also clarify that the special rules do not apply to interbranch payments because they, by definition, are not made to a partner and are outside the scope of the special rules.

Effective Dates

The regulations apply to partnership tax years that begin on or after Jan. 1, 2016, and end after Feb. 4, 2016, the date they were published in the Federal Register. There is a special transition rule for interbranch payments. The regulations were also issued as proposed regulations (REG-100861-15).