As amended by P.L. 115-97, the law known as the Tax Cuts and Jobs Act (TCJA), and effective for tax years of foreign corporations beginning after 2017, Sec. 960 adopts a new "properly attributable to" standard to determine the amount of foreign taxes deemed paid by U.S. shareholders of controlled foreign corporations (CFCs) with respect to certain income inclusions from CFCs, including amounts included in the U.S. shareholder's gross income under Sec. 951(a). Also effective for years beginning after 2017, the TCJA repealed Sec. 902, which previously provided deemed-paid foreign tax credits with respect to actual and deemed dividends received from certain foreign corporations.
Sec. 960(a) now provides that U.S. corporate shareholders that include "any item of income under section 951(a)(1)" with respect to any CFC shall be deemed to have paid "so much of such foreign corporation's foreign income taxes as are properly attributable to such item of income." Thus, as a threshold matter, Sec. 960(a) provides a basis for deemed-paid credits with respect to inclusions under Secs. 951(a)(1)(A) (Subpart F inclusions) and (B) (Sec. 956 inclusions). However, determining how to "properly attribute" a foreign income tax to an income inclusion is unclear, particularly with respect to Sec. 956 inclusions.
When a CFC invests in U.S. property, a U.S. shareholder's pro rata share of certain earnings and profits (E&P) of the CFC attributable to the investment is included in the gross income of that shareholder under Sec. 951(a)(1)(B) on the theory that the investment is essentially equivalent to a dividend (see S. Rep't No. 1881, 87th Cong., 2d Sess. 80, 87-88 (1962)).
The amount of earnings taken into account for this purpose generally corresponds to the lesser of the CFC's Sec. 956 investment or the CFC's "applicable earnings," which are roughly defined under Sec. 956(b)(1) as the CFC's current and accumulated E&P, less distributions and previously taxed income (PTI) described under Sec. 959(c)(1) (relating to prior-year Sec. 956 inclusions).
Before the TCJA, corporate U.S. shareholders generally could take a deemed-paid credit with respect to Sec. 951(a)(1)(B) inclusions under Secs. 960 and 902. The amount of foreign income taxes deemed paid with respect to a Sec. 956 inclusion was based on a fraction, the numerator of which was the Sec. 956 inclusion and the denominator of which was the CFC's post-1986 undistributed earnings. This fraction then was multiplied by the CFC's pool of post-1986 foreign income taxes to arrive at the deemed-paid foreign income taxes associated with the Sec. 956 inclusion (see Sec. 960(a), prior to amendment, and Sec. 902, prior to repeal). Special rules applied to limit deemed-paid foreign income taxes in the case of "hopscotch" Sec. 956 inclusions (i.e., inclusions from lower-tier CFCs) (see Sec. 960(c) (prior to deletion)).
Example 1. Prior law: USP owns CFC1. CFC1 makes a 100u loan to USP in the current tax year, and the loan is outstanding for the entire year. (For the examples in this item, $1 = 1u.) CFC1's applicable earnings as of the end of the year are 200u, and CFC1 has post-1986 undistributed earnings of 200u, with associated post-1986 foreign income taxes of $30 as of the end of the year.
Result: USP has a Sec. 951(a)(1)(B) inclusion of 100u (lesser of the 100u Sec. 956 investment and the 200u of applicable earnings) and is deemed to pay foreign income taxes of $15 ([100u Sec. 956 inclusion ÷200u post-1986 undistributed earnings] × $30 post-1986 foreign income taxes) with respect to the inclusion.
Applying the new "properly attributable to" standard to this and similar fact patterns involving Sec. 956 inclusions is unclear, mainly because the standard is not defined anywhere in the new legislation.
Principles that apply in analogous contexts may help to define the standard. For example, various cases define a similar term, "attributable to," as connoting causation (see Braunstein, 374 U.S. 65, 68-70 (1963); Lawinger, 103 T.C. 428 (1994)), and the rules under Sec. 861 generally allocate and apportion deductions, including taxes, to gross income based on the factual relationship between the deduction and the gross income (seeRegs. Secs. 1.861-8(a)(2) and (e)(6)). In the absence of guidance, there appear to be at least three ways to apply the new rules to fact patterns involving Sec. 956 inclusions: (1) allow foreign tax credits only to the extent of taxes paid with respect to the CFC's current-year earnings; (2) allow foreign tax credits using last-in, first-out (LIFO) ordering; and (3) allow credits using the principles of Regs. Sec. 1.904-6(a).
Credit only to the extent attributable to current-year earnings
As noted above, Sec. 960(a) provides that U.S. corporate shareholders that include "any item of income under section 951(a)(1)" with respect to any CFC shall be deemed to have paid "so much of such foreign corporation's foreign income taxes as are properly attributable to such item of income" (emphases added).
One interpretation of Sec. 960(a) is that it applies to only current-year taxes in the case of Sec. 956 inclusions. Thus, in Example 1, if all CFC1's $30 of foreign income taxes was paid in prior years, then no foreign income taxes would be deemed paid by USP by reason of the $100 Sec. 951(a)(1)(B) inclusion from CFC1, even if the entire inclusion was measured by applicable earnings generated in prior years. Similarly, if CFC1 generated 150u of its total applicable earnings of 200u in the current year and paid $15 of its $30 of foreign income taxes with respect to such current-year earnings, then USP's deemed-paid taxes with respect to the 100u inclusion from CFC1 would be $10 ([100u ÷ 150u] × $15). This interpretation arguably is consistent with the repeal of the cumulative earnings and tax pooling mechanics of Sec. 902 (see Joint Committee on Taxation, Description of H.R. 1, the "Tax Cuts and Jobs Act" (JCX-50-17), p. 260 (Nov. 3, 2017) ("The proposal eliminates the need for computing and tracking cumulative tax pools.")).
However, the repeal of Sec. 902 does not eliminate the need to compute and track taxes paid by a CFC in prior years. For example, amended Sec. 960(b) provides credits for distributions of PTI, including PTI accumulated in years before the year of distribution. Computing the amount of the credit with respect to PTI distributed in a year after the underlying income was included in gross income requires tracking the taxes associated with each annual layer of PTI.
In addition, the repeal of the cumulative earnings and tax pooling mechanics of Sec. 902 first appeared in the House and Senate versions of the TCJA, both of which also repealed Sec. 956 (for domestic corporations), leaving only the foreign high-return-amount regime (House bill), the global intangible low-taxed income (GILTI) regime (Senate bill), and the Subpart F regime (both bills) as the main anti-deferral regimes for CFCs. Each regime creates income inclusions measured by all or a portion of a CFC's current-year earnings. By contrast, the final version of the legislation retains the GILTI regime, also repeals Sec. 902 and, importantly, makes no changes to Sec. 956.
While it may have made sense to eliminate E&P and tax pooling for domestic corporations under the House and Senate bills, that approach does not seem appropriate under the TCJA when determining credits with respect to Sec. 956 inclusions, as such inclusions are based on a CFC's cumulative earnings. In the context of Subpart F income, where a U.S. shareholder's inclusion under Sec. 951(a) is limited by the CFC's current-year E&P (Sec. 952(c)(1)(A)) and generally corresponds to "items of income" earned in the current year at the CFC level, it would seem to make sense to base the credit under new Sec. 960(a) on the CFC's current-year taxes. A current-year approach to determining deemed-paid taxes may not be appropriate, however, in the context of Sec. 956, where the "item of income" included under Sec. 951(a) may consist of the CFC's current- and prior-year earnings.
Another alternative would be to simply source deemed-paid taxes first from taxes paid with respect to income earned in the current year to the extent thereof, and then from the most recently accumulated earnings on a LIFO basis.(The legislative history accompanying Sec. 956 would seem to support this approach, as it indicates that similar LIFO ordering principles are used to attribute actual distributions or income inclusions to years of earnings in the Sec. 956 context — that is, earnings from more recent years are treated as distributed or included before earnings from earlier years (see H.R. Rep't No. 213, 103d Cong., 1st Sess. 643, n. 76).) Under this method, the amount of foreign taxes deemed paid for a particular year would be limited to the amount of foreign income taxes paid or accrued on or with respect to the accumulated profits of that year; and taxes attributable to a particular annual layer would not be accessed until all earnings in all later annual layers have been depleted (compare Rev. Rul. 71-65).
Example 2: CFC1 has earnings of 90u in year 1 and 50u in year 2, and pays foreign income taxes of $30 in year 1 and $10 in year 2. CFC1's applicable earnings as of the end of year 2 are 140u. CFC1 lends 80u to USP in year 2. The loan is outstanding for the entire year.
Result: The 80u loan results in an 80u Sec. 951(a)(1)(B) inclusion to USP. The 80u inclusion is sourced first from CFC1's year 2 earnings of 50u. The remaining 30u inclusion is then sourced from CFC1's year 1 earnings of 90u. USP is deemed to pay all of CFC1's $10 of foreign income taxes paid in year 2 since all of CFC1's year 2 earnings were included in USP's income under Sec. 951(a)(1)(B). USP also is deemed to pay $10 (i.e., one-third) of CFC1's $30 of foreign income taxes paid in year 1 because it will include 30u (i.e., one-third) of CFC1's year 1 earnings of 90u under Sec. 951(a)(1)(B).
LIFO ordering would require earnings and associated taxes to be maintained and computed in annual layers, which could prove difficult to administer (the foreign tax credit system in effect prior to 1987 used a similar approach and was difficult to administer; see Regs. Sec. 1.902-3).
Credit based on the principles of Regs. Sec. 1.904-6(a)
The Joint Committee on Taxation (JCT) reports accompanying the House and Senate versions of the TCJA indicate that the IRS is expected to issue future regulations under Sec. 960 based on the tax allocation rules of Regs. Sec. 1.904-6(a). Citing Regs. Sec. 1.904-6(a), the reports state that "[i]t is anticipated that the Secretary would provide regulations with rules for allocating taxes similar to rules in place for purposes of determining the allocation of taxes to specific foreign tax credit baskets. Under such rules, taxes are not attributable to an item of subpart F income if the base upon which the tax was imposed does not include the item of subpart F income" (see Joint Committee on Taxation, Description of H.R. 1, the "Tax Cuts and Jobs Act" (JCX-50-17), p. 260 (Nov. 3, 2017); Joint Committee on Taxation, Description of the Chairman's Mark of the "Tax Cuts and Jobs Act" (JCX-51-17), p. 240 (Nov. 9, 2017)).
Certain aspects of Regs. Sec. 1.904-6 use the pooling rules of former Sec. 902 to assign foreign taxes (see Regs. Sec. 1.904-6(b)). The reference to Regs. Sec. 1.904-6(a) in the JCT reports could suggest a similar approach under amended Sec. 960(c). Under this approach, USP in Example 2 would be deemed to pay $15 of CFC1's foreign income taxes by reason of the 100u Sec. 951(a)(1)(B) inclusion ([100u ÷200u)] × $30), regardless of when the taxes were paid byCFC1.
Regs. Sec. 1.904-6(a) also generally relies on foreign law to assign foreign taxes to the appropriate category of income. The reliance on foreign income recognition principles for this purpose may raise uncertainty in cases where the amount included in the foreign tax base differs from the amount included in the U.S. tax base, such as where a relevant item of income is recognized for foreign purposes but not for U.S. purposes.
Two special rules under Regs. Sec. 1.904-6(a)(1)(iv) govern situations in which a CFC's taxes are associated with foreign income items that are excluded from the U.S. tax base: (1) foreign taxes imposed on an item that does not constitute income under U.S. tax principles (a "base difference") are treated as imposed with respect to general limitation income, and (2) foreign tax imposed on an item that would be income under U.S. tax principles in another year (a "timing difference") are allocated to the appropriate separate category as if the United States recognized the income in the same year.
The interaction of these rules with Sec. 960(a) is unclear. However, it is worth noting that the reference to Regs. Sec. 1.904-6(a) first appeared in the JCT report accompanying the House version of the TCJA, which as mentioned above would have repealed Sec. 956 for corporate U.S. shareholders (similar to the Senate version). Therefore, it is unclear whether the Regs. Sec. 1.904-6(a) approach should be given much, if any, weight in determining the amount of a CFC's foreign income taxes that is "properly attributable" to a Sec. 956 inclusions with respect to that CFC.
Waiting for a fix
While both the House and Senate bills would have repealed Sec. 956 for corporate U.S. shareholders, the TCJA ultimately retained it without any explanation. When Congress added back Sec. 956 to the TCJA, perhaps as a last-minute decision, it is possible that it simply did not consider in detail how the revised Sec. 960 would apply for Sec. 956 purposes. Each approach discussed above has its limitations. For example, the year-by-year system for determining deemed-paid taxes with respect to GILTI and Subpart F inclusions does not seem appropriate for determining the credit for Sec. 956 inclusions, which can be drawn from multiyear pools of earnings; the use of LIFO ordering would require earnings and associated taxes to be maintained and computed in annual layers, which could prove difficult to administer; and looking to the principles of Regs. Sec. 1.904-6(a) to allocate foreign taxes to "items" included in income under Sec. 951(a)(1)(B) raises several issues that would require clarification. Future guidance or a "fix" to the statutory language should clarify the approach taxpayers should use to compute deemed-paid credits with respect to Sec. 956 inclusions.
Annette B. Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
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