Editor: Mary Van Leuven, J.D., LL.M.
On Dec. 28, 2021, Treasury and the IRS issued final foreign tax credit regulations (T.D. 9959) that were officially published in the Federal Register on Jan. 4, 2022. These final regulations provide regulatory authority for Treasury's long-held position that an individual taxpayer who elects on a timely filed return to claim the foreign tax credit on the cash basis may not change to the accrual basis on an amended return.
This item discusses the background and application of this rule.
Under Sec. 905(a), a cash-method taxpayer can elect to claim a foreign tax credit on either the cash basis or accrual basis (Regs. Secs. 1.905-1(c) and (d)). If such a taxpayer elects to claim a foreign tax credit on the accrual basis, that election is binding for all future tax years. However, prior to the 2020 proposed foreign tax credit regulations, neither the Internal Revenue Code nor the Treasury regulations addressed whether a cash-method taxpayer may amend a return to claim foreign tax credits on the accrual basis.
That issue was considered in Strong v. Willcuts, No. 2497 Law (D. Minn. 1935). The court denied a taxpayer's election to claim foreign tax credits on an accrual basis that was made on an amended return on two grounds. First, the court ruled that when the taxpayer claimed a foreign tax credit on the cash basis on his original, timely filed return, the taxpayer fixed the rights of both the taxpayer and the government. Therefore, the court held that the taxpayer could not change from claiming foreign tax credits using the cash method of accounting to claiming foreign tax credits using the accrual method of accounting on an amended return because of the doctrine of elections. Second, the court found that the foreign taxes at issue did not accrue in the relevant tax year (1929), so even if the taxpayer were allowed to elect to apply the accrual method, the foreign income tax in question could not be claimed as a foreign tax credit in the relevant tax year because the foreign income tax accrued in the subsequent tax year (1930).
In TAM 8332003, the IRS cited Strong in determining that once an election to take the foreign tax credit on the cash basis is made on a timely filed tax return, an election to take the credit on the accrual basis may not be made by filing an amended return. Treasury also cited Strong in the preamble to the 2020 foreign tax credit regulations when discussing proposed Regs. Sec. 1.905-1(e), which addressed the timing of making the accrual-basis election. Under the proposed regulations, an election to claim foreign taxes on the accrual basis must be made on a timely filed, original return. The proposed regulations also provided an exception for a taxpayer who has never previously claimed a foreign tax credit to elect to claim a foreign tax credit on the accrual basis on an amended return.
Final foreign tax credit regulations
Preamble: Treasury adopted Prop. Regs. Sec. 1.905-1(e) without modification. In the preamble of the final regulations, Treasury disagreed with a public comment suggesting that a taxpayer should be allowed to make an election on an amended return because the purpose of Sec. 905(a) was to match the timing of the U.S. tax and foreign tax on the same income and that the existing case law supported the retroactive election. The public comment relied on Dougherty, 60 T.C. 917 (1973), in which the court permitted an individual taxpayer to make an election under Sec. 962 to be subject to corporate tax rates on an amended return. The commenter further argued that Strong did not hold that an election to use the accrual method of accounting for purposes of claiming foreign tax credits may not be made on an amended return and that the court's discussion of the issue was dictum that did not represent legal authority.
In response, Treasury cited the statutory language of Sec. 905(a) that, by its terms, allows only a one-time change from the cash to the accrual method and pointed out that, though timing was of concern, Congress never amended Sec. 905(a) to allow taxpayers to be able to make the election on an amended return. Additionally, Treasury noted that a retroactive election would create more compliance burdens and administrative complexity as well as time bar collection of taxes due to different expiration dates of statutes of limitation for assessments and refunds for the foreign tax credit. Treasury disagreed with the commenter's interpretation of Strong and asserted that the case provided support for the regulations' disallowance of a retroactive election, rejecting the argument that the case provided little legal authority.
Furthermore, Treasury viewed the Dougherty court's holding to be consistent with an exception provided under Regs. Sec. 1.905-1(e)(2). As Treasury explained, the Dougherty court interpreted prior case law to mean that when determining the timeliness of a delayed election, one should ask whether the original action or the failure to act was consistent with a taxpayer's final position.
Applying this approach, the Dougherty court had allowed a retroactive election because the taxpayer in the case did not take a position on an amended return that was inconsistent with the original return. Though not specifically discussed in the preamble, the taxpayer in Dougherty had not made a Sec. 962 election prior to the tax year at issue and made the election for the first time on his amended return. Thus, according to Treasury, the principle that Dougherty stands for is, in fact, reflected in the exception provided under the final regulations, which allows a taxpayer to make a retroactive election on an amended return if the taxpayer is claiming the foreign tax credit for the first time.
General application of the final regulations: Under Regs. Sec. 1.905-1(e)(1), an individual taxpayer who uses the cash method of accounting for income may elect to take a foreign tax credit in the tax year in which the taxes accrue in accordance with the rules for accrual-method taxpayers. An election to do so must be made on a timely filed, original return by checking the appropriate box on Form 1116, Foreign Tax Credit. Once the election is made, it is irrevocable and must be followed for purposes of claiming the foreign tax credit for all subsequent years.
Example 1: B is a U.S. resident who has foreign-source income and pays foreign income taxes. In year 1, B claimed a foreign tax credit on the cash-basis method and filed her year 1 return by April 15, year 2. In year 3, she decided to change her method from the cash method to the accrual method on an amended year 1 return.
The election illustrated in Example 1 is not a valid election because B cannot retroactively elect the accrual method once she has chosen the cash method on her original return. Regs. Sec. 1.905-1(e)(1) does not allow B to change her election from the cash basis to the accrual basis on an amended return. B may elect the accrual-basis method on her timely filed original return for a subsequent year.
Example 2: In year 1, B claimed a foreign tax credit using the cash method on her timely filed, original return. In year 2, B did not timely file her required return for year 2, and she did not pay any foreign income taxes. In year 5, B filed her year 2 original return and elected to claim the foreign tax credit on the accrual method. B believed her year 2 election with respect to the foreign tax credit to be a permissible election because she was making an election on her original return for year 2 and not on an amended return.
In Example 2, even though B made the election on her original return, it is not a valid election because that election must be made on a timely filed, original return.
Exception to the general rule: Under Regs. Sec. 1.905-1(e)(2), if a taxpayer claims a foreign tax credit for the first time, an election to claim the foreign tax credit on the accrual basis may be made on an amended return.
Example 3: The facts are similar to Example 1, except that B has never claimed a foreign tax credit in any of her prior tax years, and she did not claim the foreign tax credit on her timely filed, original return in year 1. In year 2, B learned that claiming the foreign tax credit on the accrual method would benefit her greatly. She amended her year 1 return and claimed the foreign tax credit on the accrual method.
B's election is permitted under the regulations because B did not claim any foreign tax credits in her prior-year returns. On her timely filed, original return, she did not choose a method for purposes of the foreign tax credit, and the election made on the amended return is the first time she chose a method to claim the foreign tax credit. Unlike the two prior examples, the taxpayer in Example 3 is claiming the foreign tax credit for the first time on her amended return.
The exception illustrated in Example 3 is consistent with the Dougherty and Strong holdings because the taxpayer elects the accrual-basis method on an amended return as the first and the last method for purposes of the foreign tax credit. The taxpayer in Example 3 is not taking a position that is inconsistent with her prior position by changing from the cash to the accrual basis. Without a prior election claiming the foreign tax credit on the cash-basis method, the taxpayer's election on an amended return is a valid election under the final regulations.
Clear time frame
The final regulations provide a clear time frame for making an election to change from the cash basis to the accrual basis for purposes of the foreign tax credit. The ambiguity that existed before the 2020 proposed regulations is no longer an issue because the final regulations expressly state that the taxpayer's election, to be valid, must be made on a timely filed, original return, unless an exception applies.
Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
Contributors are members of or associated with KPMG LLP.
The information in these articles is not intended to be “written advice concerning one or more federal tax matters” subject to the requirements of Section 10.37(a)(2) of Treasury Department Circular 230 because the content is issued for general informational purposes only. The information is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. The articles represent the views of the author or authors only, and do not necessarily represent the views or professional advice of KPMG LLP.