Redetermining foreign taxes in a post-TCJA world

The U.S. federal income tax system generally subjects U.S. taxpayers to taxation of earnings from all sources, foreign and domestic. To prevent double taxation, a credit against U.S. federal income tax is typically permitted under Sec. 901 for foreign income taxes paid or accrued. Taxpayers not electing the benefit of the Sec. 901 credit are generally entitled to a deduction for foreign taxes paid or accrued. A vast array of complexities, limitations, and restrictions govern the U.S. foreign tax credit — far too many to cover in this article.

That said, one set of rules can be particularly vexing for U.S. taxpayers who pay, or who are deemed to pay, foreign taxes — the foreign tax redetermination (FTR) rules. These rules warrant further attention. Since the passage of the law known as the Tax Cuts and Jobs Act (TCJA),¹ they can result in an immense administrative burden and pose risks to unaware taxpayers.

FTRs: Purpose and applicability

Sec. 905(c), the statute governing FTRs, applies to taxpayers who (1) accrue foreign taxes and ultimately pay a different amount; (2) accrue foreign taxes and do not pay them within two years after the end of the tax year to which they relate; or (3) receive a refund in whole or in part of foreign taxes previously paid. The statute mandates that taxpayers in these situations notify Treasury when one or more of these events take place, and it provides that Treasury shall redetermine the amount of U.S. tax for the year or years affected. With respect to FTRs, taxes due on any redetermination shall be payable on notice and demand by Treasury, while any tax overpayments shall be credited or refunded to the taxpayer in accordance with the rules under Sec. 6511.²

In effect, Sec. 905(c) acts as a statutory safeguard to ensure that foreign taxes ultimately relieved reflect the actual liabilities incurred by such taxpayers when the dust settles. While the statute provides a framework and general premise, the mechanics of the redeterminations are left to the regulatory process.

Sec. 905(c) or its predecessor has been in the Internal Revenue Code or its predecessor statutes since the Revenue Act of 1918 and has been rarely amended since then — notably, in 1997 and 2017. The 2017 amendments were made as part of the TCJA to reflect the demise of the pooling system for undistributed foreign earnings and foreign income taxes. The TCJA amendments also removed the regulatory grant that provided Treasury flexibility for adjustments to the pooling of post-1986 foreign income taxes. The amendment was necessary because of the TCJA’s repeal of the indirect tax pooling system upon the adoption of a quasi-territorial system.

It is worth pointing out that, pre-TCJA, many taxpayers deferred the repatriation of foreign earnings and thus also deferred the deemed payment of foreign taxes associated with those foreign earnings. Therefore, when an amount of foreign taxes accrued ultimately differed from the amount finally payable, taxpayers often could, under regulatory guidance, more readily adjust their pools on a prospective basis and sometimes even before the amount of the credits affected their U.S. tax liability. This was an attractive option for taxpayers, as it avoided the administrative burden of amending returns. With the dawn of the TCJA system, earnings and tax pooling went by the wayside, leaving taxpayers much more susceptible to FTRs.

Post-TCJA, taxes accrued related to Sec. 951A global intangible low-taxed income (GILTI), for example, are creditable in the Sec. 951A inclusion year, subject to a 20% “haircut,” among other limitations. The transition to a current inclusion and credit system under the TCJA exposes taxpayers to a higher risk of FTRs and the administrative burden that follows.

Regulatory changes widen applicability

On Dec. 17, 2019, Treasury and the IRS finalized rules on portions of the previous 2007 temporary and proposed FTR regulations.³ The temporary 2007 regulations had expired in 2010. By 2019, large portions of the 2007 temporary regulations were no longer applicable due to the enactment of the TCJA and the repeal of Sec. 902. Thus, the 2019 final regulations mainly adopted the general themes of the 2007 package, but much of them were scrapped as their applicability waned post-TCJA. On the same date in 2019, new proposed regulations were issued.⁴

On Nov. 12, 2020, T.D. 9922 was issued, finalizing portions of the 2019 proposed FTR regulations. On the same date, Treasury issued the 2020 proposed FTR regulations.⁵

On Jan. 4, 2022, Treasury and the IRS issued regulations finalizing portions of Regs. Secs. 1.905-3(a) and (b) from the 2020 proposed regulations.⁶ These regulatory developments, taken as a whole, represent significant changes for taxpayers and will clearly result in additional administrative and reporting burdens for many. They should be seriously considered in light of the responsibilities imposed on taxpayers by the new rules. This article focuses on a few aspects of the final regulations, as compared to the pre-TCJA regime, to highlight the meaningful changes.

Foreign tax redeterminations redefined

Like their predecessors, the current final regulations initially define FTRs as a change in the liability for foreign income taxes. The final regulations, however, apply to foreign tax changes that “may affect the taxpayer’s U.S. liability,”⁷ while prior regulations were limited to changes that “may affect the taxpayer’s foreign tax credit.”⁸ Under the prior regulations, taxpayers presumably must have claimed a foreign tax credit (FTC) in a tax year for an FTR to occur with respect to that year. This is true because prior regulations, including the 2019 final regulations, were limited to changes potentially affecting a taxpayer’s FTC.

This is no longer the case under the final 2022 regulations. Any changes in liability for foreign taxes, whether claimed via Sec. 901 or Sec. 960, potentially affecting the U.S. liability are included in the definition of an FTR. The final regulations expand the definition to include “certain other changes … that may affect a taxpayer’s U.S. tax liability.”⁹ In that spirit, the final regulations define an FTR as including (1) any change in the amount of a taxpayer’s foreign tax credit; (2) a change to claim a deduction or credit for foreign taxes where a taxpayer previously elected to claim the opposite; (3) a change in the amount of a taxpayer’s distributions or inclusions under Sec. 951, 951A, or 1293; (4) a change in the application of the high-tax exception; or (5) a change in the amount of tax determined under the passive foreign investment company rules of Sec. 1291.¹⁰

For taxpayers claiming credits for taxes paid, an FTR also occurs if any paid tax is refunded or if the foreign tax liability is determined to be less. For taxpayers claiming accrued taxes, an FTR occurs if the final foreign liability differs from the accrual. FTRs also include changes to accruals to reflect the final tax, including additional payments of tax accruing after year end for a particular year. Finally, an FTR includes any foreign income taxes not paid within 24 months after the close of the tax year to which they relate. Importantly, in this situation, the resulting FTR is treated as if the unpaid portion of the foreign income taxes was refunded at the 24-month period’s expiration.

Compared to prior regulatory language, the expansion of the definition of an FTR with respect to non–foreign tax credit redeterminations is meaningful and is likely to ensnare many more taxpayers with many more fact patterns.

Example: Assume that USP is a domestic corporation wholly owning one controlled foreign corporation, CFC. For year 1, CFC earns 3,000u of tested income and accrues and pays a foreign income tax of 250u with respect to that income. CFC has no allowable deductions other than foreign income tax expense. Therefore, CFC has net tested income of 2,750u (3,000u − 250u) for year 1. Assume CFC has no qualified business asset investment for year 1. In year 1, USP does not elect the benefits of Sec. 901 and Sec. 960. In year 3, 10u of foreign income tax associated with CFC’s year 1 income is refunded to CFC. The refund of foreign taxes in year 3 relates to year 1 and would affect USP’s amount of required year 1 inclusions under Sec. 951A. The refund results in a 10u increase to CFC’s net tested income due to a 10u decrease in the amount of foreign income tax expense. Under Regs. Sec. 1.905-3(a), an FTR includes a change that may affect a taxpayer’s U.S. tax liability, including a change in the amount of its inclusions under Sec. 951A; therefore, the refund of the year 1 taxes in year 3 is an FTR under Regs. Sec. 1.905-3.

Also notably, Regs. Sec. 1.905-3(a), by its terms, includes changes that “may affect a taxpayer’s U.S. liability.” This approach goes beyond requiring that the change immediately impact a taxpayer’s U.S. tax liability. So, if, in the example above, USP had domestic losses for year 1 that far exceeded any Sec. 951A inclusion from CFC, USP may generate a year 1 net operating loss (NOL) under the provisions of Sec. 172. USP would presumably still be required to treat the refund as an FTR because the change in CFC’s tested income would impact the amount of the U.S. NOL and therefore may affect a U.S. tax liability in the future. If the year 1 NOL were carried to year 2 to offset USP’s year 2 income, the taxpayer would likely be required to account for the year 3 redetermination, including its impact on year 1 and year 2, if any.

Similarly, the final FTR regulations provide that a redetermination is required when an FTR affects whether a taxpayer is eligible for the high-tax exception described in Sec. 954(b)(4). Therefore, when a taxpayer claims the high-tax exception for Subpart F or GILTI in any given year, the taxpayer must monitor whether any foreign income taxes considered paid or accrued in that year are adjusted in a future year, for example, through a refund. To illustrate this point, a year 3 refund of a foreign tax paid or accrued in year 1 would require analysis of whether the high-tax exception can still be applied with respect to the year 1 income previously excluded. The refund represents an FTR and may have an impact on U.S. tax liability if it affects the application of the high-tax exception. Taxpayers, even those not claiming the FTC, must be vigilant in recognizing the impact of FTRs.

Redetermination of US liability

For taxpayers claiming a credit for Sec. 901 tax (other than deemed paid taxes under Sec. 960), a redetermination of U.S. tax liability is required if an FTR occurs with respect to any year in which foreign income tax is claimed as a credit.¹¹ The redetermination of U.S. liability is required for the tax year in which the credit was claimed and any year to which such credit is carried under Sec. 904(c). This seems a reasonable result. If a taxpayer claims a Sec. 901 credit for taxes paid, and then, in a subsequent year, such tax is refunded, it seems reasonable that the taxpayer should refigure its U.S. tax liability with respect to that year. This may be little solace, however, to taxpayers claiming large amounts of Sec. 901 credits who experience an FTR for a relatively minor amount.

With respect to foreign income taxes paid or accrued by foreign corporations (i.e., Sec. 960 credits), a redetermination of U.S. liability is required (1) for any FTR experienced relating to the year in which taxes were accrued, or (2) a refund of foreign income taxes previously taken into account by the foreign corporation in the year paid. In these situations, Regs. Sec. 1.905-3(b)(2) requires a redetermination of the foreign corporation’s earnings and profits, foreign income taxes, and other related items.

The redetermination of U.S. tax liability is made by treating the redetermined foreign tax amount as the taxes actually paid or accrued in such year.¹² This includes accounting for any required changes to the characterization and amount of inclusion taken into account under Secs. 951, 951A, and 1293; the amount of any Sec. 78 gross-up dividend; and the foreign taxes deemed paid under Sec. 960. Finally, a redetermination of U.S. liability is required for any subsequent tax year in which the FTR affects the characterization or amount of any distribution or inclusion. U.S. taxpayers with common foreign income inclusions under the post-TCJA tax system are likely to experience FTRs that will require intense scrutiny to decide if a redetermination of U.S. tax liability is required.

Notification requirements

Regs. Sec. 1.905-4 provides the requirements for notifying the IRS when an FTR occurs and requires a redetermination of U.S. tax liability. Subject to certain exceptions, as discussed below, if a redetermination of U.S. liability is required, a taxpayer must notify the IRS by filing an amended return including Form 1118, Foreign Tax Credit — Corporations, or Form 1116, Foreign Tax Credit, as applicable, for the year in which the original tax was paid or accrued and meet the notification requirements laid out in Regs. Sec. 1.905-4(c) within certain time frames.¹³For an increase in U.S. tax liability, a statement must be filed by the extended due date for the original return for the taxpayer’s tax year in which the FTR occurs.¹⁴ For a decrease in tax liability, a taxpayer must file a claim for refund with the IRS within the period provided in Sec. 6511.¹⁵

It appears that both amended returns and the statement must be submitted to meet the notification requirements of Regs. Sec. 1.905-4(b). Failure to notify or amend where required may result in the application of penalties. Also, recall that this is a one-sided rule. Where an FTR occurs and an overpayment results, taxpayers are bound by the applicable statute in Sec. 6511, meaning either a three-year or 10-year statute of limitation on refund claims. However, where an FTR occurs and tax is owed, the IRS is not encumbered by the statute of limitation on assessment of tax, potentially leaving the related tax years open to assessment indefinitely. Taxpayers should be aware of these refund limitations when assessing FTRs and determining whether a redetermination of U.S. tax liability may result in a refund, to ensure refunds or credits of overpayments are not prohibited under the relevant Sec. 6511 provisions.

There are exceptions to the amended-return rules, some of which minimize the burden on taxpayers experiencing an FTR that requires a redetermination of U.S. tax liability. First, an amended return is only required for tax years in which there is a change in the amount of U.S. tax due. While amended returns are not required unless there is a change in U.S. tax liability, taxpayers still must attach a statement to their return containing the information required in Regs. Secs. 1.905-4(b)(1)(v) and 1.904-2(f ) to meet the notification requirements.¹⁶

Second, there are specific rules for partnerships and other passthrough entities that experience FTRs with respect to creditable foreign tax expenditures.¹⁷ Those rules are beyond the scope of this article, but partnership taxpayers should be mindful of the requirements to avoid procedural missteps.

Third, the regulations alleviate the need to file an amended return if the taxpayer “satisfies alternative notification requirements that may be prescribed by the IRS through forms, instructions, publications, or other guidance.”¹⁸ To the best of the authors’ knowledge, no alternatives have been offered by the IRS to date.

In addition, taxpayers under examination within the jurisdiction of the Large Business and International (LB&I) Division should be aware of the procedures outlined in Regs. Sec. 1.905-4(b)(4). The penalty for failure to meet the notification requirements for FTRs requiring a redetermination of U.S. tax liability is prescribed in Sec. 6689 and can be up to 25% of the deficiency in tax.¹⁹ The penalty accrues at 5% for each month (or portion thereof) that the deficiency remains outstanding.²⁰

Finally, given the depth and breadth of the final FTR regulations, the IRS recognized that taxpayers will likely experience multiple redeterminations of U.S. tax liability for the same tax year. If more than one FTR occurs and requires a U.S. tax liability to be redetermined, all offending FTRs occurring within the same tax year or within two consecutive tax years can be reported on one amended return, and the statement requirement can be met with one combined statement.²¹ This helpful guidance should provide taxpayers with some relief where multiple FTRs occur within the allowable periods, permitting taxpayers to amend their return only once to encompass all changes required under Sec. 905.

The majority of the FTR regulations apply for FTRs occurring in tax years ending on or after Dec. 16, 2019, and to FTRs of foreign corporations occurring in tax years that end with or within a tax year of a U.S. shareholder ending on or after Dec. 16, 2019.²² However, it is important to note that the expanded definition of FTRs in the regulations that now includes FTRs that may affect the taxpayer’s U.S. liability (e.g., changes to Sec. 951 or 951A inclusions, etc.) applies for FTRs occurring in tax years beginning on or after Dec. 28, 2021.

Vigilance for multinational taxpayers

Gone are the days of Sec. 902 FTR pooling adjustments. Considering the expanded scope of what is considered an FTR under the finalized Sec. 905(c) regulations, along with the significant penalties for failing to meet the notification requirements for FTRs, taxpayers must be extremely vigilant when accounting for the impact of any change in foreign taxes. The potential reporting and compliance burden of FTRs under the current regulations is not something that multinational taxpayers can afford to ignore.

Footnotes

¹The law known as the Tax Cuts and Jobs Act of 2017, P.L. 115-97.

²Sec. 905(c)(3).

³T.D. 9882.

⁴REG-105495-19.

⁵REG-101657-20.

⁶T.D. 9959.

⁷Regs. Sec. 1.905-3(a).

⁸Regs. Sec. 1.905-3(a), prior to amendment by T.D. 9922.

⁹Regs. Sec. 1.905-3(a).

¹⁰Id.

¹¹Regs. Sec. 1.905-3(b)(1).

¹²Regs. Sec. 1.905-3(b)(2)(ii).

¹³Regs. Sec. 1.905-4(b)(1)(i).

¹⁴Regs. Sec. 1.905-4(b)(1)(ii).

¹⁵Regs. Sec. 1.905-4(b)(1)(iii).

¹⁶Regs. Sec. 1.905-4(b)(1)(v).

¹⁷See Regs. Sec. 1.905-4(b)(2).

¹⁸Regs. Sec. 1.905-4(b)(3).

¹⁹Regs. Sec. 1.905-4(b)(4)(iv).

²⁰Sec. 6689(a).

²¹Regs. Sec. 1.905-4(b)(1)(iv).

²²Regs. Sec. 1.905-4(f).

Contributors

David Sites, CPA, is national managing partner and international tax services practice leader at Grant Thornton LLP in Washington, D.C., and a past chair of the AICPA International Tax Technical Resource Panel. Jacob Nunn, CPA, is international tax senior manager at Grant Thornton LLP in Charlotte, N.C. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA RESOURCES

Conference

AICPA & CIMA National Tax & Sophisticated Tax Conference

CPE self-study

International Tax Foundation

U.S. International Tax: Advanced Issues

For more information or to make a purchase, visit aicpa-cima.com/cpe-learning or call the Institute at 888-777-7077.