Allocating foreign taxes: IRS rules that partnerships must allocate foreign taxes in proportion to foreign income.

The IRS recently issued temporary regulations requiring partnerships to allocate foreign taxes in the same way that they allocate the income to which those taxes relate.

The temporary regulations are targeting transactions in which U.S. partners, or U.S. shareholders of partners that are controlled foreign corporations, attempt--through special partnership allocations--to claim foreign tax credits not matched by income subject to U.S. taxation (T.D. 9121, Reg.-139792-02).

The new regulations seek to disqualify taxpayers' inappropriate foreign tax credit applications and the IRS wants to ease its concerns about partnerships allocating foreign tax credits without allocating the corresponding income.

The IRS argues that allocations by foreign tax partnerships without corresponding income do not give rise to the double taxation that is the economic basis for the foreign tax credit, and that these types of allocations should not be allowed.

Temporary Regulations Establish Safe Harbor 

The temporary regulations establish a safe harbor rule under which allocations of foreign tax expenditures will be deemed in accordance with each partner's interests in the partnership.

Under this rule, if the partnership satisfies the requirements of Sec. 1.704-1(b)(2)(ii)(b) or (d)--i.e., capital account maintenance; liquidation according to capital accounts; and either deficit restoration obligations or qualified income offsets--then an allocation of a foreign tax expenditure proportionate to a partner's distributive share of the partnership income to which such taxes relate, including income allocated pursuant to section 704(c), will be deemed in accordance with the partner's interest in the partnership.

The IRS says the rule is consistent with the intent of both the foreign tax credit, which is to avoid double taxation of foreign income, and the foreign tax credit limitation, which was written to prevent foreign tax credits from offsetting tax liability on U.S. income.

Also, this rule achieves better parity between entities taxed under foreign law at the partner level and entities taxed under foreign law at the entity level.

If a partnership were taxed under foreign law at the partner level, then the amount of foreign taxes imposed would be in proportion to the partner's share of income subject to the foreign tax.

The partner would take this amount of foreign tax into account when computing U.S. tax liability.

Similarly, for partnerships taxed under foreign law at the entity level, the safe harbor rule allows a partner to take into account the share of the partnership's foreign tax expenditures proportionate to the partner's share of the income to which those taxes relate when computing U.S. tax liability.

Alternate Standard Test Takes All Circumstances Into Account

If the taxpayer does not meet the safe harbor rule, then the allocations will be tested under the standard set forth in Sec. 1.704-1(b)(3).

Under that standard, a partner's interest in a partnership is determined by taking into account all circumstances relating to the partners' economic arrangement. Those circumstances include:

* the partners' relative contributions to the partnership;

* the partners' interests in economic profits and losses (if different than their interests in taxable income or loss);

* the partners' interests in cash flow and other distributions; and

* the partners' rights to capital distributions upon liquidation.

Ultimately, the partners' interests signify the way in which the partnership has agreed to share the economic benefit or burden corresponding to the income, gain, loss, deduction or credit allocated.

The sharing arrangement may or may not correspond to the partners' overall economic arrangement.

Thus, a partnership's allocation of a foreign tax expenditure that does not meet the safe harbor rule, may--in unusual circumstances, such as where there is substantial certainty that U.S partners will deduct, rather than credit, foreign taxes--be in accordance with partners' interests under Sec. 1.704-1(b)(3).

Effective Date and Transition Rule Applicability

Generally, the new regulations apply to partnership taxable years beginning on or after April 21, 2004.

A transition rule is also provided for existing partnerships.

Under the transition rule, if a partnership agreement was entered into before April 21, 2004, then the partnership may apply the provisions of Sec. 1.704-1(b), as if the amendments made by this temporary regulation had not occurred, until any subsequent material modification to the partnership agreement--including any change in ownership--occurs.

This transition rule does not apply if, as of April 20, 2004, people who are related to each other--within the meaning of section 267(b) and 707(b)--collectively have the power to amend the partnership agreement without the consent of any unrelated party.

Michael Graham is a director at San Francisco-based Rowbotham & Company LLP. He can be reached at [e-mail].