Final loss allocation regs. result in increased FTC limitations.

The IRS has issued long-awaited proposed, final and temporary regulations on the allocation of loss recognized on the disposition of stock and other personal property. These regulations also clarify the allocation and computations of foreign tax credits (FTCs). The general effect of these new rules is to permit U.S. taxpayers to claim more FTCs currently, primarily because certain items of loss are no longer considered to reduce foreign-source income.

Background

Before this updated guidance, Prop. Regs. Sec. 1.865-1 contained the most current guidance, calling for a loss incurred on the sale of other personal property to be allocated based on that property's income. Prop. Regs. Sec. 1.865-2 provided that losses incurred with the stock's sale were generally allocated to the seller's residence, with a series of antitaxpayer exceptions; this was inconsistent with the generally favorable treatment accorded losses on sale or disposition of stock. In International Multifoods Corp., 108 TC 579 (1997), the Tax Court supported the proposed regulations that the loss on stock sales is generally sourced to the seller's residence.

The IRS had also issued proposed regulations in 1992, which amended the regulations under Sec. 904 that determine whether passive income is "highly taxed" for purposes of assigning an item of income and its related FTCs to the passive or general limitation income basket. These proposed regulations were finalized in 1996, but taxpayers had flexibility with the effective date.

New Rules

The new rules, which closely follow the original proposed regulations, include some changes that generally benefit taxpayers.

Net operating losses. Temp. Regs. Sec. 1.861-8T(e)(8) provides that net operating loss (NOL) deductions under Sec. 172 are allocated and apportioned in the same manner as the deductions that generated the NOL deduction.

Loss on personal property other than stock. The general rule under Temp. Regs. Sec. 1.865-1T(a) now provides that loss on personal property other than stock is allocated in the same manner in which gain from the sale of that personal property would be sourced. For example, this now allows a U.S. taxpayer who incurs a loss on the sale of a foreign bond to allocate that loss against U.S.-source income. Under the 1996 proposed regulations, this loss would have been foreign-source because the interest income from the bond was foreign-source, thereby reducing the Sec. 904 foreign tax limitation.

Temp. Regs. Sec. 1.865-1T(b) states that losses recognized on depreciable property are allocated between income baskets based on the allocation of depreciation deductions previously claimed on the property.

The regulations provide several examples to help clarify these new provisions. These temporary regulations are effective for losses recognized on or after Jan. 11, 1999. Taxpayers may apply the regulations to losses recognized in any tax year after 1986, subject to certain conditions.

General rule for allocation of stock loss. Final Regs. Sec. 1.865-2 generally remains the same as that proposed in 1996, and allocates all types of recognized loss (including deductions for worthlessness) on stock to the seller's residence, consistent with International Multifoods. However, the 1996 proposed regulations contained three exceptions to the residence-based rule for portfolio stock, stock in regulated investment companies (RICs) and S corporations. The final regulations apply the general residence rule for allocating recognized losses from portfolio stock and stock in RICs, but retain the S corporation exception. Further, the final regulations no longer require noninstitutional portfolio investors to recharacterize a part of the loss as foreign-source passive-basket loss, equal to the amount of the prior two years' dividends that generated foreign-source passive-basket income. Finally, Prop. Regs. Sec. 1.865-2(b)(2), which required taxpayers to allocate loss on the sale of a foreign affiliate to the passive basket if the taxpayer had recognized foreign-source gain at any time during the five-year period preceding the loss, has been deleted from the final regulations. These final regulations under Regs. Sec. 1.865-2 are effective for losses recognized on or after Jan. 11, 1999.

Grouping rules. The final regulations contain two developments for Regs. Sec. 1.904-4(c) grouping rules, which deal with the calculation of the effective tax rate on an income item for FTC basketing purposes. If the effective foreign tax rate is equal to the highest marginal U.S. Federal tax rate in effect, the item of otherwise passive income is recharacterized as general limitation basket income. The first development is that the grouping rules originally proposed in 1992 were generally finalized as proposed, except that taxpayers can apply the final regulations to any tax year beginning after 1991.

The second development relates to several clarifications of issues raised in the 1996 proposed regulations. If foreign taxes are allocated to an item or group of income that is zero, negative or U.S.-source income, the related taxes are allocated to the general limitation basket. For example, if a foreign country requires a foreign customer to withhold foreign taxes on the payment of an entire invoice for services, but some of the services subject to withholding are actually performed in the U.S., at least the portion of foreign taxes withheld for U.S.-performed services is general limitation basket, even though the underlying income is not even foreign-source. Also, foreign taxes attributable to permanent differences between the foreign and U.S. taxation of an item of income are the only foreign taxes automatically treated as general limitation, but foreign taxes attributable to timing differences are allocable to separate limitation baskets (as if the U.S. recognized the income in the same year in which the foreign country recognized the items).

FROM MAP. K E. KRAL, CPA, CHARLOTTE, NC