New rules on FTC allocations.EXECUTIVE SUMMARY * Prior to the temporary regulations, foreign income tax allocations among partners were controversial * Special allocations of foreign income taxes cannot have substantial economic effect and must be allocated in accordance Accordance is Bible Study Software for Macintosh developed by OakTree Software, Inc.[] As well as a standalone program, it is the base software packaged by Zondervan in their Bible Study suites for Macintosh. with the partners' interests. * A safe harbor Safe Harbor 1. A legal provision to reduce or eliminate liability as long as good faith is demonstrated. 2. A form of shark repellent implemented by a target company acquiring a business that is so poorly regulated that the target itself is less attractive. allows partnership allocations to be deemed in accordance with the partners' interests. ********** Temporary regulations address how to allocate To reserve a resource such as memory or disk. See memory allocation. foreign income tax among partners of partnerships formed after April 20, 2004. This article reviews the basic allocation The apportionment or designation of an item for a specific purpose or to a particular place. In the law of trusts, the allocation of cash dividends earned by a stock that makes up the principal of a trust for a beneficiary usually means that the dividends will be treated as rules and details the temporary regulations' safe harbor. Last year, the IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. issued temporary regulations (1) on partnership allocations of foreign income tax. The new rules are intended to prevent the perceived abuses of allocating foreign income tax without the corresponding income. This article describes the basic allocation rules and discusses the safe harbor rules safe harbor rule Antitrust law A federal guideline as to what constitutes antitrust activity, established by the FTC and Justice Dept, after specific legislation–which might be open to misinterpretation–is enacted. Cf Self-referral. and examples in the temporary regulations. The rules generally apply to partnerships formed after April 20, 2004. However, partnerships of related parties (as described in Secs. 267(b) and 707(b)) are subject to the new regulations if the related parties can amend the partnership agreement without the consent of any unrelated party. (2) Partnerships of unrelated parties formed before April 21,2004 are not subject to the regulations until the partnership agreement is materially modified, including via an ownership change. Partnership Allocations Under Sec. 704(a), a partner's distributive dis·trib·u·tive adj. 1. a. Of, relating to, or involving distribution. b. Serving to distribute. 2. share of income, gain, loss, deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs. and credit is determined by the partnership agreement. Partners are permitted to decide how to allocate these items. However, allocations under the partnership agreement must have "substantial economic effect" under Sec. 704(b). Otherwise, such allocations are determined by taking into account all the facts and circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or , in accordance with the "partners' interests in the partnership" (partners' interests). Typically, partnerships try to make allocations that have substantial economic effect. An allocation has substantial economic effect only if it has such effect under Kegs. Sec. 1.704-1(b)(2)(ii) and (iii). It has economic effect if the partnership agreement provides the following throughout its term: * The partners' capital accounts must be maintained in accordance with Kegs. Sec. 1.704-1(b)(2)(iv); * Liquidating distributions must be made in accordance with the partners' positive capital account balances; and * Deficit capita] account balances must be unconditionally restored by the partners following liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts. A type of proceeding pursuant to federal Bankruptcy of their partnership interests, or be subject to the qualified income offer rules in Regs. Sec. 1.704-1(b)(2)(ii)(d). (3) Under Regs. Sec. 1.704-1(b)(2)(iii), an allocation's economic effect is substantial if there is a reasonable chance that it substantially affect the dollar amounts to be received by the partners, independent of income tax effects. However, the economic effect is not substantial if (1) at least one partner's after-tax af·ter-tax also af·ter·tax adj. Relating to or being that which remains after payment, especially of income taxes: after-tax profits. economic consequences may (in present value terms) be enhanced in comparison to the results without such allocation and (2) no partner's after-tax economic consequences will (in present value terms) be substantially diminished di·min·ish v. di·min·ished, di·min·ish·ing, di·min·ish·es v.tr. 1. a. To make smaller or less or to cause to appear so. b. in comparison to the results without such allocation. Under Regs. Sec. 1.704-1(b)(4) and -2, certain items, such as tax credits and nonrecourse Nonrecourse In the case of default, the lender has no ability to claim assets over and above what the limited partners contributed. deductions, cannot have substantial economic effect. Accordingly, they must be allocated in accordance with the partners' interests. Foreign Income Tax Allocations According to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. Sec. 702(a)(6), each partner takes into account separately his or her distributive share of the partnership's foreign income taxes. Under Sec. 901(b)(5), a partner can, subject to certain limits, qualify for a foreign tax credit (FTC FTC See Federal Trade Commission (FTC). ) for a distributive share of foreign income taxes paid or accrued ac·crue v. ac·crued, ac·cru·ing, ac·crues v.intr. 1. To come to one as a gain, addition, or increment: interest accruing in my savings account. 2. by the partnership. The partnership is not entitled en·ti·tle tr.v. en·ti·tled, en·ti·tling, en·ti·tles 1. To give a name or title to. 2. To furnish with a right or claim to something: to claim a deduction (or credit) for such taxes; instead, under Sec. 703(b)(3), each partner separately decides how to report and treat them. Prior to the temporary regulations, foreign income tax allocations among partners was controversial. Foreign taxes are not deducted de·duct v. de·duct·ed, de·duct·ing, de·ducts v.tr. 1. To take away (a quantity) from another; subtract. 2. To derive by deduction; deduce. v.intr. by the partnership, but flow through to the partners separately and are charged against their capital accounts. Because an allocation of foreign taxes reduces the capital account, it should have economic effect. The issue is whether a special allocation can have substantial economic effect. Further, in the preamble A clause at the beginning of a constitution or statute explaining the reasons for its enactment and the objectives it seeks to attain. Generally a preamble is a declaration by the legislature of the reasons for the passage of the statute, and it aids in the interpretation of to the regulations, the IRS noted that some partnerships claim that they do not need to consider the tax consequences to the partners' owners in determining whether the economic effect of an allocation is substantial. The preamble states that such a position is inconsistent with the policies underlying the substantial economic effect rules. Temporary Regulations Temp. Regs. Sec. 1.704-1T(b)(4)(xi)(a) provides that allocations of foreign income taxes cannot have substantial economic effect. This is because the IRS deems them fully creditable cred·it·a·ble adj. 1. Deserving of often limited praise or commendation: The student made a creditable effort on the essay. 2. Worthy of belief: a creditable story. against a partner's U.S. tax liability, subject to certain FTC limits. Thus, foreign income taxes must be allocated in accordance with the partners' interests. Safe Harbor The temporary regulations provide a safe harbor under which partnership allocations of foreign income taxes will be deemed to be in accordance with the partners' interests. It applies only to partnerships that satisfy the economic effect requirements of Kegs. Sec. 1.704-1 (b)(2)(ii) (i.e., capital account maintenance, liquidation according to capital accounts, and either deficit restoration obligations or qualified income offsets). Under the safe harbor, an allocation of foreign income tax would be in accordance with the partners' interests when the economic effect provisions (described above) are met, and the foreign tax is allocated in proportion to the partners' distributive shares of income to which the tax relates. (4) Based on principles in Kegs. Sec. 1.904-6, a foreign tax is related to an income item when the income is included in the base on which the foreign income tax is assessed. For example, no foreign tax would be allocated to an income item that is exempt from such tax. If foreign tax is imposed on income deferred for U.S. tax purposes, it would be allocated to the income as if the income were recognized under U.S. tax principles in the year in which the tax was assessed.(5) If the foreign law provides for a specific tax rate on certain income items (e.g., capital gain), then a specific amount of foreign tax would be related to that income. According to the preamble, the safe harbor is intended to be consistent with the FTC's underlying purposes (i.e., to avoid double taxation of foreign-source income Foreign-source income Income earned from international operations. ) and limitation (i.e., to prevent FTCs from offsetting taxes attributable to U.S.-source income). Also, the safe harbor tries to achieve greater parity parity or space parity, in physics, quantity that refers to the relationship between an object or process and the image that it can produce in a mirror. between entities taxed under foreign law at the partner level versus those taxed at the entity level. If a partnership were taxed under foreign law at the partner level, the amount of foreign taxes imposed on a partner would generally be proportionate pro·por·tion·ate adj. Being in due proportion; proportional. tr.v. pro·por·tion·at·ed, pro·por·tion·at·ing, pro·por·tion·ates To make proportionate. to the partner's share of the income subject to the foreign tax. The partner would take into account this amount of foreign tax in computing computing - computer U.S. tax liability. For partnerships taxed under foreign law at the entity level, the safe harbor provides that a partner may take into account in computing U.S. tax liability, the share of the partnership's foreign tax expenditures proportionate to the partner's share of the income to which such taxes relate. General test: If an allocation does not satisfy the safe harbor, the general partners'-interests test applies. Under Regs. Sec. 1.704-1(b)(3), a partner's interest is determined by taking into account all the facts and circumstances relating to relating to relate prep → concernant relating to relate prep → bezüglich +gen, mit Bezug auf +acc the economic arrangements of the partnership, including the partners': 1. Relative contributions to the partnership. 2. Interests in economic profits and losses (if different from their interests in taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. and loss). 3. Interests in cashflow and other nonliquidating distributions. 4. Rights to capital distributions on liquidation. Obviously, the partners'-interests standard is difficult to rely on to allocate foreign taxes. According to the preamble, a partnership's allocation of a foreign tax expenditure that does not satisfy the safe harbor may be, in unusual circumstances (such as when there is substantial certainty that U.S. partners will deduct de·duct v. de·duct·ed, de·duct·ing, de·ducts v.tr. 1. To take away (a quantity) from another; subtract. 2. To derive by deduction; deduce. v.intr. , rather than credit, foreign taxes), in accordance with the partners' interests. Temp. Regs. Sec. 1.704-1T(b)(5) provides four examples illustrating the safe harbor roles. Example 1--Different tax rates for different types of income: (6) A and B form AB, a partnership for U.S. tax purposes. AB's partnership agreement satisfies the economic effect requirements under Regs. Sec. 1.704-1(b)(2)(ii). AB operates business M and earns income from passive investments in Country Y. Y imposes a 40% income tax on M, but exempts the passive income from taxation. Under the partnership agreement, all partnership items from M (including the creditable foreign income taxes) are allocated 60% to A and 40% to B. For all items from passive investments (including any foreign taxes), 80% is allocated to A and 20% to B. In year 1, AB earns $100 income from M and $30 from passive investments, and pays $40 Y income taxes. Pursuant to the partnership agreement, A is allocated 60% of M income ($60) and 60% of Y tax ($24); B is allocated 40% of M income ($40) and 40% of Y tax ($16).The $30 passive income is allocated 80%/20% to A and B, respectively Because the tax allocation is consistent with the allocation of income that generated the foreign taxes, it falls within the safe harbor. Example 2--Operations in different foreign countries: (7) A and B form AB, a partnership for U.S. tax purposes. AB's partnership agreement complies with the economic effect requirements. AB operates business M in country X and business N in Country Y. X imposes a 40% tax on M income; Y imposes a 20% tax on N income. In year 1, AB has $100 income from M and $50 income from N. X imposes $40 tax on the M income; Y imposes $10 tax on the N income. The partnership agreement provides that all partnership items from M (including foreign taxes) are allocated 75% to A and 25% to B, and all partnership items from N (including foreign taxes) are divided evenly between A and B. Accordingly, A is allocated 75% of M income ($75), 75% of X tax ($30), 50% of N income ($25), and 50% of Y tax ($5). B is allocated 25% of the M income ($25), 25% of the X tax ($10), 50% of the N income ($25), and 50% of the Y tax ($5); see Exhibit 1 below. Because the allocations of X and Y taxes follow the allocations of income to which they relate, they qualify for the safe harbor. Example 3--Timing differences: (8) The facts are the same as in Example 2, except that (1) the $50 N income is not received until year 2 and (2) AB reports on the accrual basis A method of accounting that reflects expenses incurred and income earned for Income Tax purposes for any one year. Taxpayers who use the accrual method must include in their taxable income any money that they have the right to receive as payment for services, once it for U.S. tax purposes, but on the cash basis for X and Y purposes. Thus, AB pays X $40 tax in year 1 and Y $10 tax in year 2. Pursuant to the partnership agreement, in year 1 A is allocated 75% of M income and X tax and 50% of N income ($25). B is allocated 25% of M income and X tax and 50% of N income ($25). In year 2, A and B each be allocated 50% of Y tax ($5). Because the allocations of X and Y foreign taxes correspond with the allocations of income to which the foreign taxes relate, they qualify for the safe harbor. Example 4--Special allocation: (9) A and B form AB, a partnership for U.S. tax purposes. AB's partnership agreement complies with the economic effect requirements. AB operates business M in Country X, which imposes a 20% tax on net income. In year 1, AB earns $300 gross income, has deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). expenses (exclusive of creditable foreign taxes) of $100, and pays or accrues $40 X tax. Pursuant to the partnership agreement, the first $100 gross income each year is to be allocated to A as a return on excess capital contributed. All remaining partnership items (including creditable foreign taxes) are to be divided evenly between A and B. The gross income allocation to A is not deductible for X purposes. Thus, in year 1, A is allocated $150 (75%) of the income ($100 of gross income and $50 (50%) of the remaining $100 net income). B is allocated $50 (50%) of the $100 net income. The X tax, however, is allocated evenly to A ($20) and B ($20); see Exhibit 2 at left. Because the foreign tax allocations are not consistent with the allocations of income subject to the foreign tax, they do not satisfy the safe harbor. Accordingly, X tax must be allocated in accordance with the partners' interests. The regulations, however, do not show how the foreign tax should be allocated. Conclusion The temporary regulations provide a desirable safe harbor for the allocation of foreign taxes among partners. They allow foreign tax expenditures to be allocated correspondingly to the allocations of the related income. The principles behind the safe harbor seem reasonable and sound. It would be helpful, however, if the IRS would provide examples on how foreign taxes would be allocated under the partners'-interests standard.
Exhibit 1: Income and tax allocation for Example 2
A B Total
Business M (Country X)
Income $75 $25 $100
Taxes $30 $10 $40
Business N (Country Y)
Income $25 $25 $50
Taxes $5 $5 $10
Exhibit 2: Income and tax allocations for Example 4
A B Total
Gross income $200 $100 $300
Expenses before tazes $(50) $(50) $(100)
Net income $150 $50 $200
X tax $20 $20 $40
(1) TD 9121 and REG-139792-02 (both dated 4/21/04). The temporary regulations were also issued as proposed regulations. (2) See Temp. Regs. Sec. 1.704-1T(b)(1)(ii)(b). (3) The qualified income offset rules basically prevent a partner's capital account from being negative through losses and/or and/or conj. Used to indicate that either or both of the items connected by it are involved. Usage Note: And/or is widely used in legal and business writing. distributions, to the extent that the partner is not obligated ob·li·gate tr.v. ob·li·gat·ed, ob·li·gat·ing, ob·li·gates 1. To bind, compel, or constrain by a social, legal, or moral tie. See Synonyms at force. 2. To cause to be grateful or indebted; oblige. to restore the deficit, and it is not derived from deductions attributable to nonrecourse debts A nonrecourse debt or non-recourse debt or nonrecourse loan is a secured loan (debt) that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. . (4) A partner's share of income to which the tax relates includes any income allocated to the partner under Sec. 704(c) due to any transfer of built-in built-in - (Or "primitive") A built-in function or operator is one provided by the lowest level of a language implementation. This usually means it is not possible (or efficient) to express it in the language itself. gain or loss assets to the partnership; see Temp Regs. Sec. 1.704-1T(b)(4)(xi)(a)(2). (5) See Regs. Sec. 1.904-6(a)(1)(iv). (6) See Temp. Regs. Sec. 1.704-1T(b)(5), Example 25. (7) See id., Example 26. (8) See id., Example 27. For more information about this article, contact Mr. Lau at Plau@blackmankallick.com. |
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