New regulations curtail abuse of foreign tax credit by partnerships.
The IRS recently issued temporary regulations that target foreign tax credit abuse by partnerships. The new regulations, which require that foreign taxes be allocated in accordance with the partners' ownership interests in the partnership, are consistent with the purpose of the foreign tax credit.
Although partnerships generally are granted a high degree of flexibility with regard to the allocation of the partnership's income and expenses, new treasury regulations restrict allocations of partnership expenditures relating to foreign tax liabilities. (1) Through these regulations, the Internal Revenue Service (IRS) and the Treasury Department are targeting certain abusive foreign tax credit transactions. These transactions involve allocations of partnership liabilities that allow a partner to take a foreign tax credit for foreign taxes paid on partnership income, even though the partner is not required to include the income that was subject to tax. The effect is that the partner can apply the credit against income from other sources, a result that is inconsistent with the purposes of the foreign tax credit. The new regulations are designed to prevent such abuse.
Foreign Tax Credit
The foreign tax credit (FTC) is designed to prevent the double taxation of income that often results from international transactions. As a general matter, there are two bases for which a country may impose a tax. The first is based on the relationship between the taxing country and the subject, such as citizenship, residence or place of formation of the income-producing entity. Pursuant to this relationship, the country of residence taxes all of the income of all of the persons and entities formed or residing within its boundaries. The second basis for taxing stems from the relationship between the country and transactions that result in income. In this scenario, the country of source, as it is referred to, imposes a tax on income that is derived from activity within the country. The taxing regime of the United States (U.S.) falls within the first category. Commonly referred to as a worldwide system of taxation, the U.S. taxes all U.S. persons on "all income from whatever source derived." (2) Accordingly, U.S. persons are subject to tax on income from sources within the U.S., as well as from foreign sources. As a result, U.S. persons with income from transactions that occur in a country other than the United States may be subject to two separate taxes--one in the U.S. (the residence country) and another in the country where the activity took place (the source country).
The purpose of the foreign tax credit is to provide relief from this double taxation. Avoidance of double tax is considered important to promote international trade. The FTC promotes tax neutrality in decisions to invest domestically or internationally. For example, under the worldwide system of tax, a U.S. taxpayer with foreign source income would likely bear a greater total tax burden than a competitor that has only U.S. source income. Without an FTC, this increased burden may cause the U.S. taxpayer to cease international investment in favor of domestic investment. The FTC, however, decreases the taxpayer's total tax burden, and essentially removes tax as both a factor in investment decisions and as a barrier to international trade and investment.
Mechanics and Limitations of the FTC
Subject to limitations, an FTC is granted for foreign taxes paid on foreign source income. (3) U.S. persons calculate a tentative U.S. tax liability and then take a dollar-for-dollar credit against such tax liability for certain taxes or levies paid to other countries. A levy is generally creditable if it is in fact a tax (as opposed to a fee), and its predominant character is that of an income tax. (4) Further, no FTC is allowed for foreign taxes paid on U.S. source income. (5)
Where the U.S. and foreign tax rates are equal in amount, the U.S. will allow a full credit against U.S. taxes for foreign taxes paid or accrued. For example, assume ABC Inc. is a corporation formed in the U.S. and is in the 35% bracket. ABC Inc. has $10 million of taxable income from sources within the U.S. and $1 million of taxable income derived from Country X. Country X imposes a 35% tax on income derived therein. Accordingly, ABC Inc. pays foreign taxes of $350,000 ($1 million X 35%) to Country X. ABC Inc.'s U.S. tax liability is computed as follows:
U.S. source taxable income $10,000,000 Foreign source taxable income 1,000,000 Total taxable income $11,000,000 U.S. tax rate 35% Tentative U.S. tax before credits 3,850,000 FTC 350,000 U.S. tax $3,500,000
Note that in both the U.S. and Country X the tax rate was 35%. The foreign tax liability essentially replaces the U.S. tax liability with regard to the foreign source income, and the U.S. does not collect any tax revenues on the income that was derived in Country X. Now compare this to a competitor of ABC Inc. that has $11 million of income derived solely from sources within the U.S. ABC Inc. would bear the same total tax burden as its competitor, albeit to two different countries. The competitor would pay $3,850,000 in U.S. taxes ($11 million X 35%), while ABC Inc. would also pay total taxes of $3,850,000 ($3,500,000 to the U.S. and $350,000 to Country X). The total tax burdens are the same as a result of the foreign tax credit. Accordingly, ABC Inc.'s decision to operate in the U.S. or in Country X should not be influenced by tax considerations.
The ability to take an FTC for foreign taxes paid or accrued is not unlimited, however. There is an overall limitation on the amount of credit that may be taken. (6) The allowable credit is limited to the lesser of the foreign taxes paid or the foreign tax credit limitation (FTCL). The FTCL is generally the amount of U.S. tax that would otherwise be imposed on the income (i.e., foreign source income X U.S. tax rate). (7) Where the tax rate in the foreign country is below that of the U.S., the FTCL typically limits the amount of the credit to the amount of foreign taxes paid. In contrast, where the foreign tax rate is above the applicable U.S. rate, the allowable credit will be limited by the lower U.S. rate.
The purpose of this FTCL is to prevent foreign tax credits from reducing U.S. taxes on U.S. source income. For example, suppose in the example above that Country X has a tax rate of 40% (rather than 35%), resulting in foreign taxes paid of $400,000. Under the general limitation rules, ABC Inc. will still only be able to take a credit equal to $350,000--the amount of U.S. taxes that would normally be imposed on the foreign income ($1,000,000 X 35% = $350,000). Despite the fact that ABC Inc. paid foreign taxes of $400,000, the FTC is limited to $350,000. If ABC Inc. were permitted an FTC for the full amount of foreign taxes paid, the credit would essentially shelter some of ABC Inc.'s U.S. source income, as follows:
U.S. source taxable income $10,000,000 Foreign source taxable income 1,000,000 Total taxable income $11,000,000 U.S. tax rate 35% Tentative U.S. tax before credits 3,850,000 FTC (in excess of FTCL) 400,000 U.S. tax $3,450,000
The effect of taking an FTC that exceeds the FTCL is to reduce the taxpayer's tax liability by an additional $50,000, which reduces the effective rate of tax on the U.S. source income from 35% to 34.5% (i.e., $3,450,000/10,000,000). Lowering the effective rate of U.S. tax on U.S. source income is not the intended effect of the foreign tax credit, which is aimed at avoiding double tax on foreign source income. The FTCL prevents use of the FTC to shelter U.S. source income.
A similar sheltering effect occurs where an FTC is taken for foreign taxes paid on income earned outside of the U.S., but the income that generated the FTC is not included in the gross income of the taxpayer. If the income is not included, the FTC can be used to offset the U.S. tax liability on other income. For this reason, an FTC is appropriate only when the income which generated the credit is included in the gross income of the taxpayer that takes the credit.
Partnerships and FTCs
For tax purposes, the U.S. treats partnerships as flow-through entities, taxing income only at the partner level. However, other countries often treat partnerships as taxable entities and impose taxes on the income of the partnership. Although such foreign taxes may be creditable, because the U.S. does not impose tax at the partnership level, there is no need or mechanism for a partnership to take a credit related to these foreign taxes. Instead, partners are able to take foreign tax credits against their U.S. taxes for their share of foreign taxes paid by the partnership. (8) The partners' distributive shares of the partnership's foreign taxes are determined under the partnership rules discussed below.
Operating as a partnership allows several owners to combine their resources at relatively low costs; avoid complex corporate administrative and filing requirements; and avoid the entity level taxation incurred by corporations. As a conduit, the partnership itself is not subject to tax. Rather, the income, gain, loss, deductions or credits of a partnership pass through directly to its partners. The partners' shares of partnership income and expense are generally determined in accordance with the partnership agreement. (9) Under certain circumstances, the partnership agreement may dictate that these items be allocated in a different proportion than the partners' ownership interest percentages. For example, assume that Oyer and Klein form the OK Partnership. Oyer contributes $50,000 in cash and Klein contributes assets with a fair market value of $50,000, but a tax cost basis of only $10,000. Each owns a 50% interest in the partnership. Under the OK Partnership Agreement, Oyer is allocated 90% of the depreciation expense relating to the contributed fixed assets, while Klein receives only 10%. Such a distribution is acceptable in order to bring Oyer's tax basis in the partnership into agreement with Klein's $10,000 basis in the partnership.
Although partners have flexibility in determining their distributive shares of partnership items, some limitations apply. In order for a disproportional allocation of income, gain, loss, deductions or credits under a partnership agreement to be valid, the allocation must have substantial economic effect. (10) Generally, an allocation has substantial economic effect if it reflects the true economics of the partners' arrangement and is not merely a device to reduce the taxes of the partners. Specifically, an allocation must meet three conditions to satisfy the economic effect requirement. (11) First, allocations of items must be accurately reflected and maintained in the partners' capital accounts. (12) Second, liquidating distributions must be paid out pursuant to positive capital account balances. Third, any deficit balance must be restored by the partners upon liquidation (or comply with the income offset rules). (13) Further, the economic effect of an allocation is deemed to be substantial if the allocation and resulting maintained balances will substantially determine the amount each partner will receive regardless of any tax consequences. (14) Accordingly, in the example above, the capital account of Oyer--who was allocated 90% of the depreciation deduction--would be reduced by his larger distributive share of depreciation deductions and would be subject to the above-mentioned liquidating requirements.
If, however, an allocation does not have substantial economic effect, partnership items must be allocated in accordance with the partners' interest in the partnership. (15) In effect the allocations will be based on the facts and circumstances relating to the economic arrangement of the partners, such as the partners' interests in taxable income and loss. (16) For instance, in the example above, Oyer and Klein would each be allocated 50% of all partnership items. In addition, the regulations provide special rules for certain items. The substantial economic effect rules are deemed inapplicable to these items and, therefore, the allocations must be determined in accordance with the partner's interest in the partnership standard. (17)
Temporary Regulation [section] 1.704-1T(b)(4)(xi)
The combination of the foreign tax credit and the flexibility afforded to partners in allocating items of expense leaves room for abuse. In the past, a good number of partnerships' allocations of foreign tax liabilities did not clearly reflect their distributive shares of income. For example, the foreign tax credits claimed did not necessarily match the income subject to U.S. tax. Partners could take credits even though the income which generated both the tax liability and the credit was not included in the partner's income. In an effort to address this abuse, the IRS and the Treasury Department recently issued temporary regulations which address the allocation of creditable foreign taxes. Effective April 21, 2004, partnership allocations of creditable foreign taxes may not be based solely on the substantial economic effect test. Thus, the allocation of such items must be in accordance with the partners' interests in the partnership. The new regulations ensure that persons taking an FTC include the income from which the credit derives.
The regulation provides a safe harbor whereby disproportionate partnership allocations of creditable foreign taxes will be deemed to be within the partners' interests in the partnership where the following conditions are satisfied. If a partnership agreement meets the requirements of the substantial economic effect test (i.e., it provides for a proper maintenance of the partners' capital accounts, liquidation distributions based upon positive capital balances, and restoring deficits), then an allocation of foreign tax expenditures that is in the same proportion as the allocation of foreign income which generated the foreign tax will be permissible, even if it is not in proportion to the partners' interests in the partnership. (18)
Example of Application
Assume three U.S. persons, Reed, Silver and Tang, form RST Partnership and each have a one-third interest. The RST Partnership Agreement provides that allocations will be accurately reflected in the partners' capital accounts, liquidation proceeds will be distributed in accordance with the partners' positive capital accounts balances, and any partner with a deficit balance in his capital account following the liquidation of his interest will be required to restore the deficit to the partnership. RST Partnership operates a business overseas in Country Z. Assume that Country Z imposes a 30% income tax, which qualifies as a creditable tax for U.S. tax purposes. RST earns $600,000 of net income, resulting in a tax liability of $180,000 to Country Z. Pursuant to the RST Partnership Agreement, all partnership items including creditable foreign taxes are allocated one-third to each partner. Accordingly, Reed, Silver and Tang are each allocated $200,000 of income ($600,000/3) and $60,000 of Country Z taxes ($180,000/3). This allocation is permissible because the creditable foreign taxes and the income which generated the taxes are allocated based on the partners' interests in the partnership.
Assume the same facts as above, except that under the RST Partnership Agreement, Reed is allocated 50% of all partnership items including creditable foreign taxes, and Silver and Tang are each allocated 25%. Pursuant to this allocation, Reed would be allocated $300,000 of net income and $90,000 of foreign taxes, while Silver and Tang would be allocated $150,000 of net income and $45,000 of foreign taxes each. This allocation is also permissible because it falls within the safe harbor. First, the partnership allocations satisfy the substantial economic effect requirements, because the RST Partnership Agreement provides that allocations will be accurately reflected in the partners' capital accounts, liquidation proceeds will be distributed in accordance with the partners' positive capital accounts balances, and any partner with a deficit balance in his capital account following the liquidation of his interest will be required to restore the deficit to the partnership. Secondly, the allocation of the Country Z taxes is in proportion to the allocation of the income to which the foreign taxes relate. In this example, Reed is allocated 50% of the net income and 50% of the creditable taxes. Since the requirements of the safe harbor are satisfied, the allocation of the Country Z taxes is deemed to be in accordance with the partners' interests in the partnership. It should be noted that if Reed were allocated one third of the Country Z income (as in the first example), but 50% of the foreign taxes (as in the second example), the allocation would fail because the allocations of taxes must be proportionate to the allocation of the income which generated the foreign taxes.
The temporary regulations have the full force of final regulations and apply to tax allocations for partnership tax years that begin on or after April 21, 2004. In addition, the regulations provide a transitional rule for partnership agreements that were entered into before April 21, 2004. For these agreements, the new regulations may be disregarded unless and until the partnership agreement is materially modified.
The temporary regulations prevent partnership allocations of creditable foreign taxes that do not match the allocation of the income to which the taxes relate. These anti-abuse regulations are necessary because, unlike most business expenses which are allocated among partners, foreign taxes may be credited against a partner's U.S. taxes. The regulations are consistent with the purpose of the foreign tax credit, which is to prevent the double taxation of foreign source income. They are also consistent with the goal of the foreign tax credit limitation, which prevents foreign tax credits from reducing U.S. taxes on U.S. source income. Issuance of these temporary regulations is just one step towards addressing abuses of the foreign tax credit regime, and additional limitations are expected in the future.
1. Temp. Reg. [section] 1.704-1T(b)(4)(xi).
2. Section 61 of the Internal Revenue Code of 1986, as amended (Code).
3. Code [section] 901.
4. Treas. Reg. [section] 1.901-2(a)(1).
5. Rules for the sourcing of income are located in Code [section][section] 861-865.
6. In addition, Code [section] 904(d) places further limitations on the foreign tax credit based on type of income (i.e., commonly referred to as "baskets").
7. Code [section] 904(a).
8. Code [section] 901(b)(5).
9. Code [section] 704(a).
10. Code [section] 704(b).
11. Treas. Reg. [section] 1.704-1(b)(2)(ii)(b).
12. The capital accounts must be determined and maintained in accordance with Treas. Reg. [section] 1.704-1(b)(2)(iv).
13. Treas. Reg. [section] 1.704-1(b)(2)(ii)(d).
14. Treas. Reg. [section] 1.794-1(b)(2)(iii).
15. Treas. Reg. [section] 1.794-1(b)(1).
16. Treas. Reg. [section] 1.794-1(b)(3).
17. See e.g., Treas. Reg. [section] 1.704-1-(b)(4) (dealing with revaluations) and Treas. Reg. [section] 1.704-2 (dealing with nonrecourse deductions).
18. Temp. Reg. [section] 1.704-1T(b)(4)(xi)
Laura Lee Mannino, The Peter J. Tobin College of Business, St. John's University
Richard Lai, The Peter J. Tobin College of Business, St. John's University
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|Author:||Mannino, Laura Lee; Lai, Richard|
|Publication:||Review of Business|
|Date:||Mar 22, 2005|
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