Document 2527572

Tax Insights
from Mergers & Acquisitions and International Tax Services
Revised Section 704(b) regulations
clarify partnership allocations of
creditable foreign tax expenditures
February 17, 2016
In brief
The Treasury Department (Treasury) and Internal Revenue Service (IRS) issued revised Section 704(b)
regulations on February 3, 2016. The new rules address certain situations involving partnerships’
allocations of creditable foreign tax expenditures (CFTEs), expanding and clarifying regulations first
issued in 2006 and revised in 2012. The basic purpose of those regulations is to ensure that partnerships
allocate foreign taxes among partners in the same manner as they allocate the income to which those
taxes relate. In general, Section 704(b) rules treat a partnership’s allocations of CFTEs as not having
substantial economic effect, because tax credits allocated to a partner are assumed to provide a dollarfor-dollar benefit that offsets the burden of the expense allocation. Thus, CFTE allocations are respected
only if they reflect the partners’ interests in the partnership (PIP).
Existing regulations under Section 704 provide a safe-harbor method for partnerships to allocate CFTEs
in a manner deemed to be in accordance with PIP. The preamble to the revised regulations asserts that
they are “necessary to improve the operation” of the existing safe harbor. Specifically, the revised
regulations address three issues: (1) the effect of allocations (or distributions of allocated amounts) and
guaranteed payments that give rise to foreign-law deductions in computing the income in a CFTE
category; (2) the effect of a transferee partner's Section 743(b) adjustment on income in a CFTE category;
and (3) the application of the inter-branch payment rules in particular with respect to withholding taxes.
These inter-branch payment rules implicate Section 909.
The specific modifications in the revised Section 704(b) regulations are important not only for their
direct effect on certain taxpayers, but also for what they indicate about ongoing efforts by Treasury and
the IRS to prevent taxpayers from gaining tax benefits by splitting foreign taxes from the associated
foreign income. The revised regulations are generally effective for partnership tax years that both (i)
begin on or after January 1, 2016, and (ii) end after the February 2016 date of publication in the Federal
Register. There is also a modification to existing transition rules for certain inter-branch payments.
Treasury and IRS issued the revised regulations in temporary and proposed form, and have requested
public comment.
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In detail
Background
Because the Section 704(b) rules treat
a partnership’s allocations of CFTEs
as not having substantial economic
effect, CFTE allocations are respected
only if they reflect PIP. Existing
Treas. Reg. sec. 1.704-1(b)(4)(viii)
rules provide a safe-harbor method
for a partnership to allocate CFTEs in
a manner deemed to be in accordance
with PIP. As the revised regulations’
preamble states, the purpose of the
safe harbor is to match allocations of
CFTEs with the income to which the
CFTEs relate. In order to apply the
safe harbor, a partnership must (1)
determine the partnership’s ‘CFTE
categories,’ (2) determine the
partnership’s net income in each
CFTE category, and (3) allocate the
partnership’s CFTEs to each category.
To satisfy the safe harbor, partnership
allocations of CFTEs in a category
must be in proportion to the
allocations of the partnership’s net
income in the category.
The revised regulations make certain
specific modifications that Treasury
and the IRS consider substantive and
other changes termed ‘nonsubstantive.’ The latter are intended
to clarify how items of income under
US federal income tax law are
assigned to an activity, and how a
partnership’s net income in a CFTE
category is determined.
Partnership inter-branch
payments
Previous versions of the Section
704(b) regulations have addressed
CFTE allocations with respect to
disregarded payments among
partnership branches. The revised
regulations include two new examples
(Treas. Reg. sec. 1.704-1T(b)(5),
Examples 36 and 37) relating to such
payments. The preamble explains
that the examples respond to
transactions involving serial
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disregarded payments in which
taxpayers take the position that
withholding taxes assessed on the first
payment in a series of back-to-back
disregarded payments do not need to
be apportioned among the CFTE
categories that include the income out
of which the payment is made. The
examples ‘clarify’ that Treas. Reg. sec.
1.704-1(b)(4)(viii)(d)(1) requires
withholding taxes to be apportioned
among the CFTE categories that
include the related income.
The two examples appear to
correspond to the two different types
of allocation provisions described in
Example 24(ii) and (iii). Example 36
addresses the allocation of
withholding taxes in a situation in
which the partnership agreement
contains no special provisions for
allocating amounts associated with
inter-branch payments
(corresponding to Example 24(ii)).
Example 37 addresses the allocation
of withholding taxes by a partnership
whose agreement specially allocates
inter-branch payments in accordance
with the different allocation ratios
applicable to the payee branch.
Example 37 appears to be targeting a
particular back-to-back royalty
structure. The example describes
what is sometimes known as a
tracking partnership that makes
allocations with respect to its interbranch payments as described in
Example 24(iii). Partners A, B, and C
(the partners in partnership ABC) are
specially allocated disproportionate
amounts of income related to three
disregarded entities (DEX, DEY, and
DEZ) owned by ABC. A is entitled to
80% of the items associated with DEX
and 10% of the items associated with
each of DEY and DEZ. B is entitled to
10% of the DEX items, 80% of the
DEY items, and 10% of the DEZ items.
C is entitled to 10% of the items of
each of DEX and DEY and 80% of the
items of DEZ. Consistent with
Example 24(iii), if DEX makes a
payment to DEY, then such payment
is treated as separate activity to which
the DEY allocation ratios are applied;
as a result, the payment becomes part
of the net income in the DEY CFTE
category.
According to the example, DEZ owns
IP which it licenses to DEY. DEY
sublicenses the IP to DEX. DEX earns
$100,000 of gross royalty income and
pays a $90,000 royalty to DEY
(deductible for country X purposes
and disregarded for US federal income
tax purposes). $9,000 of withholding
tax is imposed on this payment. DEY
pays an $80,000 royalty to DEZ on
which no withholding tax is imposed
(again, the payment is deductible for
local-country purposes and
disregarded for US federal income tax
purposes). The partnership seeks to
take the position the $9,000
withholding tax imposed by country X
(with respect to which DEY is the
technical taxpayer) should be included
in the DEY CFTE category, based on
the provisions of the partnership
agreement that apply the DEY
allocation ratios to the payment.
Doing so would allow the partnership
to allocate $7,200 of the CFTEs in the
DEY CFTE Category to B (80% of
$9,000), because B is allocated
$8,000 (80% of $10,000) of the net
income in the DEY CFTE category.
(As a result, with respect to the
allocation of DEY income, B would
have a 90% effective tax rate.)
Example 37 makes it clear that the
IRS believes that such an allocation is
outside the safe harbor. According to
the example: “Because the $90,000
on which the country X withholding
tax is imposed is split between the
business Y CFTE category and the
business Z CFTE category, those
withholding taxes are allocated on a
pro rata basis, $1,000 [$9,000 x
($10,000/$90,000)] to the business Y
CFTE category and $8,000 [$9,000 x
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($80,000/$90,000)] to the business
Z CFTE category.”
The CFTE allocations regulations
previously made no attempt to
address specifically their application
to withholding taxes. The example
addressing inter-branch payments
(Example 24) dealt only with net
income taxes. In the case of an interbranch payment that is deductible for
foreign law purposes, taxes imposed
on the net income of the payor branch
logically remain in the CFTE category
that includes the payor branch,
because the tax is imposed only on the
income that remains after the
deduction of the inter-branch
payment. The revised regulations
reject this logic in the case of a
withholding tax. As illustrated by
Example 37, in the case of a branch
such as DEY, the amount of the
withholding tax is not reduced by the
inter-branch payment from DEY to
DEZ, allowing the taxpayer to split the
income and the taxes.
The facts of Example 37 are drafted in
such a way that it is clear that the
payment that ends up in DEZ is
attributable to the income earned
originally by DEX. DEY earns no
other income in that year. It is not
clear how the example would apply if
DEY had $80,000 of income from
other sources in the same year. At
that point, it is no longer clear that the
payment of income by DEY to DEZ is
attributable to the income earned by
DEX.
Special rules for deductible
allocations and guaranteed
payments
The revised regulations modify rules
addressing the manner in which
deductible allocations and guaranteed
payments affect the amount of income
in a CFTE category. Under the revised
rules, allocations (or distributions of
allocated amounts) and guaranteed
payments that give rise to foreign-law
deductions reduce the amount of net
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income in a CFTE category.
Conversely, guaranteed payments that
are deductible for US federal income
tax purposes but not deductible in a
foreign jurisdiction are added back to
the net income in a CFTE category
(and the payment of such amounts is
treated as an allocation to the
recipient for purposes of determining
the partners’ shares of income in a
CFTE category). If a guaranteed
payment is deductible for both US
federal income tax purposes and in a
foreign jurisdiction, then the
partnership’s net income in a CFTE
category is increased only to the
extent the amount allowed as a
deduction for US federal income tax
purposes exceeds the amount allowed
as a deduction for purposes of the
foreign tax. In addition, the revised
regulations modify a special rule that
addressed the timing of guaranteed
payments. The revised regulations
clarify that a guaranteed payment or
preferential allocation is considered
deductible under foreign law for
purposes of the special rules if the
foreign jurisdiction allows a deduction
from its taxable base either in the
current year or in a different taxable
year.
The preamble indicates that these
modifications to the deductible
allocation and guaranteed payment
rules were in part a response to
concerns about situations in which a
guaranteed payment gives rise to a
deduction for purposes of one foreign
tax which payment is made out of
income subject to another tax
imposed by the same or a different
foreign jurisdiction. Treasury was
concerned that taxpayers interpreted
the prior rules to permit exclusion of
the income from the CFTE category
(because it was deductible for foreign
law purposes) even though the same
income was part of the tax base on
which another foreign tax was
imposed.
Revised Example 25 illustrates the
operation of these rules. In the
example, A and B are partners in
partnership AB. The partnership
agreement provides that A is entitled
to a special allocation of the first
$100,000 of the partnership’s gross
income each year as a preferred return
on excess capital contributed by A; all
other items are shared 50-50. In a
year in which the partnership has
$300,000 of gross income ($200,000
of net income) subject to country X
net income tax of $20,000 and
country Y withholding tax of $30,000,
the CFTEs associated with the country
X and country Y taxes must be
allocated differently if the $100,000
special allocation to A is deductible for
country X purposes but not for
country Y purposes. Thus, despite the
fact that the partnership has only one
CFTE category, there are two different
allocations of CFTEs. The proper
allocation of the country X CFTEs is
made with reference to the partners’
distributive shares of the $200,000 of
net income on which country X tax is
imposed, i.e., 50-50. The proper
allocation of country Y CFTEs,
however, requires the partners in
effect to add back the nondeductible
amount, increasing the net income in
the CFTE category to $300,000.
Because the partners share this
income 75-25, the country Y CFTEs
must be allocated in the same manner
to comply with the safe harbor.
Observation: In contrast to the
revised rules addressing inter-branch
payments, the changes to the
deductible allocation and guaranteed
payment rules appear to be intended
as clarifications, and do not appear to
be targeted at specific structures that
the IRS views as abusive.
Effect of Section 743(b)
adjustments
Previously, regulations under Section
704(b) provided that a partnership
determines its net income in a CFTE
category by taking into account all
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partnership items attributable to the
relevant activity or group of activities.
However, those regulations did not
state whether a Section 743(b)
adjustment would be taken into
account for that purpose. The transfer
of a partnership interest resulting in
such an adjustment would require the
partnership to adjust the basis only of
the transferee partner’s property, not
the common basis of partnership
property.
Treasury and the IRS have decided
that a transferee partner’s Section
743(b) adjustment should not be
taken into account in computing a
partnership’s net income in a CFTE
category, because the basis
adjustment is unique to the transferee
partner and ordinarily would not be
taken into account by a foreign
jurisdiction in computing its foreign
taxable base. Revised Treas. Reg. sec.
1.704-1T(b)(4)(viii)(c)(3)(i) provides
that, for purposes of computing a
partnership’s net income in a CFTE
category, the partnership determines
its items without regard to any Section
743(b) adjustments that its partners
may have to the basis of the
partnership’s property. The preamble
notes, however, that a partnership
which is itself a transferee partner in a
lower-tier partnership may have a
Section 743(b) adjustment in that
capacity. The revised regulations take
such an adjustment into account in
determining the partnership’s net
income in a CFTE category.
The preamble states that it intends no
inference as to how a Section 743(b)
adjustment is taken into account for
other US federal income tax purposes.
In addition, the preamble notes that
Treasury and the IRS will address
Section 743(b) adjustments that give
rise to basis differences subject to
Section 901(m) in a separate project.
The preamble also requests comments
regarding whether final regulations
should provide further guidance on
how to compute a partnership’s net
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income in a CFTE category. There is
specific reference to how other types
of items or adjustments to distributive
shares particular to a partner should
be taken into account for this purpose.
The preamble mentions the example
of property that is contributed with a
built-in loss which is taken into
account only in determining the
amount of items allocated to the
contributing partner under Section
704(c)(1)(C). Treasury and the IRS
also request comments on applying
the safe harbor with respect to CFTEs
that are determined by taking into
account partner-specific adjustments
similar to those that apply for US tax
purposes in computing the foreign
taxable base of a partnership.
Observation: The discussion of the
new rule with respect to Section
743(b) adjustments in the preamble
and the related request for comments
appears to set forth two criteria that
must be met before an item is
excluded from the computation of the
partnership’s net income in a CFTE
category. First, the item must be
unique to the partner; second, the
item must not be taken into account
by the relevant foreign jurisdiction in
determining its tax base. The request
for comments suggests that this twopart test might apply to exclude, for
example, allocations with respect to
contributed built-in loss property, i.e.,
Section 704(c)(1)(C) items. It would
not, however, appear to exclude items
such as remedial allocations under
Section 704(c). Even though a
remedial allocation is entirely a
creation of the US tax law and has no
effect on the foreign tax base, a
remedial allocation is generally not
unique to one particular partner, since
a step-in-the-shoes rule generally
applies to a transferee in the case of
interests that have associated Section
704(c) items.
Effective date
As noted above, other than the
modified transition rule, the revised
regulations apply generally for
partnership taxable years that both (i)
begin on or after January 1, 2016, and
end after the February 2016 date of
their publication in the Federal
Register. The preamble notes that the
IRS may challenge transactions,
including those described in the
revised regulations, under other
provisions or judicial doctrines.
Revised transition rule for certain
inter-branch payments
The revised regulations modify an
existing transition rule governing
certain inter-branch payments for
partnerships whose agreements were
entered into before February 14, 2012.
That rule permits the partnership to
continue to apply certain parts of the
2011 version, but only if there has
been no material modification to the
partnership agreement on or after
February 14, 2012. For this purpose,
any change in ownership would
constitute a material modification.
The new rule allows partnerships to
continue applying that transition rule
for tax years that both (i) begin on or
after January 1, 2016, and end after
(ii) the date of the regs’ publication in
the Federal Register, but they must
apply the revised Temp. Treas. Reg.
sec. 1.704-1T(b)(4)(viii)(c)(3)(ii).
Note that the transition rule does not
apply to any tax year during or after
which persons that are related under
Sections 267(b) or 707(b) collectively
have the power to amend the
partnership agreement without the
consent of any unrelated party.
Observation: The regulations
generally apply to 2016 allocations
regardless of when the partnership
arrangements were entered into.
Partnerships with significant
creditable foreign tax expenses should
consider whether the regulatory
changes could require different
allocations of CFTEs and thus affect
the partners’ economic deal. Although
the transition rule from 2012
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continues in effect, we note that, in
practice, the exception for related
party partnerships precludes
application of the transition rule for
many partnerships that rely on the
CFTE regulations.
The takeaway
The specific modifications in the
revised Section 704(b) regulations are
important not only for their direct
effect on a certain set of taxpayers, but
also as an indicator that Treasury and
the IRS continue to be wary of
perceived efforts by taxpayers to gain
tax benefits by splitting foreign taxes
from the associated foreign income.
The request for comments in the
regulation preamble indicates that
Treasury and the IRS are continuing
to consider these rules further;
taxpayers and their advisors should
discuss whether providing comments
could be useful in helping the
government understand real-world
application of the rules. Taxpayers
with global structures involving
partnerships and hybrid entities that
may incur foreign taxes should
continue to be alert for developments
in this area.
Let’s talk
For a deeper discussion of how this might affect your business, please contact:
Mergers & Acquisitions
Craig Gerson
(202) 312-0804
[email protected]
Karen Lohnes
(202) 414-1759
[email protected]
Elizabeth Amoni
(202) 346-5296
[email protected]
Michael Hauswirth
(202) 346-5164
[email protected]
International Tax Services
Chip Harter
(202) 414-1308
[email protected]
Alan Fischl
(202) 414-1030
[email protected]
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