Partners & Partnerships

Final Regs. on Partnership Allocations of CFTEs

The IRS issued final regulations (TD 9292, 10/19/06) under Sec. 704(b) that provide rules for the allocation of partnership creditable foreign taxes. They adopt the proposed and temporary regulations (TD 9121, 4/20/04), with substantial modifications.

Final Regs.

The final regulations retain the provisions of the proposed and temporary regulations excluding allocations of creditable foreign tax expenditures (CFTEs) from the substantial-economic-effect safe harbor of Regs. Sec. 1.704-1(b)(2), and provide a safe harbor under which allocations of CFTEs will be deemed to be in accordance with the partners’ interests in the partnership (if CFTE allocations are in proportion to the distributive shares of income to which they relate). In comparison to the brief proposed and temporary regulations, the final regulations contain considerably more details, specifying the accounting for CFTEs and the income to which the tax expense relates.

Under the final regulations, the income to which a CFTE relates is the net income in the CFTE category to which the CFTE is allocated and apportioned. As discussed in more detail below, a CFTE category is a category of net income attributable to one or more partnership activities. The net income in a CFTE category is the net income determined for Federal income tax purposes attributable to each separate partnership activity included in the CFTE category. Income from separate activities is included in the same CFTE category only if the net income from such activities is allocated among the partners in the same proportions. Income from a divisible part of a single activity that is shared in a different ratio than other income from that activity is treated as income from a separate activity. (While the concept of allocating income from a “divisible part” is not defined in the regulations, it seems to refer simply to situations with a special allocation of income from a portion of an activity, such as a disregarded branch owned by a partnership.) CFTEs are allocated and apportioned to CFTE categories under Regs. Sec. 1.904-6 principles, as modified by the final regulations. Thus, CFTEs generally are allocated to a CFTE category if the income on which the CFTE is imposed (the net income recognized for foreign tax purposes) is in the CFTE category.

The final regulations include a three-step process for determining the distributive share of income to which a CFTE relates for purposes of the safe harbor. The partnership must (1) determine its CFTE categories; (2) determine the net income in each CFTE category; and (3) allocate and apportion CFTEs to the categories based on the net income in said categories. To satisfy the safe harbor, the partnership must allocate CFTEs among the partners in the same proportion as the allocations of net income in the applicable CFTE category.

CFTEs

The temporary and proposed regulations provided that a CFTE is a foreign tax paid or accrued by a partnership for a credit under Sec. 901(a). A qualifying domestic corporate shareholder may claim a credit under Sec. 901(a) for taxes paid or accrued by a foreign corporation and deemed paid by the shareholder under Sec. 902 or 960 on distribution or inclusion of the associated earnings. The final regulations clarify that a CFTE does not include foreign taxes deemed paid by a corporate partner under Sec. 902 or 960 (i.e., on distributions received by a partnership that are dividends for U.S. tax purposes). The final regulations also clarify that they do not apply to foreign taxes paid or accrued by a partner (foreign taxes for which the partner—as distinguished from the partnership itself—has legal liability within the meaning of Regs. Sec. 1.901-2(f)). Further, a CFTE does include a foreign tax paid or accrued by a partnership eligible for a credit under an applicable U.S. income tax treaty.

Categories: Examples in the temporary and proposed regulations illustrated that the determination of the income to which a CFTE relates must be made separately for certain income categories when the partnership agreement provides for different allocations of such income. The final regulations provide additional guidance that is also intended to assist in determining the distributive share of income to which a foreign tax relates.

The relevant category of income is the CFTE category, defined in the final regulations as net income, computed for U.S. purposes, attributable to one or more partnership activities. The final regulations generally provide that net income from all of the partnership’s activities is treated as income in a single CFTE category. The general rule does not apply, however, if the partnership agreement provides for an allocation of net income from one or more activities that differs from the allocation of net income from other activities. In that case, net income from each activity or group of activities subject to a different allocation is treated as net income in a separate CFTE category. For this purpose, income from a divisible part of a single activity is treated as income from a separate activity if such income is shared in a different ratio than other income from the activity.

Thus, if a partnership agreement allocates all partnership items in the same manner, the partnership will have a single CFTE category, regardless of the number of activities in which it is engaged. Conversely, a partnership agreement that provides for different allocations of net income with respect to one or more activities will have multiple CFTE categories. Different allocations of the partnership’s net income from separate activities and, thus, multiple CFTE categories, may result if the partnership agreement contains special allocations.

Under the final regulations, whether the partnership has different sharing ratios for income from one or more activities (and, thus, has more than one CFTE category) must be determined in a reasonable manner, taking into account all the facts and circumstances. In evaluating whether aggregating or disaggregating income from particular business or investment operations is a reasonable method of determining an activity’s scope, the principal consideration is whether the proposed determination has the effect of separating CFTEs from the related foreign income. Relevant facts and circumstances include whether the partnership conducts business or investment operations in more than one geographic location or through more than one entity or branch, and whether certain types of income are exempt from foreign tax or subject to preferential foreign tax treatment. In addition, income from a divisible part of a single activity is treated as income from a separate activity, if necessary to prevent the separation of CFTEs from the related foreign income. The partnership’s activities must be determined consistently from year to year, absent a material change in facts and circumstances.

Distributive share of income: The final regulations provide several clarifications in determining a partner’s distributive share of income to which a CFTE relates. The net income in a CFTE category is the net income for Federal income tax purposes, determined by taking into account all items attributable to the relevant activity or group of activities (or portion thereof). The items of gross income included in a CFTE category must be determined in a consistent manner under any reasonable method, taking into account all the facts and circumstances. Expenses, losses or other deductions generally must be allocated and apportioned to gross income included in a CFTE category in accordance with Regs. Sec. 1.861-8 and Temp. Regs. Sec. 1.861-8T. The final regulations further permit a partnership to allocate and apportion deductions for interest and research and development costs for purposes of determining net income in a CFTE category under any reasonable method, including the rules contained in Regs. Sec. 1.861-9 through Temp. Regs. Sec. 1.861-13T and Regs. Sec. 1.861-17.

The final regulations clarify that, in applying Federal income tax principles to determine the net income attributable to a branch’s activity, the only items of gross income taken into account are those recognized by the branch for Federal income tax purposes. Thus, a payment from one branch to another neither increases the recipient’s gross income nor reduces the payer’s. This provision appears at first glance to reject the position advocated in comments on the temporary regulations that foreign income tax treatment should be taken into account in determining the income to which foreign tax expense relates. This provision, however, must be interpreted in light of Regs. Sec. 1.704-1(b)(5), Example (24) (i), which involves a payment between disregarded branches owned by a partnership. Using a single underlying fact pattern, the example analyzes three alternative allocation schemes (Examples (24) (ii)–(iv)) for partnership pretax income and taxes, and determines whether they pass muster under the new rules. In one of the three alternatives, the allocation scheme follows the safe harbor and, thus, is held to be valid. In the other two, the safe-harbor approach is not followed, but the example concludes that it may nonetheless be possible to demonstrate that the allocation actually is in accordance with the partners’ partnership interests.

Example (24) Analysis

Example (24) is somewhat difficult to read, in part because it uses a variety of labels to refer to each partnership activity. Thus, the analysis below refers to the following simplified example that tracks the three allocations set forth in Example (24).

Facts: A partnership has a disregarded entity in Germany (G) that pays interest to a Swiss disregarded entity (S). G has $100 pretax net income and $60 in interest payments to S. The $60 interest payment is deductible under German law. S has $20 pretax income before receipt of this payment; the tax rates in Germany and Switzerland are 40% and 10%, respectively. For local country tax purposes, G has $40 pretax income and owes $16 tax. S has $80 pretax income ($60 from G and $20 other income) and owes $8 tax ($6 attributable to income received from G and $2 from other income). For U.S. tax purposes, assuming the interbranch payment is ignored, G has $100 pretax income and S has $20 pretax income. Example (24) sets forth three alternative scenarios for allocating G’s and S’s income and taxes.

Scenario 1: In Regs. Sec. 1.704-1(b)(5), Example (24) (ii), the partnership agreement provides geographic allocations of net pretax income and CFTEs of the branches (ignoring interbranch payments). Applying that approach, the partnership agreement allocates $100 of pretax German income (disregarding the $60 deductible payment to S) and $16 actual German tax, 75% to partner A and 25% to partner B. It allocates the $20 pretax Swiss income (disregarding the $60 interest actually received), and $8 actual Swiss tax, 50% to A and 50% to B. In this scenario, the regulations’ safe-harbor approach is applied (i.e., the allocation pattern strictly follows the safe harbor).

Scenario 2: In Regs. Sec. 1.704-1(b)(5), Example (24) (iii), the partnership agreement allocates pretax income in the same manner as Scenario 1, but changes the tax allocation to reflect the economic effect of the disregarded interest payment. Applying this approach, the $6 Swiss tax attributable to the $60 disregarded payment is allocated not 50%/50% (i.e., the way in which the partnership allocates Swiss income), but 75%/25% (i.e., the manner in which the German income from which the disregarded payment was made is allocated).

Looking first at the German tax, it qualifies for the safe harbor, because German income is being shared 75%/25% and the $16 German tax is being shared the same way. Looking next to the Swiss tax, the example concludes that the safe harbor is (1) available for the $2 Swiss tax on the non-German income (because such Swiss income is being allocated 50%/50%, as are the related Swiss taxes); but (2) not available for the $6 Swiss tax imposed on the $60 German income (because such tax is allocated 75%/25%, but the pretax income is allocated 50%/50%).

However, the example goes on to conclude that, on substantiation that the $6 Swiss tax is paid on the $60 income received from Germany, the allocation of the Swiss tax may be established to be actually in accordance with the partners’ partnership interests. Although not expressly articulated, the reasoning appears to be that it is appropriate to allocate the Swiss tax on the disregarded interest payment in the same ratio that the partners share the German income that funded the interest payment. Presumably, the substantiation referenced in Example (24) (iii) would consist of showing that the partners’ capital accounts are maintained so that the pretax income and tax expense items above are all reflected therein (see the exhibit below).

Scenario 3: Example (24) (iii) illustrates an allocation that departed from the safe harbor because it specially allocated tax expense to reflect the partners’ actual economic arrangement for the income that underlay the tax expense. Regs. Sec. 1.704-1(b)(5), Example (24) (iv), in contrast, involves a different solution to the same issue: the partners specially allocate income to reflect their economic share of the tax expense generated by the income. Applying this approach, the partnership agreement allocates a portion of the German income (equal to the amount of the disregarded payment) 50%/50% (i.e., in the same proportion as tax is being paid on such income in Switzerland). The fact pattern thus set up is mathematically the same as if the interest payment from Germany to Switzerland is respected for U.S. purposes, in calculating G’s and S’s pretax incomes. (This is because $100 – $60 of pretax German income (equal to the $40 in fact reported for local German purposes) is allocated 75%/25%, $20 plus $60 of Swiss income (equal to the $80 reported for local Swiss purposes) is allocated 50%/50%, and the $16 German taxes and $8 Swiss taxes are allocated 75%/25% and 50%/50%, respectively).

Following Example (24) (iv), all $8 Swiss tax is allocated 50%/50% (i.e., in the same percentages as the $20 Swiss income (determined under the U.S. net-income approach, which ignores the disregarded interest actually received)); thus, the allocation of the $8 Swiss tax meets the safe harbor. The allocation of the $16 German tax does not satisfy the safe harbor: A is allocated pretax income of 75% × $40, plus 50% × $60, a total of $60; and tax of 75% × $16, or $12. B is allocated pretax income equal of 25% × $40, plus 50% × $60, a total of $40; and tax of 25% × $16, or $4. A thus is allocated 60% of the total of $100 pretax income (determined using the U.S. net-income approach), but 75% of taxes; B is allocated 40% of pretax income and 25% of taxes.

It can be seen that the safe harbor, which requires complete alignment of tax to U.S. net income, is not met. However, the example concludes that, if it can be substantiated that the allocation of the German tax to the German income other than that reported in S (i.e., $100 German U.S. net income – $60 disregarded actual payment reported as income by S) is allocated in the same percentage as the German tax has been allocated, the actual-partners’-interest-in-the-partnership standard may be satisfied. Here, there is $16 German tax on $40 German income (adjusted to carve out the $60 paid to Switzerland); such German tax has been allocated 75%/25%, and such adjusted German income has been allocated the same way. Thus, it would appear that the allocation could be respected, even though the safe harbor has not been met (assuming that the partners’ economic deal is to this effect, as reflected in their properly maintained capital accounts). As was noted, this offers the same result as if the actual payment from Germany to Switzerland was respected.

Summary: The exhibit illustrates the allocations of income and tax expense as made from a U.S. income tax viewpoint and the resultant adjustments to capital accounts (which presumably will be followed in, among other things, making distributions on partnership liquidation). These allocations are as described above and follow Example (24) in the regulations. The tax amounts are the tax that would be paid in each country, using the tax rates set forth in this example.

Example (24) can be seen to be considerably more than just an example, however. Through the fact pattern illustrated, it provides operative guidance on the treatment of payments between disregarded branches owned by a partnership. The example seems to clearly allow greater flexibility in the allocation of foreign tax expense in such a circumstance than can be gleaned from the text of the regulations.

Sec. 704(c) Allocations

The final regulations retain the general principle that all Sec. 704(c) allocations must be taken into account when determining net income in the relevant category. Because allocations of net income from a CFTE category are allocations of the net income recognized for U.S. tax purposes, the IRS and Treasury believe that all Sec. 704(c) allocations (including “reverse” Sec. 704(c) allocations and Sec. 704(c) allocations made prior to an asset’s disposition) must be taken into account in determining a partner’s distributive share of income. They did not adopt the suggestion of several commentators to take Sec. 704(c) into account only when both the U.S. and foreign jurisdictions recognize built-in gain or loss. They also rejected suggestions to take Sec. 704(c) allocations into account only on a disposition of contributed property. Thus, the final regulations provide that the net income in a CFTE category is the net income for U.S. income tax purposes, determined by taking into account all items attributable to the relevant activity, including (among others) items allocated under Sec. 704(c); see Regs. Sec. 1.704-1(b)(5), Example (26).

Preferential Income Allocations and Guaranteed Payments

If a partnership income allocation is treated as a deductible payment under foreign law, no CFTEs are related to that income, as it is not included in the foreign tax base. Conversely, if a preferential return is not deducted under foreign law (e.g., a return on preferred stock in a hybrid), it is included in the foreign income base and must attract taxes to satisfy the safe harbor.

The temporary regulations had not addressed the treatment of guaranteed payments. The final regulations provide that a guaranteed payment is treated as income in a CFTE category, to the extent that the payment is not deductible by the partnership under foreign law. In addition, such a guaranteed payment is treated as a distributive share of income for safe-harbor purposes.

Taxes Imposed on Certain Partners’ Income

A foreign jurisdiction may impose tax on partnership income allocable to certain partners and not on such income allocable to other partners. To address this issue, the final regulations provide that income in a CFTE category does not include net income that foreign law would exclude from the foreign tax base as a result of a partner’s status. This provision ensures that CFTEs will be related only to income of those partners whose income is included in the base on which the creditable foreign tax is imposed. Thus, in the partnership context, the regulations in effect follow the approach taken by the courts in Vulcan Materials Co., 96 TC 410 (1991).

Distributive share: The final regulations provide a special rule when one or more partners receive positive income allocations (income in excess of expenses) from a CFTE category that exceeds the net income in the CFTE category because one or more other partners is allocated a net loss (expenses in excess of income). Under the rule, and solely for purposes of allocating CFTEs under the safe harbor, the final regulations limit the distributive share of income of each partner that receives a positive income allocation to its positive income allocation attributable to the CFTE category, divided by the aggregate positive income allocations attributable to that category, multiplied by the net income in said category.

No net income: The final regulations also contain a special rule when CFTEs are allocated and apportioned to a CFTE category that does not have any net income for U.S. tax purposes in the year the foreign taxes are paid or accrued. In such cases, there is no net income in the CFTE category to which the CFTEs relate. Such CFTEs relate to net income recognized for U.S. tax purposes in other years or in other CFTE categories.

Under the final regulations, CFTEs allocated and apportioned to a CFTE category that has no net income for U.S. tax purposes will be deemed to relate to the aggregate net income (if any) recognized by the partnership in that CFTE category during the preceding three-year period (not taking into account years in which there is a net loss in the CFTE category for U.S. tax purposes). The CFTEs in these situations generally must be allocated among the partners in the same proportion as the allocations of such net income for the prior three-year period, to meet the safe harbor.

If the partnership does not have net income in the applicable CFTE category in either the current or any of the previous three tax years, the CFTEs must be allocated among the partners in the same proportion that the partnership reasonably expects to allocate net income in the applicable CFTE category over the succeeding three years. If the partnership does not reasonably expect to have net income in the applicable CFTE category in the succeeding three years, the CFTEs must be allocated among the partners in the same proportion as the total partnership net income for the year is allocated. If the CFTE cannot be allocated under any of the forgoing rules, it must be allocated in proportion to the partners’ outstanding capital contributions.

Allocation and apportionment: The final regulations retain the rule in the proposed and temporary regulations that the determination of the income to which a CFTE relates is made in accordance with Regs. Sec. 1.904-6. The final regulations clarify that application of Regs. Sec. 1.904-6 requires a CFTE to be allocated to a CFTE category if the net income on which the tax is imposed (the net income recognized for foreign tax purposes) is in the CFTE category. The final regulations also provide guidance on the (1) apportionment rule in Regs. Sec. 1.904-6(a)(1)(ii); (2) rules for timing differences; (3) rules for base differences; and (4) treatment of interbranch payments.

Apportionment Rule

The final regulations clarify that Regs. Sec. 1.904-6(a)(1)(ii) requires a taxpayer to apportion foreign taxes among the CFTE categories based on the relative amounts of net income (as determined under foreign law) in each CFTE category. They also provide that the related-party interest-expense rule in Regs. Sec. 1.904-6(a)(1)(ii) is disre-garded for purposes of apportioning taxes among the CFTE categories on the basis of foreign net income. If foreign law does not provide rules for the allocation and apportionment of expenses, losses or other deductions allowed under foreign law to a CFTE income category, such items must be allocated and apportioned to gross income as determined under foreign law, in a manner consistent with the allocation and apportionment of such items for purposes of determining the net income in the CFTE category for U.S. tax purposes.

Timing Differences

Temp. Regs. Sec. 1.704T-1(b)(5), Example (27), indicated that a current-year CFTE attributable to an income item recognized in the prior year for U.S. tax purposes related to, and thus had to be allocated in accordance with, the income allocated under the partnership agreement in the prior year. The IRS and Treasury have reconsidered this approach; the final regulations provide for a more administrable rule that requires the partnership to allocate a CFTE attributable to a timing difference among the partners in the same proportions as the allocations of income recognized for U.S. tax purposes in the relevant CFTE category in the year such taxes are paid or accrued; see Regs. Sec. 1.704-1(b)(5), Example (23) (reflecting modifications to Example (27) in the temporary and proposed regulations).

The final regulations also expressly incorporate the timing-difference rule of Regs. Sec. 1.904-6(a)(1)(iv). Thus, a CFTE attributable to a timing difference is allocated to the CFTE category to which the income would be assigned if it were recognized for U.S. tax purposes in the year in which the foreign tax is imposed.

Base Differences

A base difference arises when an item subject to foreign tax is not income under U.S. tax principles. In the absence of any income to which such a CFTE relates, the final regulations provide that a CFTE attributable to a base difference is related to the income recognized for U.S. tax purposes in the relevant CFTE category in the year such taxes are paid or accrued. For this purpose, a CFTE attributable to a base difference is allocated and apportioned to the CFTE category that includes the partnership items attributable to the activity to which the creditable foreign tax is imposed. Thus, the final regulations adopt similar rules for dealing with timing and base differences.

Partners’ Interests in the Partnership

The IRS and Treasury declined to adopt commentator suggestions that allocations of CFTEs that are not proportionate to allocations of the related income (and, thus, fail to meet the safe harbor) will nevertheless be valid as in accordance with the partners’ interests in the partnership standard of Regs. Sec. 1.704-1(b)(3), because they are reflected in the partners’ capital accounts as maintained under the partnership agreement. This is because, as stated in the preamble, the availability of a foreign tax credit offsets the economic burden of the CFTE. Instead, in determining the partners’ interests in the partnership with respect to an allocation of a partnership item, the allocation of the CFTE itself must be disregarded. The rule does not apply when the partners to whom the taxes are allocated reasonably expect to claim a deduction for them in determining their U.S. tax liabilities. Such scenarios stand in contrast to those with which the IRS was apparently concerned, in which foreign tax expense was directly allocated to a partner (and reflected in capital accounts) without regard to how the partnership’s underlying income was allocated. Further guidance on the application of the partners’-interest-in-the-partnership standard is provided in Regs. Sec. 1.704-1(b)(5), Example (24), as discussed earlier.

Several commentators also requested guidance on whether a reallocation of CFTEs will cause the Service to reallocate other partnership items, so that the partners’ ending capital account balances will remain unchanged. If the reallocation of the CFTEs causes the partners’ capital accounts not to reflect their contemplated economic arrangement, they may need to reallocate other partnership items to ensure the tax consequences of the partnership allocations are consistent with their contemplated economic arrangement. Consistent with the principles of the proposed and temporary regulations, the final regulations clarify that the IRS generally will not reallocate other partnership items in the year in which a CFTE is reallocated; see Regs. Sec. 1.704-1(b)(5), Example (25) (ii). According to the Service, the parties (and not the government) should determine which allocations should be changed to reflect their economic arrangement.

Other Provisions

In response to comments, the final regulations provide that allocations of CFTEs may qualify for safe-harbor treatment, as long as allocations of all other partnership items that, in the aggregate, have a material effect on the amount of CFTEs allocated to the partners are valid. The final regulations also allow safe-harbor treatment if the CFTE is allocated (whether or not under an express provision in the partnership agreement) and reported on the partnership return in proportion to the distributive shares of income to which the CFTE relates.

Effective Date and Transition Rule

The final regulations generally apply to partnership tax years beginning after Oct. 18, 2006. Under a transition rule for existing partnerships, if a partnership agreement was entered into before April 21, 2004, the partnership may apply Regs. Sec. 1.704-1(b) as if the amendments made by these final regulations had not occurred. If the partnership agreement is materially modified after April 20, 2004, however, transition relief is no longer available, and Temp. Regs. Sec. 1.704-1T(b)(4)(xi) or the final regulations apply (depending on the date on which the material modification occurs and the tax year at issue).

For this purpose, a material modification includes any change in partnership ownership. The transition rule does not apply if, as of April 20, 2004, persons related to each other (within the meaning of Secs. 267(b) and 707(b)) collectively have the power to amend the partnership agreement without the consent of any unrelated party. However, taxpayers may rely on Regs. Sec. 1.704-1(b)(4)(viii) for partnership tax years beginning after April 20, 2004.

Implications

These regulations clarify the application of the Sec. 704 regulations to foreign taxes paid and/or accrued and that are eligible for credit under Sec. 901(a). Although the final regulations retain the same basic structure as the proposed and temporary rules, they are much more extensive and include several important changes.

Perhaps the greatest area of uncertainty going forward will be the treatment of interbranch transactions. Having rejected commentators’ suggestions to respect foreign law for this purpose, the regulations, through Example (24), seem to offer taxpayers a variety of options under which the allocation of foreign tax expense may either satisfy the safe harbor for CFTEs or be deemed to be found in accordance with the partners’ interest in the partnership, including one in which the rejected comment appears in fact to have been followed. Careful attention will need to be paid to the treatment and reporting of CFTEs by partnerships with interbranch transactions.

From Marjorie Rollinson, J.D., Washington, DC