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New Rules on FTC Allocations Temporary regulations address how to allocate foreign income tax among partners of partnerships formed after April 20, 2004. This article reviews the basic allocation rules and details the temporary regulations safe harbor.
Paul C. Lau, CPA, ABV, CMA For more information about this article, contact Mr. Lau at Plau@blackmankallick.com.
Last year, the IRS issued temporary regulations1 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 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 partners distributive share of income, gain, loss, deduction 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, 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 Regs. Sec. 1.704-1(b)(2)(ii) and (iii). It has economic effect if the partnership agreement provides the following throughout its term:
Under Regs. Sec. 1.704-1(b)(2)(iii), an allocations economic effect is substantial if there is a reasonable chance that it will 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 partners after-tax economic consequences may (in present value terms) be enhanced in comparison to the results without such allocation and (2) no partners after-tax economic consequences will (in present value terms) be substantially diminished 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 deductions, cannot have substantial economic effect. Accordingly, they must be allocated in accordance with the partners interests.
Foreign Income Tax Allocations According to Sec. 702(a)(6), each partner takes into account separately his or her distributive share of the partnerships foreign income taxes. Under Sec. 901(b)(5), a partner can, subject to certain limits, qualify for a foreign tax credit (FTC) for a distributive share of foreign income taxes paid or accrued by the partnership. The partnership is not entitled 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 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 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 against a partners 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 Regs. 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 Regs. 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 FTCs underlying purposes (i.e., to avoid double taxation of foreign-source income) and limitation (i.e., to prevent FTCs from offsetting taxes attributable to U.S.-source in-come). Also, the safe harbor tries to achieve greater parity 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 to the partners share of the income subject to the foreign tax. The partner would take into account this amount of foreign tax in computing 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 partnerships foreign tax expenditures proportionate to the partners 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 partners interest is determined by taking into account all the facts and circumstances relating to 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 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 partnerships 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, 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 rules.
Because the tax allocation is consistent with the allocation of income that generated the foreign taxes, it falls within the safe harbor.
Because the allocations of X and Y taxes follow the allocations of income to which they relate, they qualify for the safe harbor.
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.
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 below.
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. |
