October 16, 2020 / North America
On September 30th, Treasury and the IRS released finalized regulations (the “Final Regulations”) and proposed regulations (“2020 Proposed Regulations”) which make major changes to the calculation of foreign tax credits. The Final Regulations expand in important respects on proposed regulations released in 2019 (“2019 Proposed Regulations”), and will require taxpayers to develop new methods and procedures for return preparation. The 2020 Proposed Regulations re-propose some of the rules that were included in the 2019 Proposed Regulations (e.g., the allocation and apportionment of deductions for purposes of calculating foreign tax credits) and contain other notable rules. This alert highlights several of the key changes in the Final Regulations and provides observations on portions of the Proposed Regulations.
The tax treatment of stewardship expenses is often given scant attention by taxpayers in preparing their returns, but takes on increased significance under the Final Regulations. The 2019 Proposed Regulations expanded the definition of stewardship expenses to include costs related to ownership of partnership interests, in addition to the stock of corporations as under prior law. The Final Regulations further expand the scope of stewardship expenses to include expenses that are incurred with respect to foreign and domestic business entities of any kind, including disregarded entities (but not foreign branches). The Final Regulations also provide that stewardship expenses are allocated to interests in entities based on the factual relationship between the expense and the entities, and further apportioned based on the tax book value of the stock, partnership interests, or assets to which the expenses relate.
Research and Experimentation Expenses
As with stewardship expenses, the Final Regulations generally retain the significant changes included in the 2019 Proposed Regulations to the allocation and apportionment approach of research and experimentation (R&E) expenses. These include significant modifications to the manner in which R&E expenses are allocated and apportioned for foreign tax credit purposes. The regulations provide that R&E expenses are allocable to a new category of “gross intangible income” (GII) which includes all gross income earned by the taxpayer attributable to intangible property, including gross income from sales, services, royalties and amounts taken into account under Section 367(d)(relating to outbound transfers of intangible assets), but not dividends or inclusions as a result of subpart F or GILTI. R&E expenses will be allocated only to GII according to the SIC codes with which the GII is reasonably connected. The regulations eliminate the former “gross income” apportionment method, leaving the sales apportionment method as the only available method. As a result, taxpayers who relied on the gross income method will have to develop new procedures from scratch. It will be necessary to identify items (including disregarded payments) included in GII, the SIC codes to which they relate, and the foreign tax credit basket into which they fall. The Final Regulations clarify several other issues, including the interaction of the foreign branch basket rules with the new GII standard and the inapplicability of exclusive apportionment rules in determining a taxpayer’s foreign derived intangible income (FDII). In addition, the 2020 Proposed Regulations include an election by which taxpayers may capitalize and amortize their R&E (and advertising) expenses, strictly for the purposes of allocating and apportioning their interest expenses as part of the FTC limitation calculation, instead of having them claimed as a deduction…
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