Taxpayer comments on the revisions to reg. section 1.861-20 in new proposed regs question rules that require using asset tax book values as a proxy for the payer’s earnings when remittances are made by a disregarded entity. Taxpayers noted the distortive effects of rules that use asset tax book values when assigning foreign taxes imposed on disregarded remittances to statutory and residual groupings.
Published November 22, 2022, new proposed regs (REG-112096-22) provide additional guidance on the reattribution of disregarded payments. The proposed regs supplement final foreign tax credit regs published in 2020 and 2022.
On December 17, 2019, Treasury and the IRS published proposed regs (REG-105495-19) addressing changes made by the Tax Cuts and Jobs Act and other related FTC rules. The 2019 FTC proposed regs were finalized in T.D. 9922, published November 12, 2020.
Also that day, Treasury and the IRS published additional proposed FTC regs (REG-101657-20). The 2020 proposed FTC regs were finalized in T.D. 9959, published January 4, 2022.
The new proposed FTC regs address:
- the definition of a reattribution asset as the basis for allocating and apportioning foreign income taxes under reg. section 1.861-20;
- the cost recovery requirement for FTC eligibility in reg. section 1.901-2; and
- the source-based attribution requirement and withholding tax on royalty payments under reg. sections 1.902-1 and 1.903-1.
Reg. Section 1.861-20ection 861(a)-(e) generally addresses U.S.-source income. Section 861(a)(1)-(9) lists U.S.-source income items, while section 861(b) provides guidance on allocating and apportioning expenses, losses, and other deductions to the income items list to calculate U.S.-source taxable income.
Reg. section 1.861-20(a)-(i) addresses the allocation and apportionment of foreign income taxes to income and to separate income categories. The guidance has:
- an overview of the rules;
- 26 definitions;
- a general three-step process for allocating and apportioning foreign income taxes;
- rules for assigning foreign gross income to statutory and residual groupings (revised by the new proposed regs);
- rules for allocating and apportioning foreign law deductions to foreign gross income in the statutory and residual groupings;
- rules for apportioning foreign income taxes among statutory and residual groupings;
- 13 examples;
- rules for allocating and apportioning section 903 in lieu of taxes; and
- applicability dates.
According to paragraph (a), these rules apply except as modified under the rules for an operative section, described in reg. section 1.861-8(f)(1) as a code provision that requires the determination of taxable income from specific sources or activities and gives rise to statutory groupings.
Under the general rule for allocation and apportionment of foreign income taxes in paragraph (c), a foreign income tax is allocated and apportioned to the statutory and residual groupings that contain the foreign gross income included in the tax base. Each separate levy of foreign income tax is allocated and apportioned separately under the rules in paragraphs (c)-(f).
A foreign income tax is allocated and apportioned to or among the statutory and residual groupings under a three-step process described in subparagraphs (c)(1)-(3):
- first, by assigning the items of foreign gross income to the groupings under paragraph (d);
- second, by allocating and apportioning the deductions allowed under foreign law to the foreign gross income in the groupings under paragraph (e); and
- third, by allocating and apportioning the foreign income tax by reference to the foreign taxable income in the groupings under paragraph (f).
Foreign Gross Income
The new proposed regs revise the first step in paragraph (d) that assigns foreign gross income to groupings. The guidance in reg. section 1.861-20(d)(1)-(3) contains:
- a general rule that applies when the taxed foreign gross income item has a corresponding U.S. item;
- rules for income items that have no corresponding U.S. items; and
- special rules for assigning specific items of foreign gross income to a statutory or residual grouping.
The income and asset attribution rules are in subdivision (d)(3)(i)-(vi), which provides special rules for assigning specific items of foreign gross income to statutory or residual groupings. The guidance clarifies treatment of:
- foreign gross income that a taxpayer includes because of its ownership of an interest in a corporation;
- foreign gross income that a taxpayer includes because of its ownership of an interest in a partnership;
- foreign law inclusion regime income;
- gain on the sale of a disregarded entity;
- disregarded payments; and
- foreign gross income included because of U.S. equity hybrid instrument ownership.
The proposed regs revise the rules in subdivision (d)(3)(v) for assigning disregarded payments.
Reg. section 1.861-20(d)(3)(v)(A)-(E) assigns to a statutory or residual grouping foreign gross income that a taxpayer includes because it receives a disregarded payment.
Under subdivision (d)(3)(v)(A), if the taxpayer is an individual or a domestic corporation, subdivision (d)(3)(v) applies to disregarded payments made between:
- a taxable unit that is a foreign branch, foreign branch owner, or non-branch taxable unit; and
- another taxable unit of the same taxpayer.
If the taxpayer is a foreign corporation, subdivision (d)(3)(v) applies to disregarded payments made between taxable units that are tested units of the same taxpayer.
Subdivision (d)(3)(v)(B) attributes U.S. gross income comprising the portion of a disregarded payment that is a reattribution payment to a taxable unit and associates the foreign gross income item arising from the receipt of the reattribution payment with the statutory and residual groupings to which that U.S. gross income is assigned.
Subdivision (d)(3)(v)(C) assigns to statutory and residual groupings items of foreign gross income arising from the receipt of the portion of a disregarded payment that is a remittance or a contribution.
Subdivision (d)(3)(v)(D) assigns to statutory and residual groupings items of foreign gross income arising from disregarded payments, other than the portions of disregarded payments that are reattribution payments in connection with disregarded sales or exchanges of property.
Subdivision (d)(3)(v)(E) provides nine definitions that apply to interpret subdivision (d)(3)(v) and the examples in paragraph (g).
Remittances and Contributions
Subdivision (d)(3)(v)(C)(1)-(3) addresses remittances and contributions and provides an ordering rule for both.
Remittances. An item of foreign gross income that a taxpayer includes because it receives a remittance by a taxable unit is assigned to the statutory or residual groupings of the recipient taxable unit that correspond to the groupings out of which the payer taxable unit made the remittance under the rules of subdivision (d)(3)(v)(C)(1)(i).
A remittance paid by a taxable unit is considered to be made ratably out of all the taxable unit’s accumulated after-tax income. That after-tax income is deemed to have arisen in the statutory and residual groupings in the same proportions as those in which the tax book value of the taxable unit’s assets is assigned to apportion interest expense under the asset method in reg. section 1.861-9 in the tax year in which the remittance is made.
If the payer taxable unit is determined to have no assets under subdivision (d)(3)(v)(C)(1)(ii), then the foreign gross income that is included because of the receipt of the remittance is assigned to the residual grouping.
Subdivision (d)(3)(v)(C)(1)(ii) addresses the determination of a taxable unit’s assets. It provides that the assets are determined under reg. section 1.987-6(b), except that to apply reg. section 1.987-6(b)(2) under subdivision (d)(3)(v)(C)(1)(ii), a taxable unit is deemed to be a section 987 qualified business unit (within the meaning of reg. section 1.987-1(b)(2)).
A taxable unit’s assets are:
- stock it holds;
- the portion of the tax book value of a reattribution asset that is assigned to the taxable unit; and
- the taxable unit’s pro rata share of the assets of another taxable unit (other than a corporation or a partnership) in which it owns an interest.
A taxable unit’s pro rata share of another taxable unit’s assets includes the portion of its reattribution assets assigned to that other taxable unit in which it owns an interest.
If a taxable unit owns an interest in a taxable unit that is a partnership, the assets of the taxable unit that is the owner include its interest in the partnership or its pro rata share of the partnership assets, as applicable, determined under the principles of reg. section 1.861-9(e).
The portion of the tax book value of a reattribution asset that is assigned to a taxable unit is an amount that bears the same ratio to the total tax book value of the reattribution asset as the sum of the attribution items of that taxable unit arising from gross income produced by the reattribution asset bears to the total gross income produced by the reattribution asset:
Asset tax book value assigned to taxable unit = total tax book value * (income produced by asset attributed to taxable unit/total income produced by asset)
The portion of a reattribution asset that is assigned to a taxable unit under subdivision (d)(3)(v)(C)(1)(ii) is not treated as an asset of the taxable unit making the reattribution payment when applying subdivision (d)(3)(v)(C)(1)(i).
Contributions. Under subdivision (d)(3)(v)(C)(2), an item of foreign gross income that a taxpayer includes because it receives a contribution by a taxable unit is assigned to the residual grouping. However, reg. section 1.904-6(b)(2)(ii) assigns some items of foreign gross income to the foreign branch category when section 904 is the operative section.
Ordering Rule. Under subdivision (d)(3)(v)(C)(3), if both a reattribution payment and either a remittance or a contribution result from a single disregarded payment, the foreign gross income is first attributed to the portion of the disregarded payment that is a reattribution payment to the extent of the amount of the reattribution payment. Any excess is then attributed to the portion of the disregarded payment that is a remittance or contribution.
Subdivision (d)(3)(v)(E)(2) defines a contribution as the excess amount of a disregarded payment, other than a disregarded payment received in exchange for property, made by a taxable unit to another taxable unit that the first unit owns, over any portion of the disregarded payment that is a reattribution payment.
Subdivision (d)(3)(v)(E)(4) defines a disregarded payment as an amount of property (within the meaning of section 317(a)) that is transferred to or from a taxable unit in a transaction that is disregarded under U.S. law, and that is reflected on the taxable unit’s separate set of books and records, including:
- a transfer of property that would be a section 118 contribution to capital if the taxable unit were a corporation under U.S. law;
- a transfer that would be a section 351 transaction if the taxable unit were a corporation under U.S. law;
- a transfer of property that would be a distribution by a corporation to a shareholder related to its stock if the taxable unit were a corporation under U.S. law;
- a payment in exchange for property or in satisfaction of an account payable; or
- any other amount reflected on the taxable unit’s separate books and records in connection with a transaction disregarded under U.S. law that would generate income, gain, deduction, or loss for the taxable unit if the transaction were regarded under U.S. law.
Subdivision (d)(3)(v)(E)(6) defines a reattribution asset as an asset that produces one or more items of gross income, computed under U.S. law, to which a disregarded payment is allocated under the rules of subdivision (d)(3)(v)(B)(2).
Subdivision (d)(3)(v)(E)(7) defines a reattribution payment as the portion of a disregarded payment equal to the sum of all reattribution amounts that are attributed to the recipient of the disregarded payment.
Subdivision (d)(3)(v)(E)(8) defines a remittance as the excess amount, other than an amount that is treated as a contribution under subdivision (d)(3)(v)(E)(2), of a disregarded payment, other than a disregarded payment received in exchange for property, made by a taxable unit to a second taxable unit (including a second taxable unit that has the same owner as the payer taxable unit) over any portion of the disregarded payment that is a reattribution payment.
Under subdivision (d)(3)(v)(E)(9), if the taxpayer is an individual or domestic corporation, a taxable unit is a foreign branch, a foreign branch owner, or a non-branch taxable unit, as defined in reg. section 1.904-6(b)(2)(i)(B). If the taxpayer is a foreign corporation, a taxable unit is a tested unit, as defined in reg. section 1.951A-2(c)(7)(iv)(A).
Proposed Regs and Preamble
The new proposed regs revise the definition of reattribution asset in subdivision (d)(3)(v)(E)(6). New prop. reg. section 1.861-20(d)(3)(v)(E)(6) defines reattribution asset as an asset that produces one or more items of gross income, computed under U.S. tax law, to which a disregarded payment, other than a disregarded payment received in exchange for property, is allocated under the rules of subdivision (d)(3)(v)(B)(2).
The new proposed definition does not apply the asset reattribution rule to disregarded payments received in exchange for property. The proposed regs’ preamble provides a useful description of the rationale behind narrowing the definition of a reattribution asset.
Reg. section 1.861-20(d)(3)(v)(B) assigns foreign gross income from a disregarded payment that is a reattribution payment to the same statutory and residual grouping as the U.S. gross income that is reattributed to the recipient taxable unit. This assignment occurs before taking into account any reattribution payments made by the recipient taxable unit.
Foreign gross income included because of a remittance is assigned to the statutory and residual groupings by reference to the proportion of the tax book value of the assets of the remitting taxable unit in the groupings as assigned to apportion interest expense (see reg. section 1.861-20(d)(3)(v)(C)(1)(i)). In other words, the character of the assets of the remitting taxable unit is a proxy for the character of the current and accumulated earnings out of which the remittance is made.
To reflect the character of the remitting taxable unit’s earnings more accurately, the reattribution asset rule in reg. section 1.861-20(d)(3)(v)(C)(1)(ii) requires that a reattribution of income from a payer taxable unit to a recipient taxable unit cause a concomitant reattribution of the tax book value of the payer taxable unit’s assets that generated the reattributed income from the payer to the recipient.
After further study, Treasury and the IRS have concluded that the reattribution asset rule is not needed for allocating and apportioning foreign tax on a remittance for disregarded property sales, especially disregarded sales of inventory property.
The preamble describes an example that assumes an inventory sale between the branches instead of a royalty payment. A domestic corporation directly owns two taxable units that are disregarded under U.S. law. Disregarded entity DE1 manufactures inventory property, and DE2 distributes inventory property to unrelated customers. DE1 sells the manufactured inventory to DE2 in exchange for a disregarded payment. The disregarded payment becomes a reattribution payment when DE2 sells the inventory property to a customer and generates gain in a transaction that is regarded under U.S. law.
Therefore, gain from the sale of the inventory is reattributed from the distributing taxable unit (DE2) to the manufacturing taxable unit (DE1), and a portion of the distributing taxable unit’s assets is reattributed to the manufacturing taxable unit. Although the assets of the manufacturing taxable unit contributed to the production of the income of both taxable units, the tax book value of the manufacturing taxable unit’s assets is not reattributed to the distributing taxable unit.
As a result, by reattributing assets only from the distributor taxable unit to the manufacturing taxable unit, the reattribution asset rule does not more accurately balance among the taxable units all the assets that produced the gain from the inventory sale. The reattribution of assets instead changes the ratios of the assets considered held by the taxable units such that a greater percentage of the distributor taxable unit’s assets consists of non-inventory assets (for example, cash), and a greater percentage of the manufacturing taxable unit’s assets consists of inventory.
Prop. reg. section 1.861-20(d)(3)(v)(E)(6) retains the general definition of reattribution asset but excludes any portion of the tax book value of property transferred in a disregarded sale from being attributed back to the selling taxable unit. Comments are requested on whether similar revisions should be made to the reattribution asset rule in situations other than disregarded property sales. Comments are also requested on other issues related to the allocation and apportionment of foreign income taxes to disregarded payments, which may be considered in future guidance projects.
Comments on prop. reg. section 1.861-20(d)(3)(v) view the narrower definition of attribution asset in subdivision (d)(3)(v)(E)(6) favorably, but nonetheless noted the distortive results of the remaining rules for disregarded remittances. The most frequent comment was that asset tax book values were a poor proxy for earnings. Commentators also noted the one-way nature of the reattribution asset rule.
Suggestions for improvement included using a three-year rolling average to characterize the earnings that funded remittances, special rules for cash and working capital, using current-year earnings to characterize remittances, using asset fair market values instead of tax book values, and allowing taxpayers to elect some of these alternative methods.
Tax Book Value
According to the Alliance for Competitive Taxation (ACT), the tax book value method often assigns value to assets that are not producing the earnings distributed or assigns no value to assets that generate most of the taxable unit’s income. According to the Business Roundtable, using the tax book value of assets as a proxy for accumulated after-tax income has a materially distortive effect that separates taxes from the income to which they relate, potentially causing permanent loss of FTCs.
Danielle Rolfes of KPMG (who is a member of Tax Analysts’ board of directors) provides an example to illustrate the distortions from using asset tax book values that was similar to the example in the proposed regs’ preamble — except that a controlled foreign corporation owns the disregarded entities instead of a U.S. corporation. The CFC owns 100 percent of the stock of DRE1, a Country X corporation, and DRE2, a Country Y corporation. DRE1 and DRE2 are disregarded entities under U.S. law. The CFC, DRE1, and DRE2 all use a calendar tax year for local and U.S. tax purposes.
DRE1 owns manufacturing equipment that it uses to produce inventory in Country X, incurring costs of $150. DRE2 purchases the finished inventory from DRE1 for $230 and sells it to customers in Country Y for $250. DRE1 and DRE2 purchase and sell the inventory 30 times during the year, yielding $3,000 total gross income (($80 + $20) * 30), $600 of which is attributable to DRE2. DRE2 incurs $237.50 of sales expenses and has $362.50 of pretax net income.
The tax book value of DRE1’s assets in 2020 is $1,000, all of which is used to manufacture the inventory. The tax book value of DRE2’s assets is $1,000, $600 of which is attributable to operating assets that produce tested income and $400 of which is attributable to cash in an interest-bearing account with a bank in Country Y. DRE2 earns $12.50 of interest on its deposit during 2020.
Country Y imposes a 20 percent corporate income tax on all of DRE2’s earnings. Therefore, before any distributions, and after giving effect to all disregarded payments to or from DRE2 that would be treated as reattribution payments under reg. section 1.861-20(d)(3)(v)(B), DRE2’s current-year after-tax net income is $300 ($375 pretax net income [$362.50 + $12.50] – $75 tax). Of that amount, $290 is attributable to general limitation tested income ($600 gross income from sales – ($237.50 sales expense + $72.50 tax)). The remaining $10 is attributable to passive foreign personal holding company income (FPHCI) ($12.50 interest income – $2.50 tax).
DRE2 makes a $500 distribution to CFC that is treated under Country Y law as a dividend subject to a 10 percent Country Y withholding tax of $50. DRE2’s operations have consistently generated the same amount of after-tax general limitation tested income ($290) and passive FPHCI ($10) each year. Before the distribution, DRE2’s aggregate accumulated after-tax earnings are $1,500, $1,450 of which is attributable to general limitation tested income and $50 of which is attributable to passive FPHCI.
If the proposed regs are adopted, the foreign gross income recognized by CFC under Country Y law from the $500 remittance is assigned to groupings based on the tax book value of DRE2’s assets in the FTC baskets and income groups. The proposed regs revise the definition of reattribution asset to exclude disregarded purchases of property from the reattribution payments that give rise to reattribution assets.
Therefore, because DRE2 only makes reattribution payments in exchange for property, the reattribution asset rules would not apply. Therefore, DRE2 has $1,000 of assets, $600 of which produces general limitation tested income and $400 of which produces passive FPHCI. The $50 withholding tax on the dividend would be assigned 60 percent ($30) to general limitation tested income and 40 percent ($20) to passive FPHCI, even though 97 percent of DRE2’s accumulated earnings were attributable to general limitation tested income ($1,450/$1,500) and 3 percent to passive FPHCI ($50/$1,500).
CFC has a deficit in the passive FPHCI income group of $10 ($10 interest income – $20 withholding tax), which means that CFC’s U.S. shareholder will not have a subpart F income inclusion for passive FPHCI and therefore will not be able to claim an FTC for any portion of the $20 withholding tax assigned to passive FPHCI.
Rolfes identifies four main factors that create the distortion in the apportionment of the withholding tax on the remittance: expected returns on passive versus active assets; multiple inventory turns; the inability to distribute earnings; and low-basis operating assets and high-basis passive assets.
Expected returns on assets. DRE2’s distribution activities generate general limitation tested income that represents most of the earnings remitted and is generally held in cash until it can be distributed. DRE2’s balance sheet consists primarily of high-yield and low-basis inventory and low-yield, high-basis cash. The cash deposits are short-term investments of DRE2’s active earnings. Therefore, the yield on those assets will always be a small fraction of the general limitation tested income that gives rise to the cash deposits.
Returns on operating assets typically exceed returns on passive investment holdings. As a result, the tax book value method overallocates foreign taxes to passive income when it is applied to a taxable unit with operating assets and passive investments.
Multiple inventory turns. Units of inventory remaining on hand at the end of a year are typically a small fraction of the units sold during the year and inventory turns frequently during the year. As a result, the tax book value of the inventory on hand at any time is not a good proxy for income earned from sales during a year. While average inventory values may be a good proxy for determining debt attributable to inventory to allocate and apportion interest expense because the debt is assumed to be incurred to own the assets, average asset values bear no relationship to the income attributable to the inventory for a year. An even more extreme example is a reseller of services, which would not even have inventory on hand.
Distribution obstacles. In most major jurisdictions that impose withholding tax on dividends (including India, China, and Korea), it is difficult to pay interim dividends because the procedures to distribute earnings can be initiated only after the statutory books for that year are closed and audited. Therefore, the opening and closing balance sheets generally will reflect the proceeds from at least a year of sales even for companies that repatriate all their earnings as quickly as possible. Cash on hand may exceed even that amount. Moreover, many jurisdictions impose exchange control limitations on cash remittances.
The Business Roundtable also describes how taxpayers that generate cash from collecting receivables for goods or services sold into foreign markets often face practical and legal restrictions on the ability to distribute interim dividends, so they maintain significant cash balances throughout the year.
Asset bases. The tax basis of cash and passive investments is typically equal or close to FMV, while the tax basis of operating assets may be significantly less than FMV, especially low-basis intangible property that drives active earnings.
In the example, the tax book value of the inventory on DRE2’s books is effectively marked down to remove DRE1’s gross margin on the intercompany sale. This markdown of DRE2’s inventory significantly understates the value of its operating assets under U.S. law compared with the value used in Country Y for applying the arm’s-length standard.
All these factors cause the use of a balance sheet approach to allocate taxes from remittances to produce less-than-ideal results, particularly for distributors and resellers of services. Also, the characterization of mixed-category assets (or assets that produce different categories of income) is not any more stable than current-year earnings.
Assets are generally characterized under the tax book value method based on the gross income they generate in the current year. If a taxable unit generates tested income for several years and then changes its operations before the beginning of a year to produce only foreign base company sales income in that year, 100 percent of a remittance out of the accumulated earnings would be characterized as giving rise to general basket FTCs in a subpart F income group. Therefore, the use of the tax book value method presents the same potential for manipulation as current-year earnings.
The effect of the current rules in the example is to overallocate foreign taxes to the passive category and away from the tested income to which the taxes are properly attributable. The result is detrimental to the taxpayer because none of the taxes attributed to passive FPHCI can be credited. Under different facts, however, the asset method could allow foreign taxes to be overallocated to a category in which they could be credited.
According to Rolfes, the rules should focus on whether the alternative produces a result that will be more accurate than the tax book value method, and not whether the method replicates the result of fully tracing remittances by tracking accumulated earnings over time. Alternatives suggested by commentators include:
- using a three-year rolling average to characterize remittances;
- special rules for cash and cash equivalents;
- using asset FMVs instead of tax book values; and
- allowing taxpayers to make elections for alternative methods.
Three-year rolling average. Using a three-year rolling average of earnings instead of asset tax book values was the most popular commentator suggestion. According to the Business Roundtable, a proxy based on a three-year average of annual earnings would be as administrable as, and more accurate than, a proxy based on the tax book value of assets, especially given the requirement to reassign assets from taxable units that make disregarded payments. It would also be more administrable than tracing a remittance to specific accumulated earnings and would address government concerns about manipulation that could occur under an approach that looks only to current-year earnings.
Rolfes suggests that it is most appropriate to characterize foreign gross income from a remittance based on the after-tax accumulated earnings from which the remittance is made. Consistent with that objective, a proxy derived from earnings is preferable to using the tax book value of assets as a proxy. New proposed regs should replace or supplement the asset method with an earnings method.
An earnings method could either require or permit an election to use a rolling three-year average of the earnings attributable to a remitting taxable unit (determined after taking into account any disregarded payments) as a proxy for the accumulated earnings out of which a remittance is made. A rolling multiyear average prevents a taxpayer from manipulating current-year earnings to change the characterization of a distribution that reflects earnings accumulated across multiple years.
Calculating a three-year average of a remitting taxable unit’s earnings does not add to complexity or administrative burdens. Taxpayers already report detailed information about gross income, expenses, and taxes separately for each taxable unit (see forms 8858 and 5471). Taxpayers must already determine gross income attributable to a taxable unit to characterize the income subject to foreign income tax at the unit level, and also allocate expenses to determine taxable income in the groups for the FTC limitation, and subpart F and global intangible low-taxed income inclusions. These rules already require FPHCI allocations to the taxable unit level, and the rules for the GILTI high-tax exclusion provide detailed guidance for allocating expenses to calculate net income in the groupings that are attributable to taxable units.
If the government is reluctant to unilaterally impose a requirement to track three years of earnings, the approach could be implemented as an election that cannot be revoked without the consent of the commissioner, that must be applied consistently to all remittances, and that requires taxpayers to demonstrate a reliable three-year schedule of earnings for all electing taxable units.
Use of a three-year rolling average in Rolfes’s example would cause the foreign gross income from the $500 distribution to be characterized as 97 percent general limitation tested income ($483) and 3 percent passive FPHCI ($17).
Citing the preamble to T.D. 9959, the ACT notes that the government did not adopt a current-year earnings method because current earnings may have already been accounted for through reattribution payments, may not reflect all of the taxable unit’s assets, and could be subject to manipulation through the timing of disregarded payments in any particular year.
The organization notes, however, that the three-year rolling average would take place after any reattribution payment and therefore would not include any earnings characterized under reg. section 1.861-20(d)(3)(v)(B)(1). Because the characterization is made on a rolling three-year average, the taxpayer’s ability to manipulate the average will be diminished because they would not be able to take advantage of volatility in the character of the payer taxable unit’s earnings in any particular year. Finally, using a three-year average as a proxy for total accumulated earnings will reduce distortions compared with either an asset-based tax book value method or an approach based on a single year of earnings.
Cash up to current earnings. If retained, the tax book value method should be modified to reduce its distortionary impact. The current rules potentially treat cash generated by an active business as a passive asset by reference to its yield rather than the activities that generated the cash. A rule in reg. section 1.861-20(d)(3)(v) could characterize an amount of cash up to a taxable unit’s current-year earnings by reference to those earnings.
An application of this rule in Rolfes’s example assumes DRE2’s cash balance is $100 at the beginning of the year and $150 at the end of the year, and its current-year earnings are $110. Under the proposed rule, $110 of the $125 average cash balance would be characterized based on DRE2’s current-year earnings, and the remaining $15 would be characterized under the general rules in reg. section 1.861-9T(g)(3). Those rules characterize assets according to the source and type of income they generate, have generated, or may be expected to generate to allocate and apportion for interest expense.
Of the $400 tax book value of the cash deposit, $300 would be assigned based on current-year earnings ($290 to general tested income and $10 to passive FPHCI), with the remaining $100 assigned under the tax book value method to passive FPHCI. The $500 remittance would be assigned 89 percent to general tested income and 11 percent to passive FPHCI.
Remittance up to current earnings. Alternatively, a new rule could treat remittances in a tax year as first attributable to the extent of the earnings generated in that year. The tax book value method would be used only to characterize foreign gross income to the extent aggregate remittances exceeded the taxable unit’s earnings for that year. This rule is similar to the existing rules for regarded distributions by corporations, which only use the tax book value method after taxes have been allocated based on the distributor’s earnings.
In Rolfes’s example, the $500 remittance exceeds the $300 current-year earnings by $200. Using this method, $300 of the remittance would be assigned based on current-year earnings ($290 to general tested income and $10 to passive FPHCI). The remaining $200 would be characterized under the tax book value method (60 percent of the $200 to general tested income and 40 percent to passive FPHCI). As a result, 82 percent of the remittance would be assigned to general tested income, and the remaining 18 percent would be assigned to passive FPHCI.
In the example, all three alternative suggestions above provide a better proxy for earnings that fund the remittance than asset tax book values (see table).
Other. Additional suggestions include making the reattribution asset rule elective, treating cash and receivables as nonpassive assets, using asset FMVs rather than tax book values, and using an elective tracing mechanism.
The Business Roundtable recommends that if a three-year rolling average is not adopted, then the reattribution asset rule in reg. section 1.861-20(d)(3)(v)(C)(1)(ii) should be elective. The rule increases the complexity of the tax book value computation without improving its accuracy. Moreover, intellectual property-driven businesses may not have significant amounts of tax basis to move, causing the requirement to transfer basis to become a nuisance.
The ACT, the Business Roundtable, and Rolfes recommend that cash and receivables be treated as nonpassive assets. Rolfes’s example assumes that cash is characterized as a passive asset, but notes there is uncertainty regarding the proper characterization of cash that is held as working capital in an active trade or business.
Because of cash sweeps and other intercompany financing arrangements, cash may be converted to short-term receivables before being used to fund operations. A payer taxable unit may have a large amount of cash or cash equivalents on its balance sheet that could be viewed as passive assets because they generate interest income. This ignores the fact that cash is generating only an incidental amount of accumulated earnings.
To address this distortion, the ACT suggests that taxpayers be provided with a working capital exception for cash and cash equivalents held to fund operations similar to prop. reg. section 1.1297-1(d)(2). These passive foreign investment company regs provide an exception to the general approach of treating cash as a passive asset and allow working capital held in a non-interest-bearing account to be treated as a nonpassive asset. However, the rule should not be limited to non-interest-bearing accounts.
The ACT also recommends an FMV method that would take into account assets that would otherwise not be considered in the tax book value method. For example, IP often has little to no tax basis and therefore does not contribute to assigning foreign gross income to the statutory and residual groupings under the tax book value method. However, IP may be the principal contributor to the gross income earned by a taxable unit and may have FMV exceeding nearly all other assets on a taxable unit’s balance sheet. Taxpayers should be provided with the opportunity to align asset values with the tax unit’s economic realities.
The organization believes a tracing mechanism should be provided to taxpayers on an elective basis to address cases in which neither tax book values nor FMVs align with the economics of the business. For example, a CFC owns two disregarded entities, DRE1 and DRE2, and the CFC is a full inclusion entity as defined in reg. section 1.954-1(b)(1)(ii). DRE1 earns only subpart F income, and DRE2 earns only tested income. DRE2 makes a remittance as defined in reg. section 1.861-20(d)(3)(v)(C) and incurs a local country withholding tax.
Under either a tax book value method or an FMV method, a portion of the foreign gross income could be assigned to the tested income category because DRE2 owns assets that produce solely tested income. However, because the CFC is a full inclusion entity, if DRE2’s taxes are assigned to the tested income grouping, the CFC has no income within the tested income grouping to support FTCs. The income and taxes are separated from one another, and the CFC suffers double taxation.
If taxpayers are allowed to match the foreign gross income to the accumulated earnings of taxable unit DRE2, no separation would occur because the income and taxes would be assigned to the same statutory and residual groupings. The income earned by DRE2 would be full inclusion income at the CFC level. While the taxpayer may incur additional complexity and administrative costs, those costs could be warranted to achieve a more precise answer. For administrative ease, because the rule related to allocation and apportionment of foreign taxes for remittances is effective for tax years beginning after December 31, 2019, the ACT recommends limiting the tracing to earnings accumulated in those years.
Rolfes notes that the rules could provide that the assets of a taxable unit that receives a reattribution payment could also be reattributed to the payer taxable unit but does not recommend this modification. Allowing two-way reattribution would not address the fundamental flaws of the tax book method, while potentially making the asset reattribution rule too complex to administer for taxpayers that have multiple disregarded entities and products with their own unique disregarded supply chains.
Applicable dates and retroactive relief. Rolfes recommends that any new guidance be provided through proposed regs that permit taxpayers to rely on them for tax years back to the applicability date of the current final regs until new final regs are issued.