Surprisingly, in the midst of the COVID-19 emergency, final regulations under Section 901(m) were published. While important for M&A transactions, Section 901(m) had largely been treated as an afterthought in light of the TCJA changes to the foreign tax credit regulations. While the final regulations generally adopt the proposed and temporary regulations as issued, including all of their complexity, some changes were made in response to comments. The most significant details of the final regulations are as follows.
- No new transactions were added to the six transactions previously identified by the statute and the proposed regulations as a Covered Asset Acquisition (CAA)
- Treasury and the IRS declined to narrow the application of the sixth identified transaction (“Sixth CAA,” as described below) that commentators believed to be too broad and inconsistent with the spirit of the CAA transactions identified in the statute
- The definition of “aggregate basis difference” was modified to generally provide a limited effective exemption for CAAs to the extent gain or loss was recognized by the US taxpayer eligible to claim the foreign tax credits or a member of its consolidated group
- The election to use foreign basis is permitted to be made retroactively provided the taxpayer applies the final regulations consistently to CAAs occurring after 2010 for all open years and adjusts any refund claim for deficiencies that would have arisen from applying the regulations to closed years
- The aggregate basis difference carryover, which modifies the calculation provided in the statute to prevent the avoidance of the purposes of Section 901(m) by the permanent separation of basis recovery from the relevant foreign taxes, is reaffirmed
- Declined to raise the general de minimis thresholds as requested by commentators, but eliminated the reduced thresholds for related parties and added a new de minimis rule that disregards any basis difference for an individual foreign asset that is less than $20,000
- In Section 901(m)/909 overlap cases, Section 901(m) applies first to disqualify foreign taxes from being credited, and the deduction with respect to such disqualified taxes may then be subject to deferral under Section 909
Refresher on Section 901(m)
Section 901(m) generally limits the foreign taxes that may be credited against a taxpayer's US tax liability when the taxpayer makes a CAA and the assets acquired have a higher US tax basis after the CAA than they did before the CAA. The foreign taxes attributable to that aggregate basis differential allocated to a particular taxable year are disqualified for foreign tax credit purposes but generally may be deducted.
The CAAs targeted by Section 901(m) are transactions that result in increased asset basis and corresponding cost-recovery deductions for US federal income tax purposes but not for foreign tax purposes, thereby creating a permanent difference between the income that is subject to foreign tax and income that is subject to US federal income tax. Prior to the enactment of Section 901(m), US foreign tax credits for the higher foreign taxes relative to US taxable income resulting from such transactions could be used to offset US tax on lower-taxed foreign income.
The following transactions are CAAs. The first three CAAs are statutorily mandated and the remaining three CAAs are added in the regulations under the authority granted to the Treasury Department by Section 901(m):
- Qualified stock purchase for which a Section 338 election is made;
- Asset purchase for U.S. tax purposes treated as a stock sale or disregarded under foreign tax law;
- Acquisition of an interest in a partnership with a Section 754 election in effect;
- Any transaction that is treated as an acquisition of assets for US federal income tax purposes and as the acquisition of an interest in a fiscally transparent entity for foreign tax purposes;
- Any transaction that is treated as a partnership distribution of one or more assets the US tax basis of which is determined by Section 732(b) or 732(d) or which causes the US tax basis of the partnership's remaining assets to be adjusted under Section 734(b), provided the transaction results in an increase in the US tax basis of one or more of the assets distributed by the partnership or retained by the partnership without a corresponding increase in the foreign basis of such assets; and
- Any transaction that is treated as an acquisition of assets for both US federal income tax purposes and foreign tax purposes, provided the transaction results in an increase in the US tax basis without a corresponding increase in the foreign basis of one or more assets (“Sixth CAA”)
Basic example of calculation of disqualified foreign tax amount:
CFC purchases Target on January 1 in Year 1 and makes a Section 338(g) election.
• Total stepped-up basis is $1,500,000 (all assets have a 15-year life)
• Basis immediately prior to acquisition was 0, so “basis difference” is $1,500,000
• Target pre-tax foreign income shown on the foreign income tax return for year 1 is $1 million and foreign tax is $250,000
Disqualified portion of year 1 tax:
$100,000 [$1,500,000 ÷ 15] x $250,000 [foreign taxes] = $25,000 disqualified foreign tax amount
$1,000,000 [foreign income]
Discussion of Specific Provisions
Narrow the broad reach of the sixth CAA
Commentators suggested that the broad reach of the Sixth CAA should be narrowed to apply only to specifically defined transactions that are likely to “hype” foreign tax credits and typically involve significant US tax planning. As written, the Sixth CAA applies to any transaction that is treated as an asset acquisition for both US federal income tax purpose and foreign tax purposes as long as the US tax basis is increased without a corresponding foreign tax basis increase. Commentators had argued that the broad reach of the provision combined with other aspects of the section 901(m) rules raised serious fairness and administrability concerns, and that the scope of the Sixth CAA should be limited to transactions that generally indicate US tax planning designed to generate excess foreign tax credits, similar to the CAAs identified in the statute. Treasury and the IRS declined to accept this comment, stating that Section 901(m) is designed to address any transaction that results in a basis difference for US and foreign tax purposes. Moreover, Treasury and the IRS explained that there is no policy justification for exempting transactions on the grounds that a transaction lacked an intent to hype foreign taxes.
| Eversheds Sutherland Observation: Treasury and the IRS specifically stressed that there is "no intent test" with respect to the application of Section 901(m). Thus, unless a transaction that results in a basis increase for US but not foreign tax purposes falls under the de minimis exception provided under the regulations, it will be subject to Section 901(m) regardless of taxpayer intent. Note that both the proposed and final Section 901(m) regulations provide an example of the application of the Sixth CAA where CFC1 transfers foreign assets to CFC2 in a Section 351 exchange with boot that is also an asset acquisition, though not taxable, for foreign tax purposes. The example concludes that the transaction is a CAA because it results in an increase in asset basis for US tax purposes, but not foreign tax purposes. |
Adjustment to aggregate basis difference where gains/losses recognized by relevant US taxpayer or a consilidated group member
Treasury and the IRS partially adopted a comment requesting an exemption from section 901(m) for a CAA where all or substantially all of the gains and losses with respect to the relevant foreign assets are recognized by a member of the US-parented group that includes the US taxpayer eligible to claim the foreign tax credits.
Treasury and the IRS agreed with the comment that an adjustment when gains and losses are fully recognized should be provided in certain cases, but stated that the request was overbroad as it would apply to gain recognized by US members of an affiliated group that do not file a consolidated return and by related controlled foreign corporations, which would allow for manipulation of foreign tax credits. As a result, the final regulations add a new rule that generally acts as a limited effective exemption by adjusting the aggregate basis difference to the extent the US taxpayer eligible to claim the foreign tax credits or a member of its consolidated group recognized the gains or losses for US federal income tax purposes as part of the original CAA or such taxpayer or a member of its consolidated group took into account a distributive share of such gains or losses recognized by a partnership.
| Eversheds Sutherland Observation: The new rule provided in the final regulations does NOT exempt an applicable transaction from being treated as a CAA as requested by Commentators. Rather, the taxpayer, in determining the amount of basis difference is permitted to make an adjustment to the aggregate basis difference depending on the amount of gain or loss recognized by a consolidated group member. Where all of the gain or loss is recognized by the US taxpayer or its consolidated group member, the result of that adjustment should generally be that there is no aggregate basis difference attributable to that CAA. Where only a part of the recognized gain is taken into account by the relevant US taxpayer, such as when the gain is recognized by a partnership with partners that are not members of the relevant consolidated group, there may still be a net aggregate basis difference, although it may be eliminated if it falls below the de minimis threshold. Qualification for the de minimis exception in material transactions is generally unlikely due to the low thresholds. Note that there is an anti-abuse rule for built-in losses acquired for the principal purpose of using one or more built-in loss assets to avoid the application of Section 901(m). This anti-abuse rule applies also to the de minimis rules. |
| Eversheds Sutherland Observation: The new rule provided in the final regulations only applies when the US taxpayer that takes the gain into account (or a member of its consolidated group) retains an interest in the foreign taxpayer sufficient to allow it to claim foreign tax credits, and thus typically will only apply in related-party transactions. |
Foreign basis election
The final regulations modify the consistency rule related to the foreign basis election, which permits a taxpayer to determine basis difference using the foreign tax basis of assets immediately after an acquisition rather than the pre-acquisition US tax basis. Such election eliminates the need to reconstruct the pre-acquisition US tax basis of assets purchased from a foreign seller that would not have kept US tax basis records. Under this election, a taxpayer may apply the foreign basis election to CAAs that occurred on or after January 1, 2011, provided that the taxpayer also retroactively applies all of the regulations with certain identified exceptions. To apply the foreign basis election to CAAs from January 1, 2011, a taxpayer must file a timely amended return by March 23, 2021, one year after the date that the final regulations were published in the Federal Register.
A comment suggested that the consistency requirement should only apply to tax years that remain open and that the requirement unfairly restricts the election for a taxpayer with a closed year. Treasury and the IRS agreed with the comment that taxpayers should not be denied the ability to retroactively apply the foreign basis election because closed tax years prevents them from satisfying the consistency requirement. However, if the consistency requirement only applies in open tax years, Treasury and the IRS believed that taxpayers would be able obtain the benefits of retroactive application of the election while avoiding some of the negative consequences, due to the differences between the statutes of limitations applicable to refunds related to foreign tax credits and assessments for deficiencies. Therefore, the final regulations modify the consistency requirement to apply only to open tax years, but require that any deficiencies that would have resulted from consistent application to closed years must also be taken into account to reduce any refund.
| Eversheds Sutherland Observation: This is a welcome change as it permits foreign basis elections where they would otherwise be barred due to a closed year. The use of the foreign tax basis as opposed to constructing a pre-acquisition US tax basis relieves a costly burden on a taxpayer where a foreign seller did not keep track of the US basis. Helpfully, the regulations follow the proposed regulations in permitting a separate election for each CAA except, it would appear, for foreign entities that are treated as a single foreign group. Note that a foreign basis election, except if made under the transition rules, must be made by using foreign basis for the relevant computations reflected on a timely filed original federal income tax return and, once made, is irrevocable. Section 9100 relief is not available. Thus, a taxpayer must carefully consider the foreign basis election when a CAA occurs, as, except for the transition rules, the taxpayer has only one opportunity to make the election and must live with the election if made. |
Overlap with Section 909
The final Section 909 regulations applied Section 901(m) first to a transaction that is both a Section 901(m) CAA and a Section 909 foreign tax credit splitting event because, as the preamble to those regulations explained, to apply Section 909 to a CAA between related parties would substantially increase the complexity and administrative burdens associated with such transactions. Consequently, the Section 909 regulations concluded that a CAA is not a foreign tax credit splitting event. See T.D. 9577 (77 Fed. Reg. 8127, 8131 (2/17/2012)). However, the preamble to the final Section 909 regulations also stated that Treasury and the IRS were considering the extent to which Section 909 should apply to disqualified taxes under Section 901(m). The final Section 901(m) regulations provide an explicit rule that Section 909 may apply to suspend deductions for disqualified foreign taxes under Section 901(m). Accordingly, section 901(m) is first applied to determine what foreign taxes may be ultimately creditable and what foreign taxes are disqualified and thus only deductible, and section 909 is then applied to determine whether any of the potential foreign tax credits or potential deductions for foreign taxes must be deferred as a result of a foreign tax credit splitting event. A double whammy.
The final regulations are effective March 23, 2020. The applicability dates for each Section are detailed and complex and should be carefully studied.
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