New Temporary Regulations Provide Important Clarifications on Allocations Relating to Foreign Taxes by PartnershipsFebruary 2016
On February 4, 2016, the IRS published temporary and proposed regulations that provide guidance on how partnerships should allocate creditable foreign tax expenditures (CFTEs). A CFTE is a foreign tax paid by a partnership that is eligible for a credit under §901(a). The issues addressed by the temporary regulations are complex, and the discussion that follows is intended only to provide a brief overview of these issues. The new regulations affect partnerships that pay or accrue foreign income taxes, and their partners. Although the new regulations provide helpful clarifications regarding situations not addressed under existing regulations, these regulations generally should not require changes to the allocation provisions of partnership agreements or LLC operating agreements.
The Temporary Regulations: Clarify the Existing Safe Harbor Rule
The regulations aim to improve the operation of the existing safe harbor rule that is used to determine whether allocations of CFTEs are deemed to be in accordance with the partners' interests in the partnership and whether those allocations will be respected for tax purposes. Allocations of CFTEs do not have substantial economic effect and, therefore, must be allocated in accordance with the partners' interests in the partnership (PIP). The existing regulations provide a safe harbor under which CFTE allocations are deemed to be allocated in accordance with PIP. The purpose of the safe harbor is, generally, to match allocations of CFTEs with the income to which they relate.
The Safe Harbor
To apply the safe harbor, a partnership must (i) determine the partnership's "CFTE categories," (ii) determine the partnership's net income in each CFTE category, and (iii) allocate the partnership's CFTEs to each category. A partnership must assign its income to certain activities and must group partnership activities into one or more CFTE categories. In order to satisfy the safe harbor, partnership allocations of CFTEs to a CFTE category must be in proportion to the allocations of the partnership's net income in the CFTE category.
Clarifications under the Temporary Regulations
The temporary regulations clarify and revise the existing rules on allocations that are deductible for foreign tax purposes and nondeductible guaranteed payments. The temporary regulations generally provide that allocations (or distributions of allocated amounts) and guaranteed payments that give rise to foreign law deductions are treated as made out of income with related CFTEs. The temporary regulations also provide rules relating to certain inter-branch payments.
Finally, the temporary regulations also clarify how certain items of income under U.S. federal income tax law are assigned to an activity, and how a partnership's net income in a CFTE category is determined.
The temporary regulations became effective on February 4, 2016 and apply for partnership taxable years that both begin on or after January 1, 2016, and end after February 4, 2016.