David Rosenbloom Offers Solution to Conflicting Provisions Under FTC Regs

Caplin & Drysdale's David Rosenbloom commented that two provisions of proposed foreign tax credit regulations (REG-105600-18) could possibly govern the allocation and apportionment among section 904(a) separate limitation categories of creditable foreign tax for a sale of stock that is not dealer property by a foreign branch to its foreign branch owner, asserting that those provisions would produce conflicting results and suggesting a solution.  Below is the full text of Mr. Rosenbloom's commentary published by Tax Notes (subscription required).

February 4, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable William Paul
Principal Deputy Chief Counsel and Deputy Chief Counsel
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable Charles Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Ms. Kirsten Wielobob
Deputy Commissioner for Services and Enforcement
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

RE: IRS REG-105600-18 — Guidance Related to the Foreign a Credit, Including Guidance Implementing Changes Made by the Tax Cuts and Jobs Act

Dear Gentlemen and Madam:

I write concerning a narrow issue raised by the above-referenced proposed regulations: the allocation and apportionment among Code section 904(a) separate limitation categories of creditable foreign tax in respect of a sale of stock that is not dealer property by a foreign branch to its foreign branch owner. Two provisions of the proposed regulations could potentially govern such allocation and apportionment and would produce conflicting results. This letter explains the issue and recommends a solution.

Issue: Which of Prop. Reg. § 1.904-6(a)(1)(iv) or Prop. Reg. § 1.904-6(a)(2)(iii)(B) Applies?

The fact pattern with respect to which the issue arises is as follows:

A foreign disregarded entity ("FDRE") that satisfies the "foreign branch" definition in Prop. Reg. § 1.904-4(f)(3)(iii) holds stock in a foreign corporation ('FSUB"). If the FDRE were a controlled foreign corporation, the stock would not be dealer property (as defined in Treas. Reg. § 1.954-2(a)(4)(v)). For reasons relating to local regulation, FDRE transfers the stock to a U.S. corporation (USP") that qualifies as a "foreign branch owner" within the meaning of Prop. Reg. § 1.904-4(f)(3)(iv). USP transfers cash to FDRE. The transaction is reflected on FDRE's separate books and records as a sale.

Under the tax laws of a foreign jurisdiction (either the residence jurisdiction of FDRE or that of FSUB), FDRE is taxable and pays foreign tax. For Federal income tax purposes, the transaction is disregarded. The cash payment from USP to FDRE is a "disregarded payment within the meaning of Prop. Reg. § 1.904-4(f)(3)(ii)(A).

On these facts, there are two provisions of the proposed regulations that could potentially determine the section 904(a) separate limitation category of USP to which the foreign tax on FDRE's gain is allocated.

Prop. Reg. § 1.904-6(a)(1)(iv) provides an allocation rule for foreign tax on income subject to a timing difference ("timing difference rule"):

If, under the law of a foreign country or possession of the United States, a tax is imposed on an item of income that constitutes income under Federal income tax principles but is not recognized for Federal income tax purposes in the current year (a timing difference), that tax is allocated and apportioned to the appropriate separate category or categories to which the tax would be allocated and apportioned if the income were recognized under Federal income tax purposes in the year in which the tax was imposed.

FDRE's gain on the sale of stock to USP is a type of item that would constitute gain under Federal income tax principles but is not recognized in the year of the sale. Rather, the gain will be recognized when the stock is later sold in a regarded transaction (e.g., a sale to a separate legal person). Had FDRE's gain on the stock sale been recognized in the current year, it would not have been included in foreign branch income because Prop. Reg. § 1.904-4(f)(2)(iii) provides that gross income attributable to a foreign branch does not include income arising from stock of a corporation that is not dealer property, including gain from the disposition of such stock. Thus, under the timing difference rule the foreign tax would not be allocated and apportioned to the foreign branch category.

There is a contrary allocation rule in Prop. Reg. § 1.904-6(a)(2)(iii)(B) (the "residual rule"):

In the case of a disregarded payment from a foreign branch owner to a foreign branch that is not a disregarded reallocation transaction, any foreign tax imposed solely by reason of that disregarded payment is allocated and apportioned to the foreign branch category.

In the above fact pattern, the disregarded payment from USP to FDRE would not be deductible to USP nor would it reduce USP's gross receipts for purposes of determining its gross income. Therefore, Prop. Reg. § 1.904-4(f)(2)(vi)(B) would not apply, and the sale would not be a "disregarded reallocation transaction within the definition provided in Prop. Reg. § 1.904-6(a)(2)(iv)(A). If, on the above facts, the foreign tax is considered imposed on FDRE solely by reason of USP's (disregarded) cash payment for FSUB stock, the foreign tax would be allocated and apportioned under the residual rule to the foreign branch category.

The timing difference rule and the residual rule thus produce conflicting results.

Recommendation: Prop. Reg. § 1.904-6(a)(1)(iv) Should Apply.

The final regulations should resolve the above-described conflict by making clear that the timing difference rule, not the residual rule, applies to foreign tax imposed in respect of a disregarded payment from a foreign branch owner to a foreign branch in exchange for stock.

Such a clarification would be consistent with the purpose of Prop. Reg. § 1.904-6(a)(2), which, according to the preamble to the proposed regulations, is intended to "coordinate the existing regulations under § 1.904-6(a)(1) with the computation of foreign branch category income in proposed § 1.904-4(f)." As set forth in Prop. Reg. § 1.904-4(f)(2)(iii), the computation of foreign branch category income expressly excludes "gain from the disposition of . . . stock" that is not dealer property. Thus, if FDRE sold the stock in a regarded transaction, FDRE's gain would not fall in the foreign branch category, and Prop. Reg. § 1.904-6(a)(1)(i) would exclude any foreign tax on such gain from that category.

Furthermore, if FDRE transferred the stock to USP without consideration, the proposed regulations would allocate and apportion the foreign tax away from the foreign branch category. Prop. Reg. § 1.904-6(a)(2)(iii)(A) provides that "if a remittance of an appreciated asset results in gain recognition under foreign law, the tax imposed on that gain is treated as attributable to a timing difference with respect to recognition of the gain" and, pursuant to the timing difference rule, is allocated and apportioned away from the foreign branch category.

The regulations appear to establish a coherent policy of excluding gain on a foreign branch's disposition of stock that is not dealer property, and any foreign tax thereon, from the foreign branch category. Prop. Reg. § 1.904-6(a)(2)(iii)(B) should be modified to align with that policy, as follows:

(B) Foreign branch owner to foreign branch. In the case of a disregarded payment from a foreign branch owner to a foreign branch that is not a disregarded reallocation transaction and that would, if regarded for Federal income tax purposes, constitute an item of income or gain that is not attributable to a foreign branch pursuant to § 1.904-4(f), any foreign tax imposed solely by reason of that disregarded payment is allocated and apportioned to a separate category under the principles of paragraph (a)(1) of this section based on the nature of the item (determined under Federal income tax principles) that is included in the foreign tax base.

The recommendation encompasses not only foreign tax on income arising from stock but also foreign tax on income arising from other property. This breadth is appropriate, however, in that the recommendation sensibly links the allocation and appointment of foreign tax to the same separate category as the income to which the tax is attributable.

* * *

I appreciate the opportunity to provide these comments. Please do not hesitate to contact me should you have any questions concerning them.

Sincerely,

H. David Rosenbloom
Caplin & Drysdale, Chartered
Washington, DC