New Regs Clarify Foreign Tax Credit Disallowance

The Tax Cuts and Jobs Act introduced a dividends received deduction (DRD) in new section 245A. Among its provisions was a disallowance of credits or deductions for foreign taxes paid on dividends eligible for the DRD.

New regs clarify the operation of the disallowance. Published on January 4, T.D. 9959 includes new reg. section 1.245A(d)-1(a)–(e).

The rules disallow a foreign tax credit or deduction for foreign income taxes that are attributable to income that is section 245A(d) income or noninclusion income of the recipient domestic corporation or the paying foreign corporation.

The new rules apply to tax years of a foreign corporation that begin after December 31, 2019, and end on or after November 2, 2020; and to tax years of a U.S. person in which the years of the foreign corporation end.

Dividends Received Deduction

Section 245A(a)–(g) generally offers a DRD for the foreign-source portion of a dividend received by the domestic corporate owner of 10 percent of the payer foreign corporation.

Under section 245A(a), the DRD is available for any dividend received from a “specified 10-percent owned foreign corporation” by a domestic corporation that is a U.S. shareholder of the foreign corporation.

Section 245A(b) defines specified 10-percent-owned foreign corporation to mean any foreign corporation that has a domestic corporation as a U.S. shareholder, not including passive foreign investment companies that are not also controlled foreign corporations.

Section 245A(c) defines a dividend’s foreign-source portion as an amount that bears the same ratio to the dividend as the specified 10-percent-owned foreign corporation’s undistributed foreign earnings bears to its total undistributed earnings.

Section 245A(d)(1)–(2) provides the disallowance rules addressed by reg. section 1.245A(d)-1. No FTC is allowed under section 901 for any taxes paid or accrued (or treated as paid or accrued) on any dividend for which a DRD is allowed. Moreover, no deduction is allowed for any tax for which an FTC is disallowed under the above rule (determined by treating the taxpayer as having elected FTC benefits).

Section 245A(e) provides that section 245A(a) does not apply to hybrid dividends received by a U.S. shareholder from a CFC. A hybrid dividend is an amount received from a CFC for which a deduction would otherwise be allowed under section 245A(a), but for which the CFC received a tax deduction in a foreign country. The FTC disallowance rules in section 245A(d) apply to hybrid dividends.

Section 245A(f) provides that a PFIC’s purging distributions under section 1291(d)(2)(B) are not treated as dividends; and section 245A(g) calls on the Treasury secretary to prescribe regs necessary or appropriate to carry out the section 245A provisions.

FTC Disallowance

Reg. section 1.245A(d)-1(a)–(e) implements the FTC and deduction disallowance rule in section 245A(d). The guidance includes:

a general disallowance rule for foreign taxes attributable to section 245A(d) income and noninclusion income;
rules for attributing foreign taxes to income;
definitions;
five examples; and
applicability dates.

Reg. section 1.245A(d)-1(a)(1)–(3) clarifies the general rule in section 245A(d) that no FTC or deduction is allowed for foreign income taxes that are paid or accrued on any dividend for which a DRD is allowed under section 245A(a).

Domestic Corporations and Successors

Reg. section 1.245A(d)-1(a)(1)(i)–(iii) addresses foreign income taxes paid or accrued by domestic corporations or their successors. No section 901 FTC or deduction is allowed in any year for:

foreign income taxes paid or accrued by a domestic corporation that are attributable to the domestic corporation’s section 245A(d) income;
foreign income taxes paid or accrued by a successor to a domestic corporation that are attributable to the successor’s section 245A(d) income; and
foreign income taxes paid or accrued by a domestic corporation that is a U.S. shareholder of a foreign corporation that are attributable to the foreign corporation’s noninclusion income and that are not otherwise disallowed under the first two rules.

Reg. section 1.245A(d)-1(a)(1)(iii) provides an exception to the third rule for domestic corporations that are U.S. shareholders of PFICs that are not also CFCs.

Foreign Corporations

Reg. section 1.245A(d)-1(a)(2) addresses foreign income taxes paid or accrued by foreign corporations. No FTC under section 901 or deduction is allowed in any year for foreign income taxes paid or accrued by a foreign corporation that are attributable to section 245A(d) income. Moreover, those taxes are also not eligible to be deemed paid under section 960 in any year.

Reg. section 1.245A(d)-1(a)(3) addresses the effect of an FTC or deduction disallowance on a corporation’s earnings and profits. The disallowance of an FTC or deduction for foreign income taxes does not affect whether the foreign income taxes reduce a corporation’s E&P.

Attribution Rules

Reg. section 1.245A(d)-1(b)(1)–(3) provides rules for attributing foreign income taxes to section 245A(d) income or noninclusion income and includes an antiavoidance rule. The attribution rules rely heavily on the rules for attributing foreign taxes to statutory and residual groupings in reg. section 1.861-20.

Section 245A(d) Income

Under reg. section 1.245A(d)-1(b)(1), foreign income taxes are attributable to section 245A(d) income to the extent that the taxes are allocated and apportioned under reg. section 1.861-20 to the section 245A(d) income group. Reg. section 1.861-20 is applied by treating the section 245A(d) income group in each section 904 category of a domestic corporation, successor, or foreign corporation as a statutory grouping and treating all other income, including the receipt of a distribution of previously taxed E&P other than section 245A(d) previously taxed E&P (PTEP), as income in the residual grouping.

Taxpayers are directed to reg. section 1.861-20(d)(2)–(3) for rules addressing the allocation and apportionment of foreign income taxes to statutory and residual groupings if the taxpayer does not take into account a corresponding U.S. item in the U.S. tax year in which the foreign income taxes are paid or accrued.

In the case of a foreign law distribution or foreign law disposition, a corresponding U.S. item is assigned to the statutory and residual groupings under reg. section 1.861-20(d)(2)(ii)(B) and (C) without regard to the application of section 246(c), the holding periods described in sections 964(e)(4)(A) and 1248(j), and reg. section 1.245A-5.

Noninclusion Income

Reg. section 1.245A(d)-1(b)(2)(i)–(iii) provides rules for attributing foreign income taxes paid or accrued by a domestic corporation that is a U.S. shareholder of a foreign corporation to the foreign corporation’s noninclusion income.

Under reg. section 1.245A(d)-1(b)(2)(i), the rules apply only when:

the taxes are allocated by reference to the character of stock tax book value; or
the taxes are allocated by reference to the income of a foreign corporation that is a reverse hybrid or foreign law CFC.

The first circumstance happens when the foreign income taxes are allocated and apportioned under reg. section 1.861-20 by reference to the character of the tax book value of the foreign corporation’s stock when allocating and apportioning the domestic corporation’s interest expense, and regardless of whether the foreign corporation’s stock is held directly or indirectly through a partnership or other passthrough entity.

If a taxpayer determines that the foreign taxes are as described above in reg. section 1.245A(d)-1(b)(2)(i), the taxpayer then determines whether the taxes are attributable to a foreign corporation’s noninclusion income under either paragraph (b)(2)(ii) or (iii).

Reg. section 1.245A(d)-1(b)(2)(ii) applies to foreign income taxes paid or accrued by a domestic corporation that is a U.S. shareholder of a foreign corporation when the taxes are imposed on foreign taxable income included by the domestic corporation because of:

a remittance;
a distribution (including a foreign law distribution) that is a U.S. return of capital or return of partnership basis amount; or
a disposition (including a foreign law disposition) that gives rise to a U.S. return of capital or return of partnership basis amount.

These foreign income taxes are attributable to noninclusion income of the foreign corporation to the extent, when applying reg. section 1.861-20 with section 904 as the operative section, that the taxes are allocated and apportioned to the domestic corporation’s:

section 245A subgroup of general category stock;
section 245A subgroup of passive category stock; or
section 245A subgroup of U.S.-source category stock.

Reg. section 1.861-20 is applied by treating the domestic corporation’s section 245A subgroups of general category, passive category, and U.S.-source category stock as the statutory groupings, and treating the tax book value of the non-section 245A subgroup of stock for each separate category as tax book value in the residual grouping.

Reg. section 1.245A(d)-1(b)(2)(iii) applies to foreign income taxes paid or accrued by a domestic corporation that is:

a U.S. shareholder of a foreign corporation that is a reverse hybrid or foreign law CFC; and
the taxes are imposed on foreign law passthrough income or foreign law inclusion regime income of the reverse hybrid or foreign law CFC.

These taxes are attributable to the noninclusion income of a reverse hybrid or foreign law CFC to the extent that they are allocated and apportioned to the noninclusion income group under reg. section 1.861-20. This reg is applied by treating the noninclusion income group in each section 904 category of the domestic corporation and the foreign corporation as a statutory grouping and treating all other income as income in the residual grouping.

The above rules do not apply to domestic corporate shareholders of a foreign corporation that is a regulated investment company (as defined in section 851), real estate investment trust (as defined in section 856), or S corporation (as defined in section 1361).

Antiavoidance Rule

Reg. section 1.245A(d)-1(b)(3) contains an antiavoidance rule providing that foreign income taxes are treated as attributable to section 245A(d) income of a domestic corporation or foreign corporation, or noninclusion income of a foreign corporation, if a transaction, series of related transactions, or arrangement is undertaken with a principal purpose of avoiding the section 245A(d) regs. This includes, for example, transactions separating foreign income taxes from the income or E&P to which the foreign income taxes relate, or by making distributions (or causing inclusions) under foreign law in multiple years that give rise to foreign income taxes that are then allocated and apportioned by reference to the same PTEP (see Example 3).

Definitions

Reg. section 1.245A(d)-1(c)(1)–(30) contains definitions, many of which are cross-references to the definitions in reg. section 1.861-20(b)(1)–(26), including:

corresponding U.S. item;
foreign law CFC;
foreign law disposition;
foreign law distribution;
foreign law inclusion regime;
foreign law inclusion regime income;
foreign law passthrough income;
foreign taxable income;
reverse hybrid;
U.S. capital gain amount; and
U.S. return of capital amount.

Also, “remittance” is defined by cross-reference to the new rules for attribution of foreign taxes to disregarded payments in reg. section 1.861-20(d)(3)(v)(E).

Reg. section 1.245A(d)-1(c) also contains definitions unique to the disallowance rules in section 245A(d). “Gross included tested income” means, for a foreign corporation described in reg. section 1.245A(d)-1(b)(2)(iii), an item of gross tested income multiplied by the inclusion percentage of a domestic corporation described in reg. section 1.245A(d)-1(b)(2)(iii) for the domestic corporation’s U.S. tax year with or within which the foreign corporation’s tax year ends (meaning the foreign corporation’s tax year as described in reg. section 1.861-20(d)(3)(i)(C) or (d)(3)(iii)).

“Noninclusion income” is a foreign corporation’s items of gross income other than items described in reg. section 1.960-1(d)(2)(ii)(B)(2) (income assigned to the subpart F income groups), section 245(a)(5) (without regard to section 245(a)(12)), and other than gross included tested income.

“Noninclusion income group” is the income group within a section 904 category that consists of noninclusion income.

“Non-section 245A subgroup” is each non-section 245A subgroup determined under reg. section 1.861-13(a)(5), applied as if the foreign corporation whose stock is being characterized were a CFC.

“Section 245A subgroup” means each section 245A subgroup determined under reg. section 1.861-13(a)(5), applied as if the foreign corporation whose stock is being characterized were a CFC.

The definition of “section 245A(d) income” depends on whether the income at issue is earned by a domestic corporation, a domestic corporation’s successor, or a foreign corporation.

For a domestic corporation, section 245A(d) income is:

a dividend (including a section 1248 dividend and a dividend received indirectly through a passthrough entity);
an inclusion under section 951(a)(1)(A) for which a deduction under section 245A(a) is allowed;
a distribution of section 245A(d) PTEP;
a hybrid dividend; or
an inclusion under section 245A(e)(2) and reg. section 1.245A(e)-1(c)(1) because of a tiered hybrid dividend.

For a successor of a domestic corporation, section 245A(d) income is the receipt of a distribution of section 245A(d) PTEP.

For a foreign corporation, section 245A(d) income is:

subpart F income that gave rise to a deduction under section 245A(a);
a tiered hybrid dividend; or
a distribution of section 245A(d) PTEP.

An item that qualifies for the deduction under section 245A(a) is considered section 245A(d) income regardless of whether the domestic corporation claims the deduction on its return.

“Section 245A(d) income group” is an income group within a section 904 category that consists of section 245A(d) income.

“Section 245A(d) PTEP” means PTEP described in reg. section 1.960-3(c)(2)(v) or (ix) if it arose either as a result of a dividend that gave rise to a deduction under section 245A(a), or as a result of a tiered hybrid dividend that, because of section 245A(e)(2) and reg. section 1.245A(e)-1(c)(1), gave rise to an inclusion in the gross income of a U.S. shareholder.

A dividend that qualifies for the deduction under section 245A(a) is considered to have given rise to a deduction under section 245A(a) regardless of whether the domestic corporation claims the deduction on its return.

“Successor” is a person, including an individual who is a citizen or resident of the United States, that acquires from any person any portion of the interest of a U.S. shareholder in a foreign corporation to apply the exclusion of PTEP from gross income in section 959(a).

“U.S. return of partnership basis amount” is, for a partnership having a domestic corporate partner, the portion of a distribution by the partnership to the domestic corporation, or the portion of the proceeds of a disposition of the domestic corporation’s interest in the partnership, that exceeds the U.S. capital gain amount.

Examples

Reg. section 1.245A(d)-1(d) contains five examples that illustrate the application of the FTC disallowance and attribution rules and how they overlap with reg. section 1.861-20.

Except as otherwise provided, all examples assume the following facts:

USP is a domestic corporation;
CFC is a CFC organized in country A, and is not a reverse hybrid or a foreign law CFC;
USP owns all of the outstanding stock of CFC;
USP would be allowed a deduction under section 245A(a) for dividends received from CFC;
all parties have a U.S. dollar functional currency and a U.S. and foreign calendar tax year; and
income refers to gross income and no party has deductions under country A or U.S. tax law (other than foreign income tax expense).

Example 1 illustrates treatment of a transaction that is a distribution under both foreign and U.S. tax law.

CFC has $800 of section 951A PTEP (as defined in reg. section 1.960-3(c)(2)(viii)) in a single annual PTEP account (as defined in reg. section 1.960-3(c)(1)), and $500 of E&P described in section 959(c)(3).

On December 31 of year 1 CFC distributes $1,000 cash to USP. For country A tax purposes, the entire $1,000 distribution is a dividend and is therefore a foreign dividend amount (as defined in reg. section 1.861-20(b)). Country A imposes a $150 withholding tax on the $1,000 foreign gross dividend income.

Under U.S. tax law, USP includes in gross income $200 of the distribution as a dividend eligible for a DRD under section 245A(a). The remaining $800 is a distribution of PTEP that is excluded from USP’s gross income and not treated as a dividend under section 959(a) and (d). The entire $1,000 distribution is also a U.S. dividend amount (as defined in reg. section 1.861-20(b)).

General. The taxpayer must first determine the portion of the $150 country A withholding tax that is attributable under reg. section 1.245A(d)-1(b)(1) to USP’s section 245A(d) income, and then determine the portion of the withholding tax described in reg. section 1.245A(d)-1(b)(2)(i) and attributable to CFC’s noninclusion income under either paragraph (b)(2)(ii) or (iii).

No FTC or deduction is allowed in any year under reg. section 1.245A(d)-1(a)(1)(i) for any portion of the $150 tax that is attributable to USP’s section 245A(d) income. Moreover, no FTC or deduction is allowed under reg. section 1.245A(d)-1(a)(1)(iii) for any portion of the tax that is attributable to CFC’s noninclusion income (to the extent the tax is not already disallowed under reg. section 1.245A(d)-1(a)(1)(i)).

Attribution of Tax to Section 245A(d) Income. Under reg. section 1.245A(d)-1(b)(1), the $150 country A withholding tax is attributable to USP’s section 245A(d) income to the extent that it is allocated and apportioned to the section 245A(d) income group (the statutory grouping) under reg. section 1.861-20. Reg. section 1.861-20(c) allocates and apportions foreign income tax to the same statutory and residual groupings to which the foreign gross income included in the foreign tax base is assigned under reg. section 1.861-20(d).

Reg. section 1.861-20(d)(3)(i) assigns foreign gross income that is a foreign dividend amount to the same statutory and residual groupings to which the U.S. dividend amount is assigned — to the extent of the U.S. dividend amount. The $1,000 foreign dividend amount is therefore assigned to the statutory and residual groupings to which the $1,000 U.S. dividend amount is assigned under U.S. tax law.

The $1,000 U.S. dividend amount contains a $200 dividend for which a deduction under section 245A(a) is allowed, which is an item of section 245A(d) income, and $800 of section 951A PTEP, the receipt of which is income in the residual grouping. Accordingly, $200 of the $1,000 of foreign gross dividend income is assigned to the section 245A(d) income group, and $800 is assigned to the residual grouping.

Under reg. section 1.861-20(f), $30 of the $150 country A withholding tax is apportioned to the section 245A(d) income group and is attributable to USP’s section 245A(d) income ($30 = $150 tax * $200 section 245A(d) income/$1,000 total dividend). The remaining $120 of the tax is apportioned to the residual grouping.

Attribution of Tax to Noninclusion Income. Under reg. section 1.245A(d)-1(b)(2), the $150 tax may be attributed to CFC’s noninclusion income if the tax is allocated and apportioned under reg. section 1.861-20 by reference to either the characterization of the tax book value of stock under the reg. section 1.861-9 asset method or the income of a foreign corporation that is a reverse hybrid or foreign law CFC.

CFC is neither a reverse hybrid nor a foreign law CFC. In addition, no portion of the $150 tax is allocated and apportioned under reg. section 1.861-20 by reference to the characterization of the tax book value of CFC’s stock under reg. section 1.861-20(d)(3)(i). Therefore, none of the tax is attributable to noninclusion income of CFC.

Disallowance. Under reg. section 1.245A(d)-1(a)(1)(i), no FTC under section 901 or deduction is allowed to USP in any year for the $30 portion of the country A withholding tax that is attributable to USP’s section 245A(d) income.

Example 2 illustrates treatment of a transaction that is a distribution under foreign, but not U.S., tax law.

As of December 31 of year 1 CFC has $800 of section 951A PTEP (as defined in reg. section 1.960-3(c)(2)(viii)) in a single annual PTEP account (as defined in reg. section 1.960-3(c)(1)), and $500 of E&P described in section 959(c)(3). CFC distributes $1,000 of its stock to USP. Under country A tax law, the entire $1,000 stock distribution is treated as a dividend to USP and is therefore a foreign dividend amount (as defined in reg. section 1.861-20(b)). Country A imposes a $150 withholding tax on the $1,000 of foreign gross dividend income.

Under U.S. tax law, USP does not recognize gross income on the stock distribution under section 305(a). The $1,000 stock distribution is therefore a foreign law distribution.

General. The taxpayer must first determine the portion of the $150 country A withholding tax that is attributable under reg. section 1.245A(b)-1(b)(1) to USP’s section 245A(d) income, and then determine the portion of the tax described in reg. section 1.245A(d)-1(b)(2)(i) and attributable to CFC’s noninclusion income under either paragraph (b)(2)(ii) or (iii).

No FTC or deduction is allowed in any year under reg. section 1.245A(b)-1(a)(1)(i) for any portion of the $150 tax that is attributable to USP’s section 245A(d) income. Moreover, no FTC or deduction is allowed under reg. section 1.245A(d)-1(a)(1)(iii) for any portion of the tax that is attributable to CFC’s noninclusion income (to the extent that the tax is not already disallowed under reg. section 1.245A(d)-1(a)(1)(i)).

Attribution of Tax to Section 245A(d) Income. Under reg. section 1.245A(d)-1(b)(1), the $150 tax is attributable to USP’s section 245A(d) income to the extent that it is allocated and apportioned to the section 245A(d) income group under reg. section 1.861-20. Reg. section 1.861-20(c) allocates and apportions foreign income tax to the same statutory and residual groupings to which the foreign gross income included in the foreign tax base is assigned under reg. section 1.861-20(d).

In general, reg. section 1.861-20(d) assigns foreign gross income to the statutory and residual groupings to which a corresponding U.S. item is assigned. If a taxpayer does not recognize a corresponding U.S. item in the year it pays or accrues foreign income tax on foreign law dividend income, reg. section 1.861-20(d)(2)(ii)(B) assigns the foreign dividend to the same statutory or residual groupings to which the foreign dividend amount would be assigned if a distribution were made under U.S. tax law in the amount of, and on the date of, the foreign law distribution.

Further, reg. section 1.861-20(d)(2)(ii)(B) computes the U.S. dividend amount (as defined in reg. section 1.861-20(b)) as if the distribution occurred on the date the distribution occurs under foreign law. Therefore, the foreign dividend amount is assigned to the same statutory and residual groupings to which it would be assigned if a $1,000 distribution occurred on December 31 of year 1 under U.S. law.

If that distribution had occurred, it would cause a $200 dividend to USP for which a deduction would be allowed under section 245A(a). The remaining $800 of the distribution would be excluded from USP’s gross income and not be treated as a dividend under section 959(a) and (d).

Under reg. section 1.245A(d)-1(c)(20) and (b)(1), the $1,000 U.S. dividend amount contains a $200 dividend for which a deduction under section 245A(a) would be allowed. It is an item of section 245A(d) income, and $800 of section 951A PTEP, which is income in the residual grouping. Accordingly, $200 of the $1,000 foreign gross dividend income is assigned to the section 245A(d) income group, and $800 is assigned to the residual grouping.

Under reg. section 1.861-20(f), $30 of the $150 tax is apportioned to the section 245A(d) income group and is attributable to USP’s section 245A(d) income ($30 = $150 tax * $200 section 245A(d) income/$1,000 total dividend). The remaining $120 of the tax is apportioned to the residual grouping.

Attribution of Tax to Noninclusion Income. Under reg. section 1.245A(d)-1(b)(2), the $150 tax may be attributed to CFC’s noninclusion income if the tax is allocated and apportioned under reg. section 1.861-20 by reference to either the characterization of the tax book value of stock under the reg. section 1.861-9 asset method, or the income of a foreign corporation that is a reverse hybrid or foreign law CFC.

Disallowance. Under reg. section 1.245A(d)-1(a)(1)(i), no FTC under section 901 or deduction is allowed in any year to USP for the $30 portion of the country A withholding tax that is attributable to USP’s section 245A(d) income.

Example 3 illustrates the treatment of successive foreign law distributions that trigger the antiavoidance rule.

In year 1 CFC earns $500 subpart F income that gives rise to a $500 inclusion to USP under section 951(a) and creates $500 E&P described in section 959(c)(3). CFC earns no income in years 2 through 4. As of January 1 of year 2 and through December 31 of year 4 CFC has $500 E&P described in section 959(c)(3) and $500 section 951(a)(1)(A) PTEP (as defined in reg. section 1.960-3(c)(2)(x)) in a single annual PTEP account (as defined in reg. section 1.960-3(c)(1)).

In each of years 2 and 3 USP makes a consent dividend election under country A law that deems CFC to distribute to USP, and USP immediately to contribute back to CFC, $500 on December 31 of each year. Under country A tax law, each deemed distribution is a dividend of $500 to USP, and each deemed contribution is a nontaxable contribution of $500 to CFC’s capital. Each $500 deemed distribution is therefore a foreign dividend amount (as defined in reg. section 1.861-20(b)).

Country A imposes $150 withholding tax on USP in each of years 2 and 3 on USP’s $500 foreign dividend amount. Under U.S. tax law, the deemed distributions in years 2 and 3 are disregarded, so USP recognizes no income, and the deemed distributions are therefore foreign law distributions.

On December 31 of year 4 CFC distributes $1,000 cash to USP, which country A law treats as a return of contributed capital on which no withholding tax is imposed. Under U.S. tax law, $500 of the $1,000 distribution is a dividend to USP for which a deduction under section 245A(a) is allowed. The remaining $500 of the distribution is a distribution of section 951(a)(1)(A) PTEP that is excluded from USP’s gross income and not treated as a dividend under section 959(a) and (d).

The entire $1,000 dividend is a U.S. dividend amount (as defined in reg. section 1.861-20(b)). The country A consent dividend elections in years 2 and 3 are made with a principal goal of avoiding the purposes of section 245A(d) and regs to disallow an FTC or deduction for country A withholding tax incurred on USP’s section 245A(d) income.

General. Taxpayers must first determine the portion of the $150 country A withholding tax in each of years 2 and 3 that is attributable under reg. section 1.245A(d)-1(b)(1) to USP’s section 245A(d) income, and then determine the portion of the $150 tax paid in each of years 2 and 3 described in reg. section 1.245A(d)-1(b)(2)(i) and attributable to CFC’s noninclusion income under either paragraph (b)(2)(ii) or (iii).

Finally, the antiavoidance rule in reg. section 1.245A(d)-1(b)(3) applies to treat any portion of the $150 tax paid in each of years 2 and 3 as attributable to USP’s section 245A(d) income or CFC’s noninclusion income if a transaction, series of related transactions, or arrangement is undertaken with a principal goal of avoiding the purposes of section 245A(d) and regs.

No FTC or deduction is allowed in any year under reg. section 1.245A(d)-1(a)(1)(i) for any portion of the $150 tax paid by USP in each of years 2 and 3 attributable to USP’s section 245A(d) income or, under reg. section 1.245A(d)-1(a)(1)(iii), for any portion of the tax that is attributable to CFC’s noninclusion income (to the extent the tax is not already disallowed under reg. section 1.245A(d)-1(a)(1)(i)).

Attribution of Tax to Section 245A(d) Income. Under reg. section 1.245A(d)-1(b)(1), the $150 tax paid in each of years 2 and 3 is attributable to USP’s section 245A(d) income to the extent that it is allocated and apportioned to the section 245A(d) income group under reg. section 1.861-20. Reg. section 1.861-20(c) allocates and apportions foreign income tax to the same statutory and residual groupings to which the foreign gross income included in the foreign tax base is assigned under reg. section 1.861-20(d).

In general, reg. section 1.861-20(d) assigns foreign gross income to the statutory and residual groupings to which a corresponding U.S. item is assigned. If a taxpayer does not recognize a corresponding U.S. item in the year in which it pays or accrues foreign income tax on a foreign law dividend, reg. section 1.861-20(d)(2)(ii)(B) assigns the foreign dividend amount to the same statutory or residual groupings to which the foreign dividend amount would be assigned if a distribution were made under U.S. tax law in the amount of, and on the date of, the foreign law distribution.

Therefore, the $500 foreign dividend amount in each of years 2 and 3 is assigned to the same statutory and residual groupings to which it would be assigned if a $500 distribution had occurred on December 31 of those years under U.S. tax law.

Year 2 $500 Deemed Distribution. Under U.S. tax law, CFC made no distributions in year 1, and earned no income and made no distributions in year 2. As of December 31 of year 2 CFC has $500 of E&P described in section 959(c)(3) and $500 of section 951(a)(1)(A) PTEP.

If CFC had distributed $500 on that date, the distribution would be a distribution of section 951(a)(1)(A) PTEP which would be a U.S. dividend amount. Reg. section 1.861-20(d)(3)(i) assigns the foreign dividend amount, to the extent of the U.S. dividend amount, to the statutory and residual groupings to which the U.S. dividend amount is assigned.

A distribution of PTEP is assigned to the residual grouping under reg. section 1.245A(d)-1(b)(1). Therefore, all $500 of the foreign dividend amount would be assigned to the residual grouping, and none of the $150 tax paid in year 2 would be treated as attributable to USP’s section 245A(d) income.

Year 3 $500 Deemed Distribution. Under U.S. tax law, CFC made no distributions in year 1, and earned no income and made no distributions in years 2 or 3. Consequently, as of December 31 of year 3, CFC has $500 of E&P described in section 959(c)(3) and $500 of section 951(a)(1)(A) PTEP. If CFC had distributed $500 on that date, the distribution would be a distribution of section 951(a)(1)(A) PTEP. For the reasons described above, all $500 of the foreign dividend amount would be assigned to the residual grouping, and none of the $150 tax paid in year 2 would be treated as attributable to USP’s section 245A(d) income.

Year 4 $1,000 Cash Distribution. Under country A tax law, the $1,000 cash distribution in year 4 is a return of capital distribution not subject to withholding tax. Under U.S. tax law, the distribution contains a $500 dividend for which a deduction under section 245A(a) is allowed. It is an item of USP’s section 245A(d) income (in the statutory grouping), and a $500 distribution of section 951(a)(1)(A) PTEP, which is income in the residual grouping.

Attribution of Tax to Noninclusion Income. Under reg. section 1.245A(d)-1(b)(2), the $150 country A withholding tax paid in each of years 2 and 3 may be attributed to CFC’s noninclusion income if the tax is allocated and apportioned under reg. section 1.861-20 by reference to either the character of the tax book value of CFC stock under reg. section 1.861-9, or the income of a foreign corporation that is a reverse hybrid or foreign law CFC. CFC is neither a reverse hybrid nor a foreign law CFC.

Also, no portion of the tax is allocated and apportioned under reg. section 1.861-20 by reference to the character of the tax book value of CFC’s stock under reg. section 1.861-20(d)(3)(i). Therefore, none of the tax is attributable to CFC’s noninclusion income.

Attribution of Tax Under Antiavoidance Rule. USP made two $500 successive foreign law distributions in years 2 and 3 that were subject to country A withholding tax and that did not individually exceed, but together exceeded, the CFC’s ($500) section 951(a)(1)(A) PTEP. The $150 country A withholding tax on each consent dividend is allocated to the residual grouping rather than to the statutory grouping of section 245A(d) income under reg. section 1.861-20(d)(2)(ii) and (d)(3)(i).

USP paid no country A withholding tax on the year 4 $1,000 cash distribution because of its consent dividend elections in years 2 and 3. If CFC had distributed its E&P in year 4 without the prior consent dividends, the distribution would have been subject to country A withholding tax, a portion of which would have been attributable to the section 245A(d) income arising from the distribution. But for application of the antiavoidance rule in reg. section 1.245A(d)-1(b)(3), USP would avoid the disallowance under section 245A(d) for this portion of the withholding tax.

Because USP made foreign law distributions that caused withholding tax from multiple foreign law distributions to be associated with the same PTEP with a principal goal of avoiding the purposes of section 245A(d) and regs, the $150 tax paid in each of years 2 and 3 is treated as being attributable to USP’s section 245A(d) income.

Disallowance. Under reg. section 1.245A(d)-1(a)(1)(i), no FTC under section 901 or deduction is allowed to USP in any year for the $150 tax paid in each of years 2 and 3 that is attributable to USP’s section 245A(d).

Example 4 illustrates treatment of a distribution that is part dividend and part return of capital.

CFC uses the modified gross income method to allocate and apportion its interest expense, and its stock has a tax book value of $10,000. In year 1, CFC earns $500 of income that is specified foreign-source general category gross income as defined in reg. section 1.861-13(a)(1)(i)(A)(9) and is therefore neither tested income nor subpart F income of CFC.

As of December 31 of year 1 CFC has $500 E&P described in section 959(c)(3). On that date, CFC distributes $1,000 cash to USP. Under country A tax law, the entire $1,000 distribution is a dividend to USP and is therefore a foreign dividend amount (as defined in reg. section 1.861-20(b)). Country A imposes a $150 withholding tax on the $1,000 of foreign gross dividend income.

Under U.S. tax law, USP includes $500 of the distribution in gross income as a dividend for which a $500 deduction is allowed under section 245A(a). The remaining $500 of the distribution reduces USP’s basis in its CFC stock under section 301(c)(2). The $500 portion of the distribution that is a dividend is a U.S. dividend amount (as defined in reg. section 1.861-20(b)); the remaining $500 is a U.S. return of capital amount.

General. The taxpayer must first determine the portion of the $150 country A withholding tax that is attributable under reg. section 1.245A(d)-1(b)(1) to USP’s section 245A(d) income and then determine the portion of the $150 tax described in reg. section 1.245A(d)-1(b)(2)(i) and attributable under either reg. section 1.245A(d)-1(b)(2)(ii) or (iii) to CFC’s noninclusion income.

No FTC or deduction is allowed under reg. section 1.245A(d)-1(a)(1)(i) for any portion of the $150 tax that is attributable to USP’s section 245A(d) income. Moreover, under reg. section 1.245A(d)-1(a)(1)(iii), no FTC or deduction is allowed for any portion of the tax attributable to CFC’s noninclusion income (to the extent the tax is not disallowed under reg. section 1.245A(d)-1(a)(1)(i)).

Section 1.861-20(c) allocates and apportions foreign income tax to the same statutory and residual groupings to which the foreign gross included in the foreign tax base is assigned under reg. section 1.861-20(d). Reg. section 1.861-20(d)(3)(i) assigns foreign gross income that is a foreign dividend amount — to the extent of the U.S. dividend amount — to the statutory and residual groupings to which the U.S. dividend amount is assigned.

Of the $1,000 foreign dividend amount, $500 is therefore assigned to the statutory and residual groupings to which the $500 U.S. dividend amount is assigned under U.S. tax law. The entire $500 U.S. dividend amount is a dividend for which a section 245A(a) deduction is allowed and is therefore section 245A(d) income that is assigned to the section 245A(d) income group.

Accordingly, $500 of the foreign dividend amount is assigned to the section 245A(d) income group. Under reg. section 1.861-20(f), $75 of the country A withholding tax is allocated to the section 245A(d) income group ($150 tax * $500 U.S. dividend amount/$1,000 total distribution), and is therefore attributable to USP’s section 245A(d) income under reg. section 1.245A(d)-1(b)(1).

Attribution of Tax to Noninclusion Income. The remaining $75 of the country A withholding tax is described in reg. section 1.245A(d)-1(b)(2)(i) because the $500 foreign dividend amount that corresponds to the $500 U.S. return of capital amount is assigned (and the remaining tax imposed on that foreign dividend amount is allocated and apportioned) by reference to the characterization of the tax book value of the CFC stock.

Under reg. section 1.245A(d)-1(b)(2)(ii), the remaining $75 tax is attributable to CFC’s noninclusion income to the extent the tax is allocated and apportioned under reg. section 1.861-20 to USP’s section 245A subgroup of general category stock, section 245A subgroup of passive category stock, and section 245A subgroup of U.S.-source category stock when section 904 is the operative section.

Under reg. section 1.861-20(d)(3)(i), the $500 portion of the foreign dividend amount that corresponds to the $500 U.S. return of capital amount is assigned to the statutory and residual groupings to which $500 of CFC’s earnings would be assigned if it recognized them in year 1. Those earnings are deemed to arise in the statutory and residual groupings in the same proportions as those of the tax book value of CFC’s stock in the groupings for year 1 under the asset method of expense allocation and apportionment in reg. section 1.861-9.

Under reg. section 1.861-9, -9T(f), and -13, when section 904 is the operative section, all CFC stock tax book value is assigned to USP’s section 245A subgroup of general category stock because CFC uses the modified gross income method to allocate and apportion its interest expense, and earns only specified foreign-source general category gross income for year 1.

Under reg. section 1.861-20(d)(3)(i), if CFC recognized $500 of earnings in year 1, these earnings would be deemed to arise in the section 245A subgroup of general category stock. Accordingly, the remaining $500 of the foreign dividend amount is assigned to USP’s section 245A subgroup of general category stock. Under reg. section 1.861-20(f), the remaining $75 of withholding tax is allocated to the section 245A subgroup and, under reg. section 1.245A(d)-1(b)(2)(ii), is attributable to CFC’s noninclusion income.

Disallowance. Under reg. section 1.245A(d)-1(a)(1)(i), no FTC under section 901 or deduction is allowed to USP in any year for the $75 portion of the tax that is attributable to section 245A(d) income of USP. Under reg. section 1.245A(d)-1(a)(1)(iii), no FTC under section 901 or deduction is allowed to USP in any taxable year for the $75 portion of the tax that is attributable to CFC’s noninclusion income.

Example 5 illustrates attribution of foreign tax to income of a reverse hybrid.

CFC is a reverse hybrid (transparent under foreign law and opaque under U.S. law). In year 1, CFC earns $500 foreign gross services income that is noninclusion income. CFC also earns under both U.S. and country A tax law $1,000 royalty income, of which $500 is gross included tested income and $500 is noninclusion income. USP includes the $500 foreign gross services income and the $1,000 foreign gross royalty income in its country A taxable income, and the items are foreign law passthrough income.

If CFC included these items under country A tax law, its $1,000 of royalty income would be the corresponding U.S. item for the foreign gross royalty income, and its $500 of services income would be the corresponding U.S. item for the foreign gross services income. Country A imposes a $150 foreign income tax on USP for the total $1,500 of foreign gross income.

General. The taxpayer must first determine the portion of the $150 country A tax that is attributable under reg. section 1.245A(d)-1(b)(1) to USP’s section 245A(d) income, and then determine the portion of the $150 tax that is described in reg. section 1.245A(d)-1(b)(2)(i) and attributable under either reg. section 1.245A(d)(b)(2)(ii) or (iii) to CFC’s noninclusion income.

No FTC or deduction is allowed under reg. section 1.245A(d)-1(a)(1)(i) for any portion of the $150 that is attributable to USP’s section 245A(d) income. Moreover, no FTC or deduction is allowed under reg. section 1.245A(d)-1(a)(1)(iii) for any portion of the tax that is attributable to CFC’s noninclusion income (to the extent the tax is not already disallowed under reg. section 1.245A(d)-1(a)(1)(i)).

Attribution of Tax to Section 245A(d) Income. Under reg. section 1.245A(d)-1(b)(1), the $150 country A tax is attributable to section 245A(d) income to the extent the tax is allocated and apportioned to the section 245A(d) income group under reg. section 1.861-20. Reg. section 1.861-20(c) allocates and apportions foreign income tax to the same statutory and residual groupings to which the foreign gross income included in the foreign tax base is assigned under reg. section 1.861-20(d).

In general, reg. section 1.861-20(d) assigns foreign gross income to the same statutory and residual groupings to which the corresponding U.S. item is assigned. Reg. section 1.861-20(d)(3)(i)(C) assigns the foreign law passthrough income that USP includes because of its ownership of CFC to statutory and residual groupings by treating the foreign law passthrough income as CFC’s foreign gross income, and by treating CFC as if it paid the $150 tax in CFC’s U.S. tax year within which its foreign tax year ends (year 1).

CFC is therefore treated as including the $1,000 foreign gross royalty item and the $500 foreign gross services income item, and paying $150 of country A tax in year 1. These foreign gross income items are assigned to the same statutory and residual groupings to which the corresponding U.S. items are assigned under U.S. tax law.

No foreign gross income is assigned to the section 245A(d) income group because neither the corresponding U.S. item of royalty income nor the corresponding U.S. item of services income is assigned to the section 245A(d) income group. Therefore, none of USP’s country A tax is allocated to the section 245A(d) income group.

Attribution of Tax to Noninclusion Income. The $150 country A tax is described in reg. section 1.245A(d)-1(b)(2). Because USP is a U.S. shareholder of CFC, CFC is a reverse hybrid, and reg. section 1.861-20(d)(3)(i)(C) allocates and apportions the tax by reference to the income of CFC. Under reg. section 1.245A(d)-1(b)(2)(iii), the $150 tax is attributable to CFC’s noninclusion income to the extent the foreign income taxes are allocated and apportioned to the noninclusion income group under reg. section 1.861-20.

For the reasons described above, under reg. section 1.861-20(d)(3)(i)(C), CFC is treated as if it included a $1,000 foreign gross royalty item and a $500 foreign gross services income item and paid $150 of country A tax in year 1. These foreign gross income items are assigned to the same statutory and residual groupings to which the corresponding U.S. items are assigned under U.S. tax law.

Under U.S. tax law, the $500 services income and $500 of the $1,000 royalty income are noninclusion income items that are therefore assigned to the noninclusion income group. The remaining $500 of the foreign gross royalty income item is assigned to the residual grouping.

Under reg. section 1.861-20(f), $100 of the $150 country A tax is apportioned to the noninclusion income group ($150 tax * $1,000 noninclusion income/$1,500 total income), and the remaining $50 is apportioned to the residual grouping. Under reg. section 1.245A(d)-1(b)(2)(iii), the $100 of tax apportioned to the noninclusion income group under reg. section 1.861-20(d)(3)(i)(C) is attributable to noninclusion income of CFC.

Disallowance. Under reg. section 1.245A(d)-1(a)(1)(iii), no FTC under section 901 or deduction is allowed to USP in any year for the $100 of country A foreign income tax that is attributable to CFC’s noninclusion income.

This article was originally published by Forbes.com. Read the original article here.